**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-K**

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition periodfrom                         to**

**Commissionfile number:  000-24085**

**AXT, Inc.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                   |   | **94-3031310**       |
|------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of               |   | (I.R.S. Employer     |
| incorporation or  organization)                |   | Identification  No.) |
| **4281 Technology Drive, Fremont, California** |   | **94538**            |
| (Address of  principal executive offices)      |   | (Zip Code)           |

 

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

Securities registeredpursuant to Section 12(b) of the Act:

|                                 | **Title of each class** | ** **                   |   | ** ** | **Name of each exchange on which registered** | ** ** |
|---------------------------------|----------------------------------------|------------------------------|--------|------------|-----------------------------------------------------------------------------|------------|
| Common Stock,  $0.001 par value |                                   | The NASDAQ Stock  Market LLC |

 

Securities registered pursuant to Section 12(g) ofthe Act:

**None**

Indicate by checkmark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. o Yes  x No

Indicate by checkmark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. o Yes  x No

Indicate by checkmarkwhether the registrant (1) has filed all reports required to be filed by Section 13or 15 (d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. x Yes  o No

Indicate by checkmark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, tothe best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

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

Large acceleratedfiler o      Accelerated filer o      Non-accelerated filer x

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

The aggregate market valueof the voting stock held by non-affiliates of the registrant, based upon theclosing sale price of the common stock on June 30, 2006 as reported on theNasdaq National Market, was approximately $55,603,853. Shares of common stockheld by each officer, director and by each person who owns 5% or more of theoutstanding common stock have been excluded in that such persons may be deemedto be affiliates. This determination of affiliate status is not a conclusivedetermination for other purposes.

As of February 28,2007, 29,894,949 shares, $0.001 par value, of the registrant’s common stockwere outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portionsof the definitive proxy statement for the registrant’s 2007 annual meeting ofstockholders to be filed with the Commission pursuant to Regulation 14A notlater than 120 days after the end of the fiscal year covered by this form areincorporated by reference into Part III of this Form 10-Kreport. Except for those portions specifically incorporated by referenceherein, such document shall not be deemed to be filed with the Commission aspart of this Form 10-K.

 

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**TABLEOF CONTENTS**

| **PART I**   |
|-------------------|
| Item 1.           |   | Business |   | 2 |
| Item 1A.          |   | Risk  Factors |   | 12 |
| Item 1B.          |   | Unresolved Staff Comments |   | 27 |
| Item 2.           |   | Properties |   | 27 |
| Item  3.          |   | Legal  Proceedings |   | 28 |
| Item 4.           |   | Submission of Matters to a Vote of Security Holders |   | 28 |
| **PART II**  |
| Item 5.           |   | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   | 29 |
| Item 6.           |   | Selected Consolidated Financial Data |   | 31 |
| Item 7.           |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |   | 33 |
| Item 7A.          |   | Quantitative and Qualitative Disclosures About Market  Risk |   | 53 |
| Item 8.           |   | Consolidated Financial Statements and Supplementary  Data |   | 54 |
| Item 9.           |   | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure |   | 54 |
| Item 9A.          |   | Controls and Procedures |   | 54 |
| Item  9B.         |   | Other  Information |   | 54 |
| **PART III** |
| Item 10.          |   | Directors, Executive Officers, and Corporate  Governance |   | 55 |
| Item 11.          |   | Executive Compensation |   | 55 |
| Item 12.          |   | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters |   | 55 |
| Item 13.          |   | Certain Relationships and Related Transactions and  Director Independence |   | 55 |
| Item 14.          |   | Principal Accountant Fees and Services |   | 56 |
| **PART IV**  |
| Item 15.          |   | Exhibits and Financial Statement Schedules |   | 57 |

 

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**PART I**

This Annual Report (including the following sectionregarding Management’s Discussion and Analysis of Financial Condition andResults of Operations) contains forward-looking statements regarding ourbusiness, financial condition, results of operations and prospects. Words suchas “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates”and similar expressions or variations of such words are intended to identifyforward-looking statements, but are not the exclusive means of identifyingforward-looking statements in this Annual Report. Additionally, statementsconcerning future matters such as the development of new products, enhancementsor technologies, sales levels, expense levels and other statements regardingmatters that are not historical are forward-looking statements.

Although forward-lookingstatements in this Annual Report reflect the good faith judgment of ourmanagement, such statements can only be based on facts and factors currentlyknown by us. Consequently, forward-looking statements are inherently subject torisks and uncertainties and actual results and outcomes may differ materiallyfrom the results and outcomes discussed in or anticipated by the forward-lookingstatements. Factors that could cause or contribute to such differences inresults and outcomes include without limitation those discussed under theheading “Risk Factors” in Item 1A below, as well as those discussed elsewherein this Annual Report. Readers are urged not to place undue reliance on theseforward-looking statements, which speak only as of the date of this AnnualReport. We undertake no obligation to revise or update any forward-lookingstatements in order to reflect any event or circumstance that may arise afterthe date of this Annual Report. Readers are urged to carefully review andconsider the various disclosures made in this Annual Report, which attempt toadvise interested parties of the risks and factors that may affect ourbusiness, financial condition, results of operations and prospects.

**Item 1.**                        *Business*

AXT, Inc.(“AXT”, “we,” “us,” and “our” refer to AXT, Inc. and all of itssubsidiaries) is a leading developer and producer of high-performance compoundand single element semiconductor substrates, including substrates made fromgallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge). Wecurrently sell the following substrate products in the sizes and for theapplications indicated: 

| Substrates             | ** ** | ** **                                                      | ** ** | **Substrate  Diameter**                                                                                    | ** ** | **Applications** |
|------------------------|------------|-----------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|------------------|
| GaAs (semi-insulating) |       | 2”, 3”, 4”, 5”, 6” |       | ·  Power amplifiers and radio frequency  integrated circuits for wireless handsets (cell phones) |
|                        |       |                                                            |       | ·  Direct broadcast television                                                                   |
|                        |       |                                                            |       | ·  High-performance transistors                                                                  |
|                        |       |                                                            |       | ·  Satellite communications                                                                      |
| GaAs (semi-conducting) |       | 2”, 3”, 4”                                       |       | ·  High brightness light emitting diodes                                                         |
|                   |       |                                                            |       | ·  Lasers                                                                                        |
|                   |       |                                                            |       | ·  Optical couplers                                                                              |
| InP                    |       | 2”, 3”, 4”                             |       | ·  Broadband and fiber optic communications                                                      |
| Ge                     |       | 2”, 4”                                                |       | ·  Satellite and terrestrial solar cells                                                         |

 

We manufacture all of our semiconductor substratesusing our proprietary vertical gradient freeze (VGF) technology, which enablesus to add capacity quickly and cost effectively. Most of our revenue is fromsales of GaAs substrates. We manufacture all of our products in the People’sRepublic of China (PRC or China), which generally has favorable costs forfacilities and labor. We also have five joint ventures in China that provide usfavorable pricing, reliable supply and shorter lead-times for raw materialscentral to our final manufactured products. We consolidate, for accountingpurposes, three of these joint ventures and have equity interests of 25% ineach of the other two. We use our direct sales 

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force in the United Statesand independent sales representatives in Europe and Asia to market oursubstrates. Our ten largest customers for 2006 were: Avago TechnologiesManufacturing (Singapore) Pte. Ltd., Freescale Semiconductor, Inc., MBETechnology Pte. Ltd., Ningbo Ker Ning Da Ri Fang Magnet Co., Ltd., Osram OptoSemiconductors GmbH, Picogiga International SAS, IQE, plc., Sumika Epi SolutionCo., Ltd., Visual Photonics Epitaxy Co., Ltd., and Recapture Metals Limited. Webelieve that, as the demand for compound semiconductor substrates is expectedto increase, we are positioned to leverage our PRC-based manufacturingcapabilities and access to favorably priced raw materials to increase ourmarket share.

In 2005, we made a number of important changes to ourmanagement team. Philip C.S. Yin, Ph.D., joined the company in March 2005as chief executive officer and restructured the organization from the top down.In June 2005, two new positions were created: chief operating officer andchief technology officer. Also, the former president of AXT’s China operationsbecame president of joint venture operations. In September 2005, our newvice president of global sales and marketing joined us. This new structureenables us to maximize the expertise and skill sets of our team while placingenhanced emphasis on manufacturing, production and quality, and quality systemsimprovement.

With the new management team in place, quality,quality systems and revenue began to improve beginning in the third quarter of2005. In December 2005, we reduced the workforce at our Fremont,California facility by 15 full-time equivalent positions that we no longerrequired to support production and operations, or approximately 29% of theworkforce based at this facility.

We were incorporated in California in December 1986and reincorporated in Delaware in May 1998. We changed our name fromAmerican Xtal Technology, Inc. to AXT, Inc. in July 2000. Ourcorporate office is located at 4281 Technology Drive, Fremont, California94538, and our telephone number at this address is (510) 683-5900. Ourweb site is *www.axt.com*; however,the information on our web site does not constitute a part of this AnnualReport on Form 10-K and is not incorporated herein. We makeavailable, free of charge, on or through our web site, our annual, quarterlyand current reports, and any amendments to those reports.

**Industry Background**

Certain electronic and opto-electronic applicationshave performance requirements that exceed the capabilities of conventionalsilicon substrates and often require high-performance compound or singleelement substrates. Examples of higher performance non-silicon based substratesinclude GaAs, InP, gallium nitride (GaN), silicon carbide (SiC) and Ge.

For example, power amplifiers and radio frequencyintegrated circuits for wireless handsets are made with semi-insulating GaAssubstrates. Semi-conducting GaAs substrates are used to create opto-electronicproducts including high brightness light emitting diodes (HBLEDs) which areoften used to backlight wireless handsets and liquid crystal display (LCD) TVsand for automotive and general illumination applications. InP is a highperformance semiconductor substrate used in broadband and fiber opticapplications. Ge substrates are used in emerging applications such as solarcells for space and terrestrial photovoltaic applications.

The total market for high performance GaAs, InP and Gesubstrates is expected to grow from $529 million in 2005 to$1.1 billion in 2010, a compound annual growth rate of approximately 16%,according to Strategy Analytics, an independent research firm.

The primary costs of manufacturing compoundsemiconductor substrates are labor, raw materials and manufacturing equipmentsuch as crystal growing furnaces. Substrate manufacturers are shiftingproduction to larger wafers to reduce manufacturing costs. Strategy Analyticsestimates that demand for 6” wafers will grow at a compound annual growthrate of approximately 28% from 2005 through 2010.

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Suppliers of compoundsemiconductor substrates typically compete on product quality, productlead-time, price, device performance, meeting customer specifications andproviding customer support. A compound semiconductor substrate customertypically has two or three substrate suppliers that it has qualified for theproduction of its products. These qualified suppliers must meetindustry-standard specifications for quality, on-time delivery and customersupport. Once a substrate supplier has qualified with a customer, price,consistent quality and current and future product delivery lead times becomethe most important competitive factors. A supplier that cannot meet customers’current lead times or that a customer perceives will not be able to meet futuredemand and provide consistent quality can lose current market share.

**The AXT Advantage**

We believe that webenefit from the following advantages:

·       *Low-cost manufacturing operation in the PRC.*   Since2004, we have manufactured all of our products in China, which generally hasfavorable costs for facilities and labor. Approximately 983 of our 1,022employees are in China. Our primary competitors have their manufacturingoperations in Germany or Japan.

·       *Favorable access to raw materials.  *Ourjoint ventures provide us favorable pricing, reliable supply and shorter lead-timesfor raw materials central to our final manufactured products. These materialsinclude gallium, arsenic, germanium, germanium dioxide, paralytic boron nitridecrucibles and boron oxide. As a result, we believe that our joint ventures willenable us to meet potential increases in demand from our customers.

·       *Flexible manufacturing infrastructure*.   Ourtotal manufacturing space in China is approximately 190,000 square feet, 90,000square feet of which we currently use and the remainder of which we haveconfigured for relatively rapid expansion. We believe that our competitorstypically purchase crystal growing furnaces from original equipmentmanufacturers. In contrast, we design and build our own VGF crystal growingfurnaces, which should allow us to increase our production capacity morequickly and cost effectively.

Given these advantages, webelieve that, as the demand for compound semiconductor substrates increases, weare positioned to leverage our PRC-based manufacturing capabilities and accessto favorably priced raw materials to increase our market share. As an example,we are currently working to add significant additional capacity in 6” GaAssubstrates to meet expected increasing market demands. In addition, each of ourfive joint ventures are also increasing capacity.

**Strategy**

Our goal is tobecome the leading worldwide supplier of high-performance compound and singleelement semiconductor substrates. Key elements of our strategy include:

*Continueto provide customers high and consistent quality products and service.*   We seek to improve ourmanufacturing processes continually in order to meet and exceed our customers’high product quality standards, ensure on-time delivery of our products andoptimize the cost of ownership. In addition, we plan to continue to enhance oursupport functions, including service and applications engineering.

*Increasemarket share.We*   intend to leverage our productquality, competitive pricing and lead times both to establish relationshipswith new customers and to increase our market share with current customers inthe integrated circuits for wireless handsets and HBLED markets.

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*Addcapacity to meet customers’ increasing demand for substrates.*   We believe that the markets for our substrates arecurrently capacity constrained. We intend to add additional capacity in orderto meet our customers’ current and anticipated increased demands, specificallyin 6” GaAs substrates.

*Establish leadership inemerging substrate applications.*   We intend to expand our served markets byexploring new opportunities for our substrates. For example, due to Ge’sinherent high efficiency and the increasing supply constraints of traditionalpoly-silicon, some customers have begun to research the use of Ge substratesfor terrestrial solar cell applications.

**Technology**

Our coretechnologies include our proprietary VGF technique used to produce high qualitycrystals that are processed into compound substrates, and the technologies ofour joint venture companies, which enable us to manufacture a range of productsthat are used in the manufacture of compound semiconductor substrates or can besold as raw materials to third parties.

Our VGFtechnique is designed to control the crystal-growth process with minimaltemperature variation and is the technique we use to produce our GaAs, InP andGe substrates. Unlike traditional techniques, our VGF technique places the hotcompound melt above the cool crystal, and minimizes the temperature gradientbetween the crystal and the melt which reduces the turbulence at the interfaceof the melt and the solid crystal. In comparison, in the Liquid EncapsulationCzochralski (LEC) technique the melt and crystal are inverted, there is ahigher temperature gradient between the melt and the crystal, and moreturbulence at the interface of the melt and solid crystal. These aspects of theVGF technique enable us to grow crystals that have a relatively low defectdensity and high uniformity. The crystal and the resulting substrate aremechanically strong, resulting in lower breakage rates during a customer’smanufacturing process. Since the temperature gradient is controlledelectronically rather than by physical movement, the sensitive crystal is notdisturbed as it may be during some competitors’ VGF-like growth processes. Inaddition, the melt and growing crystal are contained in a closed chamber, whichisolates the crystal from the outside environment to reduce potentialcontamination. This substrate isolation allows for more precise control of thegallium-to-arsenic ratio, resulting in better consistency anduniformity of the crystals.

Our VGFtechnique offers several benefits when compared to traditional crystal growingtechnologies. The Horizontal Bridgman (HB) technique is the traditional methodfor producing semi-conducting GaAs substrates for opto-electronic applications.The HB technique holds the GaAs melt in a semi-cylindrical 

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container, causing crystals grown using the HB method tohave a semi-circular, or D-shaped, cross-section. Accordingly, morecrystal material is discarded when the D-shaped substrate is subsequentlytrimmed to a round shape. In addition, crystals grown using the HB techniquehave a higher defect density than VGF-grown crystals. The HB technique cannotbe used cost-effectively to produce substrates greater than three inches indiameter. The HB technique houses the GaAs melt in a quartz container duringthe growth process, which can contaminate the GaAs melt with silicon impurities,making it unsuitable for producing semi-insulating GaAs substrates.

Our VGFtechnique also offers advantages over the LEC technique for producingsemi-insulating GaAs substrates for electronic applications. During the LECprocess, the crystal is grown by dipping a seed crystal through molten boricoxide into a melt of gallium and arsenic poly-crystal material and slowlypulling the seed up into the cool zone above the boron oxide where the crystalhardens. Unlike the VGF technique, the LEC technique is designed so that thehotter GaAs melt is located beneath the cooler crystal, resulting in greater turbulencein the melt, and at a temperature gradient that is significantly higher thanthe VGF technique. The turbulence and high temperature gradient cause LEC-growncrystals to have a higher dislocation density than VGF-grown crystals,resulting in a higher rate of breakage during the device manufacturing process.As an open process, the LEC technique also results in greater propensity forcontamination and difficulty controlling the ratio of gallium to arsenic. Itrequires large, complex electro-mechanical systems that are expensive andrequire highly skilled personnel to operate.

The following table provides acomparison of these three techniques: 

| ** **                           | ** ** | **VGF**                         | ** ** | **HB**          | ** ** | **LEC**        | ** ** |
|--------------------------------------|------------|---------------------------------|------------|-----------------|------------|----------------|------------|
| Substrate applications               |       | Electronic and  opto-electronic |       | Opto-electronic |       | Electronic     |       |
| Largest wafer size in commercial use |       | 6”                         |       | 3”         |       | 6”        |       |
| Stress/defect levels                 |       | Very Low                        |       | Low             |       | High           |       |
| Crystal purity                       |       | Good                            |       | Poor            |       | Good           |       |
| Applicability to multiple materials  |       | GaAs, InP, Ge                   |       | GaAs            |       | GaAs, InP, GaP |       |
| Equipment and labor cost             |       | Very Low                        |       | Low             |       | High           |       |
| Amount of waste material             |       | Very Low                        |       | High            |       | Low            |       |
| Equipment flexibility                |       | Versatile                       |       | Limited         |       | Limited        |       |
| Equipment downtime                   |       | Minimal                         |       | Moderate        |       | High           |       |
| Number of competitors                |       | Several                         |       | Declining       |       | Declining      |       |

 

**Products**

We design, develop, manufacture anddistribute high-performance semiconductor substrates. The table below setsforth our products and selected applications:

| Product        | ** ** | ** **                                        | ** ** | **Applications**              |
|----------------|------------|---------------------------------------------------|------------|-------------------------------|
| **Substrates** | ** ** | **Electronic**                                    | ** ** | **Opto-electronic**           |
| GaAs           |       | ·  Cellular phones                      |       | ·  LEDs             |
|                |       | ·  Direct broadcast television          |       | ·  Lasers           |
|                |       | ·  High-performance transistors         |       | ·  Optical couplers |
|                |       | ·  Satellite communications             |       |                          |
| InP            |       | ·  Fiber optic communications           |       | ·  Lasers           |
|           |       | ·  Satellite communications             |       |                          |
|           |       | ·  High-performance transistors         |       |                          |
|           |       | ·  Automotive collision avoidance radar |       |                          |
| Ge             |       | ·  Satellite solar cells                |       |                          |

 

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*Substrates.**  *We currently sell compoundsubstrates manufactured from GaAs and InP, as well as single-element substratesmanufactured from Ge. We supply GaAs substrates in two-, three-, four-, five-and six-inch diameters. We manufacture InP substrates in two-, three- andfour-inch diameters and Ge substrates in two- and four-inch diameters.

*Materials.**  *Weparticipate in five joint ventures in China that sell raw materials used by usin substrate manufacturing and by others. These joint ventures produce productsincluding 99.99% pure gallium (4N Ga), high purity gallium, arsenic, andgermanium, germanium dioxide, paralytic boron nitride (pBN) crucibles, andboron oxide (B2O3). In 2006 and 2005, sales of rawmaterials to parties other than us were approximately $5.3 million and $4.8million, respectively, which comprised of all of these products.

**Customers**

Wesell our compound semiconductor substrates and materials worldwide. Our toprevenue producing customers include:

| ·Avago Technologies Manufacturing  (Singapore) Pte. Ltd. |   | ·  Intelligent Epitaxy Technology              |   | ·  Picogiga International SAS         |
|---------------------------------------------------------------|--------|----------------------------------------------------------|--------|-------------------------------------------------|
| ·Bookham                                                 |   | ·  IQE (Europe) Limited                        |   | ·  Recapture Metals Limited           |
| ·China Electronics Technology Group                      |   | ·  IQE, plc.                                   |   | ·  Sumika Epi Solution Co., Ltd.      |
| ·Continental Metals, Inc.                           |   | ·  Ningbo Ker Ning Da Ri Fang Magnet Co., Ltd. |   | ·  Visual Photonics Epitaxy Co., Ltd. |
| ·Epitech Technology Corporation                          |   | ·  MBE Technology Pte. Ltd.                    |   | ·  Xiamen Sanan Electronics Co., Ltd. |
| ·Epiworks, Inc.                                     |   | ·  MCP, UK.                                    |   | ·  Xiamen Xinde Co., Ltd.             |
| ·Freescale Semiconductor, Inc.                      |   | ·  Osram Opto Semiconductors GmbH              |   |                                            |

 

Historically, we have sold a significant portion ofour products in any particular period to a limited number of customers. Onecustomer, Visual Photonics Epitaxy Co., Ltd., represented greater than 10% ofrevenue, totaling 12.8%, for the year ended December 31, 2006, twocustomers, Osram Opto Semiconductors GmbH, and MBE Technology Pte. Ltd.,represented greater than 10% of revenue, totaling 20.7%, for the year ended December 31,2005, while no customers represented greater than 10% of revenue for the yearended December 31, 2004. Our top five customers represented 40.0% ofrevenue for the year ended December 31, 2006, 37.5% of revenue for theyear ended December 31, 2005, and 30.1% of revenue for the year ended December 31,2004. We expect that sales to a small number of customers will continue tocomprise a significant portion of our revenue in the future.

The third party customersfor our raw materials products are in many instances the same as our customersfor substrates. There have been no third party customers for our raw materialsthat account for greater than 10% of revenue for the years ended December 31,2006, 2005 and 2004. Our joint ventures are a key strategic benefit for us asthey give us a strong competitive advantage of allowing our customers to workwith one supplier for all their substrate and raw material requirements.

**Manufacturing, RawMaterials and Supplies**

We believe that our results are partially due to ourmanufacturing efficiency and high product yields and we continually emphasizequality and process control throughout our manufacturing operations. We performour substrate manufacturing operations at our facilities in Beijing, China.During 2004, we discontinued our manufacturing and research and developmentactivities at our Fremont, California 

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facility. We believe thatour capital investment and subsequent operating costs are lower for ourmanufacturing facilities in China relative to the U.S. Many of ourmanufacturing operations are fully automated and computer monitored orcontrolled, enhancing reliability and yield. We use proprietary equipment inour substrate manufacturing operations to protect our intellectual property andcontrol the timing and pace of capacity additions. All of our manufacturingfacilities are ISO 9001 or 9002 certified. In January 2006, our Beijingfacility successfully passed the ISO 14001 certification audit.

Although we purchasesupply parts, components and raw materials from several domestic and internationalsuppliers, we depend on a single or limited number of suppliers for certaincritical materials used in the production of our substrates, such as quartztubing, and polishing solutions. We generally purchase these materials throughstandard purchase orders and not pursuant to long-term supply contracts.Although we seek to maintain sufficient inventory levels of certain materialsto guard against interruptions in supply and to meet our near term needs, andhave to date been able to obtain sufficient supplies of materials in a timelymanner, there may be shortages of certain key materials, such as gallium.Accordingly, to help ensure continued supply of materials, we formed five jointventures with and made investments in some suppliers of key raw materialsrequired to manufacture our products, including gallium, arsenic, germanium,germanium dioxide, pyrolitic boron nitride crucibles, and boron oxide. Webelieve that these joint ventures and investments will be advantageous inprocuring materials to support our growth and cost management goals.

**Sales and Marketing**

We advertise in trade publications, distributepromotional materials, conduct marketing and sales programs, and participate inindustry trade shows and conferences in order to raise market awareness of ourproducts. We sell our substrate products through our direct sales force in theU.S. and through independent sales representatives in France, Germany, Japan,South Korea, Taiwan and the United Kingdom. Our direct sales force isknowledgeable in the use of compound and single-element substrates. Ourapplications engineers work with customers during all stages of the substratemanufacturing process, from developing the precise composition of the substratethrough manufacturing and processing the substrate to the customer’sspecifications. We believe that maintaining a close relationship with customersand providing them with ongoing engineering support improves customersatisfaction and will provide us with a competitive advantage in selling othersubstrates to our customers. The substrate division launched a program in late2000 with selected customers in which we guaranteed that certain volumes ofsix-inch GaAs and other substrates would be delivered on specific dates and thecustomer made a prepayment for part of the value of the entire order. Severalmajor customers participated in this program. We did not continue this program.As of December 31, 2006, there were no remaining unearned pre-paymentsunder this program.

*InternationalSales.**  *Internationalsales are an important part of our business. For the year ended December 31,2006, sales to customers outside North America (primarily United States)accounted for 71% of our revenue, as compared with 81% in 2005 and with 79% in2004. The primary markets for sales of our substrate products outside of theUnited States include countries in Asia and Western Europe.

In 2006, through our jointventures we expanded our raw material offering that included 4N, 6N, and 7Ngallium, boron oxide, germanium, arsenic, germanium dioxide, paralytic boronnitride crucibles used in crystal growth and parts for MBE (Molecular BeamEpitaxy). Our joint ventures are a key strategic benefit for us as they give usa strong competitive advantage of allowing our customers to work with onesupplier for all their substrate and raw material requirements.

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**Research andDevelopment**

To maintain and improve our competitive position, wefocus our research and development efforts on designing new proprietaryprocesses and products, improving the performance of existing products andreducing manufacturing costs. We have assembled a multi-disciplinary team ofskilled scientists, engineers and technicians to meet our research anddevelopment objectives.

Our current substrate research and developmentactivities focus on continued development and enhancement of GaAs, InP and Gesubstrates, including haze reduction, improved yield, enhanced surface andelectrical characteristics and uniformity, greater substrate strength andincreased crystal length. During 2006, we continued to spend some research anddevelopment resources to reduce surface quality problems we experienced withour GaAs and InP substrates for some customers, particularly related to surfacemorphology. We continue to work on issues related to surface quality.

Research and development expenses were $2.4 million in2006, compared with $1.7 million in 2005 and $1.5 million in 2004. We expect tomaintain our rate of expenditure on research and development costs in 2007.

Research and developmentat our joint ventures will remain at a minimal level.

**Competition**

The semiconductor substrate industry is characterizedby rapid technological change and price erosion, as well as intense foreign anddomestic competition. We believe we currently have a leading position in themarket for GaAs substrates for HBLED applications primarily as a result of ourexpertise in VGF technology, overall product quality, response times andprices. However, we face actual and potential competition from a number ofestablished domestic and international companies who have advantages notavailable to us.

We believe that theprimary competitive factors in the markets in which our substrate productscompete are:

·       quality;

·       price;

·       performance;

·       meeting customerspecifications; and

·       customer support andsatisfaction.

Our ability tocompete in target markets also depends on factors such as:

·       the timing and success ofthe development and introduction of new products and product features by us andour competitors;

·       the availability ofadequate sources of raw materials;

·       protection of our productsby effective use of intellectual property laws; and

·       general economicconditions.

Our primary competition in the market for compoundsemiconductor substrates includes Crystal Technologies, Freiberger CompoundMaterials, Japan Energy, Mitsubishi Chemical Corporation, and Sumitomo ElectricIndustries. We believe that at least two of our competitors are shipping highvolumes of GaAs substrates manufactured using a technique similar to our VGFtechnique. In addition, as a result of quality problems that we haveexperienced, we believe that some customers have allocated some of their 

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requirements for VGF grownsubstrates across more competitors and we believe that we may have lost revenueand market share as a result of these customer decisions. In addition, we alsoface competition from compound semiconductor device manufacturers that producesubstrates for their own internal use, including Hitachi, and from companies suchas IBM that are actively developing alternative compound semiconductormaterials.

We are the only compoundsemiconductor substrate supplier to offer a full suite of raw materials and webelieve that it gives us a strong competitive advantage in our marketplace.

**Protection of ourIntellectual Property**

Our success and the competitive position of our VGFtechnique depend on our ability to maintain trade secrets and otherintellectual property protections. We rely on a combination of patents,trademark and trade secret laws, non-disclosure agreements and otherintellectual property protection methods to protect our proprietary technology.We believe that, due to the rapid pace of technological innovation in themarkets for our products, our ability to establish and maintain a position oftechnology leadership depends as much on the skills of our developmentpersonnel as upon the legal protections afforded our existing technologies. Toprotect our trade secrets, we take certain measures to ensure their secrecy,such as executing non-disclosure agreements with our employees, customers andsuppliers. However, reliance on trade secrets is only an effective businesspractice insofar as trade secrets remain undisclosed and a proprietary productor process is not reverse engineered or independently developed.

To date, we have been issued three U.S. patents whichrelate to our VGF products and processes. We have six patent applicationspending, (in Patent Cooperation Treaty (“PCT”)/national stage process) inEurope, Canada, China, Japan and South Korea which are based on our U.S.patents that relate to our VGF processes. We have one issued foreign patent.

In connection with a final settlement of litigation,we entered into a global intellectual property cross-licensing agreement withSumitomo Electric Industries, Ltd. (SEI). Under the terms of the settlement, wewill make on-going royalty payments through 2012 on certain products sold by usin Japan.

In the normal course ofbusiness, we periodically receive and make inquiries regarding possible patentinfringement. In dealing with such inquiries, it may become necessary or usefulfor us to obtain or grant licenses or other rights. However, there can be noassurance that such licenses or rights will be available to us on commerciallyreasonable terms. If weare not able to resolve or settle claims, obtainnecessary licenses on commercially reasonable terms and/or successfullyprosecute or defend its position, our business, financial condition and resultsof operations could be materially and adversely affected.

**EnvironmentalRegulations**

We are subject to federal,state and local environmental laws and regulations, including laws in China aswell as the U.S. These laws, rules and regulations govern the use,storage, discharge and disposal of hazardous chemicals during manufacturing,research and development and sales demonstrations. We maintain a number ofenvironmental, health and safety programs that are primarily preventive innature. As part of these programs, we regularly monitor ongoing compliance. Ifwe fail to comply with applicable regulations, we could be subject tosubstantial liability for clean-up efforts, personal injury and fines orsuspension or cessation of our operations.

**Employees**

As of December 31, 2006, we had 1,022 employees,of whom 819 were principally engaged in manufacturing, 119 in sales andadministration, and 84 in research and development. Of these employees, 39 arelocated in the U.S., and 983 in China. As of December 31, 2005, we had 842employees, of whom 

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680 were principallyengaged in manufacturing, 116 in sales and administration, and 46 in researchand development. Of these employees, 55 were located in the U.S., and 787 inChina.

In December 2005, aspart of our ongoing effort to reduce our Fremont, California facilityheadcount, we reduced the workforce at the facility by 15 full-time equivalentpositions that we no longer required to support production and operations, orapproximately 29% of the workforce based at this facility. Some of our employeesin China are represented by a union, but we have never experienced a workstoppage. Although morale has been affected by our workforce reductions inCalifornia, we consider our relations with our employees to be good.

**Available of Information**

Our principal executive offices are located at 4281 Technology Drive,Fremont, CA 94538, and our main telephone number is (510) 683-5900. The public may read and copy any material wefile with the Securities and Exchange Commission, or SEC, at the SEC’s PublicReference Room at 450 Fifth Street, N.W., Washington D.C., 20549. Thepublic may obtain information on the operations of the Public Reference Room bycalling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site, *http://www.sec.gov*, that contains reports,proxy and information statements and other information regarding issuers thatfile electronically with the SEC.

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**Item 1A.**                *Risk Factors*

For ease ofreference, we have divided these risks and uncertainties into the followinggeneral categories:

·       Risksrelated to our general business;

·       Risksrelated to international aspects of our business;

·       Risksrelated to our financial results and capital structure;

·       Risksrelated to our intellectual property; and

·       Risks related to complianceand other legal matters.

**Risks Related toOur General Business**

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

Our products are complex and may contain defects. Wehave experienced quality control problems with many of our products, whichcaused customers to return products to us, reduce orders for our products, orboth. Although our quality has improved, resulting in some increases in productsales, we believe that we continue to experience some reduction in orders as aresult of our prior product quality problems. If we continue to experiencequality control problems, or experience these or other problems in newproducts, customers may cancel or reduce orders or purchase products from ourcompetitors, we may be unable to maintain or increase sales to our customersand sales of our products could decline. Defects in our products could cause usto incur higher manufacturing costs and suffer product returns and additionalservice expenses, all of which could adversely impact our 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.

***Decreases in average selling prices of our productsmay reduce gross margins.***

The market for compoundsemiconductor substrates is characterized by pressures on average sellingprices resulting from factors such as increased competition or overcapacity. Wehave experienced and expect to continue to experience price pressures on ourproducts, and if average selling prices decline in the future, our revenue andgross margins could decline. We may be unable to reduce the cost of ourproducts sufficiently to offset the effect of lower selling prices and allow usto keep pace with competitive pricing pressures, and our margins could beadversely affected.

***The loss of one or more of our key substrate customerswould significantly hurt our operating results.***

A small number ofsubstrate customers have historically accounted for a substantial portion ofour total revenue. Our top five customers represented 40.0% of revenues for theyear ended December 31, 2006, 37.5% of revenue for the year ended December 31,2005, and 30.1% of revenue for the year ended December 31, 2004. We expectthat a significant portion of our future revenue will continue to be derivedfrom a limited number of substrate customers. Our customers are not obligatedto purchase a specified quantity of our products or to provide us with bindingforecasts of product purchases. In addition, our customers may reduce,delay or cancel orders at any time without any significant penalty. In thepast, we had experienced slower bookings, significant push-outs andcancellation of orders from customers. If we lose a major customer or if acustomer cancels, reduces or delays orders, our revenue would decline. In addition,customers that have accounted for significant revenue in the past may notcontinue to generate revenue for us in any future period. Any delay inscheduled shipments of our products could cause revenue 

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to fallbelow our expectations and the expectations of market analysts or investors,causing our stock price to decline.

***Our results of operations may suffer if we do noteffectively manage our inventory.***

We must manage ourinventory of component parts, work-in-process and finished goods effectively tomeet 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 below the standardprices at which we value inventory, we may need to take a charge for areduction in inventory values. We have in the past had to take inventoryvaluation and impairment charges. Any future unexpected changes in demand orincreases in costs of production that cause us to take additional charges forun-saleable, obsolete or excess inventory, or to reduce inventory values, couldadversely affect our results of operations.

***If we have low product yields, or if there is adeliberate sabotage of our products, the shipment of our products may bedelayed and our operating results may be adversely impacted.***

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

·       impuritiesin the materials used;

·       contaminationof the manufacturing environment;

·       substratebreakage;

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

·       performanceof personnel involved in the manufacturing process.

If our yields decrease, our revenue could decline ifwe are unable to produce needed product on time. At the same time, ourmanufacturing costs could remain fixed, or could increase. We have experiencedproduct shipment delays and difficulties in achieving acceptable yields on bothnew and older products, and delays and poor yields have adversely affected ouroperating results. We may experience similar problems in the future and wecannot predict when they may occur or their severity. In particular, many ofour manufacturing processes are new and are still being refined, which canresult in lower yields.

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

***If we do not successfully develop new products torespond to rapidly changing customer requirements, our ability to generaterevenue, obtain new customers, and retain existing customers may suffer.***

Our success depends on our ability to offer newproducts and product features that incorporate leading technology and respondto technological advances. In addition, our new products must meet customerneeds and compete effectively on quality, price and performance. The lifecycles of our products are difficult to predict because the markets for ourproducts are characterized by rapid technological change, changing customerneeds and evolving industry standards. If our competitors introduce productsemploying new technologies or performance characteristics, our existingproducts could become obsolete and unmarketable. During the past three years,we have seen our competitors selling more substrates manufactured using acrystal growth technology similar to ours, which has eroded our technologicaldifferentiation. Other companies, including Triquent, are actively developingsubstrate materials that could 

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be used to manufacturedevices that could provide the same high-performance, low-power capabilities asGaAs- and InP-based devices at competitive prices. If these substrate materialsor VGF-derived 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 new productscould be greater than anticipated. If we fail to offer new products or productenhancements or fail to achieve higher quality products, we may not generatesufficient revenue to offset our development costs and other expenses or meetour customers’ requirements.

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

The markets for ourproducts are intensely competitive. We face competition for our substrateproducts from other manufacturers of substrates, such as Freiberger CompoundMaterials, Hitachi Cable and Sumitomo Electric, from semiconductor devicemanufacturers that produce substrates for their own use, and from companies,such as Triquent, that are actively developing alternative materials to GaAsand marketing semiconductor devices using these alternative materials. Webelieve that at least two of our major competitors are shipping high volumes ofGaAs substrates 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 tobecome profitable. We face many competitors that have a number of significantadvantages over us, including:

·       greaterexperience in the business;

·       moremanufacturing experience;

·       extensiveintellectual property;

·       broadername recognition; and

·       significantlygreater financial, technical and marketing resources.

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

The level and intensity of competition has increasedover the past year and we expect competition to continue to increase in thefuture. Competitive pressures caused by the current economic conditions haveresulted in reductions in the prices of our products, and continued orincreased competition could reduce our market share, require us to furtherreduce the prices of our products, affect our ability to recover costs andresult in reduced gross margins.

In addition, newcompetitors have and may continue to emerge, such as a small crystal growingcompany established by a former employee of ours in China that is supplyingingots to the market. While new competitors such as this company currently donot appear to be fully competitive, competition from sources such as this couldincrease, particularly if these competitors are able to obtain large capitalinvestments.

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***Demand for our products may decrease if our customersexperience difficulty manufacturing, marketing or selling their products.***

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

·       thecompetition our customers face in their particular industries;

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

·       thefinancial and other resources of our customers; and

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

If demand for the end-userapplications for which our products are used decreases, or our customers areunable to develop, market and sell their products, demand for our products willdecrease.

***The financial condition of our customers may affecttheir 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. 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 purchase critical raw materials and parts for ourequipment from single or limited sources, and could lose sales if these sourcesfail 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. Although several of these rawmaterials are purchased from suppliers in which we hold an ownership interest,we generally purchase these materials through standard purchase orders and notpursuant to long-term supply contracts and no supplier guarantees supply of rawmaterials or equipment to us. If we lose any of our key suppliers, ourmanufacturing efforts could be significantly hampered and we could be preventedfrom timely producing and delivering products to our customers. Prior toinvesting in our raw material joint ventures, we sometimes experienced delaysobtaining critical raw materials and spare parts, including gallium, due toshortages of these materials and could experience such delays again in thefuture due to shortages of materials and may be unable to obtain an adequatesupply of materials. These shortages and delays could result in highermaterials costs and cause us to delay or reduce production of our products. Ifwe have to delay or reduce production, we could fail to meet customer deliveryschedules and our revenue and operating results could suffer.

***We have made and may continue to make strategicinvestments in raw materials suppliers, which may not be successful and mayresult in the loss of all or part of our investment.***

We have made investmentsthrough our five joint ventures in raw material suppliers in China, whichprovide us with opportunities to gain supplies of key raw materials that areimportant to our substrate business. These affiliates each have a market beyondthat provided by us. We do not have influence over all of these companies, eachof which is located in China, and in some we have made only a strategic,minority investment. We may not be successful in achieving the financial,technological or commercial 

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advantageupon which any given investment is premised, and we could end up losing all orpart of our investment.

***Our substrate products have a long qualification cyclethat makes it difficult to plan our expenses and forecast 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. Ifwe do not achieve anticipated sales in a period as expected, we may experiencean unplanned shortfall in our revenue. As a result, we may not be able to coverexpenses, causing our operating results to vary. In addition, if a customerdecides not to incorporate our products into its initial design, we may nothave another opportunity to sell products to this customer for many months oreven years. In the current competitive and economic climate, the average salescycle for our products has lengthened even further and is expected to continueto make it difficult to forecast our future sales accurately. We anticipatethat sales of any future substrate products will also have lengthy sales cyclesand will, therefore, be subject to risks substantially similar to thoseinherent in the lengthy sales cycles of our current substrate products.

**Risks Related toInternational Aspects of Our Business**

***Changes in tariffs, import restrictions, exportrestrictions or other trade barriers may reduce gross margins.***

We may incur increases incosts due to changes in tariffs, import or export restrictions, or other tradebarriers, or unexpected changes in regulatory requirements, any of which couldreduce our gross margins. For example, in September 2006 and November 2006,tax authorities in the People’s Republic of China (PRC) changed the treatmentof refunds of value-added taxes that companies pay when they purchase certainraw materials, including gallium and arsenic. The cumulative effect is that ourPRC joint venture companies no longer receive a refund of value-added tax forexports of gallium or arsenic, including certain shipments to our wholly-ownedPRC subsidiary that are treated as exports under PRC tax regulations. However,our PRC joint venture companies sell only a portion of their gallium intransactions that are considered exports, and none of those PRC joint venturecompanies currently exports arsenic. Therefore, after having conducted furtheranalysis on our consolidated financial results, which include a portion of thefinancial impact of these tax releases on our PRC joint venture companies, webelieve that our consolidated financial results will not be materiallyaffected. However, given the relatively fluid regulatory environment in thePRC, there could be additional tax or other regulatory changes in the future.Any such changes could directly and materially adversely impact our financial resultsand general business condition.

***Our operating results depend in large parton continued customer acceptance of our substrate products manufactured inChina and continued improvements in product quality.***

We manufacture all of ourproducts in China, and source most of our raw materials in China. Accordingly,we continue to seek customer qualification of our China-manufactured products. Inaddition, we have in the past experienced quality problems with ourChina-manufactured products. Our previous quality problems caused us to losemarket share to our competitors, as some customers reduced their orders from usuntil our surface quality was as good and consistent as that offered bycompetitors and customers allocated their requirements for compound semiconductorsubstrates across more competitors. If we are unable to continue to achievecustomer qualifications for our products, or if we againexperience quality problems, customers may not increase purchases of ourproducts, our China facility will become underutilized, and we will be unableto achieve expected revenue growth. We may again lose sales of our 

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productsto competitors and experience loss of market share. If we are unable torecover and retain our market share, we may be unable to grow our business.

***Problems incurred by our joint ventures or venturepartners could result in a material adverse impact on our financial conditionor results of operations***

We have invested in five joint venture operations inChina that produce products including 99.99% pure gallium (4N Ga), high puritygallium, arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN)crucibles and boron oxide. We purchase a portion of the materials produced bythese ventures for our use and sell the remainder of their production to thirdparties. Our ownership interest in these entities ranges from 25% to 83%. Weconsolidate the three ventures in which we own a majority or controllingfinancial interest and employ equity accounting for the two joint ventures inwhich we have a 25% interest. Several of these ventures occupy space withinlarger facilities owned and/or operated by one of the other venture partners.Several of these venture partners are engaged in other manufacturing activitiesat or near the same facility. In some facilities, we share access to certainfunctions, including water, hazardous waste treatment or air quality treatment.If any of our joint venture partners in any of these five ventures experiencesproblems with its operations, disruptions of our joint venture operations couldresult, having a material adverse effect on the financial condition and resultsof operation of our joint ventures, and correspondingly on our financialcondition or results of operations.

In addition, if any of our joint ventures or venturepartners with which our joint ventures share facilities is deemed to haveviolated applicable laws, rules or regulations governing the use, storage,discharge or disposal of hazardous chemicals during manufacturing, research anddevelopment, or sales demonstrations, the operations of our joint venturescould be adversely affected and we could be subject to substantial liabilityfor clean-up efforts, personal injury and fines or suspension or cessation ofour joint venture operations as a result of the actions of the joint venturesor other venture partners. Employees working for our joint ventures or any ofthe other venture partners could bring litigation against us as a result ofactions taken at the joint venture or venture partner facilities, even thoughwe are not directly controlling the operations, including actions for exposureto chemicals or other hazardous materials at the facilities of our jointventures or the facilities of any venture partner that are shared by our jointventures. If litigation is brought against us, litigation is inherentlyuncertain and, while we would expect to defend ourselves vigorously, it ispossible that our business, financial condition, results of operations or cashflows could be affected in any particular period by any litigation if broughtagainst us, particularly if litigation with us, as a non-Chinese company, isdeemed advantageous. Even if we are not deemed responsible for the actions ofthe joint ventures or venture partners, litigation could be costly, timeconsuming to defend and divert management attention; in addition, pursuit of uscould occur if we are deemed to be the most financially viable of the partners.

Going forward, we believe that investing in additionaljoint ventures will be important to remaining competitive in our marketplaceand ensuring a supply of critical raw materials. However, we may not beable to identify complementary joint venture opportunities or, even onceopportunities are identified, we may not be able to reach agreement on theterms of the venture with the other venture partners. Additional joint venturescould cause us to incur contingent liabilities or other expenses, any of whichcould adversely affect our financial condition and operating results.

Since all of ourjoint venture activity is expected to occur in China, these activities couldsubject us to a number of risks associated with conducting operationsinternationally, including:

·       difficultiesin managing geographically disparate operations;

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

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

·       politicaland economic instability, civil unrest or war;

·       terroristactivities that impact international commerce;

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

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

·       nationalization offoreign-owned assets, including intellectual property.

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

Our operating results canvary significantly based upon the impact of changes in global economicconditions on our customers. The revenue growth and profitability of ourbusiness depends on the overall demand for our substrates, and we areparticularly dependent on the market conditions for the wireless, solid-stateillumination, fiber optics and telecommunications industries. Because our 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 decreasedrevenue. Customers may find themselves facing excess inventory from earlierpurchases, and may defer or reconsider purchasing products due to the downturnin their business and in the general economy.

***We derive a significant portion of our revenue frominternational sales, and our ability to sustain and increase our internationalsales involves significant risks.***

Our revenue growth depends in part on the expansion ofour international sales and operations. International sales represented 71%,81% and 79% of our total revenue for the years ended December 31, 2006,2005 and 2004, respectively. We expect that sales to customers outside theU.S., particularly sales to customers in Asia, will continue to represent asignificant portion of our revenue.

Currently, an increasing percentage of our sales is tocustomers headquartered in Asia. All of our manufacturing facilities and someof our suppliers are also located outside the U.S. Managing our overseasoperations presents challenges, including periodic regional economic downturns,trade balance issues, varying business conditions and demands, politicalinstability, variations in enforcement of intellectual property and contract rightsin different jurisdictions, differences in the ability to develop relationshipswith suppliers and other local businesses, changes in U.S. and internationallaws and regulations including U.S. export restrictions, fluctuations ininterest and currency exchange rates, the ability to provide sufficient levelsof technical support in different locations, cultural differences, shippingdelays and terrorist acts or acts of war, among other risks. Many of thesechallenges are present in China, which represents a large potential market forsemiconductor devices and where we anticipate significant opportunity forgrowth. Global uncertainties with respect to: (i) economic growth rates in various countries; (ii) sustainabilityof demand for electronics products; (iii) capital spending bysemiconductor manufacturers; (iv) price weakness for certain semiconductordevices; and (v) political instability in regions where we have operationsmay also affect our business, financial condition and results of operations.

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

·       changesin tariffs, import restrictions, export restrictions, or other trade barriers;

·       unexpectedchanges in regulatory requirements;

·       longerperiods to collect accounts receivable;

·       changesin export license requirements;

·       politicaland economic instability;

·       unexpectedchanges in diplomatic and trade relationships; and

·       foreignexchange rate fluctuations.

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

Also, denominating somesales in Japanese yen subjects us to fluctuations in the exchange rates betweenthe U.S. dollar and the Japanese yen. The functional currency of our Chinesesubsidiary and joint ventures is the local currency. We incur transaction gainsor losses resulting from consolidation of expenses incurred in local currenciesfor these entities, as well as in translation of the assets and liabilities oftheir assets at each balance sheet date. If we do not effectively manage the risksassociated with international sales, our revenue, cash flows and financialcondition could be adversely affected.

***Because of power shortages in the PRC, we may have totemporarily close our China operations, which would adversely impact ourability to manufacture our products and meet customer orders, and would resultin reduced revenue.***

The Chinese government faced a power shortage over thesummer of 2004 and reported that power demand in 24 provinces outstrippedsupply in peak periods during January to April of 2004. Instabilityin electrical supply caused sporadic outages among residential and commercialconsumers. As a result, the Chinese government implemented tough measures in2004 to ease the energy shortage. Provinces imposed power brownouts during 2004to reduce electricity demand, and some companies in Beijing were ordered togive their employees a week off to ease the pressure on power supply. Plants,most of which are state-owned, were closed and reopened on a staggered scheduleto reduce power consumption during the capital’s hottest months during 2004. Asa result, we closed most of our operations for a week in late July 2004 inconformance with this policy.

In 2006 we were able toswitch the electrical supply for our manufacturing facility onto the same powergrid as that used by vital PRC government services such as hospitals andpolice. However, if even despite this switch we are required to make temporaryclosures of our subsidiary and joint venture operations, we may be unable tomanufacture our products, and would then be unable to meet customer ordersexcept from inventory on hand. As a result, our revenue could be adverselyimpacted, and our relationships with our customers could suffer, impacting ourability to generate future revenue. In addition, if power is shut off at ourBeijing subsidiary at any time, either voluntarily or as a result of unplannedbrownouts, during certain phases of our manufacturing process including ourcrystal growth phase, the work in process may be ruined and rendered unusable,causing us to incur expense that will not be covered by revenue, and negativelyimpacting our cost of revenue and gross margins.

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***Changes in China’s political, social and economicenvironment may affect our financial performance.***

Our financial performance may be affected by changesin China’s political, social and economic environment. The role of the Chinesecentral and local governments in the Chinese economy is significant. Chinesepolicies toward economic liberalization, and laws and policies affectingtechnology companies, foreign investment, currency exchange rates and othermatters could change, resulting in greater restrictions on our ability to dobusiness and operate our manufacturing facilities in China. Any imposition ofsurcharges or any increase in Chinese tax rates could hurt our operatingresults. The Chinese government could revoke, terminate or suspend our licensefor national security and similar reasons without compensation to us. If thegovernment of China were to take any of these actions, we would be preventedfrom conducting all or part of our business. Any failure on our part to complywith governmental regulations could result in the loss of our ability tomanufacture our products in China.

China from time to time hasexperienced 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 negatively affect our ability to operate ourfacilities in China.

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

In July 2005, Chinaagreed to a shift in Chinese currency policy. It established a 2% revaluationof the renminbi and referenced the renminbi to a basket of currencies, with adaily trading band of +/-0.3%. Depending on market conditions and thestate of the Chinese economy, it is possible that China will make moreadjustments in the future. Over the next five to ten years, China may move to amanaged float system, with opportunistic interventions. This reservediversification may negatively impact the United States dollar and U.S.interest rates, which, in turn, could negatively impact our operating resultsand financial condition. The functional currency of our Chinese subsidiary,including our joint ventures, is the local currency; since most of ouroperations are conducted in China, most of our costs are incurred in Chinesecurrency, which subjects us to fluctuations in the exchange rates between theU.S. dollar and the Chinese renminbi. We incur transaction gains or lossesresulting from consolidation of expenses incurred in local currencies for thesesubsidiaries, as well as in translation of the assets and liabilities of theseassets at each balance sheet date. These risks may be increased by thefluctuation and revaluation of the Chinese renminbi. If we do not effectivelymanage the risks associated with this currency risk, our revenue, cash flowsand financial condition could be adversely affected.

***A reoccurrence of Severe Acute Respiratory Syndrome(SARS) or the outbreak of a different contagious disease such as the Avian Flumay adversely impact our manufacturing operations and some of our key suppliersand customers.***

All of our substratemanufacturing activities are conducted in China. In addition, we acquire keyraw materials, including gallium, from our joint ventures and other suppliersin China. The 2003 SARS outbreak was most notable in China and a small numberof cases were reported in 2004. One employee at our LED production facility inChina contracted SARS in late April 2003 prompting us to close thefacility for ten days. There was no significant impact to our ability to fillcustomer orders. If there were to be another outbreak of SARS or a differentcontagious disease, such as Avian Flu, and if our employees contracted thedisease, we might be required to temporarily close our manufacturing operations.Similarly, if one of our key suppliers is required to close for an extendedperiod, we might not have enough raw material inventory to continuemanufacturing operations. In addition, while we possess management skills amongour China staff that enable us to maintain our manufacturing operations withminimal on-site supervision from our US-based staff, our business could also beharmed if travel to or from Asia and the United States is restricted orinadvisable, as it was during parts of 2003. None of our substrate competitorsis as dependent on manufacturing facilities in China as we are. If ourmanufacturing operations were 

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closedfor a significant period, we could lose revenue and market share during thatperiod, which would depress our financial performance and could be difficult torecapture. Finally, if one of our key customers is required to close for anextended period, we might not be able to ship product to them, our revenuewould decline and our financial performance would suffer.

**Risks Related toOur Financial Results and Capital Structure**

***The compound semiconductor industry is cyclical andhas experienced a downturn which has adversely impacted our operating results.***

Our continuing business depends in significant partupon manufacturers of electronic and opto-electronic compound semiconductordevices, as well as the current and anticipated market demand for these devicesand products using these devices. As a supplier to the compound semiconductorindustry, we are subject to the business cycles that characterize the industry.The timing, length and volatility of these cycles are difficult to predict. Thecompound semiconductor industry has historically been cyclical because ofsudden changes in demand, the amount of manufacturing capacity and changes inthe technology employed in compound semiconductors. The rate of changes indemand, including end demand, is high, and the effect of these changes upon usoccurs quickly, exacerbating the volatility of these cycles. These changes haveaffected the timing and amounts of customers’ purchases and investments in newtechnology. These industry cycles create pressure on our revenue, gross marginand net income (loss).

The industry has in the past experienced periods ofoversupply that result in significantly reduced demand and prices for compoundsemiconductor devices and components, including our products, both as a resultof general economic changes and overcapacity. When these periods occur and ouroperating results and financial condition are adversely affected, oversupplycreates pressure on our revenue, gross margins and net income (loss). Inventorybuildups in telecommunications products and slower than expected sales ofcomputer equipment resulted in overcapacity and led to reduced sales by ourcustomers, and therefore reduced purchases of our products. During periods ofweak demand such as those experienced historically, customers typically reducepurchases, delay delivery of products and/or cancel orders of component partssuch as our products. Increased price competition has resulted, causing pressureon our net sales, gross margin and net income (loss). We experiencedcancellations, price reductions, delays and push-outs of orders, which haveresulted in reduced revenue. If the economic downturn occurred again, furtherorder cancellations, reductions in order size or delays in orders could occurand would materially adversely affect our business and results of operations. Actionsto reduce our costs, such as those we have recently taken, may beinsufficient to align our structure with prevailing business conditions. We maybe required to undertake additional cost-cutting measures, and may beunable to invest in marketing, research and development and engineering at thelevels we believe are necessary to maintain our competitive position. Our failureto make these investments could seriously harm our business.

During periods ofincreasing demand for compound 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. 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 we fail to manage periodic contractions, wemay utilize our cash balances and our existing cash and cash equivalentsand investment balances could decline.***

We anticipate that ourexisting cash resources will fund any anticipated operating losses andpurchases of capital equipment, as well as provide adequate working capital forthe next twelve months. However, our liquidity is affected by many factorsincluding, among others, the extent to which we pursue additional 

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capitalexpenditures, the level of our production, and other factors related to theuncertainties of the industry and global economies. If we fail to manage ourcontractions successfully we may draw down our cash reserves, which wouldadversely affect our operating results and financial condition, reduce ourvalue and possibly impinge our ability to raise debt and equity funding in thefuture, at a time when we might be required to raise additional cash. Accordingly,there can be no assurance that events in the future will not require us to seekadditional capital or, if required, that such capital would be available onterms acceptable to us, if at all. As part of our effort to reduce costs, wemay lose key staff, production resources and technology that we will need togrow when end markets recover. These events could reduce our ability to growprofitably as markets recover.

***Unpredictable fluctuations in our operating resultscould disappoint analysts or our investors, which could cause our stock priceto decline.***

We have not been able to sustain growth for anysignificant period in the last five years, and may not be able to return tohistoric growth levels in the current economic environment. Our net loss in2002 was the largest in our history and our losses continued during 2003, 2004,2005, and the first two quarters of 2006. We recorded net income in the thirdand fourth quarters of 2006.

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

·       ourability to develop, manufacture and deliver high quality products in a timelyand cost-effective manner;

·       declinein general economic conditions or downturns in the industry in which wecompete;

·       fluctuationsin demand for our products;

·       expansionof our manufacturing capacity;

·       expansionof our operations in China;

·       limitedavailability and increased cost of raw materials;

·       thevolume and timing of orders from our customers, and cancellations, push-outsand delays of customer orders once made;

·       fluctuationof our manufacturing yields;

·       decreasesin the prices of our or our competitors’ products;

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

·       increasesin our expenses, including expenses for research and development.

Due to these factors, we believe that period-to-periodcomparisons of our operating results may not be meaningful indicators of ourfuture performance.

A substantial percentageof our operating expenses is fixed in the short term, and we may be unable toadjust spending to compensate for an unexpected shortfall in revenue. 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 stock price has been and may continue to bevolatile.***

Our stock price hasfluctuated significantly since we began trading on the NASDAQ Global Market.For the year ended December 31, 2006, the high and low closing salesprices of our common stock were 

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$5.37and $1.98, respectively. A number of factors could cause the price of ourcommon stock to continue to fluctuate substantially, including:

•     actual or anticipatedfluctuations in our quarterly or annual operating results;

•     changes in expectations aboutour future financial performance or changes in financial estimates ofsecurities analysts;

•     announcements oftechnological innovations by us or our competitors;

•     new product introduction byus or our competitors;

•     large customer orders ororder cancellations; and

•     the operating and stock priceperformance 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 adopted certain anti-takeover measures thatmay make it more difficult for a third party to acquire us.***

Our board of directors has the authority to issue upto 2,000,000 shares of preferred stock and to determine the price, rights,preferences and privileges of those shares without any further vote or actionby the stockholders. The rights of the holders of common stock will be subjectto, and may be adversely affected by, the rights of the holders of any preferredstock that may be issued in the future. The issuance of shares of preferredstock could have the effect of making it more difficult for a third party toacquire a majority of our outstanding voting stock. We have no presentintention to issue additional shares of preferred stock.

We have adopted a preferred stock purchase rights planintended to guard against certain takeover tactics. The adoption of this planwas not in response to any proposal to acquire us, and the board is not awareof any such effort. The existence of this plan could also have the effect ofmaking it more difficult for a third party to acquire a majority of ouroutstanding voting stock. In addition, certain provisions of our certificate ofincorporation may have the effect of delaying or preventing a change ofcontrol, which could adversely affect the market price of our common stock.

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

·       thedivision of our board of directors into three separate classes, each withthree-year terms;

·       theright of our board to elect a director to fill a space created by a boardvacancy or the expansion of the board;

·       theability of our board to alter our amended and restated bylaws; and

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

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Furthermore,because we are incorporated in Delaware, we are subject to the provisions of Section 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:

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

·       the board of directorsapproves the merger or combination or the transaction which resulted in thelarge stockholder owning 15% or more of our outstanding voting stock.

**Risks Related toOur Intellectual Property**

***Intellectual property infringement claims may becostly to resolve and could divert management 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 that 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. For example, we have previously been involved intwo separate lawsuits alleging patent infringement, and could in the future beinvolved in similar litigation.

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

We rely on a combination of patents, copyrights,trademark and trade secret laws, non-disclosure agreements and otherintellectual property protection methods to protect our proprietary technology.However, we believe that, due to the rapid pace of technological innovation inthe markets for our products, our ability to establish and maintain a positionof technology leadership also depends on the skills of our developmentpersonnel. Despite our efforts to protect our intellectual property, thirdparties can develop products or processes similar to ours. Our means ofprotecting our proprietary rights may not be adequate, and our competitors mayindependently develop similar technology, duplicate our products or designaround our patents. We believe that at least two of our competitors have begunto ship GaAs substrates produced using a process similar to our VGF technique. Ourcompetitors may also develop and patent improvements to the VGF technology uponwhich we rely, and thus may limit any exclusivity we enjoy by virtue of ourpatents or trade secrets.

It is possible that pending or future United States orforeign patent applications made by us will not be approved, that our issuedpatents will not protect our intellectual property, or that third parties willchallenge the ownership rights or the validity of our patents. In addition, thelaws of some foreign countries may not protect our proprietary rights to asgreat an extent as do the laws of the United States and it may be moredifficult to monitor the use of our intellectual property. Our competitorsmay be able to legitimately ascertain non-patented proprietary technologyembedded in our systems. If this occurs, we may not be able to prevent thedevelopment of technology substantially similar to ours.

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

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For example, in the pastwe have been involved in litigation with Sumitomo Electric Industries, Ltd. (“SEI”)in Japan as well as interference actions in the United States. We and SEIapproved a settlement of this litigation during the fourth quarter of 2004 andthe litigation was withdrawn and we abandoned the interference proceeding. Wemade an initial payment of approximately $1.4 million and will have to payongoing royalties to SEI on certain of our products.

**Risks Related toCompliance and Other Legal Matters**

***We need to continue to improve or implement oursystems, procedures and controls and may not receive a favorable attestationreport on our internal control systems by our independent registered publicaccounting firm.***

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

In addition, the shift of our manufacturing operationsto China has placed and continues to place a significant strain on ouroperations and management resources. We have upgraded our inventory controlsystems and may implement additional systems relating to consolidation of ourfinancial results, but continue to rely on certain manual processes in ouroperations and in connection with consolidation of our financial results. If wefail to manage these changes effectively, our operations 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 to comply with environmental and safetyregulations, we may be subject to significant fines or forced to cease ouroperations; in addition, we could be subject to suits for personal injuriescaused by hazardous materials.***

We are subject to federal, state and local environmentaland safety laws and regulations in all of our operating locations, includinglaws and regulations of China, such as laws and regulations related to thedevelopment, manufacture and use of our products, the operation of ourfacilities, and the use of our real property. These laws and regulations governthe use, storage, discharge and disposal of hazardous chemicals duringmanufacturing, research and development, and sales demonstrations. If we failto comply with applicable regulations, we could be subject to substantialliability for clean-up efforts, personal injury and fines or suspension or beforced to cease our operations, and/or suspend or terminate the development,manufacture or use of certain of our products, the use of our facilities, orthe use of our real property, each of which could have a material adverseeffect on our business, financial condition and results of operations.

In March 2001, we settled a claim made by theCalifornia Occupational Safety and Health Administration, or Cal-OSHA, in aninvestigation primarily regarding impermissible levels of potentially hazardousmaterials in certain areas of our manufacturing facility in Fremont, Californiafor $200,415, and during 2004 we were the target of press allegations andcorrespondence purportedly on behalf of current and/or former employeesconcerning our environmental compliance programs and exposure of our 

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employees to hazardousmaterials. In June 2005, a complaint was filed against us and a currentand former officer, alleging personal injury, general negligence, intentionaltort, wage loss and other damages, including punitive damages, as a result ofexposure of plaintiffs, who are former employees of AXT, including a minorchild in utero, to high levels of gallium arsenide in gallium arsenide wafers,and methanol. There is a possibility that other current and/or former employeesmay bring additional litigation against us. Although we have put in placeengineering, administrative and personnel protective equipment programs toaddress these issues, our ability to expand or continue to operate our presentlocations could be restricted or we could be required to acquire costlyremediation equipment or incur other significant expenses. Existing or futurechanges in laws or regulations in the United States and China may require us toincur significant expenditures or liabilities, or may restrict our operations. Inaddition, our employees could be exposed to chemicals or other hazardousmaterials at our facilities and we may be subject to lawsuits seeking damagesfor wrongful death or personal injuries allegedly caused by exposure tochemicals or hazardous materials at our facilities.

Litigation is inherentlyuncertain and while we would expect to defend ourselves vigorously, it ispossible that our business, financial condition, results of operations or cashflows could be affected in any particular period by litigation pending and anyadditional litigation brought against us.

***Existing or future litigation could result insignificant judgments against us, or cause us to incur costly settlements.***

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

***Legislative actions, higher insurance costs andpotential new accounting pronouncements are likely to cause our general andadministrative expenses to increase and impact our future financial positionand results of operations.***

In order to comply with rules andregulations adopted pursuant to the Sarbanes-Oxley Act of 2002 by the SEC, aswell as changes to listing standards adopted by the NASDAQ Stock Market, andaccounting changes adopted affecting accounting for stock-based compensation,we may be required to increase our internal controls and hire additionalpersonnel and outside legal, accounting and advisory services, all of whichwill cause our general and administrative costs to increase. Insurers mayincrease premiums as a result of the high claims rates they incurred over thepast year. Changes in accounting rules, including legislative and other rules toaccount for employee stock options as a compensation expense among others,could materially increase the expense that we report under generally acceptedaccounting principles and adversely affect our operating results.

***The effect of terrorist threats and actions on thegeneral economy could decrease our revenue.***

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 is uncertain. Theremay be embargos of ports or products, or destruction of 

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shipmentsor our facilities, or attacks that affect our personnel. There may be otherpotentially adverse effects on our operating results due to a significant eventthat we cannot foresee. Since we perform all of our manufacturing operations inChina, and a significant portion of our customers are located outside of theUntied States, terrorist activity or threats against US-owned enterprise are aparticular concern to us.

***If any of our facilities is damaged by occurrencessuch as fire, explosion, or natural disaster, we might not be able tomanufacture our products.***

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

**Item 1B.**               *Unresolved Staff Comments*

None.

**Item 2.**                        *Properties*

Ourprincipal properties as of February 21, 2007 are as follows:

| **Location**   | ** ** | ** ** | ** ** | **Square  Feet**               | ** ** | **Principal Use**                                                                         | ** ** | **Ownership** | ** ** |
|----------------|------------|------------|------------|--------------------------------|------------|------------------------------------------------------------------------------------------------|------------|---------------|------------|
| Fremont, CA    |       | 80,000     |       | Vacant                         |       | Owned                                                                                          |       |
| Fremont, CA    |       | 55,000     |       | Production and Administration  |       | Operating lease, expires  March 2013                                                      |       |
| Beijing, China |       | 31,000     |       | Production and Administration  |       | Owned                                                                                          |       |
| Beijing, China |       | 31,000     |       | Production                     |       | Owned                                                                                          |       |
| Beijing, China |       | 32,000     |       | Production                     |       | Owned                                                                                          |       |
| Beijing, China |       | 16,000     |       | Housing                        |       | Owned                                                                                          |       |
| Beijing, China |       | 34,000     |       | Production                     |       | Owned                                                                                          |       |
| Beijing, China |       | 48,000     |       | Production                     |       | Owned                                                                                          |       |
| Beijing, China |       | 22,000     |       | Production and  Administration |       | Owned                                                                                          |       |
| Beijing, China |       | 53,000     |       | Production                     |       | Owned                                                                                          |       |
| Xianxi, China  |       | 56,500     |       | Production                     |       | Owned by Beijing Ji Ya  Semiconductor Material, Co., Ltd.*                                     |       |
| Xianxi, China  |       | 7,500      |       | Administration                 |       | Owned by Beijing Ji Ya  Semiconductor Material, Co., Ltd.*                                     |       |
| Xianxi, China  |       | 1,000      |       | Administration                 |       | Owned by Beijing Ji Ya  Semiconductor Material, Co., Ltd.*                                     |       |
| Nanjing, China |       | 22,000     |       | Production                     |       | Owned by Nanjing Jin Mei  Gallium Co., Ltd.*                                                   |       |
| Nanjing, China |       | 5,700      |       | R&D and Administration     |       | Owned by Nanjing Jin Mei  Gallium Co., Ltd.*                                                   |       |
| Nanjing, China |       | 3,900      |       | Production                     |       | Owned by Nanjing Jin Mei  Gallium Co., Ltd.*                                                   |       |
| Beijing, China |       | 7,600      |       | Production and Administration  |       | Owned by Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd.* |       |

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*                    Joint venturesin which we hold an interest. We hold a 46% interest in Beijing Ji YaSemiconductor Material Co., Ltd., a 83% interest in Nanjing Jin Mei GalliumCo., Ltd., and a 70% interest in Beijing BoYu Semiconductor Vessel CraftworkTechnology Co., Ltd (BoYu).

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We consider each facilityto be in good operating condition and adequate for its present use, and believethat each facility has sufficient plant capacity to meet its current andanticipated operating requirements.

**Item 3.**                        *Legal Proceedings*

From time to time we may be involved in judicialor administrative proceedings concerning matters arising in the ordinary courseof business. We do not expect that any of these matters, individually or in theaggregate, will have a material adverse effect on our business, financialcondition, cash flows or results of operation.

On October 15, 2004, a purported securities classaction lawsuit was filed in the United States Court for the Northern Districtof California, City of Harper Woods Employees Retirement System v. AXT, Inc.et al., No. C 04 4362 MJJ. The Court consolidated the case with asubsequent related case and appointed a lead plaintiff. On April 5, 2005,the lead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc.et al., No. C 04 4362 MJJ. The lawsuit complaint names AXT, Inc. andour former chief technology officer as defendants, and is brought on behalf ofa class of all purchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during thisperiod that were false and misleading. No specific amount of damages isclaimed. On September 23, 2005, the Court granted our motion to dismissthe complaint, with leave to amend. The lead plaintiff filed an amendedcomplaint, which we have moved to dismiss. We believe that there aremeritorious defenses against this litigation and intend to vigorously defendit. Due to the inherent uncertainties of litigation, we cannot accuratelypredict the ultimate outcome of the litigation. Any unfavorable outcome of thelitigation could have an adverse impact on our business, financial conditionand results of operations.

On June 1, 2005, alawsuit was filed in the Superior Court of California, County of Alameda, Zhaoet al. v. American Xtal Technology, et al., No. R 605215713. The lawsuitcomplaint names as defendants AXT, Inc., our former chief technologyofficer and one of our suppliers. The lawsuit is brought on behalf of twoformer employees and their minor child. The complaint alleges personal injury,general negligence, intentional tort, wage loss and other damages, includingpunitive damages, as a result of exposure of the child while in utero to highlevels of gallium arsenide and methanol used in the production of galliumarsenide wafers. We believe that there are meritorious defenses against thislitigation and intend to vigorously defend it. Our commercial general liabilityinsurance carrier has agreed to fund our defense of the case, but has reservedthe right to deny coverage, in whole or in part, in the future under selectedpolicy provisions and applicable law. The plaintiffs have made an initial settlementdemand within our insurance limits. Due to the inherent uncertainties oflitigation, we cannot accurately predict the ultimate outcome of thelitigation. Any unfavorable outcome of the litigation could have an adverseimpact on our business, financial condition and results of operations.

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

None.

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**PART II**

**Item 5.**                        *Market for Registrant’s Common Equity, Related Stockholder Matters andIssuer Purchases of Equity Securities*

Ourcommon stock has been trading publicly on the NASDAQ Global Market, (NASDAQ)under the symbol “AXTI” since May 20, 1998, the date we consummated ourinitial public offering. The following table sets forth the range of high andlow sales prices of the common stock for the periods indicated, as reported byNASDAQ. Such quotations represent inter-dealer prices without retail markup,markdown or commission and may not necessarily represent actual transactions.

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2006**       |       |     |       |    |       |
| First Quarter  |       | $        | 3.87       |    | $          | 1.98 |   |
| Second Quarter |       | $        | 4.47       |    | $          | 2.84 |   |
| Third Quarter  |       | $        | 4.26       |    | $          | 2.84 |   |
| Fourth Quarter |       | $        | 5.37       |    | $          | 4.19 |   |
| **2005**       |       |     |       |    |       |
| First Quarter  |       | $        | 1.57       |    | $          | 1.10 |   |
| Second Quarter |       | $        | 1.42       |    | $          | 1.08 |   |
| Third Quarter  |       | $        | 1.65       |    | $          | 1.14 |   |
| Fourth Quarter |       | $        | 2.47       |    | $          | 1.21 |   |

 

As of December 31, 2006, there were 91 holders ofrecord of our common stock. Because many shares of AXT’s common stock are heldby brokers and other institutions on behalf of stockholders, we are unable toestimate the total number of stockholders.

We have never paid ordeclared any cash dividends on our common stock and do not anticipate payingcash dividends in the foreseeable future. Dividends accrue on our outstanding Series Apreferred stock at the rate of $0.20 per annum per share of Series Apreferred stock.

***Issuer Purchases of Equity Securities***

Duringthe year ended December 31, 2006, we did not repurchase any shares of ourcommon stock. During the year ended December 31, 2005, we repurchased thefollowing shares of our common stock:

| **Period**                                    | ** ** | ** ** | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average Price  Paid Per  Share** | ** ** | **Total Number of  Shares  Purchased as  Part of a Publicly  Announced Plan  or Program(1)** | ** ** | **Approximate  Dollar Value  of Shares That  May Yet Be  Purchased  Under the  Plan or  Program** | ** ** |
|-----------------------------------------------|------------|------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|------------|
| Jan. 1, 2005  through Mar. 31, 2005 |       |       | 23,383     |                                             |       |                                         | $          | 1.23                                                                                                                                 |       |                                                                                                                                 |       | 23,383 |   |   |   | $ | 1,971,313 |   |   |
| Apr. 1, 2005  through Jun. 30, 2005 |       |       | 134,700    |                                             |       |                                         | 1.22       |                                                                                                                                 |       |                                                                                                                                 | 134,700    |   |   |   | 1,807,145 |   |   |
| Jul 1, 2005 through  Sep. 30, 2005       |       |       | 43,433     |                                             |       |                                         | 1.22       |                                                                                                                                 |       |                                                                                                                                 | 43,433     |   |   |   | 1,754,160 |   |   |
| Oct 1, 2005 through  Dec. 31, 2005  |       |       | —     |                                             |       |                                         | —     |                                                                                                                                 |       |                                                                                                                                 | —     |   |   |   | 1,754,160 |   |   |
| Total                                         |       |       | 201,516    |                                             |       |                                         | $          | 1.22                                                                                                                                 |       |                                                                                                                                 |       | 201,516 |   |   |   | $ | 1,754,160 |   |   |

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(1)          Pursuantto a Plan publicly announced on August 25, 2004 and extended in July,2005, in accordance with Rule 10b5-1 of the Securities Exchange Actof 1934 to provide for the repurchase of up to $2 million of the Company’scommon stock. Repurchases were made from time to time in the open market duringthe twelve-month period ended July 31, 2006, at prevailing market prices.Repurchases were made under the program using the Company’s own cash resources.As of December 31, 2005, we had 22,977,301 shares of common stockoutstanding and 201,516 were repurchased in 2005 under this program. Norepurchases were made during 2006.

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***Use of Proceeds***

In December 2006, wereceived net proceeds of $24.1 million from the public offering of 5,750,000 shares of our common stock wesold. The net proceeds will be used for corporate and joint venture capacityexpansion, research and development, working capital requirements, andpotential acquisitions of complementary products, technologies or businesses.

***Comparison of Stockholder Return***

Setforth below is a line graph comparing the annual percentage change in thecumulative total return to the stockholders of the Company on our common stockwith the CRSP Total Return Index for the Nasdaq Stock Market (U.S. Companies)and the Nasdaq Electronic Components Index for the period commencing December 31,2001, and ending December 31, 2006.

**COMPARISON OF 5 YEAR CUMULATIVETOTAL RETURN*Among AXT, Inc., The NASDAQ Composite IndexAnd The NASDAQ Electronic Components Index**

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*                    $100 investedon 12/31/01 in stock or index-including reinvestment of dividends. Fiscal yearending December 31.

Other consolidatedfinancial statements and supplementary data required by this item are set forthat the pages indicated at Item 15(a).

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**Item 6.**                        *Selected Consolidated Financial Data*

Thefollowing selected consolidated financial data is derived from and should beread in conjunction with our consolidated financial statements and relatednotes set forth in Item 8 below, and in our previously filed reports on Form 10-K.See also Item 7. “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” for further information relating to items reflectingour results of operations and financial condition.

| ** **                                                                   | ** ** | **Years Ended December 31,**                        | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                   | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statements of Operations**                                                 | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                                      |       | $                                                                  | 44,445     |   | $ | 26,536 |   | $ | 35,454 |   | $ | 34,713 |   | $ | 44,865 |   |
| Cost of revenue                                                              |       | 31,709                                                             |       | 24,337 |   | 35,705 |   | 32,478 |   | 53,758 |   |
| Gross profit  (loss)                                                         |       | 12,736                                                             |       | 2,199 |   | (251 | ) | 2,235 |   | (8,893 | ) |
| Operating expenses:                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Selling, general, and administrative                                         |       | 12,650                                                             |       | 12,955 |   | 11,561 |   | 10,475 |   | 13,860 |   |
| Research and development                                                     |       | 2,351                                                              |       | 1,723 |   | 1,479 |   | 1,337 |   | 2,339 |   |
| Impairment charges                                                           |       | 1,417                                                              |       | — |   | 210 |   | — |   | 14,632 |   |
| Restructuring charge (benefit)                                               |       | (2                                                                 | )          | 836 |   | 1,308 |   | — |   | — |   |
| Total operating expenses                                                     |       | 16,416                                                             |       | 15,514 |   | 14,558 |   | 11,812 |   | 30,831 |   |
| Loss from  continuing operations                                             |       | (3,680                                                             | )          | (13,315 | ) | (14,809 | ) | (9,577 | ) | (39,724 | ) |
| Interest income,  net                                                        |       | 443                                                                |       | 516 |   | 262 |   | 172 |   | 2,746 |   |
| Other income  (expense), net                                                 |       | 2,709                                                              |       | (910 | ) | 94 |   | (1,688 | ) | (15,886 | ) |
| Loss from  continuing operations before provision (benefit) for income taxes |       | (528                                                               | )          | (13,709 | ) | (14,453 | ) | (11,093 | ) | (52,864 | ) |
| Provision  (benefit) for income taxes                                        |       | (1,454                                                             | )          | (950 | ) | 71 |   | — |   | 2,119 |   |
| Income (loss)  from continuing operations                                    |       | 926                                                                |       | (12,759 | ) | (14,524 | ) | (11,093 | ) | (54,983 | ) |
| Discontinued operations:                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Gain (loss) from discontinued operations, net of tax                         |       | 18                                                                 |       | (59 | ) | 472 |   | (6,163 | ) | (34,625 | ) |
| Gain (loss) from disposal, net of tax                                        |       | —                                                             |       | 603 |   | 419 |   | (9,475 | ) | — |   |
| Benefit for income taxes                                                     |       | —                                                             |       | — |   | — |   | — |   | (8,427 | ) |
| Gain (loss) from  discontinued operations                                    |       | 18                                                                 |       | 544 |   | 891 |   | (15,638 | ) | (26,198 | ) |
| Net income (loss)                                                            |       | $                                                                  | 944        |   | $ | (12,215 | ) | $ | (13,633 | ) | $ | (26,731 | ) | $ | (81,181 | ) |
| Basic income (loss) per  share:                                              |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations                                     |       | $                                                                  | 0.03       |   | $ | (0.56 | ) | $ | (0.64 | ) | $ | (0.49 | ) | $ | (2.46 | ) |
| Gain (loss) from discontinued operations, net of tax                         |       | —                                                             |       | 0.02 |   | 0.04 |   | (0.69 | ) | (1.17 | ) |
| Net loss                                                                     |       | $                                                                  | 0.03       |   | $ | (0.54 | ) | $ | (0.60 | ) | $ | (1.18 | ) | $ | (3.63 | ) |
| Diluted income (loss)  per share:                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations                                     |       | $                                                                  | 0.03       |   | $ | (0.56 | ) | $ | (0.64 | ) | $ | (0.49 | ) | $ | (2.46 | ) |
| Gain (loss) from discontinued operations, net of tax                         |       | —                                                             |       | 0.02 |   | 0.04 |   | (0.69 | ) | (1.17 | ) |
| Net income (loss)                                                            |       | $                                                                  | 0.03       |   | $ | (0.54 | ) | $ | (0.60 | ) | $ | (1.18 | ) | $ | (3.63 | ) |
| Shares used in per share  calculations:                                      |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                        |       | 23,303                                                             |       | 23,047 |   | 23,063 |   | 22,781 |   | 22,433 |   |
| Diluted                                                                      |       | 24,600                                                             |       | 23,047 |   | 23,063 |   | 22,781 |   | 22,433 |   |

 

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| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                     | ** ** |
| **Balance  Sheet Data:**                         | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                       |       | $                                           | 16,116     |   | $ | 17,472 |   | $ | 12,117 |   | $ | 24,339 |   | $ | 13,797 |   |
| Short-term  investments                          |       | 19,428                                      |       | 5,555 |   | 20,062 |   | 14,669 |   | 8,205 |   |
| Working capital                                  |       | 66,359                                      |       | 36,347 |   | 46,141 |   | 57,335 |   | 65,375 |   |
| Restricted  deposits                             |       | 7,150                                       |       | 7,450 |   | 8,215 |   | 9,302 |   | 11,150 |   |
| Long-term  investments                           |       | —                                      |       | — |   | — |   | — |   | 3,657 |   |
| Total assets                                     |       | 98,332                                      |       | 74,798 |   | 87,540 |   | 107,023 |   | 145,667 |   |
| Long-term capital  lease, net of current portion |       | —                                      |       | — |   | — |   | — |   | 4,847 |   |
| Long-term debt,  net of current portion          |       | 6,839                                       |       | 7,420 |   | 7,880 |   | 8,842 |   | 13,289 |   |
| Stockholders’ equity                        |       | 81,200                                      |       | 55,618 |   | 68,017 |   | 82,298 |   | 105,657 |   |
|                                                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

All periods have beenrestated to reflect the accounting for discontinued operations. As a result,the discontinued opto-electronics and consumer products divisions have beeneliminated from continuing operations in the statements of operations.

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**Item 7.****         *Management’sDiscussion and Analysis of Financial Condition and Results of Operations***

In addition to historicalinformation, the following discussion contains forward-looking statements thatare subject to risks and uncertainties. Actual results may differ substantiallyfrom those referred to herein due to a number of factors, including but notlimited to risks described in the section entitled Item 1A. “Risk Factors”and elsewhere in this Annual Report. This discussion should be read inconjunction with Item 6. *“*Selected Consolidated Financial Data*”* and our consolidated financialstatements and related notes included elsewhere in this Form 10-K.

**Critical AccountingPolicies and Estimates**

We prepare our consolidated financial statements inaccordance with accounting principles generally accepted in the United Statesof America. Accordingly, we make estimates, assumptions and judgments thataffect the amounts reported on our consolidated financial statements. Theseestimates, assumptions and judgments about future events and their effects onour results cannot be determined with certainty, and are made based upon ourhistorical experience and on other assumptions that are believed to bereasonable under the circumstances. These estimates may change as new eventsoccur or additional information is obtained, and we may periodically be facedwith uncertainties, the outcomes of which are not within our control and maynot be known for a prolonged period of time.

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 consolidated financialstatements and requires us to make difficult, subjective or complex judgmentsthat could have a material impact on our consolidated financial statements.Different estimates that we could have used, or changes in the estimates thatare reasonably likely to occur, may have a material impact on our financialcondition or results of operations. We also refer you to our “The Company andSummary of Significant Accounting Policies” discussed in the accompanying notesto our consolidated financial statements included elsewhere in this Form 10-K.

***Revenue Recognition***

We manufacture and sell high-performance compoundsemiconductor substrates and sell certain raw materials including gallium,germanium dioxide, and pBN crucibles. After we ship our products, there are noremaining obligations or customer acceptance requirements that would precluderevenue recognition. Our products are typically sold pursuant to a purchaseorder placed by our customers, and our terms and conditions of sale do notrequire customer acceptance. We recognize revenue upon shipment and transfer oftitle of products to our customers, which is either upon shipment from ourdock, receipt at the customer’s dock, or removal from consignment inventory atthe customer’s location, provided that we have received a signed purchaseorder, the price is fixed or determinable, title and risk of ownership havetransferred, collection of resulting receivables is probable, and productreturns are reasonably estimable. We do not provide training, installation orcommissioning services. Additionally, we do not provide discounts or otherincentives to customers except for one customer with whom we agreed in thefourth quarter of 2004 to provide a certain amount of cumulative discountson future product purchases from us. We recognize these discounts as areduction in revenue as products are sold to this customer.

We provide for futurereturns based on historical experience, current economic trends and changes incustomer demand at the time revenue is recognized. In the first quarter of2004, we recorded a reserve for sales returns of $0.7 million related to ourfailure to follow certain testing requirements and provision of testing dataand information to certain customers. This reserve was based on discussionswith some of the affected customers and review of specific shipments. As of December 31,2006, this reserve was zero since approximately $0.5 million had been utilizedand approximately $0.2 million had been reversed to revenue as we favorablyresolved an outstanding matter with a customer.

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***Allowance for Doubtful Accounts***

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

From our allowance for doubtful accounts of $4.0million at December 31, 2003, we wrote off $3.5 million of fully reservedaccounts receivable resulting in the allowance for doubtful accounts of $0.5million at December 31, 2004. From our allowance for doubtful accounts of$0.5 million at December 31, 2004, we wrote off $0.1 million of fullyreserved accounts receivable for a Korean customer and decreased the allowanceby $0.3 million due to improved collections mainly from a Japanese customer,while increasing the allowance for a large customer in China of $0.4 million,resulting in the allowance for doubtful accounts of $0.5 million at December 31,2005. During 2006, we increased our collection efforts and collected the entireamount from this large customer in China requiring us to reverse this $0.4million allowance resulting in the allowance for doubtful accounts of $0.1million at December 31, 2006. As of December 31, 2006, our accountsreceivable balance was $9.7 million, which was net of an allowance for doubtfulaccounts of $0.1 million. As of December 31, 2005, our accounts receivablebalance was $5.2 million, which was net of an allowance for doubtful accountsof $0.5 million. If actual uncollectible accounts differ substantially from ourestimates, revisions to the estimated allowance for doubtful accounts would berequired, which could have a material impact on our financial results for the period.

The allowance for salesreturns is also deducted from gross accounts receivable. From our allowance forsales returns of $0.5 million as of December 31, 2003, we increased thereserve for sales returns resulting in the allowance for sales returns of $0.6million as of December 31, 2004. From our allowance for sales returns of$0.6 million as of December 31, 2004, we utilized $0.5 million forinvestigation related returns, resulting in the allowance for sales returns of$0.1 million as of December 31, 2005. During 2006, the allowance for salesreturns remained at approximately $0.1 million. The total allowances deductedfrom gross accounts receivable as of December 31, 2006 is $0.1 million,compared to $0.6 million as of December 31, 2005.

***Warranty Reserve***

We maintain a warrantyreserve based upon our claims experience during the prior twelve months.Warranty costs are accrued at the time revenue is recognized. As of December 31,2006 and 2005, accrued product warranties totaled $0.5 million and $0.1 million,respectively. If actual warranty costs differ substantially from our estimates,revisions to the estimated warranty liability would be required, which couldhave a material impact on our financial condition and results of operations.

***Inventory Valuation***

Inventories are stated atthe lower of cost or market. Cost is determined using the weighted average costmethod. Our inventory consists of raw materials as well as finished goods andwork-in-process that include material, labor and manufacturing overhead costs.Given the nature of our substrate products, and the materials used in themanufacturing process, the wafers and ingots comprising work-in-process may beheld in inventory for up to two years and three years, respectively, as therisk of obsolescence for these materials is low. We routinely evaluate thelevels of our inventory in light of current market conditions in order toidentify excess and obsolete inventory and provide a valuation allowance forcertain inventories based upon the age and quality of the product and theprojections for sale of the completed products. If actual demand for ourproducts were to be substantially lower than estimated, additional inventory 

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adjustmentsfor excess or obsolete inventory might be required, which could have a materialimpact on our business, financial condition and results of operations.

***Impairment of Investments***

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

We invest in equityinstruments of privately-held companies for business and strategic purposes.These investments are classified as other assets and are accounted for underthe cost method as we do not have the ability to exercise significant influenceover their operations. We monitor our investments for impairment and recordreductions in carrying value when events or changes in circumstances indicatethat the carrying value may not be recoverable. Determination of impairment ishighly subjective and is based on a number of factors, including an assessmentof the strength of investee’s management, the length of time and extent towhich the fair value has been less than our cost basis, the financial conditionand near-term prospects of the investee, fundamental changes to the businessprospects of the investee, share prices of subsequent offerings, and our intentand ability to hold the investment for a period of time sufficient to allow forany anticipated recovery in our carrying value. In the third quarter of 2004,we recorded an impairment charge of $0.2 million to write down the value of ourinvestment in a private company. We made the decision to write down theinvestment as a result of the declining financial position of the investee,evidenced by an audit opinion with a going concern explanatory paragraphreceived by the investee. The $0.2 million was the remaining balance of thisinvestment. No further write-downs were recorded in 2006 or 2005.

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

We evaluate therecoverability of property, plant and equipment, and intangible assets inaccordance with SFAS No. 144, *“Accountingfor the Impairment or Disposal of Long-Lived Assets.”* When eventsand circumstances indicate that long-lived assets may be impaired, we comparethe carrying value of the long-lived assets to the projection of futureundiscounted cash flows attributable to such assets. In the event that thecarrying value exceeds the future undiscounted cash flows, we record animpairment charge against income equal to the excess of the carrying value overthe asset’s fair value. Fair value is generally determined by calculating thediscounted future cash flows using a discount rate based upon our weightedaverage cost of capital, and specific appraisal in certain instances.Significant judgments and assumptions are required in the forecast of futureoperating results used in the preparation of the estimated future cash flows,including long-term forecasts of the amounts and timing of overall marketgrowth and our percentage of that market, groupings of assets, discount rateand terminal growth rates. Changes in these estimates could have a materialadverse effect on the assessment of long-lived assets, thereby requiring us towrite down the assets. In the third quarter of 2006, we incurred an impairmentcharge of $1.4 million to write down our U.S. property in Fremont, California,which has been decontaminated and is being prepared for sale. This property hasbeen classified as “Assets held for sale” in the amount of $4.7 million on theconsolidated balance sheet as of December 31, 2006.

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***Stock Based Compensation***

We grant options to substantially all managementemployees and believe that this program helps us to attract, motivate andretain high quality employees, to the ultimate benefit of our stockholders.Effective January 1, 2006, we adopted the provisions ofSFAS No. 123 (revised 2004), “Share-Based Payment,”(“SFAS No. 123(R)”) using the modified prospective transition method.Under this transition method, stock compensation expense for fiscal 2006includes compensation expense for all stock-based compensation awards grantedprior to, but not yet vested as of January 1, 2006, based on the grantdate fair value estimated in accordance with the original provision ofSFAS No. 123,”Accounting for Stock-Based Compensation” (“SFAS No. 123”).Stock compensation expense for all stock-based compensation awards grantedafter January 1, 2006 is based on the grant-date fair value estimated inaccordance with the provisions of SFAS No. 123(R). We recognize thesecompensation costs net of an estimated forfeiture rate over the requisiteservice period of the award, which is generally the vesting term of four yearsfor stock options.

In March 2005, the SEC issued Staff AccountingBulletin No. 107 (“SAB 107”) regarding the SEC’s interpretationof SFAS No. 123(R) and the valuation of share-based payments forpublic companies. We have applied the provisions of SAB 107 in theadoption of SFAS No. 123(R). Stock compensation expense recorded incost of revenue, research and development, and selling, general andadministrative expenses is the amortization of the fair value of share-basedpayments made to employees and members of our board of directors, primarily inthe form of stock options as we adopted the provision ofSFAS No. 123(R) on January 1, 2006 (see Note 1—Summaryof Significant Accounting Policies—Stock-Based Compensation). All of our stockcompensation is accounted for as an equity instrument.

We account for stock compensation costs in accordancewith SFAS No. 123(R)and apply the provisions of SAB 107. Weutilize the Black-Scholes option pricing model to estimate the grant date fairvalue of employee stock compensation awards, which requires the input of highlysubjective assumptions, including expected volatility and expected life.Historical and implied volatility were used in estimating the fair value of ourstock compensation awards, while the expected life for our options wasestimated based on historical trends. Further, as required under SFAS No. 123(R),we now estimate forfeitures for stock compensation awards that are not expectedto vest. Changes in these inputs and assumptions can materially affect themeasure of estimated fair value of our stock compensation. We charge theestimated fair value to earnings on a straight-line basis over the vestingperiod of the underlying awards, which is generally four years for our stockoption awards.

The Black-Scholes option pricing model was developedfor use in estimating the fair value of traded options that have no vestingrestrictions and are fully transferable. As our stock option awards havecharacteristics that differ significantly from traded options, and as changesin the subjective assumptions can materially affect the estimated value, ourestimate of fair value may not accurately represent the value assigned by athird party in an arms-length transaction. There currently is no market-basedmechanism to verify the reliability and accuracy of the estimates derived fromthe Black-Scholes option pricing model or other allowable valuation models, noris there a means to compare and adjust the estimates to actual values. Whileour estimate of fair value and the associated charge to earnings materiallyaffects our results of operations, it has no impact on our cash position.

The guidance in SFAS No. 123(R) andSAB 107 is relatively new and the application of these principles may besubject to further interpretation and guidance. There are significantvariations among allowable valuation models, and there is a possibility that wemay adopt a different valuation model or refine the inputs and assumptionsunder our current valuation model in the future resulting in a lack ofconsistency in future periods. Our current or future valuation model and theinputs and assumptions we make may also lack comparability to other companiesthat use different models, inputs, or assumptions, and the resultingdifferences in comparability could be material.

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Prior to the adoption of SFAS No. 123(R), wemeasured compensation expense for stock compensation made to our employee andmembers of our board of directors, primarily in the form of stock options andpurchases under the employee stock purchase plan, using the intrinsic valuemethod provided by Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees”. We applied the disclosure provisions ofSFAS No. 123, as amended by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosures” as if the fair-value-basedmethod had been applied in measuring compensation expense. We recorded employeestock compensation expense prior to fiscal 2006 for options granted toemployees with an exercise price less than the market value of the underlyingcommon stock on the date of grant.

On November 10, 2005,the Financial Accounting Standards Board (FASB) issued FASB Staff AccountingPosition No. FAS 123 (R)-3 “*TransitionElectionRelated to Accounting for Tax Effects of Share-Based Payment Awards.”*Wehave elected to adopt the alternative transition method provided in the FASBStaff Position for calculating the tax effects of stock-based compensationpursuant to SFAS No. 123(R). The alternative transition method includessimplified methods to establish the beginning balance of the additional paid-incapital pool (“APIC pool”) related to the tax effects of employee stock-basedcompensation, and to determine the subsequent impact on the APIC pool andconsolidated statements of cash flows of the tax effects of the employeestock-based compensation awards that are outstanding upon adoption of SFAS No. 123(R).

***Income Taxes***

We account for income taxes in accordance withSFAS No. 109 (SFAS 109), *“Accountingfor Income Taxes,”* which requires that deferred tax assets andliabilities be recognized using enacted tax rates for the effect of temporarydifferences between the book and tax bases of recorded assets and liabilities.SFAS 109 also requires that deferred tax assets be reduced by a valuationallowance if it is more likely than not that a portion of the deferred taxasset will not be realized.

We provide for incometaxes based upon the geographic composition of worldwide earnings and taxregulations governing each region, particularly China. The calculation of taxliabilities involves significant judgment in estimating the impact ofuncertainties in the application of complex tax laws, particularly in foreigncountries such as China.

**Results ofOperations**

***Overview***

We were founded in 1986 tocommercialize and enhance our proprietary vertical gradient freeze (VGF)technique for producing high-performance compound semiconductor substrates. Wehave one operating segment: our substrate business, with limited additional rawmaterials sales. We recorded our first substrate sales in 1990 and oursubstrate division currently sells gallium arsenide (GaAs) and indium phosphide(InP) substrates to manufacturers of semiconductor devices for use inapplications 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 had 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 toqualify our germanium substrates with the few existing satellite solar cellsystem manufacturers.

***Continuing Operations***

Our sales of substrate products is dependant on thesemiconductor industry, which is highly cyclical and has historicallyexperienced downturns both as a result of economic changes and overcapacity.

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In March 2004, we learned of certain failures tocomply with requirements for product testing and the provision of testing dataand information relating to requirements of certain customers. Specifically, wedetermined that in some cases we had not provided accurate data to customersconfirming that products shipped were compliant with all specificationsprovided by the customer, or had been manufactured at the location specified bythe customer. As a result of our conclusions, we reorganized our production andquality control procedures, established quality control and assurance as adirect reporting group to the chief executive officer, and implementedmeasures, including additional employee training, statistical sampling ofproduct shipments during the quarter, and review of our satisfaction ofcustomer specifications each quarter, to ensure adherence to operationalcontrols. We also implemented certain executive management changes.

As a result of the weaknesses identified, in the firstquarter of 2004 we increased our sales return reserve by $0.7 million,based on our best estimate of future returns related to this matter.Approximately $0.5 million of the $0.7 million sales returns reservehad been utilized and approximately $0.2 million has been reversed torevenue as of December 31, 2005 as we favorably resolved an outstandingmatter with a customer. This reserve was based, in part, on discussion withaffected customers. The amount of the reserve was determined in part based uponthe amount of our historical product returns, payment history of prior periodreceivables, discussions with customers concerning the non-compliant productand testing data, and estimated levels of our product maintained by customers,and likelihood that products previously shipped would be returned to us.

During the second quarter of 2004, we announced plansto cease all production activities in the United States and to manufacture ourproducts only in China.

In 2005, we made a number of important changes to ourmanagement team. Philip C.S. Yin, Ph.D., joined the company in March 2005as chief executive officer and restructured the organization from the top down.In June 2005, two new positions were created: chief operating officer andchief technology officer. Also, the former president of AXT’s China operationsbecame president of joint venture operations. In September 2005, our newvice president of global sales and marketing joined the company. This newstructure enabled us to maximize the expertise and skill sets of our team whileplacing enhanced emphasis on manufacturing, production and quality, and qualitysystems improvement.

With the new management team in place, quality,quality systems and revenue began to improve beginning the third quarter of2005. In December 2005, we continued to execute our workforce reduction inour Fremont, California facility and accordingly we eliminated approximately 15positions in California. See further discussion under “Restructuring Charges”below.

During 2006 we sold all ofour shares of common stock of Finisar Corporation generating net proceeds of$4.4 million and recording a gain of $3.3 million. In December 2006,we received net proceeds of $24.1 million from the public offering of 5,750,000 shares of our common stock. During thefourth quarter of 2006 we completed an increase in our production capacity for 6inch diameter GaAs substrates by fifty percent and are currently in the processof an additional forty percent increase by the middle of 2007.

***Discontinued Opto-Electronics Business***

In June 2003, we announced the discontinuation ofour opto-electronics division, which we had established as part of ouracquisition of Lyte Optronics, Inc. in May 1999. The discontinuedopto-electronics division manufactured blue, cyan, and greenhigh-brightness light emitting diodes (HBLEDs) for the illumination markets,including full-color displays, wireless handset backlighting and trafficsignals, and also manufactured vertical cavity surface emitting lasers (VCSELs)and laser diodes for fiber optic communications and storage area networks.Accordingly, the results of operations of the opto-electronics divisionhave been segregated from continuing operations and are reported separately as 

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discontinued operations inour consolidated statements of operations for all periods presented. See Note 2to our consolidated financial statements for details regarding the accountingfor discontinued operations.

In September 2003, we completed the sale ofsubstantially all of the assets of our opto-electronics business to LumeiOptoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group,Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. Aportion of the purchase price equal to $1.0 million was held in escrow tosatisfy any claims that the purchasers might make for breaches ofrepresentations or warranties by us. Of this total escrow, $0.8 millioncould be released after the one year anniversary of the sale of theopto-electronics business and the remainder could be released after the secondanniversary of the sale. To date, we have resolved all claims made against the$1.0 million that was held in escrow. For the year ended December 31,2005 we recorded $0.6 million gains from escrow, $0.1 million inproperty tax refunds and interest.

In June 2005, wecompleted the sale of a building located in Monterey Park, California. Thisasset had been classified as “assets held for sale” in the amount of $1.25 millionon the consolidated balance sheet as of December 31, 2004. We received netproceeds on the sale of the property of approximately $1.3 million andaccordingly recorded a gain on disposal of approximately $0.1 million.

***Revenue***

| ** **                     | ** ** | ** **                             | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|--------------------------------|------------|----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                     | ** ** | **Year Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| **($ in thousands)** | ** ** | ** **                             | ** ** | **2006**     | ** ** | **2005**   | ** ** | **2004**                   | ** ** | **(Decrease)**             | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| GaAs                           |       | $                                      | 36,511     |         | $          | 20,831     |       | $                          | 27,272     |                       |       | $ | 15,680 |   |   |   | 75.3 | % |   |   | $ | (6,441 | ) |   |   | (23.6 | )% |   |
| InP                            |       | 1,705                                  |       | 906          |       | 1,588      |       |                       | 799        |                       |       |   | 88.2 |   |   |   | (682 | ) |   |   | (42.9 | ) |   |
| Ge                             |       | 909                                    |       | 42           |       | 100        |       |                       | 867        |                       |       |   | 2,064.3 |   |   |   | (58 | ) |   |   | (58.0 | ) |   |
| Raw Materials                  |       | 5,293                                  |       | 4,752        |       | 6,399      |       |                       | 541        |                       |       |   | 11.4 |   |   |   | (1,647 | ) |   |   | (25.7 | ) |   |
| Other                          |       | 27                                     |       | 5            |       | 95         |       |                       | 22         |                       |       |   | 440.0 |   |   |   | (90 | ) |   |   | (94.7 | ) |   |
| Total revenue                  |       | $                                      | 44,445     |         | $          | 26,536     |       | $                          | 35,454     |                       |       | $ | 17,909 |   |   |   | 67.5 | % |   |   | $ | (8,918 | ) |   |   | (25.2 | )% |   |
|                                |            |                                        |            |              |            |            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenue increased $17.9 million or 67.5%, to$44.4 million in 2006 from $26.5 million in 2005. Total GaAssubstrate revenue increased $15.7 million, or 75.3%, to $36.5 millionin 2006 from $20.8 million in 2005. Sales of 5 inch and 6 inch diameterGaAs substrates were $16.7 million in 2006 compared with $4.8 millionin 2005. The increase in larger diameter substrate revenue was due to the factthat, while the GaAs device market grew in strength for both cellular and theWLAN (Wide Local Area Network) markets, the compound semiconductor industry hasbeen experiencing capacity constraints; with our excess capacity and ourability to increase capacity in a timely and cost efficient manner, we wereable to benefit from the overflow business from our competition.

Sales of 2 inch, 3 inch and 4 inch diameter GaAssubstrates were $19.7 million in 2006 compared with $15.9 million in2005. The increase in revenue from smaller diameter substrates was generallydue to the continued market growth of LED laser diodes and commercial epitaxy.

InP substrate revenue increased $0.8 million, or88.2%, to $1.7 million in 2006 from $0.9 million in 2005. Whileoverall demand for InP has increased over the past year, the higher thanexpected increase in InP substrate revenue was due to the receipt of one largecustomer order for a government contract, which is not expected to repeat.While we are beginning to see evidence of renewed growth in the opticalnetworking industry, which uses InP to manufacture telecom lasers and mayresult in growth in InP substrate sales, we have not yet seen a large movementin this direction.

Ge substrate revenue increased $0.9 million, or2,064.3%, to $0.9 million in 2006 from $42,000 in 2005. The increase in Gesubstrate revenue was due to an increase in customers in the PRC that have nowqualified our product, as demand for photovoltaic applications is strong in thePRC.

39

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Raw materials revenue increased $0.5 million, or11.4%, to $5.3 million in 2006 from $4.8 million in 2005. Theincrease in raw materials revenue was primarily due to sales of germaniumdioxide to a new customer, and increased sales of gallium to existingcustomers. The new customer for germanium dioxide is located in North America, andhas been purchasing consistently in 2006. We expect this trend to continue. Ourraw materials business is increasingly becoming an important part of ourbusiness, both in terms of providing us protection against raw materialspricing increases and supply constraints, and in opportunities for sales of rawmaterials. Accordingly, we expect to continue to expand our raw materials salesefforts and explore new and additional investment opportunities.

Revenue decreased $8.9 million or 25.2%, to $26.5 millionin 2005 from $35.5 million in 2004. Total GaAs substrate revenue decreased$6.4 million, or 23.6%, to $20.8 million in 2005 from $27.3 millionin 2004. Overall sales of smaller diameter GaAs substrates decreased $7.2 milliondue to the earlier quality issues, the continuing pricing pressures causingprices to decline, overall lower demand from our wireless application customersand a decline in orders from customers who were qualifying our China-grownproducts. On the other hand, sales of larger diameter GaAs substrates, whichwere used exclusively to manufacture electronic devices, increased $1.4 millioncompared to 2004 due to an increase in orders from customers who have qualifiedour China-grown products. InP substrate revenue decreased $0.7 million, or42.9%, to $0.9 million in 2005 from $1.6 million in 2004. InPsubstrates were used almost exclusively for telecommunications applications.The decrease in GaAs and InP substrate revenue was due to the pricing pressurescausing prices to decline and overall lesser demand from our telecommunicationsand wireless application customers. Raw material sales decreased $1.7 million,or 25.7%, to $4.8 million in 2005 from $6.4 million in 2004. Thedecrease in raw material sales was due to customers’ lower demand, particularlyfor raw gallium and germanium dioxide.

Only one customerrepresented greater than 10% revenue, totaling 12.8% for the year ended December 31,2006. Two customers represented greater than 10% of revenue, totaling 20.7% forthe year ended December 31, 2005, while no customer represented greaterthan 10% of revenue for the year ended December 31, 2004. Our top fivecustomers represented 40.0%, 37.5%, and 30.1% of revenue for the years ended December 31,2006, 2005, and 2004, respectively.

***Revenue byGeographic Region***

| ** **                                 | ** ** | ** **                              | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|--------------------------------------------|------------|-----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **                                 | ** ** | **2006**                                | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                 | ** ** | **($ in thousands)**          | ** ** |
| North America*                             |       | $                                       | 13,029     |         | $          | 5,168      |       | $                          | 7,514      |                       |       | $ | 7,861 |   |   |   | 152.1 | % |   |   | $ | (2,346 | ) |   |   | (31.2 | )% |   |
| *% of total revenue*                       | * *   | *29*                                    | *%*        | *19*         | *%*        | *21*       | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Europe                                     |       | 8,365                                   |       | 6,186        |       | 6,840      |       |                       | 2,179      |                       |       |   | 35.2 |   |   |   | (654 | ) |   |   | (9.6 | ) |   |
| *% of total revenue*                       | * *   | *19*                                    | *%*        | *23*         | *%*        | *19*       | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Japan                                      |       | 3,347                                   |       | 2,854        |       | 5,156      |       |                       | 493        |                       |       |   | 17.3 |   |   |   | (2,302 | ) |   |   | (44.6 | ) |   |
| *% of total revenue*                       | * *   | *8*                                     | *%*        | *11*         | *%*        | *15*       | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Taiwan                                     |       | 7,647                                   |       | 3,843        |       | 8,397      |       |                       | 3,804      |                       |       |   | 99.0 |   |   |   | (4,554 | ) |   |   | (54.2 | ) |   |
| *% of total revenue*                       | * *   | *17*                                    | *%*        | *15*         | *%*        | *24*       | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Asia Pacific  (excluding Japan and Taiwan) |       | 12,057                                  |       | 8,485        |       | 7,547      |       |                       | 3,572      |                       |       |   | 42.1 |   |   |   | 938 |   |   |   | 12.4 |   |   |
| *% of total revenue*                       | * *   | *27*                                    | *%*        | *32*         | *%*        | *21*       | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total revenue                              |       | $                                       | 44,445     |         | $          | 26,536     |       | $                          | 35,454     |                       |       | $ | 17,909 |   |   |   | 67.5 | % |   |   | $ | (8,918 | ) |   |   | (25.2 | )% |   |

----

*                    Primarily theUnited States.

40

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Sales to customers outside of North America representedapproximately 71%, 81%, and 79% of our revenue during 2006, 2005 and 2004,respectively.

North America revenue increased by $7.9 million,or 152.1%, to $13.0 million in 2006 from $5.2 million in 2005. Webelieve our quality has improved as shown by customers that have qualified ourproducts manufactured in the PRC as sales to existing customers for largerdiameter wafers increased by $4.7 million, while sales to existingcustomers for smaller diameter wafers increased by $1.9 million. Rawmaterial sales increased by $1.3 million.

Revenue from customers in Europe increased by $2.2 million,or 35.2%, to $8.4 million in 2006 from $6.2 million in 2005. Thisincrease resulted from $1.9 million increased sales to customers inFrance, mainly in larger diameter wafers, $0.4 million increased sales tocustomers in Germany, mainly in smaller diameter wafers, partially offset by a$0.1 million decrease in sales to customers in Switzerland, mainly insmaller diameter wafers.

Japan revenue increased by $0.5 million, or17.3%, to $3.3 million in 2006 from $2.9 million in 2005. Increasedsales to existing customers accounted for $0.4 million, mainly in largerdiameter wafers, while sales to new customers accounted for $0.1 million.

Taiwan revenue increased by $3.8 million, or99.0%, to $7.7 million in 2006 from $3.8 million in 2005. Theincrease was due to sales to existing customers of $3.8 million mainly inlarge diameter wafers.

Asia Pacific (excluding Japan and Taiwan) revenueincreased by $3.6 million, or 42.1%, to $12.1 million in 2006 from$8.5 million in 2005. Of this increase, sales to customers in Malaysia andSingapore accounted for $2.1 million of the increase, mainly in largerdiameter wafers, while sales to customers in the PRC increased by $1.0 million,and sales to customers in Korea increased by $0.5 million.

Asia Pacific (excludingJapan and Taiwan) revenue increased to 32% of total revenue in 2005 comparedwith 21% of total revenue in 2004. The increase was primarily due to increasedsales of GaAs substrates to customers in China and Singapore, which productsare being used in opto-electronics applications. The Taiwan revenue decreasedby $4.6 million or 54.2%, to $3.8 million in 2005 from$8.4 million in 2004. The decrease in Taiwan and other geographic areasfor our GaAs substrates was due to continuing pricing pressures causing averagesales prices to decline, overall lower demand from our wireless applicationcustomers, and delays in orders from customers who had not yet qualified ourChina-grown products.

***Gross Margin***

| ** **           | ** ** | ** **                              | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|----------------------|------------|-----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **           | ** ** | **2006**                                | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**          | ** ** |
| Gross profit  (loss) |       | $                                       | 12,736     |         | $          | 2,199      |       | $                          | (251       | )                          |       | $ | 10,537 |   |   |   | 479.2 | % |   |   | $ | 2,450 |   |   |   | 976 | % |   |
| *Gross  Margin %*    | * *   | *28.7*                                  | *%*        | *8.3*        | *%*        | *(0.7*     | *)%*       |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                      |            |                                         |            |              |            |            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Gross margin increased to 28.7% of total revenue in2006 from 8.3% of total revenue in 2005. Gross margin in 2006 was positivelyimpacted by sales of approximately $2.9 million of GaAs wafers that werepreviously fully reserved, and by approximately $0.1 million as a resultof a reversal of a sales return reserve established in 2004 as we favorablyresolved an outstanding matter with a customer. In addition, we sold a greateramount of InP substrates and larger diameter GaAs wafers in 2006, whichcontributed higher gross margins. In December 2005, we reduced theworkforce at our Fremont, California facility to eliminate positions that we nolonger required to support production, and this reduction accounted forapproximately 1.5 percentage points to gross margin in 2006. In addition, wehad manufacturing equipment that became fully depreciated in 2006, and theabsence of depreciation expense for this 

41

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equipment contributedapproximately 1.5 percentage points to gross margin in 2006. Finally, highersubstrates gross margins were also achieved through better slicing techniques,longer length ingot growth, shorter runtimes, and higher production volumes,partially offset by higher prices of raw materials for gallium and arsenic.

Gross margin increased to8.3% of total revenue in 2005 from negative 0.7% of total revenue in 2004. In2004, our gross margin was negatively impacted by the following factors: (i) a$2.1 million charge for excess and obsolete inventory in the third quarterof 2004, (ii) an approximately $1.4 million charge incurred inconnection with our settlement of our patent dispute with Sumitomo ElectricIndustries, Ltd. in the third quarter of 2004, and (iii) the establishmentof a sales return reserve of $0.7 million in the first quarter of 2004related to our failure to follow certain testing requirements, which reducedrevenues without affecting costs of revenues. The improvement in gross marginin 2005 was due to the increased sales in the larger diameter wafers as demandincreased, and the sales of fully reserved wafers which accounted for revenueof approximately $2.1 million in 2005.

***Selling, Generaland Administrative Expenses***

| ** **                                   | ** ** | ** **                              | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                   | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **                                   | ** ** | **2006**                                | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                   | ** ** | **($ in thousands)**          | ** ** |
| Selling, general and administrative expenses |       | $                                       | 12,650     |         | $          | 12,955     |       | $                          | 11,561     |                       |       | $ | (305 | ) |   |   | (2.4 | )% |   |   | $ | 1,394 |   |   |   | 12.1 | % |   |
| *% of  total revenue*                        | * *   | *28.5*                                  | *%*        | *48.8*       | *%*        | *32.6*     | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                              |            |                                         |            |              |            |            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Selling, general and administrative expenses decreased$0.3 million to $12.7 million for 2006 compared to $13.0 millionfor 2005. The decrease was primarily due to decreases of $1.3 million fordecontamination expenses as we prepare our U.S. property in Fremont, Californiafor sale, $0.8 million for bad debt expenses as we collected on past dueaccounts and improved aging, $0.3 million for legal fees reimbursed by ourinsurance company for fees incurred in connection with ongoing litigation asdescribed in Note 18 of the consolidated financial statements, $0.2 millionfor legal and professional fees,and $0.1 million for recruiting fees,partially offset by increases of $0.5 million for compensation relatedpayments, $0.5 million for stock-based compensation expense, $0.4 millionfor consulting fees for compliance with the Sarbanes-Oxley Act of 2002, $0.3 millionfor customer compensation costs, $0.3 million for sales commissions andother miscellaneous expenses, $0.2 million for consulting fees forcorporate design and human resources, and $0.2 million  for joint venture labor related costs.

Selling, general and administrative expenses increased$1.4 million to $13.0 million for 2005 compared with $11.6 millionfor 2004. The increase in absolute dollars and as a percentage of revenue wasprimarily due to $2.0 million of decontamination expenses for our Fremont,California facilities, higher travel expenses of $0.3 million asoperations have moved resulting in more travel to China, higher recruitingexpenses of $0.1 million mainly in recruiting our new chief executiveofficer, partially offset by $0.6 million lower insurance costs asoperations have moved to China where rates are lower, $0.2 million indecreased Delaware franchise taxes, $0.1 million lower sales commissionsdue to lower sales and lower rates, and $0.1 million lower bad debtexpenses as collections and aging improved.

42

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***Research andDevelopment Expenses***

| ** **                         | ** ** | ** **                              | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|------------------------------------|------------|-----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                         | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **                         | ** ** | **2006**                                | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                         | ** ** | **($ in thousands)**          | ** ** |
| Research and  development expenses |       | $                                       | 2,351      |         | $          | 1,723      |       | $                          | 1,479      |                       |       | $ | 628 |   |   |   | 36.4 | % |   |   | $ | 244 |   |   |   | 16.5 | % |   |
| *% of  total revenue*              | * *   | *5.3*                                   | *%*        | *6.5*        | *%*        | *4.2*      | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                    |            |                                         |            |              |            |            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Research and development expenses increased $0.6 million,or 36.4%, to $2.4 million for 2006, from $1.7 million for 2005.During 2006, we incurred $0.4 million in severance payments to Dr. MorrisYoung, our chief technology officer who retired on December 31, 2006. Wealso incurred $0.2 million for stock-based compensation expense.

Research and development expenses increased $0.2 million,or 16.5%, to $1.7 million for 2005, from $1.5 million for 2004. Theincrease was due to the transition of Dr. Morris Young as our chieftechnology officer from his former position, and by severance payments toemployees that had been performing research and development activities.

We believe that continuedinvestment in product development is critical to attaining our strategicobjectives of maintaining and enhancing our technology leadership. As a result,we expect research and development expenses to remain at the levels of recentquarters, excluding severance payments.

***Impairment andRestructuring Charges***

| ** **                      | ** ** | ** **                              | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                      | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **                      | ** ** | **2006**                                | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                      | ** ** | **($ in thousands)**          | ** ** |
| Impairment charge               |       | $                                       | 1,417      |         | $          | —     |       | $                          | 210        |                       |       | $ | 1,417 |   |   |   | NM |   |   |   | $ | 210 |   |   |   | NM |   |   |
| *% of total revenue*            | * *   | *3.2*                                   | *%*        | *—*     | *%*        | *0.6*      | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Restructuring  charge (benefit) |       | $                                       | (2         | )            | $          | 836        |       | $                          | 1,308      |                       |       | $ | (838 | ) |   |   | (100.2 | )% |   |   | $ | (472 | ) |   |   | (36.1 | )% |   |
| *% of  total revenue*           | * *   | *0.0*                                   | *%*        | *3.2*        | *%*        | *3.7*      | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |

----

NM: percentage notmeaningful

***Impairment Charges***

In the third quarter of 2006, we incurred animpairment charge of $1.4 million to write down our U.S. property inFremont, California, which has been decontaminated and is being prepared forsale. This property has been classified as “Assets held for sale” in the amountof $4.7 million on the consolidated balance sheet as of December 31,2006.

In the third quarter of2004, we recorded an impairment charge of $0.2 million to write down thevalue of our investment in a private company. We made the decision to writedown the investment as a result of the declining financial position of theinvestee, evidenced by an audit opinion with a going concern explanatoryparagraph received by the investee. The $0.2 million was the remainingbalance of this investment. No further write-downs were recorded in 2006 or2005.

***Restructuring Charges***

In 2006, we recognized a $2,000 benefit related to anadjustment to a prior accrual.

43

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In March 2005, we announced that we would bereducing the workforce at our Beijing, China manufacturing facility byapproximately 100 positions or approximately 15%. This measure was taken aspart of our ongoing effort to reduce our cost structure and bring capacity inline with current market demand. Accordingly, we recorded a restructuringcharge of $56,000 in March 2005 relating to the reduction in work force,which we completed in June 2005. We saved approximately $0.3 million in payroll and relatedexpense relating to this reduction inforce.

In April 2005, we closed our Japan office as partof our ongoing effort to reduce our cost structure. Accordingly, we recorded restructuringcharges of $98,000 and $9,000, in the second and third quarters of 2005,respectively, relating to the closure of our Japan office. We savedapproximately $0.3 million in payroll and related expense.

In December 2005, we further reduced theworkforce at our Fremont, California facility by approximately 15positions that were longer required to support production and operations, orapproximately 29 percent. This measure was being taken as part of ourongoing effort to downsize our Fremont, California facilityheadcount. Accordingly, we recorded a restructuring charge of approximately$0.3 million in December 2005 related to the reduction in force forseverance-related expenses from the reduction in force, all of which will becash expenditures. The cash outflow from this charge was incurred over thefirst two quarters of 2006. We saved approximately $0.9 million annuallyin payroll and related expenses. Also in December 2005, we recorded anadditional restructuring charge of approximately $0.2 million, primarilyrelated to the final liquidation procedures of AXT’s Japan office so as to eliminatethe remaining assets. There was no further cash outflow from this charge.

Overall for the year ended December 31,2005, we recorded restructuring charges of $0.2 million relating tolease costs associatedwith facilities located in California that are no longer required to supportproduction. The remaining restructuring accrual for future lease paymentsrelated to abandoned U.S. facilities of $0.3 million was paid out through2006, and was included on the accompanying consolidated balance sheet as accruedrestructuring. Refer to Note 8 to our consolidated financial statements.

In 2004 in the secondquarter, we announced plans to cease all production activities in the UnitedStates and to manufacture our products only in China. In June 2004, weincurred a restructuring charge of $1.1 million as a result of ourdecision to close down our remaining manufacturing facilities in the UnitedStates. In the third and fourth quarter of 2004, we incurred additionalrestructuring charges of $0.2 million for a total of $1.3 million in2004. These charges comprised costs related to the reduction in work forceeffected in June 2004, and lease costs associated with the facilitieslocated in California that are no longer required to support production. Inaggregate, we eliminated 50 positions, 47 of which were production workers. Asof December 31, 2004, we saved approximately $0.6 million inannual payroll and related expenses.

***Interest Income,Net***

| ** **            | ** ** | ** **                              | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|-----------------------|------------|-----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **            | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **            | ** ** | **2006**                                | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**          | ** ** |
| Interest income,  net |       | $                                       | 443        | * *     | $          | 516        |       | $                          | 262        |                       |       | $ | (73 | ) |   |   | (14.1 | )% |   |   | $ | 254 |   |   |   | 96.9 | % |   |
| *% of  total revenue* | * *   | *1.0*                                   | *%*        | *1.9*        | *%*        | *0.7*      | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                       |            |                                         |            |              |            |            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest income, net decreased $0.1 million to$0.4 million for 2006 from $0.5 million for 2005 as a result ofhigher interest rates earned on our investments, partially offset by higherinterest rates on our debt, which we have continued to pay down. We also hadlower cash balances.

44

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Interest income, netincreased $0.3 million to $0.5 million for 2005 from $0.3 millionfor 2004 as a result of our lower debt levels as we continued to pay down ourdebt.

***Other Income and(Expense), Net***

| ** **                            | ** ** | ** **                              | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **                            | ** ** | **2006**                                | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **($ in thousands)**          | ** ** |
| Other income and  (expense), net |       | $                                       | 2,709      |         | $          | (910       | )          | $                          | 94         |                       |       | $ | 3,619 |   |   |   | 397.7 | % |   |   | $ | (1,004 | ) |   |   | (1,068.1 | )% |   |
| *% of  total revenue*                 | * *   | *6.1*                                   | *%*        | *(3.4*       | *)%*       | *0.3*      | *%*        |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                       |            |                                         |            |              |            |            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income and expense, net, was $2.7 millionin 2006 compared to other expense, net, of $0.9 million in 2005. Otherincome, net was $2.7 million for 2006 primarily due to a realized gain of$3.3 million on the sale of all of our shares of common stock of FinisarCorporation, partially offset by minority interests in our joint ventures.Other expense was $0.9 million for 2005 due to $0.7 million forminority interests in our joint ventures, and $0.2 million for foreignexchange losses primarily related to the Japanese yen.

Other expense was $0.9 million for 2005 comparedwith other income of $0.1 million for 2004. The $1.0 million changefrom other income to other expense was mainly due to $0.4 million increasein minority interest’s share in our joint ventures, $0.3 million increasein foreign exchange losses primarily related to the Japanese yen and to theChinese renminbi, $0.2 million other income in 2004 received from acustomer to terminate a supply guarantee contract, and $0.1 million losseson asset and marketable security disposals.

Minority interest inearnings of consolidated subsidiaries is included in other income and(expense), net and for the years ended December 31, 2006, 2005, and 2004were ($1.0 million) ($0.7 million), and ($0.3 million),respectively, as the consolidated subsidiaries’ profitability increased.

***Provision (benefit)for Income Taxes***

| ** **                            | ** ** | ** **                              | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **                            | ** ** | **2006**                                | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **($ in thousands)**          | ** ** |
| Provision  (benefit) for income taxes |       | $                                       | (1,454     | )            | $          | (950       | )          | $                          | 71         |                       |       | $ | (504 | ) |   |   | (53.1 | )% |   |   | $ | (1,021 | ) |   |   | (1,438 | )% |   |
| *% of  total revenue*                 | * *   | *3.3*                                   | *%*        | *3.6*        | *%*        | *(0.2*     | *)%*       |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                       |            |                                         |            |              |            |            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In 2005, the InternalRevenue Service closed its examination of our tax return for the 2002 tax year,including the calculation of our 1999 and 2000 net operating loss carry back.As a result, we reversed approximately $2.1 million and $1.1 millionof income tax payable accrued for potential exposures relating to 2006 and2005, respectively. These amounts are shown as benefits from income taxes in2006 and 2005. The other amounts in 2006 and 2005 relate to provisions forincome taxes related to our foreign subsidiaries. Provision for income taxesfor 2004 was $71,000, which was related to our foreign subsidiaries. Due to ourcontinuing operating losses and uncertainty regarding our future profitability,we recorded a full valuation allowance against our net deferred tax assets of $49.9 millionin 2006, and $50.9 million in 2005.

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***Gain or Loss fromDiscontinued Operations***

| ** **                                            | ** ** | ** **                                  | ** ** | ** **   | ** ** | ** ** | ** ** | **2005 to 2006** | ** ** | **2004 to 2005** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|--------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **Years Ended December 31,** | ** ** | **Increase** | ** ** | ** ** | ** ** | **Increase**               | ** ** | ** **                 | ** ** |
| ** **                                            | ** ** | **2006**                                    | ** ** | **2005**     | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **% Change**          | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                            | ** ** | **($ in thousands)**              | ** ** |
| Gain (loss) from  discontinued operations, net of tax |       |                                        | $          | 18           |       |       | $          | 544                        |       | $                          | 891        |   |   | $ | (526 | ) |   |   | (96.7 | )% |   |   | $ | (347 | ) |   |   | (38.9 | )% |   |
|                                                       |            |                                             |            |              |            |            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In 2006, we recorded $18,000 in interest income oncash balances held in discontinued operations.

In 2005, the $0.5 million gain from discontinuedoperations was made up of a gain of $0.6 million, which was the remainingportion of the first $0.8 million held in escrow due to us from the saleof our opto-electronics business, and partially offset by $0.1 million inexpenses for consulting fees, rent and tax payments.

In 2004, we realized a$0.4 million gain on discontinued opto-electronics operations as a resultof the partial release of escrow funds. Also in 2004, we entered into anagreement with a real estate developer for the purchase of our discontinuedopto-electronics’ property held for sale and realized a gain of $0.3 millionreflecting an adjustment to the realizable market value of the property. Theremaining gain of $0.2 million was a result of our reversal of accruedliabilities of general and administrative expenses no longer required.

**Liquidity and Capital Resources**

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                               | ** ** | **($ in thousands)**              | ** ** |
| Net cash provided  by (used in):                         |       |                                        |       |   |   |   |   |
| Operating activities                                     |       | $                                           | (10,263    | ) | $ | (7,746 | ) | $ | (340 | ) |
| Investing activities                                     |       | (15,809                                     | )          | 13,886 |   | (7,846 | ) |
| Financing activities                                     |       | 24,248                                      |       | (792 | ) | (4,216 | ) |
| Effect of  exchange rate changes                         |       | 468                                         |       | 7 |   | 180 |   |
| Net change in  cash and cash equivalents                 |       | (1,356                                      | )          | 5,355 |   | (12,222 | ) |
| Cash and cash  equivalents—beginning period         |       | 17,472                                      |       | 12,117 |   | 24,339 |   |
| Cash and cash  equivalents—end of period            |       | 16,116                                      |       | 17,472 |   | 12,117 |   |
| Short-term  investments—end of period               |       | 19,428                                      |       | 5,555 |   | 20,062 |   |
| Total cash, cash  equivalents and short-term investments |       | $                                           | 35,544     |   | $ | 23,027 |   | $ | 32,179 |   |

 

We consider cash and cash equivalents, and short-terminvestments as liquid and available for use. Short-term investments arecomprised of government bonds and high-grade commercial debt instruments. Alsohistorically included in short-term investments was our investment in commonstock of Finisar Corporation, a United States publicly-traded company. During2006 we sold all of our shares of common stock of Finisar Corporationgenerating net proceeds of $4.4 million and recording a gain of $3.3 million,which is included in other income and (expense). As of December 31, 2006,our principal sources of liquidity were $35.5 million in cash and cashequivalents and short-term investments, excluding restricted deposits.

Cash and cash equivalents and short-term investments,increased $14.9 million to $35.5 million as of December 31, 2006from $20.6 million as of December 31, 2005, excluding $2.4 millionfor our investment in Finisar common stock as of December 31, 2005. Thecombined increase in cash and cash equivalents and short-term investments wasprimarily due to the net proceeds of $24.1 million received from thepublic offering of 5,750,000shares of our common stock in December 2006,net proceeds of $4.4 million from the sale of all of our shares ofcommon stock of Finisar, partiallyoffset by the purchase of machinery and 

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equipment of $4.5 million,payments of long-term debt of $0.4 million, and the continual funding ofour operations.

Net cash used in operating activities of $10.3 millionfor 2006 was primarily comprised of our net income of $0.9 million,adjusted for non-cash items of depreciation of $2.6 million, an assetimpairment charge of $1.4 million, stock-based compensation of $0.8 million,and a loss on disposal of property, plant and equipment of $0.1 million,partially offset by a realized gain on sale of investments of $3.3 million,and by a net increase of $12.8 million in assets and liabilities. The netincrease in assets and liabilities of $12.8 million resulted from a $4.4 millionincrease in accounts receivable, net, a $4.1 million increase ininventories, net, a $2.2 million increase in prepaid expenses, primarilyfrom foreign taxes prepaid and prepayments to vendors, a $2.3 milliondecrease in income taxes payable, primarily from the reversal of approximately$2.1 million of income tax payable accrued for potential exposures thathave expired, a $0.6 million decrease in accrued liabilities, primarilyfor restructuring costs and decommissioning expenses, a $0.5 million increasein other assets, and partiallyoffset by a $0.7 million increase in accounts payable and a $0.6 millionincrease in other long-term liabilities, primarily minority interests. Accountsreceivable, net, increased by $4.4 million, or 84.8%, to $9.7 millionas of December 31, 2006 from $5.2 million as of December 31,2005. The increase was primarily a result of our increased sales, as well asdecreased accounts receivable allowances of $0.1 million as of December 31,2006 compared to $0.6 million as of December 31, 2005 reflectingcontinuous improvements in our collection efforts from customers. Our dayssales outstanding was 68 days as of December 31, 2006 compared to 62 daysas of December 31, 2005. Inventories, net, increased $4.1 million, or25.4% to $20.3 million as of December 31, 2006 from $16.2 millionas of December 31, 2005, as we increased inventory in raw materials, workin process and finished goods to increase production in anticipation ofincreased forecast sales.

Net cash used in operating activities increased $7.4 millionfrom $0.3 million in 2004 to $7.7 million in 2005, and was primarilycomprised of our net loss of $12.2 million, adjusted for non-cash items ofdepreciation of $3.7 million, restructuring charge $0.7 million,amortization of marketable securities $0.2 million, stock-basedcompensation of $0.2 million, a loss on disposal of property, plant andequipment of $0.3 million, and by a net increase of $0.6 million inassets and liabilities.

Net cash used in investing activities of $15.8 millionfor the year ended December 31, 2006 included net purchases of investmentsecurities totaling $11.8 million, net purchases of property and equipmentof $4.3 million, partially offset by a decrease in our restricted depositsof $0.3 million.

Net cash provided by investing activities of $13.9 millionfor the year ended December 31, 2005 included proceeds from the sale ofour Monterey Park, CA property of $1.3 million, net sales of high gradeinvestment securities totaling $14.1 million and a decrease in ourrestricted deposits of $0.8 million, partially offset by purchases ofproperty and equipment of $2.3 million.

We are currently expanding capacity at our Chinafacilities and we expect to invest up to approximately $4.9 million incapital expansion and other projects in 2007 related to our China facilities.We believe that the expansion will be sufficient to fulfill expected futureorders.

Net cash provided by financing activities of $24.2 millionfor the year ended December 31, 2006 consisted of $24.1 million netproceeds from the issuance of 5,750,000 shares of common stock as a result ofour December 2006 follow-on stock offering, $0.6 million from theproceeds from the exercise of employee stock options, partially offset bypayments of $0.4 million related to long-term borrowings.

Net cash used in financing activities of $0.8 millionfor the year ended December 31, 2005 consisted of payments of $0.7 millionrelated to long-term borrowings and $0.2 million for the repurchase of ourcommon stock under our 10b5-1 plan, and partially offset by $0.1 millionproceeds from the issuance of common stock under our employee stock purchaseplan.

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In December 2004, we reached a final settlementof our litigation with Sumitomo Electric Industries, Ltd. (SEI), which includesa global intellectual property cross-licensing agreement. We recorded a chargeof approximately $1.4 million in the quarter ended September 30, 2004in connection with this settlement. Under the terms of the settlement, we madea payment to SEI in the amount of Japanese Yen one hundred and forty-seven million(¥147,000,000) on January 4, 2005, and we will make on-going royaltypayments through 2012 on certain products sold by AXT in Japan. Subsequent tothat payment, SEI dropped the litigation in Japan and we abandoned theinterference proceedings in the U.S.

We believe that we haveadequate cash and investments to meet our needs over the next 12 months. If oursales decrease, however, our ability to generate cash from operations will beadversely affected which could adversely affect our future liquidity, requireus to use cash at a more rapid rate than expected, and require us to seekadditional capital. There can be no assurance that such additional capital willbe available or, if available it will be at terms acceptable to us. Cash fromoperations could be affected by various risks and uncertainties, including, butnot limited to those set forth below under Item 1A. “Risk Factors” above.

***Off-Balance Sheet Arrangements***

We have never entered into any off-balance sheetfinancing arrangements and have never established any special purpose entities.We have not entered into any options on non-financial assets.

We had entered into contracts to supply several largecustomers with GaAs wafers. The contracts guaranteed delivery of a certainnumber of wafers between January 1, 2001 and December 31, 2004. Thecontract sales prices were subject to review quarterly and could be adjusted inthe event that raw material prices changed. In the event of non-delivery of thedetermined wafer quantities in any monthly delivery period, we could be subjectto non-performance penalties of between 5% and 10% of the value of thedelinquent monthly deliveries. We have not received any claims fornon-performance penalties due to non-delivery. As of December 31, 2006, wehad met all of our current delivery obligations under these contracts and donot show any amount owing. Partial prepayments received for these supplycontracts totaling $125,000 was included in customer prepayments in theaccompanying consolidated balance sheet as of December 31, 2005.

We indemnify certaincustomers for attorney fees and damages and costs awarded against these partiesin certain circumstances if our products are found to infringe certain patentsand they are sued by the patent holder and awarded damages. There are limits onand exceptions to our potential liability for indemnification relating tointellectual patent infringement claims. We cannot estimate the amount ofpotential future payments, if any, that we might be required to make as aresult of these agreements. To date, we have not paid any claim or beenrequired to defend any action related to our indemnification obligations, andaccordingly, we have not accrued any amounts for such indemnificationobligations. However, we may record charges in the future as a result of theseindemnification obligations.

***Contractual Obligations***

As of December 31, 2006, the credit facilitymaintained by us with a bank included a letter of credit supporting repaymentof our industrial bonds with an outstanding amount of approximately $7.2 million.We have pledged and placed certain investment securities with an affiliate ofthe bank as additional collateral for this facility. We have also pledgedcertain investments for a credit facility for our workers compensationinsurance policy for portions of 2003. Accordingly, $7.2 million of ourcash and short-term investments are restricted.

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We lease certain office space, manufacturingfacilities and property under long-term operating leases expiring at variousdates through March 2013. On March 11, 2003, we completed the sale ofour property located at 4281 Technology Drive, Fremont, California, for $6.3 million.Net cash proceeds from the sale were $5.2 million. The gain incurred by uson this transaction was less than $15,000. Under the terms of the saleagreement, we have agreed to lease back the property for a ten-year period.Accordingly, on March 11, 2003, we signed an operating lease for thisproperty through March 2013. Total rent expense under these operatingleases were approximately $0.9 million, $1.3 million and $1.3 millionfor years ended December 31, 2006, 2005 and 2004, respectively.

Thefollowing table summarizes our contractual obligations as of December 31,2006 (in thousands):

| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **More than  5 years** | ** ** |
| Long-term debt                   |       | $                                         | 7,289      |   |   | $ | 450 |   |   | $ | 1,039 |   | $ | 900 |   |   | $ | 4,900 |   |   |
| Operating leases                 |       | 4,577                                     |       |   | 645 |   |   | 1,446 |   | 1,530 |   |   | 956 |   |   |
| Total                            |       | $                                         | 11,866     |   |   | $ | 1,095 |   |   | $ | 2,485 |   | $ | 2,430 |   |   | $ | 5,856 |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Selected Quarterly Results of Operations***

The following table setsforth unaudited quarterly results for the eight quarters endedDecember 31, 2005. We believe that all necessary adjustments, consistingonly of normal recurring adjustments, have been included in the amounts statedbelow to present fairly such quarterly information. The operating results forany quarter are not necessarily indicative of results for any subsequentperiod.

| ** **                                                                            | ** ** | **Quarters Ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                            | ** ** | **Dec. 31,  2006** | ** ** | **Sept. 30,  2006** | ** ** | **June 30,  2006** | ** ** | **Mar. 31,  2006** | ** ** | **Dec. 31,  2005** | ** ** | **Sept. 30,  2005** | ** ** | **June 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** |
| Revenue                                                                               |       | $                       | 13,072     |   | $ | 12,547 |   | $ | 10,355 |   | $ | 8,471 |   | $ | 7,717 |   | $ | 6,153 |   | $ | 6,032 |   | $ | 6,634 |   |
| Cost of revenue                                                                       |       | 8,084                   |       | 9,068 |   | 7,596 |   | 6,961 |   | 7,069 |   | 5,008 |   | 5,905 |   | 6,355 |   |
| Gross profit                                                                          |       | 4,988                   |       | 3,479 |   | 2,759 |   | 1,510 |   | 648 |   | 1,145 |   | 127 |   | 279 |   |
| Operating expenses:                                                                   |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative                                                   |       | 2,926                   |       | 2,641 |   | 3,853 |   | 3,230 |   | 3,089 |   | 2,898 |   | 2,716 |   | 4,252 |   |
| Research and development                                                              |       | 854                     |       | 392 |   | 571 |   | 534 |   | 466 |   | 472 |   | 423 |   | 362 |   |
| Impairment charge                                                                     |       | —                  |       | 1,417 |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Restructuring charge (benefit)                                                        |       | —                  |       | — |   | — |   | (2 | ) | 460 |   | 14 |   | 237 |   | 125 |   |
| Total operating expenses                                                              |       | 3,780                   |       | 4,450 |   | 4,424 |   | 3,762 |   | 4,015 |   | 3,384 |   | 3,376 |   | 4,739 |   |
| Income (loss)  from continuing operations                                             |       | 1,208                   |       | (971 | ) | (1,665 | ) | (2,252 | ) | (3,367 | ) | (2,239 | ) | (3,249 | ) | (4,460 | ) |
| Interest income,  net                                                                 |       | 101                     |       | 103 |   | 111 |   | 128 |   | 130 |   | 136 |   | 131 |   | 119 |   |
| Other income and  (expense), net                                                      |       | 1,016                   |       | 641 |   | 814 |   | 238 |   | 416 |   | 193 |   | 196 |   | 105 |   |
| Income (loss)  from continuing operations before provision (benefit) for income taxes |       | 2,325                   |       | (227 | ) | (740 | ) | (1,886 | ) | (3,653 | ) | (2,296 | ) | (3,314 | ) | (4,446 | ) |
| Provision  (benefit) for income taxes                                                 |       | (1,048                  | )          | (862 | ) | 138 |   | 318 |   | (1,048 | ) | 45 |   | 18 |   | 35 |   |
| Income (loss)  from continuing operations                                             |       | 3,373                   |       | 635 |   | (878 | ) | (2,204 | ) | (2,605 | ) | (2,341 | ) | (3,332 | ) | (4,481 | ) |
| Discontinued operations:                                                              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gain (loss) from discontinued operations, net of tax                                  |       | 11                      |       | 4 |   | 2 |   | 1 |   | (126 | ) | 9 |   | — |   | 58 |   |
| Gain from disposal, net of tax                                                        |       | —                  |       | — |   | — |   | — |   | — |   | 250 |   | 53 |   | 300 |   |
| Gain (loss) from discontinued operations, net of tax                                  |       | 11                      |       | 4 |   | 2 |   | 1 |   | (126 | ) | 259 |   | 53 |   | 358 |   |
| Net income (loss)                                                                     |       | $                       | 3,384      |   | $ | 639 |   | $ | (876 | ) | $ | (2,203 | ) | $ | (2,731 | ) | $ | (2,082 | ) | $ | (3,279 | ) | $ | (4,123 | ) |

 

***Recent Accounting Pronouncements***

In November 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 151, “*Inventory Costs—An Amendment of ARB No. 43,Chapter 4*” (“SFAS 151”). SFAS 151 amends the guidance in ARB No. 43,Chapter 4, “*Inventory Pricing*”, to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage). Among other provisions, the new rule requiresthat items such as idle facility expense, excessive spoilage, double freightand re-handling costs must be recognized as current-period charges regardlessof whether they meet the criterion of “so abnormal” as stated in ARB No. 43.Additionally, SFAS 151 requires that the allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities. The adoption of SFAS 151, effective January 1,2006, did not have a material impact on our consolidated financial position,results of operations or cash flows.

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In December 2004, the FASB issued SFAS No. 153,“*Exchanges of Non-monetary Assets—An Amendment ofAPB Opinion No. 29*” (“SFAS 153”). SFAS 153 eliminates theexception from fair value measurement for non-monetary exchanges of similarproductive assets in paragraph 21(b) of APB Opinion No. 29, “*Accounting for Non-monetary Transactions*,” and replaces itwith the exception for exchanges that do not have commercial substance. SFAS153 specifies that a non-monetary exchange has commercial substance if thefuture cash flows of the entity are expected to change significantly as aresult of the exchange. The adoption of SFAS 153, effective January 1,2006, did not have a material impact on our consolidated financial position,results of operations or cash flows.

In December 2004, the FASB issued SFAS No. 123(revised 2004), “*Share-Based Payment*,”(“SFAS 123(R)”). SFAS 123(R) requires that all share-based paymentsto employees, including grants of stock options, be recognized in the financialstatements based on their fair value. Refer to Note 1 of the notes toconsolidated financial statements for further discussion.

In May 2005, the FASB issued SFAS 154, “*Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20and FASB Statement No. 3*” (“SFAS 154”). SFAS 154 changes therequirements for the accounting for and reporting of a change in accountingprinciple, and applies to all voluntary changes in accounting principle. Italso applies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not include specific transitionprovisions. This statement requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. The adoption of SFAS 154, effective January 1, 2006,did not have a material impact on our consolidated financial position, resultsof operations or cash flows.

In November 2005, the FASB issued FASB StaffPosition FAS 115-1 and FAS 124-1, “*The Meaningof Other-Than-Temporary Impairment and Its Application to Certain Investments*”(“FSP FAS 115-1”), which provides guidance on determining wheninvestments in certain debt and equity securities are considered impaired,whether that impairment is other-than-temporary, and on measuring suchimpairment loss. FSP FAS 115-1 also includes accountingconsiderations subsequent to the recognition of an other-than temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments. The adoption of FSPFAS 115-1, effective January 1, 2006, did not have a material impacton our consolidated financial position, results of operations or cash flows.

In February 2006, the FASB issued SFAS No. 155,“*Accounting for Certain Hybrid Instruments—anamendment of FASB Statements No. 133 and 140*” (“SFAS 155”).SFAS 155 amends SFAS No. 133, “*Accounting for DerivativeInstruments and Hedging Activities*” (“SFAS 133”) and SFAS No. 140,“*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities*” (“SFAS 140”).SFAS 155 allows entities the option of applying fair value accounting tocertain hybrid financial instruments in their entirety if they contain embeddedderivatives that would otherwise require bifurcation under SFAS 133.SFAS 155 will be effective for us as of January 1, 2007. We arecurrently assessing the impact that the adoption of SFAS 155 may haveon our consolidated financial position, results of operations or cash flows.

In March 2006, the FASB issued SFAS No. 156,“*Accounting for Servicing of Financial Assets*”(SFAS 156”). This statement amends SFAS No. 140, “*Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities*”, (“SFAS 140”) with respect to the accounting forseparately recognized servicing assets and servicing liabilities. SFAS 156will be effective for us as of January 1, 2007. We are currently assessingthe impact that the adoption of SFAS 156 may have on our consolidatedfinancial position, results of operations or cash flows.

In June 2006, the FASB issued FASB Interpretation No. 48, “*Accounting For Uncertain Tax Positions—An Interpretation of FASBStatement No. 109”*(“FIN 48”). FIN 48 clarifies the accountingfor 

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uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with FASB Statement No. 109,“*Accounting for Income Taxes*”. Itprescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. FIN 48 also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition. FIN 48 is effective for fiscal years beginning after Decemeber 15,2006. We are currently assessing the impact that the adoption of FIN 48 mayhave on our consolidated financial position, results of operations or cashflows.

In June 2006, the FASB ratified the consensusreached by the Emerging Issues Task Force (“EITF”) on Issue No. 06-3,“*How Taxes Collected from Customers and Remitted toGovernmental Authorities Should Be Presented in the Income Statement (That Is,Gross versus Net Presentation)*”, (“ EITF 06-3”). EITF 06-3includes any tax assessed by a governmental authority that is directly imposedon a revenue-producing transaction between a seller and a customer and mayinclude, but is not limited to, sales, use, value added, and some excise taxes.EITF 06-3 concludes that the presentation of taxes on either a gross(included in revenues and costs) or a net (excluded from revenues) basis is anaccounting policy decision that should be disclosed. In addition, for any suchtaxes that are reported on a gross basis, a company should disclose the amountsof those taxes in interim and annual financial statements for each period forwhich an income statement is presented if those amounts are significant. Theprovisions of EITF 06-3 should be applied to financial reports forinterim and annual reporting periods beginning after December 15, 2006,with earlier adoption permitted. We are currently assessing the impact that theadoption of EITF 06-3 may have on our consolidated financialposition, results of operations or cash flows.

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

In September 2006, the FASB issued SFAS No. 158,“*Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans—an amendment of FASB Statements No. 87, 88,106, and 132(R)*” (“SFAS 158”). SFAS 158 requires balance sheet recognitionof the overfunded or underfunded status of pension and postretirement benefitplans. Under SFAS 158, actuarial gains and losses, prior service costs orcredits, and any remaining transition assets or obligations that have not beenrecognized under previous accounting standards must be recognized as acomponent of accumulated other comprehensive income (loss) within stockholders’equity, net of tax effects, until they are amortized as a component of netperiodic benefit cost. In addition, the measurement date and the date at whichplan assets and the benefit obligation are measured, are required to be thecompany’s fiscal year-end. SFAS 158 is effective for us as of December 31,2007, except for the measurement date provisions, which are effective December 31,2009. We are currently assessing the impact that the adoption of SFAS 158 mayhave on our consolidated financial position, results of operations or cashflows.

In September 2006, the United States Securitiresand Exchange Commission (“SEC”) released Staff Accounting Bulletin No. 108,“*Considering the Effects of Prior Year MisstatementsWhen Quantifying Misstatements in Current Year Financial Statements*”(“SAB 108”). SAB 108 provides interpretative guidance on how public companiesquantify financial statement misstatements. There have been two commonapproaches used to quantify such errors. Under an income statement approach,the “roll-over” method, the error is quantified as the amount by which thecurrent year income statement is misstated. Alternatively, under a balancesheet approach, the “iron curtain” method, the error is quantified as thecumulative amount by which the current year balance sheet is misstated. In SAB108, the SEC established an approach that requires quantification of financialstatement misstatements based on the effects of the 

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misstatements on each ofthe company’s financial statements and the related financial statementdisclosures. This model is commonly referred to as a “dual approach” because itrequires quantification of errors under both the roll-over and iron curtainmethods. SAB 108 was effective for us as of December 31, 2006. Theadoption of SAB 108 did not have a material impact on our consolidatedfinancial position, results of operations or cash flows.

In February 2007, theFASB issued Statement of Financial Accounting Standards No. 159, “*The Fair Value Option for Financial Assets and Liabilities*”(“SFAS 159”). SFAS 159 provides entities with the option to report selectedfinancial assets and liabilities at fair value. Business entities adopting SFAS159 will report unrealized gains and losses in earnings at each subsequentreporting date on items for which fair value option has been elected. SFAS 159establishes presentation and disclosure requirements designed to facilitatecomparisons between entities that choose different measurement attributes forsimilar types of assets and liabilities. SFAS 159 requires additionalinformation that will help investors and other financial statement users tounderstand the effect of an entity’s choice to use fair value on its earnings.SFAS 159 is effective for fiscal years beginning after November 15, 2007,with earlier adoption permitted. We are currently assessing the impact that theadoption of SFAS 159 may have on our consolidated financial position,results of operations or cash flows.

***Item 7A.******               *Quantitative and QualitativeDisclosures about Market Risk**

***Foreign Currency Risk***

Since 2004 we no longeruse short-term forward exchange contracts for hedging purposes to reduce the effectsof adverse foreign exchange rate movements. We had previously purchased foreignexchange contracts to hedge against certain trade accounts receivabledenominated in Japanese yen. The change in the fair value of the forwardcontracts was recognized as part of the related foreign currency transactionsas they occur. As of December 31, 2006, and 2005, we had no outstandingcommitments with respect to foreign exchange contracts.

***Interest Rate Risk***

Cashand cash equivalents earning interest and certain variable rate debtinstruments are subject to interest rate fluctuations. The following table setsforth the probable impact of a 10% change in interest rates (in thousands):

| **Instrument**                             | ** ** | ** ** | ** ** | **Balance as of  December 31,  2006** | ** ** | **Current  Interest  Rate** | ** ** | **Projected Annual  Interest  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|--------------------------------------------|------------|------------|------------|------------------------------------------------------|------------|-----------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Cash                                       |       |       | $          | 6,892                                                |       |                        |       | 0.50                                                  | %          |                                                                 |       | $                                                                     | 34         |   |   |   | $ | 31 |   |   |   | $ | 38 |   |   |
| Cash equivalents                           |       |       | 9,224      |                                                 |       |                        | 5.23       |                                                  |       |                                                                 | 482        |                                                                  |       |   | 434 |   |   |   | 531 |   |   |
| Investment in  debt and equity instruments |       |       | 26,578     |                                                 |       |                        | 4.52       |                                                  |       |                                                                 | 1,201      |                                                                  |       |   | 1,081 |   |   |   | 1,321 |   |   |
| Long-term debt                             |       |       | (7,289     | )                                                    |       |                        | 5.47       |                                                  |       |                                                                 | (399       | )                                                                     |       |   | (359 | ) |   |   | (439 | ) |   |
|                                       |       |       |       |                                                 |       |                        |       |                                                  |       |                                                                 | $          | 1,318                                                                 |       |   |   | $ | 1,187 |   |   |   | $ | 1,451 |   |   |

 

***Equity Risk***

We maintain minorityinvestments in privately-held companies. These investments are reviewed forother than temporary declines in value on a quarterly basis. These investmentsare classified as other assets in the consolidated balance sheets and areaccounted for under the cost method as we do not have the ability to exercisesignificant influence over their operations. We monitor our investments forimpairment and record reductions in carrying value when events or changes incircumstances indicate that the carrying 

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valuemay not be recoverable. Reasons for other than temporary declines in valueinclude whether the related company would have insufficient cash flow tooperate for the next twelve months, significant changes in the operatingperformance and changes in market conditions. As of December 31, 2006 and2005, the minority investments totaled $0.4 million for both years. In 2004, werecorded a $0.2 million charge related to impairment in one of the U.S. privatecompanies.

**Item 8.**                        *Consolidated Financial Statements and Supplementary Data*

The consolidated financialstatements, related notes thereto and financial statement schedule required bythis item are listed and set forth beginning on page 57, and isincorporated by reference here. Supplementary financial information regardingquarterly financial information required by this item is set forth under thecaption “Quarterly Results of Operations” in Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” andis incorporated by reference here.

***Item 9.******                        Changes inand Disagreements with Accountants on Accounting and Financial Disclosure***

None.

***Item 9A.******                Controlsand Procedures***

***Evaluation ofdisclosure controls and procedures.******  ***Under thesupervision and with the participation of our management, our Chief ExecutiveOfficer and Chief Financial Officer have evaluated the effectiveness of ourdisclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended. Based upon that evaluation,our Chief Executive Officer and our Chief Financial Officer concluded that theour disclosure controls and procedures were effective as of the end of theperiod covered by this report.

***Changes in internalcontrol over financial reporting.******  ***As required byRule 13a-15(d), our management, including our Chief ExecutiveOfficer and Chief Financial Officer, also conducted an evaluation of ourinternal control over financial reporting to determine whether any changesoccurred during the period covered by this report that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting. Based on that evaluation, there has been no suchchange during the period covered by this report.

***Limitations of the effectiveness of internal control.******  ***A controlsystem, no matter how well conceived and operated, can provide only reasonable,not absolute, assurance that the objectives of the internal control system aremet. Because of the inherent limitations of any internal control system, noevaluation of controls can provide absolute assurance that all control issues,if any, within a company have been detected. Notwithstanding these limitations,our disclosure controls and procedures are designed to provide reasonableassurance of achieving their objectives. Our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and proceduresare, in fact, effective at the “reasonable assurance” level.

**Item 9B.**               *Other Information*

None.

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**PART III**

The United StatesSecurities and Exchange Commission (“SEC”) allows us to include informationrequired in this report by referring to other documents or reports we havealready or will soon be filing. This is called “Incorporation by Reference.” Weintend to file our definitive proxy statement pursuant to Regulation 14A notlater than 120 days after the end of the fiscal year covered by this report,and certain information therein is incorporated in this report by reference.

**Item 10.**                 *Directors, Executive Officers and Corporate Governance*

The information required by this item pursuant to Item401 of Regulation S-K concerning directors is incorporated by reference to theinformation in the section entitled “Proposal No. 1, Election of Directors”in the Proxy Statement.

The information required by this item pursuant to Item401 of Regulation S-K concerning executive officers is incorporated byreference to the section entitled “Proposal No.1 Election of Directors” and “ExecutiveCompensation and Other Matters” in the Proxy Statement.

The information required by this item pursuant to Item405 of Regulation S-K concerning compliance with Section 16(a) of theSecurities Exchange Act of 1934, as amended, is incorporated by reference toinformation in the section entitled “Security Ownership of Certain Holders—Section 16(a) BeneficialOwnership Reporting Compliance” in the Proxy Statement.

The Board of Directors ofAXT, Inc. has adopted a code of ethics that applies to our principalexecutive officers, principal financial officer, and corporate controller, aswell as other employees. A copy of this code of ethics has been posted on ourInternet website at *www.axt.com*.Any amendments to, or waivers from, a provision of our code of ethics thatapplies to our principal executive officer, principal financial officer,controller, or persons performing similar functions and that relates to anyelement of the code of ethics enumerated in paragraph (b) of Item 406 ofRegulation S-K shall be disclosed by posting such information on our website.

**Item 11.**                 *Executive Compensation*

The information requiredby this Item is incorporated herein by reference to information set forth inour definitive Proxy statement to be filed in connection with our annualmeeting of stockholders to be held on May 22, 2007, under the sectionentitled “Executive Compensation and Other Matters.”

**Item 12.**                 *Security Ownership of Certain Beneficial Owners and Management and Related StockholderMatters*

The information requiredby this Item is incorporated herein by reference to information set forth inour definitive Proxy statement to be filed in connection with our annualmeeting of stockholders to be held on May 22, 2007, under the sectionentitled “Security Ownership of Certain Beneficial Owners and Management andEquity Compensation Plan Information.”

**Item 13.**                 *Certain Relationships and Related Transactions and DirectorIndependence*

Since January 2002, there has not been, nor isthere currently proposed, any transaction or series of similar transactions towhich we were or are to be a party in which the amount involved exceeds$60,000, and in which any director, executive officer or holder of more than 5%of any class of our voting securities or members of that person’s immediatefamily had or will have a direct or indirect material interest other than thetransactions described below.

We entered into anoperating lease in July 2001 for warehouse space in Fremont, CA with4160 Business Center, LLC, a real estate holding company, in which DavisZhang, president of our joint 

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ventureoperations, was the sole shareholder. Lease payments to 4160 Business Center,LLC were approximately $484,000 for the year ended December 31, 2002 and$121,000 for the three months ended March 31, 2003. In April of 2003,Mr. Zhang sold this warehouse to a party unrelated to us. We began leasingthis warehouse from the new owner on the date of sale up to the end of thelease expiration in July, 2006. Mr. Zhang no longer holds a $3.7 millionnote on the property as of December 31, 2006.

**Item 14.**                 *Principal Accountant Fees and Services*

The information required by this Item is incorporatedherein by reference to information set forth in our definitive Proxy statementto be filed in connection with our annual meeting of stockholders to be held onMay 22, 2007, under the section entitled “Principal Accounting Firm Fees.”

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**PART IV**

**Item 15.**                 *Exhibits and Financial Statement Schedules*

(a)          The following documentsare filed as part of this report:

(1)         FinancialStatements:

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

| Report of Independent  Registered Public Accounting Firm, Burr, Pilger & Mayer LLP |   | 58 |   |
|---------------------------------------------------------------------------------------------|--------|----|--------|
| Consolidated Balance Sheets                                                                 |   | 59 |   |
| Consolidated Statements of Operations                                                       |   | 60 |   |
| Consolidated  Statements of Stockholders’ Equity                                       |   | 61 |   |
| Consolidated  Statements of Cash Flows                                                      |   | 62 |   |
| Notes to Consolidated Financial Statements                                                  |   | 63 |   |

 

(2)         Financial StatementSchedules

All schedules havebeen omitted because the required information is not applicable or because theinformation required is included in the consolidated financial statements ornotes thereto.

(b)         Exhibits

See Index to Exhibits attached elsewhere to this Form 10-K.The exhibits listed in the accompanying Index to Exhibits are filed as part of,or incorporated by reference into, this report on Form 10-K.

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Stockholders and Board of Directors of AXT, Inc.:

We have audited the accompanying consolidated balancesheets of AXT, Inc. and its subsidiaries (the Company) as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity and cash flows for each of the three years in the periodended December 31, 2006. These consolidated financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor have we been engaged toperform, an audit of the Company’s internal control over financial reporting.Our audits included consideration of internal control over financial reportingas a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.Accordingly, we express no such opinion. An audit also includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of AXT, Inc. and its subsidiaries as of December 31, 2006and 2005, and the results of their operations and their cash flows for each ofthe three years in the period ended December 31, 2006 in conformity withaccounting principles generally accepted in the United States of America.

As discussed in Note 1 to the consolidated financialstatements, on January 1, 2006 the Company changed its method ofaccounting for stock-based compensation as a result of adopting Statement ofFinancial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” applying the modified prospective method.

/s/ BURR, PILGER & MAYER LLP

San Jose, California March 21, 2007

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**AXT, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                      | ** ** | **December 31,**                                          | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                                                                                      | ** ** | **2006**                                                       | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                      | ** ** | **(In thousands, except  per share data)** | ** ** |
| **ASSETS**                                                                                                                                                      | ** ** | ** **                                                     | ** ** | ** ** | ** ** |
| Current assets                                                                                                                                                  |       |                                                           |       |   |   |
| Cash and cash equivalents                                                                                                                                       |       | $                                                              | 16,116     |   | $ | 17,472 |   |
| Short-term investments                                                                                                                                          |       | 19,428                                                         |       | 5,555 |   |
| Accounts receivable, net of allowances of $140 and  $619 as of December 31, 2006 and 2005, respectively                                                    |       | 9,658                                                          |       | 5,226 |   |
| Inventories, net                                                                                                                                                |       | 20,263                                                         |       | 16,156 |   |
| Prepaid expenses and other current assets                                                                                                                       |       | 3,985                                                          |       | 1,801 |   |
| Assets held for sale                                                                                                                                            |       | 4,659                                                          |       | — |   |
| Total current assets                                                                                                                                            |       | 74,109                                                         |       | 46,210 |   |
| Property, plant  and equipment, net                                                                                                                             |       | 12,775                                                         |       | 17,306 |   |
| Restricted  deposits                                                                                                                                            |       | 7,150                                                          |       | 7,450 |   |
| Other assets                                                                                                                                                    |       | 4,298                                                          |       | 3,832 |   |
| Total assets                                                                                                                                                    |       | $                                                              | 98,332     |   | $ | 74,798 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                  | ** ** | ** **                                                     | ** ** | ** ** | ** ** |
| Current  liabilities                                                                                                                                            |       |                                                           |       |   |   |
| Accounts payable                                                                                                                                                |       | $                                                              | 3,764      |   | $ | 3,070 |   |
| Accrued liabilities                                                                                                                                             |       | 1,797                                                          |       | 2,562 |   |
| Accrued compensation and related charges                                                                                                                        |       | 1,102                                                          |       | 726 |   |
| Accrued product warranty                                                                                                                                        |       | 459                                                            |       | 120 |   |
| Accrued restructuring costs                                                                                                                                     |       | —                                                         |       | 465 |   |
| Customer prepayments                                                                                                                                            |       | —                                                         |       | 125 |   |
| Current portion of long-term debt                                                                                                                               |       | 450                                                            |       | 300 |   |
| Income taxes payable                                                                                                                                            |       | 178                                                            |       | 2,495 |   |
| Total current liabilities                                                                                                                                       |       | 7,750                                                          |       | 9,863 |   |
| Long-term debt, net of current portion                                                                                                                          |       | 6,839                                                          |       | 7,420 |   |
| Other long-term  liabilities                                                                                                                                    |       | 2,543                                                          |       | 1,897 |   |
| Total liabilities                                                                                                                                               |       | 17,132                                                         |       | 19,180 |   |
| Commitments and  contingencies (Note 18)                                                                                                                        |       |                                                           |       |   |   |
| Stockholders’  equity:                                                                                                                                     |       |                                                           |       |   |   |
| Preferred stock, $0.001 par value; 2,000 shares  authorized; 883 shares issued and outstanding as of December 31, 2006  and 2005, respectively             |       | 3,532                                                          |       | 3,532 |   |
| Common stock, $0.001 par value; 70,000 shares authorized;  29,011 and 22,977 shares issued and outstanding as of December 31, 2006  and 2005, respectively |       | 29                                                             |       | 23 |   |
| Additional paid-in-capital                                                                                                                                      |       | 180,936                                                        |       | 155,441 |   |
| Accumulated deficit                                                                                                                                             |       | (103,832                                                       | )          | (104,776 | ) |
| Other comprehensive income                                                                                                                                      |       | 535                                                            |       | 1,398 |   |
| Total stockholders’ equity                                                                                                                                 |       | 81,200                                                         |       | 55,618 |   |
| Total liabilities  and stockholders’ equity                                                                                                                |       | $                                                              | 98,332     |   | $ | 74,798 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**AXT, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                                   | ** ** | **Years Ended December 31,**                        | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | **(In thousands, except per share data)** | ** ** |
| Revenue                                                                      |       | $                                                                  | 44,445     |   | $ | 26,536 |   | $ | 35,454 |   |
| Cost of revenue                                                              |       | 31,709                                                             |       | 24,337 |   | 35,705 |   |
| Gross profit  (loss)                                                         |       | 12,736                                                             |       | 2,199 |   | (251 | ) |
| Operating expenses:                                                          |       |                                                               |       |   |   |   |   |
| Selling, general and administrative                                          |       | 12,650                                                             |       | 12,955 |   | 11,561 |   |
| Research and development                                                     |       | 2,351                                                              |       | 1,723 |   | 1,479 |   |
| Impairment charge                                                            |       | 1,417                                                              |       | — |   | 210 |   |
| Restructuring charge (benefit)                                               |       | (2                                                                 | )          | 836 |   | 1,308 |   |
| Total operating expenses                                                     |       | 16,416                                                             |       | 15,514 |   | 14,558 |   |
| Loss from  continuing operations                                             |       | (3,680                                                             | )          | (13,315 | ) | (14,809 | ) |
| Interest income,  net                                                        |       | 443                                                                |       | 516 |   | 262 |   |
| Other income and  (expense), net                                             |       | 2,709                                                              |       | (910 | ) | 94 |   |
| Loss from  continuing operations before provision (benefit) for income taxes |       | (528                                                               | )          | (13,709 | ) | (14,453 | ) |
| Provision  (benefit) for income taxes                                        |       | (1,454                                                             | )          | (950 | ) | 71 |   |
| Income (loss)  from continuing operations                                    |       | 926                                                                |       | (12,759 | ) | (14,524 | ) |
| Discontinued operations:                                                     |       |                                                               |       |   |   |   |   |
| Gain (loss) from discontinued operations, net of tax                         |       | 18                                                                 |       | (59 | ) | 472 |   |
| Gain from disposal, net of tax                                               |       | —                                                             |       | 603 |   | 419 |   |
| Gain from  discontinued operations, net of tax                               |       | 18                                                                 |       | 544 |   | 891 |   |
| Net income (loss)                                                            |       | $                                                                  | 944        |   | $ | (12,215 | ) | $ | (13,633 | ) |
| Basic income  (loss) per share:                                              |       |                                                               |       |   |   |   |   |
| Income (loss) from continuing operations                                     |       | $                                                                  | 0.03       |   | $ | (0.56 | ) | $ | (0.64 | ) |
| Gain from discontinued operations, net of tax                                |       | —                                                             |       | 0.02 |   | 0.04 |   |
| Net income (loss)                                                            |       | $                                                                  | 0.03       |   | $ | (0.54 | ) | $ | (0.60 | ) |
| Shares used in  computing basic net income (loss) per share                  |       | 23,303                                                             |       | 23,047 |   | 23,063 |   |
| Diluted income  (loss) per share:                                            |       |                                                               |       |   |   |   |   |
| Income (loss) from continuing operations                                     |       | $                                                                  | 0.03       |   | $ | (0.56 | ) | $ | (0.64 | ) |
| Gain from discontinued operations, net of tax                                |       | —                                                             |       | 0.02 |   | 0.04 |   |
| Net income (loss)                                                            |       | $                                                                  | 0.03       |   | $ | (0.54 | ) | $ | (0.60 | ) |
| Shares used in computing  diluted net income (loss) per share                |       | 24,600                                                             |       | 23,047 |   | 23,063 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**AXT, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

| ** **                                                            | ** ** | ** **               | ** ** | ** ** | ** ** | **Common Stock** | ** ** | ** **     | ** ** | **Other**                     | ** ** | ** **        | ** ** | ** **        | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------|------------|------------|------------|-----------------------|------------|----------------|------------|-------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                            | ** ** | **Preferred Stock** | ** ** | ** ** | ** ** | ** **            | ** ** | **Additional** | ** ** | **Accumulated**               | ** ** | **Comprehensive** | ** ** | ** **        | ** ** | **Comprehensive** | ** ** |
|                                                                       | ** ** | **Shares**               | ** ** | **Amount** | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Paid In Capital** | ** ** | **Deficit**       | ** ** | **Income/(loss)** | ** ** | **Total** | ** ** | **Income/(loss)** | ** ** |
| ** **                                                            | ** ** | **(In thousands)**  | ** ** |
| Balance as of December 31, 2003                             |       |                     | 883        |       |       |                  | $          | 3,532          |       |                          |       | 22,957            |       |              |       | $ | 23 |   |   |   | $ | 155,155 |   |   |   | $ | (78,928 | ) |   |   | $ | (2,516 | ) |   | $ | 82,298 |   |   |   |   |   |
| Common stock options exercised                                        |       |                     |       |       |       |                  |       |           |       |                          | 56         |              |       |              |       |   |   |   | 153 |   |   |   |   |   |   |   |   |   |   | 153 |   |   |   |   |   |
| Issuance of Employee Stock Purchase Plan stock                        |       |                     |       |       |       |                  |       |           |       |                          | 106        |              |       |              |       |   |   |   | 117 |   |   |   |   |   |   |   |   |   |   | 117 |   |   |   |   |   |
| Compensation related to stock options                                 |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   | 6 |   |   |   |   |   |   |   |   |   |   | 6 |   |   |   |   |   |
| Comprehensive loss:                                                   |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                              |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   | (13,633 | ) |   |   |   |   |   | (13,633 | ) |   | $ | (13,633 | ) |   |
| Unrealized gain (loss) on marketable securities                       |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   | (1,104 | ) |   | (1,104 | ) |   | (1,104 | ) |   |
| Currency translation adjustment                                       |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   | 180 |   |   | 180 |   |   | 180 |   |   |
| Balance as of December 31, 2004                             |       |                     | 883        |       |       |                  | 3,532      |           |       |                          | 23,119     |              |       |              | 23         |   |   |   | 155,431 |   |   |   | (92,561 | ) |   |   | 1,592 |   |   | 68,017 |   |   | (14,557 | ) |   |
| Common stock options exercised                                        |       |                     |       |       |       |                  |       |           |       |                          | 5          |              |       |              |       |   |   |   | 5 |   |   |   |   |   |   |   |   |   |   | 5 |   |   |   |   |   |
| Issuance of Employee Stock Purchase Plan stock                        |       |                     |       |       |       |                  |       |           |       |                          | 55         |              |       |              |       |   |   |   | 59 |   |   |   |   |   |   |   |   |   |   | 59 |   |   |   |   |   |
| Common stock repurchased                                              |       |                     |       |       |       |                  |       |           |       |                          | (202       | )                 |       |              |       |   |   |   | (246 | ) |   |   |   |   |   |   |   |   |   | (246 | ) |   |   |   |   |
| Compensation related to stock options                                 |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   | 192 |   |   |   |   |   |   |   |   |   |   | 192 |   |   |   |   |   |
| Comprehensive loss:                                                   |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                              |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   | (12,215 | ) |   |   |   |   |   | (12,215 | ) |   | (12,215 | ) |   |
| Unrealized (loss) gain on marketable securities                       |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   | (201 | ) |   | (201 | ) |   | (201 | ) |   |
| Currency translation adjustment                                       |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   | 7 |   |   | 7 |   |   | 7 |   |   |
| Balance as of December 31, 2005                             |       |                     | 883        |       |       |                  | 3,532      |           |       |                          | 22,977     |              |       |              | 23         |   |   |   | 155,441 |   |   |   | (104,776 | ) |   |   | 1,398 |   |   | 55,618 |   |   | (12,409 | ) |   |
| Common stock options exercised                                        |       |                     |       |       |       |                  |       |           |       |                          | 284        |              |       |              |       |   |   |   | 556 |   |   |   |   |   |   |   |   |   |   | 556 |   |   |   |   |   |
| Stock-based compensation                                              |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   | 822 |   |   |   |   |   |   |   |   |   |   | 822 |   |   |   |   |   |
| Issuance of common stock, net of stock issuance costs of  $1,752 |       |                     |       |       |       |                  |       |           |       |                          | 5,750      |              |       |              | 6          |   |   |   | 24,117 |   |   |   |   |   |   |   |   |   |   | 24,123 |   |   |   |   |   |
| Comprehensive loss:                                                   |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                            |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   | 944 |   |   |   |   |   |   | 944 |   |   | 944 |   |   |
| Unrealized (loss) gain on marketable securities                       |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   | (1,331 | ) |   | (1,331 | ) |   | (1,331 | ) |   |
| Currency translation adjustment                                       |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   | 468 |   |   | 468 |   |   | 468 |   |   |
| Balance as of  December 31, 2006                            |       |                     | 883        |       |       |                  | $          | 3,532          |       |                          |       | 29,011            |       |              |       | $ | 29 |   |   |   | $ | 180,936 |   |   |   | $ | (103,832 | ) |   |   | $ | 535 |   |   | $ | 81,200 |   |   | $ | 81 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**AXT, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                 | ** ** | **(In thousands)**                     | ** ** |
| **Cash flows from operating activities:**                                                  |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                          |       | $                                           | 944        |   | $ | (12,215 | ) | $ | (13,633 | ) |
| Adjustments to reconcile net income (loss) to cash  (used in) provided by operations: |       |                                        |       |   |   |   |   |
| Depreciation                                                                               |       | 2,625                                       |       | 3,745 |   | 4,869 |   |
| Amortization of  marketable securities premium/discount                                    |       | (79                                         | )          | 192 |   | 307 |   |
| Stock-based compensation                                                                   |       | 822                                         |       | 192 |   | 6 |   |
| Non-cash restructuring  charge                                                             |       | —                                      |       | 736 |   | 1,308 |   |
| Impairment of  investments                                                                 |       | —                                      |       | — |   | 210 |   |
| Impairment of property,  plant and equipment                                               |       | 1,417                                       |       | — |   | — |   |
| Realized gain on sale of  investments                                                      |       | 3,301                                       |       | — |   | — |   |
| Loss on disposal of  property, plant and equipment                                         |       | 115                                         |       | 290 |   | 10 |   |
| Gain on disposal of  discontinued operations                                               |       | —                                      |       | (53 | ) | (472 | ) |
| Changes in assets and liabilities:                                                         |       |                                        |       |   |   |   |   |
| Accounts receivable, net                                                                   |       | (4,432                                      | )          | (1,192 | ) | 2,263 |   |
| Inventories                                                                                |       | (4,107                                      | )          | 306 |   | 7,621 |   |
| Prepaid expenses                                                                           |       | (2,184                                      | )          | 722 |   | (948 | ) |
| Other assets                                                                               |       | (466                                        | )          | — |   | (77 | ) |
| Accounts payable                                                                           |       | 694                                         |       | 1,175 |   | (743 | ) |
| Accrued liabilities                                                                        |       | (640                                        | )          | (1,775 | ) | (1,001 | ) |
| Income taxes                                                                               |       | (2,317                                      | )          | (430 | ) | (140 | ) |
| Other long-term  liabilities                                                               |       | 646                                         |       | 561 |   | 80 |   |
| Net cash (used in)  provided by operating activities                                       |       | (10,263                                     | )          | (7,746 | ) | (340 | ) |
| **Cash flows from investing activities:**                                                  |       |                                        |       |   |   |   |   |
| Purchases of property,  plant and equipment                                                |       | (4,458                                      | )          | (2,329 | ) | (2,139 | ) |
| Proceeds from disposal  of property, plant and equipment                                   |       | 173                                         |       | 33 |   | 10 |   |
| Purchases of marketable  securities                                                        |       | (27,346                                     | )          | (10,227 | ) | (25,876 | ) |
| Proceeds from sale of  marketable securities                                               |       | 15,522                                      |       | 24,341 |   | 19,072 |   |
| Proceeds from sale of  assets held for sale                                                |       | —                                      |       | 1,303 |   | — |   |
| Decrease (increase) in  restricted deposits                                                |       | 300                                         |       | 765 |   | (1,087 | ) |
| Net cash provided by  (used in) investing activities                                       |       | (15,809                                     | )          | 13,886 |   | (7,846 | ) |
| **Cash flows from financing activities:**                                                  |       |                                        |       |   |   |   |   |
| Proceeds from issuance  of common stock                                                    |       | 24,679                                      |       | 64 |   | 270 |   |
| Repurchase of common  stock                                                                |       | —                                      |       | (246 | ) | — |   |
| Proceeds from long-term  debt borrowings                                                   |       | —                                      |       | 49 |   | — |   |
| Long-term debt payments                                                                    |       | (431                                        | )          | (659 | ) | (4,486 | ) |
| Net cash provided by  (used in) financing activities                                       |       | 24,248                                      |       | (792 | ) | (4,216 | ) |
| Effect of exchange rate  changes                                                           |       | 468                                         |       | 7 |   | 180 |   |
| Net increase (decrease)  in cash and cash equivalents                                      |       | (1,356                                      | )          | 5,355 |   | (12,222 | ) |
| Cash and cash  equivalents at the beginning of the period                                  |       | 17,472                                      |       | 12,117 |   | 24,339 |   |
| Cash and cash  equivalents at the end of the period                                        |       | $                                           | 16,116     |   | $ | 17,472 |   | $ | 12,117 |   |
| **Supplemental Disclosures:**                                                              |       |                                        |       |   |   |   |   |
| Interest paid                                                                              |       | $                                           | 372        |   | $ | 266 |   | $ | 271 |   |
| Income taxes paid                                                                          |       | $                                           | 1,978      |   | $ | 111 |   | $ | 197 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**AXT, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1. The Company andSummary of Significant Accounting Policies**

***The Company***

AXT, Inc. (“AXT”, “we,” “us,” and “our” refer toAXT, Inc. and all of its subsidiaries) designs, develops, manufactures anddistributes high-performance compound semiconductor substrates. Our substrateproducts are used primarily in wireless communications, lighting displayapplications, and fiber optic communications. We believe our vertical gradientfreeze, or VGF, technique for manufacturing semiconductor substrates providessignificant benefits over other methods and enabled us to become a leadingmanufacturer of such substrates. We pioneered the commercial use of VGFtechnology to manufacture gallium arsenide (GaAs) substrates and subsequentlyused VGF technology to manufacture substrates from indium phosphide (InP), andgermanium (Ge). We also manufacture and sell raw materials related to oursubstrate business through five joint ventures located in China. These jointventures produce products including 99.99% pure gallium (4N Ga), high puritygallium, arsenic, and germanium, germanium dioxide, paralytic boron nitride(pBN) crucibles, and boron oxide. AXT’s ownership interest in these entitiesranges from 25 percent to 83 percent. We consolidate the three ventures inwhich we own a majority share and employ equity accounting for the two jointventures in which we have a 25 percent interest. We purchase the materialsproduced by these ventures for our use and sell other portions of theirproduction to third parties.

On June 24, 2003, ourBoard of Directors approved management’s plan to exit our unprofitableOpto-electronics business. Substantially all of the assets of this divisionwere sold in September 2003. The decision to dispose of the business wasdue to continuing operating losses and negative cash flows from the divisionand significant uncertainty regarding future profitability.

***Use of Estimates***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ materially from these estimates.

***Principles of Consolidation***

The consolidated financialstatements include the accounts of AXT and our majority-owned subsidiaries. Allsignificant intercompany accounts and transactions have been eliminated.Investments in business entities in which we do not have control, but have theability to exercise significant influence over operating and financial policies(generally 20-50% ownership), are accounted for by the equity method.

***Fair Value of Financial Instruments***

The carrying amounts ofcertain of our financial instruments including cash and cash equivalents,accounts receivable, short-term investments, accounts payable and accruedliabilities approximate fair value due to their short maturities. The carryingamounts of short-term and long-term debt approximate fair value due to themarket interest rates that these debts bear, and interest rates currently availableto us.

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***Reclassifications***

Certain reclassificationshave been made to the prior years’ consolidated financial statements to conformto current year presentation. These reclassifications had no impact onpreviously reported total assets, stockholders’ equity or net loss.

***Foreign Currency Translation***

The functional currencies of our Japanese and Chinesesubsidiaries are the local currencies. Transaction gains and losses resultingfrom transactions denominated in currencies other than the U.S. dollar or inthe functional currencies of our subsidiaries are included in other income and(expense) and income, net for the periods presented.

The assets and liabilitiesof the subsidiaries are translated at the rates of exchange on the balancesheet date. Revenue and expense items are translated at the average rate ofexchange for the period. Gains and losses from foreign currency translation areincluded in other comprehensive income (loss) in stockholders’ equity.

***Revenue Recognition***

We recognizerevenue upon the shipment of our products to customers when:

·       wehave received a signed purchase order placed by our customers,

·       theprice is fixed or determinable,

·       titleand risk of ownership has transferred to our customers upon shipment from ourdock, receipt at customer’s dock, or removal from consignment inventory atcustomer’s location,

·       collectionof resulting receivables is probable, and

·       productreturns are reasonably estimable.

We do not providetraining, installation or commissioning services. Our terms and conditions ofsale do not require customer acceptance. We assess the probability ofcollection based on a number of factors including past history with thecustomer and credit worthiness. We provide for future returns based onhistorical experience, current economic trends and changes in customer demandat the time revenue is recognized. Additionally, we do not provide discounts orother incentives to customers except for one customer with whom we agreed inthe fourth quarter of 2004 to provide a certain amount of cumulativediscounts on future product purchases from us. We will recognize thesediscounts in future periods as a reduction in revenue as products are sold tothis customer.

***Concentration of Credit Risk***

Our business is very dependant on the semiconductorindustry, which is highly cyclical and has historically experienced downturnsas a result of economic changes, overcapacity, and technological advancements.Significant technological changes in the industry or customer requirements, orthe emergence of competitive products with new capabilities or technologies,could adversely affect operating results. In addition, a significant portion ofour revenues and net income (loss) is derived from international sales.Fluctuations of the United States dollar against foreign currencies and changesin local regulatory or economic conditions, particularly in an emerging marketsuch as China, could adversely affect operating results.

We depend on a single or limited number of suppliersfor certain critical materials used in the production of our substrates, suchas quartz tubing, and polishing solutions. We generally purchase thesematerials through standard purchase orders and not pursuant to long-term supplycontracts.

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Financial instruments that potentially subject us toconcentration of credit risk consist primarily of cash equivalents, short-terminvestments, and trade accounts receivable. We invest primarily in money marketaccounts, commercial paper instruments, and investment grade securities. We areexposed to credit risks in the event of default by the issuers to the extent ofthe amount recorded on the consolidated balance sheets.

We perform ongoing creditevaluations of our customers’ financial condition, and limit the amount ofcredit extended when deemed necessary, but generally do not require collateral.The credit risk in our accounts receivable is substantially mitigated by ourcredit evaluation process, reasonably short collection terms and thegeographical dispersion of sales transactions. One customer represented greaterthan 10% of revenue, totaling 12.8%, for the year ended December 31, 2006,two customers represented greater than 10% of revenue, totaling 20.7%, for theyear ended December 31, 2005, while no customers represented greater than10% of revenue for the year ended December 31, 2004. Our top fivecustomers represented 40.0% of revenues for the year ended December 31,2006, 37.5% of revenue for the year ended December 31, 2005, and 30.1% ofrevenue for the year ended December 31, 2004. We expect that sales to asmall number of customers will continue to comprise a significant portion ofour revenue in the future. Two customers each accounted for 10% or more of ourtrade accounts receivable balance as of December 31, 2006 at 20.4% and 13.7%,respectively. Two customers each accounted for 10% or more of our tradeaccounts receivable balance as of December 31, 2005 at 30.0% and 18.8%,respectively.

***Cash Equivalents and Short-Term Investments***

We classify our investments in debt and equity securitiesas available-for-sale securities as prescribed by Statement of FinancialAccounting Standards (“SFAS”) No. 115, *“Accountingfor Certain Investments in Debt and Equity Securities.”* We considerinvestments in highly liquid instruments purchased with an original maturity ofthree months or less to be cash equivalents. Our short-term investments arereported at fair value as of the respective balance sheet dates with unrealizedgains and losses included in accumulated other comprehensive income (loss) withinstockholders’ equity on the consolidated balance sheets. The amortized cost ofsecurities is adjusted for amortization of premiums and accretion of discountsto maturity. Such amortization is included in other income and (expense) andincome, net in the consolidated statements of operations. Realized gains andlosses and declines in value judged to be other than temporary onavailable-for-sale securities are also included in other income and (expense)and income, net in the consolidated statements of operations. The cost ofsecurities sold is based upon the specific identification method.

All available-for-sale securities with a quoted marketvalue below cost (or adjusted cost) are reviewed in order to determine whetherthe decline is other-than-temporary. Factors considered in determining whethera loss is temporary include the magnitude of the decline in market value, thelength of time the market value has been below cost (or adjusted cost), creditquality, and our ability and intent to hold the securities for a period of timesufficient to allow for any anticipated recovery in market value.

We maintain in restricteddeposits an amount approximately equal to the amount of the taxable bond.

***Accounts Receivable and Allowance for DoubtfulAccounts***

Accounts receivable are recorded at the invoicedamount and are not interest bearing. We maintain an allowance for doubtfulaccounts to reserve for potentially uncollectible trade receivables. We alsoreview our trade receivables by aging category to identify specific customerswith known disputes or collectibility issues. We exercise judgment whendetermining the adequacy of these reserves as we evaluate historical bad debttrends, general economic conditions in the United States and internationally,and changes in customer financial conditions. Uncollectible receivables arerecorded as bad debt expense when all efforts to collect have been exhaustedand recoveries are recognized when they are received. From our 

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allowance for doubtfulaccounts of $4.0 million at December 31, 2003, we wrote off $3.5 millionof fully reserved accounts receivable resulting in the allowance for doubtfulaccounts of $0.5 million at December 31, 2004. From our allowance fordoubtful accounts of $0.5 million at December 31, 2004, we wrote off $0.1million of fully reserved accounts receivable for a Korean customer anddecreased the allowance by $0.3 million due to improved collections mainly froma Japanese customer, while increasing the allowance for a large customer inChina of $0.4 million, resulting in the allowance for doubtful accounts of $0.5million at December 31, 2005. During 2006, we increased our collectionefforts and collected the entire amount from this large customer in Chinarequiring us to reverse this $0.4 million allowance resulting in the allowancefor doubtful accounts of $0.1 million at December 31, 2006. As of December 31,2006, our accounts receivable balance was $9.7 million, which was net of anallowance for doubtful accounts of $0.1 million. As of December 31, 2005,our accounts receivable balance was $5.2 million, which was net of an allowancefor doubtful accounts of $0.5 million. If actual uncollectible accounts differsubstantially from our estimates, revisions to the estimated allowance fordoubtful accounts would be required, which could have a material impact on ourfinancial results for the period.

The allowance for salesreturns is also deducted from gross accounts receivable. From our allowance forsales returns of $0.5 million as of December 31, 2003, we increased thereserve for sales returns by $0.1 million resulting in the allowance for salesreturns of $0.6 million as of December 31, 2004. From our allowance forsales returns of $0.6 million as of December 31, 2004, we utilized $0.5million for investigation related returns, resulting in the allowance for salesreturns of $0.1 million as of December 31, 2005. During 2006, theallowance for sales returns remained at approximately $0.1 million. The totalallowances deducted from gross accounts receivable as of December 31, 2006is $0.1 million, compared to $0.6 million as of December 31, 2005.

***Inventories***

Inventories are stated atthe lower of cost (approximated by standard cost) or market. Cost is determinedusing the weighted average cost method. Our inventory consists of raw materialsas well as finished goods and work-in-process that include material, labor andmanufacturing overhead costs. Provision for potentially obsolete or slow movinginventory is made based on management’s analysis of inventory levels and salesforecasts.

***Property, Plant and Equipment***

Property, plant andequipment are stated at cost less accumulated depreciation computed using thestraight-line method over the estimated economic lives of the assets, whichvary from 3 to 27.5 years. Leasehold improvements are amortized over theshorter of the estimated useful life or the term of the lease. We generallydepreciate computers and software over 3 years, office equipment, furniture andfixtures over 3 years, automobiles over 5 years, leasehold improvements over 10years, and buildings over 27.5 years. Repairs and maintenance costs areexpensed as incurred.

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

We evaluate therecoverability of property, plant and equipment, and intangible assets inaccordance with SFAS No. 144, *“Accountingfor the Impairment or Disposal of Long-Lived Assets.”* When eventsand circumstance indicate that long-lived assets may be impaired, managementcompares the carrying value of the long-lived assets to the projection offuture undiscounted cash flows attributable to such assets and in the eventthat the carrying value exceeds the future undiscounted cash flows, we recordan impairment charge against income equal to the excess of the carrying valueover the asset’s fair value. In the third quarter of 2006, we incurred animpairment charge of $1.4 million to write down our U.S. property in Fremont,California, which has been decontaminated and is being prepared for sale. Thisproperty has 

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beenclassified as “Assets held for sale” in the amount of $4.7 million on theconsolidated balance sheet as of December 31, 2006.

***Segment Reporting***

Our business is conductedin a single operating segment. Our chief executive officer reviews a single setof financial data that encompasses our entire operations for purposes of makingoperating decisions and assessing financial performance.

***Investments***

We invest in equityinstruments of privately-held companies for business and strategic purposes.These investments are classified as other assets and are accounted for underthe cost method as we do not have the ability to exercise significant influenceover their operations. We monitor our investments for impairment and recordreductions in carrying value when events or changes in circumstances indicate thatthe carrying value may not be recoverable. Determination of impairment ishighly subjective and is based on a number of factors, including an assessmentof the strength of investee’s management, the length of time and extent towhich the fair value has been less than our cost basis, the financial conditionand near-term prospects of the investee, fundamental changes to the businessprospects of the investee, share prices of subsequent offerings, and our intentand ability to hold the investment for a period of time sufficient to allow forany anticipated recovery in our carrying value. In the third quarter of 2004,we recorded an impairment charge of $0.2 million to write down the value of ourinvestment in a private company. We made the decision to write down theinvestment as a result of the declining financial position of the investee,evidenced by an audit opinion with a going concern explanatory paragraphreceived by the investee. The $0.2 million was the remaining balance of thisinvestment. No further write-downs were recorded in 2006 or 2005.

***Stock-Based Compensation***

We have employee stock option plans, which aredescribed more fully in Note 11—Employee Benefit Plans. Effective January 1,2006, we adopted the provisions of SFAS No. 123 (revised 2004), “*Share-Based Payment*,” (“SFAS 123(R)”).SFAS 123(R) establishes accounting for stock-based awards exchanged foremployee services. Accordingly, stock-based compensation cost is measured ateach grant date, based on the fair value of the award, and is recognized asexpense over the employee’s requisite service period of the award. All of theCompany’s stock compensation is accounted for as an equity instrument. TheCompany previously applied Accounting Principles Board (“APB”) Opinion No. 25,“*Accounting for Stock Issued to Employees*,”and related interpretations and provided the required pro forma disclosures ofSFAS No. 123, “*Accounting for Stock-BasedCompensation*”**(“SFAS123”).

We have elected the modified prospectiveapplication transition method for adopting SFAS 123(R). Under this method, theprovisions of SFAS 123(R) apply to all awards granted or modified afterthe date of adoption. The unrecognized expense of awards not yet vested at thedate of adoption will be recognized in net income (loss) in the periods afterthe date of adoption using the same Black-Scholes valuation method andassumptions determined under the original provisions of SFAS 123, as disclosedin our previous quarterly and annual reports.

***Prior to the Adoption of SFAS 123(R)***

Priorto the adoption of SFAS 123(R), we provided the disclosures required underSFAS 123, as amended by SFAS No. 148, “*Accountingfor Stock-Based Compensation—Transition and Disclosures*.” SFAS 123(R) requiresus to present pro forma information for the comparative period prior toadoption as if we had accounted for all our employee stock options under thefair value method of the original 

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SFAS 123. The following table illustrates the effect on net lossand net loss per share if we had applied the fair value recognition provisionsof SFAS 123 to stock-based employee compensation to the prior-year periods (inthousands, except per share data):

| ** **                                                                                    | ** ** | **Year Ended  December 31,  2005** | ** ** | **Year Ended  December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Net loss:                                                                                     |       |                                         |       |                                         |       |   |   |   |   |
| As reported                                                                                   |       |                                         | $          | (12,392                                      | )          |   |   | $ | (13,810 | ) |   |
| Add: Stock-based employee compensation expense  included in net loss as reported    |       |                                         | 192        |                                         |       |   | 6 |   |   |
| Less: Stock-based  compensation expense using the fair value based method, net of related tax |       |                                         | (1,035     | )                                            |       |   | (1,330 | ) |   |
| Pro forma net loss                                                                            |       |                                         | $          | (13,235                                      | )          |   |   | $ | (15,134 | ) |   |
| Basic and diluted  net loss per common share                                                  |       |                                         |       |                                         |       |   |   |   |   |
| As reported                                                                                   |       |                                         | $          | (0.54                                        | )          |   |   | $ | (0.60 | ) |   |
| Pro forma                                                                                     |       |                                         | $          | (0.57                                        | )          |   |   | $ | (0.66 | ) |   |
| Shares used in computing  basic and diluted net loss per share                                |       |                                         | 23,047     |                                         |       |   | 23,063 |   |   |

 

***Impact of the Adoption of SFAS 123 (R)***

Weelected to adopt the modified prospective application transition method asprovided by SFAS 123(R), and we recorded $822,000 in our consolidated statements of operations foryear ended December 31, 2006. We elected not to capitalize anystock-based compensation to inventory as of January 1, 2006 when theprovisions of SFAS 123(R) were initially adopted. We utilized the Black-Scholes valuation model for estimating the fairvalue of the stock compensation granted both before and after the adoption ofSFAS 123(R). In accordance with the modified prospective applicationtransition method, our consolidated financial statements for prior periods havenot been restated to reflect, and do not include, the impact ofSFAS 123(R). The following table summarizes compensation costs related toour stock-based compensation awards (in thousands, except per share data):

| ** **                                                                         | ** ** | **Year Ended  December 31,  2006** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| Stock-based  compensation in the form of employee stock options, included in: |       |                                         |       |   |   |
| Cost of revenue                                                                    |       |                                         | $          | 96 |   |   |
| Selling, general  and administrative                                               |       |                                         | 539        |   |   |
| Research and  development                                                          |       |                                         | 187        |   |   |
| Total stock-based compensation                                                     |       |                                         | $          | 822 |   |   |
| Tax effect on  stock-based compensation                                            |       |                                         | —     |   |   |
| Net effect on net  income or loss                                                  |       |                                         | $          | 822 |   |   |
| Shares used in computing basic net income (loss) per  share                        |       |                                         | 23,303     |   |   |
| Shares used in  computing diluted net income (loss) per share                      |       |                                         | 24,600     |   |   |
| Effect on basic net income per share                                               |       |                                         | $          | (0.04 | ) |   |
| Effect on diluted net  income per share                                            |       |                                         | $          | (0.03 | ) |   |

 

As of December 31, 2006, the total compensation cost related tounvested stock-based awards granted to employees under our stock option planbut not yet recognized was approximately $1,167,000, net of 

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estimated forfeitures of $31,000. This costwill be amortized on a straight-line basis over a weighted-average period ofapproximately 2.59 years and will be adjusted for subsequent changes inestimated forfeitures. We elected not to capitalize any stock-basedcompensation to inventory as of December 31, 2006, due to theimmateriality of the amount.

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

Weestimate the fair value of stock options using a Black-Scholes valuation model,consistent with the provisions of SFAS 123(R), Securities and ExchangeCommission Staff Accounting Bulletin No. 107 and our prior period proforma disclosures of net loss, including stock-based compensation (determinedunder a fair value method as prescribed by SFAS 123). The weighted-averagegrant date fair value of our stock options granted to employees during2006, 2005, and 2004 was $2.89, $0.89, and $1.17 per share, respectively. Thefair value of options granted was estimated at the date of grant using thefollowing weighted-average assumptions:

| ** **                | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------|------------|---------------------------------------------|------------|
| ** **                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Risk-free  interest rate  |       | 4.7                                         | %          | 4.3 | % | 3.6 | % |
| Expected life (in  years) |       | 3.9                                         |       | 5.0 |   | 5.0 |   |
| Dividend yield            |       | —                                      |       | — |   | — |   |
| Estimated  forfeitures    |       | 12.4                                        | %          | — |   | — |   |
| Volatility                |       | 78.2                                        | %          | 89.7 | % | 103.0 | % |

 

The dividend yield of zerois based on the fact that the Company has never paid cash dividends and has nopresent intention to pay cash dividends. Expected volatility is based on thecombination of historical volatility of the Company’s common stock and theexpected future volatility over the period commensurate with the expected lifeof the options. The risk-free interest rates are taken from the Daily FederalYield Curve Rates as of the grant dates as published by the Federal Reserve andrepresent the yields on actively traded Treasury securities for terms equal tothe expected term of the options. The expected term calculation for stockoptions is based on the observed historical option exercise behavior and  post-vesting forfeitures of options by the Company’semployees. Assumptions related to the Employee Stock Purchase Plan are notpresented as the related compensation expense amounts are insignificant. TheEmployee Stock Purchase Plan was suspended in February 2005.

***Research and Development***

Research and developmentcosts consisting primarily of salaries including stock compensation expense andrelated personnel costs, depreciation and product testing are expensed asincurred.

***Advertising Costs***

Advertising costs,included in selling, general and administrative, are expensed as incurred.Advertising costs for the years ended December 31, 2006, 2005, and 2004were $52,000, $22,000 and $51,000, respectively.

***Shipping and Handling costs***

We include fees billed tocustomers and costs incurred for shipping and handling as a component of costof sales.

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***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.

***Comprehensive Income(Loss)***

We report comprehensiveincome or loss in accordance with the provisions of SFAS No. 130, “*Reporting Comprehensive Income,”*whichestablishes standards for reporting comprehensive income and its components inthe financial statements. The components of other comprehensive income(loss) consist of unrealized gains and losses on marketable securities andforeign currency translation adjustments. Comprehensive income (loss) andthe components of accumulated other comprehensive income (loss) are presentedin the accompanying consolidated statements of stockholders’ equity.

***Net Income (Loss) Per Share***

Basic net income(loss) per share is computed using the weighted average number of commonshares outstanding during the periods. Diluted net income (loss) per shareis computed using the weighted average number of common shares outstanding andpotentially dilutive common shares outstanding during the periods. Potentiallydilutive common shares consist of common shares issuable upon the exercise ofstock options. Potentially dilutive common shares are excluded in net lossperiods, as their effect would be anti-dilutive.

***Recent Accounting Pronouncements***

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151, “*InventoryCosts—An Amendment of ARB No. 43, Chapter 4*” (“SFAS 151”).SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “*Inventory Pricing*”, to clarify the accounting for abnormalamounts of idle facility expense, freight, handling costs, and wasted material(spoilage). Among other provisions, the new rule requires that items suchas idle facility expense, excessive spoilage, double freight and re-handlingcosts must be recognized as current-period charges regardless of whether theymeet the criterion of “so abnormal” as stated in ARB No. 43. Additionally,SFAS 151 requires that the allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities. The adoption of SFAS 151, effective January 1, 2006, didnot have a material impact on our consolidated financial position, results ofoperations or cash flows.

In December 2004, the FASB issued SFAS No. 153,“*Exchanges of Non-monetary Assets—An Amendment ofAPB Opinion No. 29*” (“SFAS 153”). SFAS 153 eliminatesthe exception from fair value measurement for non-monetary exchanges of similarproductive assets in paragraph 21(b) of APB Opinion No. 29, “*Accounting for Non-monetary Transactions*,” and replaces itwith the exception for exchanges that do not have commercial substance. SFAS 153specifies that a non-monetary exchange has commercial substance if the futurecash flows of the entity are expected to change significantly as a result ofthe exchange. The adoption of SFAS 153, effective January 1, 2006,did not have a material impact on our consolidated financial position, resultsof operations or cash flows.

In May 2005, the FASB issued SFAS No. 154,“*Accounting Changes and Error Corrections—areplacement of APB Opinion No. 20 and FASB Statement No. 3*”(“SFAS 154”). SFAS 154 changes the requirements for the accountingfor and reporting of a change in accounting principle, and applies to allvoluntary changes in accounting principle. It also applies to changes requiredby an accounting 

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pronouncement in theunusual instance that the pronouncement does not include specific transitionprovisions. This statement requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. The adoption of SFAS 154, effective January 1,2006, did not have a material impact on our consolidated financial position,results of operations or cash flows.

In November 2005, the FASB issued FASB StaffPosition FAS 115-1 and FAS 124-1, “*The Meaningof Other-Than-Temporary Impairment and Its Application to Certain Investments*”(“FSP FAS 115-1”), which provides guidance on determining wheninvestments in certain debt and equity securities are considered impaired,whether that impairment is other-than-temporary, and on measuring suchimpairment loss. FSP FAS 115-1 also includes accountingconsiderations subsequent to the recognition of an other-than temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments. The adoption of FSPFAS 115-1, effective January 1, 2006, did not have a materialimpact on our consolidated financial position, results of operations or cashflows.

In February 2006, the FASB issued Statement of FinancialAccounting Standards No. 155, “*Accounting for CertainHybrid Instruments—an amendment of FASB Statements No. 133 and 140”*(“SFAS 155”)*.* SFAS 155 amends SFAS No. 133,“*Accounting for Derivative Instruments and HedgingActivities*” (“SFAS 133”) and SFAS No. 140, “*Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities*” (“SFAS 140”). SFAS 155allows entities the option of applying fair value accounting to certain hybridfinancial instruments in their entirety if they contain embedded derivativesthat would otherwise require bifurcation under SFAS 133. SFAS 155will be effective for us as of January 1, 2007. We are currently assessingthe impact that the adoption of SFAS 155 may have on our consolidatedfinancial position, results of operations or cash flows.

In March 2006, the FASB issued Statementof Financial Accounting Standards No. 156, “*Accounting for Servicingof Financial Assets*” (SFAS 156”). This statement amends SFAS No. 140,“*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities*”, (“SFAS 140”) withrespect to the accounting for separately recognized servicing assets andservicing liabilities. SFAS 156 will be effective for us as of January 1,2007. We are currently assessing the impact that the adoption of SFAS 156may have on our consolidated financial position, results of operations orcash flows.

In June 2006, the FASB issued FASB Interpretation No. 48, “*Accounting For Uncertain Tax Positions—An Interpretation of FASBStatement No. 109”*(“FIN 48”). FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with FASB Statement No. 109, “*Accounting for Income Taxes*”. It prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return. FIN48 also provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure and transition. FIN 48 iseffective for fiscal years beginning after Decemeber 15, 2006. We are currentlyassessing the impact that the adoption of FIN 48 may have on our consolidatedfinancial position, results of operations or cash flows.

In June 2006, the FASB ratified the consensusreached by the Emerging Issues Task Force (“EITF”) on Issue No. 06-3,“*How Taxes Collected from Customers and Remitted toGovernmental Authorities Should Be Presented in the Income Statement (That Is,Gross versus Net Presentation)*”, (“EITF 06-3”). EITF 06-3includes any tax assessed by a governmental authority that is directly imposedon a revenue-producing transaction between a seller and a customer and mayinclude, but is not limited to, sales, use, value added, and some excise taxes.EITF 06-3 concludes that the presentation of taxes on either a gross(included in revenues and costs) or a net (excluded from revenues) basis is anaccounting policy decision that should be disclosed. In addition, for any suchtaxes that are reported on a gross basis, a company should disclose the amountsof those taxes in interim and annual financial statements for each period forwhich an income 

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statement is presented ifthose amounts are significant. The provisions of EITF 06-3 should beapplied to financial reports for interim and annual reporting periods beginningafter December 15, 2006, with earlier adoption permitted. We are currentlyassessing the impact that the adoption of EITF 06-3 may have onour consolidated financial position, results of operations or cash flows.

In September 2006, the FASB issued Statement ofFinancial Accounting Standards No. 157, “*Fair ValueMeasurements*” (“SFAS 157”). SFAS 157 provides a new singleauthoritative definition of fair value and provides enhanced guidance formeasuring the fair value of assets and liabilities and requires additionaldisclosures related to the extent to which companies measure assets andliabilities at fair value, the information used to measure fair value, and theeffect of fair value measurements on earnings. SFAS 157 is effective forus as of January 1, 2008. We are currently assessing the impact that theadoption of SFAS 157 may have on our consolidated financial position,results of operations or cash flows.

In September 2006, the FASB issued Statement ofFinancial Accounting Standards No. 158, “*Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans—anamendment of FASB Statements No. 87, 88, 106, and 132(R)*” (“SFAS 158”).SFAS 158 requires balance sheet recognition of the overfunded orunderfunded status of pension and postretirement benefit plans. Under SFAS 158,actuarial gains and losses, prior service costs or credits, and any remainingtransition assets or obligations that have not been recognized under previousaccounting standards must be recognized as a component of accumulated othercomprehensive income (loss) within stockholders’ equity, net of tax effects,until they are amortized as a component of net periodic benefit cost. Inaddition, the measurement date and the date at which plan assets and thebenefit obligation are measured, are required to be the company’s fiscal year-end.SFAS 158 is effective for us as of December 31, 2007, except for themeasurement date provisions, which are effective December 31, 2009. We arecurrently assessing the impact the adoption of SFAS 158 may have on ourconsolidated financial position, results of operations or cash flows.

In September 2006, the United States Securitiesand Exchange Commission (“SEC”) released Staff Accounting Bulletin No. 108,“*Considering the Effects of Prior Year MisstatementsWhen Quantifying Misstatements in Current Year Financial Statements*”(“SAB 108”). SAB 108 provides interpretative guidance on how public companiesquantify financial statement misstatements. There have been two commonapproaches used to quantify such errors. Under an income statement approach, the“roll-over” method, the error is quantified as the amount by which the currentyear income statement is misstated. Alternatively, under a balance sheetapproach, the “iron curtain” method, the error is quantified as the cumulativeamount by which the current year balance sheet is misstated. In SAB 108, theSEC established an approach that requires quantification of financial statementmisstatements based on the effects of the misstatements on each of the company’sfinancial statements and the related financial statement disclosures. Thismodel is commonly referred to as a “dual approach” because it requiresquantification of errors under both the roll-over and iron curtain methods. SAB108 was effective for us as of December 31, 2006. The adoption of SAB 108did not have a material impact on our consolidated financial position, resultsof operations or cash flows.

In February 2007, theFASB issued Statement of Financial Accounting Standards No. 159, “*The Fair Value Option for Financial Assets and Liabilities*”(“SFAS 159”). SFAS 159 provides entities with the option to reportselected financial assets and liabilities at fair value. Business entitiesadopting SFAS 159 will report unrealized gains and losses in earnings ateach subsequent reporting date on items for which fair value option has beenelected. SFAS 159 establishes presentation and disclosure requirementsdesigned to facilitate comparisons between entities that choose differentmeasurement attributes for similar types of assets and liabilities. SFAS 159requires additional information that will help investors and other financialstatement users to understand the effect of an entity’s choice to use fairvalue on its earnings. SFAS 159 is effective for fiscal years beginningafter November 15, 2007, with earlier adoption permitted. We are currentlyassessing the impact that the adoption of SFAS 159 may have onour consolidated financial position, results of operations or cash flows.

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**Note 2.Discontinued Operations and Related Assets Held for Sale**

In June 2003, we announced the discontinuation ofour opto-electronics division, which we had established as part of ouracquisition of Lyte Optronics, Inc. in May 1999. The discontinuedopto-electronics division manufactured blue, cyan, and green high-brightnesslight emitting diodes (HBLEDs) for the illumination markets, includingfull-color displays, wireless handset backlighting and traffic signals, andalso manufactured vertical cavity surface emitting lasers (VCSELs) and laserdiodes for fiber optic communications and storage area networks. Accordingly,the results of operations of the opto-electronics division have been segregatedfrom continuing operations and are reported separately as discontinuedoperations in our consolidated statements of operations for all periodspresented.

In September 2003, we completed the sale ofsubstantially all of the assets of our opto-electronics business to LumeiOptoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group,Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. Aportion of the purchase price equal to $1.0 million was held in escrow tosatisfy any claims that the purchasers might make for breaches ofrepresentations or warranties by us. Of this total escrow, $0.8 millioncould be released after the one year anniversary of the sale of theopto-electronics business and the remainder could be released after the secondanniversary of the sale. To date, we have resolved all claims made against the$1.0 million that was held in escrow. For the year ended December 31,2005, we recorded a $0.6 million gain from escrow refund, a $0.1 milliongain in property tax refunds and gain on disposal of properties, offset by $0.2 millionin expenses totaling a net gain of $0.5 million. Of the $0.8 millionescrow amount, approximately $0.2 million was received in 2004, while theremaining $0.6 million was received in 2005.

In June 2005, we completed the sale of a buildinglocated in Monterey Park, California. This asset had been classified as “assetsheld for sale” in the amount of $1.25 million on the consolidated balancesheet as of December 31, 2004. We received net proceeds on the sale of theproperty of approximately $1.3 million and accordingly recorded a gain ondisposal of $0.1 million.

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

| ** **                                                        | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                           |       |                                        | $          | — |   |   | $ | — |   | $ | — |   |
| Cost of revenue                                                   |       |                                        | —     |   |   | — |   | — |   |
| Gross loss                                                        |       |                                        | —     |   |   | — |   | — |   |
| Operating  expenses:                                              |       |                                        |       |   |   |   |   |   |   |
| Selling, general and administrative                               |       |                                        | —     |   |   | (59 | ) | (222 | ) |
| Total operating expenses                                          |       |                                        | —     |   |   | (59 | ) | (222 | ) |
| Gain (loss) from  operations                                      |       |                                        | —     |   |   | 59 |   | 222 |   |
| Other income  (expense), net                                      |       |                                        | 18         |   |   | — |   | 250 |   |
| Gain (loss) from  discontinued operations before gain on disposal |       |                                        | 18         |   |   | (59 | ) | 472 |   |
| Gain on disposal                                                  |       |                                        | —     |   |   | 603 |   | 419 |   |
| Net gain from  discontinued operations                            |       |                                        | $          | 18 |   |   | $ | 544 |   | $ | 891 |   |

 

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Thecarrying value of the assets and liabilities of the discontinuedopto-electronics business included in the consolidated balance sheets are asfollows (in thousands):

| ** **                        | ** ** | **As of  December 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|
| ** **                        | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Current assets:                   |       |                              |       |   |   |
| Cash                              |       | $                                 | 395        |   | $ | 472 |   |
| Total current assets              |       | 395                               |       | 472 |   |
| Other assets                      |       | —                            |       | — |   |
| Total assets                      |       | $                                 | 395        |   | $ | 472 |   |
| Current  liabilities:             |       |                              |       |   |   |
| Accrued liabilities               |       | $                                 | —     |   | $ | 95 |   |
| Total liabilities                 |       | —                            |       | 95 |   |
| Net assets                        |       | 395                               |       | 377 |   |
| Total liabilities and  net assets |       | $                                 | 395        |   | $ | 472 |   |

 

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**Note 3. Cash, CashEquivalents and Investments**

Ourcash, cash equivalents and investments are classified as follows (inthousands):

| ** **         | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **         | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gain**     | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** |
| **Classified as:** | ** ** |                            | ** ** | ** **                      |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |
|                    |            |                                 |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Cash                                         |       |   | $          | 6,892      | ** ** |   |       | $          | —     | ** ** |       |       | $      | —     |       |   | $          | 6,892      |   |   | $          | 12,803     | ** ** |   |       | $          | —     | ** ** |       |   | $   | — |   |   | $      | 12,803 |   |
|----------------------------------------------|------------|--------|------------|------------|------------|--------|------------|------------|------------|------------|------------|------------|--------|------------|------------|--------|------------|------------|--------|--------|------------|------------|------------|--------|------------|------------|------------|------------|------------|--------|-----|--------|--------|--------|--------|--------|--------|
| Cash equivalents:                            |       |   |       | ** ** |       |   |       | ** ** |       |       |       |       |   |       |       |   |       | ** ** |   |   |       | ** ** |       |   |       |       |       |       |       |
| Money market fund                            |       |   | 7,045      | ** ** |       |   | —     | ** ** |       |       | —     |       |   | 7,045      |       |   | 1,729      | ** ** |   |   | —     | ** ** |       |   | —     |       |       | 1,729      |       |
| US Treasury and agency securities       |       |   | 2,179      | ** ** |       |   | —     | ** ** |       |       | —     |       |   | 2,179      |       |   | —     | ** ** |   |   | —     | ** ** |       |   | —     |       |       | —     |       |
| Commercial paper                             |       |   | —     | ** ** |       |   | —     | ** ** |       |       | —     |       |   | —     |       |   | 2,940      | ** ** |   |   | —     | ** ** |       |   | —     |       |       | 2,940      |       |
| Total cash equivalents                       |       |   | 9,224      | ** ** |       |   | —     | ** ** |       |       | —     |       |   | 9,224      |       |   | 4,669      | ** ** |   |   | —     | ** ** |       |   | —     |       |       | 4,669      |       |
| Total cash and cash equivalents              |       |   | 16,116     | ** ** |       |   | —     | ** ** |       |       | —     |       |   | 16,116     |       |   | 17,472     | ** ** |   |   | —     | ** ** |       |   | —     |       |       | 17,472     |       |
| Investments:                                 |       |   |       | ** ** |       |   |       | ** ** |       |       |       |       |   |       |       |   |       | ** ** |   |   |       | ** ** |       |   |       |       |       |       |       |
| US Treasury and agency securities            |       |   | 12,277     | ** ** |       |   | —     | ** ** |       |       | (39        | )          |   | 12,238     |       |   | 4,460      | ** ** |   |   | —     | ** ** |       |   | (12        | )          |       | 4,448      |       |
| Asset-backed securities                      |       |   | 809        | ** ** |       |   | —     | ** ** |       |       | (1         | )          |   | 808        |       |   | 3,285      | ** ** |   |   | —     | ** ** |       |   | (11        | )          |       | 3,274      |       |
| Commercial paper                             |       |   | 500        | ** ** |       |   | —     | ** ** |       |       | —     |       |   | 500        |       |   | —     | ** ** |   |   | —     | ** ** |       |   | —     |       |       | —     |       |
| Corporate bonds                              |       |   | 13,035     | ** ** |       |   | —     | ** ** |       |       | (3         | )          |   | 13,032     |       |   | 2,504      | ** ** |   |   | —     | ** ** |       |   | (13        | )          |       | 2,491      |       |
| Corporate equity securities                  |       |   | —     | ** ** |       |   | —     | ** ** |       |       | —     |       |   | —     |       |   | 1,468      | ** ** |   |   | 1,324      | ** ** |       |   | —     |       |       | 2,792      |       |
| Total investments                            |       |   | 26,621     | ** ** |       |   | —     | ** ** |       |       | (43        | )          |   | 26,578     |       |   | 11,717     | ** ** |   |   | 1,324      | ** ** |       |   | (36        | )          |       | 13,005     |       |
| Total cash, cash equivalents and investments |       |   | $          | 42,735     | ** ** |   |       | —     | ** ** |       |       | $          | (43    | )          |       | $      | 42,694     |       |   | $      | 29,189     | ** ** |       |   | $          | 1,324      | ** ** |       |       | $      | (36 | )      |   | $      | 30,477 |   |
| **Contractual maturities on  investments:**  | ** ** |   | ** ** | ** ** |       |   | ** ** | ** ** |       |       | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |       |   | ** ** | ** ** |       | ** ** | ** ** |
| Due within 1 year                       |       |   | $          | 13,767     | ** ** |   |       |       | ** ** |       |       |       |   |       | $          | 13,727 |       |       | $      | 8,384  | ** ** |       |       |   | ** ** |       |       |       |       |   | $   | 9,682  |   |
| Due after 1 through 5 years             |       |   | 12,854     | ** ** |       |   |       | ** ** |       |       |       |       |   | 12,851     |       |   | 3,333      | ** ** |   |   |       | ** ** |       |   |       |       |       | 3,323      |       |
|                                         |       |   | $          | 26,621     | ** ** |   |       |       | ** ** |       |       |       |   |       | $          | 26,578 |       |       | $      | 11,717 | ** ** |       |       |   | ** ** |       |       |       |       |   | $   | 13,005 |   |

 

The investments include $7.2 million and $7.5 millionrecorded as restricted deposits on the consolidated balance sheets as of December 31,2006 and 2005, respectively, as a result of the outstanding principal amount onour industrial revenue bonds.

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We manage our investments as a single portfolio ofhighly marketable securities that is intended to be available to meet ourcurrent cash requirements. For the year ended December 31, 2006, we had$3.3 million of gross realized gains on sales of our available-for-salesecurities. For the year ended December 31, 2005, we had no gross realizedgain or loss on sales of our available-for-sale securities.

Thegross unrealized losses related to our portfolio of available-for-salesecurities were primarily due to a decrease in the fair value of debtsecurities as a result of an increase in interest rates during 2006. We havedetermined that the gross unrealized losses on our available-for-salesecurities as of December 31, 2006 are temporary in nature. We reviewed ourinvestment portfolio to identify and evaluate investments that have indicationsof possible impairment. Factors considered in determining whether a loss istemporary include the magnitude of the decline in market value, the length oftime the market value has been below cost (or adjusted cost), credit quality,and our ability and intent to hold the securities for a period of timesufficient to allow for any anticipated recovery in market value. The followingtable provides a breakdown of our available-for-sale securities with unrealizedlosses as of December 31, 2006 and 2005 (in thousands):

| ** **                        | ** ** | **In Loss Position  < 12 months** | ** ** | **In Loss Position  > 12 months** | ** ** | **Total In  Loss Position** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------|------------|
| **2006**                          | ** ** | ** **                                               | ** ** | **Fair  Value**                                          | ** ** | **Gross  Unrealized  (Loss)**         | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** |
| Investments:                      |       |                                                     |       |                                                     |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| US Treasury and agency securities |       | $                                                        | 10,841     |                                                     |       | $                                     | (38        | ) |   | $ | 1,397 |   |   | $ | (1 | ) |   | $ | 12,238 |   |   | $ | (39 | ) |   |
| Asset-backed securities           |       | —                                                   |       |                                                     | —     |                                  |       | 809 |   |   | (1 | ) |   | 809 |   |   | (1 | ) |   |
| Corporate bonds                   |       | 1,387                                                    |       |                                                     | (3         | )                                     |       | 296 |   |   | — |   |   | 1,683 |   |   | (3 | ) |   |
| Total in loss  position           |       | $                                                        | 12,228     |                                                     |       | $                                     | (41        | ) |   | $ | 2,502 |   |   | $ | (2 | ) |   | $ | 14,730 |   |   | $ | (43 | ) |   |
|                                   |            |                                                          |            |                                                          |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                        | ** ** | **In Loss Position  < 12 months** | ** ** | **In Loss Position  > 12 months** | ** ** | **Total In  Loss Position** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------|------------|
| **2005**                          | ** ** | ** **                                               | ** ** | **Fair  Value**                                          | ** ** | **Gross  Unrealized  (Loss)**         | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** |
| Investments:                      |       |                                                     |       |                                                     |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| US Treasury and agency securities |       | $                                                        | 2,757      |                                                     |       | $                                     | (9         | ) |   | $ | 1,691 |   |   | $ | (3 | ) |   | $ | 4,448 |   |   | $ | (12 | ) |   |
| Asset-backed securities           |       | 1,642                                                    |       |                                                     | (4         | )                                     |       | 1,632 |   |   | (7 | ) |   | 3,274 |   |   | (11 | ) |   |
| Corporate bonds                   |       | 2,491                                                    |       |                                                     | (13        | )                                     |       | — |   |   | — |   |   | 2,491 |   |   | (13 | ) |   |
| Total in loss  position           |       | $                                                        | 6,890      |                                                     |       | $                                     | (26        | ) |   | $ | 3,323 |   |   | $ | (10 | ) |   | $ | 10,213 |   |   | $ | (36 | ) |   |
|                                   |            |                                                          |            |                                                          |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Note 4.Inventories, Net**

Thecomponents of inventory are summarized below (in thousands):

| ** **      | ** ** | **As of December 31,** | ** ** |
|-----------------|------------|---------------------------------------|------------|
| ** **      | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Inventories:    |       |                                  |       |   |   |
| Raw materials   |       | $                                     | 8,419      |   | $ | 6,667 |   |
| Work in process |       | 11,222                                |       | 9,141 |   |
| Finished goods  |       | 622                                   |       | 348 |   |
|            |       | $                                     | 20,263     |   | $ | 16,156 |   |

 

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**Note 5. Property,Plant and Equipment, Net**

Thecomponents of our property, plant and equipment are summarized below (inthousands):

| ** **                                       | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Property, plant  and equipment:                  |       |                                  |       |   |   |
| Land                                             |       | $                                     | —     |   | $ | 1,120 |   |
| Building                                         |       | 10,019                                |       | 16,421 |   |
| Machinery and  equipment                         |       | 19,523                                |       | 17,798 |   |
| Leasehold  improvements                          |       | 769                                   |       | 868 |   |
| Construction in progress                         |       | 2,363                                 |       | 623 |   |
|                                             |       | 32,674                                |       | 36,830 |   |
| Less: accumulated  depreciation and amortization |       | (19,899                               | )          | (19,524 | ) |
|                                             |       | $                                     | 12,775     |   | $ | 17,306 |   |

 

Depreciation expense was$2.6 million, $3.7 million, and $4.9 million for the years ended 2006, 2005,and 2004, respectively.

**Note 6. Investmentsin Privately-held Companies**

We have made strategic investments in privatecompanies located in China in order to gain access to raw materials atcompetitive cost that are critical to our substrate business.

Ourinvestments are summarized below (in thousands) :

| ** **                                                            | ** ** | **Investment Balance  As of December 31,** | ** ** | **Accounting** | ** ** | **Ownership** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|----------------|------------|---------------|------------|
| **Company**                                                           | ** ** | ** **                                                     | ** ** | **2006**       | ** ** | **2005**      | ** ** | **Method** | ** ** | **Percentage** | ** ** |
| Beijing Ji Ya  Semiconductor Material Co., Ltd                        |       | $                                                              | 996        |           | $          | 996           |       | Consolidated |   |   | 46 | % |   |
| Nanjing Jin Mei  Gallium Co., Ltd                                     |       | 592                                                            |       | 592            |       | Consolidated  |       |   | 83 |   |   |
| Beijing BoYu  Semiconductor Vessel Craftwork Technology Co., Ltd |       | 410                                                            |       | 410            |       | Consolidated  |       |   | 70 |   |   |
| Xilingol Tongli  Germanium Co. Ltd                                    |       | 1,304                                                          |       | 864            |       | Equity        |       |   | 25 |   |   |
| Emeishan Jia Mei High  Purity Metals Co., Ltd                         |       | 670                                                            |       | 596            |       | Equity        |       |   | 25 |   |   |
|                                                                       |            |                                                                |            |                |            |               |            |  |  |  |  |  |  |  |  |

 

Our ownership of Beijing Ji Ya Semiconductor MaterialCo., Ltd. (Ji Ya) at inception was 51%. During 2005, our ownership share wasreduced to 46% as 5% of our ownership was given to Ji Ya’s  management upon fulfillment of working at JiYa for at least four years. There are no further outstanding commitments. Wewill continue to consolidate Ji Ya as we have significant influence inmanagement and have a majority control of the board. Our chief financialofficer is chairman of the board, while our chief executive officer, our chiefoperating officer, and our president of joint venture operations are members ofthe board.

We have a similar arrangement with Nanjing Jin MeiGallium Co., Ltd. (Jin Mei) where our ownership at inception was 88%. During2005, our ownership share was reduced to 83% as 5% of our ownership was givento Jin Mei’s management upon fulfillment of working at Jin Mei for at leastthree years. There are no further outstanding commitments. We will continue toconsolidate Jin Mei as we have significant influence in management and have amajority control of the board. Our chief operating officer is chairman of theboard, while our chief executive officer and our president of joint ventureoperations are members of the board.

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We have significant influence in management overBeijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd (BoYu),have a controlling financial interest of 70%, and have a majority control ofthe board. Our chief executive officer is chairman of the board, while ourchief operating officer and our president of joint venture operations aremembers of the board.

The investmentbalances for the two companies accounted for under the equity method areincluded in other assets in the consolidated balance sheets and totaled $2.0million and $1.5 million at December 31, 2006 and 2005, respectively. Weown 25% of the ownership interests in each of these companies. These twocompanies are not considered variable interest entities because:

·       bothcompanies have sustainable businesses of their own;

·       ourvoting power is proportionate to our ownership interests;

·       weonly recognize our respective share of the losses and/or residual returnsgenerated by the companies if they occur; and

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

Undistributed retainedearnings relating to our investments in these privately-held companies were$4.4 million and $2.6 million as of December 31, 2006 and 2005,respectively. Net income recorded from our investments was $1.8 million, $1.1million, and $0.7 million, for the years ended December 31, 2006, 2005,and 2004, respectively.

**Note 7. Investments**

As of December 31,2006 we only maintain minority investments in private companies. During 2006 wesold all of our shares of common stock of the only publicly traded company weheld, Finisar Corporation, generating net proceeds of $4.4 million andrecording a gain of $3.3 million, which is included in other income and(expense). Our investments in private companies are reviewed for other thantemporary declines in value on a quarterly basis. These investments areclassified as other assets in the consolidated balance sheets and are accountedfor under the cost method as we do not have the ability to exercise significantinfluence over their operations. We monitor our investments for impairment andrecord reductions in carrying value when events or changes in circumstancesindicate that the carrying value may not be recoverable. 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. As of December 31,2006 and 2005, the minority investments totaled approximately $0.4 million forboth years.

**Note 8.Restructuring Costs**

As of December 31,2006 and 2005, our restructuring accruals are as follows (in thousands):

| **2006**                                               | ** ** | ** ** | ** ** | **Restructuring  Accrual as of  December 31, 2005** | ** ** | **Reversals/  Additions** | ** ** | **Payments** | ** ** | **Restructuring  Accrual as of  December 31, 2006** | ** ** |
|--------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------|------------|---------------------------|------------|--------------|------------|-------------------------------------------------------------------------|------------|
| Future lease  payments related to abandoned facilities |       |       | $          | 250                                                                     |       |                      |       | $            | —     |                                                                    |       |   | $ | (250 | ) |   |   | $ | — |   |   |
| Workforce  reduction                                   |       |       | 215        |                                                                    |       |                      | (2         | )            |       |                                                                    | (213       | ) |   |   | — |   |   |
| Total                                                  |       |       | $          | 465                                                                     |       |                      |       | $            | (2         | )                                                                       |       |   | $ | (463 | ) |   |   | $ | — |   |   |

 

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| **2005**                                               | ** ** | ** ** | ** ** | **Restructuring  Accrual as of  December 31, 2004** | ** ** | **Additions** | ** ** | **Payments** | ** ** | **Restructuring  Accrual as of  December 31, 2005** | ** ** |
|--------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------|------------|---------------|------------|--------------|------------|-------------------------------------------------------------------------|------------|
| Future lease  payments related to abandoned facilities |       |       | $          | 552                                                                     |       |          |       | $            | 236        |                                                                    |       |   | $ | (538 | ) |   |   | $ | 250 |   |   |
| Workforce  reduction                                   |       |       | —     |                                                                    |       |          | 329        |         |       |                                                                    | (114       | ) |   |   | 215 |   |   |
| Japan office  closure                                  |       |       | —     |                                                                    |       |          | 271        |         |       |                                                                    | (271       | ) |   |   | — |   |   |
| Total                                                  |       |       | $          | 552                                                                     |       |          |       | $            | 836        |                                                                    |       |   | $ | (923 | ) |   |   | $ | 465 |   |   |

 

| **2004**                                               | ** ** | ** ** | ** ** | **Restructuring  Accrual as of  December 31, 2003** | ** ** | **Additions** | ** ** | **Payments** | ** ** | **Restructuring  Accrual as of  December 31, 2004** | ** ** |
|--------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------|------------|---------------|------------|--------------|------------|-------------------------------------------------------------------------|------------|
| Future lease  payments related to abandoned facilities |       |       | $          | —                                                                  |       |          |       | $            | 845        |                                                                    |       |   | $ | (293 | ) |   |   | $ | 552 |   |   |
| Workforce  reduction                                   |       |       | —     |                                                                    |       |          | 463        |         |       |                                                                    | (463       | ) |   |   | — |   |   |
| Total                                                  |       |       | $          | —                                                                  |       |          |       | $            | 1,308      |                                                                    |       |   | $ | (756 | ) |   |   | $ | 552 |   |   |

 

In March 2005, we announced that we would bereducing the workforce at our Beijing, China manufacturing facility byapproximately 100 positions or approximately 15%. This measure was taken aspart of our ongoing effort to reduce our cost structure and bring capacity inline with current market demand. Accordingly, we recorded a restructuringcharge of $0.1 million in March 2005 relating to the reduction in workforce, which we completed in June 2005. We anticipate annual savings of $0.3 millionrelating to this reduction in force.

In April 2005, we closed our Japan office as partof our ongoing effort to reduce our cost structure. Accordingly, we recorded restructuringcharges of $0.1 million in the second and third quarters of 2005, respectively,relating to the closure of our Japan office. We also anticipate payroll andrelated expense annual savings of approximately $0.3 million.

In December 2005, we further reduced theworkforce at our Fremont, California facility by approximately 15positions that are no longer required to support production and operations, orapproximately 29 percent, over the next 120 days. This measure wasbeing taken as part of our ongoing effort to downsize our Fremont,California facility headcount. Accordingly, we recorded a restructuring chargeof approximately $0.3 million in December 2005 related to the reduction inforce for severance-related expenses from the reduction in force, all of whichwill be cash expenditures. We anticipate that the cash outflow from this chargeto be incurred over the two quarters commencing in the first quarter of 2006and we expect to save $0.9 million annually in payroll and related expenses.Also in December 2005, we recorded an additional restructuring charge ofapproximately $0.2 million, primarily related to the final liquidationprocedures of AXT’s Japan office so as to eliminate the remaining assets. Thereis no expected cash outflow of this charge.

Overall for the year ended December 31,2005, we recorded restructuring charges of $0.2 million relating to lease costs associated with facilitieslocated in California that are no longer required to support production. Theremaining restructuring accrual for future lease payments related to abandonedU.S. facilities of $0.3 million was paid out during 2006, and was included onthe accompanying consolidated balance sheet as accrued restructuring.

For 2004, we announcedplans to cease all production activities in the United States and to manufactureour products only in China during the second quarter. In June 2004, weincurred a restructuring charge of $1.1 million as a result of our decision toclose down our remaining manufacturing facilities in the United States. In thethird and fourth quarter of 2004, we incurred additional restructuring chargesof $231,000 for a total of $1.3 million in 2004. These charges comprised costsrelated to the 

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reductionin work force effected in June 2004, and lease costs associated with thefacilities located in California that are no longer required to supportproduction. In aggregate, we eliminated 50 positions, 47 of which wereproduction workers. As of December 31, 2004, we savedapproximately $560,000 in payroll and related expenses.

**Note 9. Debt**

***Credit Facility***

As of December 31,2006, the credit facility maintained by us with a bank included a letter ofcredit supporting repayment of our industrial bonds with an outstanding amountof $7.2 million. We have pledged and placed cash and certain investment securitieswith the trust department of the bank as additional collateral for thisfacility. Accordingly, $7.2 million of cash and short-term investments arerestricted.

***Long-Term Debt***

Thecomponents of long-term debt are summarized below (in thousands):

| ** **                                                                                                                                                                                                               | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                                                                                                                               | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Taxable revenue  bonds, collateralized by a letter of credit from a bank, bearing interest at  the H15 30 day bond yield for commercial paper which was 5.47% as of  December 31, 2006, maturing December 2023 |       | $                                     | 7,150      |   | $ | 7,450 |   |
| Joint venture  long term debt by outside shareholder at zero% interest maturing in 2008                                                                                                                             |       | 139                                   |       | 270 |   |
|                                                                                                                                                                                                                     |       | 7,289                                 |       | 7,720 |   |
| Less current  portion                                                                                                                                                                                                    |       | (450                                  | )          | (300 | ) |
|                                                                                                                                                                                                                     |       | $                                     | 6,839      |   | $ | 7,420 |   |
| Maturities of  long-term debt as of December 31, 2006 were as follows:                                                                                                                                              |       |                                  |       |   |   |
| 2007                                                                                                                                                                                                                     |       | $                                     | 450        |   |   |   |
| 2008                                                                                                                                                                                                                     |       | 589                                   |       |   |   |
| 2009                                                                                                                                                                                                                     |       | 450                                   |       |   |   |
| 2010                                                                                                                                                                                                                     |       | 450                                   |       |   |   |
| 2011                                                                                                                                                                                                                     |       | 450                                   |       |   |   |
| Thereafter                                                                                                                                                                                                               |       | 4,900                                 |       |   |   |
|                                                                                                                                                                                                                     |       | $                                     | 7,289      |   |   |   |

 

**Note 10.Stockholders’ Equity**

In August 2004, we announced the adoption of astock repurchase program in accordance with Rule 10b5-1 of theSecurities Exchange Act of 1934 to provide for the repurchase of up to $2million of our common stock. This plan was extended for one year in July 2005.Repurchases were made from time to time in the open market during thetwelve-month period ended July 31, 2006, at prevailing market prices usingour own cash resources. As of December 31, 2005, we had 22,977,301 sharesof common stock outstanding and 201,516 shares were repurchased in 2005 underthis program. As of December 31, 2006, we had 29,010,546 shares of commonstock outstanding and no shares were repurchased in 2006 under this program,which has now expired.

The 883,000 shares of$0.001 par value Series A preferred stock issued and outstanding at December 31,2006, and 2005, valued at $3,532,000 are non-voting and non-convertiblepreferred stock with a 5.0% cumulative annual dividend rate payable whendeclared by the board of directors and $4 per 

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shareliquidation preference over common stock. These preferred shares were issuedwhen we completed our acquisition of Lyte Optronics, Inc. on May 28,1999.

**Note 11. EmployeeBenefit Plans**

***Stock Option Plans***

In March 1993, our board of directors approvedthe 1993 Stock Option Plan (1993 Plan), which provided for granting ofincentive and non-qualified stock options to our employees and directors. Underthe 1993 Plan, 880,000 shares of common stock were authorized for issuance.Options granted under the 1993 Plan were generally for periods not to exceedten years and were granted at the fair market value of the stock at the date ofgrant as determined by the board of directors. Options granted under the 1993Plan generally vested 25% upon grant and 25% each year thereafter, with fullvesting occurring on the third anniversary of the grant date. This plan terminatedon March 12, 2003.

In July 1997, our board of directors approved the1997 Stock Option Plan (1997 Plan), which provides for granting of incentiveand non-qualified stock options to our employees and directors. Under the 1997Plan, 5,423,583 shares of common stock have been authorized for issuance.Options granted under the 1997 Plan are generally for periods not to exceed tenyears (five years if the option is granted to a 10% stockholder) and aregranted at the fair market value of the stock at the date of grant asdetermined by the board of directors. Options granted under the 1997 Plangenerally vest 25% at the end of one year and 2.1% each month thereafter, withfull vesting after four years.

Thefollowing summarizes our stock option activity under the 1993 Plan and the 1997Plan, and related weighted average exercise price within each category for eachof the years ended December 31, 2004, 2005, and 2006 (in thousands, exceptper share data):

| ** **                                                        | ** ** | **Available  for Grant** | ** ** | **Number of  Options  Outstanding** | ** ** | **Weighted-  average  Exercise  Price** | ** ** | **Weighted-  average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                        | ** ** | ** **                    | ** ** | ** **                               | ** ** | ** **                              | ** ** | **(in years**)                                  | ** ** | ** **                      | ** ** |
| Options  outstanding as of December 31, 2003                 |       |                          | 2,398      |                                     |       |                                    | 2,588      |                                                 |       |                            | $          | 10.79 |   |   |   |   |   |   |   |   |   |   |
| Granted                                                           |       |                          | (600       | )                                        |       |                                    | 600        |                                                 |       |                            | 1.51       |   |   |   |   |   |   |   |   |   |   |
| Exercised                                                         |       |                          | —     |                                     |       |                                    | (56        | )                                                    |       |                            | 2.73       |   |   |   |   |   |   |   |   |   |   |
| Canceled                                                          |       |                          | 822        |                                     |       |                                    | (822       | )                                                    |       |                            | 15.47      |   |   |   |   |   |   |   |   |   |   |
| Options  outstanding as of December 31, 2004                 |       |                          | 2,620      |                                     |       |                                    | 2,310      |                                                 |       |                            | 2.70       |   |   |   |   |   |   |   |   |   |   |
| Granted                                                           |       |                          | (866       | )                                        |       |                                    | 866        |                                                 |       |                            | 1.27       |   |   |   |   |   |   |   |   |   |   |
| Exercised                                                         |       |                          | —     |                                     |       |                                    | (5         | )                                                    |       |                            | 1.28       |   |   |   |   |   |   |   |   |   |   |
| Canceled                                                          |       |                          | 254        |                                     |       |                                    | (254       | )                                                    |       |                            | 2.45       |   |   |   |   |   |   |   |   |   |   |
| Options  outstanding as of December 31, 2005                 |       |                          | 2,008      |                                     |       |                                    | 2,917      |                                                 |       |                            | 2.30       |   |   |   |   |   |   |   |   |   |   |
| Granted                                                           |       |                          | (180       | )                                        |       |                                    | 180        |                                                 |       |                            | 4.52       |   |   |   |   |   |   |   |   |   |   |
| Exercised                                                         |       |                          | —     |                                     |       |                                    | (284       | )                                                    |       |                            | 1.96       |   |   |   |   |   |   |   |   |   |   |
| Canceled                                                          |       |                          | 85         |                                     |       |                                    | (85        | )                                                    |       |                            | 1.50       |   |   |   |   |   |   |   |   |   |   |
| Options outstanding  as of December 31, 2006                 |       |                          | 1,913      |                                     |       |                                    | 2,728      |                                                 |       |                            | $          | 2.51 |   |   |   | 6.37 |   |   |   | $ | 7,091 |   |   |
| Options vested  and expected to vest as of December 31, 2006 |       |                          |       |                                     |       |                                    | 2,516      |                                                 |       |                            | $          | 2.55 |   |   |   | 6.20 |   |   |   | $ | 6,508 |   |   |
| Options exercisable as  of December 31, 2006                 |       |                          |       |                                     |       |                                    | 1,857      |                                                 |       |                            | $          | 2.74 |   |   |   | 5.41 |   |   |   | $ | 4,715 |   |   |

 

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Theoptions outstanding and exercisable as of December 31, 2006 were in thefollowing exercise price ranges (in thousands, except per share data):

| ** **                             | ** ** | **Options Outstanding as of  December 31, 2006** | ** ** | **Options Vested and  Exercisable as of  December 31, 2006** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| **Range of  Exercise Price** | ** ** | ** **                                                                | ** ** | **Shares**                                                                            | ** ** | **Weighted-average  Exercise Price** | ** ** | **Weighted-average  Remaining  Contractual Life** | ** ** | **Shares** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
| $1.17 - $ 1.38                    |       |                                                                      | 1,475      |                                                                                  |       |   | $ | 1.29 |   |   |   | 7.01 |   |   |   | 851 |   |   |   | $ | 1.30 |   |   |
| $1.39 - $ 1.44                    |       |                                                                      | 11         |                                                                                  |       |   | $ | 1.41 |   |   |   | 8.39 |   |   |   | 4 |   |   |   | $ | 1.41 |   |   |
| $1.45 - $ 2.24                    |       |                                                                      | 620        |                                                                                  |       |   | $ | 2.17 |   |   |   | 5.68 |   |   |   | 556 |   |   |   | $ | 2.18 |   |   |
| $2.25 - $ 5.00                    |       |                                                                      | 504        |                                                                                  |       |   | $ | 3.99 |   |   |   | 6.17 |   |   |   | 328 |   |   |   | $ | 3.65 |   |   |
| $5.01 - $41.50                         |       |                                                                      | 118        |                                                                                  |       |   | $ | 13.41 |   |   |   | 2.77 |   |   |   | 118 |   |   |   | $ | 13.41 |   |   |
|                                   |       |                                                                      | 2,728      |                                                                                  |       |   | $ | 2.51 |   |   |   | 6.37 |   |   |   | 1,857 |   |   |   | $ | 2.74 |   |   |
|                                        |            |                                                                           |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The total intrinsic value of options exercised for theyear ended December 31, 2006 was $0.4 million. Cash received from optionexercises for the year ended December 31, 2006 was $0.6 million. The totalfair value of options vested for the year ended December 31, 2006 was $2.0million.

As of December 31,2005 and 2004, options to purchase 1,536,000 shares and 1,114,000 shares atweighted average exercise prices of $3.03 and $3.40 per share were vested andexerciseable, respectively.

***Employee Stock Purchase Plan***

In February 1998, ourboard of directors approved the 1998 Employee Stock Purchase Plan (1998Purchase Plan). Our stockholders approved the 1998 Purchase Plan in March 1998.A total of 900,000 shares of our common stock were reserved for issuance underthe 1998 Purchase Plan, of which a total of approximately 845,000 shares werepurchased as of December 31, 2005. The 1998 Purchase Plan permitedeligible employees to acquire shares of our common stock through payrolldeductions. The common stock purchase price was 85% of the lower of the marketprice of the common stock at the purchase date or the date of offer to theemployee. A total of approximately 55,000 and 106,000 shares, respectively, ofcommon stock have been issued under the 1998 Purchase Plan for the years ended December 31,2005 and 2004, respectively. We suspended the 1998 Purchase Plan in February 2005.

***Retirement Savings Plan***

We have a 401(k) SavingsPlan (Savings Plan) which qualifies as a thrift plan under Section 401(k) ofthe Internal Revenue Code. All full-time U.S. employees are eligible toparticipate in the Savings Plan after 90 days from the date of hire. In 2005 weamended the savings plan to allow all full-time participants (as defined) tocontribute up to 10% of their earnings to the Savings Plan with a discretionarymatching amount provided by us. Our contributions to the Savings Plan were $0.4million, $0.3 million, and $0.2 million for the years ended December 31,2006, 2005 and 2004, respectively.

**Note 12. Guarantees**

***Indemnification Agreements***

We enter into standard indemnification arrangements inthe ordinary course of business. Pursuant to these arrangements, we indemnify,hold harmless, and agree to reimburse the indemnified parties for lossessuffered or incurred by the indemnified party, generally their businesspartners or customers, in connection with any U.S. patent, or any copyright orother intellectual property infringement claim by any third party with respectto our products. The term of these indemnification agreements is generallyperpetual anytime after the execution of the agreement. The maximum potentialamount of future 

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payments we could berequired to make under these agreements is unlimited. We have never incurredcosts to defend lawsuits or settle claims related to these indemnificationagreements. As a result, we believe the estimated fair value of theseagreements is minimal.

We have entered intoindemnification agreements with our directors and officers that may require usto indemnify our directors and officers against liabilities that may arise byreason of their status or service as directors or officers, other thanliabilities arising from wilful misconduct of a culpable nature; to advancetheir expenses incurred as a result of any proceeding against them as to whichthey could be indemnified; and to obtain directors’ and officers’ insurance ifavailable on reasonable terms, which we currently have in place.

***Product Warranty***

Wewarrant our products for a specific period of time, generally twelve months,against material defects. We provide for the estimated future costs of warrantyobligations in cost of sales when the related revenue is recognized. Theaccrued warranty costs represents the best estimate at the time of sale of thetotal costs that we expect to incur to repair or replace product parts, whichfail while still under warranty. The amount of accrued estimated warranty costsare primarily based on historical experience as to product failures as well ascurrent information on repair costs. On a quarterly basis, we review theaccrued balances and update the historical warranty cost trends. The followingtable reflects the change in our warranty accrual during 2006 and 2005 (inthousands):

| ** **                                    | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Beginning accrued  warranty and related costs |       | $                                       | 120        |   | $ | 135 |   |
| Charged to cost  of revenue                   |       | 668                                     |       | 54 |   |
| Actual warranty  expenditures                 |       | (329                                    | )          | (69 | ) |
| Ending accrued warranty  and related costs    |       | $                                       | 459        |   | $ | 120 |   |

 

***Sales Returns***

In March 2004, werecorded a reserve for sales returns of $0.7 million related to our failure tofollow certain testing requirements and provision of testing data andinformation to certain customers. This reserve was based on discussions withsome of the affected customers and review of specific shipments. As of December 31,2006, this reserve was zero since approximately $0.5 million had been utilizedand approximately $0.2 million had been reversed to revenue in 2005 as wefavorably resolved an outstanding matter with a customer.

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**Note 13. IncomeTaxes**

Thecomponents of the provision (benefit) for income taxes are summarized below (inthousands):

| ** **                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:                            |       |                                        |       |   |   |   |   |   |   |
| Federal                             |       | $                                           | (2,064     | ) | $ | (1,099 | ) |   | $ | — |   |   |
| State                               |       | 4                                           |       | — |   |   | — |   |   |
| Foreign                             |       | 606                                         |       | 149 |   |   | 71 |   |   |
| Total current                       |       | (1,454                                      | )          | (950 | ) |   | 71 |   |   |
| Deferred:                           |       |                                        |       |   |   |   |   |   |   |
| Federal                             |       | —                                      |       | — |   |   | — |   |   |
| State                               |       | —                                      |       | — |   |   | — |   |   |
| Total deferred                      |       | —                                      |       | — |   |   | — |   |   |
| Total net benefit  for income taxes |       | $                                           | (1,454     | ) | $ | (950 | ) |   | $ | 71 |   |   |

 

Areconciliation of the effective income tax rates and the U.S. statutory federalincome tax rate is summarized below:

| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Statutory federal  income tax rate               |       | 35.0                                        | %          | (35.0 | )% | (35.0 | )% |
| State income  taxes, net of federal tax benefits |       | 0.5                                         |       | (1.8 | ) | (1.7 | ) |
| Change in  valuation allowance                   |       | 50.3                                        |       | 30.9 |   | 30.1 |   |
| Stock compensation                               |       | 60.8                                        |       | — |   | — |   |
| Foreign rate  differences                        |       | (470.7                                      | )          | (2.2 | ) | 5.4 |   |
| Dividend from PRC  investee                      |       | 45.0                                        |       | — |   | — |   |
| Net loss from  privately-held PRC investments    |       | (15.3                                       | )          | — |   | — |   |
| Other                                            |       | 3.4                                         |       | 0.9 |   | 1.7 |   |
| Effective tax rate                               |       | (291.0                                      | )%         | (7.2 | )% | 0.5 | % |

 

Deferredtax assets and liabilities are summarized below (in thousands):

| ** **                               | ** ** | **As of December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|
| ** **                               | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Deferred tax  assets:                    |       |                                  |       |   |   |
| Net operating loss                       |       | $                                     | 43,149     |   | $ | 42,546 |   |
| Accruals and reserves not yet deductible |       | 4,648                                 |       | 5,345 |   |
| Credits                                  |       | 3,359                                 |       | 4,329 |   |
|                                     |       | 51,156                                |       | 52,220 |   |
| Deferred tax  liabilities:               |       |                                  |       |   |   |
| State taxes                              |       | —                                |       | (72 | ) |
| Unrepatriated foreign earnings           |       | (1,239                                | )          | (1,239 | ) |
|                                     |       | (1,239                                | )          | (1,311 | ) |
| Net deferred tax assets                  |       | 49,917                                |       | 50,909 |   |
| Valuation allowance                      |       | (49,917                               | )          | (50,909 | ) |
| Net deferred tax  assets                 |       | $                                     | —     |   | $ | — |   |

 

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As of December 31, 2006, we had federal and statenet operating loss carryforwards of approximately $120.1 million and $46.8million, respectively, which will expire beginning in 2020 and 2007,respectively. In addition, we had federal tax credit carryforwards ofapproximately $1.6 million, which will expire beginning in 2019. We also hadstate tax credit carryforwards of approximately $2.7 million which will expirebeginning 2007.

In 2005, the Internal Revenue Service closed itsexamination of our tax return for the 2002 tax year, including the calculationof our 1999 and 2000 net operating loss carry back. As a result of this, wereversed approximately $2.1 million in 2006 and $1.1 million in 2005 ofincome taxes payable accrued for potential exposures relating to those years.This amount is shown as a benefit from income taxes on our consolidated statementsof operations.

The deferred tax asset valuation allowance as of December 31,2006 is attributed to U.S. federal, and state deferred tax assets, which resultprimarily from future deductible accruals, reserves, net operating losscarryforwards, and tax credit carryforwards. We believe that, based on a numberof factors, the available objective evidence creates sufficient uncertaintyregarding our ability to realize the deferred tax assets such that a fullvaluation allowance has been recorded. These factors include our history oflosses, and the lack of carryback capacity to realize deferred tax assets. Thevaluation allowance decreased by $1.0 million, increased by$12.1 million, and increased by $4.2 million for the years endedDecember 31, 2006, 2005 and 2004, respectively.

In accordance with Section 382of the Internal Revenue Code, the amounts of and benefits from net operatingloss and tax credit carryforwards may be impaired or limited in certaincircumstances. Events which cause limitations in the amount of net operatinglosses or credits that we may utilize in any one year include, but are notlimited to, a cumulative ownership change of more than 50% as defined, over athree year period.

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**Note 14. Net lossper Share**

Areconciliation of the numerators and denominators of the basic and diluted netloss per share calculations is as follows (in thousands, except per sharedata):

| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                                                |       |                                        |       |   |   |   |   |
| Income (loss) from continuing operations                                                  |       | $                                           | 926        |   | $ | (12,759 | ) | $ | (14,524 | ) |
| Gain from discontinued operations, net of tax                                             |       | 18                                          |       | 544 |   | 891 |   |
| Less: Preferred stock dividends                                                           |       | (177                                        | )          | (177 | ) | (177 | ) |
| Net income (loss) to common stockholders                                                  |       | $                                           | 767        |   | $ | (12,392 | ) | $ | (13,810 | ) |
| Denominator:                                                                              |       |                                        |       |   |   |   |   |
| Denominator for basic net income (loss) per  share—weighted average common shares    |       | 23,303                                      |       | 23,047 |   | 23,063 |   |
| Effect of dilutive securities:                                                            |       |                                        |       |   |   |   |   |
| Common stock options                                                                      |       | 1,297                                       |       | — |   | — |   |
| Denominator for  dilutive net income (loss) per share                                     |       | 24,600                                      |       | 23,047 |   | 23,063 |   |
| Basic net income  (loss) per share:                                                       |       |                                        |       |   |   |   |   |
| Income (loss) from continuing operations                                                  |       | $                                           | 0.03       |   | $ | (0.56 | ) | $ | (0.64 | ) |
| Gain from discontinued operations, net of taxes                                           |       | —                                      |       | 0.02 |   | 0.04 |   |
| Net income (loss) to common stockholders                                                  |       | $                                           | 0.03       |   | $ | (0.54 | ) | $ | (0.60 | ) |
| Diluted net income  (loss) per share:                                                     |       |                                        |       |   |   |   |   |
| Income (loss) from continuing operations                                                  |       | $                                           | 0.03       |   | $ | (0.56 | ) | $ | (0.64 | ) |
| Gain from discontinued operations, net of taxes                                           |       | —                                      |       | 0.02 |   | 0.04 |   |
| Net income (loss) to common stockholders                                                  |       | $                                           | 0.03       |   | $ | (0.54 | ) | $ | (0.60 | ) |
| Options excluded  from diluted net income (loss) per share as the impact is anti-dilutive |       | 362                                         |       | 2,917 |   | 2,310 |   |

 

**Note 15. SegmentInformation and Foreign Operations**

***Segment Information***

We operate in one segmentfor the design, development, manufacture and distribution of high-performancecompound semiconductor substrates and sale of materials. In accordance withSFAS No. 131, *“Disclosures aboutSegments of an Enterprise and Related Information,”* our chiefoperating decision-maker has been identified as the Chief Executive Officer,who reviews operating results to make decisions about allocating resources and assessingperformance for the company. All material operating units qualify foraggregation due to their identical customer base and similarities in economiccharacteristics, nature of products and services, and procurement,manufacturing and distribution processes. Since we operate in one segment, allfinancial segment and product line information can be found in the consolidatedfinancial statements.

 

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***Geographical Information***

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

| ** **                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Product revenue:                           |       |                                        |       |   |   |   |   |
| North America*                             |       | $                                           | 13,029     |   | $ | 5,168 |   | $ | 7,514 |   |
| Europe                                     |       | 8,365                                       |       | 6,186 |   | 6,840 |   |
| Japan                                      |       | 3,347                                       |       | 2,854 |   | 5,156 |   |
| Taiwan                                     |       | 7,647                                       |       | 3,843 |   | 8,397 |   |
| Asia Pacific  (excluding Japan and Taiwan) |       | 12,057                                      |       | 8,485 |   | 7,547 |   |
|                                       |       | $                                           | 44,445     |   | $ | 26,536 |   | $ | 35,454 |   |

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*                    Primarily theUnited States

Long-livedassets consist primarily of property, plant and equipment, and are attributedto the geographic location in which they are located. Long-lived assets bygeographic region were as follows (in thousands):

| ** **         | ** ** | **As of December 31,** | ** ** |
|--------------------|------------|---------------------------------------|------------|
| ** **         | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Long-lived assets: |       |                                  |       |   |   |
| North America      |       | $                                     | 426        |   | $ | 6,547 |   |
| Asia Pacific       |       | 12,349                                |       | 10,759 |   |
|               |       | $                                     | 12,775     |   | $ | 17,306 |   |

 

**Note 16. ForeignExchange Contracts and Transaction Gains/Losses**

We discontinued the use of short-term forward exchangecontracts for hedging purposes to reduce the effects of adverse foreignexchange rate movements since 2004. As of December 31, 2006, and 2005, wehad no outstanding commitments with respect to foreign exchange contracts.

We incurred foreigncurrency transaction exchange losses (gains) of $123,000, $222,000, and($60,000) for the years ended December 31, 2006, 2005, and 2004,respectively.

**Note 17. RelatedParty Transactions**

Since January 2002, there has not been, nor isthere currently proposed, any transaction or series of similar transactions towhich AXT was or is to be a party in which the amount involved exceeds $60,000,and in which any director, executive officer or holder of more than 5% of anyclass of our voting securities or members of that person’s immediate family hador will have a direct or indirect material interest other than the transactionsdescribed below.

We entered into anoperating lease in July 2001 for warehouse space in Fremont, CA with4160 Business Center, LLC, a real estate holding company, in which DavisZhang, our president of joint venture operations, was the sole shareholder.Lease payments to 4160 Business Center, LLC were approximately $484,000 for theyear ended December 31, 2002 and $121,000 for the three months ended March 31,2003. In April of 2003, Mr. Zhang sold this warehouse to a partyunrelated to us. We began leasing this warehouse from the new owner on the dateof sale. Mr. Zhang no longer holds a $3.7 million note on the property asof December 31, 2006.

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**Note 18.Commitments and Contingencies**

***Legal Matters***

On October 15, 2004, a purported securities classaction lawsuit was filed in the United States Court for the Northern Districtof California, City of Harper Woods Employees Retirement System v. AXT, Inc.et al., No. C 04 4362 MJJ. The Court consolidated the case with asubsequent related case and appointed a lead plaintiff. On April 5, 2005,the lead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc.et al., No. C 04 4362 MJJ. The lawsuit complaint names AXT, Inc. andour former chief technology officer as defendants, and is brought on behalf ofa class of all purchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during thisperiod that were false and misleading. No specific amount of damages isclaimed. On September 23, 2005, the Court granted our motion to dismissthe complaint, with leave to amend. The lead plaintiff filed an amendedcomplaint, which we have moved to dismiss. We believe that there aremeritorious defenses against this litigation and intend to vigorously defendit. Due to the inherent uncertainties of litigation, we cannot accuratelypredict the ultimate outcome of the litigation. Any unfavorable outcome of thelitigation could have an adverse impact on our business, financial conditionand results of operations.

On June 1, 2005, alawsuit was filed in the Superior Court of California, County of Alameda, *Zhao et al. v. American Xtal Technology, et al.*, No. R605215713. The lawsuit complaint names as defendants AXT, Inc., our formerchief technology officer and one of our suppliers. The lawsuit is brought onbehalf of two former employees and their minor child. The complaint allegespersonal injury, general negligence, intentional tort, wage loss and otherdamages, including punitive damages, as a result of exposure of the child whilein utero to high levels of gallium arsenide and methanol used in the productionof gallium arsenide wafers. We believe that there are meritorious defensesagainst this litigation and intend to vigorously defend it. Our commercialgeneral liability insurance carrier has agreed to fund our defense of the case,but has reserved the right to deny coverage, in whole or in part, in the futureunder selected policy provisions and applicable law. The plaintiffs have madean initial settlement demand within our insurance limits. Due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcomeof the litigation. Any unfavorable outcome of the litigation could have anadverse impact on our business, financial condition and results of operations.

***Leases***

Welease certain office space, manufacturing facilities and property underlong-term operating leases expiring at various dates through March 2013.Total rent expenses under these operating leases were $0.9 million, $1.3million and $1.3 million for the years ended December 31, 2006, 2005 and2004, respectively. Total minimum lease payments under these leases as of December 31,2006 are summarized below (in thousands):

| ** ** | ** ** | **Lease Payment** | ** ** |
|------------|------------|------------------------|------------|
| 2007       |       |                   | $          | 645 |   |   |
| 2008       |       |                   | 712        |   |   |
| 2009       |       |                   | 734        |   |   |
| 2010       |       |                   | 754        |   |   |
| 2011       |       |                   | 776        |   |   |
| Thereafter |       |                   | 956        |   |   |
|       |       |                   | $          | 4,577 |   |   |

 

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***Contract Commitments***

We had entered intocontracts to supply several large customers with GaAs wafers. The contractsguaranteed delivery of a certain number of wafers between January 1, 2001and December 31, 2004. The contract sales prices were subject to reviewquarterly and could be adjusted in the event that raw material prices changed.In the event of non-delivery of the determined wafer quantities in any monthlydelivery period, we could be subject to non-performance penalties of between 5%and 10% of the value of the delinquent monthly deliveries. We have not receivedany claims for non-performance penalties due to non-delivery. As of December 31,2006, we had met all of our current delivery obligations under these contractsand do not show any amount owing. Partial prepayments received for these supplycontracts totaling $125,000 was included in customer prepayments in theaccompanying consolidated balance sheet as of December 31, 2005.

**Note 19. Unaudited Quarterly Consolidated FinancialData**

| ** **                             | ** ** | **Quarter**                                                        | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                             | ** ** | **First**                                                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| ** **                             | ** ** | **(in thousands, except per share data)** | ** ** |
| **2005:**                              | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                |       | $                                                                  | 6,634      |   | $ | 6,032 |   | $ | 6,153 |   | $ | 7,717 |   |
| Gross profit                           |       | 279                                                                |       | 127 |   | 1,145 |   | 648 |   |
| Net loss                               |       | (4,123                                                             | )          | (3,279 | ) | (2,082 | ) | (2,731 | ) |
| Net loss per  share, basic and diluted |       | $                                                                  | (0.18      | ) | $ | (0.14 | ) | $ | (0.09 | ) | $ | (0.12 | ) |
| **2006:**                              | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                |       | $                                                                  | 8,471      |   | $ | 10,355 |   | $ | 12,547 |   | $ | 13,072 |   |
| Gross profit                           |       | 1,510                                                              |       | 2,759 |   | 3,479 |   | 4,988 |   |
| Net income (loss)                      |       | (2,203                                                             | )          | (876 | ) | 639 |   | 3,384 |   |
| Net income (loss)  per share, basic    |       | $                                                                  | (0.10      | ) | $ | (0.04 | ) | $ | 0.03 |   | $ | 0.14 |   |
| Net income (loss) per  share, diluted  |       | $                                                                  | (0.10      | ) | $ | (0.04 | ) | $ | 0.02 |   | $ | 0.13 |   |

 

**Note 20. SubsequentEvents**

On January 9, 2007 we announced the closing ofthe sale of an additional 862,500 shares of common stock from our December 19,2006 public offering pursuant to the underwriter’s exercise of their over-allotmentoption at a price of $4.50 per share. We received additional net proceeds fromthe exercise of the over-allotment option of approximately $3.6 million, afterdeducting the underwriting discount and estimated offering expenses.

On February 27, 2007, we entered into anagreement with Recapture Metals Limited of Ontario, Canada (“Recapture”),pursuant to which Recapture will supply our subsidiary in the PRC with onethousand kilograms per month of 99.99999% pure gallium, during the eighteenmonth period beginning July 1, 2007. Under the terms of the agreement, weare required to purchase a minimum of eighteen thousand kilograms of gallium,unless the agreement is terminated prior to the expiration of the eighteenmonth period on December 31, 2008.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereto duly authorized.

|                            |   | AXT, Inc. |
|----------------------------|--------|----------------|
|                       |   | By:            | /s/ PHILIP C.S. YIN |
|                       |   |           | Philip C.S. Yin |
|                       |   |           | *Chief Executive Officer* |
|                       |   |           | *(Principal Executive Officer)* |
|                       |   |           | /s/ WILSON W. CHEUNG |
|                       |   |           | Wilson W. Cheung |
|                       |   |           | *Chief Financial Officer* |
|                       |   |           | *(Principal Financial and Accounting Officer)* |
| Date:  March 23, 2007 |   |           | * * |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below hereby constitutes and appoints Philip C.S. Yinand Wilson W. Cheung, and each of them, his true and lawful attorney-in-factand agent, with full power of substitution, each with power to act alone, tosign and execute on behalf of the undersigned any and all amendments to thisReport on Form 10-K, and to perform any acts necessary in order tofile the same, with all exhibits thereto and other documents in connectiontherewith with the Securities and Exchange Commission, granting unto saidattorney-in-fact and agent full power and authority to do and perform each andevery act and thing requested and necessary to be done in connection therewith,as fully to all intents and purposes as he might or could do in person, herebyratifying and confirming all that said attorney-in-fact and agent, or their orhis or her substitutes, shall do or cause to be done by virtue hereof.

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

|                      | **Signature** | ** **                                                        | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|----------------------|---------------|-------------------------------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ PHILIP C.S. YIN  |          | Chief Executive Officer  and Director                             |       | March 23, 2007  |
| Philip C.S. Yin      | * *      | *(Principal Executive Officer)*                                   |       |                 |
| /s/ WILSON W. CHEUNG |          | Chief Financial Officer                                           |       | March 23,  2007 |
| Wilson W. Cheung     | * *      | *(Principal Financial Officer and Principal  Accounting Officer)* |       |                 |
| /s/ RAYMOND A. LOW   |          | Vice President, Corporate  Controller                             |       | March 23, 2007  |
| Raymond A. Low       |          |                                                              |       |                 |
| /s/ JESSE CHEN       |          | Chairman of the Board of  Directors                               |       | March 23, 2007  |
| Jesse Chen           |          |                                                              |       |                 |
| /s/ DAVID C. CHANG   |          | Director                                                          |       | March 23, 2007  |
| David C. Chang       |          |                                                              |       |                 |
| /s/ LEONARD LEBLANC  |          | Director                                                          |       | March 23, 2007  |
| Leonard LeBlanc      |          |                                                              |       |                 |
| /s/ MORRIS S. YOUNG  |          | Director                                                          |       | March 23, 2007  |
| Morris S. Young      |          |                                                              |       |                 |

 

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**AXT, Inc.EXHIBITSTOFORM 10-K ANNUAL REPORTFor the Year Ended December 31, 2006**
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                          | ** ** | **Description** |
|-----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
|  3.1(3)          |       | Restated Certificate of  Incorporation                                                                                                                                                                                                                                                                              |
|  3.2(4)          |       | Certificate of  Designation, Preferences and Rights of Series A Preferred Stock (which  is incorporated herein by reference to Exhibit 2.1 to the registrant’s  form 8-K dated May 28, 1999).                                                                                                   |
|  3.3(5)          |       | Second Amended and  Restated By Laws                                                                                                                                                                                                                                                                                |
|  4.2(5)          |       | Rights Agreement dated  April 24, 2001 by and between AXT, Inc. and ComputerShare Trust  Company, Inc.                                                                                                                                                                                               |
| 10.1(1)               |       | Form of  Indemnification Agreement for directors and officers.*                                                                                                                                                                                                                                                |
| 10.2(1)               |       | 1993 Stock Option Plan  and forms of agreements thereunder.*                                                                                                                                                                                                                                                        |
| 10.3(1)               |       | 1997 Stock Option Plan  and forms of agreements thereunder.*                                                                                                                                                                                                                                                        |
| 10.5(1)               |       | 1998 Employee Stock  Purchase Plan and forms of agreements thereunder.*                                                                                                                                                                                                                                             |
| 10.7(2)               |       | Purchase and Sale  Agreement by and between Limar Realty Corp #23 and AXT, Inc. dated  April 1998.                                                                                                                                                                                                        |
| 10.10(3)              |       | Bond Purchase Contract  between Dain Rauscher Incorporated and AXT, Inc. dated December 1,  1998.                                                                                                                                                                                                         |
| 10.11(3)              |       | Remarketing Agreement  between Dain Rauscher Incorporated and AXT, Inc. dated December 1,  1998.                                                                                                                                                                                                          |
| 10.15(7)              |       | Reimbursement Agreement  between Wells Fargo Bank National Association and AXT, Inc. dated April 7,  2003.                                                                                                                                                                                                |
| 10.16(8)              |       | Asset purchase agreements  dated September 4, 2003 by and between Dalian Luming Science and  Technology Group, Ltd and AXT, Inc. and by and between Lumei  Optoelectronics Corp., AXT, Inc., Lyte Optronics, Inc., Beijing  Tongmei Xtal Technology and Xiamen Advanced Semiconductor Co., Ltd. |
| 10.17(9)              |       | Offer letter to  Mr. Philip C.S. Yin.*                                                                                                                                                                                                                                                                         |
| 10.18(10)             |       | Offer letter to  Mr. Minsheng Lin.*                                                                                                                                                                                                                                                                            |
| 10.19(11)             |       | Employement agreement  between the Company and Mr. Wilson W. Cheung.*                                                                                                                                                                                                                                          |
| 10.20(12)             |       | Agreement respecting  severance payment between the Company and Dr. Morris S. Young.*                                                                                                                                                                                                                          |
| 10.21(13)             |       | Employement agreement  between the Company and Mr. Davis Zhang.*                                                                                                                                                                                                                                               |
| 10.22(14)             |       | Agreement dated  February 27, 2007 by and between AXT, Inc. and Recapture Metals  Limited. **                                                                                                                                                                                                             |
| 21.1(15)              |       | List of Subsidiaries.                                                                                                                                                                                                                                                                                               |
| 23.1                  |       | Consent of Independent  Registered Public Accounting Firm, Burr, Pilger & Mayer LLP.                                                                                                                                                                                                                       |
| 24.1                  |       | Power of Attorney (see  signature page).                                                                                                                                                                                                                                                                            |
| 31.1                  |       | Certification by Chief  Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                          |
| 31.2                  |       | Certification by Chief  Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                          |
| 32.1                  |       | Certification by Chief  Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                      |
| 32.2                  |       | Certification by Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                      |

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(1)          Incorporated by reference to the exhibit as of the samenumber as filed with the SEC in our Registration Statement on Form S-1on March 17, 1998.

(2)          Incorporated by reference to the exhibit as of the samenumber as filed with the SEC in our Registration Statement on Amendment No. 2to Form S-1 on May 11, 1998.

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

(4)          Incorporated by reference to the exhibit as of the samenumber as filed with the SEC in our Form 8-K on June 14, 1999.

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

(6)          Incorporated by reference to the exhibit as of the samenumber as filed with the SEC in our Form 10-Q on November 12,2002.

(7)          Incorporated by reference to the exhibit as of the samenumber as filed with the SEC in our Form 10-Q on May 9, 2003.

(8)          Incorporated by reference to the exhibit as of the samenumber as filed with the SEC in our Form 10-Q on November 13,2003.

(9)          Incorporated by reference to exhibit 99.1 to registrant’sForm 8-K filed with the SEC on March 17, 2005.

(10)   Incorporated by reference to exhibit 99.1 to registrant’sForm 8-K filed with the SEC on June 30, 2005.

(11)   Incorporated by reference to exhibit 99.2 to registrant’sForm 8-K filed with the SEC on June 30, 2005.

(12)   Incorporated by reference to exhibit 99.1 to registrant’sForm 8-K filed with the SEC on March 30, 2005.

(13)   Incorporated by reference to exhibit 99.1 to registrant’sForm 8-K filed with the SEC on January 17, 2006.

(14)   Incorporated by reference to exhibit 10.22 toregistrant’s Form 8-K filed with the SEC on March 5, 2007.

(15)   Incorporated by reference to exhibit 21.1 to registrant’sForm S-3/A (333-135474) filed with the SEC on July 28,2006.

*                    Management contract or compensatory plan.

**             Confidential treatment has been requested of the SECfor portions of the exhibit.

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