**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 

| **ý**                                                                                                                                                                                                                                        |   | **Quarterly report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                              |
| **for the  quarterly period ended June 30, 2004**                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                              |
| **or**                                                                                                                                                                                                                                            |
|                                                                                                                                                                                                                                              |
| **o**                                                                                                                                                                                                                                             |   | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934** |
|                                                                                                                                                                                                                                              |
| **for the transition period  from                 to                 ** |

 

**CommissionFile Number 000-24085**

 

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**AXT, INC.**

(Exactname of registrant as specified in its charter)

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

 

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

(Addressof principal executive offices) (Zip code)

 

**(510)683-5900**

(Registrant’stelephone number, including area code)

 

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Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. YES ýNO o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES oNO ý

 

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

 
| **Class**                     |   | **Outstanding at July 23, 2004** |
|-------------------------------|--------|----------------------------------|
| Common Stock, $.001 par value |   | 23,046,320                       |

 

 

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AXT, INC.

FORM 10-Q

TABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION                                                                                      |   |
|--------------------------------------------------------------------------------------------------------------------|--------|
| Item 1. Financial Statements  (unaudited)                                                                          |   |
| Condensed Consolidated  Balance Sheets as of June 30, 2004 and December 31, 2003                                   |   |
| Condensed  Consolidated Statements of Operations for the three and six month periods  ended June 30, 2004 and 2003 |   |
| Condensed  Consolidated Statements of Cash Flows for the six month periods ended June  30, 2004 and 2003           |   |
| Notes  To Condensed Consolidated Financial Statements                                                              |   |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations               |   |
| Item  3. Quantitative and Qualitative Disclosures About Market Risk                                                |   |
| Item 4. Controls and  Procedures                                                                                   |   |
| PART II. OTHER INFORMATION                                                                                         |   |
| Item  1. Legal Proceedings                                                                                         |   |
| Item  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                                                                                                         |   |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

AXT, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share data)

 
|                                                                                                                               |   | **June 30,  2004** |   | **December  31,  2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|--------|-------------------------|--------|
| Assets:                                                                                                                            |   |               |   |                    |   |
| Current assets                                                                                                                     |   |               |   |                    |   |
| Cash and cash equivalents                                                                                                          |   | $                  | 14,783 |                    | $      | 24,339 |   |
| Short-term investments                                                                                                             |   | 19,858             |   | 14,669                  |   |
| Accounts receivable, net of allowance of $4,946 and  $4,304 as of June 30, 2004 and December 31, 2003, respectively                |   | 4,390              |   | 6,297                   |   |
| Inventories                                                                                                                        |   | 21,822             |   | 24,083                  |   |
| Prepaid expenses and other current assets                                                                                          |   | 2,572              |   | 1,301                   |   |
| Assets held for sale                                                                                                               |   | 1,000              |   | 1,000                   |   |
| Total current assets                                                                                                               |   | 64,425             |   | 71,689                  |   |
| Property, plant and equipment                                                                                                      |   | 20,968             |   | 21,795                  |   |
| Other assets                                                                                                                       |   | 3,290              |   | 4,237                   |   |
| Restricted deposits                                                                                                                |   | 8,615              |   | 9,302                   |   |
| Total Assets                                                                                                                       |   | $                  | 97,298 |                    | $      | 107,023 |   |
|                                                                                                                               |   |               |   |                    |   |
| Liabilities:                                                                                                                       |   |               |   |                    |   |
| Current liabilities                                                                                                                |   |               |   |                    |   |
| Current portion of long-term debt                                                                                                  |   | $                  | 1,923  |                    | $      | 3,694 |   |
| Accounts payable                                                                                                                   |   | 2,791              |   | 2,638                   |   |
| Accrued liabilities                                                                                                                |   | 7,802              |   | 8,296                   |   |
| Accrued restructuring                                                                                                              |   | 1,040              |   | —                  |   |
| Total current liabilities                                                                                                          |   | 13,556             |   | 14,628                  |   |
| Long-term debt, net of current portion                                                                                             |   | 7,885              |   | 8,842                   |   |
| Other long-term liabilities                                                                                                        |   | 1,282              |   | 1,255                   |   |
| Total liabilities                                                                                                                  |   | 22,723             |   | 24,725                  |   |
| Stockholders’ Equity:                                                                                                         |   |               |   |                    |   |
| Preferred stock, $0.001 par value per share; 2,000  shares authorized; 833 shares issued and outstanding                           |   | 3,532              |   | 3,532                   |   |
| Common stock, $0.001 par value per share; 70,000 shares authorized; 23,047 and  22,957 shares issued and outstanding, respectively |   | 155,371            |   | 155,178                 |   |
| Accumulated deficit                                                                                                                |   | (85,335            | )      | (78,928                 | )      |
| Accumulated other comprehensive income                                                                                             |   | 1,007              |   | 2,516                   |   |
| Total stockholders’ equity                                                                                                    |   | 74,575             |   | 82,298                  |   |
| Total Liabilities and Stockholders’ Equity                                                                                    |   | $                  | 97,298 |                    | $      | 107,023 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share data)

 
|                                                     |   | **Three Months  Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|----------------------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                                     |   | **2004**                          |   | **2003**                        |   | **2004** |   | **2003** |   |
|                                                     |   |                              |   |                            |   |   |   |   |   |
| Revenue                                                  |   | $                                 | 9,524  |                            | $      | 8,519 |   | $ | 19,300 |   | $ | 17,054 |   |
| Cost of revenue                                          |   | 8,695                             |   | 7,844                           |   | 17,938 |   | 16,106 |   |
| Gross profit                                             |   | 829                               |   | 675                             |   | 1,362 |   | 948 |   |
| Operating expenses:                                      |   |                              |   |                            |   |   |   |   |   |
| Selling, general and administrative                      |   | 3,203                             |   | 2,819                           |   | 5,973 |   | 5,319 |   |
| Research and development                                 |   | 350                               |   | 368                             |   | 691 |   | 747 |   |
| Restructuring charge                                     |   | 1,077                             |   | —                          |   | 1,077 |   | — |   |
| Total operating expenses                                 |   | 4,630                             |   | 3,187                           |   | 7,741 |   | 6,066 |   |
| Loss from operations                                     |   | (3,801                            | )      | (2,512                          | )      | (6,379 | ) | (5,118 | ) |
| Interest expense                                         |   | 58                                |   | 108                             |   | 167 |   | 223 |   |
| Other expense (income), net                              |   | 113                               |   | 1,269                           |   | (54 | ) | 1,038 |   |
| Loss before provision for income taxes                   |   | (3,972                            | )      | (3,889                          | )      | (6,492 | ) | (6,379 | ) |
| Provision for incomes taxes                              |   | 97                                |   | —                          |   | 137 |   | — |   |
| Loss from continuing operations                          |   | (4,069                            | )      | (3,889                          | )      | (6,629 | ) | (6,379 | ) |
| Discontinued operations:                                 |   |                              |   |                            |   |   |   |   |   |
| Gain (loss) from discontinued operations                 |   | 222                               |   | (2,747                          | )      | 222 |   | (4,574 | ) |
| Loss from disposal                                       |   | —                            |   | (11,100                         | )      | — |   | (11,100 | ) |
| Net loss                                                 |   | $                                 | (3,847 | )                               | $      | (17,736 | ) | $ | (6,407 | ) | $ | (22,053 | ) |
|                                                     |   |                              |   |                            |   |   |   |   |   |
| Basic and diluted loss per share:                        |   |                              |   |                            |   |   |   |   |   |
| Loss from continuing operations                          |   | $                                 | (0.18  | )                               | $      | (0.17 | ) | $ | (0.29 | ) | $ | (0.28 | ) |
| Gain (loss) from discontinued operations                 |   | 0.01                              |   | (0.61                           | )      | 0.01 |   | (0.69 | ) |
| Net loss                                                 |   | $                                 | (0.17  | )                               | $      | (0.78 | ) | $ | (0.28 | ) | $ | (0.97 | ) |
|                                                     |   |                              |   |                            |   |   |   |   |   |
| Basic and diluted shares used in per share  calculations |   | 23,045                            |   | 22,702                          |   | 23,020 |   | 22,665 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

4

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 
|                                                              |   | **Six Months  Ended  June 30,** |   |
|-------------------------------------------------------------------|--------|---------------------------------|--------|
|                                                              |   | **2004**                        |   | **2003** |   |
|                                                              |   |                            |   |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                             |   |                            |   |   |   |
| Net loss                                                          |   | $                               | (6,407 | ) | $ | (22,053 | ) |
| Adjustments to reconcile net loss to net cash used in operations: |   |                            |   |   |   |
| Depreciation                                                      |   | 2,437                           |   | 3,456 |   |
| Amortization of marketable securities  premium/discount           |   | 123                             |   | 225 |   |
| Non-cash restructuring charge                                     |   | 1,077                           |   | — |   |
| Loss on disposal                                                  |   | —                          |   | 11,100 |   |
| Impairment write-down on investments                              |   | —                          |   | 1,257 |   |
| Gain on disposal of property, plant and equipment                 |   | —                          |   | (11 | ) |
| Stock based compensation                                          |   | —                          |   | 28 |   |
| Changes in assets and liabilities:                                |   |                            |   |   |   |
| Accounts receivable, net                                          |   | 1,907                           |   | 11 |   |
| Inventories                                                       |   | 2,261                           |   | 5,755 |   |
| Prepaid expenses                                                  |   | (1,271                          | )      | 1,487 |   |
| Other assets                                                      |   | 39                              |   | (70 | ) |
| Accounts payable                                                  |   | 153                             |   | (830 | ) |
| Accrued liabilities                                               |   | (531                            | )      | (1272 | ) |
| Income taxes                                                      |   | —                          |   | 636 |   |
| Other long-term liabilities                                       |   | 27                              |   | (107 | ) |
| Net cash used in operating activities                             |   | (185                            | )      | (388 | ) |
|                                                              |   |                            |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                             |   |                            |   |   |   |
| Purchases of property, plant and equipment                        |   | (702                            | )      | (1,704 | ) |
| Proceeds from sale of property, plant and equipment               |   | —                          |   | 5,172 |   |
| Purchases of marketable  securities                               |   | (20,650                         | )      | (1,808 | ) |
| Proceeds from sale of marketable securities                       |   | 10,422                          |   | 4,700 |   |
| Decrease (increase) in restricted cash                            |   | 4,151                           |   | (3,623 | ) |
| Net cash (used in) provided by investing activities               |   | (6,779                          | )      | 2,737 |   |
|                                                              |   |                            |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                             |   |                            |   |   |   |
| Proceeds from (payments of):                                      |   |                            |   |   |   |
| Issuance of common stock                                          |   | 193                             |   | 185 |   |
| Capital leases payments                                           |   | —                          |   | (2,204 | ) |
| Long-term debt payments                                           |   | (2,728                          | )      | (485 | ) |
| Net cash used in financing activities                             |   | (2,535                          | )      | (2,504 | ) |
| Effect of exchange rate changes                                   |   | (57                             | )      | (45 | ) |
| Net decrease in cash and cash equivalents                         |   | (9,556                          | )      | (200 | ) |
| Cash and cash equivalents at the beginning of the  period         |   | 24,339                          |   | 13,797 |   |
| Cash and cash equivalents at the end of the period                |   | $                               | 14,783 |   | $ | 13,597 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

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AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

**Note 1. Basis of Presentation**

 

The accompanying interim condensed consolidated financial statements of AXT, Inc.(“AXT” or the “Company”) are unaudited,and have been prepared in accordance with accounting principles generallyaccepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q and Article 10 of RegulationS-X. Accordingly, certain information and footnote disclosure normally includedin financial statements prepared in accordance with accounting principles generally accepted in the UnitedStates of America have been condensed or omitted. In the opinion of management,the unaudited condensed consolidated financial statements reflect alladjustments, consisting only of normal recurring adjustments, considerednecessary to present fairly the financial position, results of operations andcash flows of AXT and its subsidiaries for all periods presented.

 

Management of the Companyhas made a number of estimates and assumptions relating to the reporting ofassets and liabilities and the disclosure of contingent assets and liabilitiesto prepare these condensed consolidated financial statements in conformity withaccounting principlesgenerally accepted in the United States of America. Actual results coulddiffer materially from those estimates.

 

The results of operationsare not necessarily indicative of the results to be expected in the future orfor the full fiscal year. It is recommended that these condensed consolidatedfinancial statements be read in conjunction with the Company’s consolidatedfinancial statements and the notes thereto included in its 2003 Annual Reporton Form 10-K and its Quarterly Report on Form 10-Q filed with the Securitiesand Exchange Commission on March 29, 2004 and May 24, 2004, respectively.

 

Revenues from continuingoperations increased in fiscal 2003 compared to fiscal 2002. In response tocontinued net losses, the Company has taken measures including the continuedshifting of production to China to reduce costs and increase cash flows. As ofJune 30, 2004, the Company had available cash, cash equivalents and liquidshort-term investments of $34.6 million, excluding restricted deposits. TheCompany believes that its existing cash and liquid investments, cash generatedfrom operations, coupled with additional efforts to reduce expenditures insupport of the continuing substrate business will be sufficient to meet workingcapital expenditure requirements for the next 12 months. However, existing cashand liquid investments could decline during the remainder of 2004 due to aweakening of the economy, a loss in revenue, or changes in our planned cashoutlay.

 

If the Company’s salesdecrease, the ability to generate cash from operations will be adverselyaffected which could adversely affect its future liquidity, requiring it to usecash at a more rapid rate than expected and to seek additional capital. There canbe no assurance that such additional capital will be available or, if available, that it will be at terms acceptableto the Company.

 

Certain reclassificationshave been made to the prior years consolidated financial statements to conformto current period presentation.

 

**Note****2. DiscontinuedOperations**

 

On June 24, 2003, theCompany announced the discontinuation of its opto-electronics division, whichwas established as part of the acquisition of Lyte Optronics, Inc. in May 1999.Accordingly, the results of operations of the opto-electronics division havebeen segregated from continuing operations and are reported separately asdiscontinued operations in the consolidated statements of operations. Thediscontinued opto-electronics division manufactured blue, cyan, and greenhigh-brightness light emitting diodes (HBLEDs) for the illumination markets,including full-color displays, wireless handset backlighting and trafficsignals, and also manufactured vertical cavity surface emitting lasers (VCSELs)and laser diodes for fiber optic communications and storage area networks.

 

On September 27, 2003 theCompany completed a sale of substantially all of the assets of itsopto-electronics business to Lumei Optoelectronics, Corp. and Dalian LumingScience and Technology Group, Co., Ltd. for the Chinese Renminbi equivalent of$9.6 million. Proceeds of $1.0 million will be held in escrow for up to oneyear and will not be recorded until all claims, if any, are settled. We expectthis escrow to be released, if no claims are made against it, on or aboutSeptember 28, 2004. Of this $1.0 million escrow, up to $250,000 will be held inescrow for a second year and will not be recorded until all claims, if any, aresettled. The Company retains a building located in Monterey Park, CA, that itintends to sell in 2004. This asset has been classified as held for sale on the condensed consolidated balance sheets as of June 30,2004 and December 31, 2003.

 

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The Company recorded aloss on disposal of $9.5 million during the nine months ended September 30,2003.  The Company recorded a gain ondiscontinued operations of $0.2 million during the three and six month periodsended June 30, 2004.

 

The Company’s financialstatements have been presented to reflect the opto-electronics business as adiscontinued operation for all periods presented. Operating results of thediscontinued operation are as follows (in thousands):

 
|                                                              |   | **Three  Months Ended June 30,** |   | **Six Months  Ended June 30,** |   |
|-------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                              |   | **2004**                         |   | **2003**                       |   | **2004** |   | **2003** |   |
|                                                              |   |                             |   |                           |   |   |   |   |   |
| Revenue                                                           |   | $                                | — |                           | $      | 2,897 |   | $ | — |   | $ | 7,019 |   |
| Cost of revenue                                                   |   | —                           |   | 4,443                          |   | — |   | 9,119 |   |
|                                                              |   |                             |   |                           |   |   |   |   |   |
| Gross loss                                                        |   | —                           |   | (1,546                         | )      | — |   | (2,100 | ) |
| Operating expenses:                                               |   |                             |   |                           |   |   |   |   |   |
| Selling, general and administrative                               |   | (222                             | )      | 750                            |   | (222 | ) | 1,536 |   |
| Research and development                                          |   | —                           |   | 342                            |   | — |   | 707 |   |
| Impairment costs                                                  |   | —                           |   | —                         |   | — |   | — |   |
| Total operating expenses                                          |   | (222                             | )      | 1,092                          |   | (222 | ) | 2,243 |   |
| Gain (loss)   from operations                                |   | 222                              |   | (2,638                         | )      | 222 |   | (4,343 | ) |
| Interest expense                                                  |   | —                           |   | 109                            |   | — |   | 231 |   |
| Gain (loss) before benefit for income taxes and loss  on disposal |   | 222                              |   | (2,747                         | )      | 222 |   | (4,574 | ) |
| Income tax (benefit)                                              |   | —                           |   | —                         |   | — |   | — |   |
| Loss on disposal                                                  |   | —                           |   | (11,100                        | )      | — |   | (11,100 | ) |
| Net gain (loss)                                                   |   | $                                | 222    |                           | $      | (13,847 | ) | $ | 222 |   | $ | (15,674 | ) |

 

The carrying value of the assets and liabilities ofthe discontinued opto-electronics business included in the consolidated balancesheets are as follows (in thousands):

 
|                             |   | **June 30,  2004** |   | **December  31, 2003** |   |
|----------------------------------|--------|--------------------|--------|------------------------|--------|
| Current assets:                  |   |               |   |                   |   |
| Cash                             |   | $                  | 560    |                   | $      | 539 |   |
| Accounts receivable, net         |   | 19                 |   | 250                    |   |
| Assets held for sale             |   | 1,000              |   | 1,000                  |   |
| Total current assets             |   | 1,579              |   | 1,789                  |   |
| Other assets                     |   | 200                |   | 200                    |   |
| Total assets                     |   | $                  | 1,779  |                   | $      | 1,989 |   |
| Current liabilities:             |   |               |   |                   |   |
| Accounts payable                 |   | $                  | — |                   | $      | 43 |   |
| Accrued liabilities              |   | 462                |   | 1,232                  |   |
| Total liabilities                |   | 462                |   | 1,275                  |   |
| Net assets                       |   | 1,317              |   | 714                    |   |
| Total liabilities and net assets |   | $                  | 1,779  |                   | $      | 1,989 |   |

 

Assets held for saleconsist of a building and are carried at management’s estimated fair value lesscosts to sell.

 

7

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**Note****3. Accounting forStock Options**

 

The Company recordscompensation expense for employee stock options based upon their intrinsicvalue on the date of grant pursuant to Accounting Principles Board Opinion No.25 (APB 25), “Accounting for Stock Issued to Employees” and has adopted thedisclosure-only alternative of Statement of Financial Accounting Standards No.123 (SFAS 123)“Accounting for Stock-Based Compensation”. Because the Company establishes theexercise price based on the fair market value of the Company’s stock at thedate of grant, the options have no intrinsic value upon grant, and therefore noexpense is recorded. Each quarter, the Company reports the potential dilutiveimpact of stock options in its diluted earnings per share using thetreasury-stock method. Out-of-the-money stock options (i.e., options where theaverage sales price of our common stock as reported on the Nasdaq NationalMarket during the period is below the exercise price of the option) are notincluded in diluted earnings per share.

 

As required under SFAS123 and Statement of Financial Accounting Standards No. 148 (SFAS 148),“Accounting for Stock-Based Compensation Transition and Disclosure,” the proforma effects of stock-based compensation on net income (loss) and net income (loss) per common share hadthe Company applied the fair value recognition principles of SFAS 123 toemployee stock options have been estimated at the date of grant using theBlack-Scholes option-pricing model.

 

The Black-Scholesoption-pricing model was developed for use in estimating the fair value oftraded options that have no restrictions and are fully transferable andnegotiable in a free trading market. Black-Scholes does not consider theemployment, transfer or vesting restrictions that are inherent in the Company’semployee options. Use of an option valuation model, as required by SFAS 123,includes highly subjective assumptions based on long-term predictions,including the expected stock price volatility and average life of each optiongrant. Because the Company’s employee options have characteristicssignificantly different from those of freely traded options, and becausechanges in the assumptions underlying the option-pricing model can materiallyaffect the Company’s estimate of the fair value of those options, in theCompany’s opinion, the existing valuation models, including Black-Scholes, arenot reliable single measures and may misstate the fair value of the Company’semployee options.

 

The Company calculatedthe fair value of each option grant on the date of grant using theBlack-Scholes option pricing model as prescribed by SFAS 123 using thefollowing assumptions:

 
|                                     |   | **Six Months  Ended  June 30,** |   |
|------------------------------------------|--------|---------------------------------|--------|
|                                     |   | **2004**                        |   | **2003** |   |
| Weighted average risk free interest rate |   | 1.6                             | %      | 2.7 | % |
| Expected life (in years)                 |   | 5.0                             |   | 5.0 |   |
| Dividend yield                           |   | —                          |   | — |   |
| Volatility                               |   | 85.3                            | %      | 114.0 | % |

 

The weighted average fairvalue as of the date of grant of options granted during the six months endedJune 30, 2004 and 2003 were $1.97 and $1.05, respectively.

 

8

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Had compensation cost forthe Company’s options been determined based on the fair value at the grantdates, as prescribed in SFAS 123 and SFAS 148, the Company’s pro forma net lossand net loss per share would have been summarized as follows (in thousands, except per share data):

 
|                                                         |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|--------------------------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                                         |   | **2004**                          |   | **2003**                        |   | **2004** |   | **2003** |   |
| Net loss :                                                   |   |                              |   |                            |   |   |   |   |   |
| As reported                                                  |   | $                                 | (3,847 | )                               | $      | (17,736 | ) | $ | (6,407 | ) | $ | (22,053 | ) |
| Stock-based compensation  determined under fair value method |   | (253                              | )      | (1,743                          | )      | (846 | ) | (3,566 | ) |
| Pro forma net loss                                           |   | $                                 | (4,100 | )                               | $      | (19,479 | ) | $ | (7,253 | ) | $ | (25,619 | ) |
| Net loss per share:                                          |   |                              |   |                            |   |   |   |   |   |
| As reported:                                                 |   |                              |   |                            |   |   |   |   |   |
| Basic and diluted                                            |   | $                                 | (0.17  | )                               | $      | (0.78 | ) | $ | (0.28 | ) | $ | (0.97 | ) |
| Pro forma net loss :                                         |   |                              |   |                            |   |   |   |   |   |
| Basic and diluted                                            |   | $                                 | (0.18  | )                               | $      | (0.86 | ) | $ | (0.32 | ) | $ | (1.13 | ) |
| Shares used in per share calculation:                        |   |                              |   |                            |   |   |   |   |   |
| Basic and diluted                                            |   | 23,045                            |   | 22,702                          |   | 23,020 |   | 22,665 |   |

 

Because additional optiongrants are expected to be made each quarter, the above pro forma disclosuresare not representative of pro forma effects on reported net income (loss) forfuture quarters.

 

**Note****4. Investments**

 

The Company classifiesits investment securities as available-for-sale securities as prescribed byStatement of Financial Accounting Standards No. 115 (SFAS 115) “Accounting for Certain Investments in Debt and EquitySecurities.” All investments are carried at fair market value, which isdetermined based on quoted market prices, with net unrealized gains and lossesincluded in comprehensive income, net of tax. A decline in the market value ofthe security below cost that is deemed other than temporary is charged toearnings, resulting in the establishment of a new cost basis for the security.The components of investments as of June 30, 2004 are summarized as follows (inthousands):

 

| **Available  for sale**     |   | **Cost** |   | **Unrealized  Gain /(loss)** |   | **Aggregate  Fair value** |   |
|-----------------------------|--------|----------|--------|------------------------------|--------|---------------------------|--------|
| Money market                |   | $        | 8,898  |                         | $      | —                    |   | $ | 8,898 |   |
| Corporate bonds             |   | 17,103   |   | (67                          | )      | 17,036                    |   |
| Government agency bonds     |   | 5,275    |   | (1                           | )      | 5,274                     |   |
| Corporate equity securities |   | 1,464    |   | 1,210                        |   | 2,674                     |   |
|                        |   | $        | 32,740 |                         | $      | 1,142                     |   | $ | 33,882 |   |
| Recorded as :               |   |     |   |                         |   |                      |   |
| Cash equivalents            |   | $        | 5,409  |                         |   |                      |   |   |
| Short-term investments      |   | 19,858   |   |                         |   |                      |   |
| Restricted deposits         |   | 8,615    |   |                         |   |                      |   |
|                        |   | $        | 33,882 |                         |   |                      |   |   |

 

**Note****5. Assets Held forSale**

 

Assets held for sale atJune 30, 2004 consist of a building located in Monterey Park, California, whichis part of the Company’s discontinued opto-electronics division (see Note 2).This building is carried at management’s estimated fair value less costs tosell, totaling $1.0 million as of both June 30, 2004 and December 31, 2003.

 

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**Note****6. Inventories**

 

The components of inventoryare summarized as follows (in thousands):

 

|            |   | **June 30,  2004** |   | **December  31,  2003** |   |
|-----------------|--------|--------------------|--------|-------------------------|--------|
| Inventories:    |   |               |   |                    |   |
| Raw materials   |   | $                  | 5,951  |                    | $      | 7,086 |   |
| Work in process |   | 14,724             |   | 16,027                  |   |
| Finished goods  |   | 1,147              |   | 970                     |   |
|            |   | $                  | 21,822 |                    | $      | 24,083 |   |

 

**Note****7. Restructuring Charge**

 

The Company’srestructuring accrual is summarized as follows (in thousands):

 
| **For the  three month period ended  June 30, 2004**   |   | **Restructuring  Accrual as of  March 31,  2004** |   | **Additions/  Reversals** |   | **Payments** |   | **Restructuring  Accrual as of  June 30, 2004** |   |
|--------------------------------------------------------|--------|--------------------------------------------------------|--------|---------------------------|--------|--------------|--------|------------------------------------------------------|--------|
| Future lease payments related to abandoned  facilities |   | $                                                      | — |                      | $      | 690          |   | $                                                    | — |   | $ | 690 |   |
| Workforce reduction                                    |   | —                                                 |   | 387                       |   | (37          | )      | 350                                                  |   |
| Total                                                  |   | $                                                      | — |                      | $      | 1,077        |   | $                                                    | (37    | ) | $ | 1,040 |   |

 
| **For the  six month period ended  June 30, 2004**     |   | **Restructuring  Accrual as of  December 31, 2003** |   | **Additions/  Reversals** |   | **Payments** |   | **Restructuring  Accrual as of  June 30, 2004** |   |
|--------------------------------------------------------|--------|-----------------------------------------------------|--------|---------------------------|--------|--------------|--------|-------------------------------------------------|--------|
| Future lease payments related to abandoned  facilities |   | $                                                   | — |                      | $      | 690          |   | $                                               | — |   | $ | 690 |   |
| Workforce reduction                                    |   | —                                              |   | 387                       |   | (37          | )      | 350                                             |   |
| Total                                                  |   | $                                                   | — |                      | $      | 1,077        |   | $                                               | (37    | ) | $ | 1,040 |   |

 

During the threeand six month period ended June 30, 2004, the Company recorded a restructuringcharge of $1.1 million related to the reduction in force effected in June 2004,and to leasecosts associated with facilities located in California that are no longerrequired to support production.

 

The remainingrestructuring accrual for future lease payments related to abandoned facilitiesof $0.7 million and workforce reduction of $0.4 million is expected to be paidout through calendar 2004, and is included on the accompanying condensedconsolidated balance sheet as accrued restructuring.

 

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**Note****8. Net Loss PerShare**

 

Basic net loss per common share iscalculated by dividing net loss available to common stockholders by theweighted average number of common shares outstanding during the period. Dilutednet loss per common and common equivalent shares include the dilutive effect ofcommon stock equivalents outstanding during the period calculated using thetreasury stock method. Common stock equivalents consist of the shares issuableupon the exercise of stock options.

 

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

 
|                                                                            |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|---------------------------------------------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                                                            |   | **2004**                          |   | **2003**                        |   | **2004** |   | **2003** |   |
| Numerator:                                                                      |   |                              |   |                            |   |   |   |   |   |
| Net loss                                                                        |   | $                                 | (3,847 | )                               | $      | (17,736 | ) | $ | (6,407 | ) | $ | (22,053 | ) |
| Less : Preferred stock dividends                                                |   | (44                               | )      | (44                             | )      | (88 | ) | (88 | ) |
| Net loss available to common stockholders                                       |   | $                                 | (3,891 | )                               | $      | (17,780 | ) | $ | (6,496 | ) | $ | (22,141 | ) |
| Denominator:                                                                    |   |                              |   |                            |   |   |   |   |   |
| Denominator for basic net loss per share - weighted  average common shares      |   | 23,045                            |   | 22,702                          |   | 23,020 |   | 22,665 |   |
| Effect of dilutive securities:                                                  |   |                              |   |                            |   |   |   |   |   |
| Common stock options                                                            |   | —                            |   | —                          |   | — |   | — |   |
| Denominator for dilutive net loss per share                                     |   | 23,045                            |   | 22,702                          |   | 23,020 |   | 22,665 |   |
| Basic and diluted net loss per share                                            |   | $                                 | (0.17  | )                               | $      | (0.78 | ) | $ | (0.28 | ) | $ | (0.97 | ) |
| Options excluded from diluted net loss per share as  the impact is antidilutive |   | 1,916                             |   | 3,124                           |   | 1,916 |   | 3,231 |   |

 

**Note****9. ComprehensiveLoss**

 

The components ofcomprehensive loss are summarized as follows (in thousands):

 
|                                                      |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-----------------------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                                      |   | **2004**                          |   | **2003**                        |   | **2004** |   | **2003** |   |
|                                                      |   |                              |   |                            |   |   |   |   |   |
| Net loss                                                  |   | $                                 | (3,847 | )                               | $      | (17,736 | ) | $ | (6,407 | ) | $ | (22,053 | ) |
| Foreign currency translation gain (loss)                  |   | 1                                 |   | 1                               |   | (57 | ) | (45 | ) |
| Unrealized gain (loss) on available for sale  investments |   | (296                              | )      | 921                             |   | (1,452 | ) | 677 |   |
| Comprehensive loss                                        |   | $                                 | (4,142 | )                               | $      | (16,814 | ) | $ | (7,916 | ) | $ | (21,421 | ) |

 

**Note 1****0. SegmentInformation**

 

The Company has oneoperating segment comprising the design, development, manufacture anddistribution of high-performance compound semiconductor substrates. TheCompany’s operating segment reports to the Interim Chief Executive Officer.

 

The Company sells itssubstrates products in the United States and in other parts of the world, andmaintains operations in the United States, Japan and China. Revenues bygeographic location based on the country where the customer is located are summarized as follows (inthousands):

 
|                   |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                   |   | **2004**                          |   | **2003**                        |   | **2004** |   | **2003** |   |
| Net revenues:          |   |                              |   |                            |   |   |   |   |   |
| United States          |   | $                                 | 2,142  |                            | $      | 2,013 |   | $ | 4,199 |   | $ | 5,917 |   |
| Europe                 |   | 2,287                             |   | 1,731                           |   | 3,702 |   | 3,040 |   |
| Canada                 |   | 35                                |   | 84                              |   | 89 |   | 107 |   |
| Japan                  |   | 1,023                             |   | 1,298                           |   | 2,259 |   | 1,786 |   |
| Taiwan                 |   | 2,539                             |   | 1,655                           |   | 5,683 |   | 3,144 |   |
| Asia Pacific and other |   | 1,498                             |   | 1,738                           |   | 3,368 |   | 3,060 |   |
| Consolidated           |   | $                                 | 9,524  |                            | $      | 8,519 |   | $ | 19,300 |   | $ | 17,054 |   |

 

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**Note 1****1. CorporateAffiliates**

 

The Company’s investmentsin its corporate affiliates are summarized as follows (in thousands):

 
| **Affiliate**                                  |   | **Investment  Balance  June 30,  2004** |   | **Investment  Balance  December 31,  2003** |   | **Accounting  Method** |   | **Ownership  Percentage** |   |
|------------------------------------------------|--------|-----------------------------------------|--------|---------------------------------------------|--------|------------------------|--------|---------------------------|--------|
| Xilingol Tongli Ge Co. Ltd.                    |   | $                                       | 820    |                                        | $      | 822                    |   | Equity                    |   | 25 | % |
| Emeis han Jia Mei High Pure Metals Co., Ltd.   |   | 599                                     |   | 603                                         |   | 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                        | %      |
| Beijing BoYu Manufacturing Co., Ltd.           |   | 409                                     |   | 409                                         |   | Consolidated           |   | 70                        | %      |
|                                                |        |                                         |        |                                             |        |                        |        |                           |        |  |  |

 

The investment balancesfor those affiliates accounted for under the equity method are included within“Other assets” in the condensed consolidated balance sheets. The minorityinterest for those affiliates that are consolidated is included within “Otherlong-term liabilities” in the condensed consolidated balance sheets and within“Other income, net” on the condensed consolidated statements of operations.

 

Undistributed retainedearnings relating to the Company’s corporate affiliates was $1,380,000 as ofJune 30, 2004 and $794,000 as of June 30, 2003. Net income recorded from theCompany’s corporate affiliates were $382,000 and $612,000 for the three month and six month periods endedJune 30, 2004, respectively. Net loss recorded from the Company’s corporateaffiliates were $41,000 and $67,000 for the three and six month periods endedJune 30, 2003, respectively.

 

The Company invested inthese companies because each provides materials that are important to theCompany’s substrate business, each can provide products at lower cost thanother suppliers, and each has a market beyond that provided by the Company. Asof June 30, 2004, the Company had no obligations to make further investments inany of these companies, although it may choose to do so under certainconditions.

 

**Note 1****2. Commitments andContingencies**

 

From time to time theCompany is involved in judicial or administrative proceedings concerningmatters arising in the ordinary course of our business. The Company does notexpect that any of these matters, individually or in the aggregate, will have amaterial adverse effect on our business, financial condition, cash flows orresults of operation.

 

On April 15, 2003,Sumitomo Electric Industries, Ltd., (SEI) filed a complaint in the TokyoDistrict Court, Civil Division against us and our Japanese distributor allegingpatent infringement of two patents held by SEI in Japan. The suit seekspenalties from AXT in the amount of $1.67 million plus interest and court costsand the cessation of AXT’s sales of gallium arsenide substrates in Japan. AXTintends to defend itself vigorously in these lawsuits and continues to sell itsproducts in Japan. Both parties have completed submitting arguments andevidence in litigation in Japan. The Company retains all of its options whichinclude appealing any court decision and launching an effort to have Sumitomo’spatent invalidated in Japan.

 

On June 11, 2003, Cree,Inc. filed a complaint in the United States Court for Northern District ofCalifornia against the Company alleging patent infringement. The complaintsought damages and injunction against infringement. On July 23, 2003, theCompany filed a counter complaint in the United States Court for NorthernDistrict of California, denying any patent infringement and alleging thatCree’s actions were intentionally designed to interfere with the Company’sprospective business relationships. The Company reached an agreement with Creeresolving the disputes between us and signed a settlement agreement on March 5,2004. The resolution of the disputes did not have a material adverse impact onthe Company’s consolidated financial position or results of operations. Allparties signed a final release regarding all disputes between them on April 15,2004.

 

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The Company has enteredinto contracts to supply several large customers with GaAs wafers. Thecontracts guarantee the delivery of a certain number of wafers between January1, 2001 and December 31, 2004 with a current contract value of $1.0 million.The contract sales prices are subject to review quarterly and can be adjustedin the event that raw material prices change. In the event of non-delivery ofthe determined wafer quantities in any monthly delivery period, the Companycould be subject to non-performance penalties of between 5% and 10% of thevalue of the delinquent monthly deliveries. The Company has not received anyclaims for non-performance penalties due to non-delivery. Partial prepaymentsreceived for these supply contracts totaling $793,000 and $994,000 are includedin accrued liabilities in the accompanying condensed consolidated balancesheets as of June 30, 2004 and December 31, 2003. As of June 30, 2004, theCompany has met all of its current delivery obligations under these contractsand expects to continue to meet delivery requirements during the remainder ofthe contract terms.

 

The Company indemnifiescertain customers for attorney fees and damages and costs awarded against theseparties in certain circumstances if its products are found to infringe certainpatents and they are sued by the patent holder and awarded damages. There arelimits on and exceptions to its potential liability for indemnificationrelating to intellectual patent infringement claims. The Company cannotestimate the amount of potential future payments, if any, that it might be requiredto make as a result of these agreements. To date, the Company has not paid anyclaim or been required to defend any action related to its indemnificationobligations, and accordingly, the Company has not accrued any amounts for suchindemnification obligations. However, we may record charges in the future as aresult of these indemnification obligations.

 

The Company’s financialstatements include accruals for potential product liability and warranty claimsbased on the Company’s claims experience. Such costs are accrued at the timerevenue is recognized. As of June 30, 2004 and December 31, 2003, accruedproduct warranties totaled $135,000 and $0 respectively, and are included in“accrued liabilities” in the accompanying condensed consolidated balance sheets.If there is a material increase in customer claims compared with our historicalexperience, or if costs of servicing claims are greater than expected, we mayrecord a charge against cost of sales.

 

The following table reconciles changes in the Company’s accrued productwarranties which is included in accrued liabilities for the three and six monthperiods ended June 30,2004 and 2003, respectively (in thousands):

 
|                                         |   | **Three****Months Ended****June 30****,** |   | **Six****Months Ended****June 30****,** |   |
|----------------------------------------------|--------|-------------------------------------------|--------|-----------------------------------------|--------|
|                                         |   | **200****4**                              |   | **200****3**                            |   | **200****4** |   | **200****3** |   |
|                                         |   |                                      |   |                                    |   |   |   |   |   |
| Beginning accrued warranty and related costs |   | $                                         | 135    |                                    | $      | — |   | $ | — |   | $ | — |   |
| Charged to cost of revenue                   |   | —                                    |   | —                                  |   | 135 |   | — |   |
| Actual warranty expenditures                 |   | —                                    |   | —                                  |   | — |   | — |   |
| Ending accrued warranty and related costs    |   | $                                         | 135    |                                    | $      | — |   | $ | 135 |   | $ | — |   |

 

In April 2004, theCompany determined that it had not followed requirements for testing of products and provisionof testing data and information relating to customer requirements for certainshipments made over the past several years. Since April 2004, the Company hascontinued to notify the affected customers concerning its findings. The Companyhas established a reserve based on its best estimate of future returns relatedto this matter. Although actual returns may differ, the Company does notbelieve future claims in the aggregate will be material. One of the customershas cancelled outstanding orders for scheduled future deliveries totalingapproximately $352,000. This customer represented approximately 2.8% of the Company’s total consolidatedrevenue for the three month period ended June 30, 2004 and 3.7% of the Company’s total consolidatedrevenue for the six month period ended June 30, 2004. The Company has recordeda reserve for sale returns of $745,000 and believes this is adequate to coverany product returns related to this matter, however, the Company is unable toassess the impact that this matter might have, if any, on our future revenuesor gross margins. Approximately $125,000 of the $745,000 sales returns reservehas been utilized in July 2004.  Refer to “Item 4 Controls andProcedures” for further information.

 

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**Note 13. Foreign Exchange Contractsand Transaction Gains/Losses**

 

The Company usesshort-term forward exchange contracts for hedging purposes to reduce theeffects of adverse foreign exchange rate movements. The Company has purchasedforeign exchange contracts to hedge against certain trade accounts receivabledenominated in Japanese yen. The change in the fair value of the forward contractsis recognized as part of the related foreign currency transactions as theyoccur. As of June 30, 2004, the Company had no outstanding commitments withrespect to foreign exchange contracts.

 

The Company incurredforeign currency transaction exchange losses of $(75,000) and $(11,000) for thethree and six month periods ended June 30, 2004, respectively, and foreigncurrency transaction exchange gains of $13,000 and $65,000for the three and six month periods ended June 30, 2003, respectively.

 

**Note 14. Recent AccountingPronouncements**

 

In January 2003, theFinancial Accounting Standards Board  (FASB) issuedInterpretation No. 46 (FIN 46), *Consolidationof Variable Interest Entities*, which addresses consolidation bybusiness enterprises of variable interest entities, or VIEs, either that do nothave sufficient equity investment at risk to permit the entity to finance itsactivities without additional subordinated financial support, or in which theequity investors lack an essential characteristic of a controlling financialinterest. In December 2003, the FASB completed deliberations of proposedmodifications to FIN 46, or FIN 46(R), resulting in an effective date of nolater than the first interim or annual period ending after March 15, 2004. TheCompany’s adoption of FIN 46(R) did not have an impact on our results ofoperations or financial position.

 

In April 2004, the Emerging Issues TaskForce issued Statement No. 03-06, (EITF 03-06), *Participating Securities and theTwo-Class Method under FASB Statement No. 128, Earnings Per Share*.EITF 03-06 addresses a number of questions regarding the computation ofearnings per share by companies that have issued securities other than commonstock that contractually entitle the holder to participate in dividends andearnings of the company when, and if, it declares dividends on its commonstock. The issue also provides further guidance in applying the two-classmethod of calculating earnings per share, clarifying what constitutes aparticipating security and how to apply the two-class method of computingearnings per share once it is determined that a security is participating,including how to allocate undistributed earnings to such a security. EITF 03-06was effective for fiscal periods beginning after March 31, 2004. The adoptionof EITF 03-06 did not have a material effect on the Company’s results ofoperations or financial position.

 

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

 

This Management’sDiscussion and Analysis of Financial Condition and Results of Operationsincludes a number of forward-looking statements made pursuant to the provisionsof Section 21E of the Securities Exchange Act of 1934. These forward-lookingstatements are based upon management’s current views with respect to futureevents and financial performance, and are subject to certain risks anduncertainties that could cause actual results to differ materially fromhistorical results or those anticipated. Such risks and uncertainties includethose set forth under “Risks Related to our Business” below. Forward-lookingstatements 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 orobjectives for future operations are forward-looking statements.

 

These forward-lookingstatements are not guarantees of future performance. Readers are cautioned notto place undue reliance on these forward-looking statements, which speak onlyas of the date hereof. This discussion should be read in conjunction withManagement’s Discussion and Analysis of Financial Condition and Results ofOperations included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2003 and the condensed consolidated financial statementsincluded elsewhere in this report.

 

**Overview**

 

We were founded in 1986to commercialize and enhance our proprietary vertical gradient freeze (VGF)technique for producing high-performance compound semiconductor substrates. Asa result of the discontinuance of our opto-electronics division, and the saleof substantially all of the assets of this business in 2003, we now have oneoperating segment: our substrate division. We made our first substrate sales in1990 and our substrate division currently sells gallium arsenide (GaAs) andindium phosphide (InP) substrates to manufacturers of semiconductor devices foruse in applications such as fiber optic and wireless telecommunications, lightemitting diodes (LEDs) and lasers. We also sell raw materials including galliumand germanium through our participation in majority- and minority-owned jointventures. We have the capability to manufacture germanium substrates for use insatellite solar cells but withdrew from this business during 2000 so that wecould more profitably use our then constrained capacity. We are now trying torequalify our germanium substrates with the few existing satellite solar cellsystem manufacturers.

 

Our total revenue fromcontinuing operations was $9.5 million for the second quarter of 2004, $8.5million for the second quarter of 2003 and $9.8 million for the first quarterof 2004. In the second quarter of 2004 we incurred a loss from continuingoperations of $4.1 million compared with a loss of $3.9 million for the secondquarter of 2003 and a loss of $2.6 million for the first quarter of 2004.

 

On June 24, 2003, weannounced the discontinuation of our opto-electronics division, which weestablished as part of our acquisition of Lyte Optronics, Inc. in May 1999.Accordingly, the results of operations of the opto-electronics division havebeen segregated from continuing operations and are reported separately as discontinuedoperations in our consolidated statements of operations for all periodspresented (see Note 3 of the notes to our condensed consolidated financialstatements for details regarding the accounting for discontinued operations).The discontinued opto-electronics division manufactured blue, cyan, and greenhigh-brightness light emitting diodes (HBLEDs) for the illumination markets,including full-color displays, wireless handset backlighting and trafficsignals, and also manufactured vertical cavity surface emitting lasers (VCSELs)and laser diodes for fiber optic communications and storage area networks.

 

On September 27, 2003 wecompleted a sale of substantially all of the assets of our opto-electronicsbusiness to Lumei Optoelectronics, Corp. and Dalian Luming Science andTechnology Group, Co., Ltd. for the China Renminbi (RMB) equivalent of $9.6million. During the first quarter of 2004, $7.8 million was converted to USdollars. The remaining funds were converted to US dollars in early April 2004.$1.0 million of the sales proceeds is maintained in an escrow account for up toone year after the sale date and will not be recorded until all claims madeagainst the escrow, if any, are settled. We expect this escrow to be released,if no claims are made against it, on or about September 28, 2004. Of this $1.0million escrow, up to $250,000 will be held in escrow for a second year andwill not be recorded until all claims made against the escrow, if any, aresettled. We retain a building located in Monterey Park, CA, that we intend to sell in 2004. This asset isclassified as held for sale on our condensed consolidatedbalance sheets as of December 31, 2003 and June 30, 2004.

 

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Our continuing business,primarily sales of our substrate products, is dependant on the semiconductorindustry, which is highly cyclical and has historically experienced downturnsboth as a result of economic changes and of overcapacity. We experienced agrowth period that lasted from our initiation of sales in 1990 through thefirst half of 2001. In the second half of 2001, we experienced a $44.9 million,or 58.5% decrease in revenue compared with the first half as a result of therapid decline in the mobile and fiber optic telecommunications markets.Together with other industry participants, we experienced lower revenues,slower bookings, push outs and cancellation of orders. As such, we recordedlosses in the third and fourth quarters of 2001.

 

During the first half of2002 our revenues grew due to improvements in the wireless market. In thesecond half of 2002 our revenue fell, however, because the substrate industrywas still facing excess capacity that caused prices to decline, and because weexperienced a loss of market share after two competitors developed technologiessimilar to ours. In addition, certain customers selected competitors’ productsin order to diversify their supply sources and due to the belief that thecompetitors’ substrates offered better surface qualities. Full year 2002revenue declined $63.9 million, or 58.8% compared with 2001. We recorded lossesin each quarter of 2002 and incurred impairment charges against fixed assetsand inventory due to the decline in demand and prices. In reaction to theeconomic downturn, we initiated an aggressive effort to reduce substratemanufacturing costs. This included moving much of our substrate manufacturingoperations to China, reducing capacity in our Fremont, CA facility anddeveloping and investing in key low-cost raw material sources.

 

In 2003, we believe thatthe wireless communications and HBLED markets grew, but our revenue did notincrease until the fourth quarter of 2003 due to continued reductions in pricesand the time required to improve our substrate surface quality and regain somelost customers. Revenue for 2003 fell by $10.2 million, or 22.6% compared with2002. We recorded net losses in each quarter of 2003. During 2003 we continuedto shift more of our manufacturing operations to China and reduced our costs incurredin the United States.

 

During the first half of2004, our revenue increased compared with the fourth quarter of 2003, primarilyas a result of increased demand for HBLEDs. We recorded net losses in the firsttwo quarters of 2004. During the second quarter of 2004, we announced plans tocease all production activities in the United States and to manufacture ourproducts only in China.

 

We cannot predict thelevel of future industry demand or of our ability to regain lost market share,but they have impacted our ability to sell our products and operate profitably.If demand for our products remains depressed for an extended period, ourbusiness will be harmed as a result. Our business performance will be mostinfluenced by market demand for compound semi-conductor substrates, our abilityto offer products that equal or exceed the quality provided by competitors,product pricing, our ability to shift more of our manufacturing production toChina, and our ability to create and defend our intellectual property while notinfringing on the intellectual property of others.

 

In April 2004, wedetermined that we hadnot followed requirements for testing of products and provision of testing dataand information relating to customer requirements for certain shipments madeover the past several years. We have notified the affected customers concerningour findings. We have established a reserve based on our best estimate offuture returns related to this matter. Although actual returns may differ, wedo not believe future claims in the aggregate will be material. One of ourcustomers has cancelled outstanding orders for scheduled future deliveriestotaling approximately $352,000. This customer represented approximately 2.8%of our total consolidated revenue for the three month period ended June 30,2004 and 3.7% of our total consolidated revenue for the six month period endedJune 30, 2004. We have recorded a reserve for sales returns of $745,000 andbelieve this is adequate to cover any product returns related to this matter,however, we are unable to assess the impact that this matter might have, ifany, on our future revenues or gross margins. Approximately $125,000 of the$745,000 sales returns reserve has been utilized in July 2004.  See “Item 4. Controls and Procedures” forfurther information.

 

In June 2004, we incurreda restructuring charge of $1.1 million as a result of our decision to closedown the remaining manufacturing facilities in the US.  This charge is comprised of costs related tothe reduction in force effected in June 2004, and lease costs associated withthe facilities located in California that are no longer required to supportproduction. See Note 8 of the notes to our condensed consolidated financial statements for furtherdetails.

 

For the second quarter of2004, our revenue from continuing operations increased to $9.5 million from$8.5 million in the second quarter of 2003, primarily due to greater sales ofGaAs substrates, which benefited from increasing demand from our key end-usemarkets, red and amber HBLEDs and wireless handsets. Our gross margin alsoincreased from the second quarter of 2003 to 8.7 percent due to higher yieldsand a greater share of our production being completed in China.

 

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**Critical Accounting Policies andEstimates**

 

We have prepared ourconsolidated financial statements in accordance with accounting principlesgenerally accepted in the United States of America. As such, we have had tomake estimates, assumptions and judgments that affect the amounts reported onour financial statements. These estimates, assumptions and judgments aboutfuture events and their effects on our results cannot be determined withcertainty, and are made based upon our historical experience and on otherassumptions that are believed to be reasonable under the circumstances. Theseestimates may change as new events occur or additional information is obtained,and we may periodically be faced with uncertainties, the outcomes of which arenot within our control and may not be known for a prolonged period of time. Thediscussion and analysis of our results of operations and financial conditionare based upon these consolidated financial statements. We have identified thepolicies below as critical to our business operations and understanding of ourfinancial condition and results of operations. A critical accounting policy isone that is both material to the presentation of our financial statements andrequires us to make difficult, subjective or complex judgments that could havea material effect on our financial condition and results of operations. Theymay require us to make assumptions about matters that are highly uncertain atthe time of the estimate, and different estimates that we could have used, orchanges in the estimate that are reasonably likely to occur, may have amaterial impact on our financial condition or results of operations.

 

We believe that thefollowing are our critical accounting policies:

 

***Revenue Recognition***

 

We recognize revenue uponshipment of products to our customers provided that we have received a signedpurchase order, the price is fixed or determinable, title has transferred,collection of resulting receivables is probable, product returns are reasonablyestimable, there are no customer acceptance requirements and there are noremaining obligations. We establish a reserve when there is uncertaintyregarding customer acceptance. We assess the probability of collection based ona number of factors including past history with the customer and creditworthiness. We provide for future returns based on historical experience,current economic trends and changes in customer demand at the time revenue isrecognized. During the first quarter of 2004, we increased our reserve for salesreturns by $745,000 related to our failure to follow certain testingrequirements and provision of testing data and information to certaincustomers. This reserve was based on discussions with some of the affectedcustomers and review of specific shipments made during the quarter. Except forsales in Japan and some sales in Taiwan, which in both cases are denominated inJapanese yen, we denominate and collect our international sales in U.S.dollars.

 

***Allowance forDoubtful Accounts***

 

We periodically review thelikelihood of collecting our accounts receivable balances and provide anallowance for doubtful accounts receivable primarily based upon the age ofthese accounts. We provide a 100% allowance for U.S. receivables in excess of90 days and for foreign receivables in excess of 120 days. As of June 30, 2004our accounts receivable balance was $4.4 million, which is net of an allowancefor doubtful accounts of $4.9 million.

 

***Warranty Reserve***

 

We maintain a warrantyreserve based upon our claims experience during the prior twelve months. Suchcosts are accrued at the time revenue is recognized. As of June 30, 2004,accrued product warranties totaled $135,000.

 

***Inventory***

 

Inventories are stated atthe lower of cost or market. Cost is determined using the standard cost method.Finished goods and work-in-process inventories include material, labor andmanufacturing overhead costs. We routinely evaluate the levels of our inventoryin light of current market conditions in order to identify excess and obsoleteinventory and we provide a valuation allowance for certain inventories basedupon the age and quality of the product. Competitive delivery times arefrequently less than the time required for us to manufacture a product,requiring us to build some work-in-process inventories in anticipation oforders. If orders are not obtained for the products built, the products willultimately be deemed obsolete and we will establish a reserve for their value.We also review our inventory to ensure costs can be realized upon ultimate saleto our customers. If we determine that the value of any items in endinginventory exceeds the sales value less any related selling costs, a reserve isestablished for the difference.

 

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***Impairment ofLong-Lived Assets***

 

We evaluate therecoverability of property, equipment, and intangible assets in accordance withStatement of Financial Accounting Standards No. 144, or SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.” When eventsand circumstances indicate that long-lived assets may be impaired, we comparethe carrying value of the long-lived assets to the projection of futureundiscounted cash flows attributable to such assets and in the event that thecarrying value exceeds the future undiscounted cash flows, we record animpairment charge against income equal to the excess of the carrying value overthe asset’s fair value.

 

***Investments***

 

We determine theappropriate classification of investments at the time of purchase.Available-for-sale investments are carried at their fair value based on quotedmarket prices as of the balance sheet date. The amortized cost of securities isadjusted for amortization of premiums and accretion of discounts to maturity.Such amortization is included in “other (income) and expense, net.” Realizedgains or losses are determined on the specific identification method and arereflected in “other (income) and expense, net.” Net unrealized gains or lossesare recorded directly in stockholders’ equity. Those unrealized losses that aredeemed to be other than temporary are reflected in “interest and other income,net.” We also maintain minority investments in private companies which areaccounted for under the cost basis. These investments are reviewed for otherthan temporary declines in value on a quarterly basis. Reasons for other thantemporary declines in value include whether the related company would haveinsufficient cash flow to operate for the next twelve months, significantchanges in the operating performance and changes in market conditions.

 

***Income Taxes***

 

We account for deferredincome taxes using the liability method, under which the expected future taxconsequences of timing differences between the book and tax basis of assets andliabilities are recognized as deferred tax assets and liabilities. Valuationallowances are established when necessary to reduce net deferred tax assetswhen management estimates, based on available objective evidence, that it ismore likely than not that the future income tax benefit represented by the netdeferred tax asset will not be realized.

 

**Results of Operations**

 

The following table setsforth certain information relating to the operations of the Company expressedas a percentage of total revenues for the periods indicated:

 
|                                                 |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|------------------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                                 |   | **2004**                          |   | **2003**                        |   | **2004** |   | **2003** |   |
| Revenues                                             |   | 100.0                             | %      | 100.0                           | %      | 100.0 | % | 100.0 | % |
| Cost of revenues                                     |   | 91.3                              |   | 92.1                            |   | 92.9 |   | 94.4 |   |
| Gross profit                                         |   | 8.7                               | %      | 7.9                             | %      | 7.1 | % | 5.6 | % |
| Operating expenses:                                  |   |                              |   |                            |   |   |   |   |   |
| Selling, general and administrative                  |   | 33.6                              |   | 33.1                            |   | 30.9 |   | 31.2 |   |
| Research and development                             |   | 3.7                               |   | 4.3                             |   | 3.6 |   | 4.4 |   |
| Restructuring charge                                 |   | 11.3                              |   | —                          |   | 5.6 |   | — |   |
| Total operating expenses                             |   | 48.6                              |   | 37.4                            |   | 40.1 |   | 35.6 |   |
| Loss from operations                                 |   | (39.9                             | )      | (29.5                           | )      | (33.0 | ) | (30.0 | ) |
| Interest expense                                     |   | (0.6                              | )      | 1.3                             |   | (0.9 | ) | 1.3 |   |
| Other (expense) income, net                          |   | (1.2                              | )      | 14.9                            |   | 0.3 |   | 6.1 |   |
| Loss before provision for income taxes               |   | (41.7                             | )      | (45.7                           | )      | (33.6 | ) | (37.4 | ) |
| Provision for incomes taxes                          |   | (1.0                              | )      | —                          |   | (0 .7 | ) | — |   |
| Loss from continuing operations                      |   | (42.7                             | )      | (45.7                           | )      | (34.3 | ) | (37.4 | ) |
| Discontinued operations:                             |   |                              |   |                            |   |   |   |   |   |
| Gain (loss) from discontinued operations, net of tax |   | 2.3                               |   | (162.5                          | )      | 1.1 |   | (91.9 | ) |
| Gain (loss) from disposal                            |   | —                            |   | —                          |   | — |   | — |   |
| Net loss                                             |   | (40.4                             | )%     | (208.2                          | )%     | (33.2 | )% | (129.3 | )% |

 

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**Three months ended June 30, 2004compared with three months ended June 30,****2003**

 

*Revenuefrom continuing operations.*Revenue from continuingoperations increased $1.0 million, or 11.8%, to $9.5 million for the threemonths ended June 30, 2004 compared with $8.5 million for the three monthsended June 30, 2003.

 

Total GaAs substraterevenue increased $0.5million, or 6.5%, to $7.5 million for the three months ended June 30, 2004compared with $7.0 million for the three months ended June 30, 2003. Sales of5” and 6” diameter GaAs substrates were $1.3 million for the three months endedJune 30, 2004 compared with $0.8 million for the three months ended June 30,2003. InP substrate revenue increased $30,000, or 6.0%, to $533,000 for thethree months ended June 30, 2004 compared with $503,000 for the three monthsended June 30, 2003. The increase in GaAs substrate revenue during the pastyear is due to market growth in the HBLED and wireless handset markets and toour ability to gain share among some Asian customers.

 

International revenueincreased to 77.1% of total revenue from continuing operations for the threemonths ended June 30, 2004 compared with 76.4% of total revenue from continuingoperations for the three months ended June 30, 2003. The increase was primarilydue to a greater share of our GaAs substrates being used in opto-electronicsapplications and the majority of our customers for these applications being inAsia.

 

*Grossmargin.*Gross margin increased to 8.7% of total revenue forthe three months ended June 30, 2004 compared with 7.9% of total revenue forthe three months ended June 30, 2003. The increase was primarily due to alarger sales volume that enabled us to cover more fixed costs as well asreduced costs that we incurred as a result of moving most of our production toChina, where we incur lower production costs than in our California operations.

 

*Selling,general and administrative expenses.*Selling, general andadministrative expenses increased to $3.2 million for the three months endedJune 30, 2004 compared with $2.8 million for the three months ended June 30,2003. The increase is due to an additional accrual of $350,000 for legal feesrelated to an investigation by our Audit Committee into product testing andcompliance practices in second quarter of 2004. As a percentage of revenue, selling, general and administrativeexpenses were 33.6% for the three months ended June 30, 2004 compared with33.1% for the three months ended June 30, 2003.

 

*Researchand development expenses.*Research and development expensesdecreased $18,000, or 4.9%, to $350,000 for the three months ended June 30,2004 compared with $368,000 for the three months ended June 30, 2003. As apercentage of total revenue, research and development expenses were 3.7% forthe three months ended June 30, 2004 compared with 4.3% for the three monthsended June 30, 2003. Although we reduced research and development expenses aspart of our effort to adjust costs in line with our current business, webelieve that continued investment in product development is critical toattaining our strategic objectives of maintaining and increasing our technologyleadership, and as a result, we expect research and development expenses toremain at current levels or increase in future periods. Research anddevelopment efforts during the first quarter of 2004 were focused primarily onimproving the yield and surface quality of our GaAs substrates.

 

*Interestexpense.*Interest expense decreased $50,000, or 46.3%, to$58,000 for the three months ended June 30, 2004 compared with $108,000 for thethree months ended June 30, 2003. Interest expense decreased due to lower debtlevels as we continue to pay down our debt.

 

*Otherincome and expense, net.*Other expense decreased $1.2 millionto $113,000 for the three months ended June 30, 2004 compared with otherexpense of $1.3 million for the three months ended June 30, 2003. The decreasewas mainly due to an impairment charge in 2003 related to a non-consolidatedsubsidiary for $1.3 million.

 

*Provisionfor income taxes.*Due to our continuing operating losses inthe United States and uncertainty regarding future profitability, we recorded afull valuation allowance for our US losses against our net deferred tax assetsof $34.6 million in 2003. We incurred a tax liability of$97,000 for our overseas businesses for the three months ended June 30, 2004.

 

**Six months ended June 30, 2004compared with six months ended June 30,****2003**

 

*Revenuefrom continuing operations.*Revenue from continuingoperations increased  $2.2 million, or13.2%, to $19.3 million for the six months ended June 30, 2004 compared with$17.1 million for the six months ended June 30, 2003.

 

Total GaAs substraterevenue increased $1.5 million, or 11.0%, to $15.5 million for the six monthsended June 30, 2004 compared with $14.0 million for the six months ended June30, 2003. Sales of 5” and 6” diameter GaAs substrates were $2.8 million for thesix

 

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months ended June 30,2004 compared with $2.1million for the six months ended June 30, 2003. InP substrate revenue decreased$18,000, or 1.7%, to $1.1million for the six months ended June 30, 2004 compared with $1.1 million forthe six months ended June 30, 2003. The increase in GaAs substrate revenueduring the past year is due to market expansion in the HBLED and wirelesshandset markets and to our ability to gain share among Asian customers.

 

International revenueincreased to 77.8% of total revenue from continuing operations for the sixmonths ended June 30, 2004 compared with 64.6% of total revenue from continuingoperations for the six months ended June 30, 2003. The increase was primarilydue to a greater share of our GaAs substrates being used in opto-electronicsapplications and the majority of our customers for these applications being inAsia.

 

*Grossmargin.*Gross margin increased to 7.1% of total revenue forthe six months ended June 30, 2004 compared with 5.6% of total revenue for thesix months ended June 30, 2003. The increase was primarily due to a largersales volume that enabled us to cover more fixed costs as well as reduced coststhat we incurred as a result of moving most of our production to China, where weincur lower production costs than in our California operations.

 

*Selling,general and administrative expenses.*Selling, general andadministrative expenses increased to $6.0 million for the six months ended June30, 2004 compared with $5.3 million for the six months ended June 30, 2003. Theincrease is due to an additional accrual of $350,000 for legal fees related tothe investigation by our Audit Committee into product testing and compliancepractices in second quarter of 2004, and $300,000 for auditing andSarbanes-Oxley related expenses for 2004. As a percentage of revenue, selling,general and administrative expenses were 30.9% for the six months ended June30, 2004 compared with 31.2% for the six months ended June 30, 2003.

 

*Researchand development expenses.*Research and development expensesdecreased $56,000, or 7.5%, to $691,000 for the six months ended June 30, 2004compared with $747,000 for the six months ended June 30, 2003. As a percentageof total revenue, research and development expenses were 3.6% for the sixmonths ended June 30, 2004 compared with 4.4% for the six months ended June 30,2003. Although we reduced research and development expenses as part of oureffort to adjust costs in line with our current business, we believe thatcontinued investment in product development is critical to attaining ourstrategic objectives of maintaining and increasing our technology leadership,and as a result, we expect research and development expenses to remain atcurrent levels or increase in future periods. Research and development effortsduring the first quarter of 2004 were focused primarily on improving the yieldand surface quality of our GaAs substrates.

 

*Interestexpense.*Interest expense decreased $56,000, or 25.1%,to $167,000 for the six months ended June 30, 2004 compared with $223,000 for the six months ended June30, 2003. Interest expense includes a prepayment penalty incurred byvoluntarily repaying off a loan before it was due with an outstanding principalbalance of $781,000, which we acquired in 1996.  Interest expense decreased due to lower debt levels as wecontinue to pay down our debt.

 

*Otherincome and expense, net.*Other income increased $1.1 millionto $54,000 for the six months ended June 30, 2004 compared with other expenseof $1.0 million for the six months ended June 30, 2003. The increase was mainlydue to an impairment charge in 2003 related to a non-consolidated subsidiaryfor $1.3 million.

 

*Provisionfor income taxes.*Due to our continuing operating losses inthe United States and uncertainty regarding future profitability, we recorded afull valuation allowance for our US losses against our net deferred tax assetsof $34.6 million in 2003. We incurred a tax liability of$137,000 for our overseas businesses for the six months ended June 30, 2004.

 

**Liquidity and Capital Resources**

 

We consider cash and cashequivalents, and short-term investments as liquid and available for use.Short-term investments are comprised of government bonds and high-gradecommercial debt instruments. Also included in short-term investments is ourcommon stock investment in Finisar Corporation. As of June 30, 2004, ourprincipal sources of liquidity were $34.6 million in cash and cash equivalentsand short-term investments, excluding restricted deposits.

 

Cash and cash equivalentsand short-term investments, excluding $2.3 million and $3.7 million for ourinvestment in Finisar common stock as of June 30, 2004 and December 31, 2003,respectively, decreased $3.0 million to $32.3 million as of June 30, 2004 comparedwith $35.3 million as of December 31, 2003.

 

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Cash and cash equivalentsdecreased $9.6 million to $14.8 million as of June 30, 2004 compared with $24.3million as of December 31, 2003. Short-term investments increased by $5.2 million to $19.9 million as of June 30, 2004compared with $14.7 million as ofDecember 31, 2003. We converted approximately $7.8 million of the total $9.6million of Chinese Renminbi from the sale of our opto-electronic assets intoUnited States dollars during the first quarter of 2004 and invested most ofthat into short-term investments. The remaining funds were converted in earlyApril 2004.

 

Net cash used byoperating activities of $185,000 for the six month period ended June 30, 2004was comprised primarily of our net loss adjusted for non-cash items whichnetted to $2.8 million, consisting primarily of depreciation of $2.4 million,and by a $2.6 million net change in assets and liabilities. The net change inassets and liabilities resulted primarily from a decrease in accountsreceivable and inventory partiallyoffset by an increase in prepaid expenses and a decrease in accruedliabilities.

 

Net accounts receivabledecreased by $1.9 million, or 30.3%, to $4.4 million as of June 30, 2004compared with $6.3 million as of December 31, 2003. The decrease reflectsbetter collections from customers and an additional sales returns reserve of$745,000 recorded in the first quarter of 2004.

 

Net inventories decreased$2.3 million, or9.4% to $21.8 million as ofJune 30, 2004 compared with $24.1 million as of December 31, 2003. The Companyadopted a strategy of using inventory to conserve cash during the first half of2004. During the second half of 2004, we do not expect to maintain the samerate of net inventory decrease as we experienced in first half of 2004.

 

Net cash used by investingactivities of $6.8 million for the quarter ended June 30, 2004 includespurchases of property and equipment of $0.7 million primarily used to transferproduction capacity to China for the substrate division, and purchases of highgrade investment securities with maturities of less than two years totaling$20.7 million, partially offset by sales of high grade investment securitiestotaling $10.4 million and a change in the investments providing our restrictedcash of $4.2 million.

 

We do not have any plansto initiate any major new capital spending projects through 2004. We arecurrently completing certain projects at our China facilities and closing ourremaining manufacturing facilities in Fremont, California. We expect to investapproximately $2.0 million in capital projects in 2004. We believe that ourexisting and planned facilities and equipment are sufficient to fulfill currentand expected future orders.

 

Net cash used infinancing activities of $2.5 million consisted of scheduled payments of $2.7 millionrelated to long-term borrowings, partially offset by proceeds of $0.2 millionthrough our employee stock compensation programs.

 

Our main Fremont,California manufacturing facility is financed by long-term borrowings, whichwere refinanced by taxable variable rate revenue bonds in 1998. These bondsmature in 2023 and bear interest at a variable rate that was 1.4% as of June30, 2004. The bonds are traded in the public market. Repayment of principal andinterest under the bonds is supported by a letter of credit from our bank andis paid on a quarterly basis. We have the option to redeem the bonds in wholeor in part during their term. As of June 30, 2004, $8.5 million was outstandingunder these bonds.

 

As of June 30, 2004, the credit facility maintained byus with a bank included a letter of credit supporting repayment of ourindustrial bonds with an outstanding amount of $8.6 million. The Company haspledged and placed certain investment securities with an affiliate of the bankas additional collateral for this facility. We have also pledged certaininvestments for a credit facility for our workers compensation insurance. As aresult, $8.6 million of our cash and short-term investments are restricted.

 

We currently hold a notepayable secured by certain buildings and land in China totaling $1.5 million asof June 30, 2004. The balance on this note is due in December 2004.

 

We believe that we haveadequate cash and investments to meet the Company’s needs over the next 12months. If our sales decrease, however, our ability to generate cash fromoperations will be adversely affected which could adversely affect our futureliquidity, require us to use more cash at a more rapid rate than expected, andrequire us to seek additional capital. There can be no assurance that suchadditional capital will be available or, if available it will be at termsacceptable to the Company. Cash from operations could be affected by variousrisks and uncertainties, including, but not limited to those set forth belowunder “Risks Related to Our Business.”

 

Outstanding contractualobligations as of June 30, 2004 are summarized as follows (in thousands):

 

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|                        |   | **Debt** |   | **Operating  Leases** |   | **Total** |   |
|-----------------------------|--------|----------|--------|-----------------------|--------|-----------|--------|
| 2004 (remaining six months) |   | $        | 1,818  |                  | $      | 717       |   | $ | 2,535 |   |
| 2005                        |   | 420      |   | 1,222                 |   | 1,642     |   |
| 2006                        |   | 420      |   | 901                   |   | 1,321     |   |
| 2007                        |   | 420      |   | 681                   |   | 1,101     |   |
| 2008                        |   | 385      |   | 681                   |   | 1,066     |   |
| Thereafter                  |   | 6,345    |   | 2,855                 |   | 9,200     |   |
|                        |   | $        | 9,808  |                  | $      | 7,057     |   | $ | 16,865 |   |

 

We lease certain officespace, manufacturing facilities and property under long-term operating leasesexpiring at various dates through March 2013. Total rent expense under theseoperating leases wasapproximately $352,000 and $705,000 for the three month and six month periodsended June 30, 2004, respectively.

 

**Recent Accounting Pronouncements**

 

In January 2003, theFinancial Accounting Standards Board (FASB) issued Interpretation No. 46, or FIN 46, *Consolidation of Variable Interest Entities*,which addresses consolidation by business enterprises of variable interestentities, or VIEs, either: (1) that do not have sufficient equity investment atrisk to permit the entity to finance its activities without additionalsubordinated financial support, or (2) in which the equity investors lack anessential characteristic of a controlling financial interest. In December 2003,the FASB completed deliberations of proposed modifications to FIN 46, or FIN46(R), resulting in an effective date of no later than the first interim orannual period ending after March 15, 2004. The Company’s adoption of FIN 46(R)did not have an impact on our results of operations or financial position.

 

In April 2004, the Emerging Issues TaskForce issued Statement No. 03-06, (EITF 03-06), *Participating Securities and theTwo-Class Method under FASB Statement No. 128, Earnings Per Share*.EITF 03-06 addresses a number of questions regarding the computation ofearnings per share by companies that have issued securities other than commonstock that contractually entitle the holder to participate in dividends andearnings of the company when, and if, it declares dividends on its commonstock. The issue also provides further guidance in applying the two-classmethod of calculating earnings per share, clarifying what constitutes aparticipating security and how to apply the two-class method of computingearnings per share once it is determined that a security is participating,including how to allocate undistributed earnings to such a security. EITF 03-06was effective for fiscal periods beginning after March 31, 2004. The adoptionof EITF 03-06 did not have a material effect on the Company’s results ofoperations or financial position.

 

**Risks Related to Our Business**

 

***We may incur claimsor other liabilities or obligations related to our failure******to follow requirementsfor testing of products and provision of testing data******and information relating to customerrequirements. Additionally, customers may******cancel or reduce future shipments inresponse to these failures.***

 

We have recentlydetermined that we hadnot followed requirements for testing of products and provision of testing dataand information relating to customer requirements. See preceeding “Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperation - Overview” and “Item 4. Controls and Procedures” below for furtherinformation. Although we are notifying affected customers concerning ourfindings, there can be no assurance that we will not incur customer claims orother liabilities or obligations in connection with this matter, nor, if wereceive any such claims, that we will not have to restate results from priorperiods. In addition, revenue in future periods may be adversely impacted ifcustomers cancel or reduce orders or decide not to continue ordering from us asa result of this disclosure. We have been notified of several cancellations offuture orders by customers pending further information regarding enhancementsto our product testing and quality control systems. We cannot be sure that wewill not receive additional cancellations of orders by other customers, or failto win expected future orders from customers, as a result of our disclosure ofour investigation conclusions.

 

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***Because of powershortages in China, we may have to temporarily close our China operations,which would adversely impact our ability to manufacture our products, meetcustomer orders, and result in reduced revenues for the period.***

 

The Chinese government has indicated that the country facesa power crunch this summer and that power demand in 24 provinces outstrippedsupply in peak periods during the first four months of 2004. Instability inelectrical supply has caused sporadic outages among residential consumers. As aresult, the Chinese government has called for tough measures to ease the energyshortage which is expected to last at least through 2005.  Provinces have imposed power brownouts toreduce electricity demand and some companies in Beijing have been ordered togive their employees a week off to ease the pressure on power supply.  It is anticipated that the plants, most ofwhich are state-owned, will be closed and reopened on a staggered schedule toreduce power consumption during the capital’s hottest months, with the firstclosings occurring in early July.  Thepolicy is expected to continue until the end of August.  We closed most of our operations for a weekin late July 2004 in conformance with this policy.  If we are required to make additional temporary closures of ourBeijing operations, we will be unable to manufacture our products, and will beunable to meet customer orders except from inventory on hand.  As a result, we could lose sales, adverselyimpacting our revenues, and our relationships with our customers could suffer,impacting our ability to generate future sales.  In addition, if power is shut off at our Beijing operations atany time, either voluntarily or as a result of unplanned brownouts, duringcertain phases of our manufacturing process including our crystal growth phase,the work in process may be ruined and rendered unusable, causing us to incurexpense that will not be covered by revenue, and negatively impacting our costof goods sold and gross margins.

 

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

 

Other companies may holdor obtain patents on inventions or may otherwise claim proprietary rights totechnology necessary to our business. The markets in which we compete arecomprised of competitors who in some cases hold substantial patent portfolioscovering aspects of products that could be similar to ours. We could becomesubject to claims that we are infringing patent, trademark, copyright or otherproprietary rights of others, and have been sued by a substrate competitorconcerning alleged patent infringement. On April 15, 2003, Sumitomo ElectricIndustries, Ltd., (SEI) filed a complaint in the Tokyo District Court, CivilDivision against the Company and its Japanese distributor alleging patent infringementof two patents held by SEI in Japan. The suit seeks penalties from us in theamount of $1.67 million plus interest and court costs and the cessation of oursales of gallium arsenide substrates in Japan. We intend to defend ourselfvigorously in these law suits. Both parties have completed submitting argumentsand evidence in litigation in Japan and we currently retain all of our optionswhich include appealing any court decision and launching an effort to haveSumitomo’s patent invalidated in Japan. However, there can be no assurance thatthe court will not rule against us on the infringement claim, or that we cansettle this matter on terms acceptable to us, if at all.

 

Litigation to determinethe validity of alleged claims, such as that between us and Sumitomo, could betime-consuming and result in significant expense to us and divert the effortsof our technical and management personnel, whether or not the litigation isultimately determined in our favor. If a law suit is decided against us, includingthe lawsuit with Sumitomo, we could be subject to significant liabilities,requiring us to seek costly licenses or preventing us from manufacturing andselling our products. We may not be able to obtain required licensingagreements on terms acceptable to us or at all. If we lose the litigation withSumitomo, we may have to pay royalties to Sumitomo on products sold in Japan,or cease sales of our products to customers in Japan.

 

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

 

We are subject tofederal, state and local environmental and safety laws and regulations in allof our operating locations. 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 withapplicable regulations, we could be subject to substantial liability forclean-up efforts, personal injury and fines or suspension or cessation of ouroperations. In March 2001, we settled a claim made by the CaliforniaOccupational Saftey and Health Administration, or Cal-OSHA, in an investigationprimarily regarding impermissible levels of potentially hazardous materials incertain areas of our manufacturing facility in Fremont, California for$200,415, and we have recently been the target of press allegations concerningour environmental compliance programs and exposure of our employees tohazardous materials, and there is a possibility that former employees may filelitigation against us. Although we have put in place engineering,administrative and personnel protective equipment programs to address theseissues, our ability to expand or continue to operate our present locationscould be restricted or we could be required to acquire costly remediationequipment or incur other significant expenses. Existing or future changes inlaws or regulations in the United States and China may require us to incursignificant expenditures or liabilities, or may restrict our operations. Inaddition, our employees could be exposed to chemicals or other hazardousmaterials at our facilities and we may be subject to lawsuits seeking damagesfor wrongful death or personal injuries allegedly caused by exposure tochemicals or

 

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hazardous materials atour facilities.

 

If litigation is broughtagainst us, litigation is inherently uncertain and while we would expect todefend ourself vigorously, it is possible that our business, financialcondition, results of operations or cash flows, could be affected in anyparticular period by such litigation if brought against us.

 

***The semiconductorindustry is cyclical and has experienced a downturn which has******adversely impacted ouroperating results.***

 

Our continuing businessdepends in significant part upon manufacturers of electronic andopto-electronic semiconductor devices, as well as the current and anticipatedmarket demand for such devices and products using such devices. As a supplierto the semiconductor industry, we are subject to the business cycles thatcharacterize the industry. The timing, length and volatility of these cyclesare difficult to predict. The semiconductor industry has historically beencyclical because of sudden changes in demand for semiconductors and capacityrequirements, including capacity utilizing the latest technology. The rate ofchanges in demand, including end demand, is high, and the effect of thesechanges upon us occurs quickly, exacerbating the volatility of these cycles.These changes have affected the timing and amounts of customers’ capitalequipment purchases and investments in new technology. These industry cyclescreate pressure on our net sales, gross margin and net income.

 

The industry haspreviously experienced periods of oversupply that result in significantlyreduced demand for semiconductor devices and components, including ourproducts, both as a result of general economic changes and overcapacity. Whenthese periods occur, our operating results and financial condition areadversely affected, and create pressure on our revenue, gross margins and netincome. Inventory buildups in telecommunications products and slower thanexpected sales of computer equipment resulted in overcapacity and led toreduced sales by our customers, and therefore reduced purchases of ourproducts. During periods of weak demand such as those experienced over the pastyears, customers typically reduce purchases, delay delivery of products and/orcancel orders of component parts such as our products. Increased pricecompetition has resulted, causing pressure on our net sales, gross margin andnet income. We experienced cancellations, price reductions, delays and pushouts of orders, which have resulted in reduced revenues. If the economicdownturn were to continue, or occur again in the future, further ordercancellations, reductions in order size or delays in orders will materiallyadversely affect our business and results of operations. Actions to reduce ourcosts, such as those we have recently taken, may be insufficient to align ourstructure with prevailing business conditions. We may be required to undertakeadditional cost-cutting measures, and may be unable to invest in marketing,research and development and engineering at the levels we believe are necessaryto maintain our competitive position. Our failure to make these investments couldseriously harm our business.

 

During periods ofincreasing demand for semiconductor devices, we must have sufficientmanufacturing capacity and inventory to meet customer demand, and must be ableto attract, hire, train and retain qualified employees to meet demand. Itappears that the semiconductor industry is in the early stages of an upturn andincreasing demand. However, we cannot predict the sustainability of a recovery,if any, and the industry’s rate of growth in this recovery, if it occurs. If weare unable to effectively manage our resources and production capacity duringan industry upturn, there could be a material adverse effect on our business,financial condition and results of operations.

 

***If the economyrecovers and we are again in a period of high demand for our******products, we may beunable to expand our manufacturing capacity quickly enough******to meet increased demand, we maymake decisions to expand capacity that are not******profitable, and we may be unable tolower our costs or increase revenue.***

 

It appears that theindustry may be in an upturn, which may cause demand to increase rapidly as ithas in prior years after other cyclical downturns in the economy and theindustries in which we operate. If this happens, in order to meet increaseddemand and maintain our market share, we may need to increase production, whichcould require us to build new facilities, expand and modify our existingfacilities, purchase additional manufacturing equipment, and add qualifiedstaff. If we are not at that time able to expand our manufacturing capacity, wewill be unable to increase production, which may adversely impact our abilityto meet increased production demand while reducing unit costs, margins andimproving our operating results.

 

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

 

•    unforeseen environmental orengineering problems;

 

•    unavailability or latedelivery of production equipment;

 

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•    delays in completing newfacilities;

 

•    delays in bringing productionequipment on-line;

 

•    work stoppages or delays;

 

•    inability to recruit and trainqualified staff; and

 

•    unanticipated cost increasesand restrictions imposed by requirements of local, state or federal regulatoryagencies in the   United States andChina.

 

If any of these risksoccurs, construction may be costlier than anticipated and completion could bedelayed, which could hurt our ability to expand capacity and increase oursales. In addition, if we experience delays in expanding our manufacturingcapacity, we may not be able to timely meet customer requirements, and we couldlose future sales. We are also completing selective investments in equipmentand facilities as part of our previously planned capacity expansion. To offsetthe additional fixed operating expenses, we must increase our revenue byincreasing production and improving yields. If demand for our products does notgrow, if prices decline significantly, or if our yields do not improve asanticipated, we may be unable to offset these costs against increased revenue,which would adversely impact our operating results.

 

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

 

We have not over the pastyear been able to sustain growth, and may not be able to return to historicgrowth levels in the current economic environment. Our net loss in 2002 was thelargest in our history and our losses continued during 2003. We believe we willendure losses for at least part of 2004.

 

We have and may continueto experience significant fluctuations in our revenue and earnings. Ourquarterly and annual revenue and operating results have varied significantly inthe past and may vary significantly in the future due to a number of factors,including:

 

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

 

•      fluctuationsin demand for our products;

 

•      expansion ofour manufacturing capacity;

 

•      expansion ofour operations in China;

 

•      limitedavailability and increased cost of raw materials;

 

•      the volume andtiming of orders from our customers, and cancellations, push outs and delays ofcustomer orders;

 

•      fluctuation ofour manufacturing yields;

 

•      decreases inthe prices of our competitors’ products;

 

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

 

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

 

•      our ability todevelop, manufacture and deliver high quality products in a timely andcost-effective manner.

 

Due to these factors, webelieve that period-to-period comparisons of our operating results may not be meaningfulindicators of our future performance. Our operating results have over the pastyear at times been below the expectations of securities analysts or

 

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investors. If this occursagain in future periods, the price of our common stock could decline orfluctuate.

 

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

 

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

 

We must manage ourinventory of component parts, work-in-process, and finished goods effectivelyto meet changing customer requirements, while keeping inventory costs down andimproving gross margins. Some of our products and supplies have in the past andmay in the future become obsolete while in inventory due to changing customerspecifications, or become excess inventory due to decreased demand for ourproducts and an inability to sell the inventory within a foreseeable period.Furthermore, if current costs of production increase or sales prices drop belowthe standard prices at which we value inventory, we may need to take a chargefor a reduction in inventory values. We have in the past had to take inventoryvaluation and impairment charges. If we are not successfully able to manage ourinventory, we may need to write off unsaleable, obsolete or excess inventory,which could adversely affect our results of operations.

 

***Decreases inaverage selling prices of our products may reduce gross margins.***

 

The market for compoundsemiconductor substrates is characterized by pressures on average sellingprices resulting from factors such as increased competition or overcapacity. Wemay experience price pressures on our products, and if average selling pricesdecline in the future, our revenues and gross margins could decline. We may beunable to reduce the cost of our products sufficiently to counter the effect oflower selling prices and allow us to keep pace with competitive pricingpressures and our margins could be adversely affected.

 

***The disposal of ouropto-electronics business may fail to result in the******benefits we anticipate.***

 

We may not obtain thebenefits we expect as a result of discontinuation of our opto-electronicsbusiness, such as greater strategic focus on our core businesses. We may berequired to return to the buyer some or all of the $1 million of the saleproceeds which will be held in escrow should the buyer successfully claim thatwe breached one of the representations or warranties made to it. Our buildingin Monterey Park may not be sold for the $1 million at which we are carrying iton our balance sheet. We may incur additional costs associated with thediscontinued operations which could materially reduce our short term earnings.

 

***A reoccurrence ofSevere Acute Respiratory Syndrome (SARS) or the outbreak of a******different contagiousdisease may adversely impact our manufacturing operations******and some of our key suppliers andcustomers.***

 

The majority of oursubstrate manufacturing activities are conducted in China. In addition, wesource key raw materials, including gallium, from our joint ventures and othersuppliers in China. The 2003 SARS outbreak was most notable in China and asmall number of cases have been reported to date in 2004. One employee at ourLED production facility in China contracted SARS in late April 2003 promptingus to close the facility for ten days. There was no significant impact to ourability to fill customer orders. If there were to be another outbreak of SARSor a different contagious disease and if our employees contracted the disease,we may be required to temporarily close our manufacturing operations.Similarly, if one of our key suppliers is required to close for an extendedperiod, we may not have enough raw material inventory to continue manufacturingoperations. In addition, while we possess management skills among our Chinastaff that enable us to maintain our manufacturing operations with minimalon-site supervision from our US-based staff, our business could also be harmedif travel to or from Asia and the United States is restricted or inadvisable,as it was during parts of 2003. None of our substrate competitors is asdependent on manufacturing facilities in China as we are. If our manufacturingoperations were closed for a significant period, we could lose revenue andmarket share during that period which would depress our financial performanceand could be difficult to recapture. Finally, if one of our key customers isrequired to close for an extended period, we may not be able to ship product tothem, our revenue would decline and our financial performance would suffer.

 

***The impact ofchanges in global economic conditions on our customers may cause******us to fail to meetexpectations, which would negatively impact the price of our******stock.***

 

Our operating results canvary significantly based upon the impact of changes in global economicconditions on our customers. More specifically, the macro-economic environmentthat we faced in 2003 was more uncertain than in some prior periods, lastedlonger than expected and has materially and adversely affected us and ouroperating results and may continue to do so. The revenue

 

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growth and profitabilityof our business depends on the overall demand for our substrates, and we areparticularly dependant on the market conditions for the wireless, solid-stateillumination, fiber optics and telecommunications industries. Because our salesare primarily to major corporate customers whose businesses fluctuate withgeneral economic and business conditions, a softening of demand for productsthat use our substrates, caused by a weakening economy may result in further orprolonged decreased revenues. Customers may find themselves facing excessinventory from earlier purchases, and may defer or reconsider purchasingproducts due to the downturn in their business and in the general economy.

 

***If we do notsuccessfully develop new products to respond to rapidly changing******customer requirements, ourability to generate sales and obtain new customers******may suffer.***

 

Our success depends onour ability to offer new products and product features that incorporate leadingtechnology and respond to technological advances. In addition, our new productsmust meet customer needs and compete effectively on quality, price andperformance. The life cycles of our products are difficult to predict becausethe markets for our products are characterized by rapid technological change,changing customer needs and evolving industry standards. If our competitorsintroduce products employing new technologies or performance characteristics,our existing products could become obsolete and unmarketable. During the pastyear, we have seen our competitors selling more substrates manufactured using acrystal growth technology similar to ours, which has eroded our technologicaldifferentiation. If we fail to offer new products, we may not generatesufficient revenue to offset our development costs and other expenses or meetour customers’ requirements. Other companies, including Triquent, are activelydeveloping substrate materials that could be used to manufacture devices thatcould provide the same high-performance, low-power capabilities as GaAs- andInP-based devices at competitive prices. If these substrate materials or VGFderived products are successfully developed and semiconductor devicemanufacturers adopt them, demand for our GaAs substrates could decline and ourrevenue could suffer.

 

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

 

***Our operatingresults depend in large part on further customer acceptance of******our existing substrateproducts manufactured in China.***

 

To shift more of oursubstrate manufacturing operations to China successfully, we will need ourcustomers to qualify products manufactured in China. If we are unable toachieve qualifications for these products, our China facility will beunderutilized, our investments in China will not be recouped and we will beunable to lower our costs by moving to China. We may lose sales of our productsto competitors who are not manufacturing in China, or whose operations in Chinahave already been qualified by customers. All of these events could reduce ourrevenue but increase our cost structure. In addition, we announced a plan tostop producing products in China during the third quarter of 2004. If customersdo not fully qualify our China production by the time we cease our Californiaproduction, we may lose additional customers.

 

Furthermore, somecustomers have reduced their orders from us until our surface quality is asgood and consistent as that offered by competitors. As a result, some customersare now allocating their requirements for VGF grown substrates across morecompetitors and we believe that we have lost revenue and market share as aresult of these customer decisions, which we may be unable to recover. If weare unable to retain our market share, our revenue and performance willdecline.

 

***Intense competitionin the markets for our products could prevent us from******increasing revenue and sustainingprofitability.***

 

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

 

•      greaterexperience in the business;

 

•      moremanufacturing experience;

 

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•      extensiveintellectual property;

 

•      broader namerecognition; and

 

•      significantlygreater financial, technical and marketing resources.

 

Our competitors coulddevelop new or enhanced products that are more effective than our products are.

 

The level and intensityof competition has increased over the past year and we expect competition tocontinue to increase in the future. Competitive pressures caused by the currenteconomic conditions have resulted in reductions in the prices of our products,and continued or increased competition could reduce our market share, requireus to further reduce the prices of our products, affect our ability to recovercosts or result in reduced gross margins.

 

***Defects in ourproducts could diminish demand for our products.***

 

Our products are complexand may contain defects. We have experienced quality control problems with someof our products over the past two years, which caused customers to returnproducts to us, reduce orders for our products, or both. If we continue toexperience quality control problems, or experience these or other problems innew products, customers may cancel or reduce orders or purchase products fromour competitors and sales of our products could decline. Defects in ourproducts could cause us to incur higher manufacturing costs and suffer productreturns and additional service expenses, all of which could adversely impactour operating results.

 

If new products developedby us contain defects when released, our customers may be dissatisfied and wemay suffer negative publicity or customer claims against us, lose sales orexperience delays in market acceptance of our new products.

 

***If we have low productyields, the shipment of our products may be delayed and******our operating results may beadversely impacted.***

 

Our products aremanufactured using complex technologies, and the number of usable substrates wecan produce can fluctuate as a result of many factors, including:

 

•      impurities inthe materials used;

 

•      contaminationof the manufacturing environment;

 

•      substratebreakage;

 

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

 

•      performance ofpersonnel involved in the manufacturing process.

 

If our yields decrease,our revenue could decline because many of our manufacturing costs are fixed, orwould increase. We have experienced product shipment delays and difficulties inachieving acceptable yields on both new and older products, and delays and pooryields have adversely affected our operating results. We may experience similarproblems in the future and we cannot predict when they may occur or theirseverity. In particular, many of our manufacturing processes are new and arestill being refined, which can result in lower yields.

 

***We derive asignificant portion of our revenue from international sales, and******our ability to sustainand increase our international sales involves******significant risks.***

 

Our revenue growth dependsin part on the expansion of our international sales and operations.International sales represented 77.8% of our total revenue for the six monthsended June 30, 2004 and 64.6% for the six months ended June 30, 2003. We expectthat sales to customers outside the U.S. will continue to represent asignificant portion of our revenue, particularly sales to customers in Asia.

 

Currently, an increasingpercentage of our sales are to customers headquartered in Asia. Certainmanufacturing facilities and

 

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suppliers are alsolocated outside the U.S. Managing our global operations presents challenges,including periodic regional economic downturns, trade balance issues, varyingbusiness conditions and demands, political instability, variations inenforcement of intellectual property and contract rights in differentjurisdictions, differences in the ability to develop relationships withsuppliers and other local businesses, changes in U.S. and international laws andregulations including U.S. export restrictions, fluctuations in interest andcurrency exchange rates, the ability to provide sufficient levels of technicalsupport in different locations, cultural differences, shipping delays andterrorist acts or acts of war, among other risks. Many of these challenges arepresent in China, which represents a large potential market for semiconductorequipment and where AXT anticipates significant opportunity for growth. Globaluncertainties with respect to: (i) economic growth rates in various countries;(ii) sustainability of demand for electronics products; (iii) capital spendingby semiconductor manufacturers; (iv) price weakness for certain semiconductordevices; and (v) political instability in regions where we have operations mayalso affect our business, financial condition and results of operations.

 

Our dependence oninternational sales involves a number of risks, including:

 

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

 

•      unexpectedchanges in regulatory requirements;

 

•      longer periodsto collect accounts receivable;

 

•      changes inexport license requirements;

 

•      political andeconomic instability;

 

•      unexpectedchanges in diplomatic and trade relationships; and

 

•      foreignexchange rate fluctuations.

 

Our sales are denominatedin 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 makeour products more expensive than competitors’ products in these markets. Also,denominating some sales in Japanese yen subjects us to fluctuations in theexchange rates between the U.S. dollar and the Japanese yen. The functional currenciesof our Japanese and Chinese subsidiaries are the local currencies. We incurtransaction gains or losses resulting from consolidation of expenses incurredin local currencies for these subsidiaries, as well as in translation of theassets and liabilities of these assets at each balance sheet date. If we do noteffectively manage the risks associated with international sales, our revenue,cash flows and financial condition could be adversely affected.

 

***Demand for ourproducts may decrease if our customers experience difficulty******manufacturing, marketingor selling their products.***

 

Our products are used ascomponents in our customers’ products. Accordingly, demand for our products issubject to factors affecting the ability of our customers to successfullyintroduce and market their products, including:

 

•      thecompetition our customers face in their particular industries;

 

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

 

•      the financialand other resources of our customers; and

 

•      the inabilityof our customers to sell their products if they infringe third partyintellectual property rights.

 

If demand for the enduser applications for which our products are used decreases, or our customersare unable to develop, market and sell their products, demand for our productswill decrease.

 

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***The financialcondition of our customers may affect their ability to pay******amounts owed to us.***

 

Many of our customers arefacing business downturns that have reduced their cash balances and theirprospects. We frequently allow our customers to pay for products we ship tothem within 30 to 120 days after delivery. Subsequent to our shipping aproduct, some customers have been unable to make payments as due, reducing ourcash balances and causing us to incur charges to allow for a possibility thatsome accounts might not be paid. At least three customers that owed us asignificant amount have filed for bankruptcy protection and we are unlikely toreceive a substantial portion or any of the amounts owed to us as part of abankruptcy settlement. Other customers may also be forced to file forbankruptcy. If our customers do not pay their accounts when due, we will berequired to incur charges that would reduce our earnings.

 

***We purchasecritical raw materials and parts for our equipment from single or******limited sources, andcould lose sales if these sources fail to fill our needs.***

 

We depend on a limitednumber of suppliers for certain raw materials, components and equipment used inmanufacturing our products, including key materials such as quartz tubing,polishing solutions, and paralytic boron nitride. We generally purchase thesematerials through standard purchase orders and not pursuant to long-term supplycontracts and no supplier guarantees supply of raw materials or equipment tous. If we lose any of our key suppliers, our manufacturing efforts could besignificantly hampered and we could be prevented from timely producing and deliveringproducts to our customers. We have experienced delays obtaining critical rawmaterials and spare parts, including gallium, due to shortages of thesematerials. We may experience delays due to shortages of materials and may beunable to obtain an adequate supply of materials. These shortages and delayscould result in higher materials costs and cause us to delay or reduceproduction of our products. If we have to delay or reduce production, we couldfail to meet customer delivery schedules and our revenue and operating resultscould suffer.

 

***The loss of one ormore of our key substrate customers would significantly hurt******our operating results.***

 

A small number ofsubstrate customers have historically accounted for a substantial portion ofour total revenue. Five customers accounted for 35.6% and 34.6% of our totalrevenue for the three month and six month periods ended June 30, 2004,respectively. One customer accounted for 5.8% and 9.5% of our revenue for thethree month and six month periods ended June 30, 2004. We expect that asignificant portion of our future revenue will continue to be derived from alimited number of substrate customers. Our customers are not obligated topurchase a specified quantity of our products or to provide us with binding forecastsof product purchases. In addition, our customers may reduce, delay or cancelorders at any time without any significant penalty, and during the past year,we have experienced slower bookings, significant push outs and cancellation oforders from some customers. In addition, due to the difficult economicenvironment, several of our previously large customers have stopped operationsentirely. If we lose a major customer or if a customer cancels, reduces ordelays orders, our revenue would decline. In addition, customers that haveaccounted for significant revenue in the past may not continue to generaterevenue for us in any future period. Any delay in scheduled shipments of ourproducts could cause net sales to fall below our expectations and the expectationsof market analysts or investors, causing our stock price to decline.

 

***Our substrateproducts have a long qualification cycle that makes it difficult******to plan our expenses andforecast our results.***

 

Customers typically placeorders with us for our substrate products three months to a year or more afterour initial contact with them. The sale of our products may be subject todelays due to our customers’ lengthy internal budgeting, approval andevaluation processes. During this time, we may incur substantial expenses andexpend sales, marketing and management efforts while the customers evaluate ourproducts. These expenditures may not result in sales of our products. If we donot achieve anticipated sales in a period as expected, we may experience an unplannedshortfall 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 notto incorporate our products into its initial design, we may not have anotheropportunity to sell products to this customer for many months or even years. Inthe current competitive and economic climate, the average sales cycle for ourproducts has lengthened even further and is expected to continue to make itdifficult to accurately forecast our future sales. We anticipate that sales ofany future substrate products will also have lengthy sales cycles and will,therefore, be subject to risks substantially similar to those inherent in thelengthy sales cycle of our current substrate products.

 

***If we are unable toprotect our intellectual property, we may lose valuable******assets or incur costly litigation.***

 

We rely on a combinationof patents, copyrights, trademark and trade secret laws, non-disclosureagreements and other intellectual property protection methods to protect ourproprietary technology. However, we believe that, due to the rapid pace oftechnological innovation in the markets for our products, our ability toestablish and maintain a position of technology leadership also depends on

 

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the skills of ourdevelopment personnel.

 

Despite our efforts toprotect our intellectual property, a third party could develop products orprocesses similar to ours. Our means of protecting our proprietary rights maynot be adequate and our competitors may independently develop similartechnology, duplicate our products or design around our patents. We believethat at least two of our competitors have begun to ship GaAs substratesproduced using a process similar to our VGF technique. Our competitors may alsodevelop and patent improvements to the VGF technology upon which we rely, andthus may limit any exclusivity we enjoy by virtue of our patents or tradesecrets.

 

It is possible thatpending or future United States or foreign patent applications made by us willnot be approved, that our issued patents will not protect our intellectualproperty, or that third parties will challenge the ownership rights or thevalidity of our patents. In addition, the laws of some foreign countries maynot protect our proprietary rights to as great an extent as do the laws of theUnited States and it may be more difficult to monitor the use of ourintellectual property. Our competitors may be able to legitimately ascertain non-patentedproprietary technology embedded in our systems. If this occurs, we may not beable to prevent the development of technology substantially similar to ours.

 

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

 

***We need to continueto improve or implement our systems, procedures and******controls and may not receivefavorable attestation of our internal control******systems by our independent auditors.***

 

The new requirementsadopted by the Securities and Exchange Commission in response to the passage ofthe Sarbanes-Oxley Act of 2002 will require annual review and evaluation of ourinternal control systems, and attestation of these systems by our independentaccountants. We are currently reviewing our internal control procedures andconsidering further documentation of such procedures that may be necessary.Although the guidelines for the evaluation and attestation of internal controlsystems have been finalized, the evaluation and attestation processes are newand untested. Therefore, we can give no assurances that our systems willsatisfy the new requirements of the Securities and Exchange Commission or thatwe will receive a favorable review and attestation by our independent auditors.

 

In the past, periods ofrapid growth and expansion has strained our management and other resources. Theexpansion of our manufacturing capacity and the shift of manufacturingoperations to China placed and continue to place a significant strain on ouroperations and management resources. We recently upgraded our inventory controlsystems and may implement additional systems relating to consolidation of ourfinancial results. If we fail to manage these changes effectively, ouroperations may be disrupted.

 

To manage our businesseffectively, we may need to implement additional and improved managementinformation systems, further develop our operating, administrative, financialand accounting systems and controls, add experienced senior level managers, andmaintain close coordination among our executive, engineering, accounting,marketing, sales and operations organizations.

 

***If we fail tomanage periodic contractions, we may utilize our cash balances******and our existing cashand cash equivalent balances could decline.***

 

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

 

We anticipate that ourexisting cash resources will fund any anticipated operating losses, purchasesof capital equipment and provide adequate working capital for the next twelvemonths. Our liquidity is affected by many factors including, among others, theextent to which we pursue additional capital expenditures, the level of ourproduction efforts, and other factors related to the

 

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uncertainties of theindustry and global economies. Accordingly, there can be no assurance thatevents in the future will not require us to seek additional capital sooner, or,if so required, that such capital will be available on terms acceptable to usif at all.

 

***We have made andmay continue to make strategic investments in raw materials******suppliers, which may notbe successful and may result in the loss of all or******part of our investment.***

 

Through fiscal 2003, wehave recorded minority investments in raw material suppliers in China, thatprovide us with opportunities to gain supply of key raw materials that areimportant to our substrate business, and other products at lower cost thanother suppliers. These affiliates each have a market beyond that provided byus. As of June 30, 2004, we had no obligations to make further investments inany of these companies, although we may choose to do so under certainconditions. We do not have influence over all of these companies, each of whichis located in China, and in some we have made only a strategic, minorityinvestment. We may not be successful in achieving the financial, technologicalor commercial advantage upon which any given investment is premised, and wecould end up losing all or part of our investment.

 

***Any futureacquisitions may disrupt our business, dilute stockholder value or******distract managementattention.***

 

As part of our strategy,we may consider acquisitions of, or significant investments in, businesses thatoffer products, services and technologies complementary to ours. Acquisitionsentail numerous risks, including:

 

•      we may havedifficulty assimilating the operations, products and personnel of the acquiredbusinesses;

 

•      our ongoingbusiness may be disrupted;

 

•      we may incurunanticipated costs;

 

•      our managementmay be unable to manage the financial and strategic position of acquired ordeveloped products, services and technologies;

 

•      we may beunable to maintain uniform standards, controls, procedures, and policies; and

 

•      ourrelationships with employees and customers may be impaired as a result of any integration.

 

For example, we incurred substantial costs inconnection with our acquisition of Lyte Optronics in May 1999, including theassumption of approximately $10.0 million of debt, which was subsequentlyrepaid, resulting in a decline of cash available. We also incurred consistentoperating losses for the business following the acquisition, and havediscontinued all operations and sold the related assets acquired in ouracquisition of Lyte Optronics during 2003.

 

To the extent that weissue shares of our stock or other rights to purchase stock in connection withany future acquisitions, dilution to our existing stockholders will result andour earnings per share may suffer. Any future acquisitions may not generateadditional revenue or provide any benefit to our business.

 

***If any of ourfacilities is damaged by actions such as fire, explosion, or******natural disaster, we maynot be able to manufacture our products.***

 

The ongoing operation ofour manufacturing and production facilities in California and China is criticalto our ability to meet demand for our products. If we are not able to use allor a significant portion of our facilities for prolonged periods for anyreason, we will not be able to manufacture products for our customers. Forexample, a natural disaster, fire or explosion caused by our use of combustiblechemicals and high temperatures during our manufacturing processes would rendersome or all of our facilities inoperable for an indefinite period of time.Actions outside of our control, such as earthquakes, could also damage ourfacilities, rendering them inoperable. Some of our manufacturing and researchand development is currently performed at our Fremont, California facilities,which are located near an active seismic fault line. If we are unable tooperate our facilities and manufacture our products, we will lose customers andrevenue and our business will be harmed.

 

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***Changes in China’spolitical, social and economic environment may affect our******financial performance.***

 

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

 

China has from time totime experienced instances of civil unrest and hostilities. Confrontations haveoccurred between the military and civilians. Events of this nature couldinfluence the Chinese economy, result in nationalization of foreign-ownedoperations such as ours, and could negatively affect our ability to operate ourfacilities in China.

 

***The effect ofterrorist threats and actions on the general economy could******decrease our revenues.***

 

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

 

***Our stock price hasbeen and may continue to be volatile.***

 

Our stock price hasfluctuated significantly since we began trading on the NASDAQ National Market.For the twelve months ended June 30, 2004, the high and low closing salesprices of our common stock were $4.58 and $1.20, respectively. A number offactors could cause the price of our common stock to continue to fluctuatesubstantially, including:

 

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

 

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

 

•      announcementsof technological innovations by us or our competitors;

 

•      new productintroduction by us or our competitors;

 

•      large customerorders or order cancellations; and

 

•      the operatingand stock price performance of comparable companies.

 

In addition, the stockmarket in general has experienced extreme volatility that often has beenunrelated to the operating performance of particular companies. These broadmarket and industry fluctuations may adversely affect the trading price of ourcommon stock, regardless of our actual operating performance.

 

***We have adoptedcertain anti-takeover measures that may make it more difficult******for a third party toacquire us.***

 

Our board of directorshas the authority to issue up to 2,000,000 shares of preferred stock and todetermine the price, rights, preferences and privileges of those shares withoutany further vote or action by the stockholders. The rights of the holders ofcommon stock will be subject to, and may be adversely affected by, the rightsof the holders of any preferred stock that may be issued in the future. Theissuance of shares of preferred stock, while potentially providing desirableflexibility in connection with possible acquisitions and for other corporatepurposes, could have the effect of making it more difficult for a third partyto acquire a majority of our outstanding voting stock. We have no presentintention to issue shares of preferred stock.

 

On April 24, 2001, ourboard of directors adopted a preferred stock purchase rights plan intended toguard against certain takeover

 

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tactics. The adoption ofthis plan was not in response to any proposal to acquire us, and the board isnot aware of any such effort. The existence of this plan could also have theeffect of making it more difficult for a third party to acquire a majority ofour outstanding voting stock. In addition, certain provisions of ourcertificate of incorporation may have the effect of delaying or preventing achange of control, which could adversely affect the market price of our commonstock.

 

In addition, provisionsin our amended and restated certificate of incorporation and bylaws may havethe effect of delaying or preventing a merger, acquisition or change of controlof us, or changes in our management, including:

 

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

 

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

 

•      the ability ofour board to alter our bylaws;

 

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

 

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

 

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

 

•      66 2/3% of theshares of voting stock not owned by these large stockholders approve the mergeror combination, or

 

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

 

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

 

In order to comply withthe newly adopted Sarbanes-Oxley Act of 2002, as well as proposed changes tolisting standards by NASDAQ, and proposed accounting changes by the Securitiesand Exchange Commission, we may be required to increase our internal controls,hire additional personnel and additional outside legal, accounting and advisoryservices, all of which will cause our general and administrative costs toincrease. Insurers may increase premiums as a result of the high claims ratesthey incurred over the past year, and our premiums for our various insurancepolicies, including our directors’ and officers’ insurance policies, increasedduring 2003. Proposed changes in the accounting rules, including legislativeand other proposals to account for employee stock options as a compensationexpense among others, could materially increase the expense that we reportunder generally accepted accounting principles and adversely affect ouroperating results.

 

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

 

**Foreign Currency Risk**

 

We use short-term forwardexchange contracts for hedging purposes to reduce the effects of adverseforeign exchange rate movements. We have purchased foreign exchange contractsto hedge against certain trade accounts receivable denominated in Japanese yen.The change in the fair value of the forward contracts is recognized as part ofthe related foreign currency transactions as they occur. As of June 30, 2004,we had no outstanding commitments with respect to foreign exchange contracts.

 

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**Interest Rate Risk**

 

Cash and cash equivalentsearning interest and certain variable rate debt instruments are subject tointerest rate fluctuations. The following table sets forth the probable impactof a 10% change in interest rates (in thousands):

 
| **Instrument**            |   | **Balance  June 30,  2004** |   | **Current  Interest  Rate** |   | **Current  Interest  Income/  (Expense)** |   | **Proforma  10% Interest  Rate Decline  Income/(Expense)** |   | **Proforma  10% Interest  Rate Increase  Income/(Expense)** |   |
|---------------------------|--------|-----------------------------|--------|-----------------------------|--------|-------------------------------------------|--------|------------------------------------------------------------|--------|-------------------------------------------------------------|--------|
| Cash and cash equivalents |   | $                           | 14,783 |                        | 1.00   | %                                         | $      | 148                                                        |   | $                                                           | 133    |   | $ | 163 |   |
| Bonds                     |   | 8,300                       |   | 1.42                        | %      | (118                                      | )      | (106                                                       | )      | (130                                                        | )      |
|                      |   |                        |   |                        |   | $                                         | 30     |                                                       | $      | 27                                                          |   | $ | 33 |   |
|                           |        |                             |        |                             |        |                                           |        |                                                            |        |                                                             |        |  |  |  |  |

 

**Equity Risk**

 

We also maintain minorityinvestments in private and publicly traded companies. These investments arereviewed for other than temporary declines in value on a quarterly basis. Reasonsfor other than temporary declines in value include whether the related companywould have insufficient cash flow to operate for the next twelve months,significant changes in the operating performance and changes in marketconditions. In 2003, we recorded $2.0 million in charges to other expense towrite down our investment in two private US companies. As of June 30, 2004, theminority investments we continue to hold amounted to $2.0 million.

 

**ITEM 4*.*CONTROLS AND PROCEDURES**

 

(a) Under the supervision and with the participationof our management, our Interim Chief Executive Officer and Chief FinancialOfficer have evaluated the effectiveness of our disclosure controls andprocedures, as such term is defined under Rule 13a-15(e) promulgated under the SecuritiesExchange Act of 1934, as amended. Based upon that evaluation, our Interim ChiefExecutive Officer and our Chief Financial Officer concluded that the ourdisclosure controls and procedures were effective as of the end of the periodcovered by this quarterly report, except as described below relating to certainproduct testing procedures, as of the end of the period covered by thisquarterly report.

 

In March 2004, as part ofthe Company’s implementation of our Code of Business Conduct and Ethics, welearned of certain failures to comply with requirements for product testing andthe provision of testing data and information relating to requirements ofcertain customers. The Audit Committee of the Company’s Board of Directorsconducted an investigation into our product testing practices and procedures,with the assistance of outside counsel.

 

The investigationconfirmed that certain requirements for product testing and the provision oftesting data and information relating to certain customer requirements were notbeing complied with. We implemented measures to ensure greater operationalcontrols and compliance with customer requirements. As a result of theinvestigation, the Audit Committee concluded that certain executive managementchanges should be implemented. Donald L. Tatzin, formerly Chief FinancialOfficer, has been appointed Interim Chief Executive Officer, Wilson W. Cheung,our Vice President, Corporate Controller, has been promoted to Chief FinancialOfficer. Morris Young, Ph.D., formerly our Chairman, President and ChiefExecutive Officer, will be responsible for improving and expanding theCompany’s China operation. He will also remain a director. The Board ofDirectors has also determined to separate the role of Chairman and Chief ExecutiveOfficer, and accordingly, Jesse Chen, a current AXT board member, has becomeChairman of the Board. In addition, the Audit Committee concluded thatadditional review of the organization and performance of operations, qualitycontrol and product testing would be conducted, resulting in possibleadditional changes in management and non-management functions. The AuditCommittee also instructed management to implement additional training programsfor employees involved in production, testing and quality assurance. The AuditCommittee believes that these measures will address the issues raised above andprovide the necessary operational oversight and assurance that the Company iscomplying with the requirements for product testing and the provision oftesting data and other customer information.

 

(b) No significant changes in internal controls overfinancial reporting were made during the quarter ended June 30, 2004, althoughas described above, we implemented executive management changes, including achange in our Chief Executive Officer and Chief Financial Officer roles, duringthe quarter, and are implementing operational changes and measures to improveour operational controls over product testing, provision of testing and othercustomer data and quality assurance.

 

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**PART II OTHER INFORMATION**

 

**Item1. Legal Proceedings**

 

From time to time theCompany is involved in judicial or administrative proceedings concerningmatters arising in the ordinary course of business. The Company does not expectthat any of these matters, individually or in the aggregate, will have amaterial adverse effect on its business, financial condition, cash flows orresults of operation.

 

On April 15, 2003,Sumitomo Electric Industries, Ltd., (SEI) filed a complaint in the TokyoDistrict Court, Civil Division against the Company and its Japanese distributoralleging patent infringement of two patents held by SEI in Japan. The suitseeks penalties from AXT in the amount of $1.67 million plus interest and courtcosts and the cessation of AXT’s sales of gallium arsenide substrates in Japan.AXT intends to defend itself vigorously in these lawsuits and continues to sellits products in Japan. Both parties have completed submitting arguments andevidence in litigation in Japan. We retain all of our options which includeappealing any court decision and launching an effort to have Sumitomo’s patentinvalidated in Japan.

 

On June 11, 2003, Cree,Inc. filed a complaint in the United States Court for Northern District ofCalifornia against the Company alleging patent infringement. The complaintsought damages and injunction against infringement. On July 23, 2003, theCompany filed a counter complaint in the United States Court for NorthernDistrict of California, denying any patent infringement and alleging thatCree’s actions were intentionally designed to interfere with the Company’sprospective business relationships. The Company reached an agreement with Creeresolving the disputes between us and signed a settlement agreement on March 5,2004. The resolution of the disputes did not have a material adverse impact onthe Company’s consolidated financial position or results of operations. Allparties signed a final release regarding all disputes between them on April 15,2004.

 

**Item 2. Changes in Securities and Useof Proceeds**

 

None

 

**Item 3. Defaults upon SeniorSecurities**

 

None

 

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

 

AXT held its annualmeeting of stockholders at its headquarters in Fremont, California on May 18,2004.  Of the 23,042,982 sharesoutstanding as of the record date, 20,907,474 shares were represented by proxyat the meeting.  Proxies were solicitedby the Company pursuant to Regulation 14A under the Securities Exchange Act of1934, as amended.  At the meeting, AXT’sstockholders voted on the following matters:

 

(1)   Proposal to elect one class IIIdirector to hold office for a three-year term, and until his successor iselected and qualified.

 
|               |   | **For**    |   | **Against** |   |
|--------------------|--------|------------|--------|-------------|--------|
| Leonard J. LeBlanc |   | 20,732,335 |   | 175,139     |   |

 

(2)   Proposal to ratify theselection of PricewaterhouseCoopers LLP as our independent auditors for theyear ending December 31, 2004.

 
|                       |   | **For**    |   | **Against** |   | **Abstain** |   |
|----------------------------|--------|------------|--------|-------------|--------|-------------|--------|
| PricewaterhouseCoopers LLP |   | 20,825,550 |   | 77,174      |   | 4,750       |   |

 

**Item5. Other Information**

 

None

 

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**Item 6. Exhibits and Reports on Form8-K**

 

**a. Exhibits**

 
| **Exhibit  Number** |   | **Description**                                                                                                                                              |
|---------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)              |   | Restated Certificate of Incorporation                                                                                                                        |
|                |   |                                                                                                                                                         |
| 3.2(2)              |   | Certificate of Designation, Preferences and Rights  of Series A Preferred Stock (which is incorporated herein by reference                                   |
|                |   |                                                                                                                                                         |
| 3.3(3)              |   | Second Amended and Restated Bylaws                                                                                                                           |
|                |   |                                                                                                                                                         |
| 3.4                 |   | Certificate of Amendment to the Restated Certificate  of Incorporation                                                                                       |
|                |   |                                                                                                                                                         |
| 31.1                |   | Certification by Interim Chief Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
|                |   |                                                                                                                                                         |
| 31.2                |   | Certification by Chief Financial Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                         |
|                |   |                                                                                                                                                         |
| 32.1                |   | Certification by Interim Chief Executive Officer  Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|                |   |                                                                                                                                                         |
| 32.2                |   | Certification by Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.         |

 

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(1)  Incorporated by reference to theexhibit of the same number filed with the SEC with our Annual Report on Form10-K for the year ended December 31, 1998.

 

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

 

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

 

**b. Reports on Form 8-K**

 

We filed or furnished thefollowing reports on Form 8-K during the quarter ended June 30, 2004:

 

On May 24, 2004 wefurnished a report on Form 8-K announcing our earnings for the quarter endedMarch 31, 2004.

 

On May 24, 2004, we fileda report on Form 8-K announcing our executive management changes.

 

On June 24, 2004, wefiled a report on Form 8-K announcing our change in certifying accountants and a workforce reduction at our Fremont manufacturing facility.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this Report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                  | AXT, INC. |
|-----------------------|-----------|
|                  |      |
| Dated: August 5, 2004 | By:       | /s/ Donald L. Tatzin |
|                  |      | Donald L. Tatzin |
|                  |      | Interim Chief Executive Officer |
|                  |      | (Principal Executive Officer) |
|                  |      |   |
|                  |      | /s/ Wilson W. Cheung |
|                  |      | Wilson W. Cheung |
|                  |      | Chief Financial Officer |
|                  |      | (Principal Financial and Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** |   | **Description**                                                                                                                                              |
|---------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)              |   | Restated Certificate of Incorporation                                                                                                                        |
|                |   |                                                                                                                                                         |
| 3.2(2)              |   | Certificate of Designation, Preferences and Rights  of Series A Preferred Stock (which is incorporated herein by reference                                   |
|                |   |                                                                                                                                                         |
| 3.3(3)              |   | Second Amended and Restated Bylaws                                                                                                                           |
|                |   |                                                                                                                                                         |
| 3.4                 |   | Certificate of Amendment to the Restated Certificate  of Incorporation                                                                                       |
|                |   |                                                                                                                                                         |
| 31.1                |   | Certification by Interim Chief Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
|                |   |                                                                                                                                                         |
| 31.2                |   | Certification by Chief Financial Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                         |
|                |   |                                                                                                                                                         |
| 32.1                |   | Certification by Interim Chief Executive Officer  Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|                |   |                                                                                                                                                         |
| 32.2                |   | Certification by Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.         |

 

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(1)  Incorporated by reference to theexhibit as of the same number as filed with the SEC in our Annual Report onForm 10-K for the year ended December 31, 1998.

 

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

 

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

 

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