**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC. 20549**

----

**FORM 10-Q**

**(MarkOne)**

**x****                             ****Quarterlyreport pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

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

**or**

**o****                                ****Transitionreport pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

**for the transition period from           to            **

**Commission File Number 000-24085**

----

**AXT, INC.**(Exact name of registrant as specifiedin its charter)

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

 

**4281 Technology Drive, Fremont, California 94538**(Address of principal executiveoffices) (Zip code)

**(510) 683-5900**(Registrant’s telephone number,including area code)

----

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days. Yes x   No o

Indicate by checkmark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of accelerated filer and large accelerated filer in Rule 12b-2of the Act. (Check one):

Large accelerated filer o         Acceleratedfiler o         Non-accelerated filer x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o   No x

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

| **Class**                       |   | **Outstanding at October 31, 2006** |
|---------------------------------|--------|---------------------------------------------------------|
| Common Stock,  $0.001 par value |   | 23,246,571                                              |

 

 

----

 

AXT, INC.FORM 10-QTABLE OF CONTENTS
|                                                                                                                        | ** ** | **Page** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I. FINANCIAL INFORMATION                                                                                     |       | 3        |       |
| Item 1. Financial Statements  (unaudited)                                                                              |       | 3        |       |
| Condensed Consolidated  Balance Sheets as of September 30, 2006 and December 31, 2005                        |       | 3        |       |
| Condensed Consolidated Statements of  Operations for the three and nine months ended September 30, 2006 and  2005 |       | 4        |       |
| Condensed Consolidated Statements of  Cash Flows for the nine months ended September 30, 2006 and 2005            |       | 5        |       |
| Notes to  Condensed Consolidated Financial Statements                                                                  |       | 6        |       |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                   |       | 17       |       |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                                    |       | 31       |       |
| Item 4. Controls and  Procedures                                                                                       |       | 31       |       |
| PART II. OTHER  INFORMATION                                                                                       |       | 32       |       |
| Item 1. Legal Proceedings                                                                                              |       | 32       |       |
| Item  1A. Risk Factors                                                                                                 |       | 32       |       |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                                   |       | 45       |       |
| Item 3.  Defaults Upon Senior Securities                                                                               |       | 45       |       |
| Item 4.  Submission of Matters to a Vote of Security Holders                                                           |       | 45       |       |
| Item 5. Other Information                                                                                              |       | 45       |       |
| Item 6.  Exhibits                                                                                                      |       | 46       |       |
| Signatures                                                                                                             |       | 47       |       |

 

2

----

 

**PART I. FINANCIAL INFORMATION**

**Item1. Financial Statements**

AXT, INC.

CONDENSEDCONSOLIDATED BALANCE SHEETS

(Unaudited,in thousands, except per share data)
| ** **                                                                                                                                                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Assets:                                                                                                                                                                                       |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                               |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                    |       | $                      | 10,587     |                  | $          | 17,472 |   |
| Short-term  investments                                                                                                                                                                       |       | 5,357                  |       | 5,555                 |       |
| Accounts  receivable, net of allowances of $202 and $609 as of September 30, 2006  and December 31, 2005, respectively                                                              |       | 8,800                  |       | 5,226                 |       |
| Inventories, net                                                                                                                                                                              |       | 17,359                 |       | 16,156                |       |
| Prepaid expenses  and other current assets                                                                                                                                                    |       | 4,079                  |       | 1,801                 |       |
| Assets held for  sale                                                                                                                                                                         |       | 4,659                  |       | —                |       |
| Total current  assets                                                                                                                                                                         |       | 50,841                 |       | 46,210                |       |
| Property, plant  and equipment, net                                                                                                                                                           |       | 10,772                 |       | 17,306                |       |
| Restricted  deposits                                                                                                                                                                          |       | 7,150                  |       | 7,450                 |       |
| Other assets                                                                                                                                                                                  |       | 3,806                  |       | 3,832                 |       |
| Total assets                                                                                                                                                                                  |       | $                      | 72,569     |                  | $          | 74,798 |   |
|                                                                                                                                                                                          |       |                   |       |                  |       |
| Liabilities and  stockholders’ equity:                                                                                                                                                   |       |                   |       |                  |       |
| Current  liabilities:                                                                                                                                                                         |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                              |       | $                      | 4,078      |                  | $          | 3,070 |   |
| Accrued  liabilities                                                                                                                                                                          |       | 3,225                  |       | 3,533                 |       |
| Accrued  restructuring                                                                                                                                                                        |       | —                 |       | 465                   |       |
| Current portion  of long-term debt                                                                                                                                                            |       | 450                    |       | 300                   |       |
| Income taxes  payable                                                                                                                                                                         |       | 1,182                  |       | 2,495                 |       |
| Total current  liabilities                                                                                                                                                                    |       | 8,935                  |       | 9,863                 |       |
| Long-term debt,  net of current portion                                                                                                                                                       |       | 6,803                  |       | 7,420                 |       |
| Other long-term  liabilities                                                                                                                                                                  |       | 2,237                  |       | 1,897                 |       |
| Total  liabilities                                                                                                                                                                            |       | 17,975                 |       | 19,180                |       |
| Commitments and  contingencies (Note 11)                                                                                                                                                 |       |                   |       |                  |       |
| Stockholders’  equity:                                                                                                                                                                   |       |                   |       |                  |       |
| Preferred stock,  $0.001 par value per share; 2,000 shares authorized; 883 shares issued and  outstanding as of September 30, 2006 and December 21, 2005.                           |       | 3,532                  |       | 3,532                 |       |
| Common stock,  $0.001 par value per share; 70,000 shares authorized; 23,247 and 22,977  shares issued and outstanding as of September 30, 2006 and  December 31, 2005, respectively |       | 23                     |       | 23                    |       |
| Additional  paid-in capital                                                                                                                                                                   |       | 156,618                |       | 155,441               |       |
| Accumulated  deficit                                                                                                                                                                          |       | (107,216               | )          | (104,776              | )          |
| Accumulated other  comprehensive income                                                                                                                                                       |       | 1,637                  |       | 1,398                 |       |
| Total  stockholders’ equity                                                                                                                                                              |       | 54,594                 |       | 55,618                |       |
| Total liabilities and  stockholders’ equity                                                                                                                                              |       | $                      | 72,569     |                  | $          | 74,798 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

3

----

 

AXT, INC.

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited,in thousands, except per share data)
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Revenue                                                                      |       | $                                                    | 12,547     |                                                | $          | 6,153 |   | $ | 31,373 |   | $ | 18,819 |   |
| Cost of revenue                                                              |       | 9,068                                                |       | 5,008                                               |       | 23,625 |   | 17,268 |   |
| Gross profit                                                                 |       | 3,479                                                |       | 1,145                                               |       | 7,748 |   | 1,551 |   |
| Operating  expenses:                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general and administrative                                          |       | 2,641                                                |       | 2,898                                               |       | 9,724 |   | 9,866 |   |
| Research and development                                                     |       | 392                                                  |       | 472                                                 |       | 1,497 |   | 1,257 |   |
| Impairment charge                                                            |       | 1,417                                                |       | —                                              |       | 1,417 |   | — |   |
| Restructuring charge (benefit)                                               |       | —                                               |       | 14                                                  |       | (2 | ) | 376 |   |
| Total operating expenses                                                     |       | 4,450                                                |       | 3,384                                               |       | 12,636 |   | 11,499 |   |
| Loss from  continuing operations                                             |       | (971                                                 | )          | (2,239                                              | )          | (4,888 | ) | (9,948 | ) |
| Interest income,  net                                                        |       | 103                                                  |       | 136                                                 |       | 342 |   | 386 |   |
| Other income  (expense), net                                                 |       | 641                                                  |       | (193                                                | )          | 1,693 |   | (494 | ) |
| Loss from  continuing operations before provision (benefit) for income taxes |       | (227                                                 | )          | (2,296                                              | )          | (2,853 | ) | (10,056 | ) |
| Provision  (benefit)for income taxes                                         |       | (862                                                 | )          | 45                                                  |       | (406 | ) | 98 |   |
| Income (loss)  from continuing operations                                    |       | 635                                                  |       | (2,341                                              | )          | (2,447 | ) | (10,154 | ) |
| Discontinued  operations:                                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Gain from discontinued operations, net of tax                                |       | 4                                                    |       | 9                                                   |       | 7 |   | 67 |   |
| Gain from disposal, net of tax                                               |       | —                                               |       | 250                                                 |       | — |   | 603 |   |
| Net income  (loss)                                                           |       | $                                                    | 639        |                                                | $          | (2,082 | ) | $ | (2,440 | ) | $ | (9,484 | ) |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Basic income  (loss) per share:                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Income (loss) from continuing operations                                     |       | $                                                    | 0.03       |                                                | $          | (0.10 | ) | $ | (0.11 | ) | $ | (0.45 | ) |
| Gain from discontinued operations, net of tax                                |       | —                                               |       | 0.01                                                |       | — |   | 0.03 |   |
| Net income (loss)                                                            |       | $                                                    | 0.03       |                                                | $          | (0.09 | ) | $ | (0.11 | ) | $ | (0.42 | ) |
| Shares used in  computing basic net income (loss) per share                  |       | 23,158                                               |       | 22,994                                              |       | 23,066 |   | 23,073 |   |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Diluted income  (loss) per share:                                            |       |                                                 |       |                                                |       |   |   |   |   |
| Income (loss) from continuing operations                                     |       | $                                                    | 0.02       |                                                | $          | (0.10 | ) | $ | (0.11 | ) | $ | (0.45 | ) |
| Gain from discontinued operations, net of tax                                |       | —                                               |       | 0.01                                                |       | — |   | 0.03 |   |
| Net income (loss)                                                            |       | $                                                    | 0.02       |                                                | $          | (0.09 | ) | $ | (0.11 | ) | $ | (0.42 | ) |
| Shares used in  computing diluted net income (loss) per share                |       | 24,378                                               |       | 22,994                                              |       | 23,066 |   | 23,073 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

4

----

 

AXT, INC.

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited,in thousands)
| ** **                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                                                         |       |                                                    |       |   |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                       |       |                                                    |       |   |   |
| Net loss                                                                     |       | $                                                       | (2,440     | ) | $ | (9,484 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                                                    |       |   |   |
| Depreciation                                                                 |       | 2,365                                                   |       | 2,874 |   |
| Amortization of investments premium/discount                                 |       | (55                                                     | )          | 188 |   |
| Non-cash restructuring charge                                                |       | —                                                  |       | 376 |   |
| Loss on disposal of property, plant and equipment                            |       | 89                                                      |       | 291 |   |
| Stock-based compensation                                                     |       | 649                                                     |       | 2 |   |
| Realized gain on sale of investments                                         |       | (2,032                                                  | )          | — |   |
| Gain on disposal of discontinued operations                                  |       | —                                                  |       | (53 | ) |
| Impairment of property, plant and equipment                                  |       | 1,417                                                   |       | — |   |
| Changes in assets and liabilities:                                           |       |                                                    |       |   |   |
| Accounts receivable, net                                                     |       | (3,574                                                  | )          | (855 | ) |
| Inventories, net                                                             |       | (1,203                                                  | )          | 862 |   |
| Prepaid expenses and other current assets                                    |       | (2,278                                                  | )          | 567 |   |
| Other assets                                                                 |       | 26                                                      |       | 74 |   |
| Accounts payable                                                             |       | 1,008                                                   |       | 421 |   |
| Accrued liabilities and restructuring                                        |       | (773                                                    | )          | (1,620 | ) |
| Income taxes payable                                                         |       | (1,313                                                  | )          | 131 |   |
| Other long-term liabilities                                                  |       | 340                                                     |       | 147 |   |
| Net cash used in operating activities                                        |       | (7,774                                                  | )          | (6,079 | ) |
|                                                                         |       |                                                    |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                       |       |                                                    |       |   |   |
| Purchases of property, plant and equipment                                   |       | (2,157                                                  | )          | (1,711 | ) |
| Proceeds from sales of property, plant and equipment                         |       | 161                                                     |       | 31 |   |
| Purchases of investments                                                     |       | (7,924                                                  | )          | (7,783 | ) |
| Proceeds from sale of investments                                            |       | 10,174                                                  |       | 16,958 |   |
| Decrease in restricted cash                                                  |       | 300                                                     |       | 615 |   |
| Proceeds from sale of assets held for sale, net                              |       | —                                                  |       | 1,303 |   |
| Net cash provided by investing activities                                    |       | 554                                                     |       | 9,413 |   |
|                                                                         |       |                                                    |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                       |       |                                                    |       |   |   |
| Proceeds from (payments of):                                                 |       |                                                    |       |   |   |
| Issuance of common stock                                                     |       | 528                                                     |       | 60 |   |
| Repurchase of common stock                                                   |       | —                                                  |       | (246 | ) |
| Long-term debt payments                                                      |       | (467                                                    | )          | (450 | ) |
| Net cash provided by (used in) financing activities                          |       | 61                                                      |       | (636 | ) |
| Effect of  exchange rate changes                                             |       | 274                                                     |       | (230 | ) |
| Net increase  (decrease) in cash and cash equivalents                        |       | (6,885                                                  | )          | 2,468 |   |
| Cash and cash  equivalents at the beginning of the period                    |       | 17,472                                                  |       | 12,117 |   |
| Cash and cash  equivalents at the end of the period                          |       | $                                                       | 10,587     |   | $ | 14,585 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

5

----

 

AXT, INC.

NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

**Note 1.Basis of Presentation**

The accompanyingcondensed consolidated financialstatements of AXT, Inc. (“AXT,” “Company,” “we,” “us” and “our”refer to AXT, Inc. and all of its consolidated subsidiaries) are unaudited, and have been prepared in accordance with accountingprinciples generally accepted in the United States of America forinterim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, the year-end condensed consolidatedbalance sheet was derived from the Company’s audited financial statements, but doesnot include all disclosures required by accounting principles generally accepted in the UnitedStates of America. In the opinion of management, the unaudited condensedconsolidated financial statements reflect all adjustments, consisting only ofnormal recurring adjustments, considered necessary to present fairly thefinancial position, results of operations and cash flows of AXT and itssubsidiaries for all periods presented.

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

The results ofoperations are not necessarily indicative of the results to be expected in thefuture or for the full fiscal year. It is recommended that these condensedconsolidated financial statements be read in conjunction with our consolidatedfinancial statements and the notes thereto included in our 2005 Annual Reporton Form 10-K filed with the Securities and Exchange Commission onMarch 30, 2006 and our Quarterly Reports on Form 10-Q for thequarterly periods ended March 31, 2006 and June 30, 2006 filed with theSecurities and Exchange Commission on May 12, 2006 and August 11, 2006,respectively.

Certain reclassifications have been made to the prioryear’s condensed consolidated financial statements to conform to currentperiod presentation.

**Note 2. Discontinued Operations and Related Assets Heldfor Sale**

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

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

Our condensed consolidated financial statements havebeen presented to reflect the opto-electronics business as a discontinuedoperation for all periods presented. Operating results of the discontinuedoperation are as follows (in thousands):

6

----

 
| ** **                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                     | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                        |       | $                                                    | —     |                                                | $          | — |   | $ | — |   | $ | — |   |
| Cost of revenue                                |       | —                                               |       | —                                              |       | — |   | — |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Gross profit                                   |       | —                                               |       | —                                              |       | — |   |   |   |
| Operating  expenses:                           |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general and administrative            |       | (4                                                   | )          | (9                                                  | )          | (7 | ) | (67 | ) |
| Research and development                       |       | —                                               |       | —                                              |       | — |   | — |   |
| Impairment costs                               |       |                                                 |       | —                                              |       | — |   |   |   |
| Total operating expenses                       |       | (4                                                   | )          | (9                                                  | )          | (7 | ) | (67 | ) |
| Gain from  discontinued operations, net of tax |       | 4                                                    |       | 9                                                   |       | 7 |   | 67 |   |
| Gain from  disposal, net of tax                |       | —                                               |       | 250                                                 |       | — |   | 603 |   |
| Net income                                     |       | $                                                    | 4          |                                                | $          | 259 |   | $ | 7 |   | $ | 670 |   |

 

The carrying valueof the assets and liabilities of the discontinued opto-electronics businessincluded in the condensed consolidated balance sheets are as follows (inthousands):

|                                   | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Current assets:                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash                              |       | $                            | 407        |                        | $          | 472 |   |
| Total current assets              |       | 407                          |       | 472                         |       |
| Total assets                      |       | $                            | 407        |                        | $          | 472 |   |
| Current  liabilities:             |       |                         |       |                        |       |
| Accrued liabilities               |       | $                            | 24         |                        | $          | 95 |   |
| Total liabilities                 |       | 24                           |       | 95                          |       |
| Net assets                        |       | 383                          |       | 377                         |       |
| Total liabilities and  net assets |       | $                            | 407        |                        | $          | 472 |   |

 

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

Effective January 1, 2006, we adopted theprovisions of Statement of Financial Accounting Standards (“SFAS”)No. 123 (revised 2004), “*Share-BasedPayment*,” (“SFAS 123(R)”). SFAS 123(R) establishesaccounting for stock-based awards exchanged for employee services. Accordingly,stock-based compensation cost is measured at each grant date, based on the fairvalue of the award, and is recognized as expense over the employee’s requisiteservice period. All of the Company’s stock compensation is accounted for as anequity instrument. The Company previously applied Accounting Principles Board (“APB”)Opinion No. 25, “*Accounting for StockIssued to Employees*,” and related interpretations and provided therequired pro forma disclosures of SFAS No. 123, “*Accountingfor Stock-Based Compensation*”**(“SFAS123”).

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

***Prior to the Adoption ofSFAS 123(R)***

Prior to the adoption of SFAS 123(R), we provided thedisclosures required under SFAS 123, as amended by SFAS No. 148, “*Accounting for Stock-Based Compensation — Transition and Disclosures*.”SFAS 123(R) requires us to present pro forma information for thecomparative period prior to adoption as if we had accounted for all ouremployee stock options under the fair value method of the original SFAS 123.The following table illustrates the effect on net loss and net loss per share ifwe had applied the fair value recognition provisions of SFAS 123 to stock-basedemployee compensation to the prior-year periods (in thousands, except per sharedata):

7

----

 

|                                                                                               | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Net loss:                                                                                     |       |                                                   |       |                                                  |       |
| As reported                                                                                   |       | $                                                      | (2,126     | )                                                     | $          | (9,616 | ) |
| Add: Stock-based employee compensation expense  included in net loss as reported              |       | 5                                                      |       | 2                                                     |       |
| Less: Stock-based  compensation expense using the fair value based method, net of related tax |       | (206                                                   | )          | (673                                                  | )          |
| Pro forma net loss                                                                            |       | $                                                      | (2,327     | )                                                     | $          | (10,287 | ) |
| Basic and  diluted net loss per common share                                                  |       |                                                   |       |                                                  |       |
| As reported                                                                                   |       | $                                                      | (0.09      | )                                                     | $          | (0.42 | ) |
| Pro forma                                                                                     |       | $                                                      | (0.10      | )                                                     | $          | (0.45 | ) |
| Shares used in  computing basic and diluted net loss per share                                |       | 22,994                                                 |       | 23,073                                                |       |

 

***Impact of the Adoption of SFASNo. 123 (R)***

We elected to adopt the modified prospectiveapplication transition method as provided by SFAS 123(R), and we recorded $206,000 and $649,000 ofstock compensation expense in our unaudited condensed consolidated statementsof operations for the three and nine months ended September 30, 2006. Weelected not to capitalize any stock-based compensation to inventory as ofJanuary 1, 2006 when the provisions of SFAS 123(R) were initiallyadopted. We utilized theBlack-Scholes valuation model for estimating the fair value of the stockcompensation granted both before and after the adoption of SFAS 123(R). Inaccordance with the modified prospective application transition method, ourcondensed consolidated financial statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS 123(R). Thefollowing table summarizes compensation costs related to our stock-basedcompensation plan (in thousands, except per share data):

|                                                                                    | ** ** | **Three Months  Ended  September 30,  2006** | ** ** | **Nine Months  Ended  September 30,  2006** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Stock-based  compensation in the form of employee stock options, included in: |       |                                                   |       |                                                  |       |
|                                                                               |       |                                                   |       |                                                  |       |
| Cost of revenue                                                                    |       | $                                                      | 20         |                                                  | $          | 80 |   |
| Selling, general  and administrative                                               |       | 148                                                    |       | 412                                                   |       |
| Research and  development                                                          |       | 38                                                     |       | 156                                                   |       |
|                                                                               |       |                                                   |       |                                                  |       |
| Total  stock-based compensation                                                    |       | $                                                      | 206        |                                                  | $          | 649 |   |
| Tax effect on  stock-based compensation                                            |       | —                                                 |       | —                                                |       |
|                                                                               |       |                                                   |       |                                                  |       |
| Net effect on  net income or loss                                                  |       | $                                                      | 206        |                                                  | $          | 649 |   |
|                                                                               |       |                                                   |       |                                                  |       |
| Effect on basic and  diluted net income (loss) per share                           |       | $                                                      | (0.01      | )                                                     | $          | (0.03 | ) |

 

As of September 30, 2006, the total compensation cost related tounvested stock-based awards granted to employees under our stock option planbut not yet recognized was approximately $856,000, net of estimated forfeituresof $20,000. This cost will be amortized on a straight-line basis over aweighted-average period of approximately 1.27 years and will be adjusted forsubsequent changes in estimated forfeitures. We elected not tocapitalize any stock-based compensation to inventory as of September 30,2006, due to the immateriality of the amount.

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

8

----

 

We estimate the fair value of stock options using aBlack-Scholes valuation model, consistent with the provisions of SFAS 123(R),Securities and Exchange Commission Staff Accounting Bulletin No. 107 and ourprior period pro forma disclosures of net loss, including stock-basedcompensation (determined under a fair value method as prescribed by SFASNo. 123). The fair value of our stock options granted to employees forthe three and nine months ended September 30, 2006 and 2005 was estimatedusing the following weighted-average assumptions:

|                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected term (in years)    |       | 5.0                                                  |       | 5.0                                                 |       | 5.0 |   | 5.0 |   |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Volatility                  |       | 82.26                                                | %          | NA                                                  |       | 84.86 | % | 92.45 | % |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Expected dividend           |       | 0                                                    | %          | 0                                                   | %          | 0 | % | 0 | % |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Risk-free interest rate     |       | 4.59                                                 | %          | NA                                                  |       | 4.80 | % | 4.18 | % |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Estimated forfeitures       |       | 1.49                                                 | %          | 0                                                   | %          | 12.33 | % | 0 | % |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted-average fair value |       | $                                                    | 2.17       |                                                | NA         |   | $ | 1.82 |   | $ | 0.89 |   |
|                             |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |

 

The following tablesummarizes the stock option transactions during the nine months endedSeptember 30, 2006 (in thousands, except per share data):
| ** **                                                         | ** ** | **Shares** | ** ** | **Weighted-  average  Exercise  Price** | ** ** | **Weighted-  average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | ** ** | ** ** | ** **                              | ** ** | **(in years**)                                  | ** ** | ** **                      | ** ** |
| Options  outstanding as of December 31, 2005                       |       | 2,917      |       | $                                       | 2.30       |                                                 |       |                            |       |   |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Granted                                                            |       | 26         |       | 2.78                                    |       |                                                 |       |                            |       |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Exercised                                                          |       | (269       | )          | 1.96                                    |       |                                                 |       |                            |       |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Canceled                                                           |       | (85        | )          | 1.50                                    |       |                                                 |       |                            |       |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Options  outstanding as of September 30, 2006                 |       | 2,589      |       | $                                       | 2.37       |                                                 | 6.62       |                            | $          | 6,037 |   |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Options vested  and expected to vest as of September 30, 2006 |       | 2,573      |       | $                                       | 2.37       |                                                 | 6.60       |                            | $          | 5,993 |   |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Options exercisable as  of September 30, 2006                 |       | 1,768      |       | $                                       | 2.80       |                                                 | 5.77       |                            | $          | 3,712 |   |

 

The options outstanding and exercisable as ofSeptember 30, 2006 were in the following exercise price ranges:
| **Options Outstanding as of September 30, 2006** | ** ** | **Options Vested and Exercisable  as of September 30, 2006** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| **Range of Exercise Price**                                     | ** ** | **Shares**                                                                                      | ** ** | **Weighted-average  Exercise Price** | ** ** | **Weighted-average  Remaining  Contractual Life** | ** ** | **Shares** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
| $1.17 - $ 1.38                                                            |       | 1,484,795                                                                                       |       | $ | 1.29 |   | 7.37 |   | 790,693 |   | $ | 1.31 |   |
| $1.39 - $ 1.44                                                            |       | 11,500                                                                                          |       | $ | 1.41 |   | 8.64 |   | 2,813 |   | $ | 1.40 |   |
| $1.45 - $ 2.24                                                            |       | 620,363                                                                                         |       | $ | 2.17 |   | 5.99 |   | 527,241 |   | $ | 2.18 |   |
| $2.25 - $ 5.00                                                            |       | 354,433                                                                                         |       | $ | 3.63 |   | 5.73 |   | 331,315 |   | $ | 3.64 |   |
| $5.01 - $41.50                                                                 |       | 117,500                                                                                         |       | $ | 13.41 |   | 3.02 |   | 116,250 |   | $ | 13.45 |   |
|                                                                           |       | 2,588,591                                                                                       |       | $ | 2.37 |   | 6.62 |   | 1,768,312 |   | $ | 2.80 |   |

 

The total intrinsic value of options exercised for thethree and nine months ended September 30, 2006 was $0.2 million and $0.4million. Cash received from option exercises for the three and nine monthsended September 30, 2006 was $0.2 million and $0.5 million, respectively.The total fair value of options vested for the three and nine months endedSeptember 30, 2006 was $0.8 million and $1.6 million, respectively. 

9

----

 

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

Our cash, cash equivalents and investments areclassified as follows (in thousands):
| ** **                                    | ** ** | **September 30, 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                                          |       | $                                | 6,591      |                            | $          | — |   | $ | — |   | $ | 6,591 |   | $ | 12,803 |   | $ | — |   | $ | — |   | $ | 12,803 |   |
| Cash  equivalents:                            |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market funds                            |       | 2,341                            |       | —                          |       | — |   | 2,341 |   | 1,729 |   | — |   | — |   | 1,729 |   |
| U.S. Treasury and agency securities           |       | 1,055                            |       | —                          |       | — |   | 1,055 |   | — |   | — |   | — |   |   |   |
| Commercial paper                              |       | 600                              |       | —                          |       | — |   | 600 |   | 2,940 |   | — |   |   |   | 2,940 |   |
| Total cash  equivalents                       |       | 3,996                            |       | —                          |       | — |   | 3,996 |   | 4,669 |   | — |   | — |   | 4,669 |   |
| Total cash and  cash equivalents              |       | 10,587                           |       | —                          |       | — |   | 10,587 |   | 17,472 |   | — |   | — |   | 17,472 |   |
|                                          |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                                  |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agency securities           |       | 5,627                            |       | —                          |       | (9 | ) | 5,618 |   | 4,460 |   |   |   | (12 | ) | 4,448 |   |
| Asset-backed securities                       |       | 1,092                            |       | —                          |       | (3 | ) | 1,089 |   | 3,285 |   | — |   | (11 | ) | 3,274 |   |
| Commercial paper                              |       | 900                              |       | —                          |       |   |   | 900 |   | — |   |   |   |   |   | — |   |
| Corporate bonds                               |       | 3,183                            |       | —                          |       | (3 | ) | 3,180 |   | 2,504 |   | — |   | (13 | ) | 2,491 |   |
| Corporate equity securities                   |       | 452                              |       | 1,268                           |       | — |   | 1,720 |   | 1,468 |   | 1,324 |   | — |   | 2,792 |   |
| Total  investments                            |       | 11,254                           |       | 1,268                           |       | (15 | ) | 12,507 |   | 11,717 |   | 1,324 |   | (36 | ) | 13,005 |   |
| Total cash, cash  equivalents and investments |       | $                                | 21,841     |                            | $          | 1,268 |   | $ | (15 | ) | $ | 23,094 |   | $ | 29,189 |   | $ | 1,324 |   | $ | (36 | ) | $ | 30,477 |   |
| ** **                                    | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Contractual  maturities on investments:**   | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Due within 1 year                             |       | $                                | 8,117      |                            |       |   |   |   | $ | 9,375 |   | $ | 8,384 |   |   |   |   |   | $ | 9,682 |   |
| Due after 1 through 5 years                   |       | 3,137                            |       |                            |       |   |   | 3,132 |   | 3,333 |   |   |   |   |   | 3,323 |   |
|                                          |       | $                                | 11,254     |                            |       |   |   |   | $ | 12,507 |   | $ | 11,717 |   |   |   |   |   | $ | 13,005 |   |

 

The investments include $7.2 million and $7.5 million,respectively, recorded as restricted deposits on the condensed consolidatedbalance sheets as of September 30, 2006 and December 31, 2005.

We manage our investments as a single portfolio ofhighly marketable securities that is intended to be available to meet ourcurrent cash requirements. For the three months ended September 30, 2006,we had $0.7 million of gross realized gains on sales of our available-for-salesecurities. For the three months ended September 30, 2005, we had no grossrealized gains or losses on sales of our available-for-sale securities. For thenine months ended September 30, 2006, we had $2.0 million of grossrealized gains on sales of our available-for-sale securities. For the ninemonths ended September 30, 2005, we had no gross realized gains or losseson sales of our available-for-sale securities.

The gross unrealized losses related to our portfolioof available-for-sale securities were primarily due to a decrease in the fairvalue of debt securities as a result of an increase in interest rates during2005 and the first nine months of 2006. We have determined that the grossunrealized losses on our available-for-sale securities as of September 30,2006 are temporary in nature. We reviewed our investment portfolio to identifyand evaluate investments that have indications of possible impairment. Factorsconsidered in determining whether a loss is temporary include the magnitude ofthe decline in market value, the length of time the market value has been belowcost (or adjusted cost), credit quality, and our ability and intent to hold thesecurities for a period of time sufficient to allow for any anticipatedrecovery in market value. The following table provides a breakdown of ouravailable-for-sale securities with unrealized losses as of September 30,2006 (in thousands):
| ** **                          | ** ** | **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:            |       |                                                         |       |                                                         |       |                                      |       |   |   |   |   |   |   |
| U.S. Treasury and agency securities |       | $                                                            | 5,618      |                                                         | $          | (9                                        | )          | $ | — |   | $ | — |   | $ | 5,618 |   | $ | (9 | ) |
| Asset-backed securities             |       | —                                                       |       | —                                                       |       | 1,089                                     |       | (3 | ) | 1,089 |   | (3 | ) |
| Corporate bonds                     |       | 3,180                                                        |       | (3                                                           | )          | —                                    |       | — |   | 3,180 |   | (3 | ) |
| Total in loss  position             |       | $                                                            | 8,798      |                                                         | $          | (12                                       | )          | $ | 1,089 |   | $ | (3 | ) | $ | 9,887 |   | $ | (15 | ) |

 

10

----

 

**Note 5.Inventories, Net**

The components ofinventories are summarized below (in thousands):

|                    | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Inventories,  net: |       |                             |       |                            |       |
| Raw materials      |       | $                                | 6,775      |                            | $          | 6,667 |   |
| Work in process    |       | 9,149                            |       | 9,141                           |       |
| Finished goods     |       | 1,435                            |       | 348                             |       |
|               |       | $                                | 17,359     |                            | $          | 16,156 |   |

 

**Note 6.Restructuring Charges**

Our restructuring accrual is as follows (inthousands):
| **For the nine months ended September 30, 2006** | ** ** | **Restructuring  Accrual as of  December 31, 2005** | ** ** | **Additions/Reversals** | ** ** | **Payments** | ** ** | **Restructuring  Accrual as of  September 30, 2006** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------|------------|--------------|------------|--------------------------------------------------------------------------|------------|
| Future lease  payments related to abandoned facilities                              |       | $                                                                       | 250        |                    | $          | —       |       | $                                                                        | (250       | ) | $ | — |   |
| Workforce  reduction                                                                |       | 215                                                                     |       | (2                      | )          | (213         | )          | —                                                                   |       |
| Total                                                                               |       | $                                                                       | 465        |                    | $          | (2           | )          | $                                                                        | (463       | ) | $ | — |   |

 

In December 2005, as part of our ongoing effortto reduce our Fremont, California facility headcount, we reduced the workforceat the facility by 15 full-time equivalent positions that we no longer requiredto support production and operations, or approximately 29% of theworkforce based at this facility. Accordingly, we recorded a restructuringcharge of approximately $273,000 related to the reduction in force forseverance-related expenses, of which $215,000 remained on the consolidatedbalance sheet as of December 31, 2005. We completed the reduction in forceby the end of the first quarter of 2006.

In the three months ended September 30, 2006, we hadincurred no restructuring charges. As of September 30, 2006, we have a zerobalance for the restructuring accrual for workforce reduction and for futurelease payments related to abandoned U.S. facilities located in California thatare no longer required to support production, as these have all been paid. 

**Note 7. Net Income (Loss) Per Share**

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

A reconciliationof the numerators and denominators of the basic and diluted net income or lossper share calculations is as follows (in thousands, except per share data):
| ** **                                                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Numerator:                                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss)                                                                   |       | $                                                    | 639        |                                                | $          | (2,082 | ) | $ | (2,440 | ) | $ | (9,484 | ) |
| Less: Preferred stock dividends                                                     |       | (44                                                  | )          | (44                                                 | )          | (132 | ) | (132 | ) |
| Net income (loss) available to common stockholders                                  |       | $                                                    | 595        |                                                | $          | (2,126 | ) | $ | (2,572 | ) | $ | (9,616 | ) |
| Denominator:                                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Denominator for basic net income (loss) per share -  weighted average common shares |       | 23,158                                               |       | 22,994                                              |       | 23,066 |   | 23,073 |   |
| Effect of dilutive securities:                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Common stock options                                                                |       | 1,220                                                |       | —                                              |       | — |   | — |   |
| Denominator for  dilutive net income (loss) per common share                        |       | 24,378                                               |       | 22,994                                              |       | 23,066 |   | 23,073 |   |
| Basic net income  (loss) per share                                                  |       | $                                                    | 0.03       |                                                | $          | (0.09 | ) | $ | (0.11 | ) | $ | (0.42 | ) |
| Diluted net  income (loss) per share                                                |       | $                                                    | 0.02       |                                                | $          | (0.09 | ) | $ | (0.11 | ) | $ | (0.42 | ) |
| Options excluded from  diluted net loss per share as the impact is anti-dilutive    |       | 120                                                  |       | 2,956                                               |       | 2,589 |   | 2,956 |   |

 

11

----

 

**Note 8.Comprehensive Income (Loss)**

The components ofcomprehensive income (loss) are as follows (in thousands):
| ** **                                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Net income  (loss)                                                                 |       | $                                                    | 639        |                                                | $          | (2,082 | ) | $ | (2,440 | ) | $ | (9,484 | ) |
| Foreign currency  translation gain (loss)                                          |       | 196                                                  |       | (12                                                 | )          | 274 |   | (230 | ) |
| Unrealized gain  (loss) on available-for-sale investments                          |       | 151                                                  |       | 377                                                 |       | 1,997 |   | (1,044 | ) |
| Less:  reclassification adjustment for realized gain included in net income (loss) |       | (650                                                 | )          | —                                              |       | (2,032 | ) | — |   |
| Comprehensive income  (loss)                                                       |       | $                                                    | 336        |                                                | $          | (1,717 | ) | $ | (2,201 | ) | $ | (10,758 | ) |

 

**Note 9.Segment Information and Foreign Operations**

***Segment Information***

We operate in one segment for the design, development,manufacture and distribution of high-performance compound semiconductorsubstrates and sale of raw materials. In accordance withSFAS No. 131, *“Disclosures about Segmentsof an Enterprise and Related Information”* (“SFAS No. 131”), ourchief operating decision-maker has been identified as our 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.

***GeographicalInformation***

The following table represents revenue amounts (inthousands) reported for products shipped to customers in the correspondinggeographic region:

|                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:       |       |                                                 |       |                                                |       |   |   |   |   |
| North America* |       | $                                                    | 3,033      |                                                | $          | 1,481 |   | $ | 7,704 |   | $ | 3,684 |   |
| Europe         |       | 2,012                                                |       | 1,328                                               |       | 5,684 |   | 4,911 |   |
| Japan          |       | 842                                                  |       | 1,087                                               |       | 2,638 |   | 1,887 |   |
| Taiwan         |       | 2,869                                                |       | 704                                                 |       | 5,782 |   | 2,840 |   |
| Asia Pacific   |       | 3,791                                                |       | 1,553                                               |       | 9,565 |   | 5,497 |   |
| Consolidated   |       | $                                                    | 12,547     |                                                | $          | 6,153 |   | $ | 31,373 |   | $ | 18,819 |   |

----

*                    Primarilythe United States

Long-lived assets consist of property, plant andequipment, and are attributed to the geographic location in which they arelocated. Long-lived assets by geographic region were as follows (in thousands):

|                     | ** ** | **As of**                   | ** ** |
|---------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
| Long-lived  assets: |       |                             |       |   |   |
| North America       |       | $                                | 160        |   | $ | 6,547 |   |
| Asia Pacific        |       | 10,612                           |       | 10,759 |   |
|                |       | $                                | 10,772     |   | $ | 17,306 |   |

 

12

----

 

***Significant Customers***

One customer represented 18.4% of our revenue for thethree months ended September 30, 2006 and two customers represented 11.5%and 10.7%, respectively, of our revenue for the three months ended September30, 2005. One customer represented 15.0% and 11.5% of our revenue for the ninemonths ended September 30, 2006 and 2005, respectively. Our top fivecustomers represented 44.1% and 45.4% of our revenue for the three months endedSeptember 30, 2006 and 2005, respectively. Our top five customersrepresented 40.3% and 35.6% of our revenue for the nine months endedSeptember 30, 2006 and 2005, respectively.

**Note 10. Investments in Privately-held Companies**

We have made strategic investments in privatecompanies located in China in order to gain access at a competitive cost to rawmaterials that are critical to our substrate business. Our investments in theseprivately-held companies are summarized below (in thousands):
| ** **                                     | ** ** | **Investment Balance as of** | ** ** | ** **                  | ** ** | ** **             | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| **Company**                                    | ** ** | **September 30,  2006**                | ** ** | **December 31,  2005** | ** ** | **Accounting  Method** | ** ** | **Ownership  Percentage** | ** ** |
| Beijing Ji Ya  Semiconductor Material Co., Ltd |       | $                                           | 996        |                        | $          | 996                    |       | Consolidated |   | 46 | % |
| Nanjing Jin Mei  Gallium Co., Ltd              |       | 592                                         |       | 592                         |       | Consolidated           |       | 83 |   |
| Beijing BoYu  Manufacturing Co., Ltd           |       | 410                                         |       | 410                         |       | Consolidated           |       | 70 |   |
| Xilingol Tongli  Ge Co. Ltd                    |       | 925                                         |       | 864                         |       | Equity                 |       | 25 |   |
| Emeishan Jia Mei High  Pure Metals Co., Ltd    |       | 673                                         |       | 596                         |       | Equity                 |       | 25 |   |
|                                                |            |                                             |            |                             |            |                        |            |  |  |  |  |

 

The investment balances for the two companiesaccounted for under the equity method are included in other assets in thecondensed consolidated balance sheets. We own 25% of the ownership interests ineach of these companies. These two companies are not considered variableinterest entities because:

·                       both companies have sustainablebusinesses of their own;

·                       our voting power isproportionate to our ownership interests;

·                       we only recognize our respectiveshare of the losses and/or residual returns generated by the companies if theyoccur; and

·                       we do not have a controllingfinancial interest in, do not maintain operational or management control of, donot control the board of directors of, and are not required to provideadditional investment or financial support to either company.

Undistributed retained earnings relating to ourinvestments were $3.9 million and $2.2 million as of September 30, 2006and 2005, respectively. Net income recorded from our investments was $609,000and $416,000 for the three months ended September 30, 2006 and 2005,respectively. Net income recorded from our investments was $1,333,000 and$747,000 for the nine months ended September 30, 2006 and 2005,respectively.

The minorityinterest for those investments that are consolidated is included within “Otherlong-term liabilities” in the condensed consolidated balance sheets and withinOther income (expense), net on the condensed consolidated statements ofoperations.

**Note 11.Commitments and Contingencies**

***LegalMatters***

On October 15,2004, a purported securities class action lawsuit was filed in the UnitedStates Court for the Northern District of California, City of Harper WoodsEmployees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ.The Court consolidated the case with a subsequent related case and appointed alead plaintiff. On April 5, 2005, the lead plaintiff filed a consolidatedcomplaint, captioned as Morgan v. AXT, Inc. et al., No. C 04 4362MJJ. The lawsuit complaint names AXT, Inc. and our chief technologyofficer as defendants, and is brought on behalf of a class of allpurchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during thisperiod that were false and misleading. No specific amount of damages isclaimed. We believe that there are meritorious defenses against this litigationand intend to vigorously defend it. On September 23, 2005, the Courtgranted our motion to dismiss the complaint, with leave to amend. The leadplaintiff filed an amended complaint, which we have moved to dismiss. Due tothe inherent uncertainties of litigation, we cannot accurately predict theultimate outcome of the litigation. Any unfavorable outcome of the litigationcould have an adverse impact on our business, financial condition and resultsof operations.

13

----

 

On June 1, 2005, a lawsuit was filed in theSuperior Court of California, County of Alameda, Zhao et al. v. American XtalTechnology, et al., No. R 605215713. The lawsuit complaint names asdefendants AXT, Inc., our chief technology officer and one of our suppliers.The lawsuit is brought on behalf of two former employees and their minor child.The complaint alleges personal injury, general negligence, intentional tort,wage loss and other damages, including punitive damages, as a result ofexposure to the child while in utero to high levels of gallium arsenide andmethanol used in the production of gallium arsenide wafers. We believe thatthere are meritorious defenses against this litigation and intend to vigorouslydefend it. Our commercial general liability insurance carrier has agreed tofund our defense of the case, but has reserved the right to deny coverage, inwhole or in part, in the future under selected policy provisions and applicablelaw. The plaintiffs have made an initial settlement demand within our insurancelimits. Due to the inherent uncertainties of litigation, we cannot accuratelypredict the ultimate outcome of the litigation. Any unfavorable outcome of thelitigation could have an adverse impact on our business, financial conditionand results of operations.

***Indemnification Agreements***

We enter into standard indemnification arrangements inthe ordinary course of business. Pursuant to these arrangements, we indemnify,hold harmless, and agree to reimburse the indemnified parties, generally theirbusiness partners or customers, for losses suffered or incurred by theindemnified party in connection with any U.S. patent, or any copyright or otherintellectual property infringement claim by any third party with respect to ourproducts. The term of these indemnification agreements is generally perpetualafter the execution of the agreement. The maximum potential amount of futurepayments we could be required to make under these agreements is unlimited. Wehave never incurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, we believe the estimated fair value ofthese agreements is minimal.

We have entered into indemnification agreements withour directors and officers that may require us to indemnify our directorsand officers against liabilities that may arise by reason of their statusor service as directors or officers, other than liabilities arising from willfulmisconduct of a culpable nature; to advance their expenses incurred as a resultof any proceeding against them as to which they could be indemnified; and toobtain directors’ and officers’ insurance if available on reasonable terms,which we currently have in place.

***ProductWarranty***

We warrant our products against material defects for aspecific period of time, generally twelve months. We provide for the estimatedfuture costs of warranty obligations in cost of revenue when the relatedrevenue is recognized. The accrued warranty costs represent the best estimateat the time of sale of the total costs that we expect to incur to repair orreplace products that fail while still under warranty. The amount of accruedestimated warranty costs is primarily based on historical experience as toproduct failures as well as current information on repair costs. On a quarterlybasis, we review the accrued balance and update this based on historicalwarranty cost trends. The following table reflects the change in our warrantyaccrual, which is included in “Accrued liabilities” on the condensedconsolidated balance sheets, during the three and nine months endedSeptember 30, 2006 and 2005 (in thousands):
| ** **                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Beginning  accrued warranty and related costs |       | $                                                    | 204        |                                                | $          | 82 |   | $ | 120 |   | $ | 135 |   |
| Charged to cost  of revenue                   |       | 553                                                  |       | (60                                                 | )          | 699 |   | (113 | ) |
| Actual warranty  expenditures                 |       | (186                                                 | )          | —                                              |       | (248 | ) | — |   |
| Ending accrued warranty  and related costs    |       | $                                                    | 571        |                                                | $          | 22 |   | $ | 571 |   | $ | 22 |   |

 

***Sales Returns***

In March 2004, we increased our reserve for repair andreplacement costs by $745,000. As of September 30, 2006, this reserve balancewas zero since approximately $487,000 had been utilized and approximately$258,000 had been reversed to revenue as we favorably resolved an outstandingmatter with a customer.

**Note 12.Foreign Exchange Transaction Gains/Losses**

We incurred foreign currency transaction exchangelosses of $59,000 and $61,000 for the three months ended September 30, 2006 and2005, respectively. We incurred foreign currency transaction exchange losses of$48,000 and of $110,000 for the nine months ended September 30, 2006 and2005, respectively. These amounts are included in “Other income (expense), net”on the condensed consolidated statements of operations.

14

----

 

**Note 13. Recent AccountingPronouncements**

In February 2006, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 155, “*Accounting for CertainHybrid Instruments — an amendment of FASB Statements No. 133 and 140”*(“SFAS 155”)*.* SFAS 155 amends SFAS No. 133, “*Accounting for Derivative Instruments and Hedging Activities*”(“SFAS 133”) and SFAS No. 140, “*Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*”(“SFAS 140”). SFAS 155 allows entities the option of applying fair valueaccounting to certain hybrid financial instruments in their entirety if theycontain embedded derivatives that would otherwise require bifurcation underSFAS 133. SFAS 155 will be effective for us as of January 1, 2007. We arecurrently assessing the impact that SFAS 155 may have on our consolidatedfinancial position, results of operations or cash flows.

In June 2006, the FASB issued FASB Interpretation No. 48, “*Accounting For Uncertain Tax Positions — An Interpretation of FASBStatement No. 109”*(“FIN 48”). FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, “*Accounting for IncomeTaxes*”. It prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. FIN 48 also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. FIN 48 is effective for fiscalyears beginning after Decemeber 15, 2006. We are currently assessing the impactof the adoption that FIN 48 may have on our consolidated financial position,results of operations or cash flows.

In June 2006, theFASB ratified the consensus reached by the EITF on Issue No. 06-3, How TaxesCollected from Customers and Remitted to Governmental Authorities Should BePresented in the Income Statement (That Is, Gross versus Net Presentation) (“EITF 06-3”). EITF 06-3 includes any tax assessed by a governmental authoritythat is directly imposed on a revenue-producing transaction between a sellerand a customer and may include, but is not limited to, sales, use, value added,and some excise taxes. EITF 06-3 concludes that the presentation of taxes oneither a gross (included in revenues and costs) or a net (excluded fromrevenues) basis is an accounting policy decision that should be disclosed. Inaddition, for any such taxes that are reported on a gross basis, a companyshould disclose the amounts of those taxes in interim and annual financialstatements for each period for which an income statement is presented if thoseamounts are significant. The provisions of EITF 06-3 should be applied tofinancial reports for interim and annual reporting periods beginning afterDecember 15, 2006, with earlier adoption permitted. We are currently assessingthe impact of the adoption that EITF 06-3 may have on our consolidated financialposition, results of operations or cash flows.

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157provides a new single authoritative definition of fair value and providesenhanced guidance for measuring the fair value of assets and liabilities andrequires additional disclosures related to the extent to which companiesmeasure assets and liabilities at fair value, the information used to measurefair value, and the effect of fair value measurements on earnings. SFAS 157 iseffective for us as of January 1, 2008. We are currently assessing the impact,if any, of SFAS 157 on our consolidated financial position, results ofoperations or cash flows.

In September 2006,the FASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans — an amendment of FASB Statements No.87, 88, 106, and 132(R)” (“SFAS 158”). SFAS 158 requires balance sheetrecognition of the overfunded or underfunded status of pension and postretirementbenefit plans. Under SFAS 158, actuarial gains and losses, prior service costsor credits, and any remaining transition assets or obligations that have notbeen recognized under previous accounting standards must be recognized as acomponent of accumulated other comprehensive income (loss) within stockholders’equity, net of tax effects, until they are amortized as a component of netperiodic benefit cost. In addition, the measurement date and the date at whichplan assets and the benefit obligation are measured, are required to be thecompany’s fiscal year-end. SFAS 158 is effective for us as of December 31,2007, except for the measurement date provisions, which are effective December31, 2009. The adoption of SFAS 158 is not expected to have a material impact onour consolidated financial position, results of operations or cash flows.

 In September2006, the SEC released Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements When Quantifying Misstatements in CurrentYear Financial Statements” (“SAB 108”). SAB 108 provides interpretativeguidance on how public companies quantify financial statement misstatements.There have been two common approaches used to quantify such errors. Under anincome statement approach, the “roll-over” method, the error is quantified asthe amount by which the current year income statement is misstated.Alternatively, under a balance sheet approach, the “iron curtain” method, theerror is quantified as the cumulative amount by which the current year balancesheet is misstated. In SAB 108, the SEC established an approach that requiresquantification of financial statement misstatements based on the effects of themisstatements on each of the company’s financial statements and the relatedfinancial statement disclosures. This model is commonly referred to as a “dualapproach” because it requires quantification of errors under both the roll-overand iron curtain methods. SAB 108 is effective for us as of January 1, 2007.The adoption of SAB 108 is not expected to have a material impact on ourconsolidated financial position, results of operations or cash flows.

15

----

 

**Note 14. Subsequent Events**

In September 2006, tax authorities in the People’sRepublic of China (“PRC”) announced their intention to impose customsduties on, and to reduce or eliminate refunds of value-added taxes thatcompanies pay when they purchase, certain raw materials, including gallium andarsenic.  The combination of these actions could significantly increaseour costs.  Implementing regulations are not expected to be publishedbefore late November 2006, and it is possible that these regulations will notbe adopted or that changes will be made in their outline before adoption. Lobbying efforts are being made to remove gallium and arsenic from the list ofaffected materials, but there is no way to know if these efforts will have anyimpact on the final form of the regulations.  There appears to be apossibility that the value-added tax refund on gallium will not be completelyeliminated, but merely reduced.  If the regulations are adopted ascurrently proposed, they would not have a material impact on our fourthquarter results because they would only be in effect for a portion ofthe quarter. They may potentially, however, have a significant adverse impacton our gross margins and net income (loss) in 2007, although we do not have thefacts necessary to estimate its magnitude at this time.  We are alsoexploring alternatives for restructuring our operations in the PRC in order tomitigate the impact of these regulations if and when they areadopted.   We will not know the exact impact of any restructuring orthe amount of time that it might take to accomplish until toward the endof this year.

16

----

 

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

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

Theseforward-looking statements are not guarantees of future performance. Readersare cautioned not to place undue reliance on these forward-looking statements,which speak only as of the date hereof. This discussion should be read in conjunctionwith “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2005 and the condensed consolidatedfinancial statements included elsewhere in this report.

**Overview**

We are a leading worldwide developer and producer ofhigh-performance compound and single element semiconductor substratescomprising gallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge).We currently sell the following substrate products:

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

 

We manufacturecompound semiconductor substrates using our proprietary vertical gradientfreeze, or VGF, technology.  Our in-houseVGF technology enables us to add capacity quickly and cost efficiently.  We manufacture all of our products in China,which generally has lower costs for facilities, labor and materials.

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

Revenue from continuing operations increased $12.6million, or 66.7%, to $31.4 million for the nine months endedSeptember 30, 2006 from $18.8 million for the same period of 2005primarily due to our improved product quality and higher customer demands forsix-inch diameter wafers. As of September 30, 2006, we had available cash,cash equivalents and short-term investments of $15.9 million, excludingrestricted deposits.

17

----

 

***Restructuring Charges***

In December 2005, as part of our ongoing effortto reduce our Fremont, California facility headcount, we further reduced thefacility’s work force by 15 full-time equivalent positions that we no longer requiredto support production and operations, or approximately 29% of theworkforce based at this facility.  Weexpect to save $0.9 million annually in payroll and related expenses. Accordingly,we recorded a restructuring charge of approximately $273,000 related to thereduction in force for severance-related expenses, of which $215,000 was thebalance as of December 31, 2005. We completed the reduction in force inthe first quarter of 2006.

As of September 30, 2006, the remaining restructuringaccrual for workforce reduction and for future lease payments related toabandoned U.S. facilities located in California that are no longer required tosupport production was zero, as these have all been paid.

**Critical Accounting Policies and Estimates**

We have prepared our condensed consolidated financialstatements in accordance with accounting principles generally accepted in theUnited States of America. As such, we have had to make estimates, assumptionsand judgments that affect the amounts reported on our financial statements.These estimates, assumptions and judgments about future events and theireffects on our results cannot be determined with certainty, and are made basedupon our historical experience and on other assumptions that are believed to bereasonable under the circumstances. These estimates may change as newevents occur or additional information is obtained, and we may periodicallybe faced with uncertainties, the outcomes of which are not within our controland may not be known for a prolonged period of time. The discussion andanalysis of our results of operations and financial condition are based upon thesecondensed consolidated financial statements.

We have identified the policies below as critical toour business operations and understanding of our financial condition andresults of operations.

A critical accounting policy is one that is bothmaterial to the presentation of our financial statements and requires us tomake difficult, subjective or complex judgments that could have a materialeffect on our financial condition and results of operations. Theymay require us to make assumptions about matters that are highly uncertainat the time of the estimate, and different estimates that we could have used,or changes in the estimate that are reasonably likely to occur, may have amaterial impact on our financial condition or results of operations.

We believe thatthe following are our critical accounting policies:

***RevenueRecognition***

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

We provide for future returns based on historicalexperience, current economic trends and changes in customer demand at the timerevenue is recognized. In the first quarter of 2004, we recorded a specificreserve for sales returns of $745,000 related to our failure to follow certaintesting requirements and provide testing data and information to certaincustomers. This reserve was based on discussions with some of the affectedcustomers and review of specific shipments. As of September 30, 2006, thisreserve balance was zero since approximately $487,000 had been utilized andapproximately $258,000 had been reversed to revenue as we favorably resolved anoutstanding matter with a customer.

***Allowancefor Doubtful Accounts***

We periodically review the likelihood of collection onour accounts receivable balances and provide an allowance for doubtful accountsreceivable primarily based upon the age of these accounts. We provide a 100%allowance for U.S. receivables in excess of 90 days and for foreign receivablesin excess of 120 days. We assess the probability of collection based on anumber of factors, including the length of time a receivable balance has beenoutstanding, our past history with the customer and their creditworthiness.

As of September 30, 2006 and December 31,2005, our accounts receivable, net, balance was $8.8 million and $5.2 million,respectively, which was net of an allowance for doubtful accounts of $0.2million and $0.6 million, respectively. If actual uncollectible accounts differsubstantially from our estimates, revisions to the estimated allowance for doubtfulaccounts would be required, which could have a material impact on our financialresults for the period.

18

----

 

***WarrantyReserve***

We maintain a warranty reserve based upon our claimsexperience during the prior twelve months. Warranty costs are accrued at thetime revenue is recognized. As of September 30, 2006 and December 31,2005, accrued product warranties totaled $571,000 and $120,000, respectively.If actual warranty costs differ substantially from our estimates, revisions tothe estimated warranty liability would be required, which could have a materialimpact on our financial condition and results of operations.

***InventoryValuation***

Inventories are stated at the lower of cost or market.Cost is determined using the weighted average cost method. Our inventoryconsists of raw materials as well as finished goods and work-in-process thatinclude material, labor and manufacturing overhead costs. Given the nature ofour substrate products, and the materials used in the manufacturing process,the wafers and ingots comprising work-in-process may be held in inventoryfor up to two years and three years, respectively, as the risk of obsolescencefor these materials is low. We routinely evaluate the levels of our inventoryin light of current market conditions in order to identify excess and obsoleteinventory, and we provide a valuation allowance for certain inventories basedupon the age and quality of the product and the projections for sale of thecompleted products. As of September 30, 2006 and December 31, 2005,we had an inventory reserve of $16.3 million and $16.9 million for excess andobsolete inventory, respectively. The majority of this inventory has not beenscrapped. If actual demand for our products were to be substantially lower thanestimated, additional inventory adjustments for excess or obsolete inventorymight be required, which could have a material impact on our business,financial condition and results of operations.

***Impairmentof Investments***

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

We invest in equity instruments of privately-heldcompanies for business and strategic purposes. These investments are classifiedas other assets and are accounted for under the cost method as we do not havethe ability to exercise significant influence over their operations. We monitorour investments for impairment and would record reductions in carrying valuewhen events or changes in circumstances indicate that the carrying valuemay not be recoverable. Determination of impairment is highly subjectiveand is based on a number of factors, including an assessment of the strength ofthe investee’s management, the length of time and extent to which the fairvalue has been less than our cost basis, the financial condition and near-termprospects of the investee, fundamental changes to the business prospects of theinvestee, share prices of subsequent offerings, and our intent and ability tohold the investment for a period of time sufficient to allow for anyanticipated recovery in our carrying value.

***Impairmentof Long-Lived Assets***

We evaluate the recoverability of property, equipmentand intangible assets in accordance with SFAS No. 144, *“Accounting for the Impairment or Disposal ofLong-Lived Assets.”* When events and circumstances indicate thatlong-lived assets may be impaired, we compare the carrying value of thelong-lived assets to the projection of future undiscounted cash flowsattributable to these assets. In the event that the carrying value exceeds thefuture undiscounted cash flows, we record an impairment charge against incomeequal to the excess of the carrying value over the assets’ fair value. Fairvalues are determined based on quoted market values, discounted cash flows orinternal and external appraisals, as applicable. Assets held for sale arecarried at the lower of carrying value or estimated net realizable value.

***EmployeeStock Options***

We grant options to substantially all managementemployees and believe that this program helps us to attract, motivate andretain high quality employees, to the ultimate benefit of our stockholders.Effective January 1, 2006, we adopted the fair value recognitionprovisions of SFAS No. 123 (revised 2004), “*Share-Based Paymen*,” (“SFAS 123(R)”),using the modified prospective application transition method. Under thistransition 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 estimatedexpense for the portion of the vesting period after January 1, 2006 forshare-based payments prior to, but not vested as of January 1, 2006, basedon the grant date fair value estimated in accordance with the originalprovisions of SFAS 123, “*Accounting for Stock-BasedCompensation.”* Results for prior periods have not been restated, asprovided for under the modified prospective application transitionmethod. See Note 3 to our condensed consolidated financial statements.

19

----

 

***IncomeTaxes***

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

We provide for income taxes based upon the geographiccomposition of worldwide earnings and tax regulations governing each region,including particularly the People’s Republic of China. The calculation of taxliabilities involves significant judgment in estimating the impact ofuncertainties in the application of complex tax laws, particularly in foreigncountries such as the People’s Republic of China.

**Resultsof Operations**

**Revenue**

|               | ** ** | **Three Months Ended September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------|------------|----------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **    | ** ** | **2006**                                                 | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**                           | ** ** | ** **   | ** ** | ** **     | ** ** |
| ** **    | ** ** | ** **                                               | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| GaAs          |       | $                                                        | 10,561     |         | $          | 5,353          |       | $ | 5,208 |   | 97.3 | % |
| InP           |       | 340                                                      |       | 234          |       | 106            |       | 45.3 | % |
| Ge            |       | 387                                                      |       | 5            |       | 382            |       | 7,640.0 | % |
| Raw materials |       | 1,251                                                    |       | 566          |       | 685            |       | 121.0 | % |
| Other         |       | 8                                                        |       | (5           | )          | 13             |       | 260 | % |
| Total revenue |       | $                                                        | 12,547     |         | $          | 6,153          |       | $ | 6,394 |   | 103.9 | % |

 

Revenue increased$6.4 million, or 103.9%, to $12.5 million for the three months endedSeptember 30, 2006 from $6.2 million for the three months endedSeptember 30, 2005. Total GaAs substrate revenue increased $5.2 million,or 97.3%, to $10.6 million for the three months ended September 30, 2006from $5.4 million for the three months ended September 30, 2005.

Sales of 5 inchand 6 inch diameter GaAs substrates were $5.3 million for the three monthsended September 30, 2006 compared with $1.6 million for the three monthsended September 30, 2005. The increase in larger diameter substraterevenue was due to the fact that, while the GaAs device market grew in strengthfor both cellular and the WLAN (Wide Local Area Network) markets, the compoundsemiconductor industry has been experiencing capacity constraints; with ourexcess capacity, we were able to benefit from the overflow business from ourcompetition.

 Sales of 2 inch, 3 inch and 4 inch diameterGaAs substrates were $5.3 million for the three months ended September 30,2006 compared with $3.5 million for the three months ended September 30,2005. The increase in revenue from smaller diameter substrates was due to thecontinued market growth generally of LED laser diodes and commercial epitaxy.

InP substraterevenue increased $106,000, or 45.3%, to $340,000 for the three months endedSeptember 30, 2006 from $234,000 for the three months endedSeptember 30, 2005. The increase in InP substrate revenue was due togreater overall demand.

Ge substraterevenue increased $382,000, or 7,640.0%, to $387,000 for the three months endedSeptember 30, 2006 from $5,000 for the three months endedSeptember 30, 2005. The increase in Ge substrate revenue was due to anincrease in customers in the People’s Republic of China (“PRC”) that have nowqualified our product, as demand for photovoltaic applications is high in thePRC.

Raw materialsrevenue increased $685,000, or 121.0%, to $1.3 million for the three monthsended September 30, 2006 from $0.6 million for the three months endedSeptember 30, 2005. The increase in raw materials revenue was primarilydue to sales of germanium dioxide to a new customer, and increased sales ofgallium to existing customers. The new customer for germanium dioxide islocated in North America, and has been purchasing consistently each quarter in2006. We expect this trend to continue.

20

----

 

**Revenue**

|               | ** ** | **Nine Months Ended September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------|------------|---------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **    | ** ** | **2006**                                                | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**                          | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs          |       | $                                                       | 25,441     |         | $          | 15,033         |       | $ | 10,408 |   | 69.2 | % |
| InP           |       | 1,249                                                   |       | 651          |       | 598            |       | 91.9 | % |
| Ge            |       | 592                                                     |       | 35           |       | 557            |       | 1,591.4 | % |
| Raw materials |       | 4,083                                                   |       | 3,095        |       | 988            |       | 31.9 | % |
| Other         |       | 8                                                       |       | 5            |       | 3              |       | 60.0 | % |
| Total revenue |       | $                                                       | 31,373     |         | $          | 18,819         |       | $ | 12,554 |   | 66.7 | % |

 

Revenue increased$12.6 million, or 66.7%, to $31.4 million for the nine months endedSeptember 30, 2006 from $18.8 million for the nine months endedSeptember 30, 2005. Total GaAs substrate revenue increased $10.4 million,or 69.2%, to $25.4 million for the nine months ended September 30, 2006from $15.0 million for the nine months ended September 30, 2005.

Sales of 5 inchand 6 inch diameter GaAs substrates were $11.4 million for the nine monthsended September 30, 2006 compared with $2.6 million for the nine monthsended September 30, 2005. The increase in larger diameter substraterevenue was due to the fact that, while the GaAs device market grew in strengthfor both cellular and the WLAN (Wide Local Area Network) markets, the compoundsemiconductor industry has been experiencing capacity constraints; with ourexcess capacity, we were able to benefit from the overflow business from ourcompetition.

Sales of 2 inch, 3inch and 4 inch diameter GaAs substrates were $13.9 million for the nine monthsended September 30, 2006 compared with $12.2 million for the nine monthsended September 30, 2005. We have sold a larger quantity of smallerdiameter wafers in 2006 than in 2005, but generated similar dollar revenue dueto continued pricing pressures, which caused average sales prices to decline.The increase in revenue from smaller diameter substrates was due to thecontinued market growth generally of LED laser diodes and commercial epitaxy.

InP substraterevenue increased $0.6 million, or 91.9%, to $1.2 million for the nine monthsended September 30, 2006 from $0.7 million for the nine months endedSeptember 30, 2005. While overall demand for InP has increased over thepast year, the higher than expected increase in InP substrate revenue was dueto the receipt of one large customer order for a government contract, which isnot expected to repeat for the remainder of 2006. While we are beginning to seeevidence of renewed growth in the optical networking industry, which uses InPto manufacture telecom lasers and may result in growth in InP substrate sales,we have not yet seen a large movement in this direction.

Ge substraterevenue increased $0.6 million, or 1,591.4%, to $0.6 million for the ninemonths ended September 30, 2006 from $35,000 for the nine months endedSeptember 30, 2005. The increase in Ge substrate revenue was due to anincrease in customers in the PRC that have now qualified our product, as demandfor photovoltaic applications is high in the PRC.

Raw materialsrevenue increased $1.0 million, or 31.9%, to $4.1 million for the nine monthsended September 30, 2006 from $3.1 million for the nine months endedSeptember 30, 2005. The increase in raw materials revenue was primarilydue to sales of germanium dioxide to a new customer, and increased sales ofgallium to existing customers. The new customer for germanium dioxide islocated in North America, and has been purchasing consistently each quarter in2006. We expect this trend to continue. Our raw materials business isincreasingly becoming an important part of our business, both in terms ofproviding us protection against raw materials pricing increases and supplyconstraints and in opportunities for sales of raw materials. Accordingly, weexpect to continue to expand our raw materials sales efforts and explore newand additional investment opportunities.

21

----

 

***Revenueby Geographic Region***
| ** **                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                 | ** ** | **2006**                                                 | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                 | ** ** | **($ in thousands)**                           | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                            |       | $                                                        | 3,033      |         | $          | 1,481          |       | $ | 1,552 |   | 104.8 | % |
| *% of  total revenue*                      |       | 24.2                                                     | %          | 24.1         | %          |           |       |   |   |
| Europe                                     |       | 2,012                                                    |       | 1,328        |       | 684            |       | 51.5 | % |
| *% of  total revenue*                      |       | 16.0                                                     | %          | 21.6         | %          |           |       |   |   |
| Japan                                      |       | 842                                                      |       | 1,087        |       | (245           | )          | (22.5 | )% |
| *% of  total revenue*                      |       | 6.7                                                      | %          | 17.7         | %          |           |       |   |   |
| Taiwan                                     |       | 2,869                                                    |       | 704          |       | 2,165          |       | 307.5 | % |
| *% of  total revenue*                      |       | 22.9                                                     | %          | 11.4         | %          |           |       |   |   |
| Asia Pacific (excluding  Japan and Taiwan) |       | 3,791                                                    |       | 1,553        |       | 2,238          |       | 144.1 | % |
| *% of  total revenue*                      |       | 30.2                                                     | %          | 25.2         | %          |           |       |   |   |
| Total revenue                              |       | $                                                        | 12,547     |         | $          | 6,153          |       | $ | 6,394 |   | 103.9 | % |

----

*                    Primarilythe United States

North Americarevenue increased by $1.5 million, or 104.8%, to $3.0 million for the threemonths ended September 30, 2006 from $1.5 million for the three monthsended September 30, 2005. We believe our quality has improved as shown bycustomers that have qualified our products manufactured in the PRC as sales toexisting customers increased by $0.7 million, while we gained $0.8 million insales to new customers.

Europe revenueincreased by $0.7 million, or 51.5%, to $2.0 million for the three months endedSeptember 30, 2006 from $1.3 million for the three months endedSeptember 30, 2005. This increase came from increased substrate sales tocustomers in France and Germany, partially offset by decreases in sales to customersin Switzerland and the United Kingdom.

Japan revenuedecreased by $0.2 million, or 22.5%, to $0.8 million for the three months endedSeptember 30, 2006 from $1.1 million for the three months endedSeptember 30, 2005. The decrease resulted from lower substrate sales toone customer.

Taiwan revenueincreased by $2.2 million, or 307.5%, to $2.9 million for the three monthsended September 30, 2006 from $0.7 million for the three months endedSeptember 30, 2005. The increase of $2.2 million was due to sales toexisting customers mainly in larger diameter wafers.

Asia Pacific(excluding Japan and Taiwan) revenue increased by $2.2 million, or 144.1%, to$3.8 million for the three months ended September 30, 2006 from $1.6million for the three months ended September 30, 2005. Of this increase,sales to customers in the PRC accounted for $0.5 million of the increase inGaAs substrate sales, $0.4 million of the increase in Ge substrate sales, and$0.5 million of the increase in raw material sales. Revenue from sales to customersin Malaysia, Korea and Singapore accounted for $0.8 million of the increase inGaAs substrate sales.

22

----

 
| ** **                                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                 | ** ** | **2006**                                                | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                 | ** ** | **($ in thousands)**                          | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                            |       | $                                                       | 7,704      |         | $          | 3,684          |       | $ | 4,020 |   | 109.1 | % |
| *% of  total revenue*                      |       | 24.6                                                    | %          | 19.6         | %          |           |       |   |   |
| Europe                                     |       | 5,684                                                   |       | 4,911        |       | 773            |       | 15.7 | % |
| *% of  total revenue*                      |       | 18.1                                                    | %          | 26.1         | %          |           |       |   |   |
| Japan                                      |       | 2,638                                                   |       | 1,887        |       | 751            |       | 39.8 | % |
| *% of  total revenue*                      |       | 8.4                                                     | %          | 10.0         | %          |           |       |   |   |
| Taiwan                                     |       | 5,782                                                   |       | 2,840        |       | 2,942          |       | 103.6 | % |
| *% of  total revenue*                      |       | 18.4                                                    | %          | 15.1         | %          |           |       |   |   |
| Asia Pacific (excluding  Japan and Taiwan) |       | 9,565                                                   |       | 5,497        |       | 4,068          |       | 74.0 | % |
| *% of  total revenue*                      |       | 30.5                                                    | %          | 29.2         | %          |           |       |   |   |
| Total revenue                              |       | $                                                       | 31,373     |         | $          | 18,819         |       | $ | 12,554 |   | 66.7 | % |

----

*                    Primarilythe United States

North Americarevenue increased by $4.0 million, or 109.1%, to $7.7 million for the ninemonths ended September 30, 2006 from $3.7 million for the nine monthsended September 30, 2005. We believe our quality has improved as shown bycustomers that have qualified our products manufactured in the PRC as sales toexisting customers increased by $2.6 million, while we gained $1.4 million insales to new customers.

Europe revenueincreased by $0.8 million, or 15.7%, to $5.7 million for the nine months endedSeptember 30, 2006 from $4.9 million for the nine months endedSeptember 30, 2005. This increase resulted from increased substrate salesto customers in France, partially offset by decreases in sales to customers inthe United Kingdom. In the United Kingdom, we lost one customer in the secondhalf of 2005 due to quality problems with our product. We are beginning toregain sales to this customer as it began placing orders with us again in 2006.

Japan revenueincreased by $0.8 million, or 39.8%, to $2.6 million for the nine months endedSeptember 30, 2006 from $ 1.9 million for the nine months endedSeptember 30, 2005. Raw material sales to a new customer accounted for$0.3 million of this increase, while $0.5 million was from substrate sales toexisting customers, mainly for larger diameter wafers.

Taiwan revenueincreased by $2.9 million, or 103.6%, to $5.8 million for the nine months endedSeptember 30, 2006 from $2.8 million for the nine months endedSeptember 30, 2005. The increase was due to sales to existing customers of$2.7 million mainly in large diameter wafers, while we gained $0.2 million insales to new customers mainly in smaller diameter wafers.

Asia Pacific(excluding Japan and Taiwan) revenue increased by $4.1 million, or 74.0%, to$9.6 million for the nine months ended September 30, 2006 from $5.5million for the nine months ended September 30, 2005. Of this increase,sales to customers in Malaysia and Singapore accounted for $2.0 million of theincrease, mainly in larger diameter wafers, while sales to customers in the PRCincreased by $1.8 million, and sales to customers in Korea increased by $0.3million.

23

----

 

***GrossProfit***
| ** **      | ** ** | **Three Months Ended September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------|------------|----------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **      | ** ** | **2006**                                                 | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **($ in thousands)**                           | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit    |       | $                                                        | 3,479      |         | $          | 1,145          |       | $ | 2,334 |   | 203.8 | % |
| *Gross Margin%* |       | 27.7                                                     | %          | 18.6         | %          |           |       |   |   |
|                 |            |                                                          |            |              |            |                |            |  |  |  |  |  |

 

Gross marginincreased to 27.7% of total revenue for the three months endedSeptember 30, 2006 from 18.6% of total revenue for the three months endedSeptember 30, 2005. Gross margin in the three months endedSeptember 30, 2006 was positively impacted by sales of approximately$802,000 of gallium arsenide (GaAs) wafers that were previously fully reserved.Product mix also contributed to higher gross margins as we sold a greateramount of InP substrates, as well as larger diameter GaAs wafers, both of whichcontributed larger gross margins. In December 2005, we reduced theworkforce at our Fremont, California facility to eliminate positions that we nolonger required to support production, and this reduction accounted forapproximately 2% of the increase in gross margin in the three months endedSeptember 30, 2006. Gross margin in the three months endedSeptember 30, 2005 was positively impacted by sales of approximately$686,000 of GaAs wafers that were previously fully reserved, and byapproximately $205,000 as a result of a reversal of a sales return reserveestablished in 2004 as we favorably resolved an outstanding matter with acustomer. See our risk factor related to “Changes in tariffs, importrestrictions, export restrictions or other trade barriers that may reduce grossmargins.”
| ** **      | ** ** | **Nine Months Ended September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------|------------|---------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **      | ** ** | **2006**                                                | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **($ in thousands)**                          | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit    |       | $                                                       | 7,748      |         | $          | 1,551          |       | $ | 6,197 |   | 399.5 | % |
| *Gross Margin%* |       | 24.7                                                    | %          | 8.2          | %          |           |       |   |   |
|                 |            |                                                         |            |              |            |                |            |  |  |  |  |  |

 

* *Gross margin increased to24.7% of total revenue for the nine months ended September 30, 2006 from8.2% of total revenue for the nine months ended September 30, 2005. Grossmargin in the nine months ended September 30, 2006 was positively impactedby sales of approximately $2.2 million of GaAs wafers that 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 ofInP substrates and larger diameter GaAs wafers in the nine months endedSeptember 30, 2006, which contributed higher gross margins. InDecember 2005, we reduced the workforce at our Fremont, Californiafacility to eliminate positions that we no longer required to supportproduction, and this reduction accounted for approximately 3% to gross marginin the nine months ended September 30, 2006. We had manufacturingequipment that became fully depreciated in 2006, and the absence ofdepreciation expense for this equipment contributed approximately 1% to grossmargin in the nine months ended September 30, 2006. Gross margin in thenine months ended September 30, 2005 was positively impacted by sales ofapproximately $1.5 million of gallium arsenide (GaAs) wafers, which werepreviously fully reserved, and by approximately $205,000 as a result of areversal of a sales return reserve established in 2004 as we favorably resolvedan outstanding matter with a customer, offset by the negative impact of a$765,000 charge to cost of revenue as a result of an inventory valuationadjustment, as well as a decline in our average selling prices. See our riskfactor related to “Changes in tariffs, import restrictions, export restrictionsor other trade barriers that may reduce gross margins.”

***Selling,General and Administrative Expenses***
| ** **                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **2006**                                                 | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**                           | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and  administrative expenses |       | $                                                        | 2,641      |         | $          | 2,898          |       | $ | (257 | ) | (8.9 | )% |
| *% of total revenue*                          |       | 21.0                                                     | %          | 47.1         | %          |           |       |   |   |
|                                               |            |                                                          |            |              |            |                |            |  |  |  |  |  |

 

Selling, generaland administrative expenses decreased $0.3 million to $2.6 million for thethree months ended September 30, 2006 from $2.9 million for the threemonths ended September 30, 2005. The decrease was primarily due to $0.3million in legal fees reimbursed by our insurance company for fees incurred inconnection with ongoing litigation described elsewhere in this report, adecrease in bad debt expense of $0.3 million as we collected on past dueaccounts, a decrease in severance payments of $0.2 million from the prior yearchange of sales staff, and a $0.1 million decrease in general legal feespartially offset by an increase in decontamination expense of $0.3 million aswe prepare our U.S. property in Fremont, California for sale, an increase inbonus payments of $0.1 million, an increase in consulting fees for compliancewith the Sarbanes-Oxley Act of 2002 of $0.1 million, and an increase instock-based compensation expense of $0.1 million.

24

----

 
| ** **                                    | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general  and administrative expenses |       | $                                                   | 9,724      |         | $          | 9,866          |       | $ | (142 | ) | (1.4 | )% |
| *% of  total revenue*                         |       | 31.0                                                | %          | 52.4         | %          |           |       |   |   |
|                                               |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Selling, generaland administrative expenses decreased $0.1 million to $9.7 million for the ninemonths ended September 30, 2006 from $9.9 million for the nine monthsended September 30, 2005. The decrease was primarily due to a decrease of$1.4 million in decontamination expense as we are preparing our U.S. propertyin Fremont, California for sale, a decrease of $0.3 million in legal feesreimbursed by our insurance company for fees incurred in connection withongoing litigation described elsewhere in this report, and a decrease of $0.1million in recruiting fees, partially offset by an increase of $0.4 million instock-based compensation expense, an increase of $0.3 million in bonuses, anincrease of $0.3 million in sales discount compensation expenses, an increaseof $0.2 million for facility depreciation reclassed from cost of revenue, anincrease of $0.2 million in audit and tax fees, and an increase of $0.2 millionfor consulting fees for compliance with the Sarbanes-Oxley Act of 2002, and anincrease of $0.1 million in general legal fees.

***Researchand Development***
| ** **                | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                | ** ** | **2006**                                             | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and  development |       | $                                                    | 392        |         | $          | 472            |       | $ | (80 | ) | (16.9 | )% |
| *% of  total revenue*     |       | 3.1                                                  | %          | 7.7          | %          |           |       |   |   |
|                           |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Research anddevelopment expenses decreased $80,000, or 16.9%, to $0.4 million for the threemonths ended September 30, 2006 from $0.5 million for the three monthsended September 30, 2005, as a result of $0.1 million salary savings frompersonnel reductions in 2006 and $0.1 million reduced expenses on new productstesting, partially offset by $0.1 million stock-based compensation costs in2006 not present in 2005.
| ** **                | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and  development |       | $                                                   | 1,497      |         | $          | 1,257          |       | $ | 240 |   | 19.1 | % |
| *% of  total revenue*     |       | 4.8                                                 | %          | 6.7          | %          |           |       |   |   |
|                           |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Research anddevelopment expenses increased $0.2 million, or 19.1%, to $1.5 million for thenine months ended September 30, 2006 from $1.3 million for the nine monthsended September 30, 2005, as a result of stock-based compensation costs of$0.2 million and increased bonuses of $0.1 million, partially offset by $0.1million salary savings from personnel reductions in 2006.

***Impairmentcharge***
| ** **            | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2006**                                             | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Impairment  charge    |       | $                                                    | 1,417      |         | $          | —         |       | $ | 1,417 |   | 100.0 | % |
| *% of  total revenue* |       | 11.3                                                 | %          | 0.0          | %          |           |       |   |   |
|                       |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

During the three months ended September 30, 2006,we incurred an impairment charge of $1.4 million to write down our U.S.property in Fremont, California, which has been decontaminated and is beingprepared for sale. This property has been classified as “Assets held for sale”in the amount of $4.7 million on the condensed consolidated balance sheet as ofSeptember 30, 2006.

25

----

 
| ** **            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Impairment  charge    |       | $                                                   | 1,417      |         | $          | —         |       | $ | 1,417 |   | 100.0 | % |
| *% of  total revenue* |       | 4.5                                                 | %          | 0.0          | %          |           |       |   |   |
|                       |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

During the nine months ended September 30, 2006,we incurred an impairment charge of $1.4 million to write down our U.S.property in Fremont, California, which has been decontaminated and is beingprepared for sale. This property has been classified as “Assets held for sale”in the amount of $4.7 million on the condensed consolidated balance sheet as ofSeptember 30, 2006.

***Restructuring***
| ** **            | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2006**                                             | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Restructuring         |       | $                                                    | —     |         | $          | 14             |       | $ | (14 | ) | (100.0 | )% |
| *% of  total revenue* |       | 0.0                                                  | %          | 0.2          | %          |           |       |   |   |
|                       |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

During the three months ended September 30, 2006,we incurred no restructuring charges. During the three months endedSeptember 30, 2005, we recorded restructuring charges of $14,000, of which$5,000 related to leasecosts associated with facilities located in California that are no longerrequired to support production, and $9,000 related to the closure of our Japanoffice.
| ** **            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Restructuring         |       | $                                                   | (2         | )            | $          | 376            |       | $ | (378 | ) | (100.5 | )% |
| *% of  total revenue* |       | (0.0                                                | )%         | 2.0          | %          |           |       |   |   |
|                       |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

During the nine months ended September 30, 2006,we recognized a $2,000 gain related to an adjustment to a prior accrual. Duringthe nine months ended September 30, 2005, we recorded restructuringcharges of $0.4 million, of which $0.2 million related to lease costs associated with facilitieslocated in California that are no longer required to support production, $0.1million related to the closure of our Japan office, and $0.1 million related tothe reduction in our PRC work force we effected in March 2005.

***InterestIncome, net***
| ** **            | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2006**                                             | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income,  net |       | $                                                    | 103        |         | $          | 136            |       | $ | (33 | ) | (24.3 | )% |
| *% of  total revenue* |       | 0.8                                                  | %          | 2.2          | %          |           |       |   |   |
|                       |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Interest income, net decreased $33,000 to $0.1 millionfor the three months ended September 30, 2006 from $0.1 million for thethree months ended September 30, 2005 as a result of higher interest ratesearned on our investments, partially offset by higher interest rates on ourdebt, which we have continued to pay down. We also had lower cash balances.
| ** **            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income,  net |       | $                                                   | 342        |         | $          | 386            |       | $ | (44 | ) | (11.4 | )% |
| *% of  total revenue* |       | 1.1                                                 | %          | 2.1          | %          |           |       |   |   |
|                       |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Interest income, net decreased $44,000 to $0.3 millionfor the nine months ended September 30, 2006 from $0.4 million for thenine months ended September 30, 2005 as a result of higher interest ratesearned on our investments, partially offset by higher interest rates on ourdebt, which we have continued to pay down. We also had lower cash balances.

26

----

 

***Other Income and Expense,net***
| ** **                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                   | ** ** | **2006**                                             | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                   | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income  (expense), net |       | $                                                    | 641        |         | $          | (193           | )          | $ | 834 |   | 432.1 | % |
| *% of  total revenue*        |       | 5.1                                                  | %          | (3.1         | )%         |           |       |   |   |
|                              |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Other income, netwas $0.6 million for the three months ended September 30, 2006 due to arealized gain of $0.7 million on the sale of 300,000 shares of common stock ofFinisar Corporation, partially offset by minority interests in our jointventures. Other expense was $0.2 million for the three months endedSeptember 30, 2005 primarily due to foreign exchange losses related to theJapanese yen and minority interests in our joint ventures.
| ** **                   | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                   | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                   | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income  (expense), net |       | $                                                   | 1,693      |         | $          | (494           | )          | $ | 2,187 |   | 442.7 | % |
| *% of  total revenue*        |       | 5.4                                                 | %          | (2.6         | )%         |           |       |   |   |
|                              |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Other income, netwas $1.7 million for the nine months ended September 30, 2006 due to arealized gain of $2.2 million on the sale of 700,000 shares of common stock ofFinisar Corporation, partially offset by minority interests in our jointventures. Other expense was $0.5 million for the nine months endedSeptember 30, 2005 primarily due to foreign exchange losses related to theJapanese yen and minority interests in our joint ventures.

***Provisionfor Income Taxes***
| ** **                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                            | ** ** | **2006**                                             | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision  (benefit) for income taxes |       | $                                                    | (862       | )            | $          | 45             |       | $ | (907 | ) | (2,015.6 | )% |
| *% of  total revenue*                 |       | (6.9                                                 | )%         | 0.7          | %          |           |       |   |   |
|                                       |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

In 2005, theInternal Revenue Service closed its examination of our tax return for the 2002tax year, including the calculation of our 1999 and 2000 net operating losscarryback. As a result of this, we reversed approximately $1.0 million of incometax payable accrued for potential exposures relating to those years shown as abenefit from income taxes in 2006, partially offset by a provision for incometaxes of $0.1 million, which was related to our foreign subsidiaries. Provisionfor income taxes, which was related to our foreign subsidiaries, was $45,000for the three months ended September 30, 2005.
| ** **                            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                            | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision  (benefit) for income taxes |       | $                                                   | (406       | )            | $          | 98             |       | $ | (504 | ) | (514.3 | )% |
| *% of  total revenue*                 |       | (1.3                                                | )%         | 0.5          | %          |           |       |   |   |
|                                       |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

In 2005, theInternal Revenue Service closed its examination of our tax return for the 2002tax year, including the calculation of our 1999 and 2000 net operating losscarryback. As a result of this, we reversed approximately $1.0 million ofincome tax payable accrued for potential exposures relating to those years,partially offset by a provision for income taxes of $0.5 million, which wasrelated to our foreign subsidiaries. Provision for income taxes, which wasrelated to our foreign subsidiaries, was $0.1 million for the three monthsended September 30, 2005. The reason for the increase was a combination ofhigher income from processing fees in our overseas subsidiary at higher taxrates.

***Gain from DiscontinuedOperations***
| ** **                                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                                            | ** ** | **2006**                                             | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                                            | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from  discontinued operations and gain from disposal, net of tax |       | $                                                    | 4          |         | $          | 259            |       | $ | (255 | ) | (98.5 | )% |
| *% of  total revenue*                                                 |       | 0.0                                                  | %          | 4.2          | %          |           |       |   |   |
|                                                                       |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

27

----

 

For the threemonths ended September 30, 2006, we recorded $4,000 in interest income oncash balances held in the discontinued operations. During the three monthsended September 30, 2005, we recorded a gain on discontinued operationsfor the release of the remaining $0.3 million that was held in escrow on thesale of our opto-electronics business to Lumei Optoelectronics Corp. The $0.3million was held in escrow to satisfy any claims that the purchaser might makefor breaches of representations or warranties by us, and was released inSeptember 2005, with approximately $9,000 in accrued interest.
| ** **                                                            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                                            | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                                            | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from discontinued  operations and gain from disposal, net of tax |       | $                                                   | 7          |         | $          | 670            |       | $ | (663 | ) | (99.0 | )% |
| *% of  total revenue*                                                 |       | 0.0                                                 | %          | 3.6          | %          |           |       |   |   |
|                                                                       |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

For the ninemonths ended September 30, 2006, we recorded $7,000 in interest income oncash balances held in the discontinued operations. For the nine months endedSeptember 30, 2005, the $0.7 million gain from discontinued operations wasmade up of a gain of $0.3 million, which was the remaining portion of the first$0.8 million held in escrow due to us from the sale of our opto-electronicsbusiness, $0.1 million in property tax refunds, a gain of $0.1 million from thesale of a building located in Monterey Park, California, and the remaining $0.3million that was held in escrow on the sale of our opto-electronics business toLumei Optoelectronics Corp. The final $0.3 million was released inSeptember 2005, with approximately $9,000 in accrued interest.

**Liquidity and Capital Resources**

As ofSeptember 30, 2006, our principal sources of liquidity were $15.9 millionin cash and cash equivalents and short-term investments, excluding restricteddeposits. 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. We continue to sell the shares of common stock in Finisar held byus, as described below.

Cash and cashequivalents and short-term investments decreased $7.1 million to $15.9 million as of September 30,2006 from $23.0 million as of December 31, 2005. Included in this $7.1million decrease was the additional cash of $2.0 million from the realized gainon our sale of 700,000 shares of Finisar common stock in the nine months endedSeptember 30, 2006. We plan to sell additional Finisar stock during theremainder of 2006. As of September 30, 2006, we continued to hold 474,000shares of Finisar common stock.

Net cash used inoperating activities of $7.8 million for the nine months endedSeptember 30, 2006 was primarily comprised of our net loss of $2.4million, adjusted for non-cash items of depreciation of $2.4 million, arealized gain on sale of investments of $2.0 million, an asset impairmentcharge of $1.4 million, stock-based compensation of $0.6 million, and by a netchange of $7.8 million in assets and liabilities. The net increase in assetsand liabilities resulted from a $3.6 million increase in accounts receivable,net, a $2.3 million increase in prepaid expenses, primarily from foreign taxesprepaid and prepayments to vendors, a $1.3 million decrease in income taxespayable, primarily from the reversal of approximately $1.0 million of incometax payable accrued for potential exposures that have expired, a $1.2 millionincrease in inventories, net, a $0.8 million decrease in accrued liabilities,primarily for restructuring costs and decommissioning expenses, and partially offset by a $1.0 millionincrease in accounts payable and a $0.3 million increase in other long-termliabilities. Net accounts receivable increased by $3.6 million, or 68.4%, to$8.8 million as of September 30, 2006 from $5.2 million as ofDecember 31, 2005. The increase was primarily a result of our increasedsales. Our days sales outstanding was 65 days as of September 30, 2006compared to 62 days as of December 31, 2005.

Net cash providedby investing activities of $0.6 million for the nine months ended September 30,2006 was primarily from the proceeds from net sales of investments of $2.3million and the decrease of restricted cash of $0.3 million, largely offset bythe purchase of property, plant and equipment, net, of $2.0 million.

We expect toinvest approximately $1.0 million in capital projects during the remainder of2006. We believe that our existing and planned facilities and equipment aresufficient to fulfill current and expected future orders.

28

----

 

Net cash used infinancing activities for the nine months ended September 30, 2006consisted of payments of $0.5 million related to long-term borrowings, largelyoffset by proceeds of $0.5 million received on exercise of stock optionsthrough our stock option program.

Our main Fremont,California manufacturing facility is financed by long-term borrowings, whichwere refinanced by taxable variable rate revenue bonds in 1998. These bondsmature in 2023 and bear interest at a variable rate that was 5.42% as ofSeptember 30, 2006. The bonds are traded in the public market. Repaymentof principal and interest under the bonds is supported by a letter of creditfrom our bank and is paid on a quarterly basis. We have the option to redeemthe bonds in whole or in part during their term. As of September 30,2006, $7.2 million was outstanding under these bonds.

As ofSeptember 30, 2006,the credit facility maintained by us with a bank included a letter of creditsupporting repayment of our revenue bonds with an outstanding amount of $7.2million. We have pledged and placed a like amount of investment securities withan affiliate of the bank as additional collateral for this facility.

We believe that wehave adequate cash and investments to meet our needs over the next twelvemonths. In June 2006, we filed a registration statement on Form S-3 withthe Securities and Exchange Commission, which was declared effective by the SECin August 2006. Under the shelf registration process, we may fromtime to time offer shares of our common stock with a total value of up to $25.0million. The shelf registration statement provides us with flexibility to fundworking capital, including future capital expenditures, research anddevelopment, and potential investments or acquisitions in complementarybusinesses, products and technologies. However, we have no specific agreements,commitments or understandings with respect to any transactions at this time.There can be no assurance that such additional capital will be available or, ifavailable, it will be at terms acceptable to us.

In September 2006, tax authorities in the PRCannounced their intention to impose customs duties on, and to reduce oreliminate refunds of value-added taxes that companies pay when they purchasecertain raw materials, including gallium and arsenic.  The combination ofthese actions could significantly increase our costs and impact our cash flows.Implementing regulations are not expected to be published before late November,and it is possible that these regulations will not be adopted or that changeswill be made in their outline before adoption.  Lobbying efforts are beingmade to remove gallium and arsenic from the list of affected materials, butthere is no way to know if these efforts will have any impact on the final formof the regulations.  There appears to be a possibility that thevalue-added tax refund on gallium will not be completely eliminated, but merelyreduced.  If the regulations are adopted as currently proposed, they wouldnot have a material impact on our fourth quarter results because theywould only be in effect for a portion of the quarter.  They may,however, potentially have a significant adverse impact on our gross margins andnet income (loss) in 2007, although we do not have the facts necessary toestimate its magnitude at this time.  We are also exploring alternativesfor restructuring our operations in the PRC in order to mitigate theimpact of these regulations if and when they are adopted.   Wewill not know the exact impact of any restructuring or the amount of time thatit might take to accomplish until toward the end of this year.

Cash fromoperations could be affected by various risks and uncertainties, including, butnot limited to, those set forth below under “Item 1A. Risk Factors.”

Outstandingcontractual obligations as of September 30, 2006 are summarized as follows(in thousands):
| ** **                       | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less Than  1 Year** | ** ** | **1 - 3 Years** | ** ** | **3 - 5 Years** | ** ** | **More Than  5 Years** | ** ** |
| Long-term debt                   |       | $                                         | 7,253      |   | $ | 450 |   | $ | 1,003 |   | $ | 900 |   | $ | 4,900 |   |
| Operating leases                 |       | 4,721                                     |       | 664 |   | 1,387 |   | 1,519 |   | 1,151 |   |
| Total                            |       | $                                         | 11,974     |   | $ | 1,114 |   | $ | 2,390 |   | $ | 2,419 |   | $ | 6,051 |   |

 

We lease certainoffice space, manufacturing facilities and property under long-term operatingleases expiring at various dates through March 2013. Total rent paymentsunder these operating leases were approximately $0.8 million and $1.0 millionfor the nine months ended September 30, 2006 and 2005, respectively.

29

----

 

**Recent Accounting Pronouncements**

In February 2006, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 155, “*Accounting for CertainHybrid Instruments — an amendment of FASB Statements No. 133 and 140”*(“SFAS 155”)*.* SFAS 155 amends SFAS No. 133, “*Accounting for Derivative Instruments and Hedging Activities*”(“SFAS 133”) and SFAS No. 140, “*Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*”(“SFAS 140”). SFAS 155 allows entities the option of applying fair valueaccounting to certain hybrid financial instruments in their entirety if theycontain embedded derivatives that would otherwise require bifurcation underSFAS 133. SFAS 155 will be effective for us as of January 1, 2007. We arecurrently assessing the impact that SFAS 155 may have on our consolidatedfinancial position, results of operations or cash flows.

In June 2006, the FASB issued FASB Interpretation No. 48, “*Accounting For Uncertain Tax Positions — An Interpretation of FASBStatement No. 109”*(“FIN 48”). FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, “*Accounting for IncomeTaxes*”. It prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. FIN 48 also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. FIN 48 is effective for fiscalyears beginning after Decemeber 15, 2006. We are currently assessing the impactof the adoption that FIN 48 may have on our consolidated financial position,results of operations or cash flows.

In June 2006, theFASB ratified the consensus reached by the EITF on Issue No. 06-3, *How Taxes Collected from Customers and Remitted toGovernmental Authorities Should Be Presented in the Income Statement (That Is,Gross versus Net Presentation)*(“ EITF 06-3”). EITF 06-3 includesany tax assessed by a governmental authority that is directly imposed on arevenue-producing transaction between a seller and a customer and may include,but is not limited to, sales, use, value added, and some excise taxes. EITF06-3 concludes that the presentation of taxes on either a gross (included inrevenues and costs) or a net (excluded from revenues) basis is an accountingpolicy decision that should be disclosed. In addition, for any such taxes thatare reported on a gross basis, a company should disclose the amounts of thosetaxes in interim and annual financial statements for each period for which anincome statement is presented if those amounts are significant. The provisionsof EITF 06-3 should be applied to financial reports for interim and annualreporting periods beginning after December 15, 2006, with earlier adoptionpermitted. We are currently assessing the impact of the adoption that EITF 06-3may have on our consolidated financial position, results of operationsor cash flows.

In September 2006,the FASB issued SFAS No. 157, “*Fair Value Measurements*”(“SFAS 157”). SFAS 157 provides a new single authoritative definition of fairvalue and provides enhanced guidance for measuring the fair value of assets andliabilities and requires additional disclosures related to the extent to whichcompanies measure assets and liabilities at fair value, the information used tomeasure fair value, and the effect of fair value measurements on earnings. SFAS157 is effective for us as of January 1, 2008. We are currently assessing theimpact, if any, of SFAS 157 on our consolidated financial position, results ofoperations or cash flows.

In September 2006,the FASB issued SFAS No. 158, “*Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans — an amendment of FASBStatements No. 87, 88, 106, and 132(R)*” (“SFAS 158”). SFAS 158requires balance sheet recognition of the overfunded or underfunded status ofpension and postretirement benefit plans. Under SFAS 158, actuarial gains andlosses, prior service costs or credits, and any remaining transition assets orobligations that have not been recognized under previous accounting standardsmust be recognized as a component of accumulated other comprehensive income(loss) within stockholders’ equity, net of tax effects, until they areamortized as a component of net periodic benefit cost. In addition, themeasurement date and the date at which plan assets and the benefit obligationare measured, are required to be the company’s fiscal year-end. SFAS 158 iseffective for us as of December 31, 2007, except for the measurement dateprovisions, which are effective December 31, 2009. The adoption of SFAS 158 isnot expected to have a material impact on our consolidated financial position,results of operations or cash flows.

In September 2006,the SEC released Staff Accounting Bulletin No. 108, “*Consideringthe Effects of Prior Year Misstatements When Quantifying Misstatements inCurrent Year Financial Statements*” (“SAB 108”). SAB 108 providesinterpretative guidance on how public companies quantify financial statementmisstatements. There have been two common approaches used to quantify sucherrors. Under an income statement approach, the “roll-over” method, the erroris quantified as the amount by which the current year income statement ismisstated. Alternatively, under a balance sheet approach, the “iron curtain”method, the error is quantified as the cumulative amount by which the currentyear balance sheet is misstated. In SAB 108, the SEC established an approachthat requires quantification of financial statement misstatements based on theeffects of the misstatements on each of the company’s financial statements andthe related financial statement disclosures. This model is commonly referred toas a “dual approach” because it requires quantification of errors under boththe roll-over and iron curtain methods. SAB 108 is effective for us as ofJanuary 1, 2007. The adoption of SAB 108 is not expected to have a materialimpact on our consolidated financial position, results of operations or cashflows.

30

----

 

**ITEM3*.*QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

**Foreign Currency Exchange Rate Exposure**

We operate in the United States andmanufacture in China. The substantial majority of our sales to date have beenmade and continue to be made in U.S. dollars. Substantially all of our expensesfrom our China operations are incurred in the Chinese Renminbi. As a result,currency fluctuations between the U.S. dollar and the Chinese Renminbi couldcause foreign currency transaction gains or losses that we would recognize inthe period incurred.

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

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

**InterestRate Risk**

Cash and cashequivalents earning interest and certain investments are subject to interestrate fluctuations. The following table sets forth the probable impact of a 10%change in interest rates (in thousands):
| **Instrument**   | ** ** | **Balance as of  September 30, 2006** | ** ** | **Current  Interest  Rate** | ** ** | **Projected Annual  Interest  Income/(Expense)** | ** ** | **Pro Forma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Pro Forma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|------------------|------------|-----------------------------------------------------------|------------|-----------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Cash             |       | $                                                         | 6,591      |                        | 0.50       | %                                                     | $          | 33                                                                         |       | $                                                                           | 30         |   | $ | 36 |   |
| Cash equivalents |       | 3,996                                                     |       | 5.21                        |       | 208                                                   |       | 187                                                                        |       | 229                                                                         |       |
| Investments      |       | 11,254                                                    |       | 4.49                        |       | 505                                                   |       | 455                                                                        |       | 556                                                                         |       |
| Long-term debt   |       | (7,150                                                    | )          | 5.42                        |       | (388                                                  | )          | (349                                                                       | )          | (426                                                                        | )          |
|             |       |                                                      |       |                        |       | $                                                     | 358        |                                                                       | $          | 323                                                                         |       | $ | 395 |   |
|                  |            |                                                           |            |                             |            |                                                       |            |                                                                            |            |                                                                             |            |  |  |  |  |

 

**EquityRisk**

We maintainminority investments in private and publicly traded companies. Theseinvestments are reviewed for other than temporary declines in value on aquarterly basis. Reasons for other than temporary declines in value includewhether the related company would have insufficient cash flow to operate forthe next twelve months, significant changes in the operating performance andchanges in market conditions. For the nine months ended September 30,2006, we recorded a $0.7 million unrealized gain in other comprehensive incometo write up our investment in the common stock of Finisar Corporation. As ofSeptember 30, 2006, the minority investments we continue to hold amountedto $3.7 million.

**ITEM4*.*CONTROLS AND 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 underRule 13a-15(e) promulgated under the Securities Exchange Act of 1934,as amended. Based upon that evaluation, our Chief Executive Officer and ourChief Financial Officer concluded that the our disclosure controls andprocedures were effective as of the end of the period covered by this quarterlyreport.

(b) No change in ourinternal control over financial reporting was made during the quarter endedSeptember 30, 2006 that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

31

----

 

**PART II. OTHER INFORMATION**

**Item1. Legal Proceedings**

From time to timewe may be involved in judicial or administrative proceedings concerningmatters arising in the ordinary course of business. We do not expect that anyof these matters, individually or in the aggregate, will have a materialadverse effect on our business, financial condition, cash flows or results ofoperation.

On October 15,2004, a purported securities class action lawsuit was filed in the UnitedStates Court for the Northern District of California, City of Harper WoodsEmployees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The Courtconsolidated the case with a subsequent related case and appointed a leadplaintiff. On April 5, 2005, the lead plaintiff filed a consolidated complaint,captioned as Morgan v. AXT, Inc. et al., No. C 04 4362 MJJ. The lawsuitcomplaint names AXT, Inc. and our chief technology officer as defendants, andis brought on behalf of a class of all purchasers of our securities fromFebruary 6, 2001 through April 27, 2004. The complaint alleges that weannounced financial results during this period that were false and misleading.No specific amount of damages is claimed. On September 23, 2005, the Courtgranted our motion to dismiss the complaint, with leave to amend. The leadplaintiff filed an amended complaint, which we have moved to dismiss. Webelieve that there are meritorious defenses against this litigation and intendto vigorously defend it. Due to the inherent uncertainties of litigation, we cannotaccurately predict the ultimate outcome of the litigation. Any unfavorableoutcome of the litigation could have an adverse impact on our business,financial condition and results of operations.

On June 1, 2005, alawsuit was filed in the Superior Court of California, County of Alameda, Zhaoet al. v. American Xtal Technology, et al., No. R 605215713. The lawsuitcomplaint names as defendants AXT, Inc., our chief technology officer and oneof our suppliers. 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 of 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. Our commercial general liability insurance carrier hasagreed to fund our defense of the case, but has reserved the right to denycoverage, in whole or in part, in the future under selected policy provisionsand applicable law. The plaintiffs have made an initial settlement demandwithin our insurance limits. Due to the inherent uncertainties of litigation,we cannot 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.

**Item1A. Risk Factors**

A description of the risk factors associated with ourbusiness is set forth below. There have been no material changes in these riskfactors from the description previously disclosed in part I, Item 1A of ourAnnual Report on Form 10-K for the year ended December 31, 2005, other than theaddition on page  of the risk factorsmarked with an asterisk (*). If any of the following risks actually occurs, itmay materially harm our business, financial condition, operating results andcash flow.  As a result, the market priceof our common stock could decline, and you could lose all or part of yourinvestment.  Additional risks anduncertainties that are not yet identified or that we think are immaterial mayalso materially harm our business, operating results and financial conditionand could result in a complete loss of your investment.

For ease of reference, we have divided these risks anduncertainties into the following general categories:

·                  Risks related toour general business;

·                  Risks related tointernational aspects of our business;

·                  Risks related toour financial results and capital structure;

·                  Risks related toour intellectual property; and

·                  Risks related tocompliance and other legal matters.

**RisksRelated to Our General Business**

***Defects in our products could diminishdemand for our products.***

Our products are complex and may contain defects.  We have experienced quality control problemswith many of our products,

32

----

 

which caused customers to return products to us,reduce orders for our products, or both. Although our quality has improved,resulting in some increases in product sales, we believe that we continue toexperience some reduction in orders as a result of our prior product qualityproblems.  If we continue to experiencequality control problems, or experience these or other problems in newproducts, customers may cancel or reduce orders or purchase products from ourcompetitors, we may be unable to maintain or increase sales to our customersand sales of our products could decline. Defects in our products could cause us to incur higher manufacturingcosts and suffer product returns and additional service expenses, all of whichcould adversely impact our operating results.

If new products developed by us contain defects whenreleased, our customers may be dissatisfied and we may suffer negativepublicity or customer claims against us, lose sales or experience delays inmarket acceptance of our new products.

***Decreases in average selling prices ofour products may reduce gross margins.***

The market for compound semiconductor substrates ischaracterized by pressures on average selling prices resulting from factorssuch as increased competition or overcapacity. We have experienced and expect to continue to experience price pressureson our products, and if average selling prices decline in the future, ourrevenue and gross margins could decline. We may be unable to reduce the cost of our products sufficiently tooffset the effect of lower selling prices and allow us to keep pace withcompetitive pricing pressures, and our margins could be adversely affected.

***The loss of one or more of our keysubstrate customers would significantly hurt our operating results.***

A small number of substrate customers havehistorically accounted for a substantial portion of our total revenue.  Our top five customers represented 35.6%, and40.3% of revenue for the nine months ended September 30, 2005 and 2006,respectively.  We expect that asignificant portion of our future revenue will continue to be derived from alimited number of substrate customers. Our customers are not obligated to purchase a specified quantity of ourproducts or to provide us with binding forecasts of product purchases.  In addition, our customers may reduce,delay or cancel orders at any time without any significant penalty.  During the past year, we have experiencedslower bookings, significant push-outs and cancellation of orders from somecustomers.  If we lose a major customeror if a customer cancels, reduces or delays orders, our revenue woulddecline.  In addition, customers thathave accounted for significant revenue in the past may not continue togenerate revenue for us in any future period. Any delay in scheduled shipments of our products could cause revenue tofall below our expectations and the expectations of market analysts orinvestors, causing our stock price to decline.

***Our results of operationsmay suffer if we do not effectively manage our inventory.***

We must manage our inventory of component parts,work-in-process and finished goods effectively to meet changing customerrequirements, while keeping inventory costs down and improving grossmargins.  Some of our products and supplieshave in the past and may in the future become obsolete while in inventory dueto changing customer specifications, or become excess inventory due todecreased demand for our products and an inability to sell the inventory withina foreseeable period.  Furthermore, ifcurrent costs of production increase or sales prices drop below the standardprices at which we value inventory, we may need to take a charge for areduction in inventory values.  We havein the past had to take inventory valuation and impairment charges.  Any future unexpected changes in demand orincreases in costs of production that cause us to take additional charges forun-saleable, obsolete or excess inventory, or to reduce inventory values, couldadversely affect our results of operations.

***If we have low product yields, or ifthere is a deliberate sabotage of our products, the shipment of our productsmay be delayed and our operating results may be adversely impacted.***

Our products are manufactured using complextechnologies, and the number of usable substrates we produce can fluctuate as aresult of many factors, including:

·                  impurities inthe materials used;

·                  contamination ofthe manufacturing environment;

·                  substratebreakage;

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

·                  performance ofpersonnel involved in the manufacturing process.

If our yields decrease, our revenue could decline ifwe are unable to produce needed product on time.  At the same time, our manufacturing costscould remain fixed, or could increase. We have experienced product shipment delays and difficulties in

33

----

 

achieving acceptable yields on both new and olderproducts, and delays and poor yields have adversely affected our operatingresults. We may experience similar problems in the future and we cannot predictwhen they may occur or their severity. In particular, many of our manufacturing processes are new and are stillbeing refined, which can result in lower yields.

If there is deliberate sabotage of our products makingthem unfit for use by our customers, our products would be rejected, resultingin compensation costs paid to our customers, and possibledisqualification.  This could lead torevenue loss and market share loss.

***If we do not successfully develop newproducts to respond to rapidly changing customer requirements, our ability togenerate revenue, obtain new customers, and retain existing customers maysuffer.***

Our success depends on our ability to offer newproducts and product features that incorporate leading technology and respondto technological advances.  In addition,our new products must meet customer needs and compete effectively on quality,price and performance.  The life cyclesof our products are difficult to predict because the markets for our productsare characterized by rapid technological change, changing customer needs andevolving industry standards.  If ourcompetitors introduce products employing new technologies or performancecharacteristics, our existing products could become obsolete and unmarketable.  During the past three years, we have seen ourcompetitors selling more substrates manufactured using a crystal growthtechnology similar to ours, which has eroded our technologicaldifferentiation.  Other companies,including Triquent, are actively developing substrate materials that could beused to manufacture devices that could provide the same high-performance,low-power capabilities as GaAs- and InP-based devices at competitiveprices.  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.

The development of new products can be a highlycomplex process, and we may experience delays in developing and introducing newproducts.  Any significant delays couldcause us to fail to timely introduce and gain market acceptance of newproducts.  Further, the costs involved inresearching, developing and engineering new products could be greater than anticipated.  If we fail to offer new products or productenhancements or fail to achieve higher quality products, we may not generatesufficient revenue to offset our development costs and other expenses or meetour customers’ requirements.

***Intense competition in the markets forour products could prevent us from increasing revenue and sustainingprofitability.***

The markets for our products are intenselycompetitive.  We face competition for oursubstrate products from other manufacturers of substrates, such as FreibergerCompound Materials, Hitachi Cable and Sumitomo Electric, from semiconductordevice manufacturers that produce substrates for their own use, and fromcompanies, such as Triquent, that are actively developing alternative materialsto GaAs and marketing semiconductor devices using these alternativematerials.  We believe that at least twoof our major competitors are shipping high volumes of GaAs substratesmanufactured using a technique similar to our VGF technique.  Other competitors may develop and begin usingsimilar technology.  If we are unable tocompete effectively, our revenue may not increase and we may be unable tobecome profitable.  We face manycompetitors that have a number of significant advantages over us, including:

·                  greaterexperience in the business;

·                  moremanufacturing experience;

·                  extensiveintellectual property;

·                  broader namerecognition; and

·                  significantlygreater financial, technical and marketing resources.

Our competitors could develop new or enhanced productsthat are more effective than our products are.

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

In addition, new competitors have and may continue toemerge, such as a small crystal growing company established by a formeremployee of ours in China that is supplying ingots to the market.  While new competitors such as this companycurrently do not appear to be fully competitive, competition from sources suchas this could increase, particularly if these competitors are able to obtainlarge capital investments.

34

----

 

***Demand for our products may decrease ifour customers experience difficulty manufacturing, marketing or selling theirproducts.***

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

·                  the competitionour customers face in their particular industries;

·                  the technical,manufacturing, sales and marketing and management capabilities of ourcustomers;

·                  the financialand other resources of our customers; and

·                  the inability ofour customers to sell their products if they infringe third-party intellectualproperty rights.

If demand for the end-user applications for which ourproducts are used decreases, or our customers are unable to develop, market andsell their products, demand for our products will decrease.

***The financial condition of ourcustomers may affect their ability to pay amounts owed to us.***

Many of our customers are facing business downturnsthat have reduced their cash balances and their prospects.  We frequently allow our customers to pay forproducts we ship to them within 30 to 120 days after delivery.  Subsequent to our shipping a product, somecustomers have been unable to make payments as due, reducing our cash balancesand causing us to incur charges to allow for a possibility that some accountsmight not be paid.  Customers may also beforced to file for bankruptcy.  If ourcustomers do not pay their accounts when due, we will be required to incurcharges that would reduce our earnings.

***We purchase critical raw materials andparts for our equipment from single or limited sources, and could lose sales ifthese sources fail to fill our needs.***

We depend on a limited number of suppliers for certainraw materials, components and equipment used in manufacturing our products,including key materials such as quartz tubing, polishing solutions andparalytic boron nitride.  Althoughseveral of these raw materials are purchased from suppliers in which we hold anownership interest, we generally purchase these materials through standardpurchase orders and not pursuant to long-term supply contracts and no supplierguarantees supply of raw materials or equipment to us.  If we lose any of our key suppliers, ourmanufacturing efforts could be significantly hampered and we could be preventedfrom timely producing and delivering products to our customers.  Prior to investing in our raw material jointventures, we sometimes experienced delays obtaining critical raw materials andspare parts, including gallium, due to shortages of these materials and couldexperience such delays again in the future due to shortages of materials andmay be unable to obtain an adequate supply of materials.  These shortages and delays could result inhigher materials costs and cause us to delay or reduce production of ourproducts.  If we have to delay or reduceproduction, we could fail to meet customer delivery schedules and our revenueand operating results could suffer.

***We have made and may continue to makestrategic investments in raw materials suppliers, which may not be successfuland may result in the loss of all or part of our investment.***

We have made investments through our five jointventures in raw material suppliers in China, which provide us withopportunities to gain supplies of key raw materials that are important to oursubstrate business.  These affiliateseach have a market beyond that provided by us. We do not have influence over all of these companies, each of which is locatedin China, and in some we have made only a strategic, minority investment.  We may not be successful in achieving thefinancial, technological or commercial advantage upon which any giveninvestment is premised, and we could end up losing all or part of ourinvestment.

***Our substrate products have a longqualification cycle that makes it difficult to plan our expenses and forecastour results.***

Customers typically place orders with us for oursubstrate products three months to a year or more after our initial contactwith them.  The sale of our products maybe subject to delays due to our customers’ lengthy internal budgeting, approvaland evaluation processes.  During thistime, we may incur substantial expenses and expend sales, marketing andmanagement efforts while the customers evaluate our products.  These expenditures may not result insales of our products.  If we do notachieve anticipated sales in a period as expected, we may experience anunplanned shortfall in our revenue.  As aresult, we may not be able to cover expenses, causing our operating results tovary.  In addition, if a customer decidesnot to incorporate our products into its initial design, we may not haveanother opportunity to sell products to this customer for many months or evenyears.  In the current competitive and

35

----

 

economic climate, the average sales cycle for ourproducts has lengthened even further and is expected to continue to make itdifficult to forecast our future sales accurately.  We anticipate that sales of any futuresubstrate products will also have lengthy sales cycles and will, therefore, besubject to risks substantially similar to those inherent in the lengthy salescycles of our current substrate products.

**RisksRelated to International Aspects of Our Business**

**** Changes in tariffs, importrestrictions, export restrictions or other trade barriers may reduce grossmargins.***

We may incur increases incosts due to changes in tariffs, import restrictions, export restrictions, orother trade barriers, or unexpected changes in regulatory requirements; orunexpected changes in export license requirements, which may reduce our grossmargins.

In September 2006, tax authorities in the People’sRepublic of China, (“PRC”), announced their intention to impose customs dutieson, and to reduce or eliminate refunds of value-added taxes that companies pay whenthey purchase, certain raw materials, including gallium and arsenic.  The combination of these actions couldsignificantly increase our costs and impact our cash flows. Implementingregulations are not expected to be published before late November, and it ispossible that these regulations will not be adopted or that changes will bemade in their outline before adoption.  Lobbying efforts are being made toremove gallium and arsenic from the list of affected materials, but there is noway to know if these efforts will have any impact on the final form of theregulations.  There appears to be a possibility that the value-added taxrefund on gallium will not be completely eliminated, but merely reduced. If the regulations are adopted as currently proposed, they would not have amaterial impact on our fourth quarter results because they would only bein effect for a portion of the quarter.  They may, however,potentially have a significant adverse impact on our gross margins and net income(loss) in 2007, although we do not have the facts necessary to estimate itsmagnitude at this time.  We are also exploring alternatives forrestructuring our operations in the PRC in order to mitigate the impact ofthese regulations if and when they are adopted.  We will not know theexact impact of any restructuring or the amount of time that it might take toaccomplish until toward the end of this year.

**** The possible imposition of additionalduties and taxes on products that we export from the People’s Republic of Chinawould have a material adverse impact on our results of operations and generalfinancial condition***

In September 2006, tax authorities in the PRCannounced their intention to impose additional value added tax and exportduties on a variety of products, including those containing gallium andarsenic.  Although we cannot be certainthat such taxes will be imposed because the implementation of the underlyingtax regulations has been postponed until late November 2006, such additionaltaxes would materially adversely affect our margins and results ofoperations.  In addition, given the fluidregulatory environment for such products, we cannot assure that additionaltaxes will not be imposed in the future, which would further adversely affectour business.

***Ouroperating results depend in large part on continued customer acceptance ofour substrate products manufactured in China and continued improvements inproduct quality.***

We manufacture all of our products in China, andsource most of our raw materials in China.  Accordingly, we continue toseek customer qualification of our China-manufactured products.  Inaddition, we have in the past experienced quality problems with ourChina-manufactured products.  Our previous quality problems caused us to losemarket share to our competitors, as some customers reduced their orders from usuntil our surface quality was as good and consistent as that offered bycompetitors and customers allocated their requirements for compoundsemiconductor substrates across more competitors.  If we are unable tocontinue to achieve customer qualifications for our products, orif we again experience quality problems, customers may not increase purchasesof our products, our China facility will become underutilized, and we will beunable to achieve expected revenue growth.  We may againlose sales of our products to competitors and experience loss of marketshare.  If we are unable to recover and retain our market share, wemay be unable to grow our business.

***Problems incurred by our joint venturesor venture partners could result in a material adverse impact on our financialcondition or results of operations***

We have invested in five joint venture operations inChina that produce products including 99.99% pure gallium (4N Ga), high puritygallium, arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN)crucibles and boron oxide.  We purchase aportion of the materials produced by these ventures for our use and sell theremainder of their production to third parties. Our ownership interest in these entities ranges from 25% to 83%.  We consolidate the three ventures in which weown a majority or controlling financial interest and employ equity accountingfor the two joint ventures in which we have a 25% interest.  Several of these ventures occupy space withinlarger facilities owned and/or operated by one of the other venture partners.Several of these

36

----

 

venture partners are engaged in other manufacturingactivities at or near the same facility. In some facilities, we share access to certain functions, includingwater, hazardous waste treatment or air quality treatment.  If any of our joint venture partners in anyof these five ventures experiences problems with its operations, disruptions ofour joint venture operations could result, having a material adverse effect onthe financial condition and results of operation of our joint ventures, andcorrespondingly on our financial condition or results of operations.

In addition, if any of our joint ventures or venturepartners with which our joint ventures share facilities is deemed to haveviolated applicable laws, rules or regulations governing the use, storage,discharge or disposal of hazardous chemicals during manufacturing, research anddevelopment, or sales demonstrations, the operations of our joint venturescould be adversely affected and we could be subject to substantial liabilityfor clean-up efforts, personal injury and fines or suspension or cessation ofour joint venture operations as a result of the actions of the joint venturesor other venture partners.  Employeesworking for our joint ventures or any of the other venture partners could bringlitigation against us as a result of actions taken at the joint venture orventure partner facilities, even though we are not directly controlling theoperations, including actions for exposure to chemicals or other hazardousmaterials at the facilities of our joint ventures or the facilities of anyventure partner that are 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 any litigation if brought against us, particularly if litigation with us, asa non-Chinese company, is deemed advantageous. Even if we are not deemed responsible for the actions of the jointventures or venture partners, litigation could be costly, time consuming todefend and divert management attention; in addition, pursuit of us could occurif we are deemed to be the most financially viable of the partners.

Going forward, we believe that investing in additionaljoint ventures will be important to remaining competitive in our marketplaceand ensuring a supply of critical raw materials.  However, we may not be able to identifycomplementary joint venture opportunities or, even once opportunities areidentified, we may not be able to reach agreement on the terms of the venturewith the other venture partners. Additional joint ventures could cause us to incur contingent liabilitiesor other expenses, any of which could adversely affect our financial conditionand operating results.

Since all of our joint venture activity is expected tooccur in China, these activities could subject us to a number of risksassociated with conducting operations internationally, including:

·                  difficulties inmanaging geographically disparate operations;

·                  difficulties inenforcing 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;

·                  political andeconomic instability, civil unrest or war;

·                  terroristactivities that impact international commerce;

·                  difficulties inprotecting 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;

·                  changing lawsand policies affecting economic liberalization, foreign investment, currencyconvertibility or exchange rates, taxation or employment; and

·                  nationalizationof foreign-owned assets, including intellectual property.

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

Our operating results can vary significantly basedupon the impact of changes in global economic conditions on our customers.  The revenue growth and profitability of ourbusiness depends on the overall demand for our substrates, and we areparticularly dependent on the market conditions for the wireless, solid-stateillumination, fiber optics and telecommunications industries.  Because our sales are primarily to majorcorporate customers whose businesses fluctuate with general economic andbusiness conditions, a softening of demand for products that use our substrates,caused by a weakening economy, may result in decreased revenue.  Customers may find themselves facing excessinventory from earlier purchases, and may defer or reconsider purchasingproducts due to the downturn in their business and in the general economy.

37

----

 

***We derive a significant portion of ourrevenue from international sales, and our ability to sustain and increase ourinternational sales involves significant risks.***

Our revenue growth depends in part on the expansion ofour international sales and operations. International sales represented 81% and 79% of our total revenue for theyears ended December 31, 2005 and 2004, respectively, and 75% and 80% ofour total revenue for the nine months ended September 30, 2006 and 2005,respectively.  We expect that sales tocustomers outside the U.S., particularly sales to customers in Asia, willcontinue to represent a significant portion of our revenue.

Currently, an increasing percentage of our sales is tocustomers headquartered in Asia.  All ofour manufacturing facilities and some of our suppliers are also located outsidethe U.S.  Managing our overseasoperations presents challenges, including periodic regional economic downturns,trade balance issues, varying business conditions and demands, political instability,variations in enforcement of intellectual property and contract rights indifferent jurisdictions, differences in the ability to develop relationshipswith suppliers and other local businesses, changes in U.S. and internationallaws and regulations including U.S. export restrictions, fluctuations ininterest and currency exchange rates, the ability to provide sufficient levelsof technical support in different locations, cultural differences, shippingdelays and terrorist acts or acts of war, among other risks.  Many of these challenges are present inChina, which represents a large potential market for semiconductor devices andwhere we anticipate significant opportunity for growth.  Global uncertainties with respect to:  (i) economic growth rates in variouscountries; (ii) sustainability of demand for electronics products;(iii) capital spending by semiconductor manufacturers; (iv) priceweakness for certain semiconductor devices; and (v) political instabilityin regions where we have operations may also affect our business, financialcondition and results of operations.

Our dependence on international sales involves anumber of risks, including:

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

·                  unexpected changesin regulatory requirements;

·                  longer periodsto collect accounts receivable;

·                  changes inexport license requirements;

·                  political andeconomic instability;

·                  unexpectedchanges in diplomatic and trade relationships; and

·                  foreign exchangerate fluctuations.

Our sales are denominated in U.S. dollars, except forsales to our Japanese and some Taiwanese customers, which are denominated inJapanese yen.  Thus, increases in thevalue of the U.S. dollar could increase the price of our products in non-U.S.markets and make our products more expensive than competitors’ products inthese markets.

Also, denominating some sales in Japanese yen subjectsus to fluctuations in the exchange rates between the U.S. dollar and theJapanese yen.  The functional currency ofour Chinese subsidiary and joint ventures is the local currency.  We incur transaction gains or lossesresulting from consolidation of expenses incurred in local currencies for theseentities, as well as in translation of the assets and liabilities of theirassets at each balance sheet date.  If wedo not effectively manage the risks associated with international sales, ourrevenue, cash flows and financial condition could be adversely affected.

***Because of power shortages in China, wemay have to temporarily close our China operations, which would adverselyimpact our ability to manufacture our products and meet customer orders, andwould result in reduced revenue.***

The Chinese government faced a power shortage over thesummer of 2004 and reported that power demand in 24 provinces outstrippedsupply in peak periods during January to April of 2004.  Instability in electrical supply causedsporadic outages among residential and commercial consumers.  As a result, the Chinese governmentimplemented tough measures in 2004 to ease the energy shortage.  Provinces imposed power brownouts during 2004to reduce electricity demand, and some companies in Beijing were ordered togive their employees a week off to ease the pressure on power supply.  Plants, most of which are state-owned, wereclosed and reopened on a staggered schedule to reduce power consumption duringthe capital’s hottest months during 2004. As a result, we closed most of our operations for a week in lateJuly 2004 in conformance with this policy. If we are required to make temporary closures of our subsidiary andjoint venture operations at any time during the next year, we may be unable tomanufacture our products, and would then be unable to meet customer ordersexcept from inventory on hand.  As aresult, our revenue could be adversely impacted, and our relationships with ourcustomers could suffer, impacting our ability to generate future revenue.  In addition, if power is shut off at ourBeijing subsidiary at any time, either voluntarily or as a result of unplannedbrownouts, during certain phases of our manufacturing process including ourcrystal growth phase, the work in process may be ruined and rendered unusable,causing us to incur expense that will not be covered by revenue, and negativelyimpacting our cost of revenue and gross margins.

38

----

 

***Changes in China’s political, socialand economic environment may affect our financial performance.***

Our financial performance may be affected by changesin China’s political, social and economic environment.  The role of the Chinese central and localgovernments in 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.  Anyimposition of surcharges or any increase in Chinese tax rates could hurt ouroperating 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 to take any of these actions, we wouldbe prevented from conducting all or part of our business.  Any failure on our part to comply withgovernmental regulations could result in the loss of our ability to manufactureour products in China.

China from time to time has experienced instances ofcivil unrest and hostilities. Confrontations have occurred between the military and civilians.  Events of this nature could influence theChinese economy, result in nationalization of foreign-owned operations such asours, and negatively affect our ability to operate our facilities in China.

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

In July 2005, China agreed to a shift in Chinesecurrency policy.  It established a 2%revaluation of the renminbi and referenced the renminbi to a basket ofcurrencies, with a daily trading band of +/-0.3%.  Depending on market conditions and the stateof the Chinese economy, it is possible that China will make more adjustments inthe future.  Over the next five to ten years,China may move to a managed float system, with opportunistic interventions.  This reserve diversification may negativelyimpact the United States dollar and U.S. interest rates, which, in turn, couldnegatively impact our operating results and financial condition.  The functional currency of our Chinesesubsidiary, including our joint ventures, is the local currency; since most ofour operations are conducted in China, most of our costs are incurred inChinese currency, which subjects us to fluctuations in the exchange ratesbetween the U.S. dollar and the Chinese renminbi.  We incur transaction gains 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.  Theserisks may be increased by the fluctuation and revaluation of the Chineserenminbi.  If we do not effectivelymanage the risks associated with this currency risk, our revenue, cash flowsand financial condition could be adversely affected.

***A reoccurrence of Severe Acute RespiratorySyndrome (SARS) or the outbreak of a different contagious disease such as theAvian Flu may adversely impact our manufacturing operations and some of our keysuppliers and customers.***

All of our substrate manufacturing activities areconducted in China.  In addition, weacquire key raw materials, including gallium, from our joint ventures and othersuppliers in China.  The 2003 SARSoutbreak was most notable in China and a small number of cases were reported in2004.  One employee at our LED productionfacility in China contracted SARS in late April 2003 prompting us to closethe facility for ten days.  There was nosignificant impact to our ability to fill customer orders.  If there were to be another outbreak of SARSor a different contagious disease, such as Avian Flu, and if our employeescontracted the disease, we might be required to temporarily close ourmanufacturing operations.  Similarly, ifone of our key suppliers is required to close for an extended period, we mightnot have enough raw material inventory to continue manufacturingoperations.  In addition, while wepossess management skills among our China staff that enable us to maintain ourmanufacturing operations with minimal on-site supervision from our US-basedstaff, our business could also be harmed if travel to or from Asia and theUnited States is restricted or inadvisable, as it was during parts of2003.  None of our substrate competitorsis as dependent on manufacturing facilities in China as we are.  If our manufacturing operations were closedfor a significant period, we could lose revenue and market share during thatperiod, which would depress our financial performance and could be difficult torecapture.  Finally, if one of our keycustomers is required to close for an extended period, we might not be able toship product to them, our revenue would decline and our financial performancewould suffer.

**RisksRelated to Our Financial Results and Capital Structure**

***The compound semiconductor industry iscyclical and has experienced a downturn which has adversely impacted ouroperating results.***

Our continuing business depends in significant partupon manufacturers of electronic and opto-electronic compound semiconductordevices, as well as the current and anticipated market demand for these devicesand products using these devices.  As asupplier to the compound semiconductor industry, we are subject to the businesscycles that characterize the industry. The timing,

39

----

 

length and volatility of these cycles are difficult topredict.  The compound semiconductorindustry has historically been cyclical because of sudden changes in demand,the amount of manufacturing capacity and changes in the technology employed incompound semiconductors.  The rate of changesin demand, including end demand, is high, and the effect of these changes uponus occurs quickly, exacerbating the volatility of these cycles.  These changes have affected the timing andamounts of customers’ purchases and investments in new technology.  These industry cycles create pressure on ourrevenue, gross margin and net income (loss).

The industry has in the past experienced periods ofoversupply that result in significantly reduced demand and prices for compoundsemiconductor devices and components, including our products, both as a resultof general economic changes and overcapacity. When these periods occur and our operating results and financialcondition are adversely affected, oversupply creates pressure on our revenue,gross margins and net income (loss). Inventory buildups in telecommunications products and slower thanexpected sales of computer equipment resulted in overcapacity and led toreduced sales by our customers, and therefore reduced purchases of ourproducts.  During periods of weak demandsuch as those experienced historically, customers typically reduce purchases,delay delivery of products and/or cancel orders of component parts such as ourproducts. Increased price competition has resulted, causing pressure on our netsales, gross margin and net income (loss). We experienced cancellations, price reductions, delays and push-outs oforders, which have resulted in reduced revenue. If the economic downturn occurred again, further order cancellations,reductions in order size or delays in orders could occur and would materiallyadversely affect our business and results of operations.  Actions to reduce our costs, such as those wehave recently taken, may be insufficient to align our structure withprevailing business conditions.  We maybe required to undertake additional cost-cutting measures, and may beunable to invest in marketing, research and development and engineering at thelevels we believe are necessary to maintain our competitive position.  Our failure to make these investments couldseriously harm our business.

During periods of increasing demand for compoundsemiconductor devices, we must have sufficient manufacturing capacity andinventory to meet customer demand, and must be able to attract, hire, train andretain qualified employees to meet demand.  If we are unable to effectively manage ourresources and production capacity during an industry upturn, there could be amaterial adverse effect on our business, financial condition and results ofoperations.

***If we fail to manage periodiccontractions, we may utilize our cash balances and our existing cash andcash equivalentand investment balances could decline.***

We anticipate that our existing cash resources willfund any anticipated operating losses and purchases of capital equipment, aswell as provide adequate working capital for the next twelve months.  However, our liquidity is affected by manyfactors including, among others, the extent to which we pursue additionalcapital expenditures, the level of our production, and other factors related tothe uncertainties of the industry and global economies.  If we fail to manage our contractionssuccessfully we may draw down our cash reserves, which would adversely affectour operating results and financial condition, reduce our value and possiblyimpinge our ability to raise debt and equity funding in the future, at a timewhen we might be required to raise additional cash.  Accordingly, there can be no assurance thatevents in the future will not require us to seek additional capital or, ifrequired, that such capital would be available on terms acceptable to us, if atall.  As part of our effort to reducecosts, we may lose key staff, production resources and technology that we willneed to grow when end markets recover. These events could reduce our ability to grow profitably as marketsrecover.

***Unpredictable fluctuations in ouroperating results could disappoint analysts or our investors, which could causeour stock price to decline.***

We have not been able to sustain growth for anysignificant period in the last five years, and may not be able to return tohistoric growth levels in the current economic environment.  Our net loss in 2002 was the largest in ourhistory and our losses continued during 2003, 2004, 2005, and the first twoquarters of 2006. We recorded net income in the third quarter of 2006.

We have experienced and may continue to experiencesignificant fluctuations in our revenue and earnings.  Our quarterly and annual revenue andoperating results have varied significantly in the past and may varysignificantly in the future due to a number of factors, including:

·                  our ability todevelop, 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;

·                  fluctuations indemand for our products;

·                  expansion of ourmanufacturing capacity;

·                  expansion of ouroperations in China;

40

----

 

·                  limitedavailability and increased cost of raw materials;

·                  the volume andtiming of orders from our customers, and cancellations, push-outs and delays ofcustomer orders once made;

·                  fluctuation ofour manufacturing yields;

·                  decreases in theprices of our or our competitors’ products;

·                  costs incurredin connection with any future acquisitions of businesses or technologies; and

·                  increases in ourexpenses, including expenses for research and development.

Due to these factors, we believe that period-to-periodcomparisons of our operating results may not be meaningful indicators of ourfuture performance.  Over the past twoyears, our operating results have at times been below the expectations ofsecurities analysts or investors.  Ifthis occurs again in future periods, the price of our common stock coulddecline or fluctuate.

A substantial percentage of our operating expenses isfixed in the short term, and we may be unable to adjust spending to compensatefor an unexpected shortfall in revenue. As a result, any delay in generating revenue could cause our operatingresults to be below the expectations of market analysts or investors, whichcould also cause our stock price to fall.

***We have adopted certain anti-takeovermeasures that may make it more difficult for a third party to acquire us.***

Our board of directors has the authority to issue upto 2,000,000 shares of preferred stock and to determine the price, rights,preferences and privileges of those shares without any further vote or actionby 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 ofpreferred stock could have the effect of making it more difficult for a thirdparty to acquire a majority of our outstanding voting stock.  We have no present intention to issueadditional shares of preferred stock.

We have adopted a preferred stock purchase rights planintended to guard against certain takeover tactics.  The adoption of this plan was not in responseto any proposal to acquire us, and the board is not aware of any sucheffort.  The existence of this plan couldalso have the effect of making it more difficult for a third party to acquire amajority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation mayhave the effect of delaying or preventing a change of control, which couldadversely affect the market price of our common stock.

In addition, provisions in our amended and restatedcertificate of incorporation and amended and restated bylaws may have theeffect of delaying or preventing a merger, acquisition or change of control ofus, or changes in our management, including:

·                  the division ofour board of directors into three separate classes, each with three-year terms;

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

·                  the ability ofour board to alter our amended and restated bylaws;

·                  the requirementthat only our board or the holders of at least 10% of our outstanding sharesmay call a special meeting of our stockholders.

Furthermore, because we are incorporated in Delaware,we are subject to the provisions of Section 203 of the Delaware GeneralCorporation 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 bythese large stockholders approve the merger or combination, or

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

**RisksRelated to Our Intellectual Property**

***Intellectual property infringementclaims may be costly to resolve and could divert management attention.***

Other companies may hold or obtain patents oninventions or may otherwise claim proprietary rights to technology necessary toour business.  The markets in which wecompete are comprised of competitors that in some cases hold substantial patentportfolios covering aspects of products that could be similar to ours.  We could become subject to claims that we areinfringing patent,

41

----

 

trademark, copyright or other proprietary rights ofothers.  For example, we have previouslybeen involved in two separate lawsuits alleging patent infringement, and couldin the future be involved in similar litigation.

***If we are unable to protect ourintellectual property, we may lose valuable assets or incur costly litigation.***

We rely on a combination of patents, copyrights,trademark and trade secret laws, non-disclosure agreements and otherintellectual property protection methods to protect our proprietarytechnology.  However, we believe that,due to the rapid pace of technological innovation in the markets for ourproducts, our ability to establish and maintain a position of technologyleadership also depends on the skills of our development personnel. Despite ourefforts to protect our intellectual property, third parties can developproducts or processes similar to ours. Our means of protecting our proprietary rights may not be adequate, andour competitors may independently develop similar technology, duplicate ourproducts or design around our patents. We believe that at least two of our competitors have begun to ship GaAssubstrates produced using a process similar to our VGF technique.  Our competitors may also develop and patentimprovements to the VGF technology upon which we rely, and thus may limit anyexclusivity we enjoy by virtue of our patents or trade secrets.

It is possible that pending or future United States orforeign patent applications made by us will not be approved, that our issuedpatents will not protect our intellectual property, or that third parties willchallenge the ownership rights 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.  Ourcompetitors may be able to legitimately ascertain non-patented proprietarytechnology embedded in our systems.  Ifthis occurs, we may not be able to prevent the development of technologysubstantially similar to ours.

We may have to resort to costly litigation to enforceour intellectual property rights, to protect our trade secrets or know-how orto determine their scope, validity or enforceability.  Enforcing or defending our proprietarytechnology is expensive, could cause us to divert resources and may not provesuccessful.  Our protective measures mayprove inadequate to protect our proprietary rights, and if we fail to enforceor protect our rights, we could lose valuable assets.

For example, in the past we have been involved inlitigation with Sumitomo Electric Industries, Ltd. (“SEI”) in Japan as well asinterference actions in the United States. We and SEI approved a settlement of this litigation during the fourthquarter of 2004 and the litigation was withdrawn and we abandoned theinterference proceeding.  We made aninitial payment of approximately $1.4 million and will have to pay ongoing royaltiesto SEI on certain of our products.

**RisksRelated to Compliance and Other Legal Matters**

***We need to continue to improve orimplement our systems, procedures and controls and may not receive a favorableattestation report on our internal control systems by our independentregistered public accounting firm.***

The requirements adopted by the Securities andExchange Commission, or SEC, in response to the passage of the Sarbanes-OxleyAct of 2002, will require annual review and evaluation of our internal controlsystems, and an attestation of these systems by our independent registeredpublic accounting firm beginning with our fiscal year ending December 31,2007.  We are currently reviewing ourinternal control procedures and considering further documentation of theseprocedures that may be necessary. We are currently evaluating the extent to which any of our jointventures may also be required to comply, if at all.  We can give no assurances that our systemswill satisfy these requirements of the SEC or, if required, that any of thesystems of our joint ventures will meet these requirements, or that we willreceive a favorable review and attestation by our independent registered publicaccounting firm.

In addition, the shift of our manufacturing operationsto China has placed and continues to place a significant strain on ouroperations and management resources.  Wehave upgraded our inventory control systems and may implement additionalsystems relating to consolidation of our financial results, but continue torely on certain manual processes in our operations and in connection withconsolidation of our financial results. If we fail to manage these changes effectively, our operationsmay be disrupted.

To manage our business effectively, we may need toimplement additional and improved management information systems, furtherdevelop our operating, administrative, financial and accounting systems andcontrols, add experienced senior level managers, and maintain closecoordination among our executive, engineering, accounting, marketing, sales andoperations organizations.

***If we fail to comply with environmentaland safety regulations, we may be subject to significant fines or forcedto cease our operations; in addition, we could be subject to suits for personalinjuries caused by hazardous materials.***

We are subject to federal, state and localenvironmental and safety laws and regulations in all of our operatinglocations, including laws and regulations of China, such as laws andregulations related to the development, manufacture and use of our products,the

42

----

 

operation of our facilities, and the use of our realproperty.  These laws and regulationsgovern the use, storage, discharge and disposal of hazardous chemicals duringmanufacturing, research and development, and sales demonstrations.  If we fail to comply with applicableregulations, we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or be forced to cease our operations,and/or suspend or terminate the development, manufacture or use of certain ofour products, the use of our facilities, or the use of our real property, eachof which could have a material adverse effect on our business, financialcondition and results of operations.

In March 2001, we settled a claim made by theCalifornia Occupational Safety and Health Administration, or Cal-OSHA, in aninvestigation primarily regarding impermissible levels of potentially hazardousmaterials in certain areas of our manufacturing facility in Fremont, Californiafor $200,415, and during 2004 we were the target of press allegations andcorrespondence purportedly on behalf of current and/or former employeesconcerning our environmental compliance programs and exposure of our employeesto hazardous materials.  InJune 2005, a complaint was filed against us and a current and formerofficer, alleging personal injury, general negligence, intentional tort, wageloss and other damages, including punitive damages, as a result of exposure ofplaintiffs, who are former employees of AXT, including a minor child in utero,to high levels of gallium arsenide in gallium arsenide wafers, andmethanol.  There is a possibility thatother current and/or former employees may bring additional litigation againstus.  Although we have put in placeengineering, administrative and personnel protective equipment programs toaddress these issues, our ability to expand or continue to operate our presentlocations could be restricted or we could be required to acquire costlyremediation equipment or incur other significant expenses.  Existing or future changes in laws orregulations in the United States and China may require us to incur significantexpenditures or liabilities, or may restrict our operations.  In addition, our employees could be exposedto chemicals or other hazardous materials at our facilities and we may besubject to lawsuits seeking damages for wrongful death or personal injuriesallegedly caused by exposure to chemicals or hazardous materials at ourfacilities.

Litigation is inherently uncertain and while we wouldexpect to defend ourselves vigorously, it is possible that our business,financial condition, results of operations or cash flows could be affected inany particular period by litigation pending and any additional litigationbrought against us.

***Existing or future litigation couldresult in significant judgments against us, or cause us to incur costlysettlements.***

In June 2005, a complaint was filed against usand a current and former officer, alleging personal injury, general negligence,intentional tort, wage loss and other damages, including punitive damages, as aresult of exposure of plaintiffs, who are former employees of AXT, including aminor child in utero, to high levels of gallium arsenide in gallium arsenidewafers, and methanol.  In addition, weare defendants in an ongoing securities litigation matter.  Litigation is inherently uncertain and whilewe would expect to defend ourselves vigorously, it is possible that ourbusiness, financial condition, results of operations or cash flows could beaffected in any particular period by litigation now pending and any additionallitigation brought against us.  Inaddition, response to this litigation could divert management’s attention fromour business and operations, causing our business and financial results tosuffer.  We could incur defense orsettlement costs in excess of the insurance covering these litigation matters,or that could result in significant judgments against us or cause us to incurcostly settlements, in excess of our insurance limits.

***Legislative actions, higher insurancecosts and potential new accounting pronouncements are likely to cause ourgeneral and administrative expenses to increase and impact our future financialposition and results of operations.***

In order to comply with rules and regulations adoptedpursuant to the Sarbanes-Oxley Act of 2002 by the SEC, as well as changes tolisting standards adopted by the NASDAQ Stock Market, and accounting changesadopted affecting accounting for stock-based compensation, we may berequired to increase our internal controls and hire additional personnel andoutside legal, accounting and advisory services, all of which will cause ourgeneral and administrative costs to increase. Insurers may increase premiums as a result of the high claims rates theyincurred over the past year.  Changes inaccounting rules, including legislative and other rules to account for employeestock options as a compensation expense among others, could materially increasethe expense that we report under generally accepted accounting principles andadversely affect our operating results.

***The effect of terrorist threats andactions on the general economy could decrease our revenue.***

The United States continues to be on alert forterrorist activity.  The potential near-and long-term impact terrorist activities may have in regards to our suppliers,customers and markets for our products and the U.S. economy is uncertain.  There may be embargos of ports orproducts, or destruction of shipments or our facilities, or attacks that affectour personnel.  There may be otherpotentially adverse effects on our operating results due to a significant eventthat we cannot foresee.  Since we performall of our manufacturing operations in China, and a significant portion of ourcustomers are located outside of the Untied States, terrorist activity orthreats against US-owned enterprise are a particular concern to us.

43

----

 

***If any of our facilities is damaged byoccurrences such as fire, explosion, or natural disaster, we might not be ableto manufacture our products.***

The ongoing operation ofour manufacturing and production facilities in China is critical to our abilityto meet demand for our products.  If weare not able to use all or a significant portion of our facilities forprolonged periods for any reason, we would not be able to manufacture productsfor our customers.  For example, a fireor explosion caused by our use of combustible chemicals and high temperaturesduring our manufacturing processes could render some or all of our facilitiesinoperable for an indefinite period of time. Actions outside of our control,such as earthquakes or other natural disasters, could also damage ourfacilities, rendering them inoperable. If we are unable to operate ourfacilities and manufacture our products, we would lose customers and revenueand our business would be harmed.

44

----

 

**Item2. Unregistered Sales of Equity Securities and Use of Proceeds**

None

**Item 3. Defaults Upon SeniorSecurities**

None

**Item 4. Submission of Matters to aVote of Security Holders**

None

**Item5. Other Information**

None

45

----

 

**Item6. Exhibits**

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

----

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

(2)             Incorporatedby reference to Exhibit 2.1 to registrant’s Form 8-K filed with theSEC on June 14, 1999.

(3)             Incorporatedby reference to Exhibit 3.4 to registrant’s Form 8-K filed with theSEC on May 30, 2001.

(4)             Incorporatedby reference to Exhibit 3.4 to registrant’s Form 10-Q filed with SECon August 5, 2004.

(5)             Incorporatedby reference to the exhibit as of the same number as filed with the SEC inour Form 8-K on May 30, 2001.

46

----

 

**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this Report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                               |   | AXT, INC. |
|-------------------------------|--------|----------------|
|                          |   |           |   |   |
| Dated:  November 9, 2006 |   | By:            |   | /s/ Philip C. S. Yin |
|                          |   |           |   | Philip C. S. Yin |
|                          |   |           |   | Chief Executive Officer |
|                          |   |           |   | (Principal Executive Officer) |
|                          |   |           |   |   |
|                          |   |           |   | /s/ Wilson W. Cheung |
|                          |   |           |   | Wilson W. Cheung |
|                          |   |           |   | Chief Financial Officer |
|                          |   |           |   | (Principal Financial and Accounting Officer) |

 

47

----

 

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

----

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

(2)             Incorporatedby reference to Exhibit 2.1 to registrant’s Form 8-K filed with theSEC on June 14, 1999.

(3)             Incorporatedby reference to Exhibit 3.4 to registrant’s Form 8-K filed with theSEC on May 30, 2001.

(4)             Incorporatedby reference to Exhibit 3.4 to registrant’s Form 10-Q filed with SECon August 5, 2004.

(5)             Incorporatedby reference to the exhibit as of the same number as filed with the SEC inour Form 8-K on May 30, 2001.

----