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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC. 20549

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FORM 10-Q


(Mark One)

|x  |  | Quarterly report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934 for the quarterly period ended
September 30, 2002           
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------
|  
|or |  |                                                                                                                                                     
|  
|o  |  | Transition report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934 for the transition period from ____________ to ____________

Commission File Number 0-24085

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AXT, INC.(Exact name of registrant as specified in its charter)

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

4281 Technology Drive, Fremont, California 94538
(Address of principal executive offices) (Zip code)
(510) 683-5900
(Registrants telephone number, including area code)

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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Act of 1934
during the preceding 12 months (or for such 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 the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date.

|                              |  |                                  
|----------------------------- |  | ---------------------------------
|Class                         |  | Outstanding at September 30, 2002
|                              |  |                                  
|Common Stock, $.001 par value |  | 22,495,094                       



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TABLE OF CONTENTS



|                              |                                                                                               |                                                             |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ----------------------------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | Item 1. Financial Statements                                                                 
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS                      
|                              |                                                                                               | CONDENSED CONSOLIDATED INCOME STATEMENTS (Unaudited)       
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS       
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Qualitative and Quantitative Disclosures About Market Risk                           
|                              | Item 4. Evaluation of Disclosure Controls and Procedures                                     
|PART II OTHER INFORMATION    
|                              | Item 1. Legal Proceedings                                                                    
|                              | Item 2. Changes in Securities and Use of Proceeds                                            
|                              | Item 3. Defaults Upon Senior Securities                                                      
|                              | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                              | Item 5. Other Information                                                                    
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                   
|Index to Exhibits            
|EXHIBIT 10.14                
|EXHIBIT 99.1                 
|EXHIBIT 99.2                 



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##### Table of Contents



AXT, INC.

TABLE OF CONTENTS

|         |  |                       |  |                                                                                                                          |  |      
|-------- |  | --------------------- |  | ------------------------------------------------------------------------------------------------------------------------ |  | -----
|         |  |                       |  |                                                                                                                          |  | Page 
|         |  |                       |  |                                                                                                                          |  |      
|PART I.  |  | FINANCIAL INFORMATION |  |                                                                                                                         
|        
|         |  | Item 1.               |  | Financial Statements                                                                                                     |  |      
|        
|         |  |                       |  | Condensed Consolidated Balance
        Sheets at September 30, 2002 and December 31, 2001                                |  | 3    
|        
|         |  |                       |  | Condensed Consolidated Income
        Statements for the three and nine months ended September 30, 2002
        and 2001 |  | 4    
|        
|         |  |                       |  | Condensed Consolidated Statements
        of Cash Flows for the nine months ended September 30, 2002 and 2001            |  | 5    
|        
|         |  |                       |  | Notes To Condensed Consolidated
        Financial Statements                                                             |  | 6-13 
|        
|         |  | Item 2.               |  | Managements Discussion
        and Analysis of Financial Condition and Results of Operations                            |  | 14-33
|        
|         |  | Item 3.               |  | Quantitative and Qualitative
        Disclosures About Market Risk                                                       |  | 34   
|        
|         |  | Item 4.               |  | Evaluation of Disclosure Controls
        and Procedures                                                                 |  | 35   
|        
|PART II. |  | OTHER INFORMATION     |  |                                                                                                                         
|        
|         |  | Item 1.               |  | Legal Proceedings                                                                                                        |  | 35   
|        
|         |  | Item 6.               |  | Exhibits and Reports on Form 8-K                                                                                         |  | 35-36
|        
|         |  |                       |  | Signatures                                                                                                               |  | 37   
|        
|         |  |                       |  | Certifications                                                                                                           |  | 37-39

2



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##### Table of Contents






PART I. FINANCIAL INFORMATION




Item 1. Financial Statements




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

|                                      |                               |                                                                                                                    |                            |        |               |         |              |        |         |         | 
|------------------------------------- | ----------------------------- | ------------------------------------------------------------------------------------------------------------------ | -------------------------- | ------ | ------------- | ------- | ------------ | ------ | ------- | ------- | 
|                                      |                               |                                                                                                                    |                            |        | September 30, |         | December 31,
|                                      |                               |                                                                                                                    |                            |        | 2002          |         | 2001        
|                                      |                               |                                                                                                                    |                            |        |               |         |             
|                                      |                               |                                                                                                                    |                            |        | (Unaudited)   |         |              |        |        
|Assets:                               |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      | Current assets                |                                                                                                                    |                            |        |               |         |              |        |        
|                                      |                               | Cash and cash equivalents                                                                                          |                            | $      | 12,647        |         |              | $      | 37,538  |        
|                                      |                               | Short-term investments                                                                                             |                            |        | 4,591         |         |              |        | 25,673  |        
|                                      |                               | Accounts receivable                                                                                                |                            |        | 11,868        |         |              |        | 15,684  |        
|                                      |                               | Inventories                                                                                                        |                            |        | 50,570        |         |              |        | 55,587  |        
|                                      |                               | Prepaid expenses and other current assets                                                                          |                            |        | 6,023         |         |              |        | 3,577   |        
|                                      |                               | Income tax receivable                                                                                              |                            |        | 7,721         |         |              |        |        |        
|                                      |                               | Deferred income taxes                                                                                              |                            |        |              |         |              |        | 10,557  |        
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      |                               |                                                                                                                    | Total current assets       |        |               | 93,420  |              |        |         | 148,616 | 
|                                      | Property, plant and equipment |                                                                                                                    |                            | 47,189 |               |         |              | 82,573 |        
|                                      | Restricted deposits           |                                                                                                                    |                            | 10,315 |               |         |              |       |        
|                                      | Long-term investments         |                                                                                                                    |                            | 6,906  |               |         |              | 6,552  |        
|                                      | Other assets                  |                                                                                                                    |                            | 5,104  |               |         |              | 4,511  |        
|                                      | Goodwill                      |                                                                                                                    |                            |       |               |         |              | 1,107  |        
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      |                               |                                                                                                                    | Total assets               |        | $             | 162,934 |              |        | $       | 243,359 | 
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       
|Liabilities and Stockholders Equity: |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      | Current liabilities           |                                                                                                                    |                            |        |               |         |              |        |        
|                                      |                               | Accounts payable                                                                                                   |                            | $      | 4,902         |         |              | $      | 2,943   |        
|                                      |                               | Accrued liabilities                                                                                                |                            |        | 10,025        |         |              |        | 13,362  |        
|                                      |                               | Income tax payable                                                                                                 |                            |        | 3,000         |         |              |        | 308     |        
|                                      |                               | Current portion of long-term debt                                                                                  |                            |        | 957           |         |              |        | 2,336   |        
|                                      |                               | Current portion of capital lease obligation                                                                        |                            |        | 3,971         |         |              |        | 4,372   |        
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      |                               |                                                                                                                    | Total current liabilities  |        |               | 22,855  |              |        |         | 23,321  | 
|                                      |                               | Long-term debt, net of current portion                                                                             |                            |        | 10,236        |         |              |        | 14,342  |        
|                                      |                               | Long-term capital lease, net of current portion                                                                    |                            |        | 5,783         |         |              |        | 10,002  |        
|                                      |                               | Other long-term liabilities                                                                                        |                            |        | 1,567         |         |              |        | 1,273   |        
|                                      |                               | Deferred income taxes                                                                                              |                            |        |              |         |              |        | 8,099   |        
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      |                               |                                                                                                                    | Total liabilities          |        |               | 40,441  |              |        |         | 57,037  | 
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      | Stockholders equity:         |                                                                                                                    |                            |        |               |         |              |        |        
|                                      |                               | Preferred stock, $.001 par value; 2,000 shares authorized; 883
shares issued and outstanding                       |                            |        | 3,532         |         |              |        | 3,532   |        
|                                      |                               | Common stock, $.001 par value per share; 70,000 shares authorized;
22,495 and 22,383 shares issued and outstanding |                            |        | 154,485       |         |              |        | 153,635 |        
|                                      |                               | Retained earnings                                                                                                  |                            |        | (34,665       | )       |              |        | 28,984  |        
|                                      |                               | Other comprehensive income                                                                                         |                            |        | (859          | )       |              |        | 171     |        
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      |                               |                                                                                                                    | Total stockholders equity |        |               | 122,493 |              |        |         | 186,322 | 
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       
|                                      |                               | Total liabilities and stockholders equity                                                                         |                            | $      | 162,934       |         |              | $      | 243,359 |        
|                                      |                               |                                                                                                                    |                            |        |               |         |              |       

See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.
CONDENSED CONSOLIDATED INCOME STATEMENTS (Unaudited)
(In thousands, except per share data)

|                                                |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |        |        | 
|----------------------------------------------- | ---------------------------------------------------------- | ------------------------ | ------- | ------------------ | ------ | ----------------- | ------ | ------ | ----- | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                |                                                            |                          |         | Three Months Ended |        | Nine Months Ended
|                                                |                                                            |                          |         | September 30,      |        | September 30,    
|                                                |                                                            |                          |         |                    |        |                  
|                                                |                                                            |                          |         | 2002               |        | 2001              |        | 2002   |       | 2001
|                                                |                                                            |                          |         |                    |        |                   |        |        |       |     
|Revenue                                         |                                                            | $                        | 14,948  |                    |        | $                 | 22,783 |        |       | $    | 50,919  |        |        | $ | 104,159 |       
|Cost of revenue                                 |                                                            |                          | 18,491  |                    |        |                   | 17,423 |        |       |      | 51,241  |        |        |   | 66,300  |       
|                                                |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Gross profit (loss)                             |                                                            |                          | (3,543  | )                  |        |                   | 5,360  |        |       |      | (322    | )      |        |   | 37,859  |       
|Operating expenses:                             |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                | Selling, general and administrative                        |                          |         | 4,993              |        |                   |        | 5,826  |       |      |         | 14,853 |        |   |         | 17,105 |       
|                                                | Research and development                                   |                          |         | 1,308              |        |                   |        | 1,701  |       |      |         | 3,756  |        |   |         | 6,834  |       
|                                                | Property, plant and equipment and goodwill impairment loss |                          |         | 15,107             |        |                   |        |       |       |      |         | 39,086 |        |   |         |       |       
|                                                |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                |                                                            | Total operating expenses |         |                    | 21,408 |                   |        |        | 7,527 |      |         |        | 57,695 |   |         |        | 23,939 | 
|                                                |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Income (loss) from operations                   |                                                            |                          | (24,951 | )                  |        |                   | (2,167 | )      |       |      | (58,017 | )      |        |   | 13,920  |       
|Interest expense                                |                                                            |                          | 364     |                    |        |                   | 493    |        |       |      | 1,114   |        |        |   | 1,637   |       
|Other (income)/expense                          |                                                            |                          | (303    | )                  |        |                   | (488   | )      |       |      | 8,188   |        |        |   | (1,542  | )     
|                                                |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Income (loss) before provision for income taxes |                                                            |                          | (25,012 | )                  |        |                   | (2,172 | )      |       |      | (67,319 | )      |        |   | 13,825  |       
|Provision expense (benefit) for income taxes    |                                                            |                          | 3,661   |                    |        |                   | (782   | )      |       |      | (3,670  | )      |        |   | 4,977   |       
|                                                |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Net income (loss)                               |                                                            | $                        | (28,673 | )                  |        | $                 | (1,390 | )      |       | $    | (63,649 | )      |        | $ | 8,848   |       
|                                                |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Basic income (loss) per share                   |                                                            |                          | (1.28   | )                  |        |                   | (0.06  | )      |       |      | (2.84   | )      |        |   | 0.40    |       
|Diluted income (loss) per share                 |                                                            |                          | (1.28   | )                  |        |                   | (0.06  | )      |       |      | (2.84   | )      |        |   | 0.39    |       
|Shares used in per share calculations:          |                                                            |                          |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                | Basic                                                      |                          |         | 22,478             |        |                   |        | 22,333 |       |      |         | 22,443 |        |   |         | 22,246 |       
|                                                | Diluted                                                    |                          |         | 22,478             |        |                   |        | 22,333 |       |      |         | 22,443 |        |   |         | 22,931 |       

See accompanying notes to these unaudited condensed consolidated financial statements.

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

|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |         |        |        |         |  
|-------------------------------------------------------- | ------------------------------------------------------------------------------------ | ------------------------------------------------------------- | --------------------------- | --------------------------------------------------- | ------ | ----------------- | ------- | ------- | ------ | ------ | ------- | -
|                                                         |                                                                                      |                                                               |                             |                                                     |        | Nine Months Ended
|                                                         |                                                                                      |                                                               |                             |                                                     |        | September 30,    
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                  
|                                                         |                                                                                      |                                                               |                             |                                                     |        | 2002              |         | 2001   
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|CASH FLOWS FROM OPERATING ACTIVITIES:                    |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|                                                         | Net income (loss):                                                                   |                                                               | $                           | (63,649                                             | )      |                   | $       | 8,848   |       
|                                                         | Adjustments to reconcile net income (loss) to cash provided by (used in)
operations: |                                                               |                             |                                                     |        |                   |         |         |       
|                                                         |                                                                                      | Depreciation                                                  |                             |                                                     | 7,498  |                   |         |         | 6,187  |       
|                                                         |                                                                                      | Deferred income taxes                                         |                             |                                                     | 3,259  |                   |         |         |       |       
|                                                         |                                                                                      | Amortization                                                  |                             |                                                     | 299    |                   |         |         | 266    |       
|                                                         |                                                                                      | Stock compensation                                            |                             |                                                     |       |                   |         |         | 83     |       
|                                                         |                                                                                      | Impairment write-down on marketable equity securities         |                             |                                                     | 9,160  |                   |         |         |       |       
|                                                         |                                                                                      | Non-cash (gain)\loss on marketable equity securities          |                             |                                                     | (251   | )                 |         |         |       |       
|                                                         |                                                                                      | Loss on disposal of property, plant and equipment             |                             |                                                     | 323    |                   |         |         |       |       
|                                                         |                                                                                      | Impairment loss on property, plant and equipment and goodwill |                             |                                                     | 39,086 |                   |         |         |       |       
|                                                         |                                                                                      | Changes in assets and liabilities:                            |                             |                                                     |        |                   |         |         |        |       
|                                                         |                                                                                      |                                                               | Accounts receivable         |                                                     |        | 3,816             |         |         |        | 4,624  |        
|                                                         |                                                                                      |                                                               | Inventories                 |                                                     |        | 5,017             |         |         |        | (6,692 | )      
|                                                         |                                                                                      |                                                               | Prepaid expenses            |                                                     |        | (2,341            | )       |         |        | (228   | )      
|                                                         |                                                                                      |                                                               | Other assets                |                                                     |        | (125              | )       |         |        | (120   | )      
|                                                         |                                                                                      |                                                               | Accounts payable            |                                                     |        | 1,959             |         |         |        | (1,532 | )      
|                                                         |                                                                                      |                                                               | Accrued liabilities         |                                                     |        | (3,336            | )       |         |        | 3,256  |        
|                                                         |                                                                                      |                                                               | Income taxes                |                                                     |        | (5,031            | )       |         |        |       |        
|                                                         |                                                                                      |                                                               | Other long-term liabilities |                                                     |        | 294               |         |         |        | 64     |        
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|                                                         |                                                                                      |                                                               |                             | Net cash (used in) provided by operating activities |        |                   | (4,022  | )       |        |        | 14,756  |  
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|CASH FLOWS FROM INVESTING ACTIVITIES:                    |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|                                                         | Purchases of property, plant and equipment                                           |                                                               |                             | (10,412                                             | )      |                   |         | (24,321 | )     
|                                                         | Purchases of marketable securities                                                   |                                                               |                             | (16,366                                             | )      |                   |         | (22,748 | )     
|                                                         | Proceeds from sale of marketable securities                                          |                                                               |                             | 15,570                                              |        |                   |         | 1,034   |       
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|                                                         |                                                                                      |                                                               |                             | Net cash used in investing activities               |        |                   | (11,208 | )       |        |        | (46,035 | )
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|CASH FLOWS FROM FINANCING ACTIVITIES:                    |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|                                                         | Proceeds from (payments of):                                                         |                                                               |                             |                                                     |        |                   |         |         |       
|                                                         |                                                                                      | Issuance of common stock                                      |                             |                                                     | 850    |                   |         |         | 4,612  |       
|                                                         |                                                                                      | Capital leases borrowings                                     |                             |                                                     |       |                   |         |         | 3,143  |       
|                                                         |                                                                                      | Capital leases payments                                       |                             |                                                     | (4,620 | )                 |         |         | (3,231 | )     
|                                                         |                                                                                      | Short-term debt payments                                      |                             |                                                     |       |                   |         |         | (966   | )     
|                                                         |                                                                                      | Long-term debt borrowings                                     |                             |                                                     | 637    |                   |         |         |       |       
|                                                         |                                                                                      | Long-term debt payments                                       |                             |                                                     | (6,699 | )                 |         |         | (2,171 | )     
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|                                                         |                                                                                      |                                                               |                             | Net cash (used in) provided by financing activities |        |                   | (9,832  | )       |        |        | 1,387   |  
|Effect of exchange rate changes                          |                                                                                      |                                                               | 171                         |                                                     |        |                   | 130     |        
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|Net decrease in cash and cash equivalents                |                                                                                      |                                                               | (24,891                     | )                                                   |        |                   | (29,762 | )      
|Cash and cash equivalents at the beginning of the period |                                                                                      |                                                               | 37,538                      |                                                     |        |                   | 68,585  |        
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|Cash and cash equivalents at the end of the period       |                                                                                      | $                                                             | 12,647                      |                                                     |        | $                 | 38,823  |        
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|Non cash activity:                                       |                                                                                      |                                                               |                             |                                                     |        |                   |         |        
|                                                         | Purchase of property, plant and equipment through financing                          |                                                               | $                           | 577                                                 |        |                   | $       | 2,170   |       
|                                                         |                                                                                      |                                                               |                             |                                                     |        |                   |         |        

See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation

The accompanying condensed consolidated balance sheets as of September 30,
2002 and December 31, 2001, the condensed consolidated income statements for
the three and nine months ended September 30, 2002 and 2001, and the condensed
consolidated statements of cash flows for the nine months ended September 30,
2002 and 2001 have been prepared by AXT, Inc. (AXT or the Company) and are
unaudited. The accompanying unaudited condensed consolidated financial
statements have been prepared in accordance with generally accepted accounting
principles for interim financial information and with the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, certain information and
footnote disclosure normally included in financial statements prepared in
accordance with generally accepted accounting principles in the United States
have been condensed or omitted. In the opinion of management, the unaudited
condensed consolidated financial statements reflect all adjustments, consisting
only of normal recurring adjustments, considered necessary to present fairly
the financial position, results of operations and cash flows of AXT and its
subsidiaries for all periods presented.

Management of the Company has made a number of estimates and assumptions
relating to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities to prepare these condensed consolidated
financial statements in conformity with generally accepted accounting
principles. Actual results could differ materially from those estimates.

The results of operations are not necessarily indicative of the results to
be expected in the future or for the full fiscal year. It is recommended that
these condensed consolidated financial statements be read in conjunction with
the Companys consolidated financial statements and the notes thereto included
in its 2001 Annual Report on Form 10-K filed with the Securities and Exchange
Commission on March 26, 2002.

Certain reclassifications have been made to the prior years consolidated
financial statements to conform to current period presentation.

Note 2. Gain on Demeter Warrants

In August 2000, the Company entered into a business transfer and
acquisition agreement with Demeter Technologies, Inc., a Delaware corporation
founded by Theodore S. Young, the former president of the Companys fiber optic
division and a former member of the Companys board of directors, and Robert
Shih, the former chief technology officer of the Companys opto-electronics
division. Under this agreement, the Company agreed to transfer certain non-core
rights to Demeter relating to research and development activities in the field
of fiber optics. The Company entered into non-competition agreements with
Messrs. Shih and Young that prohibit them from certain activities, including
the manufacture of certain VCSEL devices. The Company leased to Demeter a
portion of its owned facility in El Monte, California, subleased a portion of
its rented facility in El Monte, California, leased certain equipment,
including an MOCVD machine, and sold certain inventory relating to fiber optics
to Demeter. In exchange, Demeter granted to the Company a warrant to purchase
up to 4.5 million shares of its Series A convertible preferred stock at a price
of $0.5714 per share. Demeter was purchased by Finisar Corporation and as a
result, AXT converted its Demeter warrant for approximately 1.1 million shares
of Finisar Corporation common stock on November 21, 2000. On November 21,
2000, a gain of $27.3 million was recorded in other income as a result of the
transaction. On December 10, 2001, the Company received approximately 86,000
additional shares of common stock of Finisar Corporation that had been held in
escrow in accordance with the terms of the acquisition agreement between
Demeter and Finisar. A gain of $1.1 million was recorded in other income as a
result of receiving these additional shares. On December 31, 2001, the Company
wrote its investment in Finisar Corporation down to current market value, in
accordance with SFAS 115, resulting in a realized loss of $16.7 million
recorded in other income and expense. On February 4, 2002, the Company
received approximately 24,000 additional shares of common stock of Finisar
Corporation that had been held in escrow in accordance with the terms of the
acquisition agreement between Demeter and Finisar. A gain of $251,000 was
recorded in other income as a result of receiving these additional shares. The
investment in Finisar Corporation common stock is accounted for as available
for sale and

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classified as a short-term investment. On June 30, 2002, the Company
wrote its investment in Finisar Corporation down to current market value, in
accordance with SFAS 115, resulting in a realized loss of $9.2 million recorded
in other income and expense.

Note 3. Long-Lived Asset Impairment

In the second quarter of 2002, the Company completed an impairment review
of certain manufacturing assets used in the substrate and opto-electronics
divisions. The review was undertaken due to the recent history of operating
losses, declines in the demand for our products due to macro economic
conditions and excess capacity resulting in part from the relocation of certain
manufacturing operations in the Companys substrate division to China.

Upon completion of the review, the Company determined that the carrying
value of the manufacturing assets was not expected to be recoverable and
accordingly recorded an impairment charge in order to write-down the related
assets to their estimated fair value. The Company determined the amount of the
impairment charge by estimating the net present value of expected future cash
flows to be generated by the assets. Based on this analysis, the Company
recorded non-cash impairment charges of $14.1 million in the substrate segment
and $9.9 million in the opto-electronics segment for the laser diode operating
unit.

In the third quarter of 2002, the Company completed an impairment review
of certain manufacturing assets in the opto-electronics division. The review
was undertaken due to the unexpected operating losses incurred in the third
quarter, declines in product demand due to the Companys inability to
manufacture high volumes of its LED products to the Companys customers
requirements, and the need for the Company to reduce its current level of
production to conserve cash.

Upon completion of the review, the Company determined that the carrying
value of the manufacturing assets was not expected to be recoverable and
accordingly recorded an impairment charge in order to write-down the related
assets to their estimated fair value. The Company determined the amount of the
impairment charge by estimating the net present value of expected future cash
flows to be generated by the assets. Based on this analysis, the Company
recorded a non-cash impairment charge of $14.0 million.

Note 4. Goodwill Impairment

The Company adopted the provisions of SFAS 142, Goodwill and Other
Intangible Assets, effective January 1, 2002. Under the transition provisions
of SFAS No. 142, there was no goodwill impairment at January 1, 2002 based upon
the Companys analysis at that time. However, during the quarter ended
September 30, 2002, circumstances developed that indicated that the goodwill
was likely impaired and the Company performed an impairment analysis as of
September 30, 2002. This analysis resulted in a $1.1 million impairment of
goodwill. The circumstances that led to the impairment included a net loss for
the quarter and a significant drop in the Companys market capitalization.

Note 5. Investments

The Company classifies all of its investment securities as
available-for-sale securities as prescribed by Statement of Financial
Accounting Standards No. 115, Accounting for Certain Investments in Debt and
Equity Securities, and does not hold any debt securities with the positive
intent and ability to hold to maturity, or trading securities bought and held
principally for the purpose of selling in the near term. All investments
considered to be strategic in nature are carried at fair value, which is
determined based on quoted market prices, with net unrealized gains and losses
included in comprehensive income, net of tax. The components of investments at
September 30, 2002 are summarized below (in thousands):

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|                            |  |      |        |            |  |             |        |            |  |   |        |  
|--------------------------- |  | ---- | ------ | ---------- |  | ----------- | ------ | ---------- |  | - | ------ | -
|                            |  |      |        |            |  | Aggregate   |        | Unrealized
|Available for sale          |  | Cost |        | Fair value |  | Gain/(loss)
|                            |  |      |        |            |  |            
|Money market                |  | $    | 6,434  |            |  | $           | 6,434  |            |  | $ |       |  
|Corporate bonds             |  |      | 17,321 |            |  |             | 17,476 |            |  |   | 155    |  
|Government agency bonds     |  |      | 3,502  |            |  |             | 3,526  |            |  |   | 24     |  
|Corporate equity securities |  |      | 2,782  |            |  |             | 810    |            |  |   | (1,972 | )
|                            |  |      |        |            |  |             |        |            |  |   |        |  
|                            |  | $    | 30,039 |            |  | $           | 28,246 |            |  | $ | (1,793 | )
|                            |  |      |        |            |  |             |        |            |  |   |        |  
|Recorded as:                |  |      |        |            |  |             |        |            |  |   |        |  
|Cash equivalents            |  | $    | 6,434  |            |  |             |        |            |  |   |        |  
|Short-term investments      |  |      | 4,591  |            |  |             |        |            |  |   |        |  
|Long-term investments       |  |      | 6,906  |            |  |             |        |            |  |   |        |  
|Restricted
deposits         |  |      | 10,315 |            |  |             |        |            |  |   |        |  
|                            |  |      |        |            |  |             |        |            |  |   |        |  
|                            |  | $    | 28,246 |            |  |             |        |            |  |   |        |  
|                            |  |      |        |            |  |             |        |            |  |   |        |  

Note 6. Inventories

Inventories are stated at the lower of cost or net realizable value. Cost
is determined using the weighted average cost method. Finished goods and
work-in-process inventories include material, labor and manufacturing overhead
costs. We routinely evaluate the levels of our inventory in light of current
market conditions in order to identify excess and obsolete inventory and we
provide a valuation allowance for certain inventories based upon the age and
quality of the product. The components of inventory are summarized below (in
thousands):

|                  |                 |                      |        |               |         |              |        |        |         |  
|----------------- | --------------- | -------------------- | ------ | ------------- | ------- | ------------ | ------ | ------ | ------- | -
|                  |                 |                      |        | September 30, |         | December 31,
|                  |                 |                      |        | 2002          |         | 2001        
|                  |                 |                      |        |               |         |             
|Inventories, net: |                 |                      |        |               |         |              |        |       
|                  | Raw materials   |                      | $      | 19,833        |         |              | $      | 21,308 |        
|                  | Work in process |                      |        | 28,927        |         |              |        | 30,265 |        
|                  | Finished goods  |                      |        | 16,617        |         |              |        | 17,368 |        
|                  |                 | Valuation allowances |        |               | (14,807 | )            |        |        | (13,354 | )
|                  |                 |                      |        |               |         |              |        |       
|                  |                 | $                    | 50,570 |               |         | $            | 55,587 |       
|                  |                 |                      |        |               |         |              |        |       

Note 7. Net Income (loss) Per Share

Basic earnings per common share is calculated by dividing net income
(loss) available to common stockholders by the weighted average number of
common shares outstanding during the period. Diluted earnings per common share
include dilutive potential common shares calculated using the treasury stock
method. Dilutive potential common shares consist of the shares issuable upon
the exercise of stock options.

A reconciliation of the numerators and denominators of the basic and
diluted earnings per share calculations is summarized below (in thousands
except per share data):

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##### Table of Contents



|                                                                                 |                                                                           |                      |       |                    |   |                   |       |        |   |      |       |         |   |   |       |        |     | 
|-------------------------------------------------------------------------------- | ------------------------------------------------------------------------- | -------------------- | ----- | ------------------ | - | ----------------- | ----- | ------ | - | ---- | ----- | ------- | - | - | ----- | ------ | --- | 
|                                                                                 |                                                                           |                      |       | Three Months Ended |   | Nine Months Ended
|                                                                                 |                                                                           |                      |       | September 30,      |   | September 30,    
|                                                                                 |                                                                           |                      |       |                    |   |                  
|                                                                                 |                                                                           |                      |       | 2002               |   | 2001              |       | 2002   |   | 2001
|                                                                                 |                                                                           |                      |       |                    |   |                   |       |        |   |     
|Numerator:                                                                       |                                                                           |                      |       |                    |   |                   |       |        |   |      |       |         |   |   |       |       
|                                                                                 | Net income (loss)                                                         |                      | $     | (28,673            | ) |                   | $     | (1,390 | ) |      | $     | (63,649 | ) |   | $     | 8,848  |    
|                                                                                 | Less: Preferred stock dividends                                           |                      |       | (44                | ) |                   |       | (44    | ) |      |       | (133    | ) |   |       | (133   | )  
|                                                                                 | Net income (loss) available to common stockholders                        |                      | $     | (28,717            | ) |                   | $     | (1,434 | ) |      | $     | (63,782 | ) |   | $     | 8,715  |    
|                                                                                 |                                                                           |                      |       |                    |   |                   |       |        |   |      |       |         |   |   |       |       
|Denominator:                                                                     |                                                                           |                      |       |                    |   |                   |       |        |   |      |       |         |   |   |       |       
|                                                                                 | Denominator for basic earnings per share  weighted
average common shares |                      |       | 22,478             |   |                   |       | 22,333 |   |      |       | 22,443  |   |   |       | 22,246 |    
|                                                                                 | Effect of dilutive securities:                                            |                      |       |                    |   |                   |       |        |   |      |       |         |   |   |       |        |    
|                                                                                 |                                                                           | Common stock options |       |                    |  |                   |       |        |  |      |       |         |  |   |       |        | 685 | 
|                                                                                 |                                                                           |                      |       |                    |   |                   |       |        |   |      |       |         |   |   |       |       
|                                                                                 | Denominator for dilutive earnings per share                               |                      |       | 22,478             |   |                   |       | 22,333 |   |      |       | 22,443  |   |   |       | 22,931 |    
|Basic earnings per share                                                         |                                                                           | $                    | (1.28 | )                  |   | $                 | (0.06 | )      |   | $    | (2.84 | )       |   | $ | 0.39  |       
|Diluted earnings per share                                                       |                                                                           | $                    | (1.28 | )                  |   | $                 | (0.06 | )      |   | $    | (2.84 | )       |   | $ | 0.38  |       
|Options excluded from diluted net income per share as
the impact is antidilutive |                                                                           |                      | 2,757 |                    |   |                   | 2,670 |        |   |      | 2,845 |         |   |   | 1,136 |       

Note 8. Comprehensive Income

The components of comprehensive income are summarized below (in thousands):

|                                                         |  |                    |         |                   |  |      |         |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------- |  | ------------------ | ------- | ----------------- |  | ---- | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                         |  | Three Months Ended |         | Nine Months Ended
|                                                         |  | September 30,      |         | September 30,    
|                                                         |  |                    |         |                  
|                                                         |  | 2002               |         | 2001              |  | 2002 |         | 2001
|                                                         |  |                    |         |                   |  |      |         |     
|Net Income (loss)                                        |  | $                  | (28,673 | )                 |  | $    | (1,390  | )    |  | $ | (63,649 | ) |  | $ | 8,848   |  
|Foreign currency translation gain (loss)                 |  |                    | (33     | )                 |  |      | 263     |      |  |   | 171     |   |  |   | 131     |  
|Unrealized gain (loss) on available for sale investments |  |                    | (1,123  | )                 |  |      | (9,918  | )    |  |   | (1,201  | ) |  |   | (16,525 | )
|                                                         |  |                    |         |                   |  |      |         |      |  |   |         |   |  |   |         |  
|Comprehensive (loss) income                              |  | $                  | (29,829 | )                 |  | $    | (11,045 | )    |  | $ | (64,679 | ) |  | $ | (7,546  | )
|                                                         |  |                    |         |                   |  |      |         |      |  |   |         |   |  |   |         |  

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Note 9. Segment Information

The Company has two reportable segments as of September 30, 2002:
substrates and opto-electronics. The segments in which the Company operates
are subject to rapid technological change and significant competition. Also,
the number of suppliers of certain materials used by the Company and the number
of customers are limited.

Selected industry segment information is summarized below (in thousands):

|                          |                                      |  |                    |         |                   |  |      |         |      |  |   |         |   |  |   |         |  
|------------------------- | ------------------------------------ |  | ------------------ | ------- | ----------------- |  | ---- | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                          |                                      |  | Three Months Ended |         | Nine Months Ended
|                          |                                      |  | September 30,      |         | September 30,    
|                          |                                      |  |                    |         |                  
|                          |                                      |  | 2002               |         | 2001              |  | 2002 |         | 2001
|                          |                                      |  |                    |         |                   |  |      |         |     
|Substrates Division       |                                      |  |                    |         |                   |  |      |         |      |  |   |         |   |  |   |        
|                          | Net revenues from external customers |  | $                  | 11,726  |                   |  | $    | 20,455  |      |  | $ | 36,362  |   |  | $ | 97,326  |  
|                          | Gross profit (loss)                  |  |                    | (1,159  | )                 |  |      | 6,470   |      |  |   | 857     |   |  |   | 41,207  |  
|                          | Impairment loss                      |  |                    | 542     |                   |  |      |        |      |  |   | 14,632  |   |  |   |        |  
|                          | Operating income (loss)              |  |                    | (5,682  | )                 |  |      | 1,093   |      |  |   | (26,625 | ) |  |   | 24,111  |  
|                          | Identifiable assets                  |  |                    | 138,776 |                   |  |      | 204,276 |      |  |   | 138,776 |   |  |   | 204,276 |  
|Opto-electronics Division |                                      |  |                    |         |                   |  |      |         |      |  |   |         |   |  |   |        
|                          | Net revenues from external customers |  | $                  | 3,222   |                   |  | $    | 2,328   |      |  | $ | 14,557  |   |  | $ | 6,833   |  
|                          | Gross (loss)                         |  |                    | (2,384  | )                 |  |      | (1,110  | )    |  |   | (1,179  | ) |  |   | (3,348  | )
|                          | Impairment loss                      |  |                    | 14,565  |                   |  |      |        |      |  |   | 24,454  |   |  |   |        |  
|                          | Operating (loss)                     |  |                    | (19,269 | )                 |  |      | (3,260  | )    |  |   | (31,392 | ) |  |   | (10,191 | )
|                          | Identifiable assets                  |  |                    | 24,158  |                   |  |      | 41,005  |      |  |   | 24,158  |   |  |   | 41,005  |  
|Total                     |                                      |  |                    |         |                   |  |      |         |      |  |   |         |   |  |   |        
|                          | Net revenues from external customers |  | $                  | 14,948  |                   |  | $    | 22,783  |      |  | $ | 50,919  |   |  | $ | 104,159 |  
|                          | Gross profit (loss)                  |  |                    | (3,543  | )                 |  |      | 5,360   |      |  |   | (322    | ) |  |   | 37,859  |  
|                          | Impairment loss                      |  |                    | 15,107  |                   |  |      |        |      |  |   | 39,086  |   |  |   |        |  
|                          | Operating income (loss)              |  |                    | (24,951 | )                 |  |      | (2,167  | )    |  |   | (58,017 | ) |  |   | 13,920  |  
|                          | Identifiable assets                  |  |                    | 162,934 |                   |  |      | 245,281 |      |  |   | 162,934 |   |  |   | 245,281 |  

The Company sells its products in the United States and in other parts of
the world, and maintains operations in the United States, Japan and China.
Revenues by geographic location, based on the country in which the customer is
located, were as follows (in thousands):

|              |                        |  |                    |        |                   |  |      |        |      |  |   |        |  |  |   |         | 
|------------- | ---------------------- |  | ------------------ | ------ | ----------------- |  | ---- | ------ | ---- |  | - | ------ |  |  | - | ------- | 
|              |                        |  | Three Months Ended |        | Nine Months Ended
|              |                        |  | September 30,      |        | September 30,    
|              |                        |  |                    |        |                  
|              |                        |  | 2002               |        | 2001              |  | 2002 |        | 2001
|              |                        |  |                    |        |                   |  |      |        |     
|Net revenues: |                        |  |                    |        |                   |  |      |        |      |  |   |        |  |  |   |        
|              | United States          |  | $                  | 6,659  |                   |  | $    | 12,278 |      |  | $ | 22,077 |  |  | $ | 51,936  | 
|              | Europe                 |  |                    | 1,597  |                   |  |      | 4,037  |      |  |   | 4,148  |  |  |   | 20,151  | 
|              | Canada                 |  |                    | 172    |                   |  |      | 1,673  |      |  |   | 1,134  |  |  |   | 6,212   | 
|              | Japan                  |  |                    | 1,318  |                   |  |      |       |      |  |   | 2,289  |  |  |   |        | 
|              | Malaysia               |  |                    | 483    |                   |  |      |       |      |  |   | 6,760  |  |  |   |        | 
|              | Taiwan                 |  |                    | 3,068  |                   |  |      | 2,601  |      |  |   | 8,005  |  |  |   | 12,326  | 
|              | Asia Pacific and other |  |                    | 1,651  |                   |  |      | 2,194  |      |  |   | 6,506  |  |  |   | 13,534  | 
|              |                        |  |                    |        |                   |  |      |        |      |  |   |        |  |  |   |        
|              | Consolidated           |  | $                  | 14,948 |                   |  | $    | 22,783 |      |  | $ | 50,919 |  |  | $ | 104,159 | 
|              |                        |  |                    |        |                   |  |      |        |      |  |   |        |  |  |   |        

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Note 10. Corporate Affiliates

The Companys corporate affiliates are summarized below (in thousands):

|                                               |  |               |       |              |  |            |       |            |  |              |  |  |    |   |  | 
|---------------------------------------------- |  | ------------- | ----- | ------------ |  | ---------- | ----- | ---------- |  | ------------ |  |  | -- | - |  | 
|                                               |  | Investment    |       | Investment   |  |            |       |            |  |              |  | 
|                                               |  | Balance       |       | Balance      |  |            |       |            |  |              |  | 
|                                               |  | September 30, |       | December 31, |  | Accounting |       | Ownership 
|Affiliate                                      |  | 2002          |       | 2001         |  | Method     |       | Percentage
|                                               |  |               |       |              |  |            |       |           
|Xilingol Tongli Ge Co. Ltd.                    |  | $             | 807   |              |  | $          | 810   |            |  | Equity       |  |  | 25 | %
|Emeishan Jia Mei High Pure Metals Co., Ltd.    |  |               | 613   |              |  |            | 629   |            |  | Equity       |  |  | 25 | %
|Beijing Ji Ya Semiconductor Material Co., Ltd. |  |               | 1,071 |              |  |            | 1,071 |            |  | Consolidated |  |  | 51 | %
|Nanjing Jin Mei Gallium Co., Ltd.              |  |               | 616   |              |  |            | 616   |            |  | Consolidated |  |  | 88 | %

Undistributed retained earnings relating to the Companys corporate
affiliates was $986,000 at September 30, 2002. Net income recorded from the
Companys corporate affiliates was $25,000 and $256,000 for the three and nine
months ended September 30, 2002 respectively.

Note 11. Restructuring Costs

On December 14, 2000, the Companys Board of Directors approved
managements plan to exit its unprofitable 650 nm laser diode product line
within its opto-electronics division. As a result, during the fourth quarter
of 2000, the Company recorded a pre-tax restructuring charge of $8.2 million.
The restructuring charge included $2.1 million for incremental costs and
contractual obligations for such items as leasehold termination payments and
other facility exit costs incurred as a direct result of this plan.

The components of the restructuring charge are summarized below (in
thousands):

|                                        |  |         |       |      |  |          |     |                    |  |   |       |  |  |   |       | 
|--------------------------------------- |  | ------- | ----- | ---- |  | -------- | --- | ------------------ |  | - | ----- |  |  | - | ----- | 
|                                        |  |         |       |      |  | Utilized |     |                    |  |  
|                                        |  |         |       |      |  |          |     | Balance           
|                                        |  | Reserve |       | Cash |  | Non-cash |     | September 30, 2002
|                                        |  |         |       |      |  |          |     |                   
|Inventory write-off                     |  | $       | 1,844 |      |  | $        |    |                    |  | $ | 1,844 |  |  | $ |      | 
|Property, plant and equipment write-off |  |         | 3,436 |      |  |          |    |                    |  |   | 3,436 |  |  |   |      | 
|Goodwill write-off                      |  |         | 848   |      |  |          |    |                    |  |   | 848   |  |  |   |      | 
|Other restructuring costs               |  |         | 2,124 |      |  |          | 899 |                    |  |   | 121   |  |  |   | 1,104 | 
|                                        |  |         |       |      |  |          |     |                    |  |   |       |  |  |   |       | 
|                                        |  | $       | 8,252 |      |  | $        | 899 |                    |  | $ | 6,249 |  |  | $ | 1,104 | 
|                                        |  |         |       |      |  |          |     |                    |  |   |       |  |  |   |       | 

The fair value of assets determined to be impaired in accordance with the
guidance for assets to be disposed set forth in SFAS No. 121, Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of, was determined in accordance with management estimates, and exit costs
incurred as a direct result of the restructuring plan were determined in
accordance with EITF No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity. The restructuring
actions, as outlined by the plan, are substantially complete. The remaining
costs are approximately $1.1 million and relate to clean up of a leased
facility. The clean up is expected to be completed in 2002.

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Note 12. Commitments

From time to time the Company is involved in litigation in the normal
course of business. Management believes that the outcome of matters to date
will not have a material adverse effect on the Companys financial position,
results of operations or cash flows.

On May 1, 2001, the Santa Clara Center for Occupational Safety and Health
filed a complaint for injunctive relief and civil penalties against the Company
in the Superior Court of California, County of Alameda, Hayward Division, Case
No. H218237-5. The complaint alleged violations of California Business and
Professions Code section 17200 et seq., and violations under Proposition 65 and
California Health and Safety Code section 25249 et seq. as a result of AXTs
use of arsenic and inorganic arsenic compounds in its workplace. On June 24,
2002, the Company participated in a private mediation, and as a result, reached
a settlement of all claims, pursuant to which the Company agreed to pay the
Santa Clara Center for Occupational Safety and Health an amount equal to
$175,000. The parties have executed a settlement agreement, and the court
approved the settlement on September 20, 2002, and dismissal of the case is
pending.

The Company has entered into contracts to supply several large customers
with GaAs wafers. The contracts guarantee the delivery of a certain number of
wafers between January 1, 2001 and December 31, 2002 with a current contract
value of $8.2 million. The contract sales prices are subject to review
quarterly and can be adjusted in the event that raw material prices change. In
the event of non-delivery of the determined wafer quantities in any monthly
delivery period, the Company could be subject to non-performance penalties of
between 5% and 10% of the value of the delinquent monthly deliveries. Partial
prepayments received for these supply contracts totaling $2.9 million are
included in accrued liabilities at September 30, 2002. As of September 30,
2002 the Company has met all of its delivery obligations under these contracts
and expects to do so for the remainder of the contract terms.

Note 13. Foreign Exchange Contracts and Transaction Losses

The Company uses short-term forward exchange contracts for hedging
purposes to reduce the effects of adverse foreign exchange rate movements. The
Company has purchased foreign exchange contracts to hedge against certain trade
accounts receivable denominated in Japanese yen. The change in the fair value
of the forward contracts is recognized as part of the related foreign currency
transactions as they occur. As of September 30, 2002, the Companys outstanding
commitments with respect to the foreign exchange contracts, which were
commitments to sell Japanese yen, had a total contract value of approximately
$3.7 million.

The Company incurred a foreign transaction exchange loss of $46,121 and a
gain of $107,443 for the three and nine months ended September 30, 2002
respectively and gains of $84,500 and $394,300 for the three and nine months
ended September 30, 2001 respectively.

Note 14. Credit Facility

At June 30, 2002, the credit facility maintained by the Company with a
bank included a $5 million line of credit with no balance outstanding, term
loans in the amount of $4.8 million and a letter of credit supporting repayment
of the Companys industrial revenue bonds with an outstanding amount of $9.4
million. The credit facility is collateralized by all corporate personal and
real property owned by the Company. As of June 30, 2002, the Company was in
default of the credit facility by failure to maintain certain financial
covenants required under the terms of the facility. As a result, on September
30, 2002 we modified the credit agreement with our bank, which waived the
covenant default, terminated the credit line, amended the financial covenants
and added additional collateral to secure repayment of the bonds. At September
30, 2002 the credit facility included a letter of credit supporting our bonds
with an outstanding amount of $9.2 million and foreign exchange and overdraft
obligations in the amount of $1.1 million. The Company has pledged and placed
certain investment securities with the trust department of the bank as
additional collateral for this facility. As a result, $10.3 million of our
long-term investments are restricted. At September 30, 2002 we are in
compliance with the financial covenants as amended.

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Note 15. Income taxes

The Company recorded an income tax provision expense of $3.7 million and a
benefit of $3.7 million for the three and nine months ended September 30, 2002
respectively. Included in the provisions is a charge of $14.9 million and
$24.5 million for the three and nine months ended September 30, 2002
respectively, to record a valuation allowance against cumulative tax benefits
due to uncertainties regarding the ability to realize the deferred tax assets
arising from the asset impairment charges recorded during the second and third
quarters.

Note 16. Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 141 and No. 142, or SFAS 141,
Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets.
Under SFAS 141, all business combinations must be accounted for using the
purchase method of accounting; use of the pooling-of-interests (pooling) method
is prohibited. The provisions of the statement will apply to all business
combinations initiated after June 30, 2001. SFAS 142 will apply to all
acquired intangible assets whether acquired singly, as a part of a group, or in
a business combination. The statement will supersede APB Opinion No. 17,
Intangible Assets, and will carry forward provisions in APB Opinion No. 17
relating to internally developed intangible assets. Adoption of SFAS 142 will
result in ceasing amortization of goodwill. All of the statement should be
applied in fiscal years beginning after December 31, 2001 to all goodwill and
other intangible assets recognized in an entitys statement of financial
position at that date, regardless of when those assets were initially
recognized. During the quarter, as a result of our periodic review of the
recoverability of goodwill in accordance with SFAS 142, we recorded an
impairment charge of $1.1 million.

In October 2001, the FASB issued Statement of Accounting Standards No.
144, Accounting for Impairment or Disposal of Long-Lived Assets (SFAS 144).
SFAS 144 supercedes SFAS 121 Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of. SFAS 144 applies to all
long-lived assets (including discontinued operations) and consequently amends
Accounting Principles Board Opinion No. 30 (APB 30), Reporting Results of
Operations- Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions.
SFAS 144 develops one accounting model for long-lived assets that are to be
disposed of by sale. SFAS 144 requires the long-lived assets that are to be
disposed of by sale be measured at the lower of book value or fair value less
cost to sell. Additionally, SFAS 144 expands the scope of discontinued
operations to include all components of the entity with operations that (1) can
be distinguished from the rest of the entity and (2) will be eliminated from
the ongoing operations of the entity in a disposal transaction. SFAS 144 is
effective for the Company for all financial statements issued in fiscal 2002.
During the nine months ended September 30 2002, the Company recorded non-cash
impairment charges of $38.0 million to write down to estimated fair value, idle
manufacturing assets to be held and used.

In July 2002, the FASB issued Statement of Accounting Standards No. 146,
Accounting for Costs Associated with Exit and Disposal Activities. This
statement revises the accounting for exit and disposal activities under EITF
Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity, by spreading out the reporting
of expenses related to restructuring activities. Commitment to a plan to exit
an activity or dispose of long-lived assets will no longer be sufficient to
record a one-time charge for most anticipated costs. Instead, companies will
record exit disposal costs when they are incurred and can be measured at fair
value, and they will subsequently adjust the recorded liability for changes in
estimated cash flows. The provisions of SFAS No. 146 are effective
prospectively for exit or disposal activities initiated after December 31,
2002. Companies may not restate previously issued financial statements for the
effect of the provisions of SFAS No. 146 and liabilities that a company
previously recorded under EITF Issue 94-3 are grandfathered. We do not believe
that the adoption of SFAS No. 146 will have a material impact on our
consolidated financial statements.

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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

This Managements Discussion and Analysis of Financial Condition and
Results of Operations includes a number of forward-looking statements made
pursuant to the provisions of Section 21E of the Securities Exchange Act of
1934. These forward-looking statements are based upon managements current
views with respect to future events and financial performance, and are subject
to certain risks and uncertainties that could cause actual results to differ
materially from historical results or those anticipated. Such risks and
uncertainties include those set forth under Risks Related to our Business
below. Forward-looking statements may be identified by the use of terms such as
anticipates, believes, estimates, expects, intends, and
similar expressions. Statements concerning our financial position, business
strategy and plans or objectives for future operations are forward-looking
statements. These forward-looking statements are not guarantees of future
performance. Readers are 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 conjunction with Managements Discussion and
Analysis of Financial Condition and Results of Operations included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2001 and
the condensed consolidated financial statements included elsewhere in this
report.

Overview

We were founded in 1986 to commercialize and enhance our proprietary
vertical gradient freeze (VGF) technique for producing high-performance
compound semiconductor substrates. We currently operate two divisions: our
substrate division and our opto-electronics division. We made our first
substrate sales in 1990 and our substrate division currently sells gallium
arsenide (GaAs) and indium phosphide (InP) substrates to manufacturers of
semiconductor devices for use in applications such as fiber optic and wireless
telecommunications, light emitting diodes (LEDs) and lasers. We also sell
germanium substrates for use in satellite solar cells. We acquired Lyte
Optronics, Inc., on May 28, 1999, and currently operate part of Lytes
historical business as our opto-electronics division. The opto-electronics
division manufactures high-brightness LEDs (HBLEDs) for the illumination
markets, including full-color displays, automobile lighting and traffic
signals, and also manufactures vertical cavity surface emitting lasers (VCSELs)
and laser diodes for fiber optic communications and storage area networks. We
previously operated the consumer products division, discontinued in December
2000, which had focused on the design and manufacture of laser-pointing and
alignment products for the consumer, commercial and industrial markets.

Critical Accounting Policies and Estimates

We have prepared our consolidated financial statements in accordance with
accounting principles generally accepted in the United States. As such, we
have made estimates and judgments that affect the preparation of these
statements based upon historical experience and on other assumptions that are
believed to be reasonable under the circumstances. The discussion and analysis
of our results of operations and financial condition are based upon these
statements. Actual results may differ from these estimates under different
assumptions or conditions. We have identified the policies below as critical
to our business operations and understanding of our financial condition and
results of operations.

We recognize revenue upon shipment of products to our customers, provided
that we have received a signed purchase order, the price is fixed, title has
transferred, collection of resulting receivables is probable, product returns
are reasonably estimable, there are no customer acceptance requirements and
there are no remaining significant obligations. We assess the probability of
collection based on a number of factors including past history with the
customer and credit worthiness. We provide for future returns at the time
revenue is recognized, based on historical experience, current economic trends
and changes in customer demand. Except for sales in Japan and some sales in
Taiwan, which in both cases are denominated in Japanese yen, we denominate and
collect our international sales in U.S. dollars.

We periodically review the collectability of our accounts receivable
balances and provide an allowance for doubtful accounts receivable based upon
the age of these accounts. We provide a 100% allowance for U.S. receivables in
excess of 90 days and for foreign receivables in excess of 120 days. At
September 30, 2002 our accounts receivable balance was $11.9 million net of an
allowance for doubtful accounts of $8.2 million.

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Inventories are stated at the lower of cost or net realizable value. Cost
is determined using the weighted average cost method. Finished goods and
work-in-process inventories include material, labor and manufacturing overhead
costs. We routinely evaluate the levels of our inventory in light of current
market conditions in order to identify excess and obsolete inventory and we
provide a valuation allowance for certain inventories based upon the age and
quality of the product. We also review our inventory to ensure costs can be
realized upon ultimate sale to our customers. If we determine that the value of
any items in ending inventory plus any related selling costs exceeds the sales
value, a reserve is established for the difference.

Our industry requires substantial investments in property and equipment in
order to meet demand and changes in technology. In addition, we occasionally
make investments in companies, which are developing promising relevant
technologies. We review the carrying value of our long-lived assets and
investments in order to identify any impairment. Long-lived assets are written
down when the carrying value of these assets exceeds their related undiscounted
future cash flows. Key assumptions in estimating future cash flows include
estimates of sales volumes, changes in selling prices and cost of materials.
It is possible that actual results will differ from these estimates and such
differences may be material and require future adjustments to the carrying
value of our long-lived assets. In the second and third quarters of 2002, we
completed an impairment review of certain manufacturing assets used in the
substrate and opto-electronics divisions. The review was undertaken due to the
recent history of operating losses, declines in the demand for our products due
to macro economic conditions, the Companys inability to manufacture high
volumes of its LED products to the Companys customers requirements, and
excess capacity resulting in part from the addition of certain manufacturing
operations in our substrate division in China. Upon completion of the review,
we determined that the carrying value of the manufacturing assets was not
expected to be recoverable and accordingly recorded an impairment charge in
order to write-down the related assets to their estimated fair value. We
determined the amount of the impairment charge by estimating the net present
value of expected future cash flows to be generated by the assets. Based on
this analysis for the nine months ended September 30, 2002, we recorded
non-cash impairment charges of $14.1 million in the substrate segment and $23.9
million in the opto-electronics segment.

In connection with the preparation of our consolidated financial
statements, we must estimate our income taxes by the jurisdiction in which we
operate. This process requires us to estimate our actual current tax exposure
and asses temporary differences resulting from differing treatment of items,
such as deferred revenue and/or expense, for tax and accounting purposes. These
differences result in deferred tax assets and liabilities, which are included
within our consolidated balance sheet. We must then assess the likelihood that
our deferred tax assets will be recovered from future taxable income and to the
extent we believe that recovery is not likely, we must establish a valuation
allowance. To the extent we establish a valuation allowance or increase this
allowance in a period, we must include an expense within the tax provision in
the statement of operations.

Significant management judgment is required in determining our provision
for income taxes, our deferred tax assets and liabilities, and any valuation
allowance recorded against our net deferred tax assets. We have recorded a
valuation allowance of $24.5 million as of September 30, 2002, due to
uncertainties related to our ability to utilize our deferred tax assets,
primarily consisting of certain net operating losses carried forward and tax
credits, before they expire. The valuation allowance is based on our estimates
of taxable income by jurisdiction in which we operate and the period over which
our deferred tax assets will be recoverable. In the event that actual results
differ from these estimates or we adjust these estimates in future periods, we
may need to establish an additional valuation allowance which could materially
impact our financial position and results of operations.

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Results of Operations

The following table sets forth certain information relating to our
financial results expressed as a percentage of total revenues for the periods
indicated:

|                                                |                                                            |                          |        |                    |       |                   |       |      |      |      |        |      |       |  |       |      |      | 
|----------------------------------------------- | ---------------------------------------------------------- | ------------------------ | ------ | ------------------ | ----- | ----------------- | ----- | ---- | ---- | ---- | ------ | ---- | ----- |  | ----- | ---- | ---- | 
|                                                |                                                            |                          |        | Three Months Ended |       | Nine Months Ended
|                                                |                                                            |                          |        | September 30,      |       | September 30,    
|                                                |                                                            |                          |        |                    |       |                  
|                                                |                                                            |                          |        | 2002               |       | 2001              |       | 2002 |      | 2001
|                                                |                                                            |                          |        |                    |       |                   |       |      |      |     
|Revenues                                        |                                                            |                          | 100.0  | %                  |       |                   | 100.0 | %    |      |      | 100.0  | %    |       |  | 100.0 | %   
|Cost of revenues                                |                                                            |                          | 123.7  |                    |       |                   | 76.5  |      |      |      | 100.6  |      |       |  | 63.7  |     
|                                                |                                                            |                          |        |                    |       |                   |       |      |      |      |        |      |       |  |       |     
|Gross profit (loss)                             |                                                            |                          | (23.7  | )                  |       |                   | 23.5  |      |      |      | (0.6   | )    |       |  | 36.3  |     
|Operating expenses:                             |                                                            |                          |        |                    |       |                   |       |      |      |      |        |      |       |  |       |     
|                                                | Selling, general and administrative                        |                          |        | 33.4               |       |                   |       | 25.6 |      |      |        | 29.2 |       |  |       | 16.4 |     
|                                                | Research and development                                   |                          |        | 8.8                |       |                   |       | 7.5  |      |      |        | 7.4  |       |  |       | 6.6  |     
|                                                | Property, plant and equipment and goodwill impairment loss |                          |        | 101.1              |       |                   |       |      |      |      |        | 76.8 |       |  |       |      |     
|                                                |                                                            |                          |        |                    |       |                   |       |      |      |      |        |      |       |  |       |     
|                                                |                                                            | Total operating expenses |        |                    | 143.3 |                   |       |      | 33.1 |      |        |      | 113.4 |  |       |      | 23.0 | 
|                                                |                                                            |                          |        |                    |       |                   |       |      |      |      |        |      |       |  |       |     
|Income (loss) from operations                   |                                                            |                          | (167.0 | )                  |       |                   | (9.6  | )    |      |      | (114.0 | )    |       |  | 13.4  |     
|Interest expense                                |                                                            |                          | 2.4    |                    |       |                   | 2.2   |      |      |      | 2.2    |      |       |  | 1.6   |     
|Other (income)/expense                          |                                                            |                          | (2.0   | )                  |       |                   | (2.1  | )    |      |      | 16.1   |      |       |  | (1.5  | )   
|                                                |                                                            |                          |        |                    |       |                   |       |      |      |      |        |      |       |  |       |     
|Income (loss) before provision for income taxes |                                                            |                          | (167.4 | )                  |       |                   | (9.7  | )    |      |      | (132.3 | )    |       |  | 13.3  |     
|Provision expense (benefit) for income taxes    |                                                            |                          | 24.5   |                    |       |                   | (3.4  | )    |      |      | (7.2   | )    |       |  | 4.8   |     
|                                                |                                                            |                          |        |                    |       |                   |       |      |      |      |        |      |       |  |       |     
|Net Income (loss)                               |                                                            |                          | (191.9 | )%                 |       |                   | (6.3  | )%   |      |      | (125.1 | )%   |       |  | 8.5   | %   
|                                                |                                                            |                          |        |                    |       |                   |       |      |      |      |        |      |       |  |       |     

Three Months Ended September 30, 2002 Compared to Three Months Ended September
30, 2001

Revenue.Revenue decreased $7.8 million, or 34.4%, to $14.9 million for
the three months ended September 30, 2002 compared to $22.8 million for the
three months ended September 30, 2001. Revenue from our substrate division,
which represented 78.5% of total revenue for the three months ended September
30, 2002, decreased $8.7 million, or 42.7%, to $11.7 million compared to $20.5
million for the three months ended September 30, 2001. Total GaAs substrate
revenue decreased $2.1 million, or 18.8%, to $9.0 million for the three months
ended September 30, 2002 compared to $11.1 million for the three months ended
September 30, 2001. Sales of 5 inch and 6 inch GaAs substrates increased $1.4
million, or 82.6%, to $3.0 million for the three months ended September 30,
2002 compared to $1.6 million for the three months ended September 30, 2001.
InP substrate revenue decreased $6.8 million, or 86.2%, to $1.1 million for the
three months ended September 30, 2002 compared to $7.9 million for the three
months ended September 30, 2001. The decrease in GaAs and InP substrate
revenue is due to decreased volume and sales prices as a result of the slowdown
in our markets including telecommunications, high speed electronic devices, and
short wavelength lasers.

Revenue from our opto-electronics division, which represented 21.5% of
total revenue for the three months ended September 30, 2002 increased $894,000,
or 38.4% to $3.2 million compared to $2.3 million for the three months ended
September 30, 2001. The increase was a result of higher sales volume of HBLED
products. HBLED revenue increased $987,000, or 64.0%, to $2.5 million for the
three months ended September 30, 2002 compared to $1.5 million for the three
months ended September 30, 2001. HBLED revenue decreased $3.1 million
sequentially from the prior quarter. The decrease was primarily due to a
decrease in sales volume to our largest customer, Agilent, and to a $921,000
sales return allowance. The decrease in sales volume to Agilent was due to our
inability to manufacture a high volume of product to the customers
specification. We are currently working to improve our manufacturing processes
and are hopeful that we will resume shipping product to Agilent late in the
fourth quarter. The sales return allowance was due to products returned during
the third quarter and to anticipation of future return of products shipped
during the third quarter. VCSEL and laser diode revenue decreased $93,000, or
11.8%, to $692,000 for the three months ended September 30, 2002 compared to
$785,000 for the three months ended September 30, 2001.

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International revenue increased to 55.5% of total revenue for the three
months ended September 30, 2002 compared to 46.1% of total revenue for the
three months ended September 30, 2001. The increase was primarily due to
increased sales of HBLED products to customers in Asia.

Gross margin.Gross margin decreased to negative 23.7% of total revenue
for the three months ended September 30, 2002 compared to 23.5% of total
revenue for the three months ended September 30, 2001. Gross margin at the
substrate division decreased to negative 9.9% of substrate revenue for the
three months ended September 30, 2002 compared to 31.6% of substrate revenue
for the three months ended September 30, 2001. The decrease was primarily due
to lower volume and sales prices of substrates spread over a relatively fixed
manufacturing overhead base and charges related to aging inventory. As a
result, we have initiated manufacturing cost reductions in order to align our
costs with lower expected sales volumes and prices. We are currently shifting
much of our substrate manufacturing to China, where costs are lower, and
reducing capacity at our Fremont, California facility. Gross margin at the
opto-electronics division decreased to negative 74.0% of opto-electronics
revenue for the three months ended September 30, 2002 compared to negative
47.7% of opto-electronics revenue for the three months ended September 30,
2001. The decrease in opto-electronics margin was primarily due to the
decrease in sequential HBLED revenue from the prior quarter. In the previous
several quarters, we had increased our manufacturing overhead costs in order to
increase our production capacity to sustain higher revenue levels, which we
achieved through the second quarter of 2002. In early October, we took action
to reduce the HBLED manufacturing overhead costs to align them with expected
future revenue levels. These efforts to reduce costs will continue.

Selling, general and administrative expenses.Selling, general and
administrative expenses decreased $833,000, or 14.3%, to $5.0 million for the
three months ended September 30, 2002 compared to $5.8 million for the three
months ended September 30, 2001. As a percentage of total revenue, selling,
general and administrative expenses were 33.4% for the three months ended
September 30, 2002 compared to 25.6% for the three months ended September 30,
2001. The increase in selling, general and administrative expenses as a
percentage of total revenue was primarily due to decreased revenue from lower
sales volume and prices. We are currently taking action to reduce our selling,
general and administration costs and align them with expected future revenue
levels. As a result, except for possible increases in bad debt expense, we
expect these costs to decrease in both absolute value and as a percentage of
revenue in future quarters.

Research and development expenses.Research and development expenses
decreased $393,000, or 23.1%, to $1.3 million for the three months ended
September 30, 2002 compared to $1.7 million for the three months ended
September 30, 2001. As a percentage of total revenue, research and development
expenses were 8.8% for the three months ended September 30, 2002 compared to
7.5% for the three months ended September 30, 2001. The decrease in research
and development expenses was primarily the result of our decision to reduce
expenses and align them with expected future revenues.

Long-Lived Asset Impairment.In the third quarter of 2002, we completed an
impairment review of certain manufacturing assets in the opto-electronics
division. The review was undertaken due to the unexpected operating losses
incurred in the third quarter, declines in product demand due to our inability
to manufacture high volumes of our LED products to our customers requirements
and the need for the Company to reduce its current level of production to
conserve cash. Upon completion of the review, we determined that the carrying
value of the manufacturing assets was not expected to be recoverable and
accordingly recorded an impairment charge in order to write-down the related
assets to their estimated fair value. We determined the amount of the
impairment charge by estimating the net present value of expected future cash
flows to be generated by the assets. Based on this analysis, we recorded a
non-cash impairment charge of $14.0 million.

Goodwill Impairment. We adopted the provisions of SFAS 142, Goodwill and
Other Intangible Assets, effective January 1, 2002. Under the transition
provisions of SFAS No. 142, there was no goodwill impairment at January 1, 2002
based upon our analysis at that time. However, during the quarter ended
September 30, 2002, circumstances developed that indicated that the goodwill
was likely impaired and we performed an impairment analysis as of September 30,
2002. This analysis resulted in a $1.1 million impairment of goodwill. The
circumstances that led to the impairment included a net loss for the quarter
and a significant drop in our market capitalization.

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Interest expense.Interest expense decreased $129,000, or 26.2%, to
$364,000 for the three months ended September 30, 2002 compared to $493,000 for
the three months ended September 30, 2001 due to the repayment of debt and a
reduction of rates on our variable interest rate debts over the period.

Other income and expense.Other income decreased $185,000 to $303,000 for
the three months ended September 30, 2002 compared to income of $488,000 for
the three months ended September 30, 2001.

Provision for income taxes.Our effective tax rate decreased to 14.6% for
the three months ended September 30, 2002 compared to 36.0% for the three
months ended September 30, 2001. The current quarter tax rate is primarily the
result of recording a valuation allowance against the tax benefits related to
the asset impairment charges that were taken in the second and third quarters.
The valuation allowance was applied to the benefit due to uncertainty regarding
its recoverability.

Nine Months Ended September 30, 2002 Compared to Nine Months Ended September
30, 2001

Revenue.Revenue decreased $53.3 million, or 51.1%, to $50.9 million for
the nine months ended September 30, 2002 compared to $104.2 million for the
nine months ended September 30, 2001. Revenue from our substrate division,
which represented 71.4% of total revenue for the nine months ended September
30, 2002, decreased $60.9 million, or 62.6%, to $36.4 million compared to $97.3
million for the nine months ended September 30, 2001. Total GaAs substrate
revenue decreased $42.2 million, or 61.5%, to $26.4 million for the nine months
ended September 30, 2002 compared to $68.6 million for the nine months ended
September 30, 2001. Sales of 5 inch and 6 inch GaAs substrates decreased $12.9
million, or 62.8%, to $7.7 million for the nine months ended September 30, 2002
compared to $20.6 million for the nine months ended September 30, 2001. InP
substrate revenue decreased $16.6 million, or 79.9%, to $4.2 million for the
nine months ended September 30, 2002 compared to $20.8 million for the nine
months ended September 30, 2001. The decrease in GaAs and InP substrate revenue
is due to decreased volume and sales prices as a result of the slowdown in our
markets including telecommunications, high speed electronic devices, and short
wavelength lasers.

Revenue from our opto-electronics division, which represented 28.6% of
total revenue for the nine months ended September 30, 2002, increased $7.8
million, or 113.0% to $14.6 million compared to $6.8 million for the nine
months ended September 30, 2001. The increase was a result of higher sales
volume of HBLED products. HBLED revenue increased $8.5 million, or 205.7%, to
$12.6 million for the nine months ended September 30, 2002 compared to $4.1
million for the nine months ended September 30, 2001. The higher HBLED sales
volume was primarily concentrated with one customer, Agilent, during this
period. In the current quarter, HBLED revenue decreased $3.1 million
sequentially from the prior quarter. The decrease was primarily due to a
decrease in sales volume to Agilent, and to a $931,000 sales return allowance.
The decrease in sales volume to Agilent was due to our inability to manufacture
a high volume of product to the customer specification. We are currently
working to improve our manufacturing processes and are hopeful that we will
resume shipping product to Agilent late in the fourth quarter. The sales
return allowance was due primarily to products returned during the third
quarter and to anticipation of future return of products shipped during the
third quarter. As a result of our current manufacturing difficulties, the year
to date revenue growth in HBLED revenue is not indicative of future HBLED
revenue growth. VCSEL and laser diode revenue decreased $731,000, or 26.9%, to
$2.0 million for the nine months ended September 30, 2002 compared to $2.7
million for the nine months ended September 30, 2001.

International revenue increased to 56.6% of total revenue for the nine
months ended September 30, 2002 compared to 50.1% of total revenue for the nine
months ended September 30, 2001. The increase was primarily due to increased
sales of HBLED products to customers in Asia.

Gross margin.Gross margin decreased to negative 0.6% of total revenue
for the nine months ended September 30, 2002 compared to 36.3% of total revenue
for the nine months ended September 30, 2001. Gross margin at the substrate
division decreased to 2.4% of substrate revenue for the nine months ended
September 30, 2002 compared to 42.3% of substrate revenue for the nine months
ended September 30, 2001. The decrease was primarily due to lower volume and
sales prices of substrates spread over a relatively fixed manufacturing
overhead base and charges related to aging inventory. As a result, we have
initiated manufacturing cost reductions in order to align our costs with lower
expected sales volumes and prices. We are currently shifting much of our
substrate

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manufacturing to China, where costs are lower, and reducing capacity at our
Fremont, California facility. Gross margin at the opto-electronics division
increased to negative 8.1% of opto-electronics revenue for the nine months
ended September 30, 2002 compared to negative 49.0% of opto-electronics revenue
for the nine months ended September 30, 2001. The increase was primarily due
to increased unit sales of our HBLED products.

Selling, general and administrative expenses.Selling, general and
administrative expenses decreased $2.2 million, or 13.2%, to $14.9 million for
the nine months ended September 30, 2002 compared to $17.1 million for the nine
months ended September 30, 2001. As a percentage of total revenue, selling,
general and administrative expenses were 29.2% for the nine months ended
September 30, 2002 compared to 16.4% for the nine months ended September 30,
2001. The increase in selling, general and administrative expenses as a
percentage of total revenue was primarily due to decreased revenue from lower
sales volume and prices. We are currently taking action to reduce our selling,
general and administrative costs and align them with expected future revenues.
As a result, except for possible increases in bad debt expense, we expect these
costs to decrease in both absolute value and as a percentage of revenue in
future quarters.

Research and development expenses.Research and development expenses
decreased $3.0 million, or 45.0%, to $3.8 million for the nine months ended
September 30, 2002 compared to $6.8 million for the nine months ended September
30, 2001. As a percentage of total revenue, research and development expenses
were 7.4% for the nine months ended September 30, 2002 compared to 6.6% for the
nine months ended September 30, 2001. The decrease in research and development
expenses was primarily the result of our decision to reduce expenses and align
them with expected future revenues.

Long-Lived Asset Impairment.In the second quarter of 2002, we completed
an impairment review of certain manufacturing assets used in the substrate and
opto-electronics divisions. The review was undertaken due to the recent
history of operating losses, declines in the demand for our products due to
macro economic conditions and excess capacity resulting in part from the
relocation of certain manufacturing operations in our substrate division to
China. Upon completion of the review, we determined that the carrying value of
the manufacturing assets was not expected to be recoverable and accordingly
recorded an impairment charge in order to write-down the related assets to
their estimated fair value. We determined the amount of the impairment charge
by estimating the net present value of expected future cash flows to be
generated by the assets. Based on this analysis, we recorded non-cash
impairment charges of $14.1 million in the substrate segment and $9.9 million
in the opto-electronics segment for the laser diode operating unit. In the
third quarter of 2002, we completed an impairment review of certain
manufacturing assets in the opto-electronics division. The review was
undertaken due to the unexpected operating losses incurred in the third
quarter, declines in product demand due to our inability to manufacture high
volumes of our LED products to our customers requirements, and the need to
reduce our current level of production to conserve cash. Upon completion of
the review, we determined that the carrying value of the machinery and
equipment was not expected to be recoverable and accordingly recorded an
impairment charge in order to write-down the related assets to their estimated
fair value. We determined the amount of the impairment charge by estimating
the net present value of expected future cash flows to be generated by the
assets. Based on this analysis, we recorded a non-cash impairment charge of
$14.0 million.

Goodwill Impairment. We adopted the provisions of SFAS 142, Goodwill and
Other Intangible Assets, effective January 1, 2002. Under the transition
provisions of SFAS No. 142, there was no goodwill impairment at January 1, 2002
based upon our analysis at that time. However, during the quarter ended
September 30, 2002, circumstances developed that indicated that the goodwill
was likely impaired and we performed an impairment analysis as of September 30,
2002. This analysis resulted in a $1.1 million impairment of goodwill. The
circumstances that led to the impairment included a net loss for the quarter
and a significant drop in our market capitalization.

Interest expense.Interest expense decreased $523,000, or 31.9%, to $1.1
million for the nine months ended September 30, 2002 compared to $1.6 million
for the nine months ended September 30, 2001 due to the repayment of debt and a
reduction of rates on our variable interest rate debt over the period.

Other income and expense.Other expense increased $9.7 million to $8.2
million for the nine months ended September 30, 2002 compared to income of $1.5
million for the nine months ended September 30, 2001. The

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increase for the nine months ended September 30, 2002 is primarily due to a
non-cash charge of $9.2 million taken to write-down to current market value our
investment in Finisar Corporation common stock.

Provision for income taxes.Our effective tax rate decreased to 5.5% for
the nine months ended September 30, 2002 compared to 36.0% for the nine months
ended September 30, 2001. The current year tax rate is primarily the result of
recording a valuation allowance against the tax benefits related to the asset
impairment charges that were taken in the second and third quarters. The
valuation allowance was applied to the benefit due to uncertainty regarding its
recoverability.

Liquidity and Capital Resources

We consider cash and cash equivalents, short-term investments and
long-term investments as liquid and available for use. Short and long-term
investments are comprised of government bonds and high grade commercial debt
instruments. Also included in short-term investments is our common stock
investment in Finisar Corporation.

Cash and cash equivalents, short-term investments and long-term
investments, excluding $810,000 and $11.6 million for our investment in Finisar
common stock at September 30, 2002 and December 31, 2001 respectively,
decreased $34.7 million to $23.3 million at September 30, 2002 compared to
$58.1 million at December 31, 2001. The decrease in available cash included
restricting $10.3 million as additional collateral with our bank as a result of
the modification to our credit facility, purchases of capital equipment of
$10.4 million, debt repayments of $11.3 million and $4.0 million used in
operating activities.

Net cash used in operating activities was $4.0 million for the nine months
ended September 30, 2002 which comprised primarily of our net loss adjusted for
non-cash items of $59.4 million, and by a $253,000 net change in assets and
liabilities. The net change in assets and liabilities resulted primarily from a
decrease in accounts receivable and inventory, and an increase in accounts
payable, offset by decreases in accrued liabilities, income taxes and prepaid
expenses.

Accounts receivable decreased $3.8 million, or 24.3%, to $11.9 million at
September 30, 2002 compared to $15.7 million at December 31, 2001. The change
reflects lower sales volume, collections of $53.2 million and an increase in
our allowance for doubtful accounts of $1.5 million. Days sales outstanding
were 73 at September 30, 2002 based on sales during the previous nine months.
Inventories decreased $5.0 million, or 9.0% to $50.6 million at September 30,
2002 compared to $55.6 million at December 31, 2001. Inventory turns for the
nine month period were 1.0 at September 30, 2002. Our inventory balance
remains high in relation to current sales due to the inventory buildup we
incurred during the period of rapid growth that we experienced through the
second quarter of 2001. We are continuously monitoring our inventory levels,
have reduced inventory purchases and have put in place measures to
significantly reduce the balance. We expect that these measures will
significantly improve cash flows from operations in future periods. We expect
to reduce the current inventory balance significantly by the end of 2003.

Net cash used in investing activities of $11.2 million for the nine months
ended September 30, 2002 includes purchases of property and equipment of $10.4
million primarily used to increase wafer processing capacity in China for the
substrate division, and to increase HBLED epitaxy growth and wafer processing
capacity at the opto-electronics division. It also includes $16.4 million in
purchases of high-grade investment securities with maturities of less than two
years offset by $15.6 million in sales of these securities.

We do not have any plans to initiate any major new capital spending
projects through 2003. We are currently completing certain projects in process
and are continuously constructing minor improvements to our existing production
facilities in China and California. We expect to invest approximately $2.0
million to complete projects in progress in the fourth quarter and expect to
invest $4 million in 2003. We believe that our existing facilities and
equipment are sufficient to fulfill current and expected future orders.

Net cash used in financing activities of $9.8 million for the nine months
ended September 30, 2002 includes proceeds of $850,000 from the sale of common
stock through our employee stock compensation programs and proceeds of $637,000
from a new equipment loan, offset by payments of $6.7 million for payments on
long-term debt and $4.6 million for capital lease payments.

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We generally finance equipment purchases through secured equipment loans
and capital leases over four or five-year terms at interest rates ranging from
4.6% to 8.8% per annum. Our main Fremont, California manufacturing facility is
financed by long-term borrowings, which were refinanced by taxable variable
rate revenue bonds in 1998. These bonds mature in 2023 and bear interest at
2.0% below the prime rate. The bonds are traded in the public market. Repayment
of principal and interest under the bonds is supported by a letter of credit
from our bank and is paid on a quarterly basis. We have the option to redeem
the bonds in whole or in part during their term. At September 30, 2002, $9.2
million was outstanding under these bonds.

At June 30, 2002, the credit facility that we had with our bank included a
$5 million line of credit with no balance outstanding, term loans in the amount
of $4.8 million and a letter of credit supporting repayment of our bonds with
an outstanding amount of $9.4 million. The credit facility is collateralized
by all corporate personal and real property. As of June 30, 2002, we were in
default of the credit facility by failure to maintain certain financial
covenants required by the facility. As a result, on September 30, 2002 we
modified the credit agreement with our bank which waived the covenant default,
terminated the credit line and term loans, amended the financial covenants and
added additional collateral to secure the remaining amounts due. At September
30, 2002 the credit facility included a letter of credit supporting our bonds
with an outstanding amount of $9.2 million and foreign exchange and overdraft
obligations in the amount of $1.1 million. We have pledged and placed certain
investment securities with the trust department of our bank as additional
collateral for this facility. As a result, $10.3 million of our long-term
investments are restricted. At September 30, 2002 we were in compliance with
the financial covenants as amended.

As a result of the significant revenue declines that we have experienced
over the past several quarters, we have taken cost reduction measures and
continue to pursue additional measures to reduce our cost of doing business and
increase our cash flows. At September 30, 2002, we had available cash of $23.3
million. We believe that this balance, coupled with additional efforts to
reduce our expenditures in support of our substrates and opto-electronic
businesses, will be sufficient to fund working capital and capital expenditure
requirements for the next 12 months.

If our sales continue to decrease, our ability to generate cash from
operations will be adversely affected which could adversely affect our future
liquidity, require us to use more cash at a more rapid rate than expected, and
require us to seek additional capital, if available on acceptable terms.

Risks Related to Our Business

The semiconductor industry is cyclical and is currently experiencing a severe
and prolonged downturn which has adversely impacted our operating results.

Our business depends in significant part upon manufacturers of electronic
and opto-electronic semiconductor devices, as well as the current and
anticipated market demand for such devices and products using such devices. The
semiconductor industry is highly cyclical. The industry has in the past, and
will likely in the future, experience periods of oversupply that result in
significantly reduced demand for semiconductor devices and components,
including our products, both as a result of general economic changes and
overcapacity. When these periods occur, our operating results and financial
condition are adversely affected. Inventory buildups in telecommunications
products and slower than expected sales of computer equipment have resulted in
overcapacity and led to reduced sales by our customers. During periods of
declining demand such as those experienced over the past year, customers
typically reduce purchases, delay delivery of products and/or cancel orders of
component parts such as our products. Increased price competition may result,
causing pressure on our net sales, gross margin and net income. We have over
the past year experienced cancellations, delays and push outs of orders, which
have resulted in reduced revenues. If the economic downturn continues, further
order cancellations, reductions in order size or delays in orders will
materially adversely affect our business and results of operations. Although we
have taken actions to reduce our costs, if our actions are insufficient to
align our structure with prevailing business conditions, we may be required to
undertake additional cost-cutting measures, and may be unable to invest in
marketing, research and development and engineering at the levels we believe
are necessary to maintain our competitive position. Our failure to make these
investments could seriously harm our business. In addition, we may be required
to seek additional sources of cash, which may not be available on acceptable
terms or at all.

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

Our operating results can vary significantly based upon the impact of
changes in global economic conditions on our customers. More specifically, the
macro-economic environment that we have faced in the second half of 2001 and
are continuing to face in 2002 is more uncertain than in prior periods, has
lasted longer than expected and has materially and adversely affected us and
our operating results and may continue to do so. The revenue growth and
profitability of our business depends on the overall demand for our substrates,
LEDs and laser diodes, and we are particularly dependant on the market
conditions for the wireless, fiber optics and telecommunications industries.
Because our sales are primarily to major corporate customers whose businesses
fluctuate with general economic and business conditions, a softening of demand
for products that use our substrates, LEDs and laser diodes caused by a
weakening economy may result in further or prolonged decreased revenues.
Customers may find themselves facing excess inventory from earlier purchases,
and may defer or reconsider purchasing products due to the downturn in their
business and in the general economy.

Unpredictable fluctuations in our operating results could disappoint analysts
or our investors, which could cause our stock price to decline.

We have not over the past year been able to sustain our historical growth
rate, and may not be able to return to historic growth levels in the current
economic environment. We have and may continue to experience significant
fluctuations in our revenue and earnings. Our quarterly and annual revenue and
operating results have varied significantly in the past and may vary
significantly in the future due to a number of factors, including:



| |  | decline in general economic conditions or downturns in the industry in which we compete;                       
|- |  | ---------------------------------------------------------------------------------------------------------------
| 
| |  | fluctuations in demand for our products;                                                                       
| 
| |  | expansion of our manufacturing capacity;                                                                       
| 
| |  | expansion of our operations in China;                                                                          
| 
| |  | limited availability and increased cost of raw materials;                                                      
| 
| |  | the volume and timing of orders from our customers, and
cancellations, push outs and delays of customer orders;
| 
| |  | fluctuation of our manufacturing yields;                                                                       
| 
| |  | decreases in the prices of our competitors products;                                                          
| 
| |  | costs incurred in connection with any future acquisitions of businesses or technologies;                       
| 
| |  | increases in our expenses, including expenses for research and development; and                                
| 
| |  | our ability to develop, manufacture and deliver high quality products
in a timely and cost-effective manner.   

Due to these factors, we believe that period-to-period comparisons of our
operating results may not be a meaningful indicator of our future performance.
Our operating results have over the past year at times been below the
expectations of securities analysts or investors. If this occurs again in
future periods, the price of our common stock would likely decline or
fluctuate.

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

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The lead-time for customer orders is generally shorter than it was a year
ago. As a result, our visibility regarding future financial performance is
uncertain and we may provide investors with financial guidance that we cannot
meet. As a result, our operating results could be below the expectations of
market analysts or investors, which could also cause our stock price to fall.

If the economy recovers and we are again in a period of high demand for our
products, if we fail to expand our manufacturing capacity, we may not be able
to meet increased demand, lower our costs or increase revenue.

Although we are currently in a period of overcapacity, if the economy
recovers, demand may increase rapidly as it has in prior years. In order to
meet increased demand and maintain our market share, we may need to increase
production, which could require us to build new facilities, expand and modify
our existing facilities, purchase additional manufacturing equipment, and add
qualified staff. If we do not expand our manufacturing capacity, we will be
unable to increase production, which may adversely impact our ability to reduce
unit costs, margins and improve our operating results.

We are currently constructing and modifying facilities in California and
China. Our construction activities subject us to a number of risks, including:



| |  | unforeseen environmental or engineering problems;                                                                    
|- |  | ---------------------------------------------------------------------------------------------------------------------
| 
| |  | unavailability or late delivery of production equipment;                                                             
| 
| |  | delays in completing new facilities;                                                                                 
| 
| |  | delays in bringing production equipment on-line;                                                                     
| 
| |  | work stoppages or delays;                                                                                            
| 
| |  | inability to recruit and train qualified staff;                                                                      
| 
| |  | unanticipated cost increases and restrictions imposed by requirements
of local, state or federal regulatory agencies.

If any of these risks occurs, construction may be costlier than
anticipated and completion could be delayed, which could hurt our ability to
expand capacity and increase our sales. In addition, if we experience delays in
expanding our manufacturing capacity, we might not be able to timely meet
customer requirements, and we could lose future sales. We are also making
investments in equipment and facilities as part of our previously planned
capacity expansion. To offset the additional fixed operating expenses, we must
increase our revenue by increasing production and improving yields. If demand
for our products does not grow or if our yields do not improve as anticipated,
we may be unable to offset these costs against increased revenue, which would
adversely impact our operating results.

Our results of operations may suffer if we do not effectively manage our
inventory.

To achieve commercial success with our products, we will need to manage
our inventory of component parts and finished goods effectively to meet
changing customer requirements. Some of our products and supplies have in the
past and may in the future become obsolete while in inventory due to changing
customer specifications, excess inventory or decreased demand for our products.
We have in the past had to take inventory valuation and impairment charges. If
we are not successfully able to manage our inventory, we may need to write off
unsaleable, obsolete or excess inventory, which could adversely affect our
results of operations.

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Our HBLED and VCSEL products are in their early stages, and we may not be able
to achieve anticipated sales of these products.

We have experienced declining revenue for both our HBLED and laser diode
products as a result of a loss of revenue from our leading LED customer and a
decline in the market for our laser diode products. We may be unable to
successfully market and increase sales of these products. To market and
increase sales of our HBLED and VCSEL products, we will have to continue to
develop additional distribution channels and achieve certain product and
reliability specifications. We may be unable to obtain significant increases in
revenue and may seek potential investors for our opto-electronics business. We
must also continue our research and development efforts to apply our
proprietary VGF technique to new substrate products and successfully introduce
and market new opto-electronic semiconductor devices, including enhancements to
our HBLED and VCSEL products.

If we do not successfully develop new products to respond to rapidly changing
customer requirements, our ability to generate sales and obtain new customers
may suffer.

Our success depends on our ability to offer new products that incorporate
leading technology and respond to technological advances. In addition, our new
products must meet customer needs and compete effectively on quality, price and
performance. The life cycles of our products are difficult to predict because
the markets for our products are characterized by rapid technological change,
changing customer needs and evolving industry standards. If our competitors
introduce products employing new technologies, our existing products could
become obsolete and unmarketable. If we fail to offer new products, we may not
generate sufficient revenue to offset our development costs and other expenses
or meet our customers requirements. Other companies, including IBM and
Motorola, are actively developing substrate materials that could be used to
manufacture devices that could provide the same high-performance, low-power
capabilities as GaAs-based devices at competitive prices. If these substrate
materials are successfully developed and semiconductor device manufacturers
adopt them, demand for our GaAs substrates could decline and our revenue could
suffer. Similarly, other companies, including Kopin, are developing
alternative production technologies for HBLEDs. If they are successful, demand
for our HBLEDs could drop and our revenue could decline.

The development of new products can be a highly complex process, and we
may experience delays in developing and introducing new products. Any
significant delays could cause us to fail to timely introduce and gain market
acceptance of new products. Further, the costs involved in researching,
developing and engineering new products could be greater than anticipated.

Our operating results depend in large part on further customer acceptance of
our existing substrate products and on our ability to develop new products
based on our core VGF technology.

A large share of GaAs substrates are manufactured from crystals grown
using the traditional Liquid Encapsulated Czochralski, or LEC, or
Horizontal-Bridgeman, or HB, techniques. In order to expand sales of our
products, we must continue to promote our VGF technique as a preferred process
for producing substrates, and we must offer products with superior prices and
performance on a timely basis and in sufficient volumes. If we fail to gain
increased market acceptance of our VGF technique, we may not achieve
anticipated revenue growth.

To shift more of our substrate manufacturing operations to China
successfully, we will need our customers to qualify products manufactured in
China. If we are unable to achieve qualifications for these products, our
China facility will be underutilized, our investments in China will not be
recouped and we will be unable to lower our costs by moving to China. All of
these events could reduce our revenue but increase our cost structure.

Intense competition in the markets for our products could prevent us from
increasing revenue and sustaining profitability.

The markets for our products are intensely competitive. We face
competition for our substrate products from other manufacturers of substrates,
such as Freiberger, Hitachi Cable, Japan Energy and Sumitomo Electric and from
semiconductor device manufacturers that produce substrates for their own use,
and from companies, such as IBM and Motorola, that are actively developing
alternative materials to GaAs and some semiconductor devices are

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being marketed using these materials. We believe that at least two of our
competitors are shipping GaAs substrates manufactured using a technique similar
to our VGF technique. Other competitors may develop and begin using similar
technology. If we are unable to compete effectively, our revenue may not
increase and we may be unable to be profitable. We face many competitors that
have a number of significant advantages over us, particularly in our compound
semiconductor device products, including:



| |  | greater experience in the business;                                
|- |  | -------------------------------------------------------------------
| 
| |  | more manufacturing experience;                                     
| 
| |  | extensive intellectual property;                                   
| 
| |  | broader name recognition; and                                      
| 
| |  | significantly greater financial, technical and marketing resources.

Our competitors could develop new or enhanced products that are more
effective than the products that we have developed or may develop. For example,
some competitors in the HBLED market offer devices that are brighter than our
HBLEDs and have other desirable features. Some of our competitors may also
develop technologies that enable the production of commercial products with
characteristics similar to or better than ours, but at a lower cost.

The level and intensity of competition has increased over the past year
and we expect competition to continue to increase in the future. Competitive
pressures caused by the current economic conditions have resulted in reductions
in the prices of some of our products, and continued or increased competition
could reduce our market share, require us to further reduce the prices of our
products, affect our ability to recover costs or result in reduced gross
margins.

If we have low product yields, the shipment of our products may be delayed and
our operating results may be adversely impacted.

Our products are manufactured using complex technologies, and the number
of usable substrates and devices we can produce can fluctuate as a result of
many factors, including:



| |  | impurities in the materials used;                                               
|- |  | --------------------------------------------------------------------------------
| 
| |  | contamination of the manufacturing environment;                                 
| 
| |  | substrate breakage;                                                             
| 
| |  | equipment failure, power outages or variations in the manufacturing process; and
| 
| |  | performance of personnel involved in the manufacturing process.                 

Because many of our manufacturing costs are fixed, our revenue could
decline if our yields decrease but our costs would change little, if at all. We
have experienced product shipment delays and difficulties in achieving
acceptable yields on both new and older products, and delays and poor yields
have adversely affected our operating results. We may experience similar
problems in the future and we cannot predict when they may occur or their
severity. In addition, many of our manufacturing processes are new and are
still being refined, which can result in lower yields, particularly as we focus
on producing higher diameter substrates and new opto-electronic semiconductor
devices. For example, we recently made substantial investments in equipment and
facilities to manufacture blue, green and cyan HBLEDs and VCSELs. If we are
unable to produce adequate quantities of our high-brightness LEDs and VCSELs,
we may not be able to meet customer demand and our revenue may decrease while
our costs remain largely unchanged.

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Demand for our products may decrease if our customers experience difficulty
manufacturing, marketing or selling their products.

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



| |  | the competition our customers face in their particular industries;                                              
|- |  | ----------------------------------------------------------------------------------------------------------------
| 
| |  | the technical, manufacturing, sales and marketing and management capabilities of our customers;                 
| 
| |  | the financial and other resources of our customers; and                                                         
| 
| |  | the inability of our customers to sell their products if they infringe third party intellectual property rights.

If demand for the products offered by our customers decreases, our customers
may reduce purchases of our products.

As inventory of telecommunication products and computer equipment has
increased in the past year, resulting in overcapacity in the market, our
customers have reduced sales of their products, causing them to reduce
purchases of our products. As a result, our revenues have declined and may fail
to recover until the overcapacity has been depleted and demand for our
customers products once again increases.

We purchase critical raw materials and parts for our equipment from single or
limited sources, and could lose sales if these sources fail to fill our needs.

We depend on a limited number of suppliers for certain raw materials,
components and equipment used in manufacturing our products, including key
materials such as gallium, arsenic, quartz, and graphite susceptors. We
generally purchase these materials through standard purchase orders and not
pursuant to long-term supply contracts and none of our suppliers guarantees
supply of raw materials or equipment to us. If we lose any of our key
suppliers, our manufacturing efforts could be significantly hampered and we
could be prevented from timely producing and delivering products to our
customers. We have experienced delays obtaining critical raw materials,
including gallium, due to shortages of these materials. We may experience
delays due to shortages of materials and may be unable to obtain an adequate
supply of materials. These shortages and delays could result in higher
materials costs and cause us to delay or reduce production of our products. If
we have to delay or reduce production, we could fail to meet customer delivery
schedules, and our revenue and operating results could suffer.

We have periodically encountered a decline in quality of graphite
susceptors, which has led to lower yields of our HBLED products. If these
quality problems continue, our ability to manufacture our HBLED products would
be reduced, we could fail to meet customer delivery schedules, and our revenue
and operating results could suffer.

If we fail to comply with environmental and safety regulations, we may be
subject to significant fines or cessation of our operations.

We are subject to federal, state and local environmental and safety laws
and regulations. These laws, rules and regulations govern the use, storage,
discharge and disposal of hazardous chemicals during manufacturing, research
and development and sales demonstrations. If we fail to comply with applicable
regulations, we could be subject to substantial liability for clean-up efforts,
personal injury and fines or suspension or cessation of our operations. In
March 2001, we settled a claim made by the California Occupational Safety and
Health Administration, or Cal-OSHA, in an investigation primarily regarding
impermissible levels of potentially hazardous materials in certain areas of our
manufacturing facility in Fremont, California for $204,415. Although we have
put in place engineering, administrative and personnel protective equipment
programs to address these issues, our ability to expand or continue to operate
our present locations could be restricted or we could be required to acquire
costly remediation equipment or incur other significant expenses. In addition,
existing or future changes in laws or regulations may require us to incur
significant expenditures or liabilities, or may restrict our operations.

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The loss of one or more of our key substrate customers would significantly hurt
our operating results.

A small number of substrate and HBLED customers have historically
accounted for a substantial portion of our total revenue. Five customers
accounted for 35.7% of our total revenue for the three months ended September
30, 2002 and 30.3% for the three months ended September 30, 2001. No one
customer accounted for greater than 10% of total revenue for the three months
ended September 30, 2002, or the three months ended September 30, 2001. Our
substrate revenue accounted for 78.5% of our total revenue for the three months
ended September 30, 2002 and 89.8% for the three months ended September 30,
2001. We expect that a significant portion of our future revenue will continue
to be derived from a limited number of substrate and HBLED customers. Our
customers are not obligated to purchase a specified quantity of our products 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, and during the past year, we have experienced slower
bookings, significant push outs and cancellation of orders. If we lose a major
customer or if a customer cancels, reduces or delays orders, our revenue would
decline. In addition, customers that have accounted for significant revenue in
the past may not continue to generate revenue for us in any future period. Any
delay in scheduled shipments of our products could cause net sales to fall
below our expectations and the expectations of market analysts or investors,
causing our stock price to decline.

Defects in our products could diminish demand for our products.

Our products are complex and may contain defects. In the past we have
experienced quality control problems with some of our products, which caused
customers to return products to us or reduce orders for our products, such as
our recent reduction in orders for our LED products by Agilent. If we continue
to experience quality control problems, or experience these problems in new
products, customers may cancel or reduce orders or purchase products from our
competitors. Defects in our products could cause us to incur higher
manufacturing costs and suffer product returns and additional service expenses,
all of which could adversely impact our operating results.

We are also developing new products and product enhancements, including
substrates and compound semiconductor device products. If our new products
contain defects when released, our customers may be dissatisfied and we may
suffer negative publicity or customer claims against us, lose sales or
experience delays in market acceptance of our new products.

Our substrate and opto-electronic semiconductor device products have a long
sales cycle that makes it difficult to plan our expenses and forecast our
results.

Customers typically place orders with us for our substrate and
opto-electronic semiconductor device products three months to a year or more
after our initial contact with them. The sale of our products may be subject to
delays due to our customers lengthy internal budgeting, approval and
evaluation processes. During this time, we may incur substantial expenses and
expend sales, marketing and management efforts while the customers evaluate our
products. These expenditures may not result in sales of our products. If we do
not achieve anticipated sales in a period as expected, we may experience an
unplanned shortfall in our revenue. As a result, we may not be able to cover
expenses, causing our operating results to vary. In addition, if a customer
decides not to incorporate our products into its initial design, we may not
have another opportunity to sell products to this customer for many months or
even years. In this difficult economic climate, the average sales cycle for our
products has lengthened even further and is expected to continue to make it
difficult to accurately forecast our future sales. We anticipate that sales of
any future substrate and opto-electronic semiconductor device products under
development will also have lengthy sales cycles and will, therefore, be subject
to risks substantially similar to those inherent in the lengthy sales cycle of
our current substrate and opto-electronic semiconductor device products.

As our business matures, we may need to upgrade our systems.

In the past, periods of rapid growth and expansion has strained our
management and other resources. The expansion of our manufacturing capacity
and the shift of manufacturing operations to China has placed and continues to
place a significant strain on our operations and management resources. If we
fail to manage these changes effectively, our operations may be disrupted. To
manage our business effectively, we may need to implement

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additional and improved management information systems, further develop
our operating, administrative, financial and accounting systems and controls,
add experienced senior level managers, and maintain close coordination among
our executive, engineering, accounting, marketing, sales and operations
organizations.

If necessary, we will spend substantial sums to support our future growth
and shift to China and may incur additional unexpected costs. Our systems,
procedures or controls may not be adequate to support our operations, and we
may be unable to expand quickly enough to exploit potential market
opportunities. Our future operating results will also depend on expanding sales
and marketing, research and development and administrative support. If we
cannot attract qualified people or manage growth effectively, our business and
operating results could be adversely affected.

If we fail to manage periodic contractions, we may utilize our cash balances.

We have experienced a period of rapid contraction in our business that
caused us to reduce our costs in order to conserve our cash resources.
However, in the three months ended September 30, 2002, we utilized $5.0 million
in our operating activities and for the nine months ended September 30, 2002,
we utilized $4.0 million in our operating activities. If we fail to manage our
contractions successfully we may continue to draw down our cash reserves, which
would adversely affect our operating results and financial condition, reduce
our value and may impinge our ability to raise debt and equity funding in the
future, at a time when we may be required to raise additional cash. As part of
our effort to reduce costs, we may lose key staff, production resources, and
technology that we will need to grow when end markets recover. These events
could reduce our ability to grow profitably as markets recover.

As a result of the difficult economic conditions, we have implemented
restructuring and workforce reductions, which may adversely affect the moral
and performance of our personnel and our ability to hire new personnel.

In connection with our efforts to streamline operations, reduce costs and
bring staffing and structure in line with current demand for our products, we
implemented a corporate restructuring beginning last year and reduced our
workforce, shifted production activities to China and reduced capital
expenditures. Our restructuring may yield unanticipated consequences, such as
attrition beyond our planned reduction in workforce and loss of employee moral
and decreased performance. In addition, the recent trading levels of our stock
have decreased the value of our stock options granted to employees under our
stock option plan. As a result of these factors, our remaining personnel may
seek employment with larger, more established companies or companies that they
perceive as having less volatile stock prices. Continuity of personnel can be
very important factors in the sales and production of our products and
completion of our research and development efforts.

Any future acquisitions may disrupt our business, dilute stockholder value or
distract management attention.

As part of our strategy, we may consider acquisitions of, or significant
investments in, businesses that offer products, services and technologies
complementary to ours, such as our acquisition of Lyte Optronics in May 1999.
Acquisitions entail numerous risks, including:



| |  | we may have difficulty assimilating the operations, products and personnel of the acquired businesses;                                   
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | our ongoing business may be disrupted;                                                                                                   
| 
| |  | we may incur unanticipated costs;                                                                                                        
| 
| |  | our management may be unable to manage the financial and strategic
position of acquired or developed products, services and technologies;
| 
| |  | we may be unable to maintain uniform standards, controls and procedures and policies; and                                                
| 
| |  | our relationships with employees and customers may be impaired as a result of any integration.                                           

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For example, we incurred substantial costs in connection with our
acquisition of Lyte Optronics, including the assumption of approximately $10.0
million of debt, much of which has been repaid or renegotiated, resulting in a
decline of cash available. We incurred one-time charges and merger-related
expenses of $2.8 million and an extraordinary item of $508,000 relating to the
early extinguishment of debt in the quarter ended September 30, 1999 as a
result of the acquisition.

To the extent that we issue shares of our stock or other rights to
purchase stock in connection with any future acquisitions, dilution to our
existing stockholders will result and our earnings per share may suffer. Any
future acquisitions may not generate additional revenue or provide any benefit
to our business.

If any of our facilities is damaged by actions such as fire, explosion, or
natural disaster, we may not be able to manufacture our products.

The ongoing operation of our manufacturing and production facilities in
California and China is critical to our ability to meet demand for our
products. If we are not able to use all or a significant portion of our
facilities for prolonged periods for any reason, we will not be able to
manufacture products for our customers. For example, a natural disaster, fire
or explosion caused by our use of combustible chemicals and high temperatures
during our manufacturing processes would render some or all of our facilities
inoperable for an indefinite period of time. Actions outside of our control,
such as earthquakes, could also damage our facilities, rendering them
inoperable. Some of our crystal growth is currently performed at our Fremont,
California facilities, which are located near an active seismic fault line. If
we are unable to operate our facilities and manufacture our products, we will
lose customers and revenue and our business will be harmed.

If we lose key personnel or are unable to hire additional qualified personnel
as necessary, we may not be able to successfully manage our business or achieve
our objectives.

Our success depends upon the continued service of Morris S. Young, Ph.D.,
our president, chairman of the board and chief executive officer, as well as
other key management and technical personnel. We do not have long-term
employment contracts with, or key person life insurance on, any of our key
personnel.

We believe our future success will also depend in large part upon our
ability to attract and retain highly skilled managerial, engineering, sales and
marketing, finance and manufacturing personnel. The competition for these
employees is intense, especially in Silicon Valley, and we cannot assure you
that we will be successful in attracting and retaining new personnel. The loss
of the services of any of our key personnel, the inability to attract or retain
qualified personnel in the future or delays in hiring required personnel,
particularly engineers, could make it difficult for us to manage our business
and meet key objectives, including the timely introduction of new products.

If we are unable to protect our intellectual 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 other intellectual property
protection methods to protect our proprietary technology. However, we believe
that, due to the rapid pace of technological innovation in the markets for our
products, our ability to establish and maintain a position of technology
leadership also depends on the skills of our development personnel.

Despite our efforts to protect our intellectual property, a third party
could develop products or processes similar to ours. Our means of protecting
our proprietary rights may not be adequate and our competitors may
independently develop similar technology, duplicate our products or design
around our patents. We believe that at least two of our competitors have begun
to ship GaAs substrates produced using a process similar to our VGF technique.
Our competitors may also develop and patent improvements to the VGF, LED and
VCSEL technologies upon which we rely, and thus may limit any exclusivity we
enjoy by virtue of our patents.

It is possible that pending or future United States or foreign patent
applications made by us will not be approved, that our issued patents will not
protect our intellectual property, or that third parties will challenge the
ownership rights or the validity of our patents. In addition, the laws of some
foreign countries may not protect our proprietary rights to as great an extent
as do the laws of the United States and it may be more difficult to monitor the

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use of our intellectual property. Our competitors may be able to
legitimately ascertain non-patented proprietary technology embedded in our
systems. If this occurs, we may not be able to prevent the development of
technology substantially similar to ours.

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

We might face intellectual property infringement claims that may be costly to
resolve and could divert management attention.

Other companies may hold or obtain patents on inventions or may otherwise
claim proprietary rights to technology necessary to our business. The markets
in which we compete are comprised of competitors who in some cases hold
substantial patent portfolios covering aspects of products that could be
similar to ours. We could become subject to claims that we are infringing
patent, trademark, copyright or other proprietary rights of others, and are
currently in discussions with one company concerning alleged patent
infringement. Litigation to determine the validity of alleged claims could be
time-consuming and result in significant expense to us and divert the efforts
of our technical and management personnel, whether or not the litigation is
ultimately determined in our favor. If a lawsuit is decided against us, we
could be subject to significant liabilities, requiring us to seek costly
licenses or preventing us from manufacturing and selling our products. We may
not be able to obtain required licensing agreements on terms acceptable to us
or at all.

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

Our revenue growth depends in part on the expansion of our international
sales and operations. International sales represented 55.5% of our total
revenue for the three months ended September 30, 2002 and 46.1% for the three
months ended September 30, 2001. We expect that sales to customers outside the
U.S. will continue to represent a significant portion of our revenue.

Our dependence on international sales involves a number of risks,
including:



| |  | changes in tariffs, import or export restrictions and other trade barriers;
|- |  | ---------------------------------------------------------------------------
| 
| |  | unexpected changes in regulatory requirements;                             
| 
| |  | longer periods to collect accounts receivable;                             
| 
| |  | changes in export license requirements;                                    
| 
| |  | political and economic instability;                                        
| 
| |  | unexpected changes in diplomatic and trade relationships; and              
| 
| |  | foreign exchange rate fluctuations.                                        

Our sales are denominated in U.S. dollars, except for sales to our
Japanese and some Taiwanese customers, which are denominated in Japanese yen.
Thus, increases in the value 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 in these markets. Also, denominating some sales in
Japanese yen subjects us to fluctuations in the exchange rates between the U.S.
dollar and the Japanese yen. The functional currencies of our Japanese and
Chinese subsidiaries are the local currencies. We incur transaction gains or
losses resulting from consolidation of expenses incurred in local currencies
for these subsidiaries, as well as in translation of the assets and liabilities
of these assets at each balance sheet date. If

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we do not effectively manage the risks associated with international
sales, our revenue, cash flows and financial condition could be adversely
affected.

If our expansion in China is more costly than we expect, our operating results
will suffer.

As part of our planned expansion of our manufacturing capacity, we are
building new facilities and expanding existing facilities in China. If we are
unable to build and expand our Chinese facilities in a timely manner, we may
not be able to increase production of our products and increase revenue as
planned. If our expansion in China proves more costly than we anticipate or we
incur greater ongoing costs than we expect, our operating results would be
adversely affected. If we do not realize expected cost savings once our
expansion is complete in China, our margins may be negatively impacted and our
operating results may suffer.

Changes in Chinas political, social and economic environment may affect our
financial performance.

Our financial performance may be affected by changes in Chinas political,
social and economic environment. The role of the Chinese central and local
governments in the Chinese economy is significant. Chinese policies toward
economic liberalization, and laws and policies affecting technology companies,
foreign investment, currency exchange rates and other matters could change,
resulting in greater restrictions on our ability to do business and operate our
manufacturing facilities in China. Any imposition of surcharges or any increase
in Chinese tax rates could hurt our operating results. The Chinese government
could revoke, terminate or suspend our license for national security and
similar reasons without compensation to us. If the government of China were to
take any of these actions, we would be prevented from conducting all or part of
our business. Any failure on our part to comply with governmental regulations
could result in the loss of our ability to manufacture our products in China.

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

The effect of terrorist threats on the general economy could decrease our
revenues.

On September 11, 2001, the United States was subject to terrorist attacks
at the World Trade Center buildings in New York and the Pentagon in Washington
D.C., and continues to be on alert for further terrorist activity. In
addition, the United States continues to consider hostile activity with Iraq.
The potential near- and long-term impact of these attacks and other terrorist
activities, as well as the threat of war may have in regards to our suppliers,
customers and markets for our products and the U.S. economy, are uncertain.
There may be other potential adverse effects on our operating results due to
this significant event that we cannot foresee.

Our stock price has been and may continue to be volatile.

Our stock price has fluctuated significantly since we began trading on the
Nasdaq National Market. For the nine months ended September 30, 2002, the high
and low closing sales prices of our common stock were $16.89 and $2.08
respectively. A number of factors could cause the price of our common stock to
continue to fluctuate substantially, including:



| |  | actual or anticipated fluctuations in our quarterly or annual
operating results;                                        
|- |  | ------------------------------------------------------------------------------------------------------------------------
| 
| |  | changes in expectations about our future financial performance or
changes in financial estimates of securities analysts;
| 
| |  | announcements of technological innovations by us or our competitors;                                                    
| 
| |  | new product introduction by us or our competitors;                                                                      
| 
| |  | large customer orders or order cancellations; and                                                                       

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| |  | the operating and stock price performance of comparable companies.
|- |  | ------------------------------------------------------------------

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

If we fail to comply with Nasdaq rules, our common stock may be delisted from
the Nasdaq National Market, which could eliminate the trading market for our
common stock.

If we fail to meet the criteria for continued listing on The Nasdaq
National Market, our common stock may be delisted from The Nasdaq National
Market. If the stock is delisted, it would significantly decrease the liquidity
of an investment in AXT common stock. In addition, the stock may be deemed to
be penny stock. If our common stock is considered penny stock, it would be
subject to rules that impose additional sales practices on broker-dealers who
sell our securities. For example, broker-dealers would have to make a special
suitability determination for the purchaser and have received the purchasers
written consent to the transaction prior to sale. Also, a disclosure schedule
must be prepared prior to any transaction involving a penny stock and
disclosure is required about sales commissions payable to both the
broker-dealer and the registered representative and current quotations for the
securities. Monthly statements are also required to be sent disclosing recent
price information for the penny stock held in the account and information on
the limited market in penny stock. Because of these additional obligations,
some brokers may be unwilling to effect transactions in penny stocks. This
could have an adverse effect on the liquidity of our common stock and the
ability of investors to sell the common stock.

We may need additional capital to fund expansion of our manufacturing capacity
and our future operations, which may not be available.

We may need additional capital to fund expansion of our manufacturing and
production capacity and our future operations or acquisitions. If we raise
additional capital through the sale of equity or debt securities, the issuance
of such securities could result in dilution to existing stockholders. These
securities could have rights, preferences and privileges that are senior to
those of holders of our common stock. For example, in December 1998 we issued
debt securities for the purchase and improvement of our facilities in Fremont,
California.

If we require additional capital in the future, it might not be available
on acceptable terms, or at all. If we are unable to obtain additional capital
when needed, we may be required to reduce the scope of our product line, the
planned expansion of our manufacturing capacity or of our product development
and marketing efforts, which could adversely affect our business and operating
results.

Provisions in our charter, bylaws or Delaware law may delay or prevent a change
in control of our company.

Provisions in our amended and restated certificate of incorporation and
bylaws may have the effect of delaying or preventing a merger, acquisition or
change of control of us, or changes in our management. These provisions
include:



| |  | the division of our board of directors into three separate classes,
each with three year terms;                                             
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | the right of our board to elect a director to fill a space created by
a board vacancy or the expansion of the board;                        
| 
| |  | the ability of our board to alter our bylaws;                                                                                               
| 
| |  | the ability of our board to authorize the issuance of up to 2,000,000
shares of blank check preferred stock; and                            
| 
| |  | the requirement that only our board or the holders of at least 10% of
our outstanding shares may call a special meeting of our stockholders.

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



| |  | 66 2/3% of the shares of voting stock not owned by these large
stockholders approve the merger or combination, or                                                       
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | the board of directors approves the merger or combination or the
transaction which resulted in the large stockholder owning 15% or more
of our outstanding voting stock.

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

Our board of directors has the authority to issue up to 2,000,000 shares
of preferred stock and to determine the price, rights, preferences and
privileges of those shares without any further vote or action by the
stockholders. The rights of the holders of common stock will be subject to, and
may be adversely affected by, the rights of the holders of any preferred stock
that may be issued in the future. The issuance of shares of preferred stock,
while potentially providing desirable flexibility in connection with possible
acquisitions and for other corporate purposes, could have the effect of making
it more difficult for a third party to acquire a majority of our outstanding
voting stock. We have no present intention to issue shares of preferred stock.
Further, on April 24, 2001, our board of directors adopted a preferred stock
purchase rights plan intended to guard against certain takeover tactics. The
adoption of this plan was not in response to any proposal to acquire us, and
the board is not aware of any such effort. The existence of this plan could
also have the effect of making it more difficult for a third party to acquire a
majority of our outstanding voting stock. In addition, certain provisions of
our certificate of incorporation may have the effect of delaying or preventing
a change of control, which could adversely affect the market price of our
common stock.

The financial condition of our customers may affect their ability to pay
amounts owed to us.

Many of our customers are facing business downturns that have reduced
their cash balances and their prospects. We frequently allow our customers to
pay for products we ship to them within 30 to 90 days after delivery.
Subsequent to our shipping a product some customers have been unable to make
payments as due, reducing our cash balances and causing us to incur charges to
allow for a possibility that some accounts might not be paid. At least two
customers that owed us a significant amount have filed for bankruptcy
protection and we are unlikely to receive a substantial portion of the amount
owed to us as part of a bankruptcy settlement. Other customers may also be
forced to file for bankruptcy. If our customers do not pay their accounts when
due, we will be required to incur charges that would reduce our earnings.

Legislative actions, higher insurance cost and potential new accounting
pronouncements are likely to cause our general and administrative expenses to
increase and impact our future financial position and results of operations.

In order to comply with the newly adopted Sarbanes-Oxley Act of 2002, as
well as proposed changes to listing standards by Nasdaq, and proposed
accounting changes by the Securities and Exchange Commission, we may be
required to increase our internal controls, hire additional personnel and
additional outside legal, accounting and advisory services, all of which will
cause our general and administrative costs to increase. Insurers are likely to
increase premiums as a result of the high claims rates incurred over the past
year, and so our premiums for our various insurance policies, including our
directors and officers insurance policies, are likely to increase. Proposed
changes in the accounting rules, including legislative and other proposals to
account for employee stock options as a compensation expense among others,
could materially increase the expense that we report under generally accepted
accounting principles and adversely affect our operating results.

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Item 3.Qualitative and Quantitative Disclosures About Market Risk

Foreign Currency Risk

We use short-term forward exchange contracts for hedging purposes to
reduce the effects of adverse foreign exchange rate movements. We have
purchased foreign exchange contracts to hedge against certain trade accounts
receivable denominated in Japanese yen. The change in the fair value of the
forward contracts is recognized as part of the related foreign currency
transactions as they occur. Because the effect of movements in currency
exchange rates on forward exchange and currency options contracts generally
offset the related effect of the underlying items being hedged, these financial
instruments are not expected to subject AXT to risks that would otherwise
result from changes in currency exchange rates. As of September 30, 2002, our
outstanding commitments with respect to the foreign exchange contracts, which
were commitments to sell Japanese yen, had a total contract value of
approximately $3.7 million.

We incurred a foreign transaction exchange loss of $46,121 and a gain of
$107,443 for the three and nine months ended September 30, 2002 respectively
and gains of $84,500 and $394,300 for the three and nine months ended September
30, 2001 respectively.

Interest Rate Risk

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

|                          |  |               |        |          |  |           |      |                  |  |                  |      |          |  |          |      |   |  |   |      |  
|------------------------- |  | ------------- | ------ | -------- |  | --------- | ---- | ---------------- |  | ---------------- | ---- | -------- |  | -------- | ---- | - |  | - | ---- | -
|                          |  |               |        |          |  |           |      |                  |  | Current          |      | Proforma |  | Proforma
|                          |  | Balance       |        | Current  |  | Interest  |      | 10% Interest     |  | 10% Interest    
|                          |  | September 30, |        | Interest |  | Income/   |      | Rate Decline     |  | Rate Increase   
|Instrument                |  | 2002          |        | Rate     |  | (Expense) |      | Income/(Expense) |  | Income/(Expense)
|                          |  |               |        |          |  |           |      |                  |  |                 
|Cash and cash equivalents |  | $             | 12,647 |          |  |           | 2.01 | %                |  | $                | 254  |          |  | $        | 229  |   |  | $ | 280  |  
|Bonds                     |  |               | 9,215  |          |  |           | 1.97 | %                |  |                  | (182 | )        |  |          | (163 | ) |  |   | (200 | )
|                          |  |               |        |          |  |           |      |                  |  |                  |      |          |  |          |      |   |  |   |      |  
|                          |  |               |        |          |  |           |      |                  |  | $                | 72   |          |  | $        | 66   |   |  | $ | 80   |  
|                          |  |               |        |          |  |           |      |                  |  |                  |      |          |  |          |      |   |  |   |      |  

Equity Risk

We also maintain minority investments in private and publicly traded
companies. These investments are reviewed for other than temporary declines in
value on a quarterly basis. Reasons for other than temporary declines in value
include whether the related company would have insufficient cash flow to
operate for the next twelve months, significant changes in the operating
performance and changes in market conditions. Investments in publicly traded
companies are carried at fair market value based on quoted market prices of the
investments as of September 30, 2002. These investments are subject to market
risk of equity price changes. As of September 30, 2002, the minority
investments we continue to hold totaled $4.6 million at estimated fair value of
which investments in publicly traded companies was $810,000 and investments in
private companies was $3.8 million.

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Item 4.Evaluation of Disclosure Controls and Procedures

(a)  Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
conducted an evaluation of our disclosure controls and procedures, as such term
is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act
of 1934, as amended (the Exchange Act), within 90 days of the filing date of
this report. Based on their evaluation, our principal executive officer and
principal financial officer concluded that our disclosure controls and
procedures are effective.

(b)  There have been no significant changes (including corrective actions with
regard to significant deficiencies or material weaknesses) in our internal
controls or in other factors that could significantly affect these controls
subsequent to the date of the evaluation referenced in paragraph (a) above.




PART II OTHER INFORMATION




Item 1. Legal Proceedings

From time to time we may be involved in litigation in the normal course of
business. Management believes that the outcome of matters to date will not have
a material adverse effect on our financial position or results of operations or
cash flows.

On May 1, 2001, the Santa Clara Center for Occupational Safety and Health
filed a complaint for injunctive relief and civil penalties against the Company
in the Superior Court of California, County of Alameda, Hayward Division, Case
No. H218237-5. The complaint alleges violations of California Business and
Professions Code section 17200 et seq., and violations under Proposition 65 and
California Health and Safety Code section 25249 et seq. as a result of AXTs
use of arsenic and inorganic arsenic compounds in its workplace. On June 24,
2002, the Company participated in a private mediation, and as a result, reached
a settlement of all claims, pursuant to which the Company agreed to pay the
Santa Clara Center for Occupational Safety and Health an amount equal to
$175,000. The parties have executed a settlement agreement, and the court
approved the settlement on September 20, 2002 and dismissal of the case is
pending.




Item 2. Changes in Securities and Use of Proceeds

None




Item 3. Defaults Upon Senior Securities

None




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

None




Item 5. Other Information

None




Item 6. Exhibits and Reports on Form 8-K

a. Exhibits

|       |  |                                                                                                                                                                        
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1(1) |  | Restated Certificate of Incorporation                                                                                                                                  
|3.2(2) |  | Certificate of Designation, Preferences and Rights of Series A
Preferred Stock, as filed with the Secretary of State of the state
of Delaware on May 27, 1999 (which is

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|       |  |                                                                                                                                                           
|------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|       |  | incorporated herein by reference to Exhibit 2.1 to the registrants Form 8-K dated May 28, 1999)                                                          
|3.3(3) |  | Second Amended and Restated Bylaws                                                                                                                        
|4.1(4) |  | Registration Rights Agreement dated as of May 27, 1999, by and
among American Xtal Technology, Inc., Lyte Optronics, Inc. and Keith
Halsey and Robert Shih
|4.2(3) |  | Rights Agreement dated as of April 24, 2001, by and between AXT,
Inc. and Computershare Trust Company                                                     
|10.14  |  | Second Modification to Credit Agreement between U.S. Bank
National Association and us dated September 30, 2002                                            
|99.1   |  | Certification by Chief Executive Officer                                                                                                                  
|99.2   |  | Certification by Chief Financial Officer                                                                                                                  



---

|(1) |  | As filed with the SEC in our Annual Report on Form 10-K for the year
ended December 31, 1998.
|--- |  | ---------------------------------------------------------------------------------------------
|   
|(2) |  | As filed with the SEC in our Form 8-K on June 14, 1999.                                      
|   
|(3) |  | As filed with the SEC in our Form 8-K on May 30, 2001.                                       
|   
|(4) |  | As filed with the SEC in our Annual Report on Form 10-K for the year
ended December 31, 1999.

b. Reports on Form 8-K

None

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SIGNATURES

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



| | AXT, INC.
| | ---------



|Dated: November 12, 2002 | By: | /s/ Morris S. Young                    
|------------------------ | --- | ---------------------------------------
|                         |     | Morris S. Young
Chief Executive Officer



|Dated: November 12, 2002 | By: | /s/ Donald L. Tatzin                    
|------------------------ | --- | ----------------------------------------
|                         |     | Donald L. Tatzin
Chief Financial Officer



|Dated: November 12, 2002 | By: | /s/ John E. Drury                 
|------------------------ | --- | ----------------------------------
|                         |     | John E. Drury
Corporate Controller

I, Morris S. Young, certify that:

| |                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. I have reviewed this quarterly report on Form 10-Q of AXT, Inc.;                                                                                                                                                                                                                                                              
|
| | 2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
|
| | 3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in
all material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in this
quarterly report;                   
|
| | 4. The registrants other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:                                                                                                     

| |                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
|
| | b. evaluated the effectiveness of the registrants disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        

37



---



##### Table of Contents



| |                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5. The registrants other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrants auditors and the
audit committee of registrants board of directors (or persons performing
the equivalent function):

| |                                                                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrants ability
to record, process, summarize and report financial data and have
identified for the registrants auditors any material weaknesses in
internal controls; and
|
| | b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrants
internal controls; and                                                                                                                                        

| |                                                                                                                                                                                                                                                                                                                                                                                             
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6. The registrants other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.



|Dated: November 12, 2002 | By: | /s/ Morris S. Young                    
|------------------------ | --- | ---------------------------------------
|                         |     | Morris S. Young
Chief Executive Officer

I, Donald L. Tatzin, certify that:

| |                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. I have reviewed this quarterly report on Form 10-Q of AXT, Inc.;                                                                                                                                                                                                                                                              
|
| | 2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
|
| | 3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in
all material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in this
quarterly report;                   
|
| | 4. The registrants other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:                                                                                                     

| |                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
|
| | b. evaluated the effectiveness of the registrants disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        

| |                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5. The registrants other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrants auditors and the
audit committee of registrants board of directors:

| |                                                                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrants ability
to record, process, summarize and report financial data and have
identified for the registrants auditors any material weaknesses in
internal controls; and
|
| | b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrants
internal controls; and                                                                                                                                        

38



---



##### Table of Contents



| |                                                                                                                                                                                                                                                                                                                                                                                             
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6. The registrants other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.



|Dated: November 12, 2002 | By: | /s/ Donald L. Tatzin                    
|------------------------ | --- | ----------------------------------------
|                         |     | Donald L. Tatzin
Chief Financial Officer

39



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##### Table of Contents






Index to Exhibits

|         |  |                                                                                                                                                                                                                                                                         
|-------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibits |  |                                                                                                                                                                                                                                                                         
|Number   |  | Description                                                                                                                                                                                                                                                             
|         |  |                                                                                                                                                                                                                                                                         
|3.1(1)   |  | Restated Certificate of Incorporation                                                                                                                                                                                                                                   
|3.2(2)   |  | Certificate of Designation, Preferences and Rights of Series A
Preferred Stock, as filed with the Secretary of State of the state
of Delaware on May 27, 1999 (which is
incorporated herein by reference to Exhibit 2.1 to the registrants Form 8-K dated May 28, 1999)
|3.3(3)   |  | Second Amended and Restated Bylaws                                                                                                                                                                                                                                      
|4.1(4)   |  | Registration Rights Agreement dated as of May 27, 1999, by and
among American Xtal Technology, Inc., Lyte Optronics, Inc. and Keith
Halsey and Robert Shih                                                                                                              
|4.2(3)   |  | Rights Agreement dated as of April 24, 2001, by and between AXT,
Inc. and Computershare Trust Company                                                                                                                                                                   
|10.14    |  | Second Modification to Credit Agreement between U.S. Bank
National Association and us dated September 30, 2002                                                                                                                                                          
|99.1     |  | Certification by Chief Executive Officer                                                                                                                                                                                                                                
|99.2     |  | Certification by Chief Financial Officer                                                                                                                                                                                                                                



---

|(1) |  | As filed with the SEC in our Annual Report on Form 10-K for the year
ended December 31, 1998.
|--- |  | ---------------------------------------------------------------------------------------------
|   
|(2) |  | As filed with the SEC in our Form 8-K on June 14, 1999.                                      
|   
|(3) |  | As filed with the SEC in our Form 8-K on May 30, 2001.                                       
|   
|(4) |  | As filed with the SEC in our Annual Report on Form 10-K for the year
ended December 31, 1999.