##### Table of Contents






UNITED STATES SECURITIES AND EXCHANGE
COMMISSION


Washington, D.C. 20549


Form 10-K

|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark one) |  |                                                                                             
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|           |  | For the fiscal year ended December 31,
    2002                                             

or


|  |  |                                                                                                 
|- |  | ------------------------------------------------------------------------------------------------
|o |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|  |  | For the transition period
    from                      to                                      

Commission file number 0-24085

AXT, Inc.

(Exact name of registrant as specified in its
charter)


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

Registrants telephone number, including
area code:

(510) 683-5900


Securities registered pursuant to
Section 12(b) of the Act:

None


Securities registered pursuant to
Section 12(g) of the Act:

Common Stock, $.001 par value


Indicate by checkmark whether the registrant
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the
past
90 days.     Yes þ          No o

Indicate by checkmark if disclosure of delinquent
filers pursuant to Item 405 of Regulation S-K is not
contained herein, and will not be contained, to the best of
registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this
Form 10-K or any amendment to this
Form 10-K.     Yes o          No þ

Indicate by checkmark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes þ          No o

The aggregate market value of the voting stock
held by non-affiliates of the registrant, based upon the closing
sale price of the common stock on June 30, 2002 as reported
on the Nasdaq National Market, was approximately $128,411,024.
Shares of common stock held by each officer, director and by
each person who owns 5% or more of the outstanding common stock
have been excluded in that such persons may be deemed to be
affiliates. This determination of affiliate status is not a
conclusive determination for other purposes.

As of January 31, 2003, 22,495,094 shares,
$.001 par value, of the registrants common stock were
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement for
the registrants 2003 annual meeting of stockholders to be
filed with the Commission pursuant to Regulation 14A not
later than 120 days after the end of the fiscal year
covered by this form are incorporated by reference into
Part III of this Form 10-K report.



---






---

TABLE OF CONTENTS



|             |                                                                                                                    |  |  |  |  |  |  | 
|------------ | ------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  | 
|PART I      
|             | Item 1. Business -- Overview                                                                                      
|             | Item 2. Properties                                                                                                
|             | Item 3. Legal Proceedings                                                                                         
|             | Item 4. Submission of Matters to a Vote of Security Holders                                                       
|PART II     
|             | Item 5. Market for Registrants Common Equity and Related Stockholder Matters                                     
|             | Item 6. Selected Consolidated Financial Data                                                                      
|             | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations                     
|             | Item 7A. Qualitative and Quantitative Disclosures About Market Risk                                               
|             | Item 8. Consolidated Financial Statements and Supplementary Data                                                  
|             | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures                     
|PART III    
|             | Item 10. Directors and Executive Officers of the Registrant.                                                      
|             | Item 11. Executive Compensation.                                                                                  
|             | Item 12. Security Ownership of Certain Beneficial Owners and Management, and Equity Compensation Plan Information.
|             | Item 13. Certain Relationships and Related Transactions                                                           
|             | Item 14. Controls and Procedures                                                                                  
|PART IV     
|             | Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K                                         
|EXHIBIT 99.1
|EXHBIIT 99.2



---



##### Table of Contents



TABLE OF CONTENTS

|         |          |  |                                                                                           |  |   
|-------- | -------- |  | ----------------------------------------------------------------------------------------- |  | --
|PART I  
|         | Item 1.  |  | Business                                                                                  |  | 2 
|         | Item 2.  |  | Properties                                                                                |  | 12
|         | Item 3.  |  | Legal Proceedings                                                                         |  | 12
|         | Item 4.  |  | Submission of Matters to a Vote of Security
    Holders                                   |  | 13
|PART II 
|         | Item 5.  |  | Market for Registrants Common Equity and
    Related Stockholder Matters                 |  | 13
|         | Item 6.  |  | Selected Consolidated Financial Data                                                      |  | 14
|         | Item 7.  |  | Managements Discussion and Analysis of
    Financial Condition and Results of Operations |  | 15
|         | Item 7a. |  | Qualitative and Quantitative Disclosures About
    Market Risk                            |  | 37
|         | Item 8.  |  | Consolidated Financial Statements and
    Supplementary Data                              |  | 39
|         | Item 9.  |  | Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosures |  | 40
|PART III
|         | Item 10. |  | Directors and Executive Officers of the Registrant                                        |  | 40
|         | Item 11. |  | Executive Compensation                                                                    |  | 40
|         | Item 12. |  | Security Ownership of Certain Beneficial Owners
    and Management                        |  | 40
|         | Item 13. |  | Certain Relationships and Related Transactions                                            |  | 40
|         | Item 14. |  | Controls and Procedures                                                                   |  | 41
|PART IV 
|         | Item 15. |  | Exhibits, Financial Statement Schedules, and
    Reports on Form 8-K                      |  | 41

1



---



##### Table of Contents






PART I

This report includes forward-looking
statements that reflect our current views with respect to future
events and our potential financial performance. These
forward-looking statements are subject to certain risks and
uncertainties, including those discussed in
Business, Managements Discussion and
Analysis of Financial Condition and Results of Operations,
and elsewhere in this report, that could cause actual results to
differ materially from historical results or those anticipated.
In this report, the words anticipates,
believes, expects, intends,
future and similar expressions identify
forward-looking statements. Forward-looking statements also
include the assumptions that underlie such statements, Readers
are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of
this report.




Item 1.     Business 
Overview

We design, develop, manufacture and distribute
high-performance compound semiconductor substrates, as well as
opto-electronic semiconductor devices, such as high-brightness
light emitting diodes, or HBLEDs, and laser diodes including
vertical cavity surface emitting lasers, or VCSELs, and
Fabry-Perot laser diodes. Our substrate products are used
primarily in wireless communications, lighting display
applications, and fiber optic communications. We believe our
proprietary vertical gradient freeze, or VGF, technique for
manufacturing compound semiconductor substrates provides
significant benefits over other methods and has enabled us to
become a leading manufacturer of compound semiconductor
substrates. We pioneered the commercial use of VGF technology to
manufacture gallium arsenide, or GaAs, substrates and used VGF
technology to manufacture substrates from other materials,
including indium phosphide, or InP, and germanium, or Ge. Some
of our competitors followed our lead by developing their own
versions of VGF technology. Customers for our substrates include
Skyworks Solutions, Agilent Technologies, EMCORE, Kopin, IQE,
Nortel Networks, and Sumitomo Chemical. Our acquisition of Lyte
Optronics in 1999 provided us with expertise in epitaxial
processes for manufacturing opto-electronic semiconductor
devices. We use these capabilities to make blue, green and cyan
HBLEDs and laser diodes. Our opto-electronic semiconductor
devices are used in a wide range of applications, such as
solid-state lighting and fiber optic communications. Over the
past four years, we have implemented an initiative, which is now
largely complete, to reduce the cost of manufacturing our
substrates by moving most of our operations to China and by
investing in sources of low cost raw materials. We also expanded
our HBLED manufacturing capacity in response to an increase in
customer demand.

We were incorporated in California in December
1986 and reincorporated in Delaware in May 1988. We changed
our name from American Xtal Technology, Inc. to AXT, Inc. in
July 2000. Our principal offices are located at
4281 Technology Drive, Fremont, California 94538, and our
telephone number at this address is (510) 683-5900. Our web
site is www.axt.com; however, the information on our web
site does not constitute a part of this annual report on
Form 10-K and is not incorporated herein. We make
available, free of charge, on or through our web site, our
annual, quarterly and current reports, and any amendments to
those.

Industry Background

Historically, most semiconductor devices were
created on a single crystal base material, or substrate, of
silicon. Today, however, many electronic and opto-electronics
devices are being developed with requirements that exceed the
capabilities of silicon. These devices address the continually
increasing demand to send, receive and display information on
high-speed wireless and wireline networks. This demand created a
growing need for power-efficient high-performance systems that
can operate at high frequencies and can be produced
cost-effectively in large volumes. These systems enable the
growth and development of a wide range of end-user applications.
For example, Dataquest, Inc., expects worldwide
cellular/PCS handset production to grow from approximately
405 million units in 2002 to approximately 580 million
units by 2004.

Other examples of applications for these systems
include:



| |   |                                                                    
| | - | -------------------------------------------------------------------
| |  | voice and high-speed wireless data systems;                        
|
| |  | infrared emitters and optical detectors in
    computer systems;   
|
| |  | fiber optic networks and optical systems within
    these networks;

2



---



##### Table of Contents





| |   |                                                                                   
| | - | ----------------------------------------------------------------------------------
| |  | solid-state lighting, including exterior and
    interior automobile lighting; and
|
| |  | satellite communications systems.                                                 

As a result of the limitations of silicon-based
technologies, semiconductor device manufacturers use compound
semiconductor substrates to improve the performance of
semiconductor devices and to enable these new applications. This
use occurs even though these compound semiconductor substrates
are more expensive than silicon. Compound semiconductor
substrates are composed of multiple elements that include a
metal, such as gallium, aluminum or indium, and a non-metal,
such as arsenic, phosphorus or nitrogen. The resulting compounds
include gallium arsenide, indium phosphide and gallium nitride.
Advantages of devices manufactured on compound substrates over
devices manufactured using silicon substrates include:



| |   |                                                                             
| | - | ----------------------------------------------------------------------------
| |  | operation at higher speeds;                                                 
|
| |  | lower power consumption;                                                    
|
| |  | less noise and distortion; and                                              
|
| |  | opto-electronic properties that enable devices to
    emit and detect light.

A key step in producing a compound semiconductor
substrate is to grow a crystal of the materials. Historically,
two processes were used to grow crystals: the Liquid
Encapsulated Czochralski, or LEC, technique and the
Horizontal-Bridgeman, or HB, technique. We believe two trends
reduced the appeal of these techniques: more semiconductor
devices are being formed using an epitaxial process and
semiconductor device manufacturers are switching their
production lines to six-inch diameter substrates. The LEC and HB
techniques each have difficulties producing high quality,
low-cost compound semiconductor substrates for epitaxial
processing and substrates produced using this technique have a
high volume of defects as size increases beyond four-inches in
diameter. We introduced our VGF technique in 1986 to respond to
the limitations inherent in the LEC and HB techniques, and, in
recent years, some of our competitors who previously relied on
the LEC or HB methods have also developed their own versions of
VGF.

Compound semiconductor substrates enable the
development of a wide range of electronic products including
power amplifiers and radio frequency integrated circuits used in
wireless handsets. Compound substrates can also be used to
create opto-electronic products including HBLEDs and VCSELs used
in solid-state lighting and fiber optic communications.

HBLEDs are solid-state compound semiconductor
devices that emit light. The global demand for HBLEDs is
experiencing rapid growth because HBLEDs have a long useful
life, consume approximately 10% of the power consumed by
incandescent or halogen lighting and improve display visibility.
Applications where HBLEDs are increasingly used include wireless
handset displays, automotive displays, full color video and sign
displays, traffic lights and various consumer applications.
According to Strategies Unlimited, an independent industry
analyst, the market for HBLEDs is expected to grow from
$1.8 billion in 2002 to approximately $3.9 billion by
2006.

The AXT Advantage

We are a leading developer and supplier of
high-performance compound semiconductor substrates and
opto-electronic semiconductor devices, including HBLEDs. There
are four key causes of our success:

Our VGF technology is a competitive advantage.We pioneered the commercial use of VGF
technology to manufacture GaAs substrates and we believe that
through the use of VGF we have become a leading worldwide
supplier of GaAs substrates, particularly for six-inch diameter
substrates. Our VGF process produces substrates with high
mechanical strength and physical and chemical uniformity, as
well as a low defect rate. The following changes in our
customers technologies are increasing the share of
substrates sold with these features:



| |   |                                                                                                                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Greater use of epitaxy rather than ion
    implantation.Many of the newest
    generation of high-performance semiconductor devices for fiber
    optic and wireless communications applications, including
    heterojunction bipolar transistors, or HBTs, and pseudomorphic
    high electron mobility transistors, or

3



---



##### Table of Contents



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | PHEMTs, are popular because they offer lower
    power consumption and better device linearity than their
    predecessors. These devices are created using epitaxial
    processed substrates. Our VGF substrates are more suitable for
    these applications than are our competitors products
    manufactured using LEC and HB technologies, and competing
    materials such as silicon germanium, or SiGe.                                                                                                                                  
|
| |  | Switch to six-inch diameter wafers.Many of our semiconductor device
    manufacturing customers switched their GaAs production lines to
    six-inch diameter substrates in order to reduce unit costs and
    increase capacity. We were among the first competitors able to
    deliver large volumes of six-inch diameter VGF substrates and
    retain a significant amount of manufacturing capacity for this
    product.                                                                                                                     
|
| |  | Introduction of InP substrates.Even GaAs cannot meet the requirements
    for system performance and network bandwidth of some potential
    applications, including SONET OC-768 applications that will
    operate at speeds up to 40 gigabits per second. While the
    date of introduction of these applications is uncertain, they
    are likely to use Indium Phosphide (InP) substrates. We
    successfully used our VGF technique to develop InP and we were
    among the first to offer four- and six-inch diameter InP
    substrates.

In addition, VGF technology gives us further
benefits.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Customer technology independence.Our semiconductor device manufacturing
    customers often compete among themselves. For example, several
    of our customers compete for technological leadership in the
    wireless handset market. These customers or end-users all
    manufacture their devices on GaAs substrates. We are, therefore,
    largely immune from the effects of such competition and benefit
    from an overall need for faster, more power efficient electronic
    and opto-electronic devices.

Some customers specify VGF substrates.Our wafers are qualified with many of
the key suppliers of GaAs and InP semiconductor devices. The
qualification process, which is lengthy and must be repeated for
each customer, can be a barrier to entry for a new material or
supplier. Furthermore, certain of our customers now effectively
specify that they will only accept VGF-grown or equivalent
substrates for their manufacturing processes. As the businesses
of these customers grow, we, and those competitors that
developed a technology similar to VGF, are well positioned to
capture their business.

Our low-cost manufacturing is an advantage.In 1998, we began moving portions of
our substrate manufacturing operations to China, to benefit from
a combination of lower costs for facilities, labor and materials
than we encounter in the United States. That move continued and
at the end of 2002 most of our substrate manufacturing
activities occur in China. We also made some strategic
investments in raw materials producers, including one that
produces gallium, that assure us of a secured and low cost
source of these materials and enables us to market surplus
production to others. By the end of 2003, we anticipate that
almost all of our substrate production will be located in China.
We believe this provides us with a cost advantage vis-à-vis
our competitors.

We entered the opto-electronic semiconductor
device market quickly through our acquisition of Lyte Optronics.Our acquisition of Lyte Optronics
provided us with expertise in epitaxial processes for
manufacturing high-volumes of opto-electronic semiconductor
devices. High-quality epitaxy is a key requirement for most of
todays advanced opto-electronic semiconductor devices,
such as HBLEDs and VCSELs. Since acquiring Lyte Optronics, we
developed opto-electronic products that are among the more
difficult to create using epitaxy, including blue and green
HBLEDs and VCSELs. We have received three United States patents
and filed eight additional patent applications for our approach
to fabricating HBLEDs.

4



---



##### Table of Contents



The AXT Strategy

Our goals are to strengthen our position as a
leading developer and supplier of selected high-performance
compound semiconductor substrates and to develop a leading
position in the market for opto-electronic semiconductor
devices. Key elements of our strategy include:

Decrease our substrate manufacturing cost
structure.We will continue to shift
our substrate manufacturing operations to China and invest in
joint ventures to obtain key raw material supplies in order to
lower unit production costs.

Advance VGF technology leadership.As some of our competitors have
introduced production technologies similar to VGF, customers
seeking VGF material have had more choice and some have
allocated their orders among multiple suppliers. Given the
current industry oversupply, customers are rejecting previously
approved products if they can obtain higher yields from another
supplier. We commit much of our research and development effort
to improve the surface characteristics of our substrates and our
recently produced substrates do increase customers yields
compared with our previous products.

Strengthen our leadership position in the InP
market.We believe that there will be
growth in demand for the next generation of high-speed fiber
optic devices, such as devices used in SONET OC-768
applications. These products are manufactured on InP substrates
and we are positioning ourselves to be the leading supplier of
InP substrates.

Enhance our opto-electronic semiconductor
devices.We intend to further
penetrate the HBLED market through continued investment in
research and development and selected expansion of production
capacity. We expanded our manufacturing capacity by adding
metal-organic chemical vapor deposition, or MOCVD, reactors and
are modifying our epitaxial process to improve device
performance and yield. We invested in the research and
infrastructure required to grow our own sapphire substrates,
which are used in producing blue, green and cyan HBLEDs.

Technology

Our core technologies include our proprietary VGF
technique used to produce high quality crystals that are
processed into compound substrates, and our epitaxy technologies
that enable us to manufacture blue, green and cyan HBLEDs,
VCSELs and edge-emitting laser diodes.

VGF Furnace Schematic Diagram

5



---



##### Table of Contents



Our VGF technique is designed to control the
crystal-growth process with minimal temperature variation and is
the technique we use to produce our GaAs, InP and Ge substrates.
Unlike traditional techniques, our VGF technique places the hot
compound melt above the cool crystal, thereby reducing the
turbulence at the interface of the melt and the solid crystal,
compared with the LEC technique in which the melt and crystal
are inverted. The temperature gradient between the melt and the
crystal in the VGF technique is significantly lower than in
traditional techniques. These aspects of the VGF technique
enable us to grow crystals that have a relatively low defect
density and high uniformity. The crystal and the resulting
substrate are mechanically strong, resulting in lower breakage
rates during a customers manufacturing process. Since the
temperature gradient is controlled electronically rather than by
physical movement, the sensitive crystal is not disturbed as it
may be during some competitors VGF-like growth processes.
In addition, the melt and growing crystal are contained in a
closed chamber, which isolates the crystal from the outside
environment to reduce potential contamination. This substrate
isolation allows for more precise control of the
gallium-to-arsenic ratio, resulting in better consistency and
uniformity of the crystals.

Our VGF technique offers several benefits when
compared to traditional crystal growing technologies. The Liquid
Encapsulated Czochralski, or LEC, technique is the traditional
method for producing semi-insulating GaAs substrates for
electronic applications. During the LEC process, the crystal is
grown by dipping a seed crystal through molten boric oxide into
a melt and slowly pulling the seed up into the cool zone above
the boric oxide where the crystal hardens. Unlike the VGF
technique, the LEC technique is designed so that the hotter GaAs
melt is located beneath the cooler crystal, resulting in greater
turbulence in the melt, and at a temperature gradient that is
significantly higher than the VGF technique. The turbulence and
high temperature cause LEC-grown crystals 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 for contamination and difficulty controlling the
ratio of gallium to arsenic. It requires large, complex
electro-mechanical systems that are expensive and require highly
skilled personnel to operate.

Our VGF technique also offers advantages over the
Horizontal-Bridgeman, or HB, technique, for producing
semi-conducting GaAs substrates for opto-electronic
applications. The HB technique holds the GaAs melt in a
semi-cylindrical container, causing crystals grown using the
HB method to have a semi-circular, or D-shaped,
cross-section. Accordingly, more crystal material is discarded
when the D-shaped substrate is subsequently trimmed to a round
shape. In addition, crystals grown using the HB technique
have a higher defect density than VGF-grown crystals. The
HB technique cannot be used cost-effectively to produce
substrates greater than three inches in diameter. The
HB technique houses the GaAs melt in a quartz container
during the growth process, which can contaminate the GaAs melt
with silicon impurities, making it unsuitable for producing
semi-insulating GaAs substrates.

The following table provides a comparison of
these three techniques:

|                                    |  |                                |  |                 |  |               
|----------------------------------- |  | ------------------------------ |  | --------------- |  | --------------
|                                    |  | VGF                            |  | HB              |  | LEC           
|                                    |  |                                |  |                 |  |               
|Substrate applications              |  | Electronic and opto-electronic |  | Opto-electronic |  | Electronic    
|Largest wafer size available        |  | 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     

6



---



##### Table of Contents



Many major substrate purchasers have adjusted
their product specifications to effectively allow only VGF or
equivalent material. Some have simultaneously tightened their
specifications for surface characteristics that causes them to
reject material they had previously approved. We are improving
our surface characteristics so that we fully comply with
customer requirements.

We create our opto-electronic semiconductor
devices using MOCVD, which is an epitaxial technique to
synthesize compound semiconductor thin films onto substrates.
MOCVD reactors are available from multiple sources and wafers
fabricated using MOCVD generally possess a better combination of
uniformity and optical and electronic properties and are easier
to produce cost-effectively in high volumes than wafers
manufactured by other methods, such as molecular beam epitaxy,
vapor phase epitaxy or liquid phase epitaxy. As a result, MOCVD
reactors have become the choice of the opto-electronics industry
for fabricating devices such as LEDs, VCSELs and laser diodes.
We modify our MOCVD reactors to improve their performance and
use a proprietary growth recipe that controls temperature,
material impurity, defect density, material thickness and layer
composition while allowing for multiple wafer batch replication.

Products

We design, develop, manufacture and distribute
high-performance semiconductor substrates, as well as
opto-electronic devices, such as HBLEDs, VCSELs and laser
diodes. The table below sets forth 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 radars |  |   |  |                                                               
|                 | Ge                          |              |  |                 | Satellite solar cells                 |  |   |  |                                                               
|Opto-electronics |                             |              |   |                 |                                       |  |   | 
|                 | Blue, green and cyan HBLEDs |              |   |                 |                                       |  |  |  | Full color displays                                           
|                 |                             |              |   |                 |                                       |  |  |  | Automobile interior and exterior lighting                     
|                 |                             |              |   |                 |                                       |  |  |  | Traffic signals                                               
|                 |                             |              |   |                 |                                       |  |  |  | Back lighting for cellular phones, instrument
    panels, etc.
|                 |                             |              |   |                 |                                       |  |  |  | White light for general illumination                          
|                 | VCSELs                      |              |   |                 |                                       |  |  |  | Fiber optic and wireless communications                       
|                 |                             |              |   |                 |                                       |  |  |  | Storage area networks                                         
|                 | Laser Diodes                |              |   |                 |                                       |  |  |  | Fiber optic and wireless communications                       

Substrates.We
currently sell compound substrates manufactured from GaAs and
InP, as well as single-element substrates manufactured from Ge.
We supply GaAs substrates in two-, three-, four-, five- and six-

7



---



##### Table of Contents



inch diameters. We manufacture InP substrates in
two-, three- and four-inch diameters and Ge substrates in
four-inch diameters. We developed and may initiate production of
sapphire substrates.


Opto-electronics.We
sell blue, green and cyan HBLED products in wafer and chip form.
We began selling blue HBLED products in the first quarter of
2000 and in 2001 began shipping green and cyan HBLEDs. We
introduced our first VSCEL product in August 2000 and introduced
a range of Fabry-Parot laser products beginning in 2001 and
early 2002.

Customers

We sell our compound semiconductor substrates
worldwide to leading semiconductor device manufacturers. Our
substrate customers include:

|                                                                                                                             |  |                                                                                                                        |  |                                                                                                                                                      
|---------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------
|Agilent Technologies
    Coherent Tutcore
    EMCORE
    Exim and Mfr. Enterprise
    Gore Photonics
    IQE, Inc.
    Kopin |  | Motorola
    Nortel Networks
    Osram
    Picogiga
    Procomp Informatics
    Skyworks Solutions
    Spectro-Physics |  | Sumitomo Chemical
    Triquent Semiconductor
    TRW Space & Defense
    Uni Light Technology
    United Epitaxy Company
    Visual Photonics Epitaxy

We sell our HBLED products primarily to customers
that incorporate them into lighting products. Our HBLED
customers include Agilent, Metairie, Harvatek, Liteon, Kindwin,
and Seoul Semiconductor.

Historically, we have sold a significant portion
of our products in any particular period to a limited number of
customers. Our five largest customers accounted for 35.6% of our
total revenue from continuing operations in 2002, 28.3 % in
2001, and 26.1% in 2000. One customer accounted for 10.7% of our
revenue in 2002 and no customer accounted for more than 10%
percent of our total revenue in 2001 or 2000. We expect that
sales to certain customers will continue to comprise a
significant portion of our revenue in the future.

Manufacturing, Raw Materials and
Supplies

We believe that our success is partially due to
our manufacturing efficiency and high product yields and we
continually emphasize quality and process control throughout our
manufacturing operations. We perform our substrate manufacturing
operations at our facilities in Beijing, China and Fremont,
California. As part of our plan to reduce substrate
manufacturing costs, we shifted most of our processes to our
facilities in China, where costs are generally lower. We intend
to transfer the vast majority, if not all, of our substrate
manufacturing operations to China by the end of 2003. We believe
that our capital investment and subsequent operating costs are
lower for our manufacturing facilities in China relative to the
U.S. Many of our manufacturing operations are fully automated
and computer monitored or controlled, enhancing reliability and
yield. We use proprietary equipment in our substrate
manufacturing operations to protect our intellectual property
and control the timing and pace of capacity additions. Our
epitaxial wafer production is located in El Monte, California
and our wafer fabrication and die fabrication activities for our
opto-electronics products are located in Monterey Park,
California, Beijing, China, and Xiamen, China. All of our
manufacturing facilities are ISO 9001 or 9002 certified.

Although we purchase supply parts, components and
raw materials from several domestic and international suppliers,
we depend on a single or limited number of suppliers for certain
critical materials used in the production of our substrates and
opto-electronics products. We generally purchase these materials
through standard purchase orders and not pursuant to long-term
supply contracts. Although we seek to maintain sufficient
inventory levels of certain materials to guard against
interruptions in supply and to meet our near term needs, and
have to date been able to obtain sufficient supplies of
materials in a timely manner, there may be shortages of certain
key materials, such as gallium. Accordingly, to help ensure
continued supply of materials, we formed strategic alliances
with and made investments in some suppliers of key raw materials
required to manufacture our products. We believe that these
alliances and investments will be advantageous in procuring
materials to support our growth. In addition, excess capacity is
marketed to others, enabling us to expand our markets and
discouraging our alliance partners from becoming too dependent
upon us.

8



---



##### Table of Contents



We use MOCVD equipment to manufacture our
opto-electronics devices. We qualified two new MOCVD reactors
during the past twelve months and have one reactor awaiting
qualification. The substrate materials and raw wafers used in
our opto-electronics products are purchased from our substrate
division and other sources.

Sales and Marketing

Each of our divisions is responsible for its own
sales and marketing activities, and each maintains its own sales
and marketing personnel. In addition, each of our divisions
advertises in trade publications, distributes promotional
materials, publishes technical articles, conducts marketing
programs and participates in industry trade shows and
conferences in order to raise market awareness of our products.

Substrates.We sell
our substrate products through our direct sales force in the
U.S. and Japan and through independent sales representatives in
France, Japan, South Korea, Taiwan and the United Kingdom. Our
direct sales force consists of sales engineers who are
knowledgeable in the manufacture and use of compound and
single-element substrates. Our sales engineers work with
customers during all stages of the substrate manufacturing
process, from developing the precise composition of the
substrate through manufacturing and processing the substrate to
the customers exact specifications. We believe that
maintaining a close relationship with customers and providing
them with ongoing technical support improves customer
satisfaction and will provide us with a competitive advantage in
selling other substrates to our customers. The substrate
division launched a program in late 2000 with selected customers
in which we guaranteed that certain volumes of six-inch GaAs and
other substrates would be delivered on specific dates and the
customer made a prepayment for part of the value of its order.
Several major customers participate in this program which we
expect will conclude during 2003. At December 31, 2002, the
unearned pre-payments equaled $2.2 million.

Opto-electronics.We
sell our HBLED products through our direct sales force in the
U.S. and Taiwan and through independent sales representatives to
lamp package manufacturers in Asia. We intend to expand sales of
these products in the U.S. and Europe primarily using our direct
sales force. We sell our VCSEL and edge emitting laser diodes
through our direct sales force and through independent sales
representatives.

International Sales.International sales are an important
part of our business. In the year ended December 31, 2002,
sales to customers outside of the United States accounted for
58.2% of our revenue, as compared with 50.4% in 2001 and with
48.2% in 2000. The primary markets for sales of our products
outside of the United States include countries in Asia and
Western Europe. Our ability to sustain and increase our
international sales involves significant risks, including
volatile political, social and economic instabilities abroad,
possible fluctuations in currency exchange rates, and changes in
tariffs, import restrictions or other trade barriers.

Research and Development

To maintain and improve our competitive position,
we focus our research and development efforts on designing new
proprietary processes and products, improving the performance of
existing products and reducing manufacturing costs. We have
assembled a multi-disciplinary team of highly skilled
scientists, engineers and technicians to meet our research and
development objectives.

Our current substrate research and development
activities focus on continued development and enhancement of
six-inch GaAs crystals, including improved yield, enhanced
surface characteristics and uniformity, greater substrate
strength and increased crystal length. We developed and intend
to initiate production of sapphire substrates.

We are focusing on all three major stages of
HBLED development: epitaxy, wafer fabrication and die
fabrication. Our goal is to improve brightness and yield, create
products with a narrowly banded range of features including, for
example, wavelength, brightness, and forward voltage, and
enhance uniformity of product, both within and across production
runs. Specific colors are created by controlling the indium
content of the epitaxial layers, which we achieve, in part, from
modifications that we make to our MOCVD reactors.

9



---



##### Table of Contents



The wafer and die fabrication experience we
gained in our Lyte Optronics laser diode operation has helped us
develop similar techniques for HBLEDs.


Research and development expenses were
$4.9 million in 2002, compared with $8.2 million in
2001, and $8.8 million in 2000.

Competition

The semiconductor industry is characterized by
rapid technological change and price erosion, as well as intense
foreign and domestic competition. We believe we currently have a
leading position in the existing markets for compound
semiconductor substrates primarily as a result of our expertise
in VGF technology. However, we believe we face actual and
potential competition from a number of established domestic and
international companies.

We believe that the primary competitive factors
in the markets in which our products compete are:



| |   |                                               
| | - | ----------------------------------------------
| |  | quality;                                      
|
| |  | price;                                        
|
| |  | performance;                                  
|
| |  | meeting customer specifications;              
|
| |  | customer support and satisfaction; and        
|
| |  | customer investment in competing technologies.

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



| |   |                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------
| |  | the timing and success of the development and
    introduction of new products by us and our competitors;     
|
| |  | the availability of adequate sources of raw
    materials; and                                                
|
| |  | protection of our products by effective use of
    intellectual property laws and general economic conditions.

Our primary competition in the market for
compound semiconductor substrates includes Freiberger, Japan
Energy and Sumitomo Electric. In addition, we also face
competition from compound semiconductor device manufacturers
that produce substrates for their own internal use, and from
companies such as IBM and Motorola that are actively developing
alternative compound semiconductor materials.

Our primary competitors in the market for HBLED
products include Arima, Cree, LumiLED, Nichia Chemicals, Toyoda
Gosei and United Epitaxy. In general, HBLED manufacturers in
Taiwan and China have a competitive pricing advantage due to low
overhead and small research and development investments. Cree,
Nichia Chemicals, Sony and Toyoda Gosei have significant patent
portfolios that other competitors, including us, must either
design around or license.

We primarily compete with EMCORE, Honeywell,
Trulight, Picolight, Zarlink, Infineon, Cielo and E2O in the
market for VCSEL devices.

Protection of our Intellectual
Property

Our success and the competitive position of our
VGF technique depend on our ability to maintain trade secrets
and other intellectual property protections. We rely on a
combination of patents, copyrights, trademark and trade secret
laws, non-disclosure agreements and other intellectual property
protection methods to protect our proprietary technology. We
believe that, due to the rapid pace of technological innovation
in the markets for our products, our ability to establish and
maintain a position of technology leadership depends as much on
the skills of our development personnel as upon the legal
protections afforded our existing technologies. To protect our
trade secrets, we take certain measures to ensure their secrecy,
such as executing non-disclosure agreements with our employees,
customers and suppliers. However, reliance on trade secrets is
only an

10



---



##### Table of Contents



effective business practice insofar as trade
secrets remain undisclosed and a proprietary product or process
is not reverse engineered or independently developed.


To date, we have been issued one U.S. patents and
have three U.S. patent applications pending, which relate to our
VGF products and processes. We have three U.S. patents and eight
U.S. patent applications pending which relate to our HBLED or
laser diode technology, and have patent applications pending in
Europe, Canada, China, Japan and Korea which are based on one of
our U.S. patents that relates to our VGF and
opto-electronic processes. We have no issued foreign patents.

Environmental Regulations

We are subject to federal, state and local
environmental laws and regulations. These laws, rules and
regulations govern the use, storage, discharge and disposal of
hazardous chemicals during manufacturing, research and
development and sales demonstrations. If we fail to comply with
applicable regulations, we could be subject to substantial
liability for clean-up efforts, personal injury and fines or
suspension or cessation of our operations. We cooperated with
the California Occupational Safety and Health Administration, or
Cal-OSHA, in an investigation primarily regarding impermissible
levels of potentially hazardous materials in certain areas of
our manufacturing facility in Fremont, California. In May 2000,
Cal-OSHA levied a fine against us in the amount of $313,655 for
alleged health and safety violations. In March 2001, we settled
this claim in the amount of $200,415, and have put in place
engineering, administrative and personnel protective equipment
programs to address these issues. On May 1, 2001, the Santa
Clara Center for Occupational Safety and Health
(SCCOSH) filed a complaint for injunctive relief and civil
penalties against us alleging violations of California Business
Professions Code 17200 et seq., and Health and Safety Code
section 25249 et seq. as a result of our use of arsenic and
inorganic arsenic compounds in our workplace. We reached a
settlement with SCCOSH during 2002. See Legal
Proceedings below.

Employees

As of December 31, 2002, we had 1,306
employees, of whom 1,075 were principally engaged in
manufacturing, 197 in sales and administration, and 34 in
research and development. Of these employees, 317 are located in
the U.S., 988 in China and 1 in Japan. As a result of shifting
more of our substrate manufacturing to China, we implemented
headcount reductions in our Fremont, California facilities, and
expect further reductions as our shift of our manufacturing
activities to China is completed by the end of 2003. Our success
is in part dependent on our ability to attract and retain highly
skilled workers. Our employees are not represented by a union
and we have never experienced a work stoppage. Although morale
has been affected by our workforce reductions, we consider our
relations with our employees to be good.

11



---



##### Table of Contents






Item 2.     Properties

Our principal properties as of March 15,
2003 are as follows:

|                  |  |        |  |                               |  |                                                                     
|----------------- |  | ------ |  | ----------------------------- |  | --------------------------------------------------------------------
|                  |  | Square |  |                               |  |                                                                     
|Location          |  | Feet   |  | Principal Use                 |  | Ownership                                                           
|                  |  |        |  |                               |  |                                                                     
|Fremont, CA       |  | 80,000 |  | Production                    |  | Owned                                                               
|Fremont, CA       |  | 14,441 |  | Administration                |  | Operating lease, expires May 2005                                   
|Fremont, CA       |  | 9,280  |  | Warehouse                     |  | Operating lease, expires June 2005                                  
|Fremont, CA       |  | 24,100 |  | Warehouse                     |  | Operating lease, expires July 2006                                  
|Fremont, CA       |  | 55,000 |  | Production and Administration |  | Owned; in contract to sell and lease through
    March 2013         
|Monterey Park, CA |  | 22,000 |  | Production and Administration |  | Owned                                                               
|El Monte, CA      |  | 26,652 |  | Production                    |  | Owned                                                               
|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; under construction                                           
|Xianshee, China   |  | 56,500 |  | Production                    |  | Owned by Beijing Ji Ya Semiconductor Materials,
    Co., Ltd.       
|Xianshee, China   |  | 7,500  |  | Administration                |  | Owned by Beijing Ji Ya Semiconductor Materials,
    Co., Ltd.       
|Xianshee, China   |  | 1,000  |  | Administration                |  | Owned by Beijing Ji Ya Semiconductor Materials,
    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 Bo Yu Semiconductor Vessel
    Craftwork Technology

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




Item 3.     Legal
Proceedings

From time to time we are involved in judicial or
administrative proceedings concerning matters arising in the
ordinary course of our business. We do not expect that any of
these matters, individually or in the aggregate, will have a
material adverse effect on our business, financial condition,
cash flows or results of operation.

12



---



##### Table of Contents



On May 1, 2001, the Santa Clara Center for
Occupational Safety and Health filed a complaint for injunctive
relief and civil penalties against us in the Superior Court of
California, County of Alameda, Hayward Division, Case
No. H218237-5. The complaint alleged violations of
California Business and Professions Code section 17200 et
seq., and violations under Proposition 65 and California
Health and Safety Code section 25249 et seq. as a result of
AXTs use of arsenic and inorganic arsenic compounds in its
workplace. On June 24, 2002, we participated in a private
mediation, and as a result, reached a settlement of all claims,
pursuant to which we agreed to pay the Santa Clara Center for
Occupational Safety and Health an amount equal to $175,000. The
parties have executed a settlement agreement, and the court
approved the settlement on December 31, 2002, and dismissal
of the case is pending.






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

None




PART II






|        |                                                                          
|------- | -------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity
    and Related Stockholder Matters

Our common stock has been trading publicly on the
Nasdaq National Market under the symbol AXTI since
May 20, 1998, the date we consummated our initial public
offering. The following table sets forth, for the periods
indicated, the range of quarterly high and low closing sales
prices for our common stock on the Nasdaq National Market.

|            |                                            |      |   |        |  |  |   |        | 
|----------- | ------------------------------------------ | ---- | - | ------ |  |  | - | ------ | 
|            |                                            | High |   | Low   
|            |                                            |      |   |       
|Fiscal 2002 |                                            |      |   |        |  |  |   |       
|            | First Quarter ended March 31, 2002         |      | $ | 16.890 |  |  | $ | 8.850  | 
|            | Second Quarter ended June 30, 2002         |      | $ | 11.600 |  |  | $ | 7.000  | 
|            | Third Quarter ended September 30,
    2002 |      | $ | 8.390  |  |  | $ | 2.080  | 
|            | Fourth Quarter ended December 31, 2002     |      | $ | 2.820  |  |  | $ | 0.970  | 
|Fiscal 2001 |                                            |      |   |        |  |  |   |       
|            | First Quarter ended March 31, 2001         |      | $ | 44.560 |  |  | $ | 14.500 | 
|            | Second Quarter ended June 30, 2001         |      | $ | 40.670 |  |  | $ | 13.720 | 
|            | Third Quarter ended September 30,
    2001 |      | $ | 26.700 |  |  | $ | 10.200 | 
|            | Fourth Quarter ended December 31, 2001     |      | $ | 16.850 |  |  | $ | 10.300 | 

As of December 31, 2002, there were 89
registered holders of record of our common stock. Because many
shares of AXTs common stock are held by brokers and other
institutions on behalf of stockholders, we are unable to
estimate the total number of stockholders represented by these
registered holders.

We have never paid or declared any cash dividends
on our common stock and do not anticipate paying cash dividends
in the foreseeable future. We are restricted in our ability to
pay dividends under the terms of our credit facility with our
bank. Dividends accrue on our preferred stock at the rate of
$0.20 per annum per share of preferred stock.

13



---



##### Table of Contents








|        |                                         
|------- | ----------------------------------------
|Item 6. | Selected Consolidated Financial
    Data

The following selected consolidated financial
data are derived from and should be read in conjunction with,
and are referenced to, our consolidated financial statements and
related notes and Item 7. Managements
Discussion and Analysis of Financial Condition and Results of
Operations.

|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |        |       | 
|------------------------------------------------------------------------------ | ---------------------------------------------------------- | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------ | ------ | ------ | - | ------ | ------ | ----- | 
|                                                                               |                                                            |                                      
|                                                                               |                                                            | Years Ended December 31,             
|                                                                               |                                                            |                                      
|                                                                               |                                                            | 2002                                  |         | 2001   |        | 2000 |         | 1999   |        | 1998
|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |     
|                                                                               |                                                            |                                      
|                                                                               |                                                            | (In thousands, except per share data)
|Income Statement Data:                                                         |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|Revenue                                                                        |                                                            | $                                     | 63,175  |        |        | $    | 119,530 |        |        | $    | 121,503 |        |        | $ | 75,372 |        |        | $ | 49,074 |       
|Cost of revenue                                                                |                                                            |                                       | 74,031  |        |        |      | 82,191  |        |        |      | 73,684  |        |        |   | 50,026 |        |        |   | 29,003 |       
|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|Gross profit (loss)                                                            |                                                            |                                       | (10,856 | )      |        |      | 37,339  |        |        |      | 47,819  |        |        |   | 25,346 |        |        |   | 20,071 |       
|Operating expenses:                                                            |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|                                                                               | Selling, general, and administrative                       |                                       |         | 18,648 |        |      |         | 21,487 |        |      |         | 18,041 |        |   |        | 10,474 |        |   |        | 6,019  |      
|                                                                               | Research and development                                   |                                       |         | 4,868  |        |      |         | 8,204  |        |      |         | 8,769  |        |   |        | 2,566  |        |   |        | 2,504  |      
|                                                                               | Restructuring costs                                        |                                       |         | 39,086 |        |      |         |       |        |      |         | 6,409  |        |   |        |       |        |   |        |       |      
|                                                                               | Acquisition costs                                          |                                       |         |       |        |      |         |       |        |      |         |       |        |   |        | 2,810  |        |   |        |       |      
|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|                                                                               |                                                            | Total operating expenses              |         |        | 62,602 |      |         |        | 29,691 |      |         |        | 33,219 |   |        |        | 15,850 |   |        |        | 8,523 | 
|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|Income (loss) from operations                                                  |                                                            |                                       | (73,458 | )      |        |      | 7,648   |        |        |      | 14,600  |        |        |   | 9,496  |        |        |   | 11,548 |       
|Interest expense                                                               |                                                            |                                       | 1,326   |        |        |      | 2,081   |        |        |      | 3,616   |        |        |   | 2,201  |        |        |   | 875    |       
|Other (income) and expense, net                                                |                                                            |                                       | 12,705  |        |        |      | 13,373  |        |        |      | (28,432 | )      |        |   | (1,423 | )      |        |   | (715   | )     
|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|Income (loss) from continuing operations before
    provision for income taxes |                                                            |                                       | (87,489 | )      |        |      | (7,806  | )      |        |      | 39,416  |        |        |   | 8,718  |        |        |   | 11,388 |       
|Provision (benefit) for income taxes                                           |                                                            |                                       | (6,308  | )      |        |      | (2,810  | )      |        |      | 14,978  |        |        |   | 4,380  |        |        |   | 4,668  |       
|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|Income (loss) from continuing operations                                       |                                                            |                                       | (81,181 | )      |        |      | (4,996  | )      |        |      | 24,438  |        |        |   | 4,338  |        |        |   | 6,720  |       
|Discontinued operations:                                                       |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|                                                                               | Loss from discontinued operations, net of tax
    benefits |                                       |         |       |        |      |         |       |        |      |         | (1,487 | )      |   |        | (3,658 | )      |   |        | (2,436 | )    
|                                                                               | Loss on disposal, net of tax benefits                      |                                       |         |       |        |      |         |       |        |      |         | (1,341 | )      |   |        |       |        |   |        |       |      
|Extraordinary item, net of tax benefits                                        |                                                            |                                       |        |        |        |      |        |        |        |      |        |        |        |   | (508   | )      |        |   |       |       
|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|Net income (loss)                                                              |                                                            | $                                     | (81,181 | )      |        | $    | (4,996  | )      |        | $    | 21,610  |        |        | $ | 172    |        |        | $ | 4,284  |       
|                                                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|Basic income (loss) per share:                                                 |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|                                                                               | Income (loss) from continuing operations                   |                                       | $       | (3.63  | )      |      | $       | (0.23  | )      |      | $       | 1.24   |        |   | $      | 0.23   |        |   | $      | 0.42   |      
|                                                                               | Loss from discontinued operations                          |                                       |         |       |        |      |         |       |        |      |         | (0.14  | )      |   |        | (0.19  | )      |   |        | (0.15  | )    
|                                                                               | Extraordinary item                                         |                                       |         |       |        |      |         |       |        |      |         |       |        |   |        | (0.03  | )      |   |        |       |      
|                                                                               | Net income (loss)                                          |                                       |         | (3.63  | )      |      |         | (0.23  | )      |      |         | 1.10   |        |   |        | 0.01   |        |   |        | 0.27   |      
|Diluted income (loss) per share:                                               |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|                                                                               | Income (loss) from continuing operations                   |                                       | $       | (3.63  | )      |      | $       | (0.23  | )      |      | $       | 1.16   |        |   | $      | 0.22   |        |   | $      | 0.41   |      
|                                                                               | Loss from discontinued operations                          |                                       |         |       |        |      |         |       |        |      |         | (0.13  | )      |   |        | (0.18  | )      |   |        | (0.15  | )    
|                                                                               | Extraordinary item                                         |                                       |         |       |        |      |         |       |        |      |         |       |        |   |        | (0.03  | )      |   |        |       |      
|                                                                               | Net income (loss)                                          |                                       |         | (3.63  | )      |      |         | (0.23  | )      |      |         | 1.03   |        |   |        | 0.01   |        |   |        | 0.26   |      
|Shares used in per share calculations:                                         |                                                            |                                       |         |        |        |      |         |        |        |      |         |        |        |   |        |        |        |   |        |       
|                                                                               | Basic                                                      |                                       |         | 22,433 |        |      |         | 22,278 |        |      |         | 19,677 |        |   |        | 18,655 |        |   |        | 16,076 |      
|                                                                               | Diluted                                                    |                                       |         | 22,433 |        |      |         | 22,278 |        |      |         | 21,059 |        |   |        | 19,771 |        |   |        | 16,325 |      

14



---



##### Table of Contents



|                                                |  |                |         |      |  |      |         |      |  |      |         |  |  |   |         |  |  |   |         | 
|----------------------------------------------- |  | -------------- | ------- | ---- |  | ---- | ------- | ---- |  | ---- | ------- |  |  | - | ------- |  |  | - | ------- | 
|                                                |  |               
|                                                |  | December 31,  
|                                                |  |               
|                                                |  | 2002           |         | 2001 |  | 2000 |         | 1999 |  | 1998
|                                                |  |                |         |      |  |      |         |      |  |     
|                                                |  |               
|                                                |  | (In thousands)
|Balance Sheet Data:                             |  |                |         |      |  |      |         |      |  |      |         |  |  |   |         |  |  |   |         | 
|Cash and cash equivalents                       |  | $              | 13,797  |      |  | $    | 37,538  |      |  | $    | 68,585  |  |  | $ | 6,062   |  |  | $ | 16,438  | 
|Short-term investments                          |  |                | 8,205   |      |  |      | 25,673  |      |  |      | 30,852  |  |  |   |        |  |  |   |        | 
|Working capital                                 |  |                | 65,375  |      |  |      | 125,295 |      |  |      | 140,387 |  |  |   | 40,462  |  |  |   | 41,644  | 
|Restricted deposits                             |  |                | 11,150  |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|Long-term investments                           |  |                | 3,657   |      |  |      | 6,552   |      |  |      |        |  |  |   |        |  |  |   |        | 
|Total assets                                    |  |                | 145,667 |      |  |      | 243,359 |      |  |      | 250,220 |  |  |   | 115,762 |  |  |   | 102,983 | 
|Long-term capital lease, net of current portion |  |                | 4,847   |      |  |      | 10,002  |      |  |      | 7,278   |  |  |   | 6,853   |  |  |   | 3,854   | 
|Long-term debt, net of current portion          |  |                | 13,289  |      |  |      | 14,342  |      |  |      | 15,123  |  |  |   | 15,254  |  |  |   | 18,416  | 
|Stockholders equity                            |  |                | 105,657 |      |  |      | 186,322 |      |  |      | 185,347 |  |  |   | 62,459  |  |  |   | 61,164  | 

Income statement data from our substrate division
and discontinued consumer products division is included in all
periods presented. Income statement data from our
opto-electronics division is included from the time of the
acquisition of Alpha Photonics by Lyte Optronics on
September 29, 1998. All periods have been restated to
reflect the accounting for discontinued operations. As a result,
the discontinued consumer products division has been eliminated
from continuing operations in the income statements.






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

The following discussion and analysis of our
financial condition and results of operations should be read in
conjunction with Selected Consolidated Financial
Data and our consolidated financial statements and related
notes included elsewhere in this Form 10-K. In addition to
historical information, the discussion in this Form 10-K
contains forward-looking statements that involve risks and
uncertainties that could cause our actual results to differ
materially from those projected. The statements contained in the
Report on Form 10-K that are not purely historical are
forward looking statements within the meaning of
Section 27A of the Securities Act and Section 21E of
the Exchange Act, including, without limitation, statements
regarding our expectations, beliefs, intentions or strategies
regarding the future. All forward-looking statements included in
this Report on Form 10-K are based on information available
to us on the date hereof, and we assume no obligation to update
any such forward-looking statements. These statements involve
known and unknown risks, uncertainties and other factors, which
may cause our actual results to differ materially from those
implied by the forward-looking statements. In some cases, you
can identify forward-looking statements by terminology such as
may, will, should,
expects, plans, anticipates,
believes, estimates,
predicts, potential, or
continue or the negative of these terms or other
comparable terminology. Factors that might cause or contribute
to such differences include, but are not limited to, those set
forth under Risks Related to Our Business and
elsewhere in this Form 10-K.

Overview

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

15



---



##### Table of Contents



Our total revenue from continuing operations was
$63.2 million for 2002, $119.5 million for 2001 and
$121.5 million for 2000. In 2002 we incurred a loss from
continuing operations of $81.2 million compared to a loss
of $5.0 million for 2001 and income of $24.4 million
for 2000.

Several non-recurring events occurred that had a
substantial impact on our performance and financial results for
the years-ended December 31, 2002, 2001 and 2000. In 2002,
we recorded excess inventory impairment charges of
$9.7 million that are included in cost of revenue,
equipment impairment charges of $38.0 million and goodwill
impairment charges of $1.1 million that are included in
operating expenses, a write-down in our investment in Finisar
Corporation of $10.8 million and a loss on a building held
for sale of $3.1 million that are included in other
expense. In 2001, we realized a net $15.6 million non-cash
loss as a result of writing down our investment in Finisar
Corporation common stock. This loss is included in other
expense. In 2000, we realized a $27.3 million non-cash gain
as a result of acquiring Finisar Corporation common stock in
connection with Finisar Corporations acquisition of
Demeter Technologies, a company in which we held warrants to
purchase preferred stock. This gain is included in other income.
On December 14, 2000, the Board of Directors approved our
plan to discontinue our unprofitable consumer products division.
As a result of discontinuing the consumer products division, we
incurred a pre-tax loss on disposal of $2.2 million. The
results of operations of the consumer products division have
been segregated from continuing operations and are reported
separately as discontinued operations in the income statements.
In 2000 we exited our unprofitable 650nm laser diode
product line at the opto-electronics division. As a result of
exiting this product line, we incurred a restructuring charge of
$8.2 million, of which $1.8 million has been
classified as cost of goods sold and $6.4 million has been
classified as operating expense.

Our business, particularly sales of our substrate
products, are dependant on the semiconductor industry, which is
highly cyclical and has historically experienced downturns both
as a result of economic changes and of overcapacity. Following a
strong period during the first half of 2001, we are now in the
midst of a significant and prolonged downturn, and, together
with other industry participants, have experienced lower
revenues, slower bookings, push outs and cancellation of orders.
We cannot predict the severity or duration of the downturn, but
it has impacted our ability to sell our products and operate
profitably. If demand for our products remains depressed for an
extended period, our business will be harmed as a result.

In the second half of 2001, we experienced a
$43.2 million, or 53.1% decrease in revenue compared to the
first half as a result of the rapid decline in the mobile and
fiber optic telecommunications markets. As such, we recorded
losses in the third and fourth quarters. In 2002, the downward
revenue trend that began in the second half of 2001 continued
and full year 2002 revenue declined $56.4 million, or 47.1%
compared to 2001. We recorded losses in each quarter of 2002. In
reaction to the economic downturn, we have initiated an
aggressive effort to reduce substrate manufacturing costs. This
includes moving much of our substrate manufacturing operations
to China, reducing capacity in our Fremont, CA facility and
developing and investing in key low cost raw material sources.
We are hopeful that the cost reduction efforts should allow us
to operate profitably again by the end of 2003 and will position
us well for future growth. During the second half of 2002, we
experienced certain manufacturing and quality problems that had
a negative impact in obtaining orders from several large
customers for HBLEDs at the opto-electronics division, as well
as on our substrates, which resulted in decreased orders at our
substrate division. As a result, the divisions continued to
experience losses in each quarter of 2002. We have initiated
measures to improve our manufacturing and quality issues and
have taken measures to reduce operating costs. As a result, we
are hopeful that the opto-electronics division will also be
profitable by the end of 2003.

During 2002 and 2001, we raised approximately
$850,000 and $4.8 million, respectively, from the exercise
of options by employees to purchase our common stock under our
employee stock option plan. During 2000, we raised approximately
$96.0 million from the sale of common stock in a private
offering, a registered public offering and the exercise of
options by employees to purchase our common stock under our
employee stock option plan.

Our five largest customers accounted for 35.6% of
our total revenue from continuing operations in 2002, 28.3% in
2001 and 26.1% in 2000. One customer accounted for 10.7% of our
revenue in 2002 and no customer accounted for more than 10% of
our total revenue in 2001 or 2000.

16



---



##### Table of Contents



Each of our divisions is responsible for its own
sales and marketing activities, and each maintains its own sales
and marketing personnel. We sell our substrate products through
our direct sales force in the U.S. and through independent sales
representatives in France, Japan, South Korea, Taiwan and the
United Kingdom. We sell our HBLED and laser diode products
through our direct sales force and through independent sales
representatives.

Critical Accounting Policies and
Estimates

We have prepared our consolidated financial
statements in accordance with accounting principals generally
accepted in the United States of America. As such, we have had
to make estimates, assumptions and judgments that affect the
amounts reported on our financial statements. These estimates,
assumptions and judgments about future events and their effects
on our results cannot be determined with certainty, and are made
based upon our historical experience and on other assumptions
that are believed to be reasonable under the circumstances.
These estimates may change as new events occur or additional
information is obtained, and we may periodically be faced with
uncertainties, the outcomes of which are not within our control
and may not be known for a prolonged period of time. The
discussion and analysis of our results of operations and
financial condition are based upon these statements. We have
identified the policies below as critical to our business
operations and understanding of our financial condition and
results of operations. A critical accounting policy is one that
is both material to the presentation of our financial statements
and requires us to make difficult, subjective or complex
judgments that could have a material effect on our financial
condition and results of operations. They may require us to make
assumptions about matters that are highly uncertain at the time
of the estimate, and different estimates that we could have
used, or changes in the estimate that are reasonably likely to
occur, may have a material impact on our financial condition or
results of operations.

We believe that the following are our critical
accounting policies:



| |                    
| | -------------------
| | Revenue Recognition

We recognize revenue upon shipment of products to
our customers provided that we have received a signed purchase
order, the price is fixed or determinable, title has
transferred, collection of resulting receivables is probable,
product returns are reasonably estimable, there are no customer
acceptance requirements and there are no remaining obligations.
We assess the probability of collection based on a number of
factors including past history with the customer and credit
worthiness. We provide for future returns based on historical
experience, current economic trends and changes in customer
demand at the time revenue is recognized. Except for sales in
Japan and some sales in Taiwan, which in both cases are
denominated in Japanese yen, we denominate and collect our
international sales in U.S. dollars. We do not provide for
warranty related exposure as such exposure has historically been
immaterial.



| |                                    
| | -----------------------------------
| | Allowance for Doubtful
    Accounts

We periodically review the likelihood of
collecting our accounts receivable balances and provide an
allowance for doubtful accounts receivable 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
receivables in excess of 120 days. At December 31,
2002 our accounts receivable balance was $7.2 million net
of an allowance for doubtful accounts of $6.7 million.



| |          
| | ---------
| | Inventory

Inventories are stated at the lower of cost or
net realizable value. Cost is determined using the weighted
average cost method. Finished goods and work-in-process
inventories include material, labor and manufacturing overhead
costs. We routinely evaluate the levels of our inventory in
light of current market conditions in order to identify excess
and obsolete inventory and we provide a valuation allowance for
certain inventories based upon the age and quality of the
product. The lives of our substrate products are relatively long
and accordingly, obsolescence has historically not been a
significant factor. We also review our inventory to ensure costs
can be realized upon ultimate sale to our customers. If we
determine that the value of any items in

17



---



##### Table of Contents



ending inventory exceeds the sales value less any
related selling costs, a reserve is established for the
difference. As a result of fourth quarter 2002 and expected 2003
market conditions, during the fourth quarter of 2002, we
recorded a charge of $9.7 million to reserve for excess
inventory.




| |                                    
| | -----------------------------------
| | Impairment of Long-Lived
    Assets

We review the carrying value of our long-lived
assets and investments in order to identify any impairment.
Long-lived assets are written down to their current fair market
value when the carrying value of an asset exceeds their related
undiscounted future cash flows. To determine the fair market
value of our long-lived assets, we obtain appraisals from
outside consultants. During 2002, we recorded long-lived asset
and goodwill impairment charges of $42.2 million.



| |            
| | -----------
| | Investments

The Company classifies its investments in
marketable securities as available-for-sale securities as
prescribed in Financial Accounting Standard No. 115,
Accounting for Certain Investments in Debt and Equity
Securities. All investments are carried at fair market
value, which is determined based on quoted market prices, with
net unrealized gains and losses included in comprehensive
income, net of tax. If a decline in fair value is judged to be
other than temporary, the cost basis of the individual security
is written down to fair value as a new cost basis with the
amount of the write down included in other (income) expense. We
recorded an impairment charge of $10.8 million in 2002 and
$15.6 million in 2001 to write-down our investment in
Finisar Corporation common stock.



| |             
| | ------------
| | Income Taxes

The Company accounts for deferred income taxes
using the liability method, under which the expected future tax
consequences of timing differences between the book and tax
basis of assets and liabilities are recognized as deferred tax
assets and liabilities. Valuation allowances are established
when necessary to reduce net deferred tax assets when management
estimates, based on available objective evidence, that it is
more likely than not that the future income tax benefit
represented by the net deferred tax asset will not be realized.

18



---



##### Table of Contents



Results of Operations

The following table sets forth certain operating
data as a percentage of total revenues for the periods indicated.

|                                                                               |                                                            |                          |        |      |      |      |       |      |      |   |       |      |      |  
|------------------------------------------------------------------------------ | ---------------------------------------------------------- | ------------------------ | ------ | ---- | ---- | ---- | ----- | ---- | ---- | - | ----- | ---- | ---- | -
|                                                                               |                                                            |                         
|                                                                               |                                                            | Years Ended December 31,
|                                                                               |                                                            |                         
|                                                                               |                                                            | 2002                     |        | 2001 |      | 2000
|                                                                               |                                                            |                          |        |      |      |     
|Revenue                                                                        |                                                            |                          | 100.0  | %    |      |      | 100.0 | %    |      |   | 100.0 | %   
|Cost of revenue                                                                |                                                            |                          | 117.2  | %    |      |      | 68.8  | %    |      |   | 60.6  | %   
|                                                                               |                                                            |                          |        |      |      |      |       |      |      |   |       |     
|Gross profit (loss)                                                            |                                                            |                          | (17.2  | )%   |      |      | 31.2  | %    |      |   | 39.4  | %   
|Operating expenses:                                                            |                                                            |                          |        |      |      |      |       |      |      |   |       |     
|                                                                               | Selling, general, and administrative                       |                          |        | 29.5 | %    |      |       | 18.0 | %    |   |       | 14.8 | %   
|                                                                               | Research and development                                   |                          |        | 7.7  | %    |      |       | 6.9  | %    |   |       | 7.2  | %   
|                                                                               | Restructuring costs                                        |                          |        | 61.9 | %    |      |       | 0.0  | %    |   |       | 5.3  | %   
|                                                                               |                                                            |                          |        |      |      |      |       |      |      |   |       |     
|                                                                               |                                                            | Total operating expenses |        |      | 99.1 | %    |       |      | 24.9 | % |       |      | 27.3 | %
|                                                                               |                                                            |                          |        |      |      |      |       |      |      |   |       |     
|Income (loss) from operations                                                  |                                                            |                          | (116.3 | )%   |      |      | 6.3   | %    |      |   | 12.1  | %   
|Interest expense                                                               |                                                            |                          | 2.1    | %    |      |      | 1.7   | %    |      |   | 3.0   | %   
|Other (income) and expense, net                                                |                                                            |                          | 20.1   | %    |      |      | 11.2  | %    |      |   | (23.4 | )%  
|                                                                               |                                                            |                          |        |      |      |      |       |      |      |   |       |     
|Income (loss) from continuing operations before
    provision for income taxes |                                                            |                          | (138.5 | )%   |      |      | (6.6  | )%   |      |   | 32.5  | %   
|Provision (benefit) for income taxes                                           |                                                            |                          | (10.0  | )%   |      |      | (2.4  | )%   |      |   | 12.3  | %   
|                                                                               |                                                            |                          |        |      |      |      |       |      |      |   |       |     
|Income (loss) from continuing operations                                       |                                                            |                          | (128.5 | )%   |      |      | (4.2  | )%   |      |   | 20.2  | %   
|Discontinued operations:                                                       |                                                            |                          |        |      |      |      |       |      |      |   |       |     
|                                                                               | Loss from discontinued operations, net of tax
    benefits |                          |        | 0.0  | %    |      |       | 0.0  | %    |   |       | (1.2 | )%  
|                                                                               | Loss on disposal, net of tax benefits                      |                          |        | 0.0  | %    |      |       | 0.0  | %    |   |       | (1.1 | )%  
|                                                                               |                                                            |                          |        |      |      |      |       |      |      |   |       |     
|Net income (loss)                                                              |                                                            |                          | (128.5 | )%   |      |      | (4.2  | )%   |      |   | 17.9  | %   
|                                                                               |                                                            |                          |        |      |      |      |       |      |      |   |       |     



| |                                                                          
| | -------------------------------------------------------------------------
| | Year Ended December 31, 2002 Compared
    to Year Ended December 31, 2001

Revenue from continuing operations.Revenue decreased $56.4 million,
or 47.1%, to $63.2 million in 2002 compared to
$119.5 million in 2001. Revenue from our substrate
division, which represents 71.0% of total revenue for the year
ended 2002, decreased $63.9 million, or 58.8%, to
$44.9 million compared to $108.8 million in 2001.
Total GaAs substrate revenue decreased $42.5 million, or 56.4%,
to $32.9 million in 2002 compared to $75.4 million in
2001. Sales of 5 and 6 diameter GaAs substrates
decreased $12.8 million, or 59.2%, to $8.8 million in
2002 compared to $21.6 million in 2001. InP substrate
revenue decreased $21.7 million, or 77.0%, to
$6.5 million in 2002 compared to $28.2 million in
2001. The decrease in GaAs and InP substrate revenue is due to
decreased volume and sales prices as a result of the slowdown in
our markets including telecommunications, high speed electronic
devices, and short wavelength lasers.

Revenue from our opto-electronics division, which
represents 29.0% of total revenue for 2002, increased
$7.6 million, or 70.6%, to $18.3 million in 2002,
compared to $10.7 million in 2001. The increase was a
result of higher sales volume of HBLED products. HBLED revenue
increased $8.4 million, or 114.0%, to $15.8 million in
2002 compared to $7.4 million in 2001. While revenue earned
from HBLED products increased, the per unit price declined
during 2002 and we may face further reductions in market prices
in the future.

VCSEL revenue decreased $392,000, or 38.8% to
$619,000 in 2002 compared to $1.0 million in 2001. The
decrease in VCSEL revenue was primarily due to a weakening in
consumer demand. Laser diode sales decreased $437,000, or 18.7%,
to $1.9 million in 2002 compared to $2.3 million in
2001. The decrease in laser diode sales was primarily due to the
exit of our unprofitable 650 nm laser diode product line in
2001.

19



---



##### Table of Contents



International revenue increased to 58.2% of total
revenue in 2002 compared to 50.4% of total revenue in 2001. The
increase was primarily due to increased sales of HBLED products
to customers in Asia.

Gross margin.Gross
margin decreased to negative 17.2% of revenue in 2002 compared
to 31.2% in 2001. Gross margin at the substrate division
decreased to negative 19.8% of revenue in 2002 compared to 38.0%
in 2001. The decrease was primarily due to lower unit sales and
average sales prices of GaAs and InP substrates spread over a
relatively fixed manufacturing overhead base and a
$9.7 million charge to write-down excess inventory. As a
result, we have initiated manufacturing cost reductions in order
to align our costs with lower expected sales volumes and prices.
We are currently shifting most of our substrate manufacturing to
China and reducing capacity in our Fremont, California facility.
Gross margin at the opto-electronics division increased to
negative 10.7% of revenue for 2002 compared to negative 37.0%
for 2001. The increase was primarily due to increased unit sales
of blue HBLED products.

Selling, general and administrative expenses.Selling, general and administrative
expenses decreased $2.8 million, or 13.2%, to
$18.6 million in 2002 compared to $21.5 million in
2001. As a percentage of total revenue, selling, general and
administrative expenses were 29.5% in 2002 compared to 18.0% in
2001. In order to align our cost structure with the rapid
decline in revenues, we have initiated and are aggressively
pursuing cost reductions in this area, which led to the decrease
in 2002.

Research and development expenses.Research and development expenses
decreased $3.3 million or 40.7%, to $4.9 million in
2002 compared to $8.2 million in 2001. As a percentage of
total revenue, research and development expenses were 7.7% in
2002 compared to 6.9% in 2001. Although we reduced research and
development expenses in 2002 as part of our effort to reduce
costs, we believe that continued investment in product
development is critical to attaining our strategic objectives of
maintaining and increasing our technology leadership, and as a
result, we expect research and development expenses to remain at
current levels in future periods. Research and development
efforts during 2002 were focused primarily on improving the
yield and surface quality of our GaAs substrates, and improving
the brightness, reliability, and yield of our HBLED products.

Interest expense.Interest expense decreased $755,000,
or 36.3%, to $1.3 million in 2002 compared to
$2.1 million in 2001. The decrease was primarily due to the
repayment of certain long-term real estate notes and capital
equipment leases.

Other income and expense.Other expense was $12.7 million
in 2002 compared to $13.4 million in 2001. The amount in
2002 includes non-cash charges of $10.8 million related to
the write-down to market value of our investment in Finisar
Corporation common stock and $3.1 million to write-down a
building held for sale to net realizable value. The 2001 balance
includes a non-cash charge of $15.6 million to write-down
to market value our investment in Finisar common stock.

Provision for income taxes.Due to our continuing operating losses
during 2002 and uncertainty regarding future profitability, we
recorded a full valuation allowance against our net deferred tax
assets of $31.2 million in 2002. As a result, our effective
tax rate decreased to 7.2% in 2002 and will be 0% in the
foreseeable future. Our effective tax rate in 2001 was 36%.



| |                                                                          
| | -------------------------------------------------------------------------
| | Year Ended December 31, 2001 Compared
    to Year Ended December 31, 2000

Revenue from continuing operations.Revenue decreased $2.0 million,
or 1.6%, to $119.5 million in 2001 compared to
$121.5 million in 2000. Revenue from our substrate
division, which represents 91.0% of total revenue for the year
ended 2001, decreased $4.6 million, or 4.0%, to
$108.8 million compared to $113.4 million in 2000.
Total GaAs substrate revenue decreased $22.6 million, or
23.1%, to $75.4 million in 2001 compared to
$97.9 million in 2000. Sales of 5 and 6
diameter GaAs substrates was unchanged at $21.6 million for
2001 and 2000. InP substrate revenue increased
$14.3 million, or 102.0%, to $28.2 million in 2001
compared to $14.0 million in 2000. While our substrate
division experienced sequential quarter over quarter revenue
growth during the first half of 2001, substrate revenue declined
substantially in the second half due to a decline in the
wireless and fiber optic telecommunication markets. Substrate
revenue in the first half of 2001 was $76.9 million
compared to $31.9 million in the second half of 2001, as
the global economic

20



---



##### Table of Contents



environment weakened through the middle of the
year and customers reduced their requirements dramatically.


Revenue from our opto-electronics division, which
represents 9.0% of total revenue for 2001, increased
$2.6 million, or 32.0%, to $10.7 million in 2001,
compared to $8.1 million in 2000. The increase was a result
of higher sales volume of HBLED products. HBLED revenue
increased $5.4 million, or 263.9%, to $7.4 million in
2001 compared to $2.0 million in 2000. VCSEL revenue
increased $816,000, or 418.5% to $1.0 million in 2001
compared to $195,000 in 2000. Laser diode sales decreased
$3.8 million, or 61.9%, to $2.3 million in 2001
compared to $6.2 million in 2000. The decrease in laser
diode sales was primarily due to the exit of our unprofitable
650 nm laser diode product line.

International revenue increased to 50.4% of total
revenue in 2001 compared to 48.2% of total revenue in 2000. The
increase was primarily due to increased sales of HBLED products
to customers in Asia.

Gross margin.Gross
margin decreased to 31.2% of revenue in 2001 compared to 39.4%
in 2000. Gross margin at the substrate division decreased to
38.0% of revenue in 2001 compared to 45.9% in 2000. The decrease
was primarily due to lower unit sales and average sales prices
of GaAs substrates in the second half of 2001. As a result, we
initiated manufacturing cost reductions in order to align our
costs with lower expected sales volumes and prices. We began
shifting much of our substrate manufacturing to China and
reducing capacity in our Fremont, California facility. Gross
margin at the opto-electronics division increased to negative
37.0% of revenue for 2001 compared to negative 51.6% for 2000.
The increase was primarily due to increased unit sales of blue
HBLED products.

Selling, general and administrative expenses.Selling, general and administrative
expenses increased $3.5 million, or 19.1%, to
$21.5 million in 2001 compared to $18.0 million in
2000. As a percentage of total revenue, selling, general and
administrative expenses were 18.0% in 2001 compared to 14.8% in
2000. The increase was due to the addition of personnel and
facilities in anticipation of increased revenues after the
expansion of orders experienced in 2000. Due to the decline in
substrate revenue in the second half of 2001, we initiated cost
reductions in this area.

Research and development expenses.Research and development expenses
decreased $565,000, or 6.4%, to $8.2 million in 2001
compared to $8.8 million in 2000. As a percentage of total
revenue, research and development expenses were 6.9% in 2001
compared to 7.2% in 2000.

Interest expense.Interest expense decreased
$1.5 million, or 42.5%, to $2.1 million in 2001
compared to $3.6 million in 2000. The decrease was
primarily due to the repayment of outstanding short-term debt
with equity financing proceeds in September 2000.

Other income and expense.Other expense was $13.4 million
in 2001 compared to income of $28.4 million in 2000. The
balance in 2001 includes the realization of a net
$15.6 million non-cash loss from the write-down to market
value of our investment in Finisar Corporation common stock in
accordance with SFAS 115. The balance in 2000 includes the
realization of a $27.3 million non-cash gain on Demeter
Technology warrants that were exchanged for Finisar Corporation
common stock as a result of Finisar Corporations
acquisition of Demeter Technology in 2000.

Provision for income taxes.Our effective tax rate decreased to
36.0% in 2001 compared to 38.0% in 2000. The decrease was
primarily the result of shifting certain substrate manufacturing
operations to China.

Liquidity and Capital Resources

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

Cash and cash equivalents, short-term investments
and long-term investments, excluding $1.1 million and
$11.7 million for our investment in Finisar common stock at
December 31, 2002 and 2001 respectively, decreased
$33.5 million to $24.5 million at December 31,
2002 compared to $58.1 million at December 31,

21



---



##### Table of Contents



2001. The decrease in available cash included
restricting $10.2 million as additional collateral with our
bank as a result of a modification to our credit facility,
restricting $1.0 million as collateral for a
$1 million letter of credit supporting our workers
compensation insurance policy, purchases of capital equipment of
$14.2 million and debt repayments of $12.9 million
offset by borrowings of $3.9 million.


Cash and cash equivalents decreased
$23.7 million to $13.8 million at December 31,
2002 compared to $37.5 million at December 31, 2001.

Net cash provided by operating activities of
$725,000 for the year ended December 31, 2002 was comprised
primarily of our net loss adjusted for non-cash items of
$65.5 million, consisting primarily of the equipment and
goodwill impairment charges of $39.1 million, the
write-down to market value of our investment in Finisar
Corporation common stock of $10.6 million, and depreciation
of $9.5 million and by a $16.4 million net change in
assets and liabilities. The net change in assets and liabilities
resulted primarily from a decrease in inventory and accounts
receivable, an increase in accounts payable, offset by increases
in income tax receivables and a decrease in accrued liabilities.

Accounts receivable decreased $8.5 million,
or 54.1%, to $7.2 million at December 31, 2002
compared to $15.7 million at December 31, 2001. The
change reflects lower sales volume, collections of
$71.7 million and no change in our allowance for doubtful
accounts of $6.7 million. Inventories decreased
$18.0 million, or 32.4% to $37.6 million at
December 31, 2002 compared to $55.6 million at
December 31, 2001. The decrease in inventory included an
increase in the valuation reserve of $11.8 million and a
real decrease in on-hand components of $6.2 million. As a
result of the continued decline in unit sales during 2002 and
uncertainty regarding the future, we have initiated plans to
aggressively reduce inventory levels during 2003.

Net cash used in investing activities of
$16.0 million for the year ended December 31, 2002
includes purchases of property and equipment of
$14.2 million primarily used to transfer production
capacity to China for the substrate division and to increase
HBLED epitaxy growth and wafer processing capacity at the
opto-electronics division. It also includes $799,000 in
purchases of high grade investment securities with maturities of
less than two years and a transfer of $1.0 million to
restricted deposits to collateralize a letter of credit with a
bank that supports our workers compensation insurance
policy.

We do not have any plans to initiate any major
new capital spending projects through 2003. We are currently
completing certain projects at our China facilities and are
continuously constructing minor improvements to our existing
production facilities in China and California. We expect to
invest approximately $6.0 million in capital projects in
2003. We believe that our existing and planned facilities and
equipment are sufficient to fulfill current and expected future
orders.

Net cash used in financing activities of
$8.1 million consisted of proceeds of $850,000 from the
exercise of options by our employees, additional long-term
borrowings of $3.9 million, offset by payments of
$6.9 million to reduce long-term borrowings and
$6.0 million for capital lease payments.

We generally finance equipment purchases through
secured equipment loans and capital leases over four or
five-year terms at interest rates ranging from 3.6% to 8.8% per
annum. Our main Fremont, California manufacturing facility is
financed by long-term borrowings, which were refinanced by
taxable variable rate revenue bonds in 1998. These bonds mature
in 2023 and bear interest at a variable rate that was 1.6% at
December 31, 2002. The bonds are traded in the public
market. Repayment of principal and interest under the bonds is
supported by a letter of credit from our bank and is paid on a
quarterly basis. We have the option to redeem the bonds in whole
or in part during their term. At December 31, 2002,
$9.1 million was outstanding under these bonds.

At June 30, 2002, the credit facility
maintained by the Company with a bank included a $5 million
line of credit with no balance outstanding, term loans in the
amount of $4.8 million and a letter of credit supporting
repayment of the Companys industrial revenue bonds with an
outstanding amount of $9.4 million. The credit facility is
collateralized by all corporate personal and real property owned
by the Company. As of June 30, 2002, the Company was in
default of the credit facility by failure to maintain certain
financial covenants required under the terms of the facility. As
a result, on September 30, 2002 we modified the credit
agreement with our bank, which waived the covenant default,
terminated the credit line, amended the financial covenants

22



---



##### Table of Contents



and added additional collateral to secure
repayment of the bonds. At December 31, 2002 the credit
facility included a letter of credit supporting our bonds with
an outstanding amount of $9.1 million and foreign exchange
and overdraft obligations in the amount of $1.1 million.
The Company has pledged and placed certain investment securities
with the trust department of the bank as additional collateral
for this facility. As a result, $10.2 million of our
long-term investments are restricted. As of December 31,
2002, we are out of compliance with our tangible net worth
covenant as amended on September 30, 2002. We have obtained
a waver from our bank for this covenant default through
April 30, 2003. Effective April 7, 2003, our bonds
will be supported by a new letter of credit supported by another
bank.


As a result of the significant revenue declines
that we have experienced over the past six quarters, we have
taken cost reduction measures and continue to pursue additional
measures to reduce our costs and increase our cash flows. At
December 31, 2002, we had available cash and cash
equivalents of $13.8 million. We believe that our existing
cash and cash equivalents, and cash generated from operations,
coupled with additional efforts to reduce our expenditures in
support of our substrate and opto-electronic businesses, will be
sufficient to meet our working capital expenditure requirements
for the next 12 months. However, our existing cash and cash
equivalents could continue to decline during 2003 due to a
continued or further weakening of the economy or changes in our
planned cash outlay.

If our sales continue to decrease, our ability to
generate cash from operations will be adversely affected which
could adversely affect our future liquidity, require us to use
more cash at a more rapid rate than expected, and require us to
seek additional capital. There can be no assurance that such
additional capital will be available or, if available it will be
at terms acceptable to the Company. Cash from operations could
be affected by various risks and uncertainties, including, but
not limited to those set forth below under Risks Related
to Our Business.

Outstanding contractual obligations as of
December 31, 2002 are summarized below (in thousands):

|                                                   |  |         |        |      |  |           |        |       |  |   |       |  |  |   |        | 
|-------------------------------------------------- |  | ------- | ------ | ---- |  | --------- | ------ | ----- |  | - | ----- |  |  | - | ------ | 
|                                                   |  | Capital |        |      |  | Operating |        |      
|                                                   |  | Leases  |        | Debt |  | Leases    |        | Total
|                                                   |  |         |        |      |  |           |        |      
|2003                                               |  | $       | 4,090  |      |  | $         | 965    |       |  | $ | 1,200 |  |  | $ | 6,255  | 
|2004                                               |  |         | 2,757  |      |  |           | 5,047  |       |  |   | 1,231 |  |  |   | 9,035  | 
|2005                                               |  |         | 1,908  |      |  |           | 965    |       |  |   | 1,115 |  |  |   | 3,988  | 
|2006                                               |  |         | 549    |      |  |           | 905    |       |  |   | 836   |  |  |   | 2,290  | 
|2007                                               |  |         |       |      |  |           | 722    |       |  |   | 771   |  |  |   | 1,493  | 
|Thereafter                                         |  |         |       |      |  |           | 5,650  |       |  |   |      |  |  |   | 5,650  | 
|                                                   |  |         |        |      |  |           |        |       |  |   |       |  |  |   |        | 
|                                                   |  | $       | 9,304  |      |  | $         | 14,254 |       |  | $ | 5,153 |  |  | $ | 28,711 | 
|                                                   |  |         |        |      |  |           |        |       |  |   |       |  |  |   |        | 
|Less amounts representing interest at 3.6% to 8.8% |  |         | (895   | )    |  |           |        |       |  |   |       |  |  |   |        | 
|                                                   |  |         |        |      |  |           |        |       |  |   |       |  |  |   |        | 
|                                                   |  |         | 8,409  |      |  |           |        |       |  |   |       |  |  |   |        | 
|Less short-term portion                            |  |         | (3,562 | )    |  |           |        |       |  |   |       |  |  |   |        | 
|                                                   |  |         |        |      |  |           |        |       |  |   |       |  |  |   |        | 
|Long-term portion                                  |  | $       | 4,847  |      |  |           |        |       |  |   |       |  |  |   |        | 
|                                                   |  |         |        |      |  |           |        |       |  |   |       |  |  |   |        | 

Recent Accounting Pronouncements

In June 2002, the Financial Accounting Standards
Board (FASB) issued Statement of Accounting Standards
No. 146, Accounting for Costs Associated with Exit
or Disposal Activities.SFAS No. 146 addresses
the timing and amount of costs recognized as a result of
restructuring and similar activities. The company will apply
SFAS No. 146 to activities initiated after
December 31, 2002. The adoption of SFAS No. 146 is not
expected to have a material impact on the Companys
consolidated statements of income or financial position.

In December 2002, the FASB issued Statement of
Financial Accounting Standards No. 148 (SFAS
No. 148), Accounting for Stock-Based
Compensation  Transition and Disclosure 
an amendment to FASB Statement No. 123, Accounting for
Stock-Based Compensation.SFAS No. 148 provides
alternative

23



---



##### Table of Contents



methods of transition for a voluntary change to
the fair value based method of accounting for stock-based
employee compensation. In addition, SFAS No. 148 amends the
disclosure requirements of Statement 123 to require more
prominent and more frequent disclosures in financial statements
about the effects of stock-based compensation. The transition
guidance and annual disclosure provisions of SFAS No. 148
are effective for fiscal years ending after December 15,
2002. The interim disclosure provisions are effective for
financial reports containing financial statements for interim
periods beginning after December 15, 2002.


In November 2002, the FASB issued FASB
Interpretation No. 45 (FIN 45),
Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of
Others.FIN No. 45 requires that a liability be
recorded in the guarantors balance sheet upon issuance of
a guarantee. In addition, FIN No. 45 requires disclosures
about the guarantees that an entity has issued, including a
reconciliation of changes in the entitys product warranty
liabilities. The initial recognition and initial measurement
provisions of FIN No. 45 are applicable on a prospective
basis to guarantees issued or modified after December 31,
2002, irrespective of the guarantors fiscal year-end. The
disclosure requirements of FIN No. 45 are effective for
financial statements of interim or annual periods ending after
December 15, 2002. Our adoption of FIN No. 45 did not
have a material effect on our consolidated financial statements.

In January 2003, the FASB issued FASB
Interpretation No. 46 (FIN 46), Consolidation
of Variable Interest Entities, an Interpretation of ARB
No. 51. FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary
of the entity if the equity investors in the entity do not have
the characteristics of a controlling financial interest or do
not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support
from other parties. FIN 46 is effective immediately for all
new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or
acquired prior to February 1, 2003, the provisions of
FIN 46 must be applied for the first interim or annual
period beginning after June 15, 2003. We are currently
evaluating the impact that the adoption of this standard will
have on our financial statements.

Risks Related to Our Business



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

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

24



---



##### Table of Contents





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

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



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

We have not over the past year been able to
sustain growth, and may not be able to return to historic growth
levels in the current economic environment. Our net loss in 2002
is the largest in our history. We have and may continue to
experience significant fluctuations in our revenue and earnings.
Our quarterly and annual revenue and operating results have
varied significantly in the past and may vary significantly in
the future due to a number of factors, including:



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

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

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

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

25



---



##### Table of Contents





| |                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If the economy recovers and we are again in
    a period of high demand for our products, we may be unable to
    expand our manufacturing capacity quickly enough to meet
    increased demand, and we may be unable to lower our costs or
    increase revenue.

Although we are currently in a period of
overcapacity, reduced sales, and decreased margins, if the
economy recovers, demand may increase rapidly as it has in prior
years after other cyclical downturns in the economy and the
industries in which we operate. If this happens, in order to
meet increased demand and maintain our market share, we may need
to increase production, which could require us to build new
facilities, expand and modify our existing facilities, purchase
additional manufacturing equipment, and add qualified staff. If
we are not at that time able to expand our manufacturing
capacity, we will be unable to increase production, which may
adversely impact our ability to meet increased production demand
while reducing unit costs, margins and improving our operating
results.

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



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

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



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

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



| |                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may need additional capital to fund our
    future operations, expansion of capacity, or changes in
    manufacturing processes, which may not be
    available.

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

26



---



##### Table of Contents



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



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

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



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

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

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



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

Some of our competitors have developed a crystal
growth technique similar to our VGF technology. As a result,
some customers are now allocating their requirements for VGF
grown substrates across more competitors and we believe that we
may have lost revenue and market share as a result of these
customer decisions, which we may be unable to recover. If we are
unable to retain our market share, our revenue and performance
will decline.

To shift more of our substrate manufacturing
operations to China successfully, we will need our customers to
qualify products manufactured in China. If we are unable to
achieve qualifications for these products, our China facility
will be underutilized, our investments in China will not be
recouped and we will be unable to lower our costs by moving to
China. We may lose sales of our products to competitors who are
not

27



---



##### Table of Contents



manufacturing in China, or whose operations in
China have already been qualified by customers. All of these
events could reduce our revenue but increase our cost structure.




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

The markets for our products are intensely
competitive. We face competition for our substrate products from
other manufacturers of substrates, such as Freiberger, Hitachi
Cable, Japan Energy and Sumitomo Electric and from semiconductor
device manufacturers that produce substrates for their own use,
and from companies, such as IBM and Motorola, that are actively
developing alternative materials to GaAs and some semiconductor
devices are being marketed using these materials. We believe
that at least two of our competitors are shipping GaAs
substrates manufactured using a technique similar to our VGF
technique. Other competitors may develop and begin using similar
technology. If we are unable to compete effectively, our revenue
may not increase and we may be unable to be profitable. We face
many competitors that have a number of significant advantages
over us, particularly in our compound semiconductor device
products, including:



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

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

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



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

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



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

Because many of our manufacturing costs are
fixed, our revenue could decline if our yields decrease but our
costs would change little, if at all. We have experienced
product shipment delays and difficulties in achieving acceptable
yields on both new and older products, and delays and poor
yields have adversely affected our operating results, as have
quality control problems experienced on both our substrate and
LED products. We may experience similar problems in the future
and we cannot predict when they may occur or their

28



---



##### Table of Contents



severity. In addition, many of our manufacturing
processes are new and are still being refined, which can result
in lower yields, particularly as we focus on producing higher
diameter substrates and new opto-electronic semiconductor
devices. For example, we recently made substantial investments
in equipment and facilities to manufacture blue, green and cyan
HBLEDs and VCSELs. If we are unable to produce adequate
quantities of our high-brightness LEDs and VCSELs, we may not be
able to meet customer demand and our revenue may decrease while
our costs remain largely unchanged.




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

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



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



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

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



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

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

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



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

We are subject to federal, state and local
environmental and safety laws and regulations in all of our
operating locations. These laws, rules and regulations govern
the use, storage, discharge and disposal of

29



---



##### Table of Contents



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




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

A small number of substrate and HBLED customers
have historically accounted for a substantial portion of our
total revenue. Five customers accounted for 35.6% of our total
revenue for the year ended December 31, 2002 and 28.3% for
the year ended December 31, 2001. One customer accounted
for 10.7% of our revenue for the year ended December 31,
2002. Our substrate revenue accounted for 71% of our total
revenue for the year ended December 31, 2002 and 91% for
the year ended December 31, 2001. We expect that a
significant portion of our future revenue will continue to be
derived from a limited number of substrate and HBLED customers.
Our customers are not obligated to purchase a specified quantity
of our products or to provide us with binding forecasts of
product purchases. In addition, our customers may reduce, delay
or cancel orders at any time without any significant penalty,
and during the past year, we have experienced slower bookings,
significant push outs and cancellation of orders. In addition,
due to the difficult economic environment, several of our
previously large customers have stopped operations entirely. If
we lose a major customer or if a customer cancels, reduces or
delays orders, our revenue would decline. In addition, customers
that have accounted for significant revenue in the past may not
continue to generate revenue for us in any future period. Any
delay in scheduled shipments of our products could cause net
sales to fall below our expectations and the expectations of
market analysts or investors, causing our stock price to decline.



| |                                                                    
| | -------------------------------------------------------------------
| | Defects in our products could diminish
    demand for our products.

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

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



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

Customers typically place orders with us for our
substrate and opto-electronic semiconductor device products
three months to a year or more after our initial contact with
them. The sale of our products may be subject to delays due to
our customers lengthy internal budgeting, approval and
evaluation processes. During this time, we may incur substantial
expenses and expend sales, marketing and management efforts
while the customers evaluate our products. These expenditures
may not result in sales of our products. If we do not achieve
anticipated sales in a period as expected, we may experience an
unplanned shortfall in our revenue. As a result, we may not be
able to cover expenses, causing our operating results to vary.
In addition, if a customer decides not to incorporate our
products into its initial design, we may not have another
opportunity to sell

30



---



##### Table of Contents



products to this customer for many months or even
years. In this difficult economic climate, the average sales
cycle for our products has lengthened even further and is
expected to continue to make it difficult to accurately forecast
our future sales. We anticipate that sales of any future
substrate and opto-electronic semiconductor device products
under development will also have lengthy sales cycles and will,
therefore, be subject to risks substantially similar to those
inherent in the lengthy sales cycle of our current substrate and
opto-electronic semiconductor device products.




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

In the past, periods of rapid growth and
expansion has strained our management and other resources. The
expansion of our manufacturing capacity and the shift of
manufacturing operations to China has placed and continues to
place a significant strain on our operations and management
resources, and we are in the process of upgrading our inventory
control systems and may implement additional systems relating to
consolidation of our financial results. If we fail to manage
these changes effectively, our operations may be disrupted. In
addition, the Sarbanes-Oxley Act requires us to improve the
quality of our systems and procedures.

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

If necessary, we will spend substantial sums to
support our future growth and shift to China and to comply with
the reporting and attestation requirements of the Sarbanes-Oxley
Act. We may incur additional unexpected costs. Our systems,
procedures or controls may not be adequate to support our
operations, and we may be unable to expand quickly enough to
exploit potential market opportunities.



| |                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we fail to manage periodic contractions,
    we may utilize our cash balances and our existing cash and cash
    equivalent balances could decline.

We have experienced a period of rapid contraction
in our business that caused us to reduce our costs in order to
conserve our cash resources. However, in the three months ended
September 30, 2002, we utilized $5.0 million in our
operating activities and for the year ended December 31,
2002, our cash and cash equivalent balances, exclusive of
restricted cash, declined by $33.5 million to
$24.5 million.

If we fail to manage our contractions
successfully we may continue to draw down our cash reserves,
which would adversely affect our operating results and financial
condition, reduce our value and may impinge our ability to raise
debt and equity funding in the future, at a time when we may be
required to raise additional cash. As part of our effort to
reduce costs, we may lose key staff, production resources, and
technology that we will need to grow when end markets recover.
These events could reduce our ability to grow profitably as
markets recover.



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

In connection with our efforts to streamline
operations, reduce costs and bring staffing and structure in
line with current demand for our products, we implemented a
corporate restructuring beginning in 2001 and reduced our
workforce, shifted production activities to China and reduced
capital expenditures. Our restructuring may yield unanticipated
consequences, such as attrition beyond our planned reduction in
workforce and loss of employee morale and decreased performance.
In addition, the recent trading levels of our stock have
decreased the value of our stock options granted to employees
under our stock option plan. As a result of these factors, our
remaining personnel may seek employment with larger, more
established companies or companies that they perceive as having
less volatile stock prices. Continuity of personnel can be very
important factors in the sales and production of our products
and completion of our research and development efforts.

31



---



##### Table of Contents





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

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



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

For example, we incurred substantial costs in
connection with our acquisition of Lyte Optronics, including the
assumption of approximately $10.0 million of debt, much of
which has been repaid or renegotiated, resulting in a decline of
cash available. We have also incurred consistent operating
losses for the business since the acquisition.

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



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

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



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

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

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

32



---



##### Table of Contents





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

We rely on a combination of patents, copyrights,
trademark and trade secret laws, non-disclosure agreements and
other intellectual property protection methods to protect our
proprietary technology. However, we believe that, due to the
rapid pace of technological innovation in the markets for our
products, our ability to establish and maintain a position of
technology leadership also depends on the skills of our
development personnel.

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

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

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



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

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



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

Our revenue growth depends in part on the
expansion of our international sales and operations.
International sales represented 58.2% of our total revenue for
the year ended December 31, 2002 and 50.4% for the year
ended December 31, 2001. We expect that sales to customers
outside the U.S. will continue to represent a significant
portion of our revenue, particularly sales to customers in Asia.

33



---



##### Table of Contents



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



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

Our sales are denominated in U.S. dollars, except
for sales to our Japanese and some Taiwanese customers, which
are denominated in Japanese yen. Thus, increases in the value of
the U.S. dollar could increase the price of our products in
non-U.S. markets and make our products more expensive than
competitors products in these markets. Also, denominating
some sales in Japanese yen subjects us to fluctuations in the
exchange rates between the U.S. dollar and the Japanese
yen. The functional currencies of our Japanese and Chinese
subsidiaries are the local currencies. We incur transaction
gains or losses resulting from consolidation of expenses
incurred in local currencies for these subsidiaries, as well as
in translation of the assets and liabilities of these assets at
each balance sheet date. If we do not effectively manage the
risks associated with international sales, our revenue, cash
flows and financial condition could be adversely affected.



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

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



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

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

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



| |                                                                                                        
| | -------------------------------------------------------------------------------------------------------
| | The effect of terrorist threats and actions
    on the general economy could decrease our
    revenues.

On September 11, 2001, the
United States was subject to terrorist attacks at the World
Trade Center buildings in New York and the Pentagon in
Washington D.C., and continues to be on alert for further
terrorist activity. In addition, the United States continues to
consider hostile activity with Iraq. The potential near- and
long-term impact of these attacks and other terrorist
activities, as well as the threat of war may have in regards

34



---



##### Table of Contents



to our suppliers, customers and markets for our
products and the U.S. economy, are uncertain. There may be
other potential adverse effects on our operating results due to
this significant event that we cannot foresee.




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

Our stock price has fluctuated significantly
since we began trading on the Nasdaq National Market. For the
year ended December, 2002, the high and low closing sales prices
of our common stock were $16.89 and $0.97, respectively. A
number of factors could cause the price of our common stock to
continue to fluctuate substantially, including:



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

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



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

If we fail to meet the criteria for continued
listing on The Nasdaq National Market, our common stock may be
delisted from The Nasdaq National Market. For example, the sales
price of our common stock on the Nasdaq National Market dropped
below $1.00; if the price should be sustained at a level below
one $1.00 for a period of 30 days, and we are thereafter
unable to sustain the sales price above $1.00 for ten
consecutive trading days in the subsequent 90 days, our stock
could be delisted. If the stock is delisted, we may trade on the
over-the-counter market, or even in the pink sheets, which would
significantly decrease the liquidity of an investment in AXT
common stock. In addition, the stock may be deemed to be penny
stock. If our common stock is considered penny stock, it would
be subject to rules that impose additional sales practices on
broker-dealers who sell our securities. For example,
broker-dealers would have to make a special suitability
determination for the purchaser and have received the
purchasers written consent to the transaction prior to
sale. Also, a disclosure schedule must be prepared prior to any
transaction involving a penny stock and disclosure is required
about sales commissions payable to both the broker-dealer and
the registered representative and current quotations for the
securities. Monthly statements are also required to be sent
disclosing recent price information for the penny stock held in
the account and information on the limited market in penny
stock. Because of these additional obligations, some brokers may
be unwilling to effect transactions in penny stocks. This could
have an adverse effect on the liquidity of our common stock and
the ability of investors to sell the common stock.



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

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



| |   |                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------
| |  | the division of our board of directors into three
    separate classes, each with three year terms;                         
|
| |  | the right of our board to elect a director to
    fill a space created by a board vacancy or the expansion of the
    board;

35



---



##### Table of Contents





| |   |                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the ability of our board to alter our bylaws;                                                                                                       
|
| |  | the ability of our board to authorize the
    issuance of up to 2,000,000 shares of blank check preferred
    stock; and                            
|
| |  | the requirement that only our board or the
    holders of at least 10% of our outstanding shares may call a
    special meeting of our stockholders.

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



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



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

Our board of directors has the authority to issue
up to 2,000,000 shares of preferred stock and to determine the
price, rights, preferences and privileges of those shares
without any further vote or action by the stockholders. The
rights of the holders of common stock will be subject to, and
may be adversely affected by, the rights of the holders of any
preferred stock that may be issued in the future. The issuance
of shares of preferred stock, while potentially providing
desirable flexibility in connection with possible acquisitions
and for other corporate purposes, could have the effect of
making it more difficult for a third party to acquire a majority
of our outstanding voting stock. We have no present intention to
issue shares of preferred stock.

Further, on April 24, 2001, our board of
directors adopted a preferred stock purchase rights plan
intended to guard against certain takeover tactics. The adoption
of this plan was not in response to any proposal to acquire us,
and the board is not aware of any such effort. The existence of
this plan could also have the effect of making it more difficult
for a third party to acquire a majority of our outstanding
voting stock. In addition, certain provisions of our certificate
of incorporation may have the effect of delaying or preventing a
change of control, which could adversely affect the market price
of our common stock.



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

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



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

In order to comply with the newly adopted
Sarbanes-Oxley Act of 2002, as well as proposed changes to
listing standards by Nasdaq, and proposed accounting changes by
the Securities and Exchange Commission, we may be required to
increase our internal controls, hire additional personnel and
additional outside legal, accounting and advisory services, all
of which will cause our general and administrative costs to
increase. Insurers are likely to increase premiums as a result
of the high claims rates incurred over the past year, and so

36



---



##### Table of Contents



our premiums for our various insurance policies,
including our directors and officers insurance
policies, are likely to increase. Proposed changes in the
accounting rules, including legislative and other proposals to
account for employee stock options as a compensation expense
among others, could materially increase the expense that we
report under generally accepted accounting principles and
adversely affect our operating results.


Liquidity

The Company incurred losses of $81.2 million
during the year ended December 31, 2002 resulting in a
$23.7 million decrease in cash. To achieve profitability,
we will need to generate higher revenues while maintaining
reasonable cost and expense levels.

The Company anticipates that its existing cash
resources will fund any anticipated operating losses, purchases
of capital equipment and provide adequate working capital for
the next twelve months. The Companys liquidity is affected
by many factors including, among others, the extent to which the
Company pursues additional capital expenditures, the level of
the Companys production efforts, and other factors related
to the uncertainties of the industry and global economies.
Accordingly, there can be no assurance that events in the future
will not require the Company to seek additional capital sooner,
or, if so required, that such capital will be available on terms
acceptable to the Company if at all.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Qualitative and Quantitative Disclosures
    About Market Risk

Foreign Currency Risk

Since our Japanese and some Taiwanese invoices
are denominated in Japanese yen, doing business in Japan
subjects us to fluctuations in exchange rates between the
U.S. dollar and the Japanese yen. We incurred a foreign
transaction exchange gain of $28,000 in 2002, a loss of $357,000
in 2001, and a loss of $552,000 in 2000. We purchase foreign
exchange contracts to hedge against certain trade accounts
receivable in Japanese yen. Under these contracts, increases or
decreases in currency commitments and balance sheet positions,
as translated into U.S. dollars, are primarily offset by
realized gains or losses on the hedging contracts. The
outstanding commitments with respect to such foreign exchange
contracts had a total contract value of approximately
$2.8 million as of December 31, 2002. Many of the
contracts were entered into six months prior to the due date and
the dates coincide with the receivable terms on customer
invoices. By matching the receivable collection date and
contract due date, we attempt to economically minimize the
impact of foreign exchange fluctuations.

Interest Rate Risk

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

|                          |  |              |        |          |  |           |      |                  |  |                  |      |   |  |   |      |   |  |   |      |  
|------------------------- |  | ------------ | ------ | -------- |  | --------- | ---- | ---------------- |  | ---------------- | ---- | - |  | - | ---- | - |  | - | ---- | -
|                          |  |              |        |          |  | Current   |      | Proforma         |  | Proforma        
|                          |  | Balance      |        | Current  |  | Interest  |      | 10% Interest     |  | 10% Interest    
|                          |  | December 31, |        | Interest |  | Income/   |      | Rate Decline     |  | Rate Increase   
|Instrument                |  | 2002         |        | Rate     |  | (Expense) |      | Income/(Expense) |  | Income/(Expense)
|                          |  |              |        |          |  |           |      |                  |  |                 
|Cash and cash equivalents |  | $            | 13,797 |          |  |           | 3.80 | %                |  | $                | 524  |   |  | $ | 472  |   |  | $ | 577  |  
|Bonds (see Note 7)        |  |              | 9,050  |          |  |           | 1.60 | %                |  |                  | (145 | ) |  |   | (130 | ) |  |   | (159 | )
|Capital lease             |  |              | 765    |          |  |           | 4.20 | %                |  |                  |      |   |  |   |      |   |  |   |      |  
|Capital lease             |  |              | 2,344  |          |  |           | 3.60 | %                |  |                  | (84  | ) |  |   | (76  | ) |  |   | (93  | )
|                          |  |              |        |          |  |           |      |                  |  |                  |      |   |  |   |      |   |  |   |      |  
|                          |  |              |        |          |  |           |      |                  |  | $                | 295  |   |  | $ | 266  |   |  | $ | 325  |  
|                          |  |              |        |          |  |           |      |                  |  |                  |      |   |  |   |      |   |  |   |      |  

37



---



##### Table of Contents



Equity Risk

We also maintain minority investments in private
and publicly traded companies. These investments are reviewed
for other than temporary declines in value on a quarterly basis.
Reasons for other than temporary declines in value include
whether the related company would have insufficient cash flow to
operate for the next twelve months, significant changes in the
operating performance and changes in market conditions. As of
December 31, 2002, the minority investments we continue to
hold totaled $ 4.9 million at estimated fair value. In
2000, we recorded a $27.3 million non-cash gain as a result
of acquiring Finisar Corporation common stock in connection with
Finisar Corporations acquisition of Demeter Technologies,
a company in which we held warrants to purchase preferred stock.
In 2001 and 2002, we recorded a $15.6 million and
$10.8 million non-cash loss respectively, as a result of
writing down our investment in Finisar Corporation common stock
to market value. These gains and losses are included in other
expense.

38



---



##### Table of Contents








|        |                                                             
|------- | ------------------------------------------------------------
|Item 8. | Consolidated Financial Statements and
    Supplementary Data

Selected Quarterly Results of
Operations

The following table sets forth unaudited
quarterly results in dollars and percentages for the eight
quarters ended December 31, 2002. We believe that all
necessary adjustments, consisting only of normal recurring
adjustments, have been included in the amounts stated below to
present fairly such quarterly information. The operating results
for any quarter are not necessarily indicative of results for
any subsequent period.

|                                                |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |          |       |   |         |       |       |   |        |       |       |   |        |       |       |   |        |       |       | 
|----------------------------------------------- | ----------------------------------- | ------------------------ | ------- | --------- | ----- | -------- | ------- | -------- | ------ | -------- | ------- | --------- | ------ | -------- | ------ | -------- | ----- | - | ------- | ----- | ----- | - | ------ | ----- | ----- | - | ------ | ----- | ----- | - | ------ | ----- | ----- | 
|                                                |                                     |                         
|                                                |                                     | Quarters Ended          
|                                                |                                     |                         
|                                                |                                     | Dec. 31,                 |         | Sept. 30, |       | June 30, |         | Mar. 31, |        | Dec. 31, |         | Sept. 30, |        | June 30, |        | Mar. 31,
|                                                |                                     | 2002                     |         | 2002      |       | 2002     |         | 2002     |        | 2001     |         | 2001      |        | 2001     |        | 2001    
|                                                |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |         
|Revenue                                         |                                     | $                        | 12,256  |           |       | $        | 14,948  |          |        | $        | 19,194  |           |        | $        | 16,777 |          |       | $ | 15,371  |       |       | $ | 22,783 |       |       | $ | 41,272 |       |       | $ | 40,104 |      
|Cost of revenue                                 |                                     |                          | 22,790  |           |       |          | 18,491  |          |        |          | 16,266  |           |        |          | 16,484 |          |       |   | 15,892  |       |       |   | 17,423 |       |       |   | 25,067 |       |       |   | 23,809 |      
|                                                |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |          |       |   |         |       |       |   |        |       |       |   |        |       |       |   |        |      
|Gross profit (loss)                             |                                     |                          | (10,534 | )         |       |          | (3,543  | )        |        |          | 2,928   |           |        |          | 293    |          |       |   | (521    | )     |       |   | 5,360  |       |       |   | 16,205 |       |       |   | 16,295 |      
|Operating expenses:                             |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |          |       |   |         |       |       |   |        |       |       |   |        |       |       |   |        |      
|                                                | Selling, general and administrative |                          |         | 3,795     |       |          |         | 4,993    |        |          |         | 4,658     |        |          |        | 5,202    |       |   |         | 4,382 |       |   |        | 5,826 |       |   |        | 5,412 |       |   |        | 5,867 |      
|                                                | Research and development            |                          |         | 1,112     |       |          |         | 1,308    |        |          |         | 1,095     |        |          |        | 1,353    |       |   |         | 1,370 |       |   |        | 1,701 |       |   |        | 2,430 |       |   |        | 2,703 |      
|                                                | Restructuring costs                 |                          |         |          |       |          |         | 15,107   |        |          |         | 23,979    |        |          |        |         |       |   |         |      |       |   |        |      |       |   |        |      |       |   |        |      |      
|                                                |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |          |       |   |         |       |       |   |        |       |       |   |        |       |       |   |        |      
|                                                |                                     | Total operating expenses |         |           | 4,907 |          |         |          | 21,408 |          |         |           | 29,732 |          |        |          | 6,555 |   |         |       | 5,752 |   |        |       | 7,527 |   |        |       | 7,842 |   |        |       | 8,570 | 
|                                                |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |          |       |   |         |       |       |   |        |       |       |   |        |       |       |   |        |      
|Income (loss) from operations                   |                                     |                          | (15,441 | )         |       |          | (24,951 | )        |        |          | (26,804 | )         |        |          | (6,262 | )        |       |   | (6,273  | )     |       |   | (2,167 | )     |       |   | 8,363  |       |       |   | 7,725  |      
|Interest expense                                |                                     |                          | 212     |           |       |          | 364     |          |        |          | 365     |           |        |          | 385    |          |       |   | 444     |       |       |   | 493    |       |       |   | 515    |       |       |   | 629    |      
|Other (income) and expense, net                 |                                     |                          | 4,517   |           |       |          | (303    | )        |        |          | 9,208   |           |        |          | (717   | )        |       |   | 14,915  |       |       |   | (488   | )     |       |   | (345   | )     |       |   | (709   | )    
|                                                |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |          |       |   |         |       |       |   |        |       |       |   |        |       |       |   |        |      
|Income (loss) before provision for income taxes |                                     |                          | (20,170 | )         |       |          | (25,012 | )        |        |          | (36,377 | )         |        |          | (5,930 | )        |       |   | (21,632 | )     |       |   | (2,172 | )     |       |   | 8,193  |       |       |   | 7,805  |      
|Provision (benefit) for income taxes            |                                     |                          | (2,637  | )         |       |          | 3,661   |          |        |          | (4,959  | )         |        |          | (2,372 | )        |       |   | (7,788  | )     |       |   | (782   | )     |       |   | 2,949  |       |       |   | 2,810  |      
|                                                |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |          |       |   |         |       |       |   |        |       |       |   |        |       |       |   |        |      
|Net income (loss)                               |                                     | $                        | (17,533 | )         |       | $        | (28,673 | )        |        | $        | (31,418 | )         |        | $        | (3,558 | )        |       | $ | (13,844 | )     |       | $ | (1,390 | )     |       | $ | 5,244  |       |       | $ | 4,995  |      
|                                                |                                     |                          |         |           |       |          |         |          |        |          |         |           |        |          |        |          |       |   |         |       |       |   |        |       |       |   |        |       |       |   |        |      

|                                                |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |          |      |   |        |      |      |   |       |      |      |   |       |      |      |   |       |      |      |  
|----------------------------------------------- | ----------------------------------- | ------------------------ | ------ | --------- | ---- | -------- | ------ | -------- | ----- | -------- | ------ | --------- | ----- | -------- | ----- | -------- | ---- | - | ------ | ---- | ---- | - | ----- | ---- | ---- | - | ----- | ---- | ---- | - | ----- | ---- | ---- | -
|                                                |                                     |                         
|                                                |                                     | Quarters Ended          
|                                                |                                     |                         
|                                                |                                     | Dec. 31,                 |        | Sept. 30, |      | June 30, |        | Mar. 31, |       | Dec. 31, |        | Sept. 30, |       | June 30, |       | Mar. 31,
|                                                |                                     | 2002                     |        | 2002      |      | 2002     |        | 2002     |       | 2001     |        | 2001      |       | 2001     |       | 2001    
|                                                |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |         
|Revenue                                         |                                     |                          | 100.0  | %         |      |          | 100.0  | %        |       |          | 100.0  | %         |       |          | 100.0 | %        |      |   | 100.0  | %    |      |   | 100.0 | %    |      |   | 100.0 | %    |      |   | 100.0 | %   
|Cost of revenue                                 |                                     |                          | 185.9  | %         |      |          | 123.7  | %        |       |          | 84.7   | %         |       |          | 98.3  | %        |      |   | 103.4  | %    |      |   | 76.5  | %    |      |   | 60.7  | %    |      |   | 59.4  | %   
|                                                |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |          |      |   |        |      |      |   |       |      |      |   |       |      |      |   |       |     
|Gross profit (loss)                             |                                     |                          | (85.9  | )%        |      |          | (23.7  | )%       |       |          | 15.3   | %         |       |          | 1.7   | %        |      |   | (3.4   | )%   |      |   | 23.5  | %    |      |   | 39.3  | %    |      |   | 40.6  | %   
|Operating expenses:                             |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |          |      |   |        |      |      |   |       |      |      |   |       |      |      |   |       |     
|                                                | Selling, general and administrative |                          |        | 31.0      | %    |          |        | 33.4     | %     |          |        | 24.3      | %     |          |       | 31.0     | %    |   |        | 28.5 | %    |   |       | 25.6 | %    |   |       | 13.1 | %    |   |       | 14.6 | %   
|                                                | Research and development            |                          |        | 9.1       | %    |          |        | 8.8      | %     |          |        | 5.7       | %     |          |       | 8.1      | %    |   |        | 8.9  | %    |   |       | 7.5  | %    |   |       | 5.9  | %    |   |       | 6.7  | %   
|                                                | Restructuring costs                 |                          |        | 0.0       | %    |          |        | 101.1    | %     |          |        | 124.9     | %     |          |       | 0.0      | %    |   |        | 0.0  | %    |   |       | 0.0  | %    |   |       | 0.0  | %    |   |       | 0.0  | %   
|                                                |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |          |      |   |        |      |      |   |       |      |      |   |       |      |      |   |       |     
|                                                |                                     | Total operating expenses |        |           | 40.0 | %        |        |          | 143.2 | %        |        |           | 154.9 | %        |       |          | 39.1 | % |        |      | 37.4 | % |       |      | 33.0 | % |       |      | 19.0 | % |       |      | 21.4 | %
|                                                |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |          |      |   |        |      |      |   |       |      |      |   |       |      |      |   |       |     
|Income (loss) from operations                   |                                     |                          | (126.0 | )%        |      |          | (166.9 | )%       |       |          | (139.6 | )%        |       |          | (37.3 | )%       |      |   | (40.8  | )%   |      |   | (9.5  | )%   |      |   | 20.3  | %    |      |   | 19.3  | %   
|Interest expense                                |                                     |                          | 2.4    | %         |      |          | 2.4    | %        |       |          | 1.9    | %         |       |          | 2.3   | %        |      |   | 2.9    | %    |      |   | 2.2   | %    |      |   | 1.2   | %    |      |   | 1.6   | %   
|Other (income) and expense, net                 |                                     |                          | 36.9   | %         |      |          | (2.0   | )%       |       |          | 48.0   | %         |       |          | (4.3  | )%       |      |   | 97.0   | %    |      |   | (2.1  | )%   |      |   | (0.8  | )%   |      |   | (1.8  | )%  
|                                                |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |          |      |   |        |      |      |   |       |      |      |   |       |      |      |   |       |     
|Income (loss) before provision for income taxes |                                     |                          | (164.6 | )%        |      |          | (167.3 | )%       |       |          | (189.5 | )%        |       |          | (35.3 | )%       |      |   | (140.7 | )%   |      |   | (9.5  | )%   |      |   | 19.9  | %    |      |   | 19.5  | %   
|Provision (benefit) for income taxes            |                                     |                          | (21.5  | )%        |      |          | 24.5   | %        |       |          | (25.8  | )%        |       |          | (14.1 | )%       |      |   | (50.7  | )%   |      |   | (3.4  | )%   |      |   | 7.1   | %    |      |   | 7.0   | %   
|                                                |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |          |      |   |        |      |      |   |       |      |      |   |       |      |      |   |       |     
|Net income (loss)                               |                                     |                          | (143.1 | )%        |      |          | (191.8 | )%       |       |          | (163.7 | )%        |       |          | (21.2 | )%       |      |   | (90.1  | )%   |      |   | (6.1  | )%   |      |   | 12.7  | %    |      |   | 12.5  | %   
|                                                |                                     |                          |        |           |      |          |        |          |       |          |        |           |       |          |       |          |      |   |        |      |      |   |       |      |      |   |       |      |      |   |       |     

Other Consolidated Financial Statements and
Supplementary Data required by this item are set forth at the
pages indicated at Item 14(a).

39



---



##### Table of Contents








|        |                                                                                              
|------- | ---------------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial
    Disclosures

None.




PART III

The SEC allows us to include information required
in this report by referring to other documents or reports we
have already or will soon be filing. This is called
Incorporation by Reference. We intend to file our
definitive proxy statement pursuant to Regulation 14A not
later 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 and Executive Officers of the
    Registrant.

The information required by this Item is
incorporated herein by reference to information set forth in our
definitive proxy statement to be filed in connection with our
annual meeting of stockholders to be held on June 24, 2003,
under the section entitled Proposal No. 1 
Election of Directors.

Information concerning our executive officers is
incorporated herein by reference to information set forth in our
definitive proxy statement to be filed in connection with our
annual meeting of stockholders to be held on June 24, 2003,
under the section entitled Executive Compensation and
Other Matters.

The information required by this Item with
respect to compliance with Section 16(a) of the Securities
Exchange Act of 1934 is incorporated herein by reference to
information set forth in the definitive Proxy statement to be
filed in connection with our annual meeting of stockholders to
be held on June 24, 2003, under the heading
Section 16(a) Beneficial Ownership Reporting
Compliance.

We have revised our Insider Trading Policy to
allow our directors, officers and other employees covered under
the policy to establish, under limited circumstances
contemplated by Rule 10b5-1 under the Securities Exchange
Act of 1934, written programs that permit automatic trading of
our stock or trading of our stock by an independent person (such
as an investment bank) who is not aware of material inside
information at the time of the trade. On February 29, 2003
Morris S. Young, our Chief Executive Officer, activated a
trading plan under Rule 10b5-1. We believe that some other
of our directors or officers may establish such programs in
future periods.






|         |                        
|-------- | -----------------------
|Item 11. | Executive Compensation.

The information required by this Item is
incorporated herein by reference to information set forth in our
definitive Proxy statement to be filed in connection with our
annual meeting of stockholders to be held on June 24, 2003,
under the section entitled Executive Compensation and
Other Matters.






|         |                                                                                                                  
|-------- | -----------------------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management, and Equity Compensation Plan
    Information.

The information required by this Item is
incorporated herein by reference to information set forth in our
definitive Proxy statement to be filed in connection with our
annual meeting of stockholders to be held on June 24, 2003,
under the section entitled Security Ownership of Certain
Beneficial Owners and Management and Equity
Compensation Plan Information.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

Since January 2002, there has not been, nor is
there currently proposed, any transaction or series of similar
transactions to which 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 immediate
family had or will have a direct or indirect material interest
other than the transactions described below.

40



---



##### Table of Contents



We have entered into an operating lease for
warehouse space in Fremont, California with 4160 Business
Center, LLC, a real estate holding company, in which Davis
Zhang, the president of our substrate division, is the sole
shareholder. Lease payments to 4160 Business Center, LLC were
approximately $484,000 for the year ended December 31, 2002.






|         |                        
|-------- | -----------------------
|Item 14. | Controls and Procedures

(a) Under the supervision and with the
participation of our management, including our chief executive
officer and chief financial officer, we evaluated the
effectiveness of the design and operation of our disclosure
controls and procedures, as such term is defined under
Rule 13a-14(c) promulgated under the Securities Exchange
Act of 1934, as amended, within the 90 day period prior to
the filing date of this report. Based on this evaluation, our
chief executive officer and chief financial officer concluded
that our disclosure controls and procedures were effective as of
that date.

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




PART IV




Item 15.     Exhibits,
Financial Statement Schedules, and Reports on
Form 8-K

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



| |                          
| | -------------------------
| | (1) Financial Statements:

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                    |  |  |       | 
|--------------------------------------------------- |  |  | ----- | 
|Report of Independent Accountants                   |  |  | 42    | 
|Consolidated Balance Sheets                         |  |  | 43    | 
|Consolidated Statements of Income                   |  |  | 44    | 
|Consolidated Statements of Stockholders
    Equity |  |  | 45    | 
|Consolidated Statements of Cash Flows               |  |  | 46    | 
|Notes to Consolidated Financial Statements          |  |  | 47-65 | 



| |                                                                                                                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (2) Financial Statement
    Schedules                                                                                                                                                                                                                                                 
|
| | All schedules have been omitted because the
    required information is not present or not present in amounts
    sufficient to require submission of the schedules or because the
    information required is included in the Consolidated Financial
    Statements or Notes thereto.
|
| | (3) Exhibits                                                                                                                                                                                                                                                                          
|
| | See Index to Exhibits on page 69-70 hereof.
    The exhibits listed in the accompanying Index to Exhibits are
    filed as part of, or incorporated by reference into, this report
    on Form 10K.                                                                                   

(b) Reports on Form 8-K

None

41



---



##### Table of Contents



REPORT OF INDEPENDENT ACCOUNTANTS

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

In our opinion, the accompanying consolidated
balance sheets and the related consolidated statements of
income, of stockholders equity and of cash flows present
fairly, in all material respects, the financial position of AXT,
Inc. and its subsidiaries at December 31, 2002 and 2001,
and the results of their operations and their cash flows for
each of the three years in the period ended December 31,
2002 in conformity with accounting principles generally accepted
in the United States of America. These financial statements are
the responsibility of the Companys management; our
responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally
accepted in the United States of America, which require that we
plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the
overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

/s/ PRICEWATERHOUSECOOPERS LLP

San Jose, California

February 7, 2003, except for notes 7, 19 and
21, as to which the date is March 18, 2003


42



---



##### Table of Contents



AXT, INC.

CONSOLIDATED BALANCE SHEETS

|                                                |                                                                                                              |                                            |        |         |         |  |        |         |         | 
|----------------------------------------------- | ------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ------ | ------- | ------- |  | ------ | ------- | ------- | 
|                                                |                                                                                                              |                                           
|                                                |                                                                                                              | December 31,                              
|                                                |                                                                                                              |                                           
|                                                |                                                                                                              | 2002                                       |        | 2001   
|                                                |                                                                                                              |                                            |        |        
|                                                |                                                                                                              |                                           
|                                                |                                                                                                              | (In thousands, except per                 
|                                                |                                                                                                              | share data)                               
|ASSETS                                         
|Current assets                                  |                                                                                                              |                                            |        |         |         |  |        |        
|                                                | Cash and cash equivalents                                                                                    |                                            | $      | 13,797  |         |  | $      | 37,538  |        
|                                                | Short-term investments                                                                                       |                                            |        | 8,205   |         |  |        | 25,673  |        
|                                                | Accounts receivable, net                                                                                     |                                            |        | 7,195   |         |  |        | 15,684  |        
|                                                | Inventories                                                                                                  |                                            |        | 37,598  |         |  |        | 55,587  |        
|                                                | Prepaid expenses and other current assets                                                                    |                                            |        | 4,002   |         |  |        | 3,577   |        
|                                                | Income tax receivable                                                                                        |                                            |        | 8,783   |         |  |        |        |        
|                                                | Assets held for sale                                                                                         |                                            |        | 5,957   |         |  |        |        |        
|                                                | Deferred income taxes                                                                                        |                                            |        |        |         |  |        | 10,557  |        
|                                                |                                                                                                              |                                            |        |         |         |  |        |        
|                                                |                                                                                                              | Total current assets                       |        |         | 85,537  |  |        |         | 148,616 | 
|Property, plant and equipment                   |                                                                                                              |                                            | 39,982 |         |         |  | 82,573 |        
|Other assets                                    |                                                                                                              |                                            | 5,341  |         |         |  | 4,511  |        
|Goodwill                                        |                                                                                                              |                                            |       |         |         |  | 1,107  |        
|Restricted deposits                             |                                                                                                              |                                            | 11,150 |         |         |  |       |        
|Long-term investments                           |                                                                                                              |                                            | 3,657  |         |         |  | 6,552  |        
|                                                |                                                                                                              |                                            |        |         |         |  |        |        
|                                                |                                                                                                              | Total assets                               |        | $       | 145,667 |  |        | $       | 243,359 | 
|                                                |                                                                                                              |                                            |        |         |         |  |        |        
|LIABILITIES AND STOCKHOLDERS
    EQUITY       
|Current liabilities                             |                                                                                                              |                                            |        |         |         |  |        |        
|                                                | Accounts payable                                                                                             |                                            | $      | 4,228   |         |  | $      | 2,943   |        
|                                                | Accrued liabilities                                                                                          |                                            |        | 8,344   |         |  |        | 13,362  |        
|                                                | Income tax payable                                                                                           |                                            |        | 3,063   |         |  |        | 308     |        
|                                                | Current portion of long-term debt                                                                            |                                            |        | 965     |         |  |        | 2,336   |        
|                                                | Current portion of capital lease obligation                                                                  |                                            |        | 3,562   |         |  |        | 4,372   |        
|                                                |                                                                                                              |                                            |        |         |         |  |        |        
|                                                |                                                                                                              | Total current liabilities                  |        |         | 20,162  |  |        |         | 23,321  | 
|Long-term debt, net of current portion          |                                                                                                              |                                            | 13,289 |         |         |  | 14,342 |        
|Long-term capital lease, net of current portion |                                                                                                              |                                            | 4,847  |         |         |  | 10,002 |        
|Deferred income taxes                           |                                                                                                              |                                            |       |         |         |  | 8,099  |        
|Other long-term liabilities                     |                                                                                                              |                                            | 1,712  |         |         |  | 1,273  |        
|                                                |                                                                                                              |                                            |        |         |         |  |        |        
|                                                |                                                                                                              | Total liabilities                          |        |         | 40,010  |  |        |         | 57,037  | 
|                                                |                                                                                                              |                                            |        |         |         |  |        |        
|Commitments and Contingencies (Note 19)         |                                                                                                              |                                            |        |         |         |  |        |        
|Stockholders equity:                           |                                                                                                              |                                            |        |         |         |  |        |        
|                                                | Preferred stock, $.001 par value; 2,000 shares
    authorized; 883 shares issued and outstanding             |                                            |        | 3,532   |         |  |        | 3,532   |        
|                                                | Common stock, $.001 par value; 70,000 shares
    authorized; 22,495 and 22,383 shares issued and outstanding |                                            |        | 154,485 |         |  |        | 153,635 |        
|                                                | Retained earnings                                                                                            |                                            |        | (52,197 | )       |  |        | 28,984  |        
|                                                | Other comprehensive income                                                                                   |                                            |        | (163    | )       |  |        | 171     |        
|                                                |                                                                                                              |                                            |        |         |         |  |        |        
|                                                |                                                                                                              | Total stockholders equity                 |        |         | 105,657 |  |        |         | 186,322 | 
|                                                |                                                                                                              |                                            |        |         |         |  |        |        
|                                                |                                                                                                              | Total liabilities and stockholders equity |        | $       | 145,667 |  |        | $       | 243,359 | 
|                                                |                                                                                                              |                                            |        |         |         |  |        |        

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

43



---



##### Table of Contents



AXT, INC.

CONSOLIDATED STATEMENTS OF INCOME

|                                                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |        |        | 
|------------------------------------------------------------------------------ | ------------------------------------------------------------------ | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                                               |                                                                    |                                      
|                                                                               |                                                                    | Years Ended December 31,             
|                                                                               |                                                                    |                                      
|                                                                               |                                                                    | 2002                                  |         | 2001   |        | 2000
|                                                                               |                                                                    |                                       |         |        |        |     
|                                                                               |                                                                    |                                      
|                                                                               |                                                                    | (In thousands, except per share data)
|Revenue                                                                        |                                                                    | $                                     | 63,175  |        |        | $    | 119,530 |        |        | $ | 121,503 |       
|Cost of revenue                                                                |                                                                    |                                       | 74,031  |        |        |      | 82,191  |        |        |   | 73,684  |       
|                                                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|Gross profit (loss)                                                            |                                                                    |                                       | (10,856 | )      |        |      | 37,339  |        |        |   | 47,819  |       
|Operating expenses:                                                            |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                               | Selling, general and administrative                                |                                       |         | 18,648 |        |      |         | 21,487 |        |   |         | 18,041 |       
|                                                                               | Research and development                                           |                                       |         | 4,868  |        |      |         | 8,204  |        |   |         | 8,769  |       
|                                                                               | Restructuring costs                                                |                                       |         | 39,086 |        |      |         |       |        |   |         | 6,409  |       
|                                                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                               |                                                                    | Total operating expenses              |         |        | 62,602 |      |         |        | 29,691 |   |         |        | 33,219 | 
|                                                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|Income (loss) from operations                                                  |                                                                    |                                       | (73,458 | )      |        |      | 7,648   |        |        |   | 14,600  |       
|Interest expense                                                               |                                                                    |                                       | 1,326   |        |        |      | 2,081   |        |        |   | 3,616   |       
|Other (income) and expense, net                                                |                                                                    |                                       | 12,705  |        |        |      | 13,373  |        |        |   | (28,432 | )     
|                                                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|Income (loss) from continuing operations
    before provision for income taxes |                                                                    |                                       | (87,489 | )      |        |      | (7,806  | )      |        |   | 39,416  |       
|Provision (benefit) for income taxes                                           |                                                                    |                                       | (6,308  | )      |        |      | (2,810  | )      |        |   | 14,978  |       
|                                                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|Income (loss) from continuing operations                                       |                                                                    |                                       | (81,181 | )      |        |      | (4,996  | )      |        |   | 24,438  |       
|Discontinued operations:                                                       |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                               | Loss from discontinued operations, net of tax
    benefits of $912 |                                       |         |       |        |      |         |       |        |   |         | (1,487 | )     
|                                                                               | Loss on disposal, net of tax benefits of $822                      |                                       |         |       |        |      |         |       |        |   |         | (1,341 | )     
|                                                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|Net income (loss)                                                              |                                                                    | $                                     | (81,181 | )      |        | $    | (4,996  | )      |        | $ | 21,610  |       
|                                                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|Basic income (loss) per share:                                                 |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                               | Income (loss) from continuing operations                           |                                       | $       | (3.63  | )      |      | $       | (0.23  | )      |   | $       | 1.24   |       
|                                                                               | Loss from discontinued operations                                  |                                       |         |       |        |      |         |       |        |   |         | (0.14  | )     
|                                                                               | Net income (loss)                                                  |                                       |         | (3.63  | )      |      |         | (0.23  | )      |   |         | 1.10   |       
|Diluted income (loss) per share:                                               |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                               | Income (loss) from continuing operations                           |                                       | $       | (3.63  | )      |      | $       | (0.23  | )      |   | $       | 1.16   |       
|                                                                               | Loss from discontinued operations                                  |                                       |         |       |        |      |         |       |        |   |         | (0.13  | )     
|                                                                               | Net income (loss)                                                  |                                       |         | (3.63  | )      |      |         | (0.23  | )      |   |         | 1.03   |       
|Shares used in per share calculations:                                         |                                                                    |                                       |         |        |        |      |         |        |        |   |         |       
|                                                                               | Basic                                                              |                                       |         | 22,433 |        |      |         | 22,278 |        |   |         | 19,677 |       
|                                                                               | Diluted                                                            |                                       |         | 22,433 |        |      |         | 22,278 |        |   |         | 21,059 |       

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

44



---



##### Table of Contents



AXT, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |         |  
|----------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------- | --------------- | --- | ------------ |  | -------- | ----- | -------- |  | ------------- | ------ | -------- |  | ------------- | ------- | ----- |  | ------------- | ---- | - |  | - | ------- | ------- | - | - | ----- | ------ | - | - | ------- | ------- | - | - | ------- | ------- | -
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |              
|                                                                                                                              |                                                     | Preferred Stock |     | Common Stock |  |          |       |          |  | Other         |        |          |  |              
|                                                                                                                              |                                                     |                 |     |              |  | Deferred |       | Retained |  | Comprehensive |        |          |  | Comprehensive
|                                                                                                                              |                                                     | Shares          |     | Amount       |  | Shares   |       | Amount   |  | Compensation  |        | Earnings |  | Income        |         | Total |  | Income/(loss)
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |              
|                                                                                                                              |                                                     |                
|                                                                                                                              |                                                     | (In thousands) 
|Balance at December 31, 1999                                                                                                  |                                                     |                 | 981 |              |  | $        | 3,990 |          |  |               | 18,659 |          |  | $             | 46,340  |       |  | $             | (217 | ) |  | $ | 12,370  |         |   | $ | (24   | )      |   | $ | 62,459  |         |   | $ | 121     |        
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|Common stock options exercised                                                                                                |                                                     |                 |     |              |  |          |       |          |  |               | 711    |          |  |               | 6,038   |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 6,038   |         |   |   |         |        
|Issuance of Employee Stock Purchase Plan stock                                                                                |                                                     |                 |     |              |  |          |       |          |  |               | 63     |          |  |               | 648     |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 648     |         |   |   |         |        
|Reacquisition and retirement on common stock and
    Series A preferred stock in connection with merger of Lyte
    Optronics |                                                     |                 | (98 | )            |  |          | (458  | )        |  |               | (225   | )        |  |               | 458     |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |        |         |   |   |         |        
|Issuance of common stock in private placement                                                                                 |                                                     |                 |     |              |  |          |       |          |  |               | 234    |          |  |               | 8,507   |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 8,507   |         |   |   |         |        
|Issuance of common stock in follow on public
    offering                                                                     |                                                     |                 |     |              |  |          |       |          |  |               | 2,510  |          |  |               | 80,812  |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 80,812  |         |   |   |         |        
|Income tax benefit from stock option exercises                                                                                |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               | 2,945   |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 2,945   |         |   |   |         |        
|Amortization of deferred compensation                                                                                         |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               | 110  |   |  |   |         |         |   |   |       |        |   |   | 110     |         |   |   |         |        
|Comprehensive income                                                                                                          |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|                                                                                                                              | Net income                                          |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         | 21,610  |   |   |       |        |   |   |         | 21,610  |   |   |         | 21,610  |  
|                                                                                                                              | Unrealized gain on marketable securities            |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       | 2,185  |   |   |         | 2,185   |   |   |         | 2,185   |  
|                                                                                                                              | Currency translation adjustment                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       | 33     |   |   |         | 33      |   |   |         | 33      |  
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|Balance at December 31, 2000                                                                                                  |                                                     |                 | 883 |              |  | $        | 3,532 |          |  |               | 21,952 |          |  | $             | 145,748 |       |  | $             | (107 | ) |  | $ | 33,980  |         |   | $ | 2,194 |        |   | $ | 185,347 |         |   | $ | 23,828  |        
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|Common stock options exercised                                                                                                |                                                     |                 |     |              |  |          |       |          |  |               | 388    |          |  |               | 3,862   |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 3,862   |         |   |   |         |        
|Issuance of Employee Stock Purchase Plan stock                                                                                |                                                     |                 |     |              |  |          |       |          |  |               | 43     |          |  |               | 900     |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 900     |         |   |   |         |        
|Income tax benefit from stock option exercises                                                                                |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               | 3,125   |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 3,125   |         |   |   |         |        
|Amortization of deferred compensation                                                                                         |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               | 107  |   |  |   |         |         |   |   |       |        |   |   | 107     |         |   |   |         |        
|Comprehensive income (loss)                                                                                                   |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|                                                                                                                              | Net income (loss)                                   |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         | (4,996  | ) |   |       |        |   |   |         | (4,996  | ) |   |         | (4,996  | )
|                                                                                                                              | Unrealized gain (loss) on marketable
    securities |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       | (2,052 | ) |   |         | (2,052  | ) |   |         | (2,052  | )
|                                                                                                                              | Currency translation adjustment                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       | 29     |   |   |         | 29      |   |   |         | 29      |  
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|Balance at December 31, 2001                                                                                                  |                                                     |                 | 883 |              |  | $        | 3,532 |          |  |               | 22,383 |          |  | $             | 153,635 |       |  | $             |     |   |  | $ | 28,984  |         |   | $ | 171   |        |   | $ | 186,322 |         |   | $ | (7,019  | )      
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|Common stock options exercised                                                                                                |                                                     |                 |     |              |  |          |       |          |  |               | 88     |          |  |               | 684     |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 684     |         |   |   |         |        
|Issuance of Employee Stock Purchase Plan stock                                                                                |                                                     |                 |     |              |  |          |       |          |  |               | 24     |          |  |               | 166     |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   | 166     |         |   |   |         |        
|Comprehensive income (loss)                                                                                                   |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|                                                                                                                              | Net income (loss)                                   |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         | (81,181 | ) |   |       |        |   |   |         | (81,181 | ) |   |         | (81,181 | )
|                                                                                                                              | Unrealized gain (loss) on marketable
    securities |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       | (21    | ) |   |         | (21     | ) |   |         | (21     | )
|                                                                                                                              | Currency translation adjustment                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       | (313   | ) |   |         | (313    | ) |   |         | (313    | )
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        
|Balance at December 31, 2002                                                                                                  |                                                     |                 | 883 |              |  | $        | 3,532 |          |  |               | 22,495 |          |  | $             | 154,485 |       |  | $             |     |   |  | $ | (52,197 | )       |   | $ | (163  | )      |   | $ | 105,657 |         |   | $ | (81,515 | )      
|                                                                                                                              |                                                     |                 |     |              |  |          |       |          |  |               |        |          |  |               |         |       |  |               |      |   |  |   |         |         |   |   |       |        |   |   |         |         |   |   |         |        

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

45



---



##### Table of Contents



AXT, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |         |        |         |         |         |  
|------------------------------------------------------------ | ---------------------------------------------------------------- | ------------------------------------------------------ | ------------------------------------------------------------------ | --------------------------- | ------------------------------------------------------- | ------ | ------- | ------- | ------ | ------ | ------ | ------- | ------ | ------- | ------- | ------- | -
|                                                             |                                                                  |                                                       
|                                                             |                                                                  | Years Ended December 31,                              
|                                                             |                                                                  |                                                       
|                                                             |                                                                  | 2002                                                   |                                                                    | 2001                        |                                                         | 2000  
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |       
|                                                             |                                                                  |                                                       
|                                                             |                                                                  | (In thousands)                                        
|Cash flows from operating
    activities:                    |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|                                                             | Net income (loss)                                                |                                                        | $                                                                  | (81,181                     | )                                                       |        | $       | (4,996  | )      |        | $      | 21,610  |       
|                                                             |                                                                  | Adjustments to reconcile net income
    (loss) to cash |                                                                    |                             |                                                         |        |         |         |        |        |        |         |        |        
|                                                             |                                                                  | provided by operations:                                |                                                                    |                             |                                                         |        |         |         |        |        |        |         |        |        
|                                                             |                                                                  |                                                        | Depreciation                                                       |                             |                                                         | 9,493  |         |         |        | 8,538  |        |         |        | 6,854   |        
|                                                             |                                                                  |                                                        | Deferred income taxes                                              |                             |                                                         | 2,533  |         |         |        | (5,041 | )      |         |        | 5,718   |        
|                                                             |                                                                  |                                                        | Amortization                                                       |                             |                                                         | 403    |         |         |        | 554    |        |         |        | 548     |        
|                                                             |                                                                  |                                                        | Stock compensation                                                 |                             |                                                         |       |         |         |        | 107    |        |         |        | 110     |        
|                                                             |                                                                  |                                                        | Stock option tax benefits                                          |                             |                                                         |       |         |         |        | 3,125  |        |         |        | 2,945   |        
|                                                             |                                                                  |                                                        | Non cash restructuring costs 
    Impairment of PP&E and goodwill |                             |                                                         | 39,086 |         |         |        |       |        |         |        | 6,249   |        
|                                                             |                                                                  |                                                        | Non cash (gain)/loss on marketable securities                      |                             |                                                         | 10,577 |         |         |        | 15,636 |        |         |        | (27,328 | )      
|                                                             |                                                                  |                                                        | Loss (gain) on disposal of property, plant
    and equipment       |                             |                                                         | 3,404  |         |         |        | 229    |        |         |        | (183    | )      
|                                                             |                                                                  |                                                        | Changes in assets and liabilities:                                 |                             |                                                         |        |         |         |        |        |        |         |        |         |        
|                                                             |                                                                  |                                                        |                                                                    | Accounts receivable, net    |                                                         |        | 8,489   |         |        |        | 11,939 |         |        |         | (10,212 | )      
|                                                             |                                                                  |                                                        |                                                                    | Inventories                 |                                                         |        | 17,989  |         |        |        | (3,741 | )       |        |         | (18,220 | )      
|                                                             |                                                                  |                                                        |                                                                    | Prepaid expenses            |                                                         |        | (320    | )       |        |        | 1,240  |         |        |         | 5,282   |        
|                                                             |                                                                  |                                                        |                                                                    | Other assets                |                                                         |        | (362    | )       |        |        | (454   | )       |        |         | (369    | )      
|                                                             |                                                                  |                                                        |                                                                    | Accounts payable            |                                                         |        | 1,285   |         |        |        | (7,013 | )       |        |         | 1,715   |        
|                                                             |                                                                  |                                                        |                                                                    | Accrued liabilities         |                                                         |        | (5,019  | )       |        |        | (2,967 | )       |        |         | 9,187   |        
|                                                             |                                                                  |                                                        |                                                                    | Income taxes                |                                                         |        | (6,091  | )       |        |        |       |         |        |         |        |        
|                                                             |                                                                  |                                                        |                                                                    | Other long-term liabilities |                                                         |        | 439     |         |        |        | (12    | )       |        |         | (210    | )      
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|                                                             |                                                                  |                                                        |                                                                    |                             | Net cash provided by operating activities               |        |         | 725     |        |        |        | 17,144  |        |         |         | 3,696   |  
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|Cash flows from investing
    activities:                    |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|                                                             | Purchases of property, plant and equipment                       |                                                        |                                                                    | (14,238                     | )                                                       |        |         | (25,834 | )      |        |        | (26,278 | )     
|                                                             | Investment in marketable securities                              |                                                        |                                                                    | (17,869                     | )                                                       |        |         | (21,591 | )      |        |        |        |       
|                                                             | Investment in other assets                                       |                                                        |                                                                    |                            |                                                         |        |         | (1,307  | )      |        |        | (1,599  | )     
|                                                             | Proceeds from sale of marketable securities                      |                                                        |                                                                    | 17,070                      |                                                         |        |         | 1,034   |        |        |        |        |       
|                                                             | Proceeds from sale of property plant and equipment               |                                                        |                                                                    |                            |                                                         |        |         |        |        |        |        | 1,805   |       
|                                                             | Increase in restricted cash                                      |                                                        |                                                                    | (1,000                      | )                                                       |        |         |        |        |        |        |        |       
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|                                                             |                                                                  |                                                        |                                                                    |                             | Net cash used in investing activities                   |        |         | (16,037 | )      |        |        | (47,698 | )      |         |         | (26,072 | )
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|Cash flows from financing
    activities:                    |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|                                                             | Proceeds from (payments of):                                     |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |         |       
|                                                             |                                                                  | Issuance of common stock                               |                                                                    |                             | 850                                                     |        |         |         | 4,762  |        |        |         | 96,005 |        
|                                                             |                                                                  | Capital lease payments                                 |                                                                    |                             | (5,965                                                  | )      |         |         | (4,274 | )      |        |         | (3,850 | )      
|                                                             |                                                                  | Capital lease borrowings                               |                                                                    |                             |                                                        |        |         |         | 3,143  |        |        |         |       |        
|                                                             |                                                                  | Short-term bank borrowings                             |                                                                    |                             |                                                        |        |         |         | (1,353 | )      |        |         | (9,945 | )      
|                                                             |                                                                  | Long-term debt borrowings                              |                                                                    |                             | 3,935                                                   |        |         |         |       |        |        |         | 6,000  |        
|                                                             |                                                                  | Long-term debt payments                                |                                                                    |                             | (6,936                                                  | )      |         |         | (2,800 | )      |        |         | (3,344 | )      
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|                                                             |                                                                  |                                                        |                                                                    |                             | Net cash provided by (used in) financing
    activities |        |         | (8,116  | )      |        |        | (522    | )      |         |         | 84,866  |  
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|Effect of exchange rate changes                              |                                                                  |                                                        | (313                                                               | )                           |                                                         |        | 29      |         |        |        | 33     |        
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|Net increase (decrease) in cash and cash
    equivalents     |                                                                  |                                                        | (23,741                                                            | )                           |                                                         |        | (31,047 | )       |        |        | 62,523 |        
|Cash and cash equivalents at the beginning of the
    period |                                                                  |                                                        | 37,538                                                             |                             |                                                         |        | 68,585  |         |        |        | 6,062  |        
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|Cash and cash equivalents at the end of the period           |                                                                  | $                                                      | 13,797                                                             |                             |                                                         | $      | 37,538  |         |        | $      | 68,585 |        
|                                                             |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|Non cash activity:                                           |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|                                                             | Purchases of property, plant and equipment
    through financing |                                                        | $                                                                  | 577                         |                                                         |        | $       | 2,170   |        |        | $      | 8,170   |       
|                                                             | Exchange of Finisar shares for Demeter shares                    |                                                        | $                                                                  |                            |                                                         |        | $       |        |        |        | $      | 27,328  |       
|Supplemental Disclosures:                                    |                                                                  |                                                        |                                                                    |                             |                                                         |        |         |         |        |        |        |        
|                                                             | Interest paid                                                    |                                                        | $                                                                  | 1,326                       |                                                         |        | $       | 2,081   |        |        | $      | 3,597   |       
|                                                             | Income taxes paid                                                |                                                        | $                                                                  |                            |                                                         |        | $       | 305     |        |        | $      | 4,645   |       

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

46



---



##### Table of Contents



AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

Note 1.     The
Company and Summary of Accounting Policies

The
Company

AXT designs, develops, manufactures and
distributes high-performance compound semiconductor substrates,
as well as opto-electronic semiconductor devices, such as
high-brightness light emitting diodes, or HBLEDs, and laser
diodes including vertical cavity surface emitting lasers, or
VCSELs, and Fabry-Perot laser diodes. AXTs substrate
products are used primarily in wireless communications, lighting
display applications, and fiber optic communications. The
opto-electronics division manufactures HBLEDs, VCSELs and laser
diodes for the illumination markets, including full-color
displays, automobile lighting and traffic signals, as well as
fiber optic communications.

The Company officially changed its name from
American Xtal Technology, Inc. to AXT, Inc. on July 7, 2000.

Liquidity

The Company incurred losses of $81.2 million
during the year ended December 31, 2002 resulting in a
$23.7 million decrease in cash. To achieve profitability,
we will need to generate higher revenues while maintaining
reasonable cost and expense levels.

The Company anticipates that its existing cash
resources will fund any anticipated operating losses, purchases
of capital equipment and provide adequate working capital for
the next twelve months. The Companys liquidity is affected
by many factors including, among others, the extent to which the
Company pursues additional capital expenditures, the level of
the Companys production efforts, and other factors related
to the uncertainties of the industry and global economies.
Accordingly, there can be no assurance that events in the future
will not require the Company to seek additional capital sooner,
or, if so required, that such capital will be available on terms
acceptable to the Company if at all.

Use of
Estimates

The preparation of financial statements in
conformity with generally accepted accounting principles
requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could
differ from these estimates.

Principles of
Consolidation

The consolidated financial statements include the
accounts of the Company and its majority-owned subsidiaries. All
significant intercompany accounts and transactions have been
eliminated. Investments in business entities in which AXT does
not have control, but has the ability to exercise significant
influence over operating and financial policies (generally
20-50% ownership), are accounted for by the equity method.

Foreign
Currency Translation

The functional currencies of the Companys
Japanese and Chinese subsidiaries are the local currencies.
Transaction gains and losses resulting from transactions
denominated in currencies other than the U.S. dollar for the
Company or in the functional currencies for the subsidiaries are
included in other (income) expense for the periods presented.

The assets and liabilities of the subsidiaries
are translated at the rates of exchange on the balance sheet
date. Revenue and expense items are translated at the average
rate of exchange for the period. Gains and losses from foreign
currency translation are included in other comprehensive income
in stockholders equity.

47



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Revenue
Recognition

The Company recognizes revenue upon the shipment
of its products to the customer provided that the Company has
received a signed purchase order, the price is fixed or
determinable, title has transferred, collection of resulting
receivables is probable, product returns are reasonably
estimable, there are no customer acceptance requirements and
there are no remaining significant obligations. The Company
provides for future returns based on historical experience at
the time revenue is recognized. The Company does not
specifically provide for warranty related exposure as such
exposure has historically been immaterial.

Fair Value of
Financial Instruments

The reported amounts of certain of the
Companys financial instruments including cash and cash
equivalents, accounts receivable, accounts payable and accrued
liabilities approximate fair value due to their short
maturities. The reported amounts of short-term bank borrowings,
loans payable and capital lease obligations approximate fair
value due to the market interest rates, which these debts bear.

Concentration
of Credit Risk

Financial instruments, which potentially subject
the Company to concentration of credit risk consist primarily of
trade accounts receivable. The Company performs ongoing credit
evaluations of its customers financial condition, and
limits the amount of credit extended when deemed necessary, but
generally does not require collateral. The Company invests
primarily in money market accounts and commercial paper
instruments. Cash equivalents are maintained with high quality
institutions and their composition and maturities are regularly
monitored by management.

One customer represented greater than 10% of
product revenues for the year ended December 31, 2002, and
no customer represented greater than 10% of product revenues for
the years ended December 31, 2001 and 2000. The companies
top five customers represented 35.6% of product revenue for the
year ended December 31, 2002 and 28.3% of product revenue
for the year ended December 31, 2001.

No customer accounted for 10% or more of the
trade accounts receivable balance as of December 31, 2002
and 2001.

Cash
Equivalents

The Company considers all highly liquid debt
instruments purchased with an original maturity of three months
or less to be cash equivalents.

Investments

The Company classifies its investments in
marketable securities as available-for-sale securities as
prescribed in Financial Accounting Standard No. 115,
Accounting for Certain Investments in Debt and Equity
Securities. All investments are carried at fair market
value, which is determined based on quoted market prices, with
net unrealized gains and losses included in comprehensive
income, net of tax. If a decline in fair value is judged to be
other than temporary, the cost basis of the individual security
is written down to fair value as a new cost basis with the
amount of the write down included in other (income) expense.

Inventories

Inventories are stated at the lower of cost or
net realizable value. Cost is determined using the weighted
average cost method. Finished goods and work-in-process
inventories include material, labor and manufacturing overhead
costs.

48



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Property,
Plant and Equipment

Property, plant and equipment are stated at cost
less accumulated depreciation computed using the straight-line
method over the estimated economic lives of the assets, which
vary from three to ten years. Leasehold improvements are
amortized over the shorter of the estimated useful life or the
term of the lease. We generally depreciate computers and
software over 3 years, automobiles over 5 years,
office equipment, furniture and fixtures over 3 years,
leasehold improvements over 10 years, and buildings over
27.5 years.

Impairment of
Long-Lived Assets

Pursuant to Statement of Financial Accounting
Standard No. 144, Accounting for Impairment or
Disposal of Long-Lived Assets, the Company reviews
long-lived assets based upon a gross cash flow basis and will
reserve for impairment whenever events or changes in
circumstances indicate the carrying amount of the assets may not
be fully recoverable.

Stock-Based
Compensation

The Company accounts for stock-based employee
compensation arrangements using the intrinsic value method as
prescribed in Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees and related
Interpretations thereof. Accordingly, compensation costs for
stock options is measured as the excess, if any, of the market
price of the Companys stock at the date of grant over the
stock option exercise price. In addition, the Company provides
additional disclosure provisions as required under Statement of
Financial Accounting Standard No. 123, Accounting for
Stock-Based Compensation and SFAS 148,
Accounting for Stock-Based Compensation 
Transition and Disclosurein Note 16.

Research and
Development

Research and development costs are expensed as
incurred.

Income
Taxes

The Company accounts for deferred income taxes
using the liability method, under which the expected future tax
consequences of timing differences between the book and tax
basis of assets and liabilities are recognized as deferred tax
assets and liabilities. Valuation allowances are established
when necessary to reduce net deferred tax assets when management
estimates, based on available objective evidence, that it is
more likely than not that the future income tax benefit
represented by the net deferred tax asset will not be realized.

Comprehensive
Income

Comprehensive income is defined as the change in
equity of a company during a period from transactions and other
events and circumstances, excluding transactions resulting from
investment by owners and distribution to owners. The difference
between net income and comprehensive income for the Company
relates to foreign currency translation adjustments and
unrealized gains and losses on investment securities.
Comprehensive income for the years ended December 31, 2002,
2001 and 2000 is disclosed in the Consolidated Statements
of Stockholders Equity.

Basic and
Diluted Net Income (Loss) Per Share

Basic income (loss) per share is computed by
dividing the income (loss) available to holders of common stock
for the period by the weighted average number of shares of
common stock outstanding during the period. The calculation of
diluted income (loss) per share excludes potential common
stock if the effect of such stock is antidilutive. Potential
common stock consists of common shares issuable upon the
exercise of stock options.

49



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Reclassifications

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

Recent
Accounting Pronouncements

In June 2002, the Financial Accounting Standards
Board (FASB) issued Statement of Accounting Standards
No. 146, Accounting for Costs Associated with Exit
or Disposal Activities.SFAS No. 146 addresses
the timing and amount of costs recognized as a result of
restructuring and similar activities. The company will apply
SFAS No. 146 to activities initiated after
December 31, 2002.

In December 2002, the FASB issued Statement of
Financial Accounting Standards No. 148 (SFAS
No. 148), Accounting for Stock-Based
Compensation  Transition and Disclosure 
an amendment to FASB Statement No. 123, Accounting for
Stock-Based Compensation.SFAS No. 148 provides
alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee
compensation. In addition, SFAS No. 148 amends the
disclosure requirements of Statement 123 to require more
prominent and more frequent disclosures in financial statements
about the effects of stock-based compensation. The transition
guidance and annual disclosure provisions of SFAS No. 148
are effective for fiscal years ending after December 15,
2002. The interim disclosure provisions are effective for
financial reports containing financial statements for interim
periods beginning after December 15, 2002. The adoption of
the disclosure provisions of SFAS No. 148 did not have a
material impact on our financial position or results of
operations.

In November 2002, the FASB issued FASB
Interpretation No. 45 (FIN 45),
Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of
Others.FIN No. 45 requires that a liability be
recorded in the guarantors balance sheet upon issuance of
a guarantee. In addition, FIN No. 45 requires disclosures
about the guarantees that an entity has issued, including a
reconciliation of changes in the entitys product warranty
liabilities. The initial recognition and initial measurement
provisions of FIN No. 45 are applicable on a prospective
basis to guarantees issued or modified after December 31,
2002, irrespective of the guarantors fiscal year-end. The
disclosure requirements of FIN No. 45 are effective for
financial statements of interim or annual periods ending after
December 15, 2002. Our adoption of FIN No. 45 did not
have a material effect on our consolidated financial statements.

In January 2003, the FASB issued FASB
Interpretation No. 46 (FIN 46), Consolidation
of Variable Interest Entities, an Interpretation of ARB
No. 51. FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary
of the entity if the equity investors in the entity do not have
the characteristics of a controlling financial interest or do
not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support
from other parties. FIN 46 is effective immediately for all
new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or
acquired prior to February 1, 2003, the provisions of
FIN 46 must be applied for the first interim or annual
period beginning after June 15, 2003. The Company is
currently evaluating the impact that the adoption of this
standard will have on its financial statements.

Note
2.     Long-Lived Asset
Impairment

In the second quarter of 2002, the Company
completed an impairment review of certain manufacturing assets
used in the substrate and opto-electronics divisions. The review
was undertaken due to the recent history of operating losses,
declines in the demand for our products due to macro economic
conditions and

50



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

excess capacity resulting in part from the
relocation of certain manufacturing operations in the
Companys substrate division to China.

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

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

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

Note 3.     Goodwill
Impairment

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

Note
4.     Inventories

Inventories are stated at the lower of cost or
net realizable value. Cost is determined using the weighted
average cost method. Finished goods and work-in-process
inventories include material, labor and manufacturing overhead
costs. The Company routinely evaluates the levels of its
inventory in light of current market conditions in order to
identify excess and obsolete inventory and provides a valuation
allowance for certain inventories based upon the age and quality
of the product. In the fourth quarter of 2002, as a result of
continuing revenue declines and uncertainty regarding the
future, the Company recorded a charge of $9.7 million to
increase our valuation allowance for excess inventories. The
charge is included in cost of revenues. The components of
inventory are summarized below (in thousands):

|                |                      |              |        |         |   |   |        |         |  
|--------------- | -------------------- | ------------ | ------ | ------- | - | - | ------ | ------- | -
|                |                      |             
|                |                      | December 31,
|                |                      |             
|                |                      | 2002         |        | 2001   
|                |                      |              |        |        
|Raw materials   |                      | $            | 17,566 |         |   | $ | 21,308 |        
|Work in process |                      |              | 30,042 |         |   |   | 30,265 |        
|Finished goods  |                      |              | 15,108 |         |   |   | 17,368 |        
|                | Valuation allowances |              |        | (25,118 | ) |   |        | (13,354 | )
|                |                      |              |        |         |   |   |        |        
|                |                      | $            | 37,598 |         |   | $ | 55,587 |        
|                |                      |              |        |         |   |   |        |        

51



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 5.     Asset
Held for Sale

During the fourth quarter of 2002, the Company
began to market its property located at 4281 Technology Drive,
Fremont, California, and in November of 2002, entered into a
contract to sell the property to a third party. In accordance
with SFAS 144, Accounting for the Impairment or
Disposal of Long-Lived Assets,the company recorded a
charge of $3.1 million to write-down the building to its
net realizable value of $6.0 million, and classified the
asset as held for sale on the consolidated balance sheet. The
charge is included in other expense in the Consolidated
Statements of Income.

Note 6.     Gain on
Demeter Warrants and Loss on Investment in Finisar Corporation
Common Stock

In August 2000, the Company entered into a
business transfer and acquisition agreement with Demeter
Technologies, Inc., a Delaware corporation founded by
Theodore S. Young, the former president of the
Companys fiber optic division and a former member of the
Companys board of directors, and Robert Shih, the former
chief technology officer of the Companys opto-electronics
division. Under this agreement, the Company agreed to transfer
certain non-core rights to Demeter relating to research and
development activities in the field of fiber optics. The Company
entered into non-competition agreements with Messrs. Shih
and Young that prohibit them from certain activities, including
the manufacture of certain VCSEL devices. The Company leased to
Demeter a portion of its owned facility in El Monte, California,
subleased a portion of its rented facility in El Monte,
California, leased certain equipment, including an MOCVD
machine, and sold certain inventory relating to fiber optics to
Demeter. In exchange, Demeter granted to the Company a warrant
to purchase up to 4.5 million shares of its Series A
convertible preferred stock at a price of $0.5714 per share.
Demeter was purchased by Finisar Corporation and as a result,
AXT converted its Demeter warrant for approximately
1.1 million shares of Finisar Corporation common stock on
November 21, 2000. On November 21, 2000, a gain of
$27.3 million was recorded in other income as a result of
the transaction.

On December 10, 2001, the Company received
approximately 86,000 additional shares of common stock of
Finisar Corporation that had been held in escrow in accordance
with the terms of the acquisition agreement between Demeter and
Finisar. A gain of $1.1 million was recorded in other
income as a result of receiving these additional shares. On
December 31, 2001, the Company wrote its investment in
Finisar Corporation down to current market value, in accordance
with SFAS 115, resulting in a realized loss of
$16.7 million recorded in other income and expense.

On February 4, 2002, the Company received
approximately 24,000 additional shares of common stock of
Finisar Corporation that had been held in escrow in accordance
with the terms of the acquisition agreement between Demeter and
Finisar. A gain of $251,000 was recorded in other income as a
result of receiving these additional shares. The investment in
Finisar Corporation common stock is accounted for as available
for sale and classified as a short-term investment. On
June 30, 2002, the Company wrote its investment in Finisar
Corporation down to current market value, in accordance with
SFAS 115, due to a decline in fair market value of the stock
below its carrying value for a period exceeding six months,
resulting in a realized loss of $9.1 million recorded in
other expense. On December 31, 2002, the Company again
wrote its investment in Finisar Corporation down to current
market value, due to a further decline in fair market value,
resulting in a realized loss of $1.7 million recorded in other
expense. The carrying value of our investment in Finisar
Corporation at December 31, 2002, was $1.1 million.

Note
7.     Debt

Credit
Facility

At June 30, 2002, the credit facility
maintained by the Company with a bank included a $5 million
line of credit with no balance outstanding, term loans in the
amount of $4.8 million and a letter of credit supporting
repayment of the Companys industrial revenue bonds with an
outstanding amount of $9.4 million. The credit

52



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

facility is collateralized by all corporate
personal and real property owned by the Company. As of
June 30, 2002, the Company was in default of the credit
facility by failure to maintain certain financial covenants
required under the terms of the facility. As a result, on
September 30, 2002 we modified the credit agreement with
our bank, which waived the covenant default, terminated the
credit line, amended the financial covenants and added
additional collateral to secure repayment of the bonds. At
December 31, 2002 the credit facility included a letter of
credit supporting our bonds with an outstanding amount of
$9.1 million and foreign exchange and overdraft obligations
in the amount of $1.1 million. The Company has pledged and
placed certain investment securities with the trust department
of the bank as additional collateral for this facility. As a
result, $10.2 million of our long-term investments are
restricted. As of December 31, 2002, we were out of
compliance with our tangible net worth covenant as amended on
September 30, 2002. We have obtained a waiver from our bank
for this covenant default through April 30, 2003. Effective
April 7, 2003, our bonds will be supported by a new letter
of credit supported by another bank.

Long-Term
Debt

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

|                                                                                                                                                                                                            |  |              |        |      |  |   |        |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------ | ---- |  | - | ------ | -
|                                                                                                                                                                                                            |  |             
|                                                                                                                                                                                                            |  | December 31,
|                                                                                                                                                                                                            |  |             
|                                                                                                                                                                                                            |  | 2002         |        | 2001
|                                                                                                                                                                                                            |  |              |        |     
|Various notes payable to banks, secured by
    certain equipment, bearing interest at fixed rates between 4.55%
    and 4.72%, maturing between July 2006 and May 2007                                      |  | $            | 1,083  |      |  | $ | 916    |  
|Debenture loan to Bay Area Employment Development
    Company, guaranteed by the U.S. Small Business
    Administration, bearing interest at a fixed rate of 7.27%,
    maturing October 2016               |  |              | 823    |      |  |   | 857    |  
|Taxable revenue bonds, secured by a letter of
    credit from a bank, bearing interest at the H15 30 day bond
    yield for commercial paper that was 1.6% on December 31,
    2002, maturing December 2023 |  |              | 9,050  |      |  |   | 9,720  |  
|Mortgage notes payable to a bank, secured by
    property, bearing interest at 150 basis points above the prime
    rate that was 5.75% on December 31, 2001                                                |  |              |       |      |  |   | 5,185  |  
|Notes payable to a bank, secured by certain
    equipment in China, bearing interest at a fixed rate of 5.49%,
    maturing December 2004                                                                   |  |              | 3,298  |      |  |   |       |  
|                                                                                                                                                                                                            |  |              |        |      |  |   |        |  
|                                                                                                                                                                                                            |  |              | 14,254 |      |  |   | 16,678 |  
|Less current portion                                                                                                                                                                                        |  |              | (965   | )    |  |   | (2,336 | )
|                                                                                                                                                                                                            |  |              |        |      |  |   |        |  
|                                                                                                                                                                                                            |  | $            | 13,289 |      |  | $ | 14,342 |  
|                                                                                                                                                                                                            |  |              |        |      |  |   |        |  

Maturities of long-term debt at December 31,
2002 were as follows:

|           |  |   |        | 
|---------- |  | - | ------ | 
|2003       |  |   | 965    | 
|2004       |  |   | 5,047  | 
|2005       |  |   | 965    | 
|2006       |  |   | 905    | 
|2007       |  |   | 722    | 
|Thereafter |  |   | 5,650  | 
|           |  |   |        | 
|           |  | $ | 14,254 | 
|           |  |   |        | 

53



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 8.     Discontinued
Operations

On December 14, 2000, the Companys
Board of Directors approved managements plan to exit the
Companys unprofitable consumer products business. The plan
was substantially complete at December 31, 2001.

Certain information with respect to discontinued
operations is summarized below (in thousands):

|                                                    |                                     |                          |        |       |       | 
|--------------------------------------------------- | ----------------------------------- | ------------------------ | ------ | ----- | ----- | 
|                                                    |                                     | January 1, 2000         
|                                                    |                                     | through                 
|                                                    |                                     | December 14, 2000       
|                                                    |                                     |                         
|Revenue                                             |                                     | $                        | 4,832  |      
|Cost of revenue                                     |                                     |                          | 4,311  |      
|                                                    |                                     |                          |        |      
|Gross profit (loss)                                 |                                     |                          | 521    |      
|Operating expenses:                                 |                                     |                          |        |      
|                                                    | Selling, general and administrative |                          |        | 2,899 |      
|                                                    | Research and development            |                          |        | 160   |      
|                                                    |                                     |                          |        |      
|                                                    |                                     | Total operating expenses |        |       | 3,059 | 
|Income (loss) from operations                       |                                     |                          | (2,538 | )    
|Interest expense                                    |                                     |                          | 0      |      
|Other (income) and expense, net                     |                                     |                          | (139   | )    
|                                                    |                                     |                          |        |      
|Income (loss) before provision for income
    taxes |                                     |                          | (2,399 | )    
|Income tax benefit                                  |                                     |                          | (912   | )    
|                                                    |                                     |                          |        |      
|Loss from discontinued operations                   |                                     | $                        | (1,487 | )    
|                                                    |                                     |                          |        |      

The charge in 2000 for loss on disposal of the
consumer products business includes the following:

|                                                                                                                                          |  |   |       |  
|----------------------------------------------------------------------------------------------------------------------------------------- |  | - | ----- | -
|Carrying value of net assets in excess of
    anticipated proceeds                                                                        |  | $ | 1,060 |  
|Expenses of asset disposal and anticipated
    operating loss for the period December 15, 2000 through the
    estimated date of disposal |  |   | 1,103 |  
|                                                                                                                                          |  |   |       |  
|Loss on disposal before taxes                                                                                                             |  |   | 2,163 |  
|Income tax benefit                                                                                                                        |  |   | (822  | )
|                                                                                                                                          |  |   |       |  
|Loss on disposal                                                                                                                          |  | $ | 1,341 |  
|                                                                                                                                          |  |   |       |  

Note 9.     Restructuring
Costs

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

54



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Certain information with respect to restructuring
costs is summarized below (in thousands):

|                                        |  |         |       |          |  |          |     |                   |  |   |       |  |  |   |       | 
|--------------------------------------- |  | ------- | ----- | -------- |  | -------- | --- | ----------------- |  | - | ----- |  |  | - | ----- | 
|                                        |  |         |       |          |  |         
|                                        |  |         |       | Utilized |  |         
|                                        |  |         |       |          |  | Balance 
|                                        |  | Reserve |       | Cash     |  | Non-cash |     | December 31, 2002
|                                        |  |         |       |          |  |          |     |                  
|Inventory write-off                     |  | $       | 1,844 |          |  | $        |    |                   |  | $ | 1,844 |  |  | $ |      | 
|Property, plant and equipment write-off |  |         | 3,436 |          |  |          |    |                   |  |   | 3,436 |  |  |   |      | 
|Goodwill write-off                      |  |         | 848   |          |  |          |    |                   |  |   | 848   |  |  |   |      | 
|Other restructuring costs               |  |         | 2,124 |          |  |          | 749 |                   |  |   | 121   |  |  |   | 1,254 | 
|                                        |  |         |       |          |  |          |     |                   |  |   |       |  |  |   |       | 
|                                        |  | $       | 8,252 |          |  | $        | 749 |                   |  | $ | 6,249 |  |  | $ | 1,254 | 
|                                        |  |         |       |          |  |          |     |                   |  |   |       |  |  |   |       | 

The fair value of assets determined to be
impaired in accordance with the guidance for assets to be
disposed of in SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be
Disposed of, were the result of management estimates.
The above noted exit costs were determined in accordance with
EITF No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an
Activity. The restructuring actions, as outlined by the
plan, are substantially complete. The remaining costs, which
relate to the clean up of a leased facility are expected to be
completed by March 31, 2003. The amount reserved for these
clean up costs, and included in accrued liabilities in the
consolidated balance sheet, was $1.3 million at
December 31, 2002 and $1.6 million at
December 31, 2001.

Note 10.     Investments

The Company classifies its investment securities
as available-for-sale securities as prescribed by Statement of
Financial Accounting Standards No. 115 or SFAS 115,
Accounting for Certain Investments in Debt and Equity
Securities. All investments are carried at fair market
value, which is determined based on quoted market prices, with
net unrealized gains and losses included in comprehensive
income, net of tax. The components of investments at
December 31, 2002 are summarized below (in thousands):

|                                         |  |      |        |            |  |             |        |             |  |   |         |   |  |   |     | 
|---------------------------------------- |  | ---- | ------ | ---------- |  | ----------- | ------ | ----------- |  | - | ------- | - |  | - | --- | 
|                                         |  |      |        | Aggregate  |  | Realized    |        | Unrealized 
|Available for sale                       |  | Cost |        | Fair value |  | Gain/(loss) |        | Gain/(loss)
|                                         |  |      |        |            |  |             |        |            
|Money market                             |  | $    | 2,590  |            |  | $           | 2,590  |             |  | $ |        |   |  | $ |    | 
|Corporate bonds                          |  |      | 14,402 |            |  |             | 14,535 |             |  |   |        |   |  |   | 133 | 
|Government agency bonds                  |  |      | 6,319  |            |  |             | 6,362  |             |  |   |        |   |  |   | 43  | 
|Corporate equity securities (see Note 6) |  |      | 28,660 |            |  |             | 1,115  |             |  |   | (27,545 | ) |  |   |    | 
|                                         |  |      |        |            |  |             |        |             |  |   |         |   |  |   |     | 
|                                         |  | $    | 51,971 |            |  | $           | 24,602 |             |  | $ | (27,545 | ) |  | $ | 176 | 
|                                         |  |      |        |            |  |             |        |             |  |   |         |   |  |   |     | 
|Recorded as:                             |  |      |        |            |  |             |        |             |  |   |         |   |  |   |     | 
|Cash equivalents                         |  | $    | 2,590  |            |  |             |        |             |  |   |         |   |  |   |     | 
|Short-term investments                   |  |      | 8,205  |            |  |             |        |             |  |   |         |   |  |   |     | 
|Long-term investments                    |  |      | 3,657  |            |  |             |        |             |  |   |         |   |  |   |     | 
|Restricted deposits                      |  |      | 10,150 |            |  |             |        |             |  |   |         |   |  |   |     | 
|                                         |  |      |        |            |  |             |        |             |  |   |         |   |  |   |     | 
|                                         |  | $    | 24,602 |            |  |             |        |             |  |   |         |   |  |   |     | 
|                                         |  |      |        |            |  |             |        |             |  |   |         |   |  |   |     | 

55



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note
11.     Corporate Affiliates

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

|                                               |  |              |       |              |  |            |       |            |  |  |              |  |  |  |    |  
|---------------------------------------------- |  | ------------ | ----- | ------------ |  | ---------- | ----- | ---------- |  |  | ------------ |  |  |  | -- | -
|                                               |  | Investment   |       | Investment   |  |            |       |           
|                                               |  | Balance      |       | Balance      |  |            |       |           
|                                               |  | December 31, |       | December 31, |  | Accounting |       | Ownership 
|Affiliate                                      |  | 2002         |       | 2001         |  | Method     |       | Percentage
|                                               |  |              |       |              |  |            |       |           
|Xilingol Tongli Ge Co. Ltd.                    |  | $            | 773   |              |  | $          | 810   |            |  |  | Equity       |  |  |  | 25 | %
|Emeishan Jia Mei High Pure Metals Co., Ltd.    |  |              | 614   |              |  |            | 629   |            |  |  | Equity       |  |  |  | 25 | %
|Beijing Ji Ya Semiconductor Material Co., Ltd. |  |              | 1,071 |              |  |            | 1,071 |            |  |  | Consolidated |  |  |  | 51 | %
|Nanjing Jin Mei Gallium Co., Ltd.              |  |              | 616   |              |  |            | 616   |            |  |  | Consolidated |  |  |  | 88 | %
|Beijing BoYu Manufacturing Co., Ltd            |  |              | 409   |              |  |            |      |            |  |  | Consolidated |  |  |  | 70 | %

The investment balances for those affiliates
accounted for under the equity method are included within
Other assets in the consolidated balance sheets.

Undistributed retained earnings relating to the
Companys corporate affiliates, was $861,000 at
December 31, 2002 and $679,000 at December 31, 2001.
Net income recorded from the Companys corporate affiliates
was $131,000 for the year ended December 31, 2002 and
$701,000 for 2001.

The Company invested in these companies because
each provides materials that are important to the Companys
substrate business, each can provide products at lower cost than
suppliers, and each has a market beyond that provided by the
Company. At December 31, 2002, the Company had no
obligations to make further investments in any of these
companies, although it may choose to do so under certain
conditions.

Note 12.     Balance
Sheet Detail

The components of selected balance sheet accounts
are summarized below (in thousands):

|                               |                                                 |                                 |        |        |        |   |         |         |        |  
|------------------------------ | ----------------------------------------------- | ------------------------------- | ------ | ------ | ------ | - | ------- | ------- | ------ | -
|                               |                                                 |                                
|                               |                                                 | December 31,                   
|                               |                                                 |                                
|                               |                                                 | 2002                            |        | 2001  
|                               |                                                 |                                 |        |       
|Accounts receivable:           |                                                 |                                 |        |        |        |   |         |        
|                               | Accounts receivable, gross                      |                                 |        | 13,871 |        |   |         | 22,353  |       
|                               |                                                 | Allowance for doubtful accounts |        |        | (6,676 | ) |         |         | (6,669 | )
|                               |                                                 |                                 |        |        |        |   |         |        
|                               |                                                 |                                 | 7,195  |        |        |   | 15,684  |        
|                               |                                                 |                                 |        |        |        |   |         |        
|Property, plant and equipment: |                                                 |                                 |        |        |        |   |         |        
|                               | Land                                            |                                 | $      | 1,722  |        |   | $       | 2,447   |       
|                               | Building                                        |                                 |        | 15,849 |        |   |         | 26,990  |       
|                               | Machinery and equipment                         |                                 |        | 13,142 |        |   |         | 60,984  |       
|                               | Leasehold improvements                          |                                 |        | 2,600  |        |   |         | 3,821   |       
|                               | Construction in progress                        |                                 |        | 7,260  |        |   |         | 11,478  |       
|                               |                                                 |                                 |        |        |        |   |         |        
|                               |                                                 |                                 | 40,573 |        |        |   | 105,720 |        
|                               | Less: accumulated depreciation and amortization |                                 |        | (591   | )      |   |         | (23,147 | )     
|                               |                                                 |                                 |        |        |        |   |         |        
|                               |                                                 | $                               | 39,982 |        |        | $ | 82,573  |        
|                               |                                                 |                                 |        |        |        |   |         |        

56



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                     |                                      |              |       |       |  |   |        |       | 
|-------------------- | ------------------------------------ | ------------ | ----- | ----- |  | - | ------ | ----- | 
|                     |                                      |             
|                     |                                      | December 31,
|                     |                                      |             
|                     |                                      | 2002         |       | 2001 
|                     |                                      |              |       |      
|Accrued liabilities: |                                      |              |       |       |  |   |        |      
|                     | Accrued compensation and other       |              | $     | 1,304 |  |   | $      | 2,026 | 
|                     | Customer prepayments                 |              |       | 2,196 |  |   |        | 6,477 | 
|                     | Accrued restructuring costs          |              |       | 1,254 |  |   |        | 1,621 | 
|                     | Accrued discontinued operation costs |              |       |      |  |   |        | 619   | 
|                     | Other                                |              |       | 3,590 |  |   |        | 2,619 | 
|                     |                                      |              |       |       |  |   |        |      
|                     |                                      | $            | 8,344 |       |  | $ | 13,362 |      
|                     |                                      |              |       |       |  |   |        |      

Note 13.     Income
Taxes

The components of the provision for income taxes
are summarized below (in thousands):

|          |         |                                                                               |   |        |        |      |   |        |        |   |   |       |        | 
|--------- | ------- | ----------------------------------------------------------------------------- | - | ------ | ------ | ---- | - | ------ | ------ | - | - | ----- | ------ | 
|          |         |                                                                              
|          |         | Years Ended December 31,                                                     
|          |         |                                                                              
|          |         | 2002                                                                          |   | 2001   |        | 2000
|          |         |                                                                               |   |        |        |     
|Current:  |         |                                                                               |   |        |        |      |   |        |        |   |   |      
|          | Federal |                                                                               | $ | (8,841 | )      |      | $ | 1,917  |        |   | $ | 7,738 |       
|          | State   |                                                                               |   |       |        |      |   |       |        |   |   | 948   |       
|          | Foreign |                                                                               |   |       |        |      |   | 314    |        |   |   | 155   |       
|          |         |                                                                               |   |        |        |      |   |        |        |   |   |      
|          |         | Total current                                                                 |   |        | (8,841 | )    |   |        | 2,231  |   |   |       | 8,841  | 
|          |         |                                                                               |   |        |        |      |   |        |        |   |   |      
|Deferred: |         |                                                                               |   |        |        |      |   |        |        |   |   |      
|          | Federal |                                                                               |   | 1,301  |        |      |   | (3,481 | )      |   |   | 5,489 |       
|          | State   |                                                                               |   | 1,232  |        |      |   | (1,560 | )      |   |   | 648   |       
|          |         |                                                                               |   |        |        |      |   |        |        |   |   |      
|          |         | Total deferred                                                                |   |        | 2,533  |      |   |        | (5,041 | ) |   |       | 6,137  | 
|          |         |                                                                               |   |        |        |      |   |        |        |   |   |      
|          |         | Total provision from continuing operations before
    discontinued operations |   | $      | (6,308 | )    |   | $      | (2,810 | ) |   | $     | 14,978 | 
|          |         |                                                                               |   |        |        |      |   |        |        |   |   |      

A reconciliation of the effective income tax
rates and the U.S. statutory federal income tax rate is
summarized below:

|                                                |  |                          |       |      |  |      |       |   |  |  |      |  
|----------------------------------------------- |  | ------------------------ | ----- | ---- |  | ---- | ----- | - |  |  | ---- | -
|                                                |  |                         
|                                                |  | Years Ended December 31,
|                                                |  |                         
|                                                |  | 2002                     |       | 2001 |  | 2000
|                                                |  |                          |       |      |  |     
|Statutory federal income tax rate               |  |                          | -35.0 | %    |  |      | -35.0 | % |  |  | 35.0 | %
|State income taxes, net of federal tax benefits |  |                          | -2.7  | %    |  |      | -5.0  | % |  |  | 3.3  | %
|Foreign sales corporation benefit               |  |                          | 0.0   | %    |  |      | 0.0   | % |  |  | -1.4 | %
|Unbenefited losses and credits                  |  |                          | 29.9  | %    |  |      | 0.0   | % |  |  | 0.0  | %
|Change in valuation allowance                   |  |                          | 2.8   | %    |  |      | 0.0   | % |  |  | 0.0  | %
|Other                                           |  |                          | -2.2  | %    |  |      | 4.0   | % |  |  | 1.1  | %
|                                                |  |                          |       |      |  |      |       |   |  |  |      |  
|Effective tax rate                              |  |                          | -7.2  | %    |  |      | -36.0 | % |  |  | 38.0 | %
|                                                |  |                          |       |      |  |      |       |   |  |  |      |  

57



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Deferred tax assets and liabilities are
summarized below (in thousands):

|                          |                                                              |                      |         |        |   |   |        |        |  
|------------------------- | ------------------------------------------------------------ | -------------------- | ------- | ------ | - | - | ------ | ------ | -
|                          |                                                              |                     
|                          |                                                              | Years Ended December
|                          |                                                              | 31,                 
|                          |                                                              |                     
|                          |                                                              | 2002                 |         | 2001  
|                          |                                                              |                      |         |       
|Deferred tax assets:      |                                                              |                      |         |        |   |   |        |       
|                          | Accruals and reserves not yet deductible                     |                      | $       | 15,337 |   |   | $      | 10,151 |  
|                          | Net operating loss                                           |                      |         | 8,923  |   |   |        |       |  
|                          | Depreciation                                                 |                      |         | 5,519  |   |   |        |       |  
|                          | Credits                                                      |                      |         | 3,477  |   |   |        | 997    |  
|                          |                                                              |                      |         |        |   |   |        |       
|                          |                                                              | $                    | 33,256  |        |   | $ | 11,148 |       
|Deferred tax liabilities: |                                                              |                      |         |        |   |   |        |       
|                          | Unrealized appreciation on Finisar marketable
    securities |                      |         |       |   |   |        | (75    | )
|                          | State taxes                                                  |                      |         | (980   | ) |   |        | (291   | )
|                          | Gain on receipt of Finisar marketable securities             |                      |         |       |   |   |        | (3,664 | )
|                          | Unrepatriated Foreign Earnings                               |                      |         | (1,085 | ) |   |        | (967   | )
|                          | Depreciation                                                 |                      |         |       |   |   |        | (3,693 | )
|                          |                                                              |                      |         |        |   |   |        |       
|                          |                                                              | $                    | (2,065  | )      |   | $ | (8,690 | )     
|Net deferred tax assets   |                                                              | $                    | 31,191  |        |   | $ | 2,458  |       
|Valuation allowance       |                                                              |                      | (31,191 | )      |   |   |       |       
|Net deferred tax assets   |                                                              |                      |        |        |   |   | 2,458  |       
|                          |                                                              |                      |         |        |   |   |        |       

At December 31, 2002, the Company had
federal and state net operating loss carryforwards of
approximately $22 million and $24 million,
respectively, which will expire beginning in 2012 and 2005,
respectively. In addition, the Company had federal tax credit
carryforwards of approximately $1.1 million, which will
expire beginning in 2020. The Company also has state tax credit
carryforwards of approximately $2.4 million which will
expire beginning 2007.

The deferred tax assets valuation allowance at
December 31, 2002 is attributed to U.S. federal, and state
deferred tax assets, which result primarily from future
deductible accruals, reserves and tax depreciation expense, net
operating loss carryforwards, and tax credit carryforwards. The
Company believes that, based on a number of factors, the
available objective evidence creates sufficient uncertainty
regarding the realizability of the deferred tax assets such that
a full valuation allowance has been recorded. These factors
include the Companys history of losses, and the lack of
carryback capacity to realize deferred tax assets.

In accordance with Section 382 of the
Internal Revenue Code, the amounts of and benefits from net
operating loss and tax credit carryforwards may be impaired or
limited in certain circumstances. Events which cause limitations
in the amount of net operating losses or credits that the
Company may utilize in any one year include, but are not limited
to, a cumulative ownership change of more that 50% as defined,
over a three year period.

58



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 14.     Net
Income per Share

A reconciliation of the numerators and
denominators of the basic and diluted net income per share
calculations is as follows (in thousands, except per share data):

|                                                                                     |                                                                                 |                          |        |         |   |      |        |        |   |   |        |        | 
|------------------------------------------------------------------------------------ | ------------------------------------------------------------------------------- | ------------------------ | ------ | ------- | - | ---- | ------ | ------ | - | - | ------ | ------ | 
|                                                                                     |                                                                                 |                         
|                                                                                     |                                                                                 | Years Ended December 31,
|                                                                                     |                                                                                 |                         
|                                                                                     |                                                                                 | 2002                     |        | 2001    |   | 2000
|                                                                                     |                                                                                 |                          |        |         |   |     
|Numerator:                                                                           |                                                                                 |                          |        |         |   |      |        |        |   |   |        |       
|                                                                                     | Net income (loss)                                                               |                          | $      | (81,181 | ) |      | $      | (4,996 | ) |   | $      | 21,610 | 
|                                                                                     | Less: Preferred stock dividends                                                 |                          |        | (177    | ) |      |        | (177   | ) |   |        |       | 
|                                                                                     |                                                                                 |                          |        |         |   |      |        |        |   |   |        |       
|                                                                                     | Net income (loss) available to common
    stockholders                          |                          | $      | (81,358 | ) |      | $      | (5,173 | ) |   | $      | 21,610 | 
|                                                                                     |                                                                                 |                          |        |         |   |      |        |        |   |   |        |       
|Denominator:                                                                         |                                                                                 |                          |        |         |   |      |        |        |   |   |        |       
|                                                                                     | Denominator for basic net income per
    share  weighted average common shares |                          |        | 22,433  |   |      |        | 22,278 |   |   |        | 19,677 | 
|                                                                                     | Effect of dilutive securities:                                                  |                          |        |         |   |      |        |        |   |   |        |        | 
|                                                                                     | Common stock options                                                            |                          |        |        |   |      |        |       |   |   |        | 1,382  | 
|                                                                                     |                                                                                 |                          |        |         |   |      |        |        |   |   |        |       
|Denominator for dilutive net income per share                                        |                                                                                 |                          | 22,433 |         |   |      | 22,278 |        |   |   | 21,059 |       
|                                                                                     |                                                                                 |                          |        |         |   |      |        |        |   |   |        |       
|Basic earnings per share                                                             |                                                                                 | $                        | (3.63  | )       |   | $    | (0.23  | )      |   | $ | (1.10  | )     
|Diluted earnings per share                                                           |                                                                                 | $                        | (3.63  | )       |   | $    | (0.23  | )      |   | $ | 1.03   |       
|Options excluded from diluted net income per
    share as the impact is antidilutive |                                                                                 |                          | 2,867  |         |   |      | 2,708  |        |   |   | 118    |       
|                                                                                     |                                                                                 |                          |        |         |   |      |        |        |   |   |        |       

Note 15.                       Stockholders
Equity

In May 1998, the Company completed its initial
public offering, or IPO, and issued 2,875,000 shares of its
common stock at $10.00 per share, including the shares from an
over-allotment option. The Company received cash of
approximately $25.8 million net of underwriting discounts,
commissions and IPO expenses. Upon the closing of the IPO, all
outstanding shares of the Companys then convertible
preferred stock were automatically converted into shares of
common stock.

On May 28, 1999, the Company completed its
acquisition of Lyte Optronics, Inc. Under the terms of the
acquisition, the Company issued approximately 2,023,000 shares
of common stock and 883,000 shares of non-voting and
non-convertible preferred stock with a 5.0% cumulative annual
dividend rate payable when declared by the board of directors of
the Company and $4 per share liquidation preference over common
stock, in exchange for all of the issued and outstanding shares
of the capital stock of Lyte.

On July 25, 2000 the Company completed a
private securities offering, raising approximately
$8.5 million in exchange for 234,115 shares of common stock.

On September 19, 2000, the Company sold
pursuant to an underwritten public offering, 2,510,000 shares of
its common stock at a price of $34.25 per share, including the
shares from an over-allotment option exercised by the
underwriters of the offering. The Company received cash of
approximately $80.8 million net of underwriting discounts,
commissions and expenses. Following the public offering,
proceeds were used to repay its line of credit and for general
corporate purposes.

59



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 16.     Employee
Benefit Plans



| |                   
| | ------------------
| | Stock Option Plans

In March 1993, the Companys board of
directors approved the 1993 Stock Option Plan (1993
Plan), which provides for granting of incentive and
non-qualified stock options to employees and directors of the
Company. Under the 1993 Plan, 880,000 shares of common stock
have been reserved for issuance as of December 31, 1998.
Options granted under the 1993 Plan are generally for periods
not to exceed ten years and are granted at the fair market value
of the stock at the date of grant as determined by the board of
directors. Options granted under the 1993 Plan generally vest
25.0% upon grant and 25.0% each year thereafter, with full
vesting occurring on the third anniversary of the grant date.
The Company is no longer granting options under the 1993 Plan.
This plan terminates on March 12, 2003.

In July 1997, the Companys board of
directors approved the 1997 Stock Option Plan (1997
Plan), which provides for granting of incentive and
non-qualified stock options to employees and directors of the
Company. Under the 1997 Plan, 5,901,501 shares of common stock
have been reserved for issuance as of December 31, 2002.
Options granted under the 1997 Plan are generally for periods
not to exceed ten years (five years if the option is granted to
a 10.0% stockholder) and are granted at the fair market value of
the stock at the date of grant as determined by the board of
directors. Options granted under the 1997 Plan generally vest
25.0% at the end of one year and 2.1% each month thereafter,
with full vesting after four years.

The following summarizes the Companys stock
option activity under the 1993 Plan and the 1997 Plan, and
related weighted average exercise price within each category for
each of the years ended December 31, 2000, 2001, and 2002:

|                             |                              |           |           |                     |   |                |           |           |   |  |   |             |  |   |       |       | 
|---------------------------- | ---------------------------- | --------- | --------- | ------------------- | - | -------------- | --------- | --------- | - |  | - | ----------- |  | - | ----- | ----- | 
|                             |                              |           |           |                    
|                             |                              |           |           | Options Outstanding
|                             |                              |           |           |                    
|                             |                              |           |           |                     |   | Weighted      
|                             |                              |           |           |                     |   | Average       
|                             |                              | Options   |           |                     |   | Exercise      
|                             |                              | Available |           | Number of           |   | Exercise Price |           | Price per
|                             |                              | For Grant |           | Shares              |   | per Share      |           | Share    
|                             |                              |           |           |                     |   |                |           |          
|Balance at December 31, 1999 |                              |           | 1,361,783 |                     |   |                | 2,680,102 |           |   |  |   |             |  |   | 12.18 |      
|                             | Additional shares authorized |           |           | 2,101,501           |   |                |           |          |   |  |   |             |  |   |       |      | 
|                             | Granted                      |           |           | (1,202,550          | ) |                |           | 1,202,550 |   |  |   | 15.06-47.00 |  |   |       | 30.21 | 
|                             | Exercised                    |           |           |                    |   |                |           | (711,259  | ) |  |   | 0.20-22.69  |  |   |       | 8.49  | 
|                             | Cancelled                    |           |           | 676,164             |   |                |           | (676,164  | ) |  | $ | 1.90-47.00  |  |   |       | 17.29 | 
|                             |                              |           |           |                     |   |                |           |           |   |  |   |             |  |   |       |      
|Balance at December 31, 2000 |                              |           | 2,936,898 |                     |   |                | 2,495,229 |           |   |  |   |             |  | $ | 20.46 |      
|                             | Additional shares authorized |           |           |                    |   |                |           |          |   |  |   |             |  |   |       |      | 
|                             | Granted                      |           |           | (1,693,070          | ) |                |           | 1,693,070 |   |  |   | 10.30-43.88 |  |   |       | 16.71 | 
|                             | Exercised                    |           |           |                    |   |                |           | (388,617  | ) |  |   | 5.00-39.00  |  |   |       | 9.94  | 
|                             | Cancelled                    |           |           | 497,433             |   |                |           | (497,433  | ) |  | $ | 5.00-44.25  |  |   |       | 22.14 | 
|                             |                              |           |           |                     |   |                |           |           |   |  |   |             |  |   |       |      
|Balance at December 31, 2001 |                              |           | 1,741,261 |                     |   |                | 3,302,249 |           |   |  |   |             |  | $ | 19.63 |      
|                             | Additional shares authorized |           |           |                    |   |                |           |          |   |  |   |             |  |   |       |      | 
|                             | Granted                      |           |           | (1,137,450          | ) |                |           | 1,137,450 |   |  |   | 1.92-15.90  |  |   |       | 3.06  | 
|                             | Exercised                    |           |           |                    |   |                |           | (23,791   | ) |  |   | 5.00-9.125  |  |   |       | 6.94  | 
|                             | Cancelled                    |           |           | 879,324             |   |                |           | (879,324  | ) |  | $ | 5.00-42.50  |  |   |       | 20.10 | 
|                             |                              |           |           |                     |   |                |           |           |   |  |   |             |  |   |       |      
|Balance at December 31, 2002 |                              |           | 1,483,135 |                     |   |                | 3,536,584 |           |   |  |   |             |  | $ | 14.15 |      
|                             |                              |           |           |                     |   |                |           |           |   |  |   |             |  |   |       |      

60



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Information about stock options outstanding at
December 31, 2002 is summarized below:

|                    |                |                     |  |             |           |             |  |          |      |  |  |  |           |  |  |   |       | 
|------------------- | -------------- | ------------------- |  | ----------- | --------- | ----------- |  | -------- | ---- |  |  |  | --------- |  |  | - | ----- | 
|                    |                |                     |  |            
|Options Outstanding |                |                    
|                    |                | Options Exercisable
|                    |                | Weighted            |  |            
|                    |                | Average             |  |             |           | Weighted   
|                    |                | Remaining           |  |             |           | Average    
|Range of            |                | Number              |  | Contractual |           | Number      |  | Exercise
|Exercise Prices     |                | Outstanding         |  | Life        |           | Outstanding |  | Price   
|                    |                |                     |  |             |           |             |  |         
|                    | $ 1.92   1.92 |                     |  |             | 5,000     |             |  |          | 9.75 |  |  |  |          |  |  | $ |      | 
|                    | 2.19   2.19   |                     |  |             | 1,006,450 |             |  |          | 9.89 |  |  |  | 20,974    |  |  |   | 2.19  | 
|                    | 5.00  10.04   |                     |  |             | 397,287   |             |  |          | 5.99 |  |  |  | 333,763   |  |  |   | 7.16  | 
|                    | 10.09  12.12  |                     |  |             | 485,366   |             |  |          | 8.87 |  |  |  | 110,596   |  |  |   | 12.03 | 
|                    | 12.38  14.89  |                     |  |             | 535,987   |             |  |          | 8.26 |  |  |  | 156,747   |  |  |   | 14.79 | 
|                    | 15.00  22.69  |                     |  |             | 374,761   |             |  |          | 7.11 |  |  |  | 215,282   |  |  |   | 20.15 | 
|                    | 23.00  31.63  |                     |  |             | 391,733   |             |  |          | 7.55 |  |  |  | 140,030   |  |  |   | 26.39 | 
|                    | 31.88  43.63  |                     |  |             | 335,500   |             |  |          | 7.79 |  |  |  | 124,711   |  |  |   | 36.46 | 
|                    | 43.88  43.88  |                     |  |             | 4,000     |             |  |          | 8.04 |  |  |  | 1,917     |  |  |   | 43.88 | 
|                    | $44.38  44.38 |                     |  |             | 500       |             |  |          | 7.13 |  |  |  | 354       |  |  |   | 44.38 | 
|                    |                |                     |  |             |           |             |  |          |      |  |  |  |           |  |  |   |       | 
|                    |                |                     |  |             | 3,536,584 |             |  |          | 8.31 |  |  |  | 1,104,374 |  |  | $ | 16.99 | 
|                    |                |                     |  |             |           |             |  |          |      |  |  |  |           |  |  |   |       | 



| |                                              
| | ---------------------------------------------
| | Stock-Based Compensation Under APB
    No. 25

In connection with certain stock option grants
the Company recorded deferred compensation costs totaling
$203,000 for the year ended December 31, 1998. Compensation
cost is the difference between the exercise price and the deemed
fair value at the date of grant. Compensation cost is being
amortized over the vesting period relating to these options, of
which no amount was amortized for the year ended
December 31, 2002, $107,000 for 2001 and $110,000 for 2000.



| |                              
| | -----------------------------
| | Certain Pro Forma Disclosures

Pro forma information regarding net income and
net income per share is required by SFAS No. 123 and SFAS
148, which also requires that information be determined as if
the Company had accounted for its employee stock options granted
under the fair value method. The fair value for these options
was estimated using the Black-Scholes option pricing model.

The Company calculated the fair value of each
option grant on the date of grant using the Black-Scholes option
pricing model as prescribed by SFAS No. 123 using the
following assumptions:

|                         |  |      |       |      |  |      |       |   |  |  |       |  
|------------------------ |  | ---- | ----- | ---- |  | ---- | ----- | - |  |  | ----- | -
|                         |  | 2002 |       | 2001 |  | 2000
|                         |  |      |       |      |  |     
|Risk free interest rate  |  |      | 3.0   | %    |  |      | 3.9   | % |  |  | 5.8   | %
|Expected life (in years) |  |      | 5.0   |      |  |      | 5.0   |   |  |  | 5.0   |  
|Dividend yield           |  |      | 0.0   | %    |  |      | 0.0   | % |  |  | 0.0   | %
|Volatility               |  |      | 101.0 | %    |  |      | 104.0 | % |  |  | 124.0 | %

The weighted average grant-date fair value of
options granted during the year ended December 31, 2002 was
$2.39, $12.97 in 2001 and $25.73 in 2000.

61



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Had compensation cost for the Companys
options been determined based on the fair value at the grant
dates, as prescribed in SFAS 123 and SFAS 148, the
Companys pro forma net income and net income per share
would have been as summarized below (in thousands except per
share data):

|                             |                              |                          |   |         |       |      |   |         |       |   |   |        |      | 
|---------------------------- | ---------------------------- | ------------------------ | - | ------- | ----- | ---- | - | ------- | ----- | - | - | ------ | ---- | 
|                             |                              |                         
|                             |                              | Years Ended December 31,
|                             |                              |                         
|                             |                              | 2002                     |   | 2001    |       | 2000
|                             |                              |                          |   |         |       |     
|Net income (loss):           |                              |                          |   |         |       |      |   |         |       |   |   |       
|                             | As reported                  |                          | $ | (81,181 | )     |      | $ | (4,996  | )     |   | $ | 21,610 |     
|                             | Pro forma option expense     |                          |   | 9,182   |       |      |   | 7,046   |       |   |   | 5,193  |     
|                             | Pro forma net income         |                          | $ | (90,363 | )     |      | $ | (12,042 | )     |   | $ | 16,417 |     
|Net income (loss) per share: |                              |                          |   |         |       |      |   |         |       |   |   |       
|                             | As reported:                 |                          |   |         |       |      |   |         |       |   |   |        |     
|                             |                              | Basic                    |   | $       | (3.63 | )    |   | $       | (0.23 | ) |   | $      | 1.10 | 
|                             |                              | Diluted                  |   |         | (3.63 | )    |   |         | (0.23 | ) |   |        | 1.03 | 
|                             | Pro forma net income (loss): |                          |   |         |       |      |   |         |       |   |   |        |     
|                             |                              | Basic                    |   | $       | (4.04 | )    |   | $       | (0.54 | ) |   | $      | 0.83 | 
|                             |                              | Diluted                  |   |         | (4.04 | )    |   |         | (0.54 | ) |   |        | 0.78 | 

Because additional option grants are expected to
be made each year, the above pro forma disclosures are not
representative of pro forma effects on reported net income for
future years.



| |                             
| | ----------------------------
| | Employee Stock Purchase Plan

In February 1998, the Companys board of
directors approved the 1998 Employee Stock Purchase Plan (the
1998 Purchase Plan). The Companys stockholders
approved the 1998 Purchase Plan in March 1998. At
December 31, 2002 a total of 900,000 shares of the
Companys common stock were reserved for issuance under the
1998 Purchase Plan. A total of 279,000 shares were
purchased as of December 31, 2002. The 1998 Purchase Plan
permits eligible employees to acquire shares of the
Companys common stock through payroll deductions. The
common stock purchase price is determined as 85.0% of the lower
of the market price of the common stock at the purchase date or
the date of offer to the employee.



| |                        
| | -----------------------
| | Retirement Savings Plan

The Company has a 401(k) Savings Plan (the
Savings Plan) which qualifies as a thrift plan under
Section 401(k) of the Internal Revenue Code. All full-time
U.S. employees are eligible to participate in the Savings
Plan after 90 days from the date of hire. Participants may
contribute up to 10.0% of their earnings to the Savings Plan
with a discretionary matching amount provided by the Company.
The Companys contributions to the Savings Plan were
$315,000 for the year ended December 31, 2002, $456,000 for
2001 and $236,000 for 2000.



|         |                                               
|-------- | ----------------------------------------------
|Note 17. | Segment and Foreign Operations
    Information

The Company has three reportable segments:
substrates, opto-electronics and discontinued consumer products.
The segments in which the Company operates are subject to rapid
technological change and significant competition. Also, the
number of suppliers of certain materials used by the Company and
the number of customers are limited.

62



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Selected financial information by business
segment is summarized below (in thousands):

|                                        |                                      |                          |   |         |   |      |   |         |   |  |   |         |  
|--------------------------------------- | ------------------------------------ | ------------------------ | - | ------- | - | ---- | - | ------- | - |  | - | ------- | -
|                                        |                                      |                         
|                                        |                                      | Years Ended December 31,
|                                        |                                      |                         
|                                        |                                      | 2002                     |   | 2001    |   | 2000
|                                        |                                      |                          |   |         |   |     
|Subtrates Division                      |                                      |                          |   |         |   |      |   |         |   |  |   |        
|                                        | Net revenues from external customers |                          | $ | 44,865  |   |      | $ | 108,800 |   |  | $ | 113,374 |  
|                                        | Gross profit (loss)                  |                          |   | (8,893  | ) |      |   | 41,306  |   |  |   | 52,013  |  
|                                        | Operating income (loss)              |                          |   | (39,724 | ) |      |   | 20,222  |   |  |   | 34,087  |  
|                                        | Identifiable assets                  |                          |   | 121,132 |   |      |   | 202,342 |   |  |   | 215,527 |  
|Opto-electronics                        |                                      |                          |   |         |   |      |   |         |   |  |   |        
|                                        | Net revenues from external customers |                          | $ | 18,310  |   |      | $ | 10,730  |   |  | $ | 8,129   |  
|                                        | Gross profit (loss)                  |                          |   | (1,963  | ) |      |   | (3,967  | ) |  |   | (4,194  | )
|                                        | Operating income (loss)              |                          |   | (33,734 | ) |      |   | (12,574 | ) |  |   | (19,487 | )
|                                        | Identifiable assets                  |                          |   | 24,535  |   |      |   | 41,017  |   |  |   | 33,181  |  
|Discontinued Consumer Products Division |                                      |                          |   |         |   |      |   |         |   |  |   |        
|                                        | Identifiable assets                  |                          | $ |        |   |      | $ |        |   |  | $ | 1,512   |  
|Total                                   |                                      |                          |   |         |   |      |   |         |   |  |   |        
|                                        | Net revenues from external customers |                          | $ | 63,175  |   |      | $ | 119,530 |   |  | $ | 121,503 |  
|                                        | Gross profit (loss)                  |                          |   | (10,856 | ) |      |   | 37,339  |   |  |   | 47,819  |  
|                                        | Operating income (loss)              |                          |   | (73,458 | ) |      |   | 7,648   |   |  |   | 14,600  |  
|                                        | Identifiable assets                  |                          |   | 145,667 |   |      |   | 243,359 |   |  |   | 250,220 |  

The Company sells its substrates and
opto-electronics products in the United States and in other
parts of the world. Also, the Company has operations in Japan
and China. Revenues by geographic location based on the country
of the customer were as follows (in thousands):

|              |               |                          |   |        |  |      |   |         |  |  |   |         | 
|------------- | ------------- | ------------------------ | - | ------ |  | ---- | - | ------- |  |  | - | ------- | 
|              |               |                         
|              |               | Years Ended December 31,
|              |               |                         
|              |               | 2002                     |   | 2001   |  | 2000
|              |               |                          |   |        |  |     
|Net revenues: |               |                          |   |        |  |      |   |         |  |  |   |        
|              | United States |                          | $ | 26,401 |  |      | $ | 59,300  |  |  | $ | 62,905  | 
|              | Europe        |                          |   | 5,666  |  |      |   | 22,008  |  |  |   | 12,743  | 
|              | Canada        |                          |   | 1,256  |  |      |   | 6,679   |  |  |   | 6,661   | 
|              | Taiwan        |                          |   | 11,351 |  |      |   | 12,975  |  |  |   | 13,610  | 
|              | Japan         |                          |   | 3,055  |  |      |   | 8,473   |  |  |   | 10,934  | 
|              | Malaysia      |                          |   | 6,762  |  |      |   | 2,491   |  |  |   |         | 
|              | Asia Pacific  |                          |   | 8,684  |  |      |   | 7,604   |  |  |   | 14,650  | 
|              |               |                          |   |        |  |      |   |         |  |  |   |        
|              | Consolidated  |                          | $ | 63,175 |  |      | $ | 119,530 |  |  | $ | 121,503 | 
|              |               |                          |   |        |  |      |   |         |  |  |   |        

63



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Property, plant and equipment by geographic
location is summarized below (in thousands):

|                                    |               |              |        |        |  |   |        |        | 
|----------------------------------- | ------------- | ------------ | ------ | ------ |  | - | ------ | ------ | 
|                                    |               |             
|                                    |               | Years Ended 
|                                    |               | December 31,
|                                    |               |             
|                                    |               | 2002         |        | 2001  
|                                    |               |              |        |       
|Property, plant and equipment, net: |               |              |        |        |  |   |        |       
|                                    | United States |              | $      | 21,133 |  |   | $      | 67,978 | 
|                                    | China         |              |        | 18,849 |  |   |        | 14,595 | 
|                                    |               |              |        |        |  |   |        |       
|                                    |               | $            | 39,982 |        |  | $ | 82,573 |       
|                                    |               |              |        |        |  |   |        |       

Note 18.     Related
Party Transactions

Since January 2002, there has not been, nor is
there currently proposed, any transaction or series of similar
transactions to which 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 immediate
family had or will have a direct or indirect material interest
other than the transactions described below.

The Company entered into an operating lease for
warehouse space in Fremont, CA with 4160 Business Center, LLC, a
real estate holding company, in which Davis Zhang, the president
of our substrate division, is the sole shareholder. Lease
payments to 4160 Business Center, LLC were approximately
$484,000 for the year ended December 31, 2002.

Note
19.     Commitments and
Contingencies

From time to time we are involved in judicial or
administrative proceedings concerning matters arising in the
ordinary course of our business, including matters relating to
workers compensation claims, claims of unlawful
termination or other employee-related claims. We do not expect
that any of these matters, individually or in the aggregate,
will have a material adverse effect on our business, financial
condition, cash flows or results of operation.

On May 1, 2001, the Santa Clara Center for
Occupational Safety and Health filed a complaint for injunctive
relief and civil penalties against the Company in the Superior
Court of California, County of Alameda, Hayward Division, Case
No. H218237-5. The complaint alleged violations of
California Business and Professions Code section 17200 et
seq., and violations under Proposition 65 and California
Health and Safety Code section 25249 et seq. as a result of
AXTs use of arsenic and inorganic arsenic compounds in its
workplace. On June 24, 2002, the Company participated in a
private mediation, and as a result, reached a settlement of all
claims, pursuant to which the Company agreed to pay the Santa
Clara Center for Occupational Safety and Health an amount equal
to $175,000. The parties have executed a settlement agreement,
and the court approved the settlement on December 31, 2002,
and dismissal of the case is pending.

The Company has entered into contracts to supply
several large customers with GaAs wafers. The contracts
guarantee the delivery of a certain number of wafers between
January 1, 2001 and December 31, 2003 with a current
contract value of $5.0 million. The contract sales prices
are subject to review quarterly and can be adjusted in the event
that raw material prices change. In the event of non-delivery of
the determined wafer quantities in any monthly delivery period,
the Company could be subject to non-performance penalties of
between 5% and 10% of the value of the delinquent monthly
deliveries. The Company has not received any claims for
non-performance penalties due to non-delivery. Partial
prepayments received for these supply contracts totaling
$2.2 million are included in accrued liabilities at
December 31, 2002. As of December 31, 2002, the
Company has met all of its delivery obligations under these
contracts and expects to do so for the remainder of the contract
terms.

64



---



##### Table of Contents



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Company leases certain office space,
manufacturing facilities and property under long-term operating
leases expiring at various dates through March 2008. Total rent
expense under these operating leases was approximately $947,000
for the year ended December 31, 2002 and $779,000 in 2001.

Included in property, plant and equipment is
equipment that is leased under non-cancelable leases accounted
for as capital leases. These leases were approximately
$8.4 million at December 31, 2002 and $14 million
at December 31, 2001. These leases expire at various dates
through 2006.

Total minimum lease payments under the above
leases as of December 31, 2002, are summarized below (in
thousands):

|                                                   |  |         |        |           |  |       |       |  |  |   |        | 
|-------------------------------------------------- |  | ------- | ------ | --------- |  | ----- | ----- |  |  | - | ------ | 
|                                                   |  | Capital |        | Operating |  |      
|                                                   |  | Leases  |        | Leases    |  | Total
|                                                   |  |         |        |           |  |      
|2003                                               |  | $       | 4,090  |           |  | $     | 1,200 |  |  | $ | 5,290  | 
|2004                                               |  |         | 2,757  |           |  |       | 1,231 |  |  |   | 3,988  | 
|2005                                               |  |         | 1,908  |           |  |       | 1,115 |  |  |   | 3,023  | 
|2006                                               |  |         | 549    |           |  |       | 836   |  |  |   | 1,385  | 
|Thereafter                                         |  |         |       |           |  |       | 771   |  |  |   | 771    | 
|                                                   |  |         |        |           |  |       |       |  |  |   |        | 
|                                                   |  | $       | 9,304  |           |  | $     | 5,153 |  |  | $ | 14,457 | 
|                                                   |  |         |        |           |  |       |       |  |  |   |        | 
|Less amounts representing interest at 3.6% to 8.8% |  |         | (895   | )         |  |       |       |  |  |   |        | 
|                                                   |  |         |        |           |  |       |       |  |  |   |        | 
|                                                   |  |         | 8,409  |           |  |       |       |  |  |   |        | 
|Less short-term portion                            |  |         | (3,562 | )         |  |       |       |  |  |   |        | 
|                                                   |  |         |        |           |  |       |       |  |  |   |        | 
|Long-term portion                                  |  | $       | 4,847  |           |  |       |       |  |  |   |        | 
|                                                   |  |         |        |           |  |       |       |  |  |   |        | 

Note 20.     Foreign
Exchange Contracts and Transaction Gains/ Losses

The Company uses short-term forward exchange
contracts for hedging purposes to reduce the effects of adverse
foreign exchange rate movements. The Company has purchased
foreign exchange contracts to hedge against certain trade
accounts receivable denominated in Japanese yen. The change in
the fair value of the forward contracts is recognized as part of
the related foreign currency transactions as they occur. As of
December 31, 2002, the Companys outstanding
commitments with respect to the foreign exchange contracts,
which were commitments to sell Japanese yen, had a total
contract value of approximately $2.8 million.

The Company incurred a foreign transaction
exchange gain of $28,000 for the year ended December 31,
2002, a loss of $357,000 in 2001 and a loss of $552,000 in 2000.

Note
21.     Subsequent Events

On March 11, 2003, the Company completed the
sale of its property located at 4281 Technology Drive, Fremont,
California, for $6.3 million. Net cash proceeds from the
sale were $6.0 million. Under the terms of the sale
agreement, the Company has agreed to lease back the property for
a five-year period. Accordingly, on March 11, 2003, the
company signed an operating lease for 4281 Technology Drive
through March 2008. Annual rent under this operating lease is
approximately $600,000. This annual rent is reflected in
Note 19, Commitments and Contingencies.

On March 14, 2003, the Company announced a
program to repurchase up to 2 million shares of its common
stock over a twelve-month period ending March 7, 2004.

65



---



##### Table of Contents



Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the registrant
has caused this report to be signed on its behalf by the
undersigned, thereto duly authorized.



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



| |     |                    
| | --- | -------------------
| | By: | /s/ MORRIS S. YOUNG

| |                                          
| | -----------------------------------------
| |                                          
| | Morris S. Young                          
| | Chief Executive Officer and
    President

Date: March 21, 2003

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below hereby constitutes and
appoints Morris S. Young and Donald L. Tatzin, and each of them,
his true and lawful attorney-in-fact and agent, with full power
of substitution, each with power to act alone, to sign and
execute on behalf of the undersigned any and all amendments to
this Report on Form 10-K, and to perform any acts necessary
in order to file the same, with all exhibits thereto and other
documents in connection therewith with the Securities and
Exchange Commission, granting unto said attorney-in-fact and
agent full power and authority to do and perform each and every
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, hereby ratifying and confirming all that
said attorney-in-fact and agent, or their or his or her
substitutes, shall do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the
capacities and on the dates indicated.

|                                     |  |                                                                  |  |                |  | 
|------------------------------------ |  | ---------------------------------------------------------------- |  | -------------- |  | 
|                                     |  |                                                                  |  |               
|Signature                            |  | Title                                                            |  | Date          
|                                     |  |                                                                  |  |               
|/s/ MORRIS S. YOUNGMorris S. Young   |  | President, Chief Executive Officer and Chairman
    of the Board |  | March 21, 2003
|                                    
|/s/ DONALD L. TATZINDonald L. Tatzin |  | Senior Vice President, Chief Financial Officer                   |  | March 21, 2003
|                                    
|/s/ JOHN E. DRURYJohn E. Drury       |  | Corporate Controller                                             |  | March 21, 2003
|                                    
|/s/ DAVID C. CHANGDavid C. Chang     |  | Director                                                         |  | March 21, 2003
|                                    
|/s/ JESSE CHENJesse Chen             |  | Director                                                         |  | March 21, 2003

66



---



##### Table of Contents



CERTIFICATIONS

I, Morris S. Young, Chief Executive Officer of
the registrant, certify that:

1.     I have reviewed
this annual report on Form 10-K of AXT, Inc.;

2.     Based on my
knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary in order to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this annual
report;

3.     Based on my
knowledge, the financial statements, and other financial
information included in this annual report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this annual report;

4.     The
registrants other certifying officer and I are responsible
for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-14 and
15d-14) for the registrant and we have:



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

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



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

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



| |                        
| | -----------------------
| | /s/ MORRIS S. YOUNG    
| |                        
| | Morris S. Young        
| | Chief Executive Officer

Dated: March 21, 2003

67



---



##### Table of Contents



I, Donald L. Tatzin, Chief Financial Officer of
the registrant, certify that:

1.     I have reviewed
this annual report on Form 10-K of AXT, Inc.;

2.     Based on my
knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary in order to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this annual
report;

3.     Based on my
knowledge, the financial statements, and other financial
information included in this annual report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this annual report;

4.     The
registrants other certifying officer and I are responsible
for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-14 and
15d-14) for the registrant and we have:



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

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



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

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



| |                        
| | -----------------------
| | /s/ DONALD L. TATZIN   
| |                        
| | Donald L. Tatzin       
| | Chief Financial Officer

Dated: March 21, 2003

68



---



##### Table of Contents



AXT, INC.

EXHIBITS

TO


FORM 10-K ANNUAL REPORT


For the Year Ended


December 31, 2002


|        |          |             |  |                                                                                                                                                                                                                                                                                          
|------- | -------- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |          |            
|Number  |          | Description
|        |          |            
|        | 2.1(1)   |             |  | Agreement and Plan of Merger between American
    Xtal Technology, a California corporation, and American Xtal
    Technology Delaware Corporation, a Delaware corporation.                                                                                                              
|        | 2.2(4)   |             |  | Agreement and Plan of Reorganization dated
    May 27, 1999 (which is incorporated herein by reference to
    Exhibit 2.1 to the registrants form 8-K dated
    May 28, 1999).                                                                                                          
|        | 2.3(4)   |             |  | Certificate of Merger dated May 27, 1999,
    filed with the Secretary of State of the State of Delaware on
    May 28, 1999 (which is incorporated herein by reference to
    Exhibit 2.1 to the registrants form 8-K dated
    May 28, 1999).                                         
|        | 2.4(4)   |             |  | Articles of Merger dated May 27, 1999, filed
    with the Secretary of State of Nevada on May 28, 1999
    (which is incorporated herein by reference to Exhibit 2.1
    to the registrants form 8-K dated May 28, 1999).                                                               
|        | 2.5(4)   |             |  | Agreement and Plan of Reorganization by and among
    American XTAL Technology, Inc., Monterey Acquisition Corp., Lyte
    Optronics, Inc. and certain stockholders of Lyte Optronics, Inc.
    dated May 27, 1999.                                                                      
|        | 3.1(3)   |             |  | Restated Certificate of Incorporation                                                                                                                                                                                                                                                    
|        | 3.2(4)   |             |  | Certificate of Designation, Preferences and
    Rights of Series A Preferred Stock, as filed with the Secretary
    of State of the state of Delaware on May 27, 1999 (which is
    incorporated herein by reference to Exhibit 2.1 to the
    registrants form 8-K dated May 28, 1999).
|        | 3.3(4)   |             |  | By Laws                                                                                                                                                                                                                                                                                  
|        | 4.0(4)   |             |  | Rights Agreement                                                                                                                                                                                                                                                                         
|        | 4.0(5)   |             |  | Rights Agreement                                                                                                                                                                                                                                                                         
|        | 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.*                                                                                                                                                                                                                          
|        | 10.4(1)  |             |  | 1997 Employee Stock Purchase Plan and forms of
    agreements thereunder.*                                                                                                                                                                                                               
|        | 10.5(1)  |             |  | 1998 Employee Stock Purchase Plan and forms of
    agreements thereunder.*                                                                                                                                                                                                               
|        | 10.6(1)  |             |  | Loan Agreement between U.S. Bank National
    Association and us dated March 4, 1998.                                                                                                                                                                                                    
|        | 10.7(2)  |             |  | Purchase and Sale Agreement by and between Limar
    Realty Corp. #23 and us dated April 1998.                                                                                                                                                                                           
|        | 10.8(3)  |             |  | Loan Agreement between U.S. Bank National
    Association and us dated September 18, 1998.                                                                                                                                                                                               
|        | 10.9(3)  |             |  | Letter of Credit and Reimbursement Agreement
    between U.S. Bank National Association and us dated
    December 1, 1998.                                                                                                                                                               
|        | 10.10(3) |             |  | Bond Purchase Contract between Dain Rauscher
    Incorporated and us dated December 1, 1998.                                                                                                                                                                                             
|        | 10.11(3) |             |  | Remarketing Agreement between Dain Rauscher
    Incorporated and us dated December 1, 1998. havent
    there been any material contracts since 1998?                                                                                                                                    
|        | 21.1(1)  |             |  | List of Subsidiaries.                                                                                                                                                                                                                                                                    
|        | 24.1     |             |  | Power of Attorney (see signature page).                                                                                                                                                                                                                                                  
|        | 99.1     |             |  | Certification Pursuant to 18 U.S.C.
    Section 1350, as adopted pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.                                                                                                                                                          



---



##### Table of Contents



|        |      |             |  |                                                                                                                                
|------- | ---- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------
|Exhibit |      |            
|Number  |      | Description
|        |      |            
|        | 99.2 |             |  | Certification Pursuant to 18 U.S.C.
    Section 1350, as adopted pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.



---



|    |                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------
|(1) | As filed with the SEC in our Registration
    Statement on Form S-1 on March 17, 1998.                     
|   
|(2) | As filed with the SEC in our Registration
    Statement on Amendment No. 2 to Form S-1 on
    May 11, 1998.
|   
|(3) | As filed with the SEC in our Annual Report on
    Form 10-K for the year ended December 31, 1998.          
|   
|(4) | As filed with the SEC in our Form 8-K on
    June 14, 1999.                                                
|   
|(5) | As filed with the SEC in our Form 8-K on
    May 30, 2001.                                                 



| |   |                                                                         
| | - | ------------------------------------------------------------------------
| | * | Indicates a management contract or compensatory
    plan or arrangement.