**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-K**
| **(Mark One)**                                       |       |                                                                                                    |   |
|------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|--------|
| **x**                                                | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |   |
| **For the fiscal year ended December 31, 2005** |
| **OR**                                               |
| **o**                                                | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |   |

 

**Forthe transition period from                         to**

**Commissionfile number:  000-24085**

**AXT, Inc.**

(Exact name of registrantas specified in its charter)

| **Delaware**

(State or other jurisdiction of

incorporation or organization)            |   | **94-3031310**

(I.R.S. Employer

Identification No.) |
|------------------------------------------------------------------------------------------|--------|-------------------------------------------------------|
| **4281 Technology Drive, Fremont, California**

(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) ofthe Act:
|        | **Title of each class** | ** ** | ** ** |  | **Name of each exchange on which registered** | ** ** |
|--------|----------------------------------------|------------|------------|--|-----------------------------------------------------------------------------|------------|
|   |                                   |       |

 

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

**Common Stock, $0.001 parvalue**

(Title of class)

Indicate by checkmark if the registrant is a well-knownseasoned issuer, as defined in Rule 405 of the Securities Act.  o Yes  x No

Indicate by checkmark if the registrant is not requiredto file reports pursuant to Section 13 or Section 15(d) of the Act.  o Yes  x No

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

Indicate by checkmark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

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

Large acceleratedfiler o      Accelerated filer o      Non-accelerated filer x

Indicate by checkmark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Act).  o Yes  x No

The aggregate market value of the voting stock held bynon-affiliates of the registrant, based upon the closing sale price of thecommon stock on June 30, 2005 as reported on the Nasdaq National Market,was approximately $21,760,657. Shares of common stock held by each officer,director and by each person who owns 5% or more of the outstanding common stockhave been excluded in that such persons may be deemed to be affiliates. Thisdetermination of affiliate status is not a conclusive determination for otherpurposes.

As of March 3, 2006, 22,999,739 shares, $0.001 parvalue, of the registrant’s common stock were outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the definitive proxy statement for theregistrant’s 2006 annual meeting of stockholders to be filed with theCommission pursuant to Regulation 14A not later than 120 days after the end ofthe fiscal year covered by this form are incorporated by reference into Part IIIof this Form 10-K report. Except for those portions specificallyincorporated by reference herein, such document shall not be deemed to be filedwith the Commission as part of this Form 10-K.

 

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**TABLE OF CONTENTS**
| **PART I**   |
|-------------------|
| Item  1.          |   | Business Overview |   | 2 |
| Item 1A           |   | Risk Factors |   | 12 |
| Item 1B           |   | Unresolved Staff Comments |   | 27 |
| Item 2.           |   | Properties |   | 27 |
| Item  3.          |   | Legal Proceedings |   | 27 |
| Item 4.           |   | Submission of Matters to a Vote of Security Holders |   | 28 |
| **PART II**  |
| Item 5.           |   | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   | 29 |
| Item 6.           |   | Selected Consolidated Financial Data |   | 30 |
| Item 7.           |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations  |   | 32 |
| Item 7A.          |   | Quantitative and Qualitative Disclosures About Market  Risk |   | 48 |
| Item 8.           |   | Consolidated Financial Statements and Supplementary  Data |   | 49 |
| Item 9.           |   | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure |   | 49 |
| Item 9A.          |   | Controls and Procedures |   | 49 |
| Item  9B.         |   | Other Information |   | 50 |
| **PART III** |
| Item 10.          |   | Directors and Executive Officers of the Registrant |   | 51 |
| Item 11.          |   | Executive Compensation |   | 51 |
| Item 12.          |   | Security Ownership of Certain Beneficial Owners and  Management, and Related Stockholder Matters   |   | 51 |
| Item 13.          |   | Certain Relationships and Related Transactions |   | 51 |
| Item 14.          |   | Principal Accountant Fees and Services |   | 52 |
| **PART IV**  |
| Item 15.          |   | Exhibits and Financial Statement Schedules |   | 53 |

 

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**PART I**

This Annual Report(including the following section regarding Management’s Discussion and Analysisof Financial Condition and Results of Operations) contains forward-lookingstatements regarding our business, financial condition, results of operationsand prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,”“seeks,” “estimates” and similar expressions or variations of such words areintended to identify forward-looking statements, but are not the exclusivemeans of identifying forward-looking statements in this Annual Report.Additionally, statements concerning future matters such as the development ofnew products, enhancements or technologies, sales levels, expense levels andother statements regarding matters that are not historical are forward-lookingstatements.

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

**Item 1.**                        *Business Overview*

We design,develop, manufacture and distribute high-performance compound and singleelement semiconductor substrates comprising gallium arsenide (GaAs), indiumphosphide (InP) and germanium (Ge). Our substrate products are used primarilyin lighting display applications, wireless communications, and fiber opticcommunications. We believe our vertical gradient freeze, or VGF, technique formanufacturing semiconductor substrates provides significant benefits over othermethods and has enabled us to become a leading manufacturer of such substrates.We pioneered the commercial use of VGF technology to manufacture GaAssubstrates and subsequently used VGF technology to manufacture substrates fromInP and Ge. Some of our competitors followed our lead by developing their ownversions of VGF technology. Customers for our substrates include United EpitaxyCompany, Avago, Samsung, EMCORE, Kopin, IQE, Osram, MBE Technologies, andSumika. Over the past four years, we have implemented an initiative to reducethe cost of manufacturing our substrates by moving our manufacturing operationsto China, which is now complete, and by investing in sources of low cost rawmaterials.

We alsomanufacture and sell raw materials related to our substrate business throughfive joint ventures located in China. These joint ventures produce productsincluding 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium,germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide.AXT’s ownership interest in these entities ranges from 25 percent to 83percent. We consolidate the three ventures in which we own a majority interestand employ equity accounting for the two joint ventures in which we have a 25percent interest. We purchase the materials produced by these ventures for ouruse and sell other portions of their production to third parties.

On June 24,2003, our Board of Directors approved management’s plan to exit ourunprofitable opto-electronics business. The disposition was a result ofcontinuing operating losses and negative cash flows from the division andsignificant uncertainty regarding its future profitability.

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

With the new management team in place, quality,quality systems and revenue began to improve beginning in the third quarter of2005. In December 2005, we continued to execute our workforce reduction inour Fremont, California facility and accordingly will eliminate approximately15 positions in California over the following 120 days.

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

**IndustryBackground**

Mostsemiconductors are created on a single crystal base material, or substrate, ofsilicon. Some electronic and opto-electronics semiconductors have requirementsthat exceed the capabilities of silicon. These semiconductors are composed ofmultiple elements that include a metal, such as gallium, aluminum or indium,and a non-metal, such as arsenic, phosphorus or nitrogen. The resultingcompounds include gallium arsenide, indium phosphide and gallium nitride.Devices made on such semiconductors are power efficient, operate at highfrequencies, and can be produced cost effectively.

Theseproperties address the continually increasing demand to send, receive anddisplay information on high-speed wireless and fiber optic networks. The productsmade using semiconductor substrates include power amplifiers and radiofrequency integrated circuits used in wireless handsets. Compound semiconductorsubstrates can also be used to create opto-electronic products including highbrightness light emitting diodes, or HBLEDs, and vertical cavity surfaceemitting lasers, or VCSELs, used in solid-state lighting and fiber opticcommunications, respectively.

These semiconductors enable the growth and development of awide range of end user applications, including:

·       mobile terminals;

·       voice and high-speedwireless data systems;

·       infrared emitters andoptical detectors in computer systems;

·       fiber optic networks andoptical systems within these networks;

·       selected wi-fi networks;

·       solid-state lighting, includingfull color displays, automobile lighting, traffic lights, and channel lighting;and

·       satellite communicationssystems.

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The marketsfor several of these end-user applications are expected to grow; for example,Strategy Analytics, an independent research firm, expects worldwide mobiletelephone production to grow from approximately 700 million units in 2005 toover 900 million units in 2010.

As a result of the limitations of silicon-basedtechnologies, semiconductor device manufacturers use compound semiconductorsubstrates to improve the performance of semiconductor devices and to enablethese new applications. This use occurs even though these compoundsemiconductor substrates are more expensive than silicon. Advantages of devicesmanufactured on compound substrates over devices manufactured using siliconsubstrates include:

·       operation at higher speeds;

·       lower power consumption;

·       less noise and distortion;and

·       opto-electronic propertiesthat enable devices to emit and detect light.

A key stepin producing a compound semiconductor substrate is to grow a crystal of thematerials. Historically, two processes were used to grow crystals: the LiquidEncapsulated Czochralski, or LEC, technique and the Horizontal-Bridgeman, orHB, technique. We believe two trends reduced the appeal of these techniques:more semiconductor devices are being formed using an epitaxial process andsemiconductor device manufacturers are switching their production lines tolarger diameter substrates, including six-inch diameters for electronic deviceapplications and three- and four-inch diameters for opto-electronicdevice applications. The LEC and HB techniques each have difficulties producinghigh quality, low-cost compound semiconductor substrates for epitaxialprocessing, especially for larger sizes. Substrates produced using the LECtechnique have a high volume of defects as size increases beyond four-inchesin diameter. The HB technique has been unable to reliably produce substratesmore than three-inches in diameter.

We introducedour VGF technique in 1986 to respond to the limitations inherent in the LEC andHB techniques, and, in recent years, some of our competitors who previouslyrelied on the LEC or HB methods have also developed their own versions of VGF.We believe that a majority of the substrates sold commercially since 2003 forelectronic device applications were manufactured using VGF or similartechniques.

In addition to the semi-insulating and semi-conductingmarkets for GaAs, we believe that the Ge market holds significant potential forus. With the shortage of polysilicon and its inherent inefficiency, Ge isbecoming the material of choice for photovoltaic applications such as solarcells and other space and terrestrial applications. In January 2006, wereceived one customer qualification on Ge products and several other customersare in the qualification process. We do not expect Ge to be a significantportion of our revenue stream in 2006.

**The AXTAdvantage**

We are aleading developer and supplier of high-performance compound semiconductorsubstrates. We believe that we benefit from the following advantages:

*Our VGF technology is a competitiveadvantage for our current and prospective markets.**  *Wepioneered the commercial use of VGF technology to manufacture GaAs substratesand we believe that through the use of VGF we became a leading worldwidesupplier of GaAs substrates, particularly for HBLED applications. Our VGFprocess produces substrates with high mechanical strength and physical andchemical uniformity, as well as low crystal defect densities.

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Our VGF technology helps qualify us to compete for thesemarkets because changes in customers’ technologies are increasing the share ofsubstrates sold that are manufactured using VGF or comparable technology:

·       *Greateruse of epitaxy rather than ion implantation.  *Many of the newestgeneration of high-performance semiconductor devices for fiber optic andwireless communications applications, including heterojunction bipolartransistors, or HBTs, and pseudomorphic high electron mobility transistors, orPHEMTs, are popular because they offer lower power consumption and betterdevice linearity than their predecessors. These devices are created usingepitaxial processed substrates. Our VGF substrates are more suitable for theseapplications than are products manufactured using LEC and HB technologies, andcompeting materials such as silicon germanium, or SiGe.

·       *Switch tosix-inch diameter wafers.  *Many semiconductor device manufacturers switched their GaAsproduction lines to six-inch diameter substrates from three and four inchdiameter substrates in order to reduce unit costs and increase capacity. Wewere among the first to be able to deliver large volumes of six-inch diameterVGF substrates and retain a significant amount of manufacturing capacity forthis product. We believe we are well-positioned to take advantage of the growthin this market.

*Some customers specify VGFsubstrates.**  *Our wafers are qualified with many of the key suppliers ofGaAs and InP semiconductor devices. The qualification process, which is lengthyand must be repeated for each customer, can be a barrier to entry for a newmaterial or supplier. Furthermore, certain of our customers now effectivelyspecify that they will only accept VGF-grown or equivalent substrates for theirmanufacturing processes. The lengthy qualification period benefits us when weare already qualified with a customer, but acts as a barrier to entry for thosecustomers with which we are not qualified.

*Our low-cost manufacturing is anadvantage.**  *In 1998, we began moving portions of our substratemanufacturing operations to China, to benefit from a combination of lower costsfor facilities, labor and materials than we encounter in the United States.That move continued after 1998 and during 2004, we completed the transfer ofall of our manufacturing to China. We have also made five strategic investmentsin raw materials producers that provide us with secured and low cost sources ofimportant materials and enable us to market surplus production to others. Webelieve this provides us with a cost advantage vis-à-vis ourcompetitors who do not enjoy similar arrangements.

*Customer technology independenceprotects us from dependence on a small number of customers.**  *Our semiconductor devicemanufacturing customers often compete among themselves. For example, several ofour customers compete for technological leadership and market share in theHBLED market. These customers or end-users all manufacture some of theirdevices on GaAs substrates. Because we supply many HBLED manufacturers, we are,therefore, largely immune from the effects of such competition and benefit froman overall need for better and more efficient solid-state lighting.

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**Technology**

Our core technologies include our proprietary VGF techniqueused to produce high quality crystals that are processed into compoundsubstrates, and the technologies of our joint venture companies, which enableus to manufacture a range of products that are used in the manufacture ofcompound semiconductor substrates or can be sold to third parties.

Our VGFtechnique is designed to control the crystal-growth process with minimaltemperature variation and is the technique we use to produce our GaAs, InP andGe substrates. Unlike traditional techniques, our VGF technique places the hotcompound melt above the cool crystal, and minimizes the temperature gradientbetween the crystal and the melt which reduces the turbulence at the interfaceof the melt and the solid crystal. In comparison, in the LEC technique the meltand crystal are inverted, there is a higher temperature gradient between themelt and the crystal, and more turbulence at the interface of the melt andsolid crystal. These aspects of the VGF technique enable us to grow crystalsthat have a relatively low defect density and high uniformity. The crystal andthe resulting substrate are mechanically strong, resulting in lower breakagerates during a customer’s manufacturing process. Since the temperature gradientis controlled electronically rather than by physical movement, the sensitivecrystal is not disturbed as it may be during some competitors’ VGF-like growthprocesses. In addition, the melt and growing crystal are contained in a closedchamber, which isolates the crystal from the outside environment to reducepotential contamination. This substrate isolation allows for more precisecontrol of the gallium-to-arsenic ratio, resulting in betterconsistency and uniformity of the crystals.

Our VGFtechnique offers several benefits when compared to traditional crystal growingtechnologies. The HB technique is the traditional method for producing semi-conductingGaAs substrates for opto-electronic applications. The HB technique holds theGaAs melt in a semi-cylindrical container, causing crystals grown usingthe HB method to have a semi-circular, or D-shaped, cross-section.Accordingly, more crystal material is discarded when the D-shaped substrate issubsequently trimmed to a round shape. In addition, crystals grown using the HBtechnique have a higher defect density than VGF-grown crystals. The HBtechnique cannot be used cost-effectively to produce substrates greater thanthree inches in diameter. The HB technique houses the GaAs melt in a quartzcontainer during the growth process, which can contaminate the GaAs melt withsilicon impurities, making it unsuitable for producing semi-insulating GaAs substrates.

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

The following table provides acomparison of these three techniques: in 2003, LEC retains about 40% of thesemi-insulating market and HB is still present in the semi-conducting oropto-electronics market.

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

 

**Products**

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

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

 

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

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

**Customers**

We sell our compoundsemiconductor substrates and materials worldwide. Our customers include:

| Advanced Epitaxy Technology | IQE, Inc.     | Sogem                    |
|-----------------------------|--------------------|--------------------------|
| Avago                       | Kopin              | Sumiden                  |
| Arima Optoelectronic  Corp. | MBE Technologies   | Sumika                   |
| Bookham                     | Motorola           | United Epitaxy Company   |
| Coherent Tutcore            | Nippon Sheet Glass | Visual Photonics Epitaxy |
| Dowa                        | Osram              | Xiamen Sanan Electronics |
| EMCORE                      | Samsung            |                     |

 

Historically, we have sold a significant portion ofour products in any particular period to a limited number of customers. Twocustomers represented greater than 10% of revenue, totaling 20.7%, for the yearended December 31, 2005, while no customers represented greater than 10%of revenue for the years ended December 31, 2004 and 2003. The company’stop five customers represented 37.5% of revenues for the year ended December 31,2005, 30.1% of revenue for the year ended December 31, 2004, and 28.9% ofrevenue for the year ended December 31, 2003. We expect that sales to asmall number of customers will continue to comprise a significant portion ofour revenue in the future.

The third party customersfor our raw materials products are in many instances the same as our customersfor substrates. Our joint ventures are a key strategic benefit for us as theygive us a strong competitive advantage of allowing our customers to work withone supplier for all their substrate and raw material requirements.

**Manufacturing,Raw Materials and Supplies**

We believe that our results are partially due to ourmanufacturing efficiency and high product yields and we continually emphasizequality and process control throughout our manufacturing operations. We performour substrate manufacturing operations at our facilities in Beijing, China.During 2004, we discontinued our manufacturing and research and developmentactivities at our Fremont, California facility. We believe that our capitalinvestment and subsequent operating costs are lower for our manufacturingfacilities in China relative to the U.S. Many of our manufacturing operationsare fully automated and computer monitored or controlled, enhancing reliabilityand yield. We use proprietary equipment in our substrate manufacturingoperations to protect our intellectual property and control the timing and paceof capacity additions. All of our manufacturing facilities are ISO 9001 or 9002certified. In January 2006, our Beijing facility successfully passed theISO 14001 certification audit, and we expect to receive the final documentationin the first quarter of 2006.

Although we purchasesupply parts, components and raw materials from several domestic andinternational suppliers, we depend on a single or limited number of suppliersfor certain critical materials used in the production of our substrates, suchas quartz tubing, and polishing solutions. We generally purchase thesematerials through standard purchase orders and not pursuant to long-term supplycontracts. Although we seek to maintain sufficient inventory levels of certainmaterials to guard against interruptions in supply and to meet our near termneeds, and have to date been able to obtain sufficient supplies of materials ina timely manner, there may be shortages of certain key materials, such asgallium. 

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Accordingly,to help ensure continued supply of materials, we formed five joint ventureswith and made investments in some suppliers of key raw materials required tomanufacture our products, including gallium, arsenic, germanium, germaniumdioxide, pyrolitic boron nitride crucibles, and boron oxide. We believe thatthese joint ventures and investments will be advantageous in procuringmaterials to support our growth and cost management goals.

**Sales and Marketing**

We advertise in trade publications, distributepromotional materials, conduct marketing and sales programs, and participate inindustry trade shows and conferences in order to raise market awareness of ourproducts. We sell our substrate products through our direct sales force in theU.S. and through independent sales representatives in France, Germany, Japan,South Korea, Taiwan and the United Kingdom. Our direct sales force isknowledgeable in the use of compound and single-element substrates. Ourapplications engineers work with customers during all stages of the substratemanufacturing process, from developing the precise composition of the substratethrough manufacturing and processing the substrate to the customer’sspecifications. We believe that maintaining a close relationship with customersand providing them with ongoing engineering support improves customersatisfaction and will provide us with a competitive advantage in selling othersubstrates to our customers. The substrate division launched a program in late2000 with selected customers in which we guaranteed that certain volumes ofsix-inch GaAs and other substrates would be delivered on specific dates and thecustomer made a prepayment for part of the value of the entire order. Severalmajor customers participated in this program. As of December 31, 2005, theunearned pre-payments we retain under this program equaled $125,000. We do notexpect to continue this program.

*InternationalSales.**  *Internationalsales are an important part of our business. For the year ended December 31,2005, sales to customers outside North America (primarily United States)accounted for 80.5% of our revenue, as compared with 78.8% in 2004, and with65.4% in 2003. The primary markets for sales of our products outside of theUnited States include countries in Asia and Western Europe.

In 2005, we increased ourfocus in our five joint ventures. In 2006, through our joint ventures we planto expand our raw material offering that will include 4N, 6N, and 7N gallium,boron oxide (B2O3), germanium, arsenic,germanium dioxide, paralytic boron nitride (pBN) crucibles used in crystalgrowth and parts for MBE (Molecular Beam Epitaxy). Our joint ventures are a keystrategic benefit for us as they give us a strong competitive advantage ofallowing our customers to work with one supplier for all their substrate andraw material requirements.

**Research and Development**

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

Our current substrate research and developmentactivities focus on continued development and enhancement of GaAs, InP and Gesubstrates, including haze reduction, improved yield, enhanced surface andelectrical characteristics and uniformity, greater substrate strength andincreased crystal length. During 2005, we continued to spend some research anddevelopment resources to reduce surface quality problems we experienced withour GaAs and InP substrates for some customers, particularly related to surfacemorphology. We continue to work on issues related to surface quality.

Research and development expenses were $1.7 million in2005, compared with $1.5 million in 2004 and $1.3 million in 2003. We expect tomaintain our rate of expenditure on research and development costs in 2006.

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

**Competition**

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

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

·       quality;

·       price;

·       performance;

·       meeting customerspecifications; and

·       customer support andsatisfaction.

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

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

·       the availability ofadequate sources of raw materials;

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

·       general economicconditions.

Our primary competition in the market for compoundsemiconductor substrates includes Crystal Technologies, Freiberger CompoundMaterials, Japan Energy, Mitsubishi Chemical Corporation, and Sumitomo ElectricIndustries. We believe that at least two of our competitors are shipping highvolumes of GaAs substrates manufactured using a technique similar to our VGFtechnique. In addition, as a result of quality problems that we haveexperienced, we believe that some customers have allocated some of their requirementsfor VGF grown substrates across more competitors and we believe that we mayhave lost revenue and market share as a result of these customer decisions. Inaddition, we also face competition from compound semiconductor devicemanufacturers that produce substrates for their own internal use, includingHitachi, and from companies such as IBM that are actively developingalternative compound semiconductor materials.

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

**Protectionof our Intellectual Property**

Our success and the competitive position of our VGFtechnique depend on our ability to maintain trade secrets and other intellectualproperty protections. We rely on a combination of patents, trademark and tradesecret laws, non-disclosure agreements and other intellectual propertyprotection methods to protect our proprietary technology. We believe that, dueto the rapid pace of technological innovation in the markets for our products,our ability to establish and maintain a position of technology leadershipdepends as much on the skills of our development personnel as upon the legalprotections afforded our 

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existing technologies. Toprotect our trade secrets, we take certain measures to ensure their secrecy,such as executing non-disclosure agreements with our employees, customers andsuppliers. However, reliance on trade secrets is only an effective businesspractice insofar as trade secrets remain undisclosed and a proprietary productor process is not reverse engineered or independently developed.

To date, we have beenissued two U.S. patents and have three U.S. patent applications pending, whichrelate to our VGF products and processes. We have twenty-three patentapplications pending (in PCT/national stage process) in Europe, Canada, China,Japan and South Korea which are based on our U.S. patents that relate to ourVGF processes. We have two issued foreign patents.

**Environmental Regulations**

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

**Employees**

As of December 31, 2005, we had 842 employees, ofwhom 680 were principally engaged in manufacturing, 116 in sales andadministration, and 46 in research and development. Of these employees, 55 arelocated in the U.S., and 787 in China. As of December 31, 2004, we had1,010 employees, of whom 854 were principally engaged in manufacturing, 112 insales and administration, and 44 in research and development. Of theseemployees, 65 were located in the U.S., 943 in China and 2 in Japan.

As a result of shiftingmore of our substrate manufacturing to China, we continued to reduce our headcountin our Fremont, California facility and accordingly announced our restructuringplan in December 2005 which would eliminate approximately 15 positionsover the next 120 days. Earlier in 2005, we also reduced our workforce at ourBeijing, China manufacturing facility as part of our ongoing effort to reduceour cost structure and bring capacity in line with current market demand. Someof our employees in China are represented by a union, but we have neverexperienced a work stoppage. Although morale has been affected by our workforcereductions in California, we consider our relations with our employees to begood.

**Available of Information**

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

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

**Risks Related to Our Business**

***Our operating results depend in large part on furthercustomer acceptance of our existing substrate products manufactured in China.***

As we are now manufacturing only in China, if theshift of our substrate manufacturing operations to China is to be successful,we will need our customers to qualify products manufactured in China. If we areunable to continue to achieve qualifications for these products, our Chinafacility will be underutilized, our investments in China will not be recoupedand we will be unable to lower our costs by moving to China. We may lose salesof our products to competitors who are not manufacturing in China, or whoseoperations in China have already been qualified by customers. If customers donot fully qualify our China production, we may lose additional customers andfail to achieve revenue growth.

Furthermore, somecustomers reduced their orders from us until our surface quality is as good andconsistent as that offered by competitors. As a result, some customersallocated their requirements for compound semiconductor substrates across morecompetitors and although our quality is improving, resulting in increasedsales, we believe that we have lost revenue and market share as a result ofthese customer decisions, which we may be unable to recover. If we are unableto recover and retain our market share, we may be unable to grow our business.

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

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

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

***If we fail to comply with environmental and safetyregulations, we may be subject to significant fines or cessation of ouroperations; in addition, we could be subject to suits for personal injuriescaused by hazardous materials.***

We are subject to federal, state and localenvironmental and safety laws and regulations in all of our operatinglocations, including laws and regulations of China, including, but not limitedto, regulations related to the development, manufacture and use of ourproducts, the operation of our facilities, and the use of our real property.These laws, rules and regulations govern the use, storage, discharge anddisposal of hazardous chemicals during manufacturing, research and development,and sales demonstrations. If we fail to comply with applicable regulations, wecould be subject to substantial liability for clean-up efforts, personal injuryand fines or suspension or cessation of our operations, and/or the suspensionor termination of development, manufacture or use of certain of our products,or may affect the operation of our facilities or use of our real property, eachof which could have a material adverse effect on our business, financial conditionand results of operations.

In March 2001, we settled a claim made by theCalifornia Occupational Safety and Health Administration, or Cal-OSHA, in aninvestigation primarily regarding impermissible levels of potentially 

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hazardous materials incertain areas of our manufacturing facility in Fremont, California for$200,415, and during 2004 we were the target of press allegations andcorrespondence purportedly on behalf of current and/or former employeesconcerning our environmental compliance programs and exposure of our employeesto hazardous materials. In June 2005, a complaint was filed against us anda current and former officer, alleging personal injury, general negligence,intentional tort, wage loss and other damages, including punitive damages, as aresult of exposure of defendants, who are former employees of AXT, including aminor child in utero, to high levels of gallium arsenide in gallium arsenidewafers, and methanol. There is a possibility that other current and/or formeremployees may bring additional litigation against us. Although we have put inplace engineering, administrative and personnel protective equipment programsto address these issues, our ability to expand or continue to operate ourpresent locations could be restricted or we could be required to acquire costlyremediation equipment or incur other significant expenses. Existing or futurechanges in laws or regulations in the United States and China may require us toincur significant expenditures or liabilities, or may restrict our operations.In addition, our employees could be exposed to chemicals or other hazardousmaterials at our facilities and we may be subject to lawsuits seeking damagesfor wrongful death or personal injuries allegedly caused by exposure tochemicals or hazardous materials at our facilities.

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

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

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

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

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

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

A small number ofsubstrate customers have historically accounted for a substantial portion ofour total revenue. Our top five customers represented 37.5%, 30.1% and 28.9% ofrevenue for the years ended December 31, 2005, 2004, and 2003,respectively. We expect that a significant portion of our future revenue willcontinue to be derived from a limited number of substrate customers. Ourcustomers are not obligated to purchase a specified quantity of our products orto provide us with binding forecasts of 

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productpurchases. In addition, our customers may reduce, delay or cancel orders at anytime without any significant penalty, and during the past year, we haveexperienced slower bookings, significant push outs and cancellation of ordersfrom some customers. If we lose a major customer or if a customer cancels,reduces or delays orders, our revenue would decline. In addition, customersthat have accounted for significant revenue in the past may not continue togenerate revenue for us in any future period. Any delay in scheduled shipmentsof our products could cause revenue to fall below our expectations and theexpectations of market analysts or investors, causing our stock price to decline.

***We may incur claims or other liabilities orobligations related to our failure to follow requirements for testing ofproducts and provision of testing data and information relating to customerrequirements. Additionally, customers may cancel or reduce future shipments inresponse to these failures, or require re-qualifications.***

During the first quarterof 2004, we determined that we had not followed requirements for testing ofproducts and provision of testing data and information relating to customer requirements.We notified affected customers concerning our findings, however, there can beno assurance that we will not incur customer claims or other liabilities orobligations in connection with this matter, nor, if we receive any such claims,that we will not have to restate results from prior periods. In addition,revenue in future periods may be adversely impacted if customers decide not toorder from us as a result of this disclosure. We experienced severalcancellations of future orders by customers pending further informationregarding enhancements to our product testing and quality control systems. Inaddition, some customers are requiring additional qualification of our Chinaoperations before placing future orders with us. We cannot be sure that we willnot receive additional cancellations of orders by other customers, or fail towin expected future orders from customers, as a result of our disclosure of ourinvestigation conclusions, or that our customers will qualify our Chinaoperations and place future orders with us.

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

We have invested in five joint venture operations inChina that produce products including 99.99% pure gallium (4N Ga), high puritygallium, arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN)crucibles, and boron oxide. We purchase the materials produced by theseventures for our use and sell other portions of their production to thirdparties. Our ownership interest in these entities ranges from 25 percent to 83percent. We consolidate the three ventures in which we own a majority interestand employ equity accounting for the two joint ventures in which we have a 25percent interest. Several of these ventures occupy facilities within largerfacilities owned and/or operated by one of the other venture partners. Severalof these venture partners are engaged in other manufacturing activities at ornear the same facility. In some facilities, we share access to certainfunctions, including water, treatment of hazardous waste or air qualitytreatment. If any of our joint venture partners in any of these five venturesexperience problems with their operations, disruptions of our joint ventureoperations could result, having a material adverse effect on the financialcondition and results of operation of our joint ventures, and correspondinglyon our financial condition or results of operations.

In addition, if any of our joint ventures or venturepartners with whom our joint ventures share facilities are deemed to haveviolated applicable laws, rules or regulations governing the use, storage,discharge or disposal of hazardous chemicals during manufacturing, research anddevelopment, or sales demonstrations, the operations of our joint venturescould be adversely affected and we could be subject to substantial liabilityfor clean-up efforts, personal injury and fines or suspension or cessation ofour joint venture operations as a result of the actions of the joint venturesor other venture partners. Employees working at the operations of our jointventures or the operations of any of the other venture partners could bringlitigation against us as a result of actions taken at the joint venture orventure partner facilities, even though we are not directly controlling theoperations, including actions for exposure to chemicals or other 

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hazardous materials at thefacilities of our joint ventures or the facilities of any venture partner thatare shared by our joint ventures. If litigation is brought against us,litigation is inherently uncertain and while we would expect to defendourselves vigorously, it is possible that our business, financial condition,results of operations or cash flows could be affected in any particular periodby such litigation if brought against us, particularly if, as a non-Chinesecompany, litigation with us is deemed advantageous. Even if we are not deemedresponsible for the actions of the joint ventures or venture partners,litigation could be costly, time consuming to defend and divert managementattention; in addition, pursuit of us could occur if we are deemed to be themost financially viable of the partners.

Going forward, we believe that investing in additionaljoint ventures will be important to remaining competitive in our marketplaceand ensuring a supply of critical raw materials. However, we may not be able toidentify complementary joint venture opportunities or, even once opportunitiesare identified, we may not be able to reach agreement on the terms of theventure with the other venture partners. Additional joint ventures could causeus to incur contingent liabilities or other expenses, any of which couldadversely affect our financial condition and operating results.

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

•     difficulties in managinggeographically disparate operations;

•     difficulties in enforcingagreements through non-U.S. legal systems;

•     unexpected changes inregulatory requirements that may limit our ability to export the ventureproducts or sell into particular jurisdictions or impose multiple conflictingtax laws and regulations;

•     political and economicinstability, civil unrest or war;

•     terrorist activities thatimpact international commerce;

•     difficulties in protectingour intellectual property rights, particularly in countries where the laws andpractices do not protect proprietary rights to as great an extent as do thelaws and practices of the United States;

•     changing laws and policiesaffecting economic liberalization, foreign investment, currency convertibilityor exchange rates, taxation or employment; and

•     nationalizationof foreign owned assets, including intellectual property.

***Intellectual property infringement claims may becostly to resolve and could divert management attention.***

Other companies may holdor obtain patents on inventions or may otherwise claim proprietary rights totechnology necessary to our business. The markets in which we compete arecomprised of competitors who in some cases hold substantial patent portfolioscovering aspects of products that could be similar to ours. We could becomesubject to claims that we are infringing patent, trademark, copyright or otherproprietary rights of others. For example, we have previously been involved intwo separate lawsuits alleging patent infringement, and could in the future beinvolved in similar litigation.

***The semiconductor industry is cyclical and hasexperienced a downturn which has adversely impacted our operating results.***

Our continuing business depends in significant partupon manufacturers of electronic and opto-electronic semiconductor devices, aswell as the current and anticipated market demand for such devices and productsusing such devices. As a supplier to the semiconductor industry, we are subjectto the business cycles that characterize the industry. The timing, length andvolatility of these cycles are difficult to predict. The semiconductor industryhas historically been cyclical because of sudden changes in demand 

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for semiconductors, themanufacturing capacity of these semiconductors and changes in the technologyemployed in the semiconductors. The rate of changes in demand, including enddemand, is high, and the effect of these changes upon us occurs quickly,exacerbating the volatility of these cycles. These changes have affected thetiming and amounts of customers’ purchases and investments in new technology.These industry cycles create pressure on our revenue, gross margin and netincome (loss).

The industry has in the past experienced periods ofoversupply that result in significantly reduced demand and prices forsemiconductor devices and components, including our products, both as a resultof general economic changes and overcapacity. When these periods occur, ouroperating results and financial condition are adversely affected, and create pressureon our revenue, gross margins and net income (loss). Inventory buildups intelecommunications products and slower than expected sales of computerequipment resulted in overcapacity and led to reduced sales by our customers,and therefore reduced purchases of our products. During periods of weak demandsuch as those experienced over the past years, customers typically reducepurchases, delay delivery of products and/or cancel orders of component partssuch as our products.

Increased price competition has resulted, causingpressure on our net sales, gross margin and net income (loss). We experiencedcancellations, price reductions, delays and push outs of orders, which haveresulted in reduced revenues. If the economic downturn occurred again, further ordercancellations, reductions in order size or delays in orders could occur andwould materially adversely affect our business and results of operations.Actions to reduce our costs, such as those we have recently taken, may beinsufficient to align our structure with prevailing business conditions. We maybe required to undertake additional cost-cutting measures, and may be unable toinvest in marketing, research and development and engineering at the levels webelieve are necessary to maintain our competitive position. Our failure to makethese investments could seriously harm our business.

During periods ofincreasing demand for semiconductor devices, we must have sufficientmanufacturing capacity and inventory to meet customer demand, and must be ableto attract, hire, train and retain qualified employees to meet demand. If weare unable to effectively manage our resources and production capacity duringan industry upturn, there could be a material adverse effect on our business,financial condition and results of operations.

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

We must manage ourinventory of component parts, work-in-process, and finished goods effectivelyto meet changing customer requirements, while keeping inventory costs down andimproving gross margins. Some of our products and supplies have in the past andmay in the future become obsolete while in inventory due to changing customerspecifications, or become excess inventory due to decreased demand for ourproducts and an inability to sell the inventory within a foreseeable period.Furthermore, if current costs of production increase or sales prices drop belowthe standard prices at which we value inventory, we may need to take a chargefor a reduction in inventory values. We have in the past, including during2004, had to take inventory valuation and impairment charges. Anyfuture unexpected changes in demand or increases in costs ofproduction that cause us to take additional charges for un-saleable,obsolete or excess inventory, or to reduce inventory values, couldadversely affect our results of operations. charges.

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

Our operating results canvary significantly based upon the impact of changes in global economicconditions on our customers. The revenue growth and profitability of ourbusiness depends on the overall demand for our substrates, and we areparticularly dependant on the market conditions for the wireless, solid-stateillumination, fiber optics and telecommunications industries. Because our salesare primarily to 

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majorcorporate customers whose businesses fluctuate with general economic andbusiness conditions, a softening of demand for products that use oursubstrates, caused by a weakening economy may result in decreased revenues.Customers may find themselves facing excess inventory from earlier purchases,and may defer or reconsider purchasing products due to the downturn in theirbusiness and in the general economy.

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

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

•     impurities in the materialsused;

•     contamination of themanufacturing environment;

•     substrate breakage;

•     equipment failure, poweroutages or variations in the manufacturing process; and

•     performance of personnelinvolved in the manufacturing process.

If our yields decrease,our revenue could decline if we are unable to produce needed product on timewhile our manufacturing costs remain fixed, or could increase. We haveexperienced product shipment delays and difficulties in achieving acceptableyields on both new and older products, and delays and poor yields haveadversely affected our operating results. We may experience similar problems inthe future and we cannot predict when they may occur or their severity. Inparticular, many of our manufacturing processes are new and are still beingrefined, which can result in lower yields.

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

Our success depends on our ability to offer newproducts and product features that incorporate leading technology and respondto technological advances. In addition, our new products must meet customerneeds and compete effectively on quality, price and performance. The lifecycles of our products are difficult to predict because the markets for ourproducts are characterized by rapid technological change, changing customerneeds and evolving industry standards. If our competitors introduce productsemploying new technologies or performance characteristics, our existingproducts could become obsolete and unmarketable. During the past two years, wehave seen our competitors selling more substrates manufactured using a crystalgrowth technology similar to ours, which has eroded our technologicaldifferentiation. Other companies, including Triquent, are actively developingsubstrate materials that could be used to manufacture devices that couldprovide the same high-performance, low-power capabilities as GaAs- andInP-based devices at competitive prices. If these substrate materials orVGF-derived products are successfully developed and semiconductor devicemanufacturers adopt them, demand for our GaAs substrates could decline and ourrevenue could suffer.

The development of newproducts can be a highly complex process, and we may experience delays indeveloping and introducing new products. Any significant delays could cause usto fail to timely introduce and gain market acceptance of new products.Further, the costs involved in researching, developing and engineering newproducts could be greater than anticipated. If we fail to offer new products orproduct enhancements or fail to achieve higher quality products, we may notgenerate sufficient revenue to offset our development costs and other expensesor meet our customers’ requirements.

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

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

•     greater experience in thebusiness;

•     more manufacturingexperience;

•     extensive intellectualproperty;

•     broader name recognition; and

•     significantly greaterfinancial, technical and marketing resources.

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

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

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

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

•     the competition our customersface in their particular industries;

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

•     the financial and otherresources of our customers; and

•     the inability of ourcustomers to sell their products if they infringe third party intellectualproperty rights.

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

***The financial condition of our customers may affecttheir ability to pay amounts owed to us.***

Many of our customers arefacing business downturns that have reduced their cash balances and theirprospects. We frequently allow our customers to pay for products we ship tothem within 30 to 120 days after delivery. Subsequent to our shipping aproduct, some customers have been unable to make payments as due, reducing ourcash balances and causing us to incur charges to allow for a possibility thatsome 

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accountsmight not be paid. During 2004, a customer of one agent filed for bankruptcyprotection. We incurred a charge equal to the amount owed us and believe thatthere is a substantial likelihood that we will not be able to recoup any ofthis amount. Other customers may also be forced to file for bankruptcy. If ourcustomers do not pay their accounts when due, we will be required to incurcharges that would reduce our earnings.

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

We depend on a limitednumber of suppliers for certain raw materials, components and equipment used inmanufacturing our products, including key materials such as quartz tubing,polishing solutions, and paralytic boron nitride. Although several of these rawmaterials are purchased from suppliers in whom we hold an ownership interest,we generally purchase these materials through standard purchase orders and notpursuant to long-term supply contracts and no supplier guarantees supply of rawmaterials or equipment to us. If we lose any of our key suppliers, ourmanufacturing efforts could be significantly hampered and we could be preventedfrom timely producing and delivering products to our customers. We have in thepast experienced delays obtaining critical raw materials and spare parts,including gallium, due to shortages of these materials. Although we hope toalleviate some of these delays and shortages as a result of our interests inour joint ventures, we may experience delays due to shortages of materials andmay be unable to obtain an adequate supply of materials. These shortages anddelays could result in higher materials costs and cause us to delay or reduceproduction of our products. If we have to delay or reduce production, we couldfail to meet customer delivery schedules and our revenue and operating resultscould suffer.

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

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

***Our substrate products have a long qualification cyclethat makes it difficult to plan our expenses and forecast our results.***

Customers typically placeorders with us for our substrate products three months to a year or more afterour initial contact with them. The sale of our products may be subject todelays due to our customers’ lengthy internal budgeting, approval andevaluation processes. During this time, we may incur substantial expenses andexpend sales, marketing and management efforts while the customers evaluate ourproducts. These expenditures may not result in sales of our products. If we donot achieve anticipated sales in a period as expected, we may experience anunplanned shortfall in our revenue. As a result, we may not be able to coverexpenses, causing our operating results to vary. In addition, if a customerdecides not to incorporate our products into its initial design, we may nothave another opportunity to sell products to this customer for many months oreven years. In the current competitive and economic climate, the average salescycle for our products has lengthened even further and is expected to continueto make it difficult to accurately forecast our future sales. We anticipatethat sales of any future substrate products will also have lengthy sales cyclesand will, therefore, be subject to risks substantially similar to thoseinherent in the lengthy sales cycle of our current substrate products.

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

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

Despite our efforts to protect our intellectualproperty, a third party could develop products or processes similar to ours.Our means of protecting our proprietary rights may not be adequate and ourcompetitors may independently develop similar technology, duplicate our productsor design around our patents. We believe that at least two of our competitorshave begun to ship GaAs substrates produced using a process similar to our VGFtechnique. Our competitors may also develop and patent improvements to the VGFtechnology upon which we rely, and thus may limit any exclusivity we enjoy byvirtue of our patents or trade secrets.

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

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

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

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

Our revenue growth depends in part on the expansion ofour international sales and operations. International sales represented 81% and79% of our total revenue for the years ended December 31, 2005 and 2004,respectively. We expect that sales to customers outside the U.S. will continueto represent a significant portion of our revenue, particularly sales tocustomers in Asia.

Currently, an increasing percentage of our sales areto customers headquartered in Asia. Certain manufacturing facilities andsuppliers are also located outside the U.S. Managing our global operationspresents challenges, including periodic regional economic downturns, tradebalance issues, varying business conditions and demands, political instability,variations in enforcement of intellectual property and contract rights indifferent jurisdictions, differences in the ability to develop relationshipswith suppliers and other local businesses, changes in U.S. and internationallaws and regulations including U.S. export restrictions, fluctuations ininterest and currency exchange rates, the ability to provide sufficient levelsof technical support in different locations, cultural differences, shippingdelays and terrorist acts or acts of war, among other risks. Many of thesechallenges are present in China, which 

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represents a largepotential market for semiconductor equipment and where we anticipate significantopportunity for growth. Global uncertainties with respect to: (i) economicgrowth rates in various countries; (ii) sustainability of demand forelectronics products; (iii) capital spending by semiconductormanufacturers; (iv) price weakness for certain semiconductor devices; and (v) politicalinstability in regions where we have operations may also affect our business,financial condition and results of operations.

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

•     changes in tariffs, import orexport restrictions and other trade barriers;

•     unexpected changes inregulatory requirements;

•     longer periods to collectaccounts receivable;

•     changes in export licenserequirements;

•     political and economicinstability;

•     unexpected changes indiplomatic and trade relationships; and

•     foreign exchange ratefluctuations.

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

Also, denominating somesales in Japanese yen subjects us to fluctuations in the exchange rates betweenthe U.S. dollar and the Japanese yen. The functional currencies of our Chinesesubsidiaries are the local currencies. We incur transaction gains or lossesresulting from consolidation of expenses incurred in local currencies for thesesubsidiaries, as well as in translation of the assets and liabilities of theseassets at each balance sheet date. If we do not effectively manage the risksassociated with international sales, our revenue, cash flows and financialcondition could be adversely affected.

***Because of power shortages in China, we may have totemporarily close our China operations, which would adversely impact ourability to manufacture our products, meet customer orders, and result inreduced revenues.***

The Chinese governmentfaced a power crunch over the summer of 2004 and reported that power demand in24 provinces outstripped supply in peak periods during the first four months of2004. Instability in electrical supply caused sporadic outages amongresidential and commercial consumers. As a result, the Chinese governmentimplemented tough measures in 2004 to ease the energy shortage. Provincesimposed power brownouts during 2004 to reduce electricity demand and somecompanies in Beijing were ordered to give their employees a week off to easethe pressure on power supply. The plants, most of which are state-owned, wereclosed and reopened on a staggered schedule to reduce power consumptionduring the capital’s hottest months during 2004. As a result we closed most ofour operations for a week in late July 2004 in conformance with thispolicy. Although shortages requiring closure of facilities did not occurduring summer 2005, if we are required to make additional temporary closures ofour Beijing and joint venture operations at any time during 2006, we may beunable to manufacture our products, and would then be unable to meet customerorders except from inventory on hand. As a result, we could lose sales,adversely impacting our revenues, and our relationships with our customers couldsuffer, impacting our ability to generate future sales. In addition, if poweris shut off at our Beijing operations at any time, either voluntarily or as aresult of unplanned brownouts, during certain phases of our manufacturingprocess including our crystal growth phase, the work in process may be ruinedand rendered unusable, causing us to incur expense that will not be covered byrevenue, and negatively impacting our cost of goods sold and 

21

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grossmargins. We are attempting to partially mitigate the potential effects of poweroutages by building inventory in anticipation of power outages during thesummer. This inventory build is prepared to accommodate forecast demand ratherspecific customer orders. If the inventory we build is not ordered by customers,we may have to scrap these products and incur a cost which will reduce ourgross margins.

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

The requirements adopted by the Securities andExchange Commission, or SEC, in response to the passage of the Sarbanes-OxleyAct of 2002 will require annual review and evaluation of our internal controlsystems, and an attestation of these systems by our independent registeredpublic accounting firm beginning with our fiscal year ending December 31,2007. This may be due earlier beginning with our fiscal year ending December 31,2006 if our market capitalization increases above $75 million on thedetermining date on June 30, 2006. We are currently reviewing our internalcontrol procedures and considering further documentation of such proceduresthat may be necessary. We are currently evaluating the extent to which any ofour joint ventures may also be required to comply, if at all. We can give noassurances that our systems will satisfy the new requirements of the Securitiesand Exchange Commission, or if required, that any of the systems of our joint ventureswill meet such requirements, or that we will receive a favorable review andattestation by our independent registered public accounting firm.

In addition, the shift of our manufacturing operationsto China has placed and continues to place a significant strain on ouroperations and management resources. We have upgraded our inventory controlsystems and may implement additional systems relating to consolidation of ourfinancial results, but continue to rely on certain manual processes in our operationsand in connection with consolidation of our financial results. If we fail tomanage these changes effectively, our operations may be disrupted.

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

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

In order to comply with rules andregulations adopted pursuant to the Sarbanes-Oxley Act of 2002 by the SEC, aswell as changes to listing standards adopted by NASDAQ, and accounting changesadopted affecting accounting for stock-based compensation we may be required toincrease our internal controls, hire additional personnel and additionaloutside legal, accounting and advisory services, all of which will cause ourgeneral and administrative costs to increase. Insurers may increase premiums asa result of the high claims rates they incurred over the past year. Changes inthe accounting rules, including legislative and other rules to account foremployee stock options as a compensation expense among others, could materiallyincrease the expense that we report under generally accepted accountingprinciples and adversely affect our operating results.

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***If we fail to manage periodic contractions, we mayutilize our cash balances and our existing cash and cash equivalent balancescould decline.***

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

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

Our financial performance may be affected by changesin China’s political, social and economic environment. The role of the Chinesecentral and local governments in the Chinese economy is significant. Chinesepolicies toward economic liberalization, and laws and policies affectingtechnology companies, foreign investment, currency exchange rates and other matterscould change, resulting in greater restrictions on our ability to do businessand operate our manufacturing facilities in China. Any imposition of surchargesor any increase in Chinese tax rates could hurt our operating results. TheChinese government could revoke, terminate or suspend our license for nationalsecurity and similar reasons without compensation to us. If the government ofChina were to take any of these actions, we would be prevented from conductingall or part of our business. Any failure on our part to comply withgovernmental regulations could result in the loss of our ability to manufactureour products in China.

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

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

In July 2005, thePeople’s Republic of China agreed to a shift in Chinese currency policy andestablished a 2% revaluation of the renminbi, and the renminbi will now bereferenced to a basket of currencies, with a daily trading band of +/-0.3%.Depending on market conditions and the state of the Chinese economy, it ispossible that China will make more adjustments in the future. Over the nextfive to ten years, China may move to a managed float system, with opportunisticinterventions. This reserve diversification may negatively impact the UnitedStates dollar and U.S. interest rates, which could in turn negatively impactthe Company’s operating results and financial condition. A significant percentageof our sales are made to customers located outside of the United States,particularly Asia. Our sales are denominated in U.S. dollars, except for salesto our Japanese and some Taiwanese customers, which are denominated in Japaneseyen. Thus, increases in the value of the U.S. dollar could increase the priceof our products in non-U.S. markets and make our products more expensive thancompetitors’ products in these markets. The functional currencies of ourChinese subsidiaries, including our joint ventures, are the local currency;since most of our operations are conducted in China, many of our costs areincurred in Chinese currency, which subjects us to fluctuations in the exchangerates between the U.S. dollar and the Chinese renminbi. We incur transactiongains or losses resulting from consolidation of expenses incurred in localcurrencies for these subsidiaries, as well as in translation of the assets andliabilities of these assets 

23

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at eachbalance sheet date. These risks may be increased by the fluctuation andrevaluation of the Chinese renminbi. If we do not effectively manage the risksassociated with this currency risk, our revenue, cash flows and financialcondition could be adversely affected.

***A reoccurrence of Severe Acute Respiratory Syndrome (SARS)or the outbreak of a different contagious diseasesuch as the Avian Flu mayadversely impact our manufacturing operations and some of our key suppliers andcustomers.***

The majority of oursubstrate manufacturing activities are conducted in China. In addition, wesource key raw materials, including gallium, from our joint ventures and othersuppliers in China. The 2003 SARS outbreak was most notable in China and asmall number of cases were reported in 2004. One employee at our LED productionfacility in China contracted SARS in late April 2003 prompting us to closethe facility for ten days. There was no significant impact to our ability tofill customer orders. If there were to be another outbreak of SARS or adifferent contagious disease, such as Avian Flu, and if our employeescontracted the disease, we may be required to temporarily close ourmanufacturing operations. Similarly, if one of our key suppliers is required toclose for an extended period, we may not have enough raw material inventory to continuemanufacturing operations. In addition, while we possess management skills amongour China staff that enable us to maintain our manufacturing operations withminimal on-site supervision from our US-based staff, our business could also beharmed if travel to or from Asia and the United States is restricted orinadvisable, as it was during parts of 2003. None of our substrate competitorsis as dependent on manufacturing facilities in China as we are. If ourmanufacturing operations were closed for a significant period, we could loserevenue and market share during that period which would depress our financialperformance and could be difficult to recapture. Finally, if one of our keycustomers is required to close for an extended period, we may not be able toship product to them, our revenue would decline and our financial performancewould suffer.

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

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

***If any of our facilities is damaged by actions such asfire, explosion, or natural disaster, we may not be able to manufacture ourproducts.***

The ongoing operation ofour manufacturing and production facilities in China is critical to our abilityto meet demand for our products. If we are not able to use all or a significantportion of our facilities for prolonged periods for any reason, we will not beable to manufacture products for our customers. For example, a naturaldisaster, fire or explosion caused by our use of combustible chemicals and hightemperatures during our manufacturing processes would render some or all of ourfacilities inoperable for an indefinite period of time. Actions outside of ourcontrol, such as earthquakes, could also damage our facilities, rendering theminoperable. If we are unable to operate our facilities and manufacture ourproducts, we will lose customers and revenue and our business will be harmed.

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

We have not over the past year been able to sustaingrowth, and may not be able to return to historic growth levels in the currenteconomic environment. Our net loss in 2002 was the largest in our history andour losses continued during 2003, 2004, and 2005.

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

•     our ability to develop,manufacture and deliver high quality products in a timely and cost-effectivemanner;

•     decline in general economicconditions or downturns in the industry in which we compete;

•     fluctuations in demand forour products;

•     expansion of our manufacturingcapacity;

•     expansion of our operationsin China;

•     limited availability andincreased cost of raw materials;

•     the volume and timing oforders from our customers, and cancellations, push outs and delays of customerorders;

•     fluctuation of ourmanufacturing yields;

•     decreases in the prices ofour competitors’ products;

•     costs incurred in connectionwith any future acquisitions of businesses or technologies; and

•     increases in our expenses,including expenses for research and development.

Due to these factors, we believe that period-to-periodcomparisons of our operating results may not be meaningful indicators of ourfuture performance. Our operating results have over the past year at times beenbelow the expectations of securities analysts or investors. If this occursagain in future periods, the price of our common stock could decline orfluctuate.

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

***Our stock price has been and may continue to bevolatile.***

Our stock price hasfluctuated significantly since we began trading on the NASDAQ National Market.For the year ended December 31, 2005, the high and low closing salesprices of our common stock were $2.47 and $1.08, respectively. A number offactors could cause the price of our common stock to continue to fluctuatesubstantially, including:

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

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

•     announcements oftechnological innovations by us or our competitors;

•     new product introduction byus or our competitors;

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•     large customer orders ororder cancellations; and

•     the operating and stock priceperformance of comparable companies.

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

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

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

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

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

•     the division of our board ofdirectors into three separate classes, each with three year terms;

•     the right of our board toelect a director to fill a space created by a board vacancy or the expansion ofthe board;

•     the ability of our board toalter our bylaws;

•     the ability of our board toauthorize the issuance of up to 2,000,000 shares of blank check preferredstock; and

•     the requirement that only ourboard or the holders of at least 10% of our outstanding shares may call aspecial meeting of our stockholders.

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

•     662¤3% of theshares of voting stock not owned by these large stockholders approve the mergeror combination, or

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

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

None.

**Item 2.****                        *Properties***

Ourprincipal properties as of February 21, 2006 are as follows:

| Location       | ** ** | ** ** | ** ** | **Square  Feet**               | ** ** | **Principal Use**                                                                  | ** ** | **Ownership** |
|----------------|------------|------------|------------|--------------------------------|------------|------------------------------------------------------------------------------------|------------|---------------|
| Fremont, CA    |       | 80,000     |       | Vacant                         |       | Owned                                                                              |
| Fremont, CA    |       | 24,100     |       | Warehouse                      |       | Operating lease, expires  July 2006                                           |
| Fremont, CA    |       | 55,000     |       | Production and  Administration |       | Operating lease, expires  March 2013                                          |
| El Monte, CA   |       | 5,600      |       | Vacant                         |       | Operating lease, expires  December 2006                                       |
| Beijing, China |       | 31,000     |       | Production and Administration  |       | Owned                                                                              |
| Beijing, China |       | 31,000     |       | Production                     |       | Owned                                                                              |
| Beijing, China |       | 32,000     |       | Production                     |       | Owned                                                                              |
| Beijing, China |       | 16,000     |       | Housing                        |       | Owned                                                                              |
| Beijing, China |       | 34,000     |       | Production                     |       | Owned                                                                              |
| Beijing, China |       | 48,000     |       | Production                     |       | Owned                                                                              |
| Beijing, China |       | 22,000     |       | Production and  Administration |       | Owned                                                                              |
| Beijing, China |       | 53,000     |       | Production                     |       | Owned                                                                              |
| Xianxi, China  |       | 56,500     |       | Production                     |       | Owned by Beijing Ji Ya  Semiconductor Materials, Co., Ltd.*                        |
| Xianxi, China  |       | 7,500      |       | Administration                 |       | Owned by Beijing Ji Ya  Semiconductor Materials, Co., Ltd.*                        |
| Xianxi, 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 Co., Ltd.* |

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*                    Joint venturesin which we hold an interest of between 25 percent and 83 percent.

We consider each facility to be in good operatingcondition and adequate for its present use, and believe that each facility hassufficient plant capacity to meet its current and anticipated operatingrequirements. We do not intend to renew the operating leases of properties inFremont and El Monte, California, that expire in 2006, as we are no longerusing such facilities.

**Item 3.**                        *Legal Proceedings*

On October 15, 2004, a purported securities classaction lawsuit was filed in the United States Court for the Northern Districtof California. City of Harper Woods Employees Retirement System v. AXT, Inc.et al., No. C 04 4362 MJJ. The Court consolidated the case with a subsequentrelated case and appointed a lead plaintiff. On April 5, 2005, the leadplaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc.et al., No. C 04 4362 MJJ. The lawsuit complaint names AXT, Inc. andour chief technology officer, as defendants, and is brought on behalf of aclass of all purchasers of our securities from 

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February 6, 2001through April 27, 2004. The complaint alleges that we announced financialresults during this period that were false and misleading. No specific amount ofdamages is claimed. On September 23, 2005, the Court granted our motion todismiss the complaint, with leave to amend*.*Leadplaintiff filed an amended complaint, which we have moved to dismiss. Webelieve that there are meritorious defenses against this litigation and intendto vigorously defend it. However, due to the inherent uncertainties oflitigation, we cannot accurately predict the ultimate outcome of thelitigation. Any unfavorable outcome of the litigation could have an adverseimpact on our business, financial condition and results of operations.

On June 1, 2005, a lawsuit was filed in theSuperior Court of California, County of Alameda, *Zhao et. Al.vs. American Xtal Technology, et. al.*, No. R 605215713. Thelawsuit complaint names as defendants AXT, its chief technology officer, itsformer interim chief executive officer, a former safety department employee anda supplier to AXT. The lawsuit is brought on behalf of two former employees andtheir minor child. The complaint alleges personal injury, general negligence,intentional tort, wage loss and other damages, including punitive damages, as aresult of exposure to the child while in utero to high levels of galliumarsenide and methanol used in the production of gallium arsenide wafers.

We believe that there aremeritorious defenses against this litigation and intend to vigorously defend it.AXT’s commercial general liability insurance carrier has agreed to fund AXT’sdefense of the case, but has reserved the right to deny coverage, in whole or inpart, in the future under selected policy provisions and applicable law. Thereis $21 million in available limits under the policies in question. Due to theinherent uncertainties of litigation, we cannot accurately predict the ultimateoutcome of the litigation. Any unfavorable outcome of the litigation could havean adverse impact on our business, financial condition and results ofoperations.

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

None.

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**PART II**

**Item5.**                        *Market for Registrant’s Common Equity, Related Stockholder Matters andIssuer Purchases of Equity Securities*

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

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2005**       |       |     |       |    |       |
| First Quarter  |       | $        | 1.57       |    | $          | 1.10 |   |
| Second Quarter |       | $        | 1.42       |    | $          | 1.08 |   |
| Third Quarter  |       | $        | 1.65       |    | $          | 1.14 |   |
| Fourth Quarter |       | $        | 2.47       |    | $          | 1.21 |   |
| **2004**       |       |     |       |    |       |
| First Quarter  |       | $        | 4.68       |    | $          | 3.00 |   |
| Second Quarter |       | $        | 3.57       |    | $          | 1.73 |   |
| Third Quarter  |       | $        | 1.97       |    | $          | 1.05 |   |
| Fourth Quarter |       | $        | 2.04       |    | $          | 1.37 |   |

 

As of December 31, 2005, there were 102 holdersof record of our common stock. Because many shares of AXT’s common stock are heldby brokers and other institutions on behalf of stockholders, we are unable toestimate the total number of stockholders.

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

**IssuerPurchases of Equity Securities**

Duringthe three-month period ended December 31, 2005, we did not repurchase anyshares of our common stock. During the twelve-month period ended December 31,2005, we repurchased the following shares of our common stock:

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

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(1)          Pursuant to a Planpublicly announced on August 25, 2004 and extended in July, 2005, inaccordance with Rule 10b5-1 of the Securities Exchange Act of 1934to provide for the repurchase of up to $2 million of the Company’s commonstock. Repurchases will be made from time to time in the open market during thetwelve-month period ending July 31, 2006, at prevailing market prices.Repurchases 

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will be made under theprogram using the Company’s own cash resources. As of December 31, 2005,we had 22,977,301 shares of common stock outstanding and 201,516 wererepurchased in 2005 under this program.

**Item6.**                        *Selected Consolidated Financial Data*

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

| ** **                                                                  | ** ** | **Years Ended December 31,**                        | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                  | ** ** | **(in thousands, except per share data)** | ** ** |
| **Income Statement Data:**                                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue                                                                     |       | $                                                                  | 26,536     |   | $ | 35,454 |   | $ | 34,713 |   | $ | 44,865 |   | $ | 108,800 |   |
| Cost of revenue                                                             |       | 24,337                                                             |       | 35,705 |   | 32,478 |   | 53,758 |   | 67,494 |   |
| Gross profit  (loss)                                                        |       | 2,199                                                              |       | (251 | ) | 2,235 |   | (8,893 | ) | 41,306 |   |
| Operating expenses:                                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Selling, general, and administrative                                        |       | 12,955                                                             |       | 11,561 |   | 10,475 |   | 13,860 |   | 17,208 |   |
| Research and development                                                    |       | 1,723                                                              |       | 1,479 |   | 1,337 |   | 2,339 |   | 3,876 |   |
| Impairment charges                                                          |       | —                                                             |       | 210 |   | — |   | 14,632 |   | — |   |
| Restructuring costs                                                         |       | 836                                                                |       | 1,308 |   | — |   | — |   | — |   |
| Total operating expenses                                                    |       | 15,514                                                             |       | 14,558 |   | 11,812 |   | 30,831 |   | 21,084 |   |
| Income (loss)  from operations                                              |       | (13,315                                                            | )          | (14,809 | ) | (9,577 | ) | (39,724 | ) | 20,222 |   |
| Interest income,  net                                                       |       | 516                                                                |       | 262 |   | 172 |   | 2,746 |   | 1,847 |   |
| Other (income)  and expense, net                                            |       | (910                                                               | )          | (94 | ) | 1,688 |   | 15,886 |   | 16,057 |   |
| Income (loss)  from continuing operations before provision for income taxes |       | (13,709                                                            | )          | (14,453 | ) | (11,093 | ) | (52,864 | ) | 6,012 |   |
| Provision  (benefit) for income taxes                                       |       | (950                                                               | )          | 71 |   | — |   | 2,119 |   | 2,164 |   |
| Income (loss)  from continuing operations                                   |       | (12,759                                                            | )          | (14,524 | ) | (11,093 | ) | (54,983 | ) | 3,848 |   |
| Discontinued operations:                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Gain (loss) from discontinued operations                                    |       | 544                                                                |       | 472 |   | (6,163 | ) | (34,625 | ) | (13,818 | ) |
| Gain (loss) on disposal                                                     |       | —                                                             |       | 419 |   | (9,475 | ) | — |   | — |   |
| Benefit for income taxes                                                    |       | —                                                             |       | — |   | — |   | (8,427 | ) | (4,974 | ) |
| Gain (loss) from  discontinued operations                                   |       | 544                                                                |       | 891 |   | (15,638 | ) | (26,198 | ) | (8,844 | ) |
| Net loss                                                                    |       | $                                                                  | (12,215    | ) | $ | (13,633 | ) | $ | (26,731 | ) | $ | (81,181 | ) | $ | (4,996 | ) |
| Basic and diluted income  (loss) per share:                                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations                                    |       | $                                                                  | (0.56      | ) | $ | (0.64 | ) | $ | (0.49 | ) | $ | (2.46 | ) | $ | 0.17 |   |
| Gain (loss) from discontinued operations                                    |       | 0.02                                                               |       | 0.04 |   | (0.69 | ) | (1.17 | ) | (0.40 | ) |
| Net loss                                                                    |       | $                                                                  | (0.54      | ) | $ | (0.60 | ) | $ | (1.18 | ) | $ | (3.63 | ) | $ | (0.23 | ) |
| Shares used in per share  calculations:                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                       |       | 23,047                                                             |       | 23,063 |   | 22,781 |   | 22,433 |   | 22,278 |   |
| Diluted                                                                     |       | 23,047                                                             |       | 23,063 |   | 22,781 |   | 22,433 |   | 22,879 |   |

 

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| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                     | ** ** |
| **Balance Sheet Data:**                          |       |                                        |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                       |       | $                                           | 17,472     |   | $ | 12,117 |   | $ | 24,339 |   | $ | 13,797 |   | $ | 37,538 |   |
| Short-term  investments                          |       | 5,555                                       |       | 20,062 |   | 14,669 |   | 8,205 |   | 25,673 |   |
| Working capital                                  |       | 36,347                                      |       | 46,141 |   | 57,335 |   | 65,375 |   | 125,295 |   |
| Restricted  deposits                             |       | 7,450                                       |       | 8,215 |   | 9,302 |   | 11,150 |   | — |   |
| Long-term  investments                           |       | —                                      |       | — |   | — |   | 3,657 |   | 6,552 |   |
| Total assets                                     |       | 74,798                                      |       | 87,540 |   | 107,023 |   | 145,667 |   | 243,359 |   |
| Long-term capital  lease, net of current portion |       | —                                      |       | — |   | — |   | 4,847 |   | 10,002 |   |
| Long-term debt,  net of current portion          |       | 7,420                                       |       | 7,880 |   | 8,842 |   | 13,289 |   | 14,342 |   |
| Stockholders’ equity                        |       | 55,618                                      |       | 68,017 |   | 82,298 |   | 105,657 |   | 186,322 |   |
|                                                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

All periods have been restated to reflect theaccounting for discontinued operations. As a result, the discontinuedopto-electronics and consumer products divisions have been eliminated fromcontinuing operations in the statements of operations.

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**Item 7.****                        *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations***

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

**CriticalAccounting Policies and Estimates**

We have prepared our consolidated financial statementsin accordance with accounting principles generally accepted in the UnitedStates of America. Accordingly, we have had to make estimates, assumptions andjudgments that affect the amounts reported on our consolidated financialstatements. These estimates, assumptions and judgments about future events andtheir effects on our results cannot be determined with certainty, and are madebased upon our historical experience and on other assumptions that are believedto be reasonable under the circumstances. These estimates may change as newevents occur or additional information is obtained, and we may periodically befaced with uncertainties, the outcomes of which are not within our control andmay not be known for a prolonged period of time.

We have identified thepolicies below as critical to our business operations and understanding of ourfinancial condition and results of operations. A critical accounting policy isone that is both material to the presentation of our consolidated financialstatements and requires us to make difficult, subjective or complex judgmentsthat could have a material impact on our consolidated financial statements.Different estimates that we could have used, or changes in the estimates thatare reasonably likely to occur, may have a material impact on our financialcondition or results of operations. We also refer you to our “The Company andSummary of Significant Accounting Policies” discussed in the accompanying notesto our consolidated financial statements included elsewhere in this Form 10-K.

***Revenue Recognition***

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

We provide for futurereturns based on historical experience, current economic trends and changes incustomer demand at the time revenue is recognized. In the first quarter of2004, we recorded a reserve for sales returns of $745,000 related to ourfailure to follow certain testing requirements and provision of testing dataand information to certain customers. This reserve was based on discussionswith some of the affected customers and review of specific shipments.Approximately $487,000 of the $745,000 sales returns reserve has been utilizedand approximately $205,000 has been reversed to revenue as of December 31,

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2005 aswe favorably resolved an outstanding matter with a customer. We will continueto monitor the returns for this specific reserve. See further discussion in “Resultsof Operations” below.

***Allowance for Doubtful Accounts***

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

In previous years, three of our customers had filedfor bankruptcy protection. Upon notification of the bankruptcy, we immediatelystopped shipping orders to these customers other than on payment in advance. Atthat time, the outstanding balances of these customers had been fully reserved.The related accounts receivable balances and reserve were subsequently writtenoff in November 2004 when we finally determined that the balances wereuncollectible. This determination was made as a result of our unsuccessfulefforts to collect these accounts receivable, the significant length of timethat the receivables balance was outstanding, and the unlikelihood that wewould collect the balances from the bankrupt’s estate. As of December 31,2005, our accounts receivable balance was $5.2 million, which was net of anallowance for doubtful accounts of $533,000. From our allowance for doubtfulaccounts of $537,000 as of December 31, 2004, we wrote off $68,000 offully reserved accounts receivable for a Korean customer and decreased theallowance by $343,000 due to improved collections mainly from a Japanesecustomer, while increasing the allowance for a large customer in China of$396,000, and other doubtful accounts of $11,000, resulting in the allowancefor doubtful accounts of $533,000 as of December 31, 2005. If actualuncollectible accounts differ substantially from our estimates, revisions tothe estimated allowance for doubtful accounts would be required, which couldhave a material impact on our financial results for the period.

The allowance for salesreturns is also deducted from gross accounts receivable. From our allowance forsales returns of $550,000 as of December 31, 2004, we utilized $487,000for investigation related returns, while increasing  the allowance for sales returns based on ourhistory of sales returns $23,000 resulting in the allowance for sales returnsof $86,000 as of December 31, 2005. The total allowances deducted fromgross accounts receivable as of December 31, 2005 is $619,000, compared to$1,087,000 as of December 31, 2004.

***Warranty Reserve***

We maintain a warrantyreserve based upon our claims experience during the prior twelve months.Warranty costs are accrued at the time revenue is recognized. As of December 31,2005, accrued product warranties totaled $120,000. If actual warranty costsdiffer substantially from our estimates, revisions to the estimated warrantyliability would be required, which could have a material impact on ourfinancial condition and results of operations.

***Inventory Valuation***

Inventories are stated atthe lower of cost or market. Cost is determined using the weighted average costmethod. Our inventory consists of raw materials as well as finished goods andwork-in-process that include material, labor and manufacturing overhead costs.Given the nature of our substrate products, and the materials used in the manufacturingprocess, the wafers and ingots comprising work-in-process may be held ininventory for up to two years and three years, respectively, as the risk ofobsolescence for these materials is low. We routinely evaluate the levels ofour inventory in light of current market conditions in order to identify excessand obsolete inventory and provide a valuation allowance for certaininventories 

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basedupon the age and quality of the product and the projections for sale of thecompleted products. As of December 31, 2005, we had an inventory reserveof $16.9 million. If actual demand for our products were to be substantiallylower than estimated, additional inventory adjustments for excess or obsoleteinventory might be required, which could have a material impact on ourbusiness, financial condition and results of operations.

***Impairment of Investments***

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

We invest in equityinstruments of privately-held companies for business and strategic purposes.These investments are classified as other assets and are accounted for underthe cost method as we do not have the ability to exercise significant influenceover their operations. We monitor our investments for impairment and recordreductions in carrying value when events or changes in circumstances indicatethat the carrying value may not be recoverable. Determination of impairment ishighly subjective and is based on a number of factors, including an assessmentof the strength of investee’s management, the length of time and extent towhich the fair value has been less than our cost basis, the financial conditionand near-term prospects of the investee, fundamental changes to the businessprospects of the investee, share prices of subsequent offerings, and our intentand ability to hold the investment for a period of time sufficient to allow forany anticipated recovery in our carrying value.

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

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

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***Employee Stock Options***

We believe that employeestock options represent an appropriate and essential component of our overallcompensation program. We grant options to substantially all managementemployees and believe that this broad-based program helps us to attract,motivate, and retain high quality employees, to the ultimate benefit of ourstockholders. We currently account for share-based payments to employees usingthe intrinsic value method under Accounting Principles Board (“APB”) OpinionNo. 25, *“Accounting for Stock Issued toEmployees,”* and related interpretations thereof  and, as such, generally recognize nocompensation cost for employee stock options. We will adopt Statement ofFinancial Accounting Standards No. 123 (revised), “Share-Based Payment”(SFAS 123R) beginning January 1, 2006. The adoption of SFAS 123R isexpected to result in a material increase in expense during 2006 based onunvested options outstanding as of December 31, 2005 and currentcompensation plans. While the effect of adoption depends on the level ofshare-based payments granted in the future and unvested grants on the date weadopt SFAS 123(R), the effect of this accounting standard on our prioroperating results would approximate the effect of Statement of Financial AccountingStandards (“SFAS”) No. 123, *“Accountingfor Stock-Based Compensation,”* as amended by SFAS No. 148, *“Accounting for Stock-Based Compensation Transitionand Disclosure,”* as describedin the disclosure of pro forma net loss and net loss per share. See “Note 1—TheCompany and Summary of Significant Accounting Policies” of the notes toconsolidated financial statements.

***Income Taxes***

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

We provide for income taxes based upon the geographiccomposition of worldwide earnings and tax regulations governing each region,particularly China. The calculation of tax liabilities involves significantjudgment in estimating the impact of uncertainties in the application ofcomplex tax laws, particularly in foreign countries such as China.

**Results of Operations**

***Overview***

We were founded in 1986 tocommercialize and enhance our proprietary vertical gradient freeze (VGF)technique for producing high-performance compound semiconductor substrates. Wehave one operating segment: our substrate business, with limited additional rawmaterials sales. We recorded our first substrate sales in 1990 and oursubstrate division currently sells gallium arsenide (GaAs) and indium phosphide(InP) substrates to manufacturers of semiconductor devices for use inapplications such as fiber optic and wireless telecommunications, lightemitting diodes (LEDs) and lasers. We also sell raw materials including galliumand germanium through our participation in majority- and minority-owned jointventures. We had the capability to manufacture germanium substrates for use insatellite solar cells but withdrew from this business during 2000 so that wecould more profitably use our then constrained capacity. We are now trying tore-qualify our germanium substrates with the few existing satellite solar cellsystem manufacturers.

***Continuing Operations***

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

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In 2003, we believed that the wireless communicationsand HBLED markets grew, but our revenue did not increase until the fourthquarter of 2003 due to continued reductions in prices, and time required toimprove our substrate surface quality and regain some lost customers. Revenuefor 2003 fell by $10.2 million, or 22.6% compared with 2002. We recordednet losses in each quarter of 2003. During 2003, we continued to shift more ofour manufacturing operations to China and reduced our costs incurred in theUnited States.

In 2004, our revenue increased $0.7 million ascompared to 2003, primarily as a result of increased demand for HBLEDs.

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

As a result of the weaknesses identified, in the firstquarter of 2004 we increased our sales return reserve by $745,000, based on ourbest estimate of future returns related to this matter. Approximately $487,000of the $745,000 sales returns reserve had been utilized and approximately$205,000 has been reversed to revenue as of December 31, 2005 as wefavorably resolved an outstanding matter with a customer. This reserve wasbased, in part, on discussion with affected customers. The amount of thereserve was determined in part based upon the amount of our historical productreturns, payment history of prior period receivables, discussions withcustomers concerning the non-compliant product and testing data, and estimatedlevels of our product maintained by customers, and likelihood that productspreviously shipped would be returned to us.

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

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

With the new managementteam in place, quality, quality systems and revenue began to improve beginningthe third quarter of 2005. In December 2005, we continued to execute ourworkforce reduction in our Fremont, California facility and accordingly we willeliminate approximately 15 positions in California over the following 120 days.See further discussion under “Restructuring Charges” below.

***Discontinued Opto-Electronics Business***

In June 2003, we announced the discontinuation ofour opto-electronics division, which we had established as part of ouracquisition of Lyte Optronics, Inc. in May 1999. The discontinuedopto-electronics division manufactured blue, cyan, and greenhigh-brightness light emitting diodes (HBLEDs) for the illumination markets,including full-color displays, wireless handset backlighting and 

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traffic signals, and alsomanufactured vertical cavity surface emitting lasers (VCSELs) and laser diodesfor fiber optic communications and storage area networks. Accordingly, theresults of operations of the opto-electronics division have beensegregated from continuing operations and are reported separately asdiscontinued operations in our consolidated statements of operations for allperiods presented. See Note 2 to our consolidated financial statements fordetails regarding the accounting for discontinued operations.

In September 2003, we completed the sale ofsubstantially all of the assets of our opto-electronics business to LumeiOptoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group,Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. A portionof the purchase price equal to $1.0 million was held in escrow to satisfy anyclaims that the purchasers might make for breaches of representations orwarranties by us. Of this total escrow, $750,000 could be released after theone year anniversary of the sale of the opto-electronics business and theremainder could be released after the second anniversary of the sale. To date,we have resolved all claims made against the $1.0 million that was held inescrow. For the year ended December 31, 2005 we recorded $550,000 gainsfrom escrow, $9,000 gain from interest, and $58,000 in property tax refunds.

In June 2005, wecompleted the sale of a building located in Monterey Park, California. Thisasset had been classified as “assets held for sale” in the amount of $1.25million on the consolidated balance sheet as of December 31, 2004. Wereceived net proceeds on the sale of the property of approximately $1.3 millionand accordingly recorded a gain on disposal of $53,000.

***Impairment***

***Inventory Impairment***

In September 2004, wewrote down $2.1 million of obsolete inventory. The wafers and ingots comprisingthe written-down inventory had been manufactured within the prior two and threeyears, respectively. During the third quarter of 2004, it became apparent thatour revenues were likely to continue to decline in the fourth and subsequentquarters due to the need to re-qualify our products with several customers.Furthermore, many new orders were for products with specifications thatdiffered from the features of the products held in inventory. In accordancewith our policy, we evaluated the levels of our inventory, and determined thatin light of current market conditions, we had excess and obsolete inventorybased upon its age and quality, and that the inventory exceeded the salesprojections as revised. Accordingly, we established a reserve for the excess.The majority of this inventory has not been scrapped. There were no significantinventory impairments for the year ended December 31, 2005.

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***Other Impairment***

In thethird quarter of 2004, we recorded an impairment charge of $210,000 to writedown the value of our investment in a private company. We made the decision towrite down the investment as a result of the declining financial position ofthe investee, evidenced by an audit opinion with a going concern explanatoryparagraph received by the investee. The $210,000 was the remaining balance ofthis investment. No further write-downs were recorded in 2005.

***Revenue***

| ** **                 | ** ** | ** **                             | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|----------------------------|------------|----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                 | ** ** | **Year Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ($ in thousands) | ** ** | **2005**                               | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| GaAs                       |       | $                                      | 20,831     |                       | $          | 27,272                     |       | $ | 28,354 |   |   | $ | (6,441 | ) |   |   | -23.6 | % |   |   | $ | (1,082 | ) |   |   | -3.8 | % |   |
| InP                        |       | 906                                    |       | 1,588                      |       | 2,075                      |       |   | (682 | ) |   |   | -42.9 | % |   |   | (487 | ) |   |   | -23.5 | % |   |
| Raw Materials              |       | 4,794                                  |       | 6,499                      |       | 4,118                      |       |   | (1,705 | ) |   |   | -26.2 | % |   |   | 2,381 |   |   |   | 57.8 | % |   |
| Other                      |       | 5                                      |       | 95                         |       | 166                        |       |   | (90 | ) |   |   | -94.7 | % |   |   | (71 | ) |   |   | -42.8 | % |   |
| Total revenue              |       | $                                      | 26,536     |                       | $          | 35,454                     |       | $ | 34,713 |   |   | $ | (8,918 | ) |   |   | -25.2 | % |   |   | $ | 741 |   |   |   | 2.1 | % |   |

 

Revenue decreased $8.9 million or 25.2%, to $26.5million in 2005 compared to $35.5 million in 2004. Total GaAs substrate revenuedecreased $6.4 million, or 23.6%, to $20.8 million in 2005 compared to $27.2 millionin 2004. Overall sales of smaller diameter GaAs substrates decreased $7.2million due to the earlier quality issues, the continuing pricing pressurescausing prices to decline, overall lower demand from our wireless applicationcustomers and a decline in orders from customers who were qualifying our China-grownproducts. On the other hand, sales of larger diameter GaAs substrates, whichwere used exclusively to manufacture electronic devices, increased $1.4 millioncompared to 2004 due to an increase in orders from customers who have qualifiedour China-grown products. InP substrate revenue decreased $0.7 million, or42.9%, to $0.9 million in 2005 compared to $1.6 million in 2004. InP substrateswere used almost exclusively for telecommunications applications. The decreasein GaAs and InP substrate revenue was due to the pricing pressures causingprices to decline and overall lesser demand from our telecommunications andwireless application customers. Raw material sales decreased $1.7 million, or26.2%, to $4.8 million in 2005 compared to $6.5 million in 2004. The decreasein raw material sales was due to customers’ lower demand, particularly for rawgallium and germanium dioxide.

Revenue from continuing operations increased $741,000,or 2.1%, to $35.5 million in 2004 compared to $34.7 million in 2003. Total GaAssubstrate revenue decreased $1.1 million, or 3.8%, to $27.3 million in 2004compared to $28.4 million in 2003. Sales of 5 inch and 6 inch diameter GaAssubstrates, which were used exclusively to manufacture electronic devices,decreased $1.9 million, or 36.1%, to $3.5 million in 2004 compared to $5.4million in 2003. InP substrate revenue decreased $0.5 million, or 23.5%, to$1.6 million in 2004 compared to $2.1 million in 2003. The decrease inGaAs and InP substrate revenue was due to the pricing pressures causing pricesto decline and overall lesser demand from our telecommunications and wirelessapplication customers. Raw material sales increased $2.4 million, or 57.8%, to$6.5 million in 2004 compared to $4.1 million in 2003. The increase in rawmaterial sales was due to customers’ higher demand, particularly for rawgallium and germanium dioxide.

Two customers representedgreater than 10% of revenue, totaling 20.7% for the year ended December 31,2005. No customer represented greater than 10% of product revenues for theyears ended December 31, 2004 and 2003. Our top five customers represented37.5%, 30.1%, and 28.9% of product revenue for the years ended December 31,2005, 2004, and 2003, respectively.

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***Revenue byGeographic Region***

| ** **                                 | ** ** | ** **                              | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|--------------------------------------------|------------|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
|                                            | ** ** | **2005**                                | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                 | ** ** | **($ in thousands)**          | ** ** |
| North America*                             |       | $                                       | 5,168      |                       | $          | 7,514                      |       | $ | 12,009 |   |   | $ | (2,346 | ) |   |   | (31.2 | )% |   |   | $ | (4,495 | ) |   |   | (37.4 | )% |   |
| *% of total revenue*                       | * *   | *19*                                    | *%*        | *21*                       | *%*        | *35*                       | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Europe                                     |       | 6,186                                   |       | 6,840                      |       | 5,638                      |       |   | (654 | ) |   |   | (9.6 | ) |   |   | 1,202 |   |   |   | 21.3 |   |   |
| *% of total revenue*                       | * *   | *23*                                    | *%*        | *19*                       | *%*        | *16*                       | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Japan                                      |       | 2,854                                   |       | 5,156                      |       | 4,167                      |       |   | (2,302 | ) |   |   | (44.6 | ) |   |   | 989 |   |   |   | 23.7 |   |   |
| *% of total revenue*                       | * *   | *11*                                    | *%*        | *15*                       | *%*        | *12*                       | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Taiwan                                     |       | 3,843                                   |       | 8,397                      |       | 7,055                      |       |   | (4,554 | ) |   |   | (54.2 | ) |   |   | 1,342 |   |   |   | 19.0 |   |   |
| *% of total revenue*                       | * *   | *15*                                    | *%*        | *24*                       | *%*        | *20*                       | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Asia Pacific  (excluding Japan and Taiwan) |       | 8,485                                   |       | 7,547                      |       | 5,844                      |       |   | 938 |   |   |   | 12.4 |   |   |   | 1,703 |   |   |   | 29.1 |   |   |
| *% of total revenue*                       | * *   | *32*                                    | *%*        | *21*                       | *%*        | *17*                       | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total revenue                              |       | $                                       | 26,536     |                       | $          | 35,454                     |       | $ | 34,713 |   |   | $ | (8,918 | ) |   |   | (25.2 | )% |   |   | $ | 741 |   |   |   | 2.1 | % |   |

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*                    Primarily theUnited States.

Sales to customers outside of North Americarepresented approximately 81%, 79%, and 65% of our revenue during 2005, 2004and 2003, respectively. Asia Pacific (excluding Japan and Taiwan) revenueincreased to 32% of total revenue in 2005 compared with 21% of total revenue in2004. The increase was primarily due to increased sales of GaAs substrates tocustomers in China and Singapore, which products are being used inopto-electronics applications. The Taiwan revenue decreased by $4.6 million or54.2%, to $3.8 million in 2005 compared with $8.4 million for 2004. The decreasein Taiwan and other geographic areas for our GaAs substrates was due tocontinuing pricing pressures causing average sales prices to decline, overalllower demand from our wireless application customers, and delays in orders fromcustomers who had not yet qualified our China-grown products.

International revenueincreased during 2004 as compared to 2003 primarily due to sales growth of $1.2million in Europe, $1.7 million in Asia Pacific, $1.3 million in Taiwan,and $1.0 million in Japan. The increase was the result of our continuedpenetration into the Asian markets, particularly Taiwan, Japan and China.

***Gross Margin***

| ** **           | ** ** | ** **                              | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|----------------------|------------|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
|                      | ** ** | **2005**                                | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**          | ** ** |
| Gross profit  (loss) |       | $                                       | 2,199      |                       | $          | (251                       | )          | $ | 2,235 |   |   | $ | 2,450 |   |   |   | 976 | % |   |   | $ | (2,486 | ) |   |   | (111 | )% |   |
| *Gross  Margin %*    | * *   | *8.3*                                   | *%*        | *(0.7*                     | *)%*       | *6.4*                      | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                      |            |                                         |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Gross margin increased to 8.3% of revenue in 2005compared to negative 0.7% of revenue in 2004. The improvement in gross marginin 2005 was due to the increased sales in the larger diameter wafers as demandsincreased, and the sales of fully reserved wafers which accounted for revenueof approximately $2.1 million in 2005. In 2006, we may have a similar volume ofsales of fully reserved wafers.

Gross margin decreased to negative 0.7% of revenue in2004 compared to 6.4% of revenue in 2003. The decrease was primarily due to thefollowing factors: (i) a $2.1 million charge for excess and obsoleteinventory in the third quarter of 2004, (ii) an approximately $1.4 millioncharge incurred in connection with our settlement of our patent dispute withSumitomo Electric Industries, Ltd. in the third quarter of 2004, 

39

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and (iii) theestablishment of a sales return reserve of $745,000 in the first quarter of2004 related to our failure to follow certain testing requirements, whichreduced revenues without affecting costs of revenues.

***Selling, Generaland Administrative Expenses***
|                       | ** ** | ** **                              | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|-----------------------|------------|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **            | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **2005**                                | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**          | ** ** |
| SG&A expenses     |       | $                                       | 12,955     |                       | $          | 11,561                     |       | $ | 10,475 |   |   | $ | 1,394 |   |   |   | 12.1 | % |   |   | $ | 1,086 |   |   |   | 10.4 | % |   |
| *% of  total revenue* | * *   | *48.8*                                  | *%*        | *32.6*                     | *%*        | *30.2*                     | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                       |            |                                         |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Selling, general and administrative expenses increased$1.4 million to $12.9 million for 2005 compared with $11.6 million for 2004.The increase in absolute dollars and as a percentage of revenue was primarilydue to $2.0 million of decommissioning expenses for our Fremont, Californiafacilities, higher travel expenses of $337,000 as operations have movedresulting in more travel to China , higher recruiting expenses of $118,000mainly in recruiting our new chief executive officer, partially offset by$556,000 lower insurance costs as operations have moved to China where ratesare lower, $152,000 lower Delaware franchise tax  using the alternative method, $137,000 lowersales commissions due to lower sales, and lower rates, and $127,000 lower baddebt expenses as collections and aging improved.

Selling, general andadministrative expenses increased $1.1 million, or 10.4%, to $11.6 million in2004 compared to $10.5 million in 2003. As a percentage of total revenue,selling, general and administrative expenses were 32.6% in 2004 compared to30.2% in 2003. The increase in selling, general and administrative expenses isprimarily the result of increased legal and professional fees with respect toour product testing investigation, the Sumitomo litigation settlement, andprogress on our implementation of Section 404 of the Sarbanes-Oxley Act of2002.

***Research andDevelopment Expenses***
|                       | ** ** | ** **                              | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|-----------------------|------------|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **            | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **2005**                                | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**          | ** ** |
| R&D expenses      |       | $                                       | 1,723      |                       | $          | 1,479                      |       | $ | 1,337 |   |   | $ | 244 |   |   |   | 16.5 | % |   |   | $ | 142 |   |   |   | 10.6 | % |   |
| *% of  total revenue* | * *   | *6.5*                                   | *%*        | *4.2*                      | *%*        | *3.9*                      | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                       |            |                                         |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Research and development expenses increased $244,000,or 16.5%, to $1.7 million for 2005, compared with $1.5 million for 2004. During2005, we incurred $64,000 in severance payments to employees that had beenperforming research and development activities. We believe that continuedinvestment in product development is critical to attaining our strategicobjectives of maintaining and enhancing our technology leadership, and havetherefore appointed Dr. Morris Young as our chief technology officer. As aresult, we expect research and development expenses to remain at the levels ofrecent quarters or to increase in future periods. Research and developmentefforts during 2005 were focused primarily on improving the yield and surfacequality of our GaAs substrates, and we expect these activities to continue.

Research and development expenses increased $142,000,or 10.6%, to $1.5 million in 2004 compared to $1.3 million in 2003. As apercentage of total revenue, research and development expenses were 4.2% in2004 compared to 3.9% in 2003. As planned, we maintained our investment inproduct development in 2004 in order to improve our substrate manufacturingtechnologies.

40

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***Impairment andRestructuring Charges***
|                       | ** ** | ** **                              | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|-----------------------|------------|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **            | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **2005**                                | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**          | ** ** |
| Impairment  charges   |       | $                                       | —     |                       | $          | 210                        |       |   | $ | — |   |   |   | $ | (210 | ) |   |   | NM |   |   |   | $ | 210 |   |   |   | NM |   |   |
| *% of total revenue*  | * *   | *—*                                | * *   | *0.6*                      | *%*        | * *                   | *—*   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Restructuring  costs  |       | $                                       | 836        |                       | $          | 1,308                      |       |   | $ | — |   |   |   | $ | (472 | ) |   |   | (36.1 | )% |   |   | $ | 1,308 |   |   |   | NM |   |   |
| *% of  total revenue* | * *   | *3.2*                                   | *%*        | *3.7*                      | *%*        | * *                   | *—*   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                       |            |                                         |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

NM: percentage notmeaningful

***Impairment Charges***

In the third quarter of2004, we recorded an impairment charge of $210,000 to write down the value ofour investment in a private company. We made the decision to write down theinvestment as a result of the declining financial position of the investee,evidenced by an audit opinion with a going concern explanatory paragraphreceived by the investee. The $210,000 was the remaining balance of thisinvestment. No further write-downs were recorded in 2005.

***Restructuring Charges***

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

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

In December 2005, we further reduced theworkforce at our Fremont, California facility by approximately 15positions that are no longer required to support production and operations, orapproximately 29 percent, over the next 120 days. This measure wasbeing taken as part of our ongoing effort to downsize our Fremont,California facility headcount. Accordingly, we recorded a restructuring chargeof approximately $273,000 in December 2005 related to the reduction inforce for severance-related expenses from the reduction in force, all of whichwill be cash expenditures. We anticipate that the cash outflow from this chargeto be incurred over the two quarters commencing in the first quarter of 2006and we expect to save $0.9 million annually in payroll and related expenses. Alsoin December 2005, we recorded an additional restructuring charge ofapproximately $164,000, primarily related to the final liquidation proceduresof AXT’s Japan office so as to eliminate the remaining assets. There is noexpected cash outflow of this charge.

Overall for the year ended December 31,2005, we recorded restructuring charges of $236,000 relating to lease costs associated with facilitieslocated in California that are no longer required to support production. Theremaining restructuring accrual for future lease payments related to abandonedU.S. facilities of $250,000 is expected to be paid out through 2006, and isincluded on the accompanying consolidated balance sheet as accruedrestructuring. Refer to Note 8 to our consolidated financial statements.

41

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In 2004 in the secondquarter, we announced plans to cease all production activities in the United Statesand to manufacture our products only in China. In June 2004, we incurred arestructuring charge of $1.1 million as a result of our decision to close downour remaining manufacturing facilities in the United States. In the third andfourth quarter of 2004, we incurred additional restructuring charges of$231,000 for a total of $1.3 million in 2004. These charges comprised costsrelated to the reduction in work force effected in June 2004, and leasecosts associated with the facilities located in California that are no longerrequired to support production. In aggregate, we eliminated 50 positions, 47 ofwhich were production workers. As of December 31, 2004, we savedapproximately $560,000 in annual payroll and related expenses.

***Interest Income, Net***
|                       | ** ** | ** **                              | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|-----------------------|------------|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **            | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **2005**                                | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**          | ** ** |
| Interest income,  net |       | $                                       | 516        |                       | $          | 262                        |       | $ | 172 |   |   | $ | 254 |   |   |   | 96.9 | % |   |   | $ | 90 |   |   |   | 52.3 | % |   |
| *% of  total revenue* | * *   | *1.9*                                   | *%*        | *0.7*                      | *%*        | *0.5*                      | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                       |            |                                         |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest income, net increased $254,000 to $516,000for 2005 compared with $262,000 for 2004 as a result of our lower debt levelsas we continued to pay down our debt.

Interest income, netincreased $90,000, or 52.3%, to $262,000 in 2004 compared to $172,000 in 2003.The increase in interest income, net reflected the absence of equipmentfinancing charges. By the end of 2003, we had repaid $10.1 million in equipmentlease and loan debt.

***Other (Expense) andIncome, Net***
|                                             | ** ** | ** **                              | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                  | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **2005**                                | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                  | ** ** | **($ in thousands)**          | ** ** |
| Other (expense)  and income, net  |       | $                                       | (910       | )                          | $          | 94                         |       | $ | (1,688 | ) |   | $ | (1,004 | ) |   |   | (1068 | )% |   |   | $ | 1,782 |   |   |   | 105.6 | % |   |
| *% of  total revenue*                       | * *   | *(3.4*                                  | *)%*       | *0.3*                      | *%*        | *(4.9*                     | *)%*       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                             |            |                                         |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other expense was $910,000 for 2005 compared withother income of $94,000 for 2004. The change from other income to other expensewas mainly due to an increase in minority interest’s share in our jointventures of $393,000, foreign exchange losses related to the Japanese yen of$238,000 and to the Chinese renminbi of $44,000, and $237,000 of other incomein 2004 received from a customer to terminate a supply guarantee contract, andother losses on asset and marketable security disposals of $93,000.

Other income was $94,000 in 2004 compared to otherexpense of $1.7 million in 2003. Other expense in 2003 included a charge of $2.1million related to the write-down of investments we held in two privately heldU.S. companies. In 2004, other (expense) comprised of foreign exchange gain(loss) and minority interests from our China joint ventures was offset by again of $237,000 as a result of a customer’s forfeiture of deposits originallymade in connection with the program we launched in late 2000 with selectedcustomers to guarantee volume delivery of substrates. We terminated allremaining obligations under the program with this customer by mutual consent.

Minority interest inearnings of consolidated subsidiaries is included in other (expense) andincome, net and for the years ended December 31, 2005, 2004, and 2003 were($660,000), ($267,000) and ($4,000), respectively, as the consolidatedsubsidiaries’ profitability increased.

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***Provision (benefit)for Income Taxes***
|                                       | ** ** | ** **                              | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **Years Ended Dec. 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | **2005**                                | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **($ in thousands)**          | ** ** |
| Provision  (benefit) for income taxes |       | $                                       | (950       | )                          | $          | 71                         |       |   | $ | — |   |   |   | $ | (1,021 | ) |   |   | (1438 | )% |   |   | $ | 71 |   |   |   | NM |   |   |
| *% of  total revenue*                 | * *   | *3.6*                                   | *%*        | *0.2*                      | *%*        | * *                   | *—*   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                       |            |                                         |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

NM: percentage not meaningful

In 2005, the InternalRevenue Service closed its examination of our tax return for the 2002 tax year,including the calculation of our 1999 and 2000 net operating loss carry back. Asa result of this, we reversed approximately $1.1 million of income taxpayable accrued for potential exposures relating to those years. This amount isshown as a benefit from income taxes in 2005. Provision for income taxes for2004 was $71,000, which was related to our foreign subsidiaries. Due to ourcontinuing operating losses and uncertainty regarding our future profitability,we recorded a full valuation allowance against our net deferred tax assets of$50.9 million in 2005, and $38.8 million in 2004.

***Gain or Loss fromDiscontinued Operations***
|                                           | ** ** | ** **                                  | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
|-------------------------------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | **Years Ended December 31,** | ** ** | **Increase**               | ** ** | ** **                 | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **2005**                                    | ** ** | **2004**                   | ** ** | **2003**                   | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                | ** ** | **($ in thousands)**              | ** ** |
| Gain (loss) from discontinued  operations |       | $                                           | 544        |                       | $          | 891                        |       | $ | (15,638 | ) |   | $ | (347 | ) |   |   | (38.9 | )% |   |   | $ | 16,529 |   |   |   | 105.7 | % |   |
|                                           |            |                                             |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In 2005, the gain from discontinued operations is madeup of a gain of $559,000 which was the remaining portion of the first $750,000held in escrow due to us from the sale of our opto-electronics business toLumei Optoelectronics Corp. and includes $9,000 interest, $58,000 in propertytax refunds, and a gain of $53,000 from the sale of a building located inMonterey Park, California. During the fourth quarter we recorded a loss of$126,000 as a result of consulting fees of $52,000, rental accruals of $31,000,tax payments of $23,000, and $20,000 for accounts receivables written off.

In 2004, we realized a$419,000 gain on discontinued opto-electronics operations as a result of thepartial release of escrow funds. Also in 2004, we entered into an agreementwith a real estate developer for the purchase of our discontinuedopto-electronics’ property held for sale and realized a gain of $250,000 reflectingan adjustment to the realizable market value of the property. The remaininggain of $222,000 was a result of our reversal of accrued liabilities of generaland administrative expenses no longer required. Loss from our discontinuedopto-electronics division for 2003 was $15.6 million, which included a loss ondisposal of $9.5 million and the operating loss of $6.1 million. Loss from ourdiscontinued opto-electronics division for 2002 was $26.2 million, whichincluded the operating loss and certain impairment charges for a total of $34.6million, partially offset by a benefit for income taxes of $8.4 million. Seefurther discussion under “Results of Operations—Overview” elsewhere inManagement’s Discussion and Analysis of Financial Condition and Results ofOperations of this Form 10-K.

**AmericanJobs Creation Act of 2004—Repatriation of Foreign Earnings**

The American Jobs Creation Act of 2004 (the “Jobs Act”),enacted on October 22, 2004, allows us to repatriate earnings from ourforeign subsidiaries at a reduced tax rate. Under the Jobs Act, we may elect,for one taxable year, an 85% dividends received deduction for eligibledividends from our foreign subsidiaries. The deduction would result in anapproximate 5.25% federal tax rate on the repatriated 

43

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earnings. To qualify forthe deduction, the repatriated earnings must be reinvested in the United Statespursuant to a domestic reinvestment plan established by our chief executiveofficer and approved by the company’s board of directors. Certain othercriteria in the Jobs Act must be satisfied as well. We may elect to apply thisprovision to qualifying earnings repatriations in fiscal 2006. We are in theprocess of evaluating whether we will repatriate foreign earnings under therepatriation provisions of the Jobs Act.

We are not yet in aposition to determine the impact of a qualifying repatriation, should we chooseto make one, on our income tax expense for fiscal 2006, the amount of ourindefinitely reinvested foreign earnings, or the amount of our deferred taxliability with respect to foreign earnings.

**Liquidityand Capital Resources**
|                                                          | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                               | ** ** | **($ in thousands)**              | ** ** |
| Net cash provided by  (used in):                         |       |                                        |       |   |   |   |   |
| Operating activities                                     |       | $                                           | (7,746     | ) | $ | (340 | ) | $ | 6,269 |   |
| Investing activities                                     |       | 13,886                                      |       | (7,846 | ) | 13,723 |   |
| Financing activities                                     |       | (792                                        | )          | (4,216 | ) | (9,647 | ) |
| Effect of  exchange rate changes                         |       | 7                                           |       | 180 |   | 197 |   |
| Net change in  cash and cash equivalents                 |       | 5,355                                       |       | (12,222 | ) | 10,542 |   |
| Cash and cash  equivalents—beginning period         |       | 12,117                                      |       | 24,339 |   | 13,797 |   |
| Cash and cash  equivalents—end of period            |       | 17,472                                      |       | 12,117 |   | 24,339 |   |
| Short-term  investments—end of period               |       | 5,555                                       |       | 20,062 |   | 14,669 |   |
| Total cash, cash  equivalents and short-term investments |       | $                                           | 23,027     |   | $ | 32,179 |   | $ | 39,008 |   |
|                                                          |            |                                             |            |  |  |  |  |  |  |  |  |  |  |

 

We consider cash and cash equivalents, and short-terminvestments as liquid and available for use. Short-term investments arecomprised of government bonds and high-grade commercial debt instruments. Alsoincluded in short-term investments is our investment in common stock of FinisarCorporation, a United States publicly-traded company. As of December 31,2005, our principal sources of liquidity were $23.0 million in cash and cashequivalents and short-term investments, excluding restricted deposits.

Cash and cash equivalents and short-term investments,excluding $2.4 million and $2.7 million for our investment in Finisar commonstock as of December 31, 2005 and December 31, 2004, respectively,decreased $8.9 million to $20.6 million as of December 31, 2005 comparedwith $29.5 million as of December 31, 2004. The combined decrease in cashand cash equivalents and short-term investments was primarily due to thepurchase of machinery and equipment of $2.3 million, payments of long-term debtof $0.7 million, and the continual funding of our operations.

The decrease in operating cash flow in 2005, ascompared with 2004 included our $1.4 million payment to Sumitomo ElectricIndustries, Ltd. in connection with the settlement of our litigation andcross-license fee with them, $1.2 million decommissioning costs for ourFremont, California facilities, and $1.2 million for increases in our accountsreceivable, net for our increased fourth quarter 2005 sales, partially offsetby an increase in our accounts payable of $1.2 million primarily for theaccrual of inventory in transit at December 31, 2005.

Net accounts receivable increased by $1.2 million, or30.0%, to $5.2 million as of December 31, 2005 compared with $4.0 millionas of December 31, 2004. The increase reflects improved fourth quartersales in 2005 compared to the same period in 2004, as well as decreasedaccounts receivable allowances of $619,000 as of December 31, 2005compared to $1,087,000 as of December 31, 2004 reflecting continuousimprovements in our collection efforts from customers.

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Net inventories decreased $0.3 million, or 1.9% to$16.2 million as of December 31, 2005 compared with $16.5 million as of December 31,2004. We adopted a strategy of using inventory to conserve cash and we areexpecting to continue to decrease our levels of inventory.

Net cash provided by investing activities of $13.9million for the year ended December 31, 2005 included proceeds from thesale of our Monterey Park, CA property of $1.3 million, net sales of high gradeinvestment securities totaling $14.1 million and a decrease in our restricteddeposits of $0.8 million, partially offset by purchases of property andequipment of $2.3 million.

We do not have any plans to initiate any major newcapital spending projects in 2006. We are currently completing certain projectsat our China facilities and we expect to invest up to approximately $4.2million in capital projects in 2006 related to our China facilities. We believethat our existing and planned facilities and equipment are sufficient tofulfill current and expected future orders.

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

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

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

***Off-Balance Sheet Arrangements***

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

We had entered into contracts to supply several largecustomers with GaAs wafers. The contracts guaranteed delivery of a certainnumber of wafers between January 1, 2001 and December 31, 2004. Thecontract sales prices were subject to review quarterly and could be adjusted inthe event that raw material prices changed. In the event of non-delivery of thedetermined wafer quantities in any monthly delivery period, we could be subjectto non-performance penalties of between 5% and 10% of the value of thedelinquent monthly deliveries. We have not received any claims fornon-performance penalties due to non-delivery. As of December 31, 2005, wehave met all of our current delivery obligations under these contracts, and thecontracts have expired. Partial prepayments received for these supply contractstotaling $125,000 and $130,000 are included in accrued liabilities in theaccompanying condensed consolidated balance sheets as of December 31, 2005and 2004, respectively.

We indemnify certaincustomers for attorney fees and damages and costs awarded against these partiesin certain circumstances if our products are found to infringe certain patentsand they are sued by the patent holder and awarded damages. There are limits onand exceptions to our potential liability for 

45

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indemnificationrelating to intellectual patent infringement claims. We cannot estimate the amountof potential future payments, if any, that we might be required to make as aresult of these agreements. To date, we have not paid any claim or beenrequired to defend any action related to our indemnification obligations, andaccordingly, we have not accrued any amounts for such indemnificationobligations. However, we may record charges in the future as a result of theseindemnification obligations.

***Contractual Obligations***

As of December 31, 2005, the credit facilitymaintained by us with a bank included a letter of credit supporting repaymentof our industrial bonds with an outstanding amount of approximately $7.5million. We have pledged and placed certain investment securities with anaffiliate of the bank as additional collateral for this facility. We have alsopledged certain investments for a credit facility for our workers compensationinsurance policy for portions of 2003. Accordingly, $7.5 million of our cashand short-term investments are restricted.

We lease certain office space, manufacturingfacilities and property under long-term operating leases expiring at variousdates through March 2013. On March 11, 2003, we completed the sale ofour property located at 4281 Technology Drive, Fremont, California, for $6.3million. Net cash proceeds from the sale were $5.2 million. The gain incurredby us on this transaction was less than $15,000. Under the terms of the saleagreement, we have agreed to lease back the property for a ten-year period.Accordingly, on March 11, 2003, we signed an operating lease for thisproperty through March 2013. Total rent expenses under these operatingleases were approximately $1.3 million, $1.3 million and $1.2 million for yearsended December 31, 2005, 2004 and 2003, respectively.

Thefollowing table summarizes our contractual obligations as of December 31,2005 (in thousands):
|                                  | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **More than  5 years** | ** ** |
| Long-term debt                   |       | $                                         | 7,720      |   |   | $ | 300 |   |   | $ | 1,240 |   | $ | 900 |   |   | $ | 5,280 |   |   |
| Operating leases                 |       | 5,517                                     |       |   | 940 |   |   | 2,091 |   | 1,530 |   |   | 956 |   |   |
| Total                            |       | $                                         | 13,237     |   |   | $ | 1,240 |   |   | $ | 3,331 |   | $ | 2,430 |   |   | $ | 6,236 |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Recent Accounting Pronouncements***

In November 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 151,“Inventory Costs—An Amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). Among other provisions, the newrule requires that items such as idle facility expense, excessivespoilage, double freight and re-handling costs must be recognized ascurrent-period charges regardless of whether they meet the criterion of “soabnormal” as stated in ARB No. 43. Additionally, SFAS 151 requires thatthe allocation of fixed production overheads to the costs of conversion bebased on the normal capacity of the production facilities. SFAS 151 iseffective for fiscal years beginning after June 15, 2005 and is requiredto be adopted by the Company in the first quarter of 2006, beginning on January 1,2006. We do not expect SFAS 151 to have a material financial statement impact.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 153, “Exchanges of Non-monetary Assets—AnAmendment of APB Opinion No. 29” (“SFAS 153”). SFAS 153 eliminates theexception from fair value measurement for non-monetary exchanges of similarproductive assets in paragraph 21(b) of APB Opinion No. 29, “Accountingfor Non-monetary Transactions,” and replaces it with the exception forexchanges that do not have commercial substance. SFAS 153 specifies that anon-monetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. SFAS153 is effective for the fiscal periods beginning after June 15, 2005 andis required to be adopted by the Company in the first quarter of fiscal 2006,beginning on January 1, 2006. We do not expect it to have a materialfinancial statement impact.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123R”), which requires the measurement of all share-basedpayments to employees, including grants of stock options, using afair-value-based method and the recording of such expense in the consolidatedstatements of operations. The accounting provisions of SFAS 123R wereoriginally effective for all reporting periods beginning after June 15,2005. The pro forma disclosures previously permitted under SFAS 123 nolonger will be an alternative to financial statement recognition. See “Stock-BasedCompensation” above for the pro forma net income (loss) and net income (loss)per share amounts, as if we had used a fair-value-based method similar to themethods required under SFAS 123R to measure compensation expense foremployee stock incentive awards.

In March 2005, the SEC issued Staff AccountingBulletin (“SAB”) No. 107, providing supplemental implementation guidancefor SFAS 123R. In April 2005, the Securities and Exchange Commissionapproved a rule that delayed the effective date of SFAS 123R to the firstannual reporting period beginning after June 15, 2005. Although we havenot yet determined whether the adoption of SFAS 123R will result inamounts that are similar to the current pro forma disclosures underSFAS 123, we are evaluating the requirements under SFAS 123R and SAB107 and expect the adoption to have a significant adverse impact on ourconsolidated statements of operations and net loss per share. SFAS123R will beeffective for us beginning with the first quarter of 2006.

In May 2005, the FASB issued SFAS 154, “AccountingChanges and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3” (“SFAS 154”). SFAS 154 changes the requirements for theaccounting for and reporting of a change in accounting principle, and appliesto all voluntary changes in accounting principle. It also applies to changesrequired by an accounting pronouncement in the unusual instance that the pronouncementdoes not include specific transition provisions. This statement requiresretrospective application to prior periods’ financial statements of changes inaccounting principle, unless it is impracticable to determine either theperiod-specific effects or the cumulative effect of the change. SFAS 154 iseffective for accounting changes made in fiscal years 

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beginning after December 15,2005. We do not expect the adoption of this statement will have a materialimpact on our results of operations or financial condition.

In November 2005, theFASB issued FASB Staff Posistion FAS 115-1 and FAS 124-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments” (“FSP FAS 115-1”), which provides guidance ondetermining when investments in certain debt and equity securities areconsidered impaired, whether that impairment is other-than-temporary, and onmeasuring such impairment loss. FSP FAS 115-1 also includesaccounting considerations subsequent to the recognition of an other-thantemporary impairment and requires certain disclosures about unrealized lossesthat have not been recognized as other-than-temporary impairments. FSPFAS 115-1 is required to be applied to reporting periods beginningafter December 15, 2005. We are required to adopt FSP FAS 115-1 inthe first quarter of fiscal 2006. We do not expect the adoption of thisstatement will have a material impact on our results of operations or financialcondition.

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

***Foreign Currency Risk***

We use short-term forwardexchange contracts for hedging purposes to reduce the effects of adverseforeign exchange rate movements. We have purchased foreign exchange contractsto hedge against certain trade accounts receivable denominated in Japanese yen.The change in the fair value of the forward contracts is recognized as part ofthe related foreign currency transactions as they occur. As of December 31,2005, we had no outstanding commitments with respect to foreign exchangecontracts.

***Interest Rate Risk***

Cash and cash equivalents earning interest and certainvariable rate debt instruments are subject to interest rate fluctuations. Thefollowing table sets forth the probable impact of a 10% change in interestrates (in thousands):

| **Instrument**                             | ** ** | ** ** | ** ** | **Balance as of  December 31,  2005** | ** ** | **Current  Interest  Rate** | ** ** | **Projected Annual  Interest  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|--------------------------------------------|------------|------------|------------|------------------------------------------------------|------------|-----------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Cash                                       |       |       | $          | 12,803                                               |       |                        |       | 0.50                                                  | %          |                                                                 |       | $                                                                     | 64         |   |   |   | $ | 58 |   |   |   | $ | 70 |   |   |
| Cash equivalents                           |       |       | 4,669      |                                                 |       |                        | 4.22       |                                                  |       |                                                                 | 197        |                                                                  |       |   | 177 |   |   |   | 217 |   |   |
| Investment in  debt and equity instruments |       |       | 13,005     |                                                 |       |                        | 4.09       |                                                  |       |                                                                 | 532        |                                                                  |       |   | 479 |   |   |   | 585 |   |   |
| Long-term debt                             |       |       | (7,720     | )                                                    |       |                        | 4.43       |                                                  |       |                                                                 | (342       | )                                                                     |       |   | (308 | ) |   |   | (376 | ) |   |
|                                       |       |       |       |                                                 |       |                        |       |                                                  |       |                                                                 | $          | 451                                                                   |       |   |   | $ | 406 |   |   |   | $ | 496 |   |   |

 

***Equity Risk***

We maintain minorityinvestments in private and publicly traded companies. These investments arereviewed for other than temporary declines in value on a quarterly basis. Theseinvestments are classified as other assets in the consolidated balance sheetsand are accounted for under the cost method as we do not have the ability toexercise significant influence over their operations. We monitor ourinvestments for impairment and record reductions in carrying value when eventsor changes in circumstances indicate that the carrying value may not berecoverable. Reasons for other than temporary declines in value include whetherthe related company would have insufficient cash flow to operate for the nexttwelve months, significant changes in the operating performance and changes inmarket conditions. As of December 31, 2005 and 2004, the minorityinvestments totaled $392,000 for both years. In 2004, we recorded a $0.2 millioncharge related to impairment in one of the U.S. private companies.

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

***Selected Quarterly Results of Operations***

Thefollowing table sets forth unaudited quarterly results for the eight quartersended December 31, 2005. We believe that all necessary adjustments,consisting only of normal recurring adjustments, have been included in theamounts stated below to present fairly such quarterly information. Theoperating results for any quarter are not necessarily indicative of results forany subsequent period.

| ** **                                                          | ** ** | **Quarters Ended** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                          | ** ** | **Dec. 31,  2005** | ** ** | **Sept. 30,  2005** | ** ** | **June 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **June 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| Revenue                                                             |       |                    | $          | 7,717 |   |   |   | $ | 6,153 |   |   |   | $ | 6,032 |   |   |   | $ | 6,634 |   |   |   | $ | 7,623 |   |   |   | $ | 8,531 |   |   |   | $ | 9,524 |   |   |   | $ | 9,776 |   |   |
| Cost of revenue                                                     |       |                    | 7,069      |   |   |   | 5,008 |   |   |   | 5,905 |   |   |   | 6,355 |   |   |   | 7,000 |   |   |   | 10,767 |   |   |   | 8,695 |   |   |   | 9,243 |   |   |
| Gross profit (loss)                                                 |       |                    | 648        |   |   |   | 1,145 |   |   |   | 127 |   |   |   | 279 |   |   |   | 623 |   |   |   | (2,236 | ) |   |   | 829 |   |   |   | 533 |   |   |
| Operating  expenses:                                                |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and  administrative                                |       |                    | 3,089      |   |   |   | 2,898 |   |   |   | 2,716 |   |   |   | 4,252 |   |   |   | 3,120 |   |   |   | 2,468 |   |   |   | 3,203 |   |   |   | 2,770 |   |   |
| Research and development                                            |       |                    | 466        |   |   |   | 472 |   |   |   | 423 |   |   |   | 362 |   |   |   | 391 |   |   |   | 397 |   |   |   | 350 |   |   |   | 341 |   |   |
| Impairment charges                                                  |       |                    | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 210 |   |   |   | — |   |   |   | — |   |   |
| Restructuring costs                                                 |       |                    | 460        |   |   |   | 14 |   |   |   | 237 |   |   |   | 125 |   |   |   | 73 |   |   |   | 158 |   |   |   | 1,077 |   |   |   | — |   |   |
| Total operating expenses                                            |       |                    | 4,015      |   |   |   | 3,384 |   |   |   | 3,376 |   |   |   | 4,739 |   |   |   | 3,584 |   |   |   | 3,233 |   |   |   | 4,630 |   |   |   | 3,111 |   |   |
| Loss from operations                                                |       |                    | (3,367     | ) |   |   | (2,239 | ) |   |   | (3,249 | ) |   |   | (4,460 | ) |   |   | (2,961 | ) |   |   | (5,469 | ) |   |   | (3,801 | ) |   |   | (2,578 | ) |   |
| Interest income, net                                                |       |                    | 130        |   |   |   | 136 |   |   |   | 131 |   |   |   | 119 |   |   |   | 63 |   |   |   | 95 |   |   |   | 54 |   |   |   | 24 |   |   |
| Other (income) and expense, net                                     |       |                    | (416       | ) |   |   | (193 | ) |   |   | (196 | ) |   |   | (105 | ) |   |   | (212 | ) |   |   | 225 |   |   |   | (225 | ) |   |   | 34 |   |   |
| Loss from continuing operations before provision for  income  taxes |       |                    | (3,653     | ) |   |   | (2,296 | ) |   |   | (3,314 | ) |   |   | (4,446 | ) |   |   | (2,812 | ) |   |   | (5,149 | ) |   |   | (3,972 | ) |   |   | (2,520 | ) |   |
| Provision (benefit) for income  taxes                               |       |                    | (1,048     | ) |   |   | 45 |   |   |   | 18 |   |   |   | 35 |   |   |   | (106 | ) |   |   | 40 |   |   |   | 97 |   |   |   | 40 |   |   |
| Loss from continuing operations                                     |       |                    | (2,605     | ) |   |   | (2,341 | ) |   |   | (3,332 | ) |   |   | (4,481 | ) |   |   | (2,706 | ) |   |   | (5,189 | ) |   |   | (4,069 | ) |   |   | (2,560 | ) |   |
| Discontinued  operations:                                           |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gain (loss) from discontinued operations                            |       |                    | (126       | ) |   |   | 259 |   |   |   | 53 |   |   |   | 358 |   |   |   | 250 |   |   |   | — |   |   |   | 222 |   |   |   | — |   |   |
| Gain on disposal                                                    |       |                    | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 194 |   |   |   | 225 |   |   |   | — |   |   |   | — |   |   |
| Gain (loss) from discontinued operations                            |       |                    | (126       | ) |   |   | 259 |   |   |   | 53 |   |   |   | 358 |   |   |   | 444 |   |   |   | 225 |   |   |   | 222 |   |   |   | — |   |   |
| Net loss                                                            |       |                    | $          | (2,731 | ) |   |   | $ | (2,082 | ) |   |   | $ | (3,279 | ) |   |   | $ | (4,123 | ) |   |   | $ | (2,262 | ) |   |   | $ | (4,964 | ) |   |   | $ | (3,847 | ) |   |   | $ | (2,560 | ) |   |

 

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

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

None.

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

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

***Changes in internalcontrol over financial reporting.******  ***As required byRule 13a-15(d), our management, including our Chief ExecutiveOfficer and Chief Financial Officer, also conducted an evaluation of ourinternal control over financial reporting to determine whether any changesoccurred during the period 

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covered by this reportthat have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting. Based on that evaluation, therehas been no such change during the period covered by this report.

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

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

None.

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**PART III**

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

**Item 10.**                 *Directors and Executive Officers of the Registrant.*

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

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

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

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

**Item 11.**                 *Executive Compensation.*

The information requiredby this Item is incorporated herein by reference to information set forth inour definitive Proxy statement to be filed in connection with our annualmeeting of stockholders to be held on May 23, 2006, under the sectionentitled “Executive Compensation and Other Matters.”

**Item 12.**                 *Security Ownership of Certain Beneficial Owners and Management, andRelated Stockholder Matters.*

The information requiredby this Item is incorporated herein by reference to information set forth inour definitive Proxy statement to be filed in connection with our annualmeeting of stockholders to be held on May 23, 2006, under the sectionentitled “Security Ownership of Certain Beneficial Owners and Management andEquity Compensation Plan Information.”

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

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

We entered into anoperating lease in July 2001 for warehouse space in Fremont, CA with 4160 BusinessCenter, LLC, a real estate holding company, in which Davis Zhang, president ofour joint 

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ventureoperations, was the sole shareholder. Lease payments to 4160 Business Center,LLC were approximately $484,000 for the year ended December 31, 2002 and$121,000 for the three months ended March 31, 2003. In April of 2003,Mr. Zhang sold this warehouse to a party unrelated to us. We began leasingthis warehouse from the new owner on the date of sale. Mr. Zhang continuedto hold a $3.7 million note on the property as of December 31, 2005.

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

The information required by this Item is incorporatedherein by reference to information set forth in our definitive Proxy statementto be filed in connection with our annual meeting of stockholders to be held onMay 23, 2006, under the section entitled “Principal Accounting Firm Fees.”

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**PART IV**

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

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

(1)         FinancialStatements:

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

| Report of Independent  Registered Public Accounting Firm, Burr, Pilger & Mayer LLP |   | 54 |   |
|---------------------------------------------------------------------------------------------|--------|----|--------|
| Report of Independent Registered Public Accounting  Firm, PricewaterhouseCoopers LLP        |   | 55 |   |
| Consolidated  Balance Sheets                                                                |   | 56 |   |
| Consolidated Statements of Operations                                                       |   | 57 |   |
| Consolidated Statements of Stockholders’ Equity                                        |   | 58 |   |
| Consolidated Statements of Cash Flows                                                       |   | 59 |   |
| Notes to Consolidated Financial Statements                                                  |   | 60 |   |

 

(2)         Financial StatementSchedules

All schedules have been omitted because the requiredinformation is not applicable or because the information required is includedin the consolidated financial statements or notes thereto.

(b)         Exhibits

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

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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

We have audited the accompanying consolidated balancesheets of AXT, Inc. and subsidiaries (the Company) as of December 31,2005 and 2004, and the related consolidated statements of operations,stockholders’ equity and cash flows for each of the two years in the periodended December 31, 2005. These consolidated financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of AXT, Inc. and subsidiaries asof December 31, 2005 and 2004, and the results of their operations andtheir cash flows for each of the two years in the period ended December 31,2005, in conformity with accounting principles generally accepted in the UnitedStates of America.

/s/ BURR, PILGER &MAYER LLP

Burr, Pilger &Mayer LLPPalo Alto, California February 1, 2006

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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

In our opinion, theaccompanying consolidated statements of operations, stockholders’ equity andcash flows for the year ended December 31, 2003 present fairly, in allmaterial respects, the results of operations and cash flows of AXT, Inc.and its subsidiaries for the year ended December 31, 2003, in conformitywith 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 basedon our audit. We conducted our audit of these statements in accordance with thestandards of the PublicCompany Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation. We believe that our audit provides a reasonablebasis for our opinion.

/s/ PRICEWATERHOUSECOOPERSLLP

PricewaterhouseCoopers LLPSan Jose, CaliforniaMarch 5, 2004

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**AXT, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                            | ** ** | **December 31,**                                          | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2005**                                                       | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                            | ** ** | **(In thousands, except  per share data)** | ** ** |
| **ASSETS**                                                                                                                                                            |       |                                                           |       |   |   |
| Current assets                                                                                                                                                        |       |                                                           |       |   |   |
| Cash and cash equivalents                                                                                                                                             |       | $                                                              | 17,472     |   | $ | 12,117 |   |
| Short-term investments                                                                                                                                                |       | 5,555                                                          |       | 20,062 |   |
| Accounts receivable, net of allowance of $619 and  $1,087 as of December 31, 2005 and 2004, respectively                                                         |       | 5,226                                                          |       | 4,034 |   |
| Inventories, net                                                                                                                                                      |       | 16,156                                                         |       | 16,462 |   |
| Prepaid expenses and other current assets                                                                                                                             |       | 1,801                                                          |       | 2,523 |   |
| Assets held for sale                                                                                                                                                  |       | —                                                         |       | 1,250 |   |
| Total current assets                                                                                                                                                  |       | 46,210                                                         |       | 56,448 |   |
| Property, plant  and equipment, net                                                                                                                                   |       | 17,306                                                         |       | 19,045 |   |
| Restricted  deposits                                                                                                                                                  |       | 7,450                                                          |       | 8,215 |   |
| Other assets                                                                                                                                                          |       | 3,832                                                          |       | 3,832 |   |
| Total assets                                                                                                                                                          |       | $                                                              | 74,798     |   | $ | 87,540 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                        |       |                                                           |       |   |   |
| Current liabilities                                                                                                                                                   |       |                                                           |       |   |   |
| Accounts payable                                                                                                                                                      |       | $                                                              | 3,070      |   | $ | 1,895 |   |
| Accrued liabilities                                                                                                                                                   |       | 2,682                                                          |       | 3,640 |   |
| Accrued compensation and related charges                                                                                                                              |       | 726                                                            |       | 715 |   |
| Accrued restructuring costs                                                                                                                                           |       | 465                                                            |       | 552 |   |
| Customer prepayments                                                                                                                                                  |       | 125                                                            |       | 130 |   |
| Current portion of long-term debt                                                                                                                                     |       | 300                                                            |       | 450 |   |
| Income taxes payable                                                                                                                                                  |       | 2,495                                                          |       | 2,925 |   |
| Total current liabilities                                                                                                                                             |       | 9,863                                                          |       | 10,307 |   |
| Long-term debt,  net of current portion                                                                                                                               |       | 7,420                                                          |       | 7,880 |   |
| Other long-term  liabilities                                                                                                                                          |       | 1,897                                                          |       | 1,336 |   |
| Total liabilities                                                                                                                                                     |       | 19,180                                                         |       | 19,523 |   |
| Commitments and  contingencies (Note 18)                                                                                                                              |       |                                                           |       |   |   |
| Stockholders’ equity:                                                                                                                                            |       |                                                           |       |   |   |
| Preferred stock, $0.001 par value; 2,000 shares  authorized; 883 shares issued and outstanding as of December 31, 2005  and 2004, respectively                   |       | 3,532                                                          |       | 3,532 |   |
| Common stock, $0.001 par value; 70,000 shares  authorized; 22,977 and 23,119 shares issued and outstanding as of  December 31, 2005 and 2004, respectively  |       | 23                                                             |       | 23 |   |
| Additional paid-in-capital                                                                                                                                            |       | 155,441                                                        |       | 155,431 |   |
| Accumulated deficit                                                                                                                                                   |       | (104,776                                                       | )          | (92,561 | ) |
| Other comprehensive income                                                                                                                                            |       | 1,398                                                          |       | 1,592 |   |
| Total stockholders’ equity                                                                                                                                       |       | 55,618                                                         |       | 68,017 |   |
| Total liabilities  and stockholders’ equity                                                                                                                      |       | $                                                              | 74,798     |   | $ | 87,540 |   |

 

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

56

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**AXT, INC.CONSOLIDATED STATEMENTSOF OPERATIONS**

| ** **                                                         | ** ** | **Years Ended December 31,**                        | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                         | ** ** | **(In thousands, except per share data)** | ** ** |
| Revenue                                                            |       | $                                                                  | 26,536     |   | $ | 35,454 |   | $ | 34,713 |   |
| Cost of revenue                                                    |       | 24,337                                                             |       | 35,705 |   | 32,478 |   |
| Gross profit  (loss)                                               |       | 2,199                                                              |       | (251 | ) | 2,235 |   |
| Operating expenses:                                                |       |                                                               |       |   |   |   |   |
| Selling, general and administrative                                |       | 12,955                                                             |       | 11,561 |   | 10,475 |   |
| Research and development                                           |       | 1,723                                                              |       | 1,479 |   | 1,337 |   |
| Impairment charges                                                 |       | —                                                             |       | 210 |   | — |   |
| Restructuring costs                                                |       | 836                                                                |       | 1,308 |   | — |   |
| Total operating expenses                                           |       | 15,514                                                             |       | 14,558 |   | 11,812 |   |
| Loss from  operations                                              |       | (13,315                                                            | )          | (14,809 | ) | (9,577 | ) |
| Interest income,  net                                              |       | 516                                                                |       | 262 |   | 172 |   |
| Other (expense)  and income, net                                   |       | (910                                                               | )          | 94 |   | (1,688 | ) |
| Loss from  continuing operations before provision for income taxes |       | (13,709                                                            | )          | (14,453 | ) | (11,093 | ) |
| Provision  (benefit) for income taxes                              |       | (950                                                               | )          | 71 |   | — |   |
| Loss from  continuing operations                                   |       | (12,759                                                            | )          | (14,524 | ) | (11,093 | ) |
| Discontinued operations:                                           |       |                                                               |       |   |   |   |   |
| Gain (loss) from discontinued operations                           |       | 544                                                                |       | 472 |   | (6,163 | ) |
| Gain (loss) on disposal                                            |       | —                                                             |       | 419 |   | (9,475 | ) |
| Gain (loss) from  discontinued operations                          |       | 544                                                                |       | 891 |   | (15,638 | ) |
| Net loss                                                           |       | $                                                                  | (12,215    | ) | $ | (13,633 | ) | $ | (26,731 | ) |
| Basic and diluted income  (loss) per share:                        |       |                                                               |       |   |   |   |   |
| Loss from continuing operations                                    |       | $                                                                  | (0.56      | ) | $ | (0.64 | ) | $ | (0.49 | ) |
| Gain (loss) from discontinued operations                           |       | 0.02                                                               |       | 0.04 |   | (0.69 | ) |
| Net loss                                                           |       | $                                                                  | (0.54      | ) | $ | (0.60 | ) | $ | (1.18 | ) |
| Shares used in computing  basic and diluted net loss per share     |       | 23,047                                                             |       | 23,063 |   | 22,781 |   |

 

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

57

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**AXT, INC.CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY**

| ** **                                       | ** ** | ** **               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **     | ** ** | ** **                    | ** ** | **Retained**      | ** ** | ** **        | ** ** | ** **        | ** ** | ** **        | ** ** |    |
|--------------------------------------------------|------------|--------------------------|------------|------------|------------|-----------------------|------------|----------------|------------|-------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|---------|
| ** **                                       | ** ** | ** **               | ** ** | ** ** | ** ** | **Common Stock** | ** ** | **Earnings**   | ** ** | **Other**                     | ** ** | ** **        | ** ** | ** **        | ** ** |              |
| ** **                                       | ** ** | **Preferred Stock** | ** ** | ** ** | ** ** | ** **            | ** ** | **Additional** | ** ** | **(Accumulated**              | ** ** | **Comprehensive** | ** ** | ** **        | ** ** | **Comprehensive** | ** ** |              |
| ** **                                       | ** ** | **Shares**               | ** ** | **Amount** | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Paid In Capital** | ** ** | **Deficit)**      | ** ** | **Income/(loss)** | ** ** | **Total**         | ** ** | **Income/(loss)** | ** ** |    |
| ** **                                       | ** ** | **(In thousands)**  | ** ** |
| Balance as of  December 31, 2002            |       |                     | 883        |       |       |                  | $          | 3,532          |       |                          | 22,495     |              |       | $                 | 22         |              |       |              | $          | 154,463 |   |   |   | $ | (52,197 | ) |   |   | $ | (163 | ) |   | $ | 105,657 |   |   |   |   |   |   |
| Common stock  options exercised                  |       |                     |       |       |       |                  |       |           |       | 33                            |       |              |       |              |       |              | 73         |              |       |    |   |   |   |   |   |   |   | 73 |   |   |   |   |   |   |
| Issuance of  Employee Stock Purchase Plan stock  |       |                     |       |       |       |                  |       |           |       | 404                           |       |              | 1          |              |       |              | 591        |              |       |    |   |   |   |   |   |   |   | 592 |   |   |   |   |   |   |
| Issuance of common  stock to board members       |       |                     |       |       |       |                  |       |           |       | 25                            |       |              |       |              |       |              | 28         |              |       |    |   |   |   |   |   |   |   | 28 |   |   |   |   |   |   |
| Comprehensive loss:                              |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                         |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    | (26,731 | ) |   |   |   |   |   | (26,731 | ) |   | $ | (26,731 | ) |   |   |
| Unrealized gain  (loss) on marketable securities |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   | 2,482 |   |   | 2,482 |   |   | 2,482 |   |   |   |
| Currency  translation adjustment                 |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   | 197 |   |   | 197 |   |   | 197 |   |   |   |
| Balance as of  December 31, 2003            |       |                     | 883        |       |       |                  | 3,532      |           |       | 22,957                        |       |              | 23         |              |       |              | 155,155    |              |       |    | (78,928 | ) |   |   | 2,516 |   |   | 82,298 |   |   | (24,052 | ) |   |   |
| Common stock  options exercised                  |       |                     |       |       |       |                  |       |           |       | 56                            |       |              |       |              |       |              | 153        |              |       |    |   |   |   |   |   |   |   | 153 |   |   |   |   |   |   |
| Issuance of  Employee Stock Purchase Plan stock  |       |                     |       |       |       |                  |       |           |       | 106                           |       |              |       |              |       |              | 117        |              |       |    |   |   |   |   |   |   |   | 117 |   |   |   |   |   |   |
| Compensation  related to stock options           |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              | 6          |              |       |    |   |   |   |   |   |   |   | 6 |   |   |   |   |   |   |
| Comprehensive loss:                              |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                         |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    | (13,633 | ) |   |   |   |   |   | (13,633 | ) |   | (13,633 | ) |   |   |
| Unrealized (loss)  gain on marketable securities |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   | (1,104 | ) |   | (1,104 | ) |   | (1,104 | ) |   |   |
| Currency  translation adjustment                 |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   | 180 |   |   | 180 |   |   | 180 |   |   |   |
| Balance as of  December 31, 2004            |       |                     | 883        |       |       |                  | 3,532      |           |       | 23,119                        |       |              | 23         |              |       |              | 155,431    |              |       |    | (92,561 | ) |   |   | 1,592 |   |   | 68,017 |   |   | (14,557 | ) |   |   |
| Common stock  options exercised                  |       |                     |       |       |       |                  |       |           |       | 5                             |       |              |       |              |       |              | 5          |              |       |    |   |   |   |   |   |   |   | 5 |   |   |   |   |   |   |
| Issuance of  Employee Stock Purchase Plan stock  |       |                     |       |       |       |                  |       |           |       | 55                            |       |              |       |              |       |              | 59         |              |       |    |   |   |   |   |   |   |   | 59 |   |   |   |   |   |   |
| Common stock  repurchased                        |       |                     |       |       |       |                  |       |           |       | (202                          | )          |              |       |              |       |              | (246       | )                 |       |    |   |   |   |   |   |   |   | (246 | ) |   |   |   |   |   |
| Compensation  related to stock options           |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              | 192        |              |       |    |   |   |   |   |   |   |   | 192 |   |   |   |   |   |   |
| Comprehensive loss:                              |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                         |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    | (12,215 | ) |   |   |   |   |   | (12,215 | ) |   | (12,215 | ) |   |   |
| Unrealized (loss)  gain on marketable securities |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   | (201 | ) |   | (201 | ) |   | (201 | ) |   |   |
| Currency  translation adjustment                 |       |                     |       |       |       |                  |       |           |       |                          |       |              |       |              |       |              |       |              |       |    |   |   |   |   | 7 |   |   | 7 |   |   | 7 |   |   |   |
| Balance as of  December 31, 2005            |       |                     | 883        |       |       |                  | $          | 3,532          |       |                          | 22,977     |              |       | $                 | 23         |              |       |              | $          | 155,441 |   |   |   | $ | (104,776 | ) |   |   | $ | 1,398 |   |   | $ | 55,618 |   |   | $ | (12,409 | ) |   |   |
|                                                  |            |                          |            |            |            |                       |            |                |            |                               |            |                   |            |                   |            |                   |            |                   |            |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

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**AXT, INC.CONSOLIDATED STATEMENTSOF CASH FLOWS**
|                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                | ** ** | **(In thousands)**                     | ** ** |
| **Cash flows from operating activities:**                                                 |       |                                        |       |   |   |   |   |
| Net loss                                                                                  |       | $                                           | (12,215    | ) | $ | (13,633 | ) | $ | (26,731 | ) |
| Adjustments to reconcile net loss to cash (used in)  provided by operations:         |       |                                        |       |   |   |   |   |
| Depreciation                                                                              |       | 3,745                                       |       | 4,869 |   | 5,782 |   |
| Amortization of  marketable securities premium/discount                                   |       | 192                                         |       | 307 |   | 502 |   |
| Stock-based compensation                                                                  |       | 192                                         |       | 6 |   | 28 |   |
| Non-cash restructuring  charge                                                            |       | 736                                         |       | 1,308 |   | — |   |
| Impairment of  investments                                                                |       | —                                      |       | 210 |   | 2,128 |   |
| Loss (gain) on disposal  of property, plant and equipment                                 |       | 290                                         |       | 10 |   | (11 | ) |
| (Gain) loss on disposal  on discontinued operations                                       |       | (53                                         | )          | (472 | ) | 9,475 |   |
| Changes in assets and liabilities:                                                        |       |                                        |       |   |   |   |   |
| Accounts receivable, net                                                                  |       | (1,192                                      | )          | 2,263 |   | 232 |   |
| Inventories                                                                               |       | 306                                         |       | 7,621 |   | 11,541 |   |
| Prepaid expenses                                                                          |       | 722                                         |       | (948 | ) | 2,217 |   |
| Other assets                                                                              |       | —                                      |       | (77 | ) | (137 | ) |
| Accounts payable                                                                          |       | 1,175                                       |       | (743 | ) | (1,590 | ) |
| Accrued liabilities                                                                       |       | (1,775                                      | )          | (1,001 | ) | (5,493 | ) |
| Income taxes                                                                              |       | (430                                        | )          | (140 | ) | 8,783 |   |
| Other long-term  liabilities                                                              |       | 561                                         |       | 80 |   | (457 | ) |
| Net cash (used in)  provided by operating activities                                      |       | (7,746                                      | )          | (340 | ) | 6,269 |   |
| **Cash flows from investing activities:**                                                 |       |                                        |       |   |   |   |   |
| Purchases of property,  plant and equipment                                               |       | (2,329                                      | )          | (2,139 | ) | (2,175 | ) |
| Proceeds from disposal  of property, plant and equipment                                  |       | 33                                          |       | 10 |   | — |   |
| Purchases of marketable  securities                                                       |       | (10,227                                     | )          | (25,876 | ) | (5,941 | ) |
| Proceeds from sale of  marketable securities                                              |       | 24,341                                      |       | 19,072 |   | 13,885 |   |
| Proceeds from sale of  property and equipment from discontinued opto-electronics business |       | —                                      |       | — |   | 8,600 |   |
| Proceeds from sale of assets  held for sale                                               |       | 1,303                                       |       | — |   | 5,172 |   |
| Decrease (increase) in  restricted deposits                                               |       | 765                                         |       | (1,087 | ) | (5,818 | ) |
| Net cash provided by  (used in) investing activities                                      |       | 13,886                                      |       | (7,846 | ) | 13,723 |   |
| **Cash flows from financing activities:**                                                 |       |                                        |       |   |   |   |   |
| Proceeds from issuance  of common stock                                                   |       | 64                                          |       | 270 |   | 480 |   |
| Repurchase of common  stock                                                               |       | (246                                        | )          | — |   | — |   |
| Capital lease payments                                                                    |       | —                                      |       | — |   | (8,409 | ) |
| Proceeds from long-term  debt borrowings                                                  |       | 49                                          |       | — |   | — |   |
| Long-term debt payments                                                                   |       | (659                                        | )          | (4,486 | ) | (1,718 | ) |
| Net cash used in  financing activities                                                    |       | (792                                        | )          | (4,216 | ) | (9,647 | ) |
| Effect of exchange rate  changes                                                          |       | 7                                           |       | 180 |   | 197 |   |
| Net increase (decrease)  in cash and cash equivalents                                     |       | 5,355                                       |       | (12,222 | ) | 10,542 |   |
| Cash and cash  equivalents at the beginning of the period                                 |       | 12,117                                      |       | 24,339 |   | 13,797 |   |
| Cash and cash  equivalents at the end of the period                                       |       | $                                           | 17,472     |   | $ | 12,117 |   | $ | 24,339 |   |
| **Supplemental Disclosures:**                                                             |       |                                        |       |   |   |   |   |
| Interest paid                                                                             |       | $                                           | 266        |   | $ | 271 |   | $ | 790 |   |
| Income tax refund (paid)                                                                  |       | $                                           | 150        |   | $ | (197 | ) | $ | (248 | ) |
|                                                                                           |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

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**AXT, INC.NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

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

***The Company***

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

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

***Use of Estimates***

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

***Principles of Consolidation***

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

***Fair Value of Financial Instruments***

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

60

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***Reclassifications***

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

***Foreign Currency Translation***

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

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

***Revenue Recognition***

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

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

·       theprice is fixed or determinable,

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

·       collectionof resulting receivables is probable, and

·       productreturns are reasonably estimable.

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

***Concentration of Credit Risk***

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

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

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

We perform ongoing creditevaluations of our customers’ financial condition, and limit the amount ofcredit extended when deemed necessary, but generally do not require collateral.The credit risk in our accounts receivable is substantially mitigated by ourcredit evaluation process, reasonably short collection terms and thegeographical dispersion of sales transactions. Two customers representedgreater than 10% of product revenues totaling 20.7% for the year ended December 31,2005, while no customers represented greater than 10% of revenue for the yearsended December 31, 2004 and 2003. Our top five customers represented37.5%, 30.1%, and 28.9% of product revenue for the years ended December 31,2005, 2004, and 2003, respectively. We expect that sales to certain customerswill continue to comprise a significant portion of our revenue in the future.Two customers each accounted for 10% or more of our trade accounts receivablebalance as of December 31, 2005 at 30.0% and 18.8%, respectively. Twocustomers each accounted for 10% or more of our trade accounts receivablebalance as of December 31, 2004 at 10.1% and 10.0%, respectively.

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

We classify our investments in debt and equitysecurities as available-for-sale securities as prescribed by Statement ofFinancial Accounting Standards (SFAS) No. 115, *“Accounting for Certain Investments in Debt and Equity Securities.”*We consider investments in highly liquid instruments purchased with an originalmaturity of three months or less to be cash equivalents. Our short-terminvestments are reported at fair value as of the respective balance sheet dateswith unrealized gains and losses included in accumulated other comprehensiveincome (loss) within stockholders’ equity on the consolidated balancesheets. The amortized cost of securities is adjusted for amortization ofpremiums and accretion of discounts to maturity. Such amortization is includedin other (expense) and income, net in the consolidated statements ofoperations. Realized gains and losses and declines in value judged to be otherthan temporary on available-for-sale securities are also included in other (expense)and income, net in the consolidated statements of operations. The cost ofsecurities sold is based upon the specific identification method.

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

We maintain in restricteddeposits an amount approximately equal to the amount of the taxable bond of ourlong-term debt.

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

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

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December 31, 2005,our accounts receivable balance was $5.2 million, which was net of an allowancefor doubtful accounts of $533,000. From our allowance for doubtful accounts of$537,000 at December 31, 2004, we wrote off $68,000 of fully reservedaccounts receivable for a Korean customer and decreased the allowance by$343,000 due to improved collections mainly from a Japanese customer, whileincreasing the allowance for a large customer in China of $396,000, and otherdoubtful accounts of $11,000, resulting in the allowance for doubtful accountsof $533,000 at December 31, 2005. If actual uncollectible accounts differsubstantially from our estimates, revisions to the estimated allowance fordoubtful accounts would be required, which could have a material impact on ourfinancial results for the period.

The allowance for salesreturns is also deducted from gross accounts receivable. From our allowance forsales returns of $550,000 at December 31, 2004, we utilized $487,000 forinvestigation related returns, while increasing the allowance for sales returns based on our history of sales returns$23,000 resulting in the allowance for sales returns of $86,000 at December 31,2005. The total allowances deducted from gross accounts receivable at December 31,2005 is $619,000, compared to $1,087,000 at December 31, 2004.

***Inventories***

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

***Property, Plant and Equipment***

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

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

We evaluate therecoverability of property, equipment, and intangible assets in accordance withSFAS No. 144, *“Accounting for theImpairment or Disposal of Long-Lived Assets.”* When events andcircumstance indicate that long-lived assets may be impaired, managementcompares the carrying value of the long-lived assets to the projection offuture undiscounted cash flows attributable to such assets and in the eventthat the carrying value exceeds the future undiscounted cash flows, we recordan impairment charge against income equal to the excess of the carrying valueover the asset’s fair value.

***Segment Reporting***

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

***Investments***

We invest in equityinstruments of privately-held companies for business and strategic purposes.These investments are classified as other assets and are accounted for underthe cost method as we do not have the ability to exercise significant influenceover their operations. We monitor our investments for impairment and recordreductions in carrying value when events or changes in circumstances indicatethat 

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thecarrying value may not be recoverable. Determination of impairment is highlysubjective and is based on a number of factors, including an assessment of thestrength of investee’s management, the length of time and extent to which thefair value has been less than our cost basis, the financial condition andnear-term prospects of the investee, fundamental changes to the businessprospects of the investee, share prices of subsequent offerings, and our intentand ability to hold the investment for a period of time sufficient to allow forany anticipated recovery in our carrying value.

***Stock-Based Compensation***

Wehave employee stock option plans, which are described more fully in Note 11—EmployeeBenefit Plans. We account for stock-based employee compensation arrangementsusing the intrinsic value method as prescribed in Accounting Principles BoardOpinion No. 25, *“Accounting for StockIssued to Employees,”* and related interpretations thereof.Accordingly, compensation cost for stock options is measured as the excess, ifany, of the market price of AXT’s stock at the date of grant over the stockoption exercise price. The following table illustrates the effect on our netloss and net loss per share if we had applied the fair value recognitionprovisions of SFAS No. 123, *“Accountingfor Stock-Based Compensation,”* as amended by SFAS No. 148, *“Accounting for Stock-Based Compensation Transitionand Disclosure,”* to options granted under our stock option plans.For purposes of this pro forma disclosure, the value of the options isestimated using a Black-Scholes option pricing model and amortized to expenseover the options’ vesting periods. Because the estimated value is determined asof the date of grant, the actual value ultimately realized by the employee maybe significantly different.

|                                                                                               | ** ** | **Years Ended December 31,**                        | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                    | ** ** | **(in thousands, except per share data)** | ** ** |
| Net loss to common  stockholders:                                                             |       |                                                               |       |   |   |   |   |
| As reported                                                                                   |       | $                                                                  | (12,392    | ) | $ | (13,810 | ) | $ | (26,908 | ) |
| Add: Stock-based employee compensation expense  included in net loss as reported              |       | 192                                                                |       | 6 |   | 28 |   |
| Less: Stock-based compensation expense using the  fair value based method, net of related tax |       | (1,035                                                             | )          | (1,330 | ) | (7,323 | ) |
| Pro forma net loss                                                                            |       | $                                                                  | (13,235    | ) | $ | (15,134 | ) | $ | (34,203 | ) |
| Basic and diluted net  loss per share:                                                        |       |                                                               |       |   |   |   |   |
| As reported                                                                                   |       | $                                                                  | (0.54      | ) | $ | (0.60 | ) | $ | (1.18 | ) |
| Pro forma                                                                                     |       | $                                                                  | (0.57      | ) | $ | (0.66 | ) | $ | (1.50 | ) |
| Shares used in computing  basic and diluted net loss per share                                |       | 23,047                                                             |       | 23,063 |   | 22,781 |   |

 

Theweighted average estimated per share grant date fair value of employee stockoptions granted during 2005, 2004, and 2003 was $0.89, $1.17, and $1.70,respectively. The value of options granted was estimated at the date of grantusing the following weighted average assumptions:

|                           | ** ** | **Years Ended  December 31,** | ** ** |
|---------------------------|------------|-----------------------------------------|------------|
| ** **                | ** ** | **2005**                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| Risk-free  interest rate  |       | 4.3                                     | %          | 3.6 | % | 2.9 | % |
| Expected life (in  years) |       | 5.0                                     |       | 5.0 |   | 5.0 |   |
| Dividend yield            |       | —                                  |       | — |   | — |   |
| Volatility                |       | 89.7                                    | %          | 103.0 | % | 109.0 | % |

 

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An analysis of historical information is used todetermine the above assumptions, to the extent that historical information isrelevant, based on the terms of the grants being issued in any given period.Assumptions related to the Employee Stock Purchase Plan are not presented asthe related compensation expense amounts are insignificant. The Employee StockPurchase Plan was suspended in February 2005.

SFAS No. 123 requiresthe use of option pricing models that were not developed for use in valuingemployee stock options. The Black-Scholes option pricing model was developedfor use in estimating the fair value of short-lived exchange-traded optionsthat have no vesting restrictions and are fully transferable. In addition,option pricing models require the input of highly subjective assumptions,including the option’s expected life and the price volatility of the underlyingstock. Because our employee stock options have characteristics significantlydifferent from those of traded options, and because changes in the subjectiveinput assumptions can materially affect the fair value estimate, in the opinionof management, the existing models do not necessarily provide a reliable singlemeasure of the fair value of employee stock options.

***Research and Development***

Research and developmentcosts are expensed as incurred.

***Advertising Costs***

Advertising costs,included in selling and administrative, are expensed as incurred. Advertisingcosts for the years ended December 31, 2005, 2004, and 2003 were $22,000,$51,000 and $53,000, respectively.

***Shipping and Handling costs***

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

***Income Taxes***

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

***Comprehensive Income***

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

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

Basic net income(loss) per share is computed using the weighted average number of commonshares outstanding during the periods. Diluted net income (loss) per shareis computed using the weighted average number of common shares outstanding andpotentially dilutive common shares outstanding during the periods. Potentiallydilutive common shares consist of common shares issuable upon the exercise of 

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stockoptions. Potentially dilutive common shares are excluded in net loss periods,as their effect would be anti-dilutive.

***Recent Accounting Pronouncements***

In November 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 151,“Inventory Costs - An Amendment of ARB No. 43, Chapter 4” (“SFAS 151”).SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,”to clarify the accounting for abnormal amounts of idle facility expense,freight, handling costs, and wasted material (spoilage). Among other provisions,the new rule requires that items such as idle facility expense, excessivespoilage, double freight and re-handling costs must be recognized ascurrent-period charges regardless of whether they meet the criterion of “soabnormal” as stated in ARB No. 43. Additionally, SFAS 151 requires thatthe allocation of fixed production overheads to the costs of conversion bebased on the normal capacity of the production facilities. SFAS 151 iseffective for fiscal years beginning after June 15, 2005 and is requiredto be adopted by the Company in the first quarter of 2006, beginning on January 1,2006. We do not expect SFAS 151 to have a material financial statement impact.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 153, “Exchanges of Non-monetary Assets- An Amendment of APB Opinion No. 29” (“SFAS 153”). SFAS 153 eliminatesthe exception from fair value measurement for non-monetary exchanges of similarproductive assets in paragraph 21(b) of APB Opinion No. 29, “Accountingfor Non-monetary Transactions,” and replaces it with the exception forexchanges that do not have commercial substance. SFAS 153 specifies that anon-monetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. SFAS153 is effective for the fiscal periods beginning after June 15, 2005 andis required to be adopted by the Company in the first quarter of fiscal 2006,beginning on January 1, 2006. We do not expect it to have a materialfinancial statement impact.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123R”), which requires the measurement of all share-basedpayments to employees, including grants of stock options, using afair-value-based method and the recording of such expense in the consolidatedstatements of operations. The accounting provisions of SFAS 123R wereoriginally effective for all reporting periods beginning after June 15,2005. The pro forma disclosures previously permitted under SFAS 123 nolonger will be an alternative to financial statement recognition. See “Stock-BasedCompensation” above for the pro forma net income (loss) and net income (loss)per share amounts, as if we had used a fair-value-based method similar to themethods required under SFAS 123R to measure compensation expense foremployee stock incentive awards.

In March 2005, the SEC issued Staff AccountingBulletin (“SAB”) No. 107, providing supplemental implementation guidancefor SFAS 123R. In April 2005, the Securities and Exchange Commissionapproved a rule that delayed the effective date of SFAS 123R to the firstannual reporting period beginning after June 15, 2005. Although we havenot yet determined whether the adoption of SFAS 123R will result inamounts that are similar to the current pro forma disclosures underSFAS 123, we are evaluating the requirements under SFAS 123R and SAB107 and expect the adoption to have a significant adverse impact on ourconsolidated statements of operations and net loss per share. SFAS123R will beeffective for us beginning with the first quarter of 2006.

In May 2005, the FASB issued SFAS 154, “AccountingChanges and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3” (“SFAS 154”). SFAS 154 changes the requirements for theaccounting for and reporting of a change in accounting principle, and appliesto all voluntary changes in accounting principle. It also applies to changesrequired by an accounting pronouncement in the unusual instance that thepronouncement does not include specific transition provisions. This statementrequires retrospective application to prior periods’ financial statements of 

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changes in accountingprinciple, unless it is impracticable to determine either the period-specificeffects or the cumulative effect of the change. SFAS 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005.We do not expect the adoption of this statement will have a material impact onour results of operations or financial condition.

In November 2005, theFASB issued FASB Staff Posistion FAS 115-1 and FAS 124-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments” (“FSP FAS 115-1”), which provides guidance ondetermining when investments in certain debt and equity securities areconsidered impaired, whether that impairment is other-than-temporary, and onmeasuring such impairment loss. FSP FAS 115-1 also includes accountingconsiderations subsequent to the recognition of an other-than temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments. FSP FAS 115-1is required to be applied to reporting periods beginning after December 15,2005. We are required to adopt FSP FAS 115-1 in the first quarter offiscal 2006. We do not expect the adoption of this statement will have amaterial impact on our results of operations or financial condition.

**Note 2. DiscontinuedOperations and Related Assets Held for Sale**

In June 2003, we announced the discontinuation ofour opto-electronics division, which we had established as part of ouracquisition of Lyte Optronics, Inc. in May 1999. The discontinued opto-electronicsdivision manufactured blue, cyan, and green high-brightness light emittingdiodes (HBLEDs) for the illumination markets, including full-color displays,wireless handset backlighting and traffic signals, and also manufacturedvertical cavity surface emitting lasers (VCSELs) and laser diodes for fiberoptic communications and storage area networks. Accordingly, the results ofoperations of the opto-electronics division have been segregated fromcontinuing operations and are reported separately as discontinued operations inour consolidated statements of operations for all periods presented.

In September 2003, we completed the sale ofsubstantially all of the assets of our opto-electronics business to LumeiOptoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group,Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. A portionof the purchase price equal to $1.0 million was held in escrow to satisfy anyclaims that the purchasers might make for breaches of representations orwarranties by us. Of this total escrow, $750,000 could be released after theone year anniversary of the sale of the opto-electronics business and theremainder could be released after the second anniversary of the sale. To date,we have resolved all claims made against the $1.0 million that was held inescrow. For the year ended December 31, 2005, we recorded a $550,000 gainfrom escrow refund, a $58,000 gain in property tax refunds, a $53,000 gain ondisposal of properties, and $9,000 in interest income, offset by $126,000 inexpenses totaling a net gain of $544,000. Of the $750,000 escrow amount,approximately $200,000 was received in 2004, while the remaining $550,000 wasreceived in 2005.

In June 2005, we completed the sale of a buildinglocated in Monterey Park, California. This asset had been classified as “assetsheld for sale” in the amount of $1.25 million on the consolidated balance sheetas of December 31, 2004. We received net proceeds on the sale of theproperty of approximately $1.3 million and accordingly recorded a gain ondisposal of $53,000.

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Ourconsolidated financial statements have been presented to reflect theopto-electronics business as a discontinued operation for all periodspresented. Operating results of the discontinued operation are as follows (inthousands):

|                                                                                                        | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue                                                                                                |       | $                                           | —     |   | $ | — |   | $ | 7,245 |   |
| Cost of revenue                                                                                        |       | —                                      |       | — |   | 9,972 |   |
| Gross loss                                                                                             |       | —                                      |       | — |   | (2,727 | ) |
| Operating expenses:                                                                                    |       |                                        |       |   |   |   |   |
| Selling, general and administrative                                                                    |       | —                                      |       | (222 | ) | 2,297 |   |
| Research and development                                                                               |       | —                                      |       | — |   | 814 |   |
| Total operating expenses                                                                               |       | —                                      |       | (222 | ) | 3,111 |   |
| Gain (loss) from  operations                                                                           |       | —                                      |       | 222 |   | (5,838 | ) |
| Other (income)  expense, net                                                                           |       | —                                      |       | (250 | ) | — |   |
| Interest expense                                                                                       |       | —                                      |       | — |   | 325 |   |
| Gain (loss) from  discontinued operations before benefit for income taxes and gain (loss) on  disposal |       | —                                      |       | 472 |   | (6,163 | ) |
| Income tax  benefit                                                                                    |       | —                                      |       | — |   | — |   |
| Gain (loss) on  disposal                                                                               |       | 544                                         |       | 419 |   | (9,475 | ) |
| Net gain (loss) from  discontinued operations                                                          |       | $                                           | 544        |   | $ | 891 |   | $ | (15,638 | ) |

 

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

|                                   | ** ** | **As of  December 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|
| ** **                        | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Current assets:                   |       |                              |       |   |   |
| Cash                              |       | $                                 | 472        |   | $ | 537 |   |
| Accounts receivable, net          |       | —                            |       | 19 |   |
| Assets held for sale              |       | —                            |       | 1,250 |   |
| Total current assets              |       | 472                               |       | 1,806 |   |
| Other assets                      |       | —                            |       | 200 |   |
| Total assets                      |       | $                                 | 472        |   | $ | 2,006 |   |
| Current liabilities:              |       |                              |       |   |   |
| Accounts payable                  |       | $                                 | —     |   | $ | — |   |
| Accrued liabilities               |       | 95                                |       | 359 |   |
| Total liabilities                 |       | 95                                |       | 359 |   |
| Net assets                        |       | 377                               |       | 1,647 |   |
| Total liabilities  and net assets |       | $                                 | 472        |   | $ | 2,006 |   |

 

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**Note 3. Cash, CashEquivalents and Short-Term Investments**

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

|                    | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|--------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **         | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gain**     | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** |
| **Classified as:** |       |                            |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                    |            |                                 |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Cash                                                     |   |   | $      | 12,803 |   |   |   | $      | — |   |   |   | $          | —     |   |   | $      | 12,803 |   |   | $      | 8,638  |   |   |   | $      | —     |       |       |   | $ | — |   |   | $ | 8,638  |   |
|----------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|------------|------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|------------|------------|------------|--------|---|--------|--------|--------|---|--------|--------|
| Cash equivalents:                                        |   |   |   |   |   |   |   |   |   |   |   |   |       |       |   |   |   |   |   |   |   |   |   |   |   |   |       |       |       |
| Money market fund                                        |   |   | 1,729  |   |   |   | — |   |   |   | — |   |       | 1,729      |   |   | 1,681  |   |   |   | — |   |   |   | — |   |       | 1,681      |       |
| US Treasury  and agency securities                  |   |   | — |   |   |   | — |   |   |   | — |   |       | —     |   |   | — |   |   |   | — |   |   |   | — |   |       | —     |       |
| Commercial paper                                         |   |   | 2,940  |   |   |   | — |   |   |   | — |   |       | 2,940      |   |   | 398    |   |   |   | — |   |   |   | — |   |       | 398        |       |
| Repurchase  agreements                                   |   |   | — |   |   |   | — |   |   |   | — |   |       | —     |   |   | 1,400  |   |   |   | — |   |   |   | — |   |       | 1,400      |       |
| Total cash  equivalents                                  |   |   | 4,669  |   |   |   | — |   |   |   | — |   |       | 4,669      |   |   | 3,479  |   |   |   | — |   |   |   | — |   |       | 3,479      |       |
| Total cash and  cash equivalents                         |   |   | 17,472 |   |   |   | — |   |   |   | — |   |       | 17,472     |   |   | 12,117 |   |   |   | — |   |   |   | — |   |       | 12,117     |       |
| Short-term investments:                                  |   |   |   |   |   |   |   |   |   |   |   |   |       |       |   |   |   |   |   |   |   |   |   |   |   |   |       |       |       |
| US Treasury and  agency securities                       |   |   | 4,460  |   |   |   | — |   |   |   | (12    | )      |       | 4,448      |   |   | 10,468 |   |   |   | — |   |   |   | (16    | )      |       | 10,452     |       |
| Asset-backed  securities                                 |   |   | 3,285  |   |   |   | — |   |   |   | (11    | )      |       | 3,274      |   |   | 4,410  |   |   |   | — |   |   |   | (25    | )      |       | 4,385      |       |
| Commercial paper                                         |   |   | — |   |   |   | — |   |   |   | — |   |       | —     |   |   | 1,708  |   |   |   | — |   |   |   | (1     | )      |       | 1,707      |       |
| Corporate bonds                                          |   |   | 2,504  |   |   |   | — |   |   |   | (13    | )      |       | 2,491      |   |   | 8,737  |   |   |   | — |   |   |   | (30    | )      |       | 8,707      |       |
| Corporate equity  securities                             |   |   | 1,468  |   |   |   | 1,324  |   |   |   | — |   |       | 2,792      |   |   | 1,465  |   |   |   | 1,561  |   |   |   | — |   |       | 3,026      |       |
| Total short-term  investments                            |   |   | 11,717 |   |   |   | 1,324  |   |   |   | (36    | )      |       | 13,005     |   |   | 26,788 |   |   |   | 1,561  |   |   |   | (72    | )      |       | 28,277     |       |
| Total cash, cash  equivalents and short-term investments |   |   | $      | 29,189 |   |   |   | $      | 1,324  |   |   |   | $          | (36        | )      |   | $      | 30,477 |   |   | $      | 38,905 |   |   |   | $      | 1,561      |       |       |   | $ | (72    | )      |   | $ | 40,394 |   |
| **Contractual maturities on short-term  investments:**   |   |   |   |   |   |   |   |   |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| Due within 1 year                                        |   |   | $      | 8,384  |   |   |   |   |   |   |   |   |       |       | $      | 9,682  |   |   | $      | 21,879 |   |   |   |   |   |   |       |       |       |   | $ | 23,394 |   |
| Due after 1  through 5 years                             |   |   | 3,333  |   |   |   |   |   |   |   |   |   |       | 3,323      |   |   | 4,909  |   |   |   |   |   |   |   |   |   |       | 4,883      |       |
|                                                     |   |   | $      | 11,717 |   |   |   |   |   |   |   |   |       |       | $      | 13,005 |   |   | $      | 26,788 |   |   |   |   |   |   |       |       |       |   | $ | 28,277 |   |

 

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The short-term investments amounts include $7.5million and $8.2 million recorded as restricted deposits on the consolidatedbalance sheets as of December 31, 2005 and 2004, respectively.

We manage our short-term investments as a singleportfolio of highly marketable securities that is intended to be available tomeet our current cash requirements. For the years ended December 31, 2005and 2004, we had no gross realized gain or loss on sales of ouravailable-for-sale securities.

Thegross unrealized losses related to our portfolio of available-for-salesecurities were primarily due to a decrease in the fair value of debtsecurities as a result of an increase in interest rates during 2005. We havedetermined that the gross unrealized losses on our available-for-salesecurities as of December 31, 2005 are temporary in nature. We reviewedour investment portfolio to identify and evaluate investments that haveindications of possible impairment. Factors considered in determining whether aloss is temporary include the magnitude of the decline in market value, thelength of time the market value has been below cost (or adjusted cost), creditquality, and our ability and intent to hold the securities for a period of timesufficient to allow for any anticipated recovery in market value. The followingtable provides a breakdown of our available-for-sale securities with unrealizedlosses as of December 31, 2005 and 2004 (in thousands):

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

 

| ** **                        | ** ** | **In Loss Position  < 12 months** | ** ** | **In Loss Position  > 12 months** | ** ** | **Total In  Loss Position** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------|------------|
| **2004**                          | ** ** | ** **                                               | ** ** | **Fair  Value**                                          | ** ** | **Gross  Unrealized  (Loss)**         | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** |
| Short-term investments:           |       |                                                     |       |                                                     |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| US Treasury and agency securities |       | $                                                        | 9,452      |                                                     |       | $                                     | (16        | ) |   | $ | — |   |   | $ | — |   |   | $ | 9,452 |   |   | $ | (16 | ) |   |
| Asset-backed securities           |       | 4,385                                                    |       |                                                     | (25        | )                                     |       | — |   |   | — |   |   | 4,385 |   |   | (25 | ) |   |
| Commercial paper                  |       | 1,312                                                    |       |                                                     | (1         | )                                     |       | — |   |   | — |   |   | 1,312 |   |   | (1 | ) |   |
| Corporate bonds                   |       | 8,707                                                    |       |                                                     | (30        | )                                     |       | — |   |   | — |   |   | 8,707 |   |   | (30 | ) |   |
| Total in loss  position           |       | $                                                        | 23,856     |                                                     |       | $                                     | (72        | ) |   | $ | — |   |   | $ | — |   |   | $ | 23,856 |   |   | $ | (72 | ) |   |
|                                   |            |                                                          |            |                                                          |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Note 4. Inventories, Net**

Thecomponents of inventory are summarized below (in thousands):

| ** **      | ** ** | **As of December 31,** | ** ** |
|-----------------|------------|---------------------------------------|------------|
| ** **      | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Inventories:    |       |                                  |       |   |   |
| Raw materials   |       | $                                     | 6,667      |   | $ | 4,416 |   |
| Work in process |       | 9,141                                 |       | 10,474 |   |
| Finished goods  |       | 348                                   |       | 1,572 |   |
|            |       | $                                     | 16,156     |   | $ | 16,462 |   |

 

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**Note 5. Property, Plantand Equipment**

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

| ** **                                       | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Property, plant and  equipment:                  |       |                                  |       |   |   |
| Land                                             |       | $                                     | 1,120      |   | $ | 1,120 |   |
| Building                                         |       | 16,421                                |       | 15,751 |   |
| Machinery and  equipment                         |       | 17,798                                |       | 16,176 |   |
| Leasehold  improvements                          |       | 868                                   |       | 828 |   |
| Construction in  progress                        |       | 623                                   |       | 634 |   |
|                                             |       | 36,830                                |       | 34,509 |   |
| Less: accumulated  depreciation and amortization |       | (19,524                               | )          | (15,464 | ) |
|                                             |       | $                                     | 17,306     |   | $ | 19,045 |   |

 

Depreciation expenses were$3.7 million, $4.9 million, and $5.8 million for the years ended 2005, 2004,and 2003, respectively.

**Note 6. CorporateAffiliates**

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

Ourcorporate affiliates are summarized below (in thousands) :

| ** **                                     | ** ** | **Investment Balance  As of December 31,** | ** ** | **Accounting** | ** ** | **Ownership** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------------|------------|----------------|------------|---------------|------------|
| **Affiliate**                                  | ** ** | ** **                                                     | ** ** | **2005**       | ** ** | **2004**      | ** ** | **Method** | ** ** | **Percentage** | ** ** |
| Beijing Ji Ya  Semiconductor Material Co., Ltd |       | $                                                              | 996        |           | $          | 1,071         |       | Consolidated |   |   | 46 | % |   |
| Nanjing Jin Mei  Gallium Co., Ltd              |       | 592                                                            |       | 616            |       | Consolidated  |       |   | 83 |   |   |
| Beijing BoYu  Manufacturing Co., Ltd           |       | 410                                                            |       | 409            |       | Consolidated  |       |   | 70 |   |   |
| Xilingol Tongli  Germanium Co. Ltd             |       | 864                                                            |       | 863            |       | Equity        |       |   | 25 |   |   |
| Emeishan Jia Mei High  Purity Metals Co., Ltd  |       | 596                                                            |       | 593            |       | Equity        |       |   | 25 |   |   |
|                                                |            |                                                                |            |                |            |               |            |  |  |  |  |  |  |  |  |

 

Our ownership of Beijing Ji Ya Semiconductor MaterialCo., Ltd. (Ji Ya) at inception was 51%. As of December 31, 2005, ourownership share was reduced to 46% as 5% of our ownership was given to Ji Ya’s  management upon fulfillment of working at JiYa for at least four years. We will continue to consolidate Ji Ya as wehave significant influence in management and have a majority control of theboard.

We have a similar arrangement with Nanjing Jin MeiGallium Co., Ltd. (Jin Mei) where our ownership at inception was 88%. As of December 31,2005, our ownership share was reduced to 83% as 5% of our ownership was givento Jin Mei’s management upon fulfillment of working at Jin Mei for at leastthree years. We will continue to consolidate Jin Mei as we have significantinfluence in management and have a majority control of the board.

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The investment balances for the two affiliatesaccounted for under the equity method are included in other assets in theconsolidated balance sheets. We own 25% of the ownership interests in each ofthese affiliates. These two affiliates are not considered variable interestentities because:

·       bothaffiliates have sustainable businesses of their own;

·       ourvoting power is proportionate to our ownership interests; and

·       weonly recognize our respective share of the losses and/or residual returnsgenerated by the affiliates if they occur, or both.

We do not have controlling financial interests ineither affiliate, do not maintain operational or management control, norcontrol of the board of directors, and are not required to provide additionalinvestment or financial support to either affiliate.

Undistributed retainedearnings relating to our corporate affiliates were $2.6 million and $1.4million as of December 31, 2005 and 2004, respectively. Net incomerecorded from our corporate affiliates were $1.1 million and $668,000 for theyears ended December 31, 2005 and 2004, respectively.

**Note 7. Investments**

We maintain minorityinvestments in private and publicly traded companies. These investments arereviewed for other than temporary declines in value on a quarterly basis. Theseinvestments are classified as other assets in the consolidated balance sheetsand are accounted for under the cost method as we do not have the ability toexercise significant influence over their operations. We monitor ourinvestments for impairment and record reductions in carrying value when eventsor changes in circumstances indicate that the carrying value may not berecoverable. Reasons for other than temporary declines in value include whetherthe related company would have insufficient cash flow to operate for the nexttwelve months, significant changes in the operating performance and changes inmarket conditions. As of December 31, 2005 and 2004, the minorityinvestments totaled approximately $392,000 for both years. In 2004, we recordeda $0.2 million charge related to impairment in one of the U.S. privatecompanies.

**Note 8. RestructuringCosts**

As of December 31,2005 and 2004, our restructuring accruals are as follows (in thousands):

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

 

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

 

In March 2005, we announced that we would bereducing the workforce at our Beijing, China manufacturing facility byapproximately 100 positions or approximately 15%. This measure was taken as 

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part of our ongoing effortto reduce our cost structure and bring capacity in line with current marketdemand. Accordingly, we recorded a restructuring charge of $56,000 in March 2005relating to the reduction in work force, which we completed in June 2005. We anticipate annual savings of $0.3 millionrelating to this reduction in force.

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

In December 2005, we further reduced theworkforce at our Fremont, California facility by approximately 15positions that are no longer required to support production and operations, orapproximately 29 percent, over the next 120 days. This measure wasbeing taken as part of our ongoing effort to downsize our Fremont,California facility headcount. Accordingly, we recorded a restructuring chargeof approximately $273,000 in December 2005 related to the reduction inforce for severance-related expenses from the reduction in force, all of whichwill be cash expenditures. We anticipate that the cash outflow from this chargeto be incurred over the two quarters commencing in the first quarter of 2006and we expect to save $0.9 million annually in payroll and related expenses. Alsoin December 2005, we recorded an additional restructuring charge ofapproximately $164,000, primarily related to the final liquidation proceduresof AXT’s Japan office so as to eliminate the remaining assets. There is noexpected cash outflow of this charge.

Overall for the year ended December 31,2005, we recorded restructuring charges of $236,000 relating to lease costs associated with facilitieslocated in California that are no longer required to support production. Theremaining restructuring accrual for future lease payments related to abandonedU.S. facilities of $250,000 is expected to be paid out through 2006, and isincluded on the accompanying consolidated balance sheet as accruedrestructuring.

For 2004, we announcedplans to cease all production activities in the United States and tomanufacture our products only in China during the second quarter. In June 2004,we incurred a restructuring charge of $1.1 million as a result of our decisionto close down our remaining manufacturing facilities in the United States. Inthe third and fourth quarter of 2004, we incurred additional restructuringcharges of $231,000 for a total of $1.3 million in 2004. These chargescomprised costs related to the reduction in work force effected in June 2004,and lease costs associated with the facilities located in California that areno longer required to support production. In aggregate, we eliminated 50positions, 47 of which were production workers. As of December 31, 2004,we saved approximately $560,000 in payroll and related expenses.

**Note 9. Debt**

***Credit Facility***

As of December 31, 2005, the credit facilitymaintained by us with a bank included a letter of credit supporting repaymentof our industrial bonds with an outstanding amount of $7.5 million. We havepledged and placed cash and certain investment securities with the trustdepartment of the bank as additional collateral for this facility. Accordingly,$7.5 million of cash and short-term investments are restricted.

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***Long-Term Debt***

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

| ** **                                                                                                                                                                                                            | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                                                                                                                            | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Taxable revenue  bonds, collateralized by a letter of credit from a bank, bearing interest at  the H15 30 day bond yield for commercial paper which was 4.43% on  December 31, 2005, maturing December 2023 |       | $                                     | 7,450      |   | $ | 8,050 |   |
| Joint venture  long term debt by outside shareholder at zero % interest maturing  in 2007                                                                                                                             |       | 270                                   |       | 280 |   |
|                                                                                                                                                                                                                  |       | 7,720                                 |       | 8,330 |   |
| Less current  portion                                                                                                                                                                                                 |       | (300                                  | )          | (450 | ) |
|                                                                                                                                                                                                                  |       | $                                     | 7,420      |   | $ | 7,880 |   |
| Maturities of long-term  debt as of December 31, 2005 were as follows:                                                                                                                                           |       |                                  |       |   |   |
| 2006                                                                                                                                                                                                                  |       | $                                     | 300        |   |   |   |
| 2007                                                                                                                                                                                                                  |       | 720                                   |       |   |   |
| 2008                                                                                                                                                                                                                  |       | 520                                   |       |   |   |
| 2009                                                                                                                                                                                                                  |       | 450                                   |       |   |   |
| 2010                                                                                                                                                                                                                  |       | 450                                   |       |   |   |
| Thereafter                                                                                                                                                                                                            |       | 5,280                                 |       |   |   |
|                                                                                                                                                                                                                  |       | $                                     | 7,720      |   |   |   |

 

**Note 10. Stockholders’Equity**

In August 2004, we announced the adoption of astock repurchase program in accordance with Rule 10b5-1 of theSecurities Exchange Act of 1934 to provide for the repurchase of up to $2million of our common stock. This plan was extended in July 2005.Repurchases may be made from time to time in the open market during thetwelve-month period ending July 31, 2006, at prevailing market pricesusing our own cash resources. As of December 31, 2005, we had 22,977,301shares of common stock outstanding and 201,516 shares were repurchased in 2005under this program.

The 883,000 shares of$0.001 par value Series A preferred stock issued and outstanding at December 31,2005 valued at $3,532,000 are non-voting and non-convertible preferred stockwith a 5.0% cumulative annual dividend rate payable when declared by the boardof directors and $4 per share liquidation preference over common stock. Thesepreferred shares were issued when we completed our acquisition of LyteOptronics, Inc on May 28, 1999.

**Note 11. Employee BenefitPlans**

***Stock Option Plans***

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

In July 1997, our board of directors approved the1997 Stock Option Plan (1997 Plan), which provides for granting of incentiveand non-qualified stock options to our employees and directors. Under the 1997Plan, 5,423,583 shares of common stock have been authorized for issuance.Options granted under the 

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1997 Plan are generally forperiods not to exceed ten years (five years if the option is granted to a 10%stockholder) and are granted at the fair market value of the stock at the dateof grant as determined by the board of directors. Options granted under the1997 Plan generally vest 25% at the end of one year and 2.1% each monththereafter, with full vesting after four years.

In May 2003, we announced a voluntary stockoption exchange program for our employees. Under the program, option holders,excluding our executive officers and independent directors, had the opportunityto cancel outstanding options with an exercise price in excess of $2.10 pershare in exchange for new options to be granted at a future date that was atleast six months and one day after the date of cancellation, which was June 30,2003. The number of shares of common stock subject to the new options was equalto 75% of the number subject to the exchanged options. Under the exchangeprogram, options to purchase an aggregate of 738,027 shares of our common stock,representing approximately 48% of the options that were eligible to be tenderedin the offer as of May 27, 2003, were tendered and cancelled. New optionswill vest at the same rate as the exchanged options and have an exercise priceequal to the fair market value of our common stock at the new grant date, whichwas $3.11 per share. On December 31, 2003, the Company granted options topurchase an aggregate of 522,754 shares of our common stock in exchange forsuch tendered options. In 2004, several officers voluntarily cancelled 771,000options granted to them previously.

Thefollowing summarizes our stock option activity under the 1993 Plan and the 1997Plan, and related weighted average exercise price within each category for eachof the years ended December 31, 2003, 2004, and 2005 (in thousands):

| ** **                            | ** ** | **Available  For Grant** | ** ** | **Number of  Options  Outstanding** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------|------------|-------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| Balance as of  December 31, 2002 |       |                          | 1,455      |                                     |       |                                   | 3,564      |   |   |   | $ | 14.15 |   |   |
| Granted                               |       |                          | (1,117     | )                                        |       |                                   | 1,117      |   |   |   | 2.29 |   |   |
| Exercised                             |       |                          | —     |                                     |       |                                   | (33        | ) |   |   | 2.19 |   |   |
| Cancelled                             |       |                          | 2,060      |                                     |       |                                   | (2,060     | ) |   |   | 15.64 |   |   |
| Balance as of  December 31, 2003 |       |                          | 2,398      |                                     |       |                                   | 2,588      |   |   |   | 10.79 |   |   |
| Granted                               |       |                          | (600       | )                                        |       |                                   | 600        |   |   |   | 1.51 |   |   |
| Exercised                             |       |                          | —     |                                     |       |                                   | (56        | ) |   |   | 2.73 |   |   |
| Cancelled                             |       |                          | 822        |                                     |       |                                   | (822       | ) |   |   | 15.47 |   |   |
| Balance as of  December 31, 2004 |       |                          | 2,620      |                                     |       |                                   | 2,310      |   |   |   | 2.70 |   |   |
| Granted                               |       |                          | (866       | )                                        |       |                                   | 866        |   |   |   | 1.27 |   |   |
| Exercised                             |       |                          | —     |                                     |       |                                   | (5         | ) |   |   | 1.28 |   |   |
| Cancelled                             |       |                          | 254        |                                     |       |                                   | (254       | ) |   |   | 2.45 |   |   |
| Balance as of  December 31, 2005 |       |                          | 2,008      |                                     |       |                                   | 2,917      |   |   |   | $ | 2.30 |   |   |

 

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Informationabout stock options outstanding as of December 31, 2005 is summarizedbelow (in thousands):

| ** **                              | ** ** | **Options Outstanding** | ** ** | ** **              | ** ** |
|-----------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | ** **                   | ** ** | ** **              | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Options Exercisable** | ** ** |
| **Range of  Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding** | ** ** | **Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $1.17 - $  1.37               |       |                         | 1,200      |                    |       |   | 8.89 |   |   |   | $ | 1.25 |   |   |   | 164 |   |   |   | $ | 1.22 |   |   |
| $1.38 - $  1.42               |       |                         | 495        |                    |       |   | 6.42 |   |   |   | 1.38 |   |   |   | 406 |   |   |   | 1.38 |   |   |
| $1.43 - $  2.23               |       |                         | 609        |                    |       |   | 6.49 |   |   |   | 2.16 |   |   |   | 458 |   |   |   | 2.18 |   |   |
| $2.24 - $  4.99               |       |                         | 405        |                    |       |   | 8.09 |   |   |   | 2.93 |   |   |   | 306 |   |   |   | 3.01 |   |   |
| $5.00 - $41.50                          |       |                         | 208        |                    |       |   | 2.84 |   |   |   | 9.76 |   |   |   | 202 |   |   |   | 9.76 |   |   |
|                                    |       |                         | 2,917      |                    |       |   | 7.43 |   |   |   | $ | 2.30 |   |   |   | 1,536 |   |   |   | $ | 3.03 |   |   |

 

As of December 31,2004 and 2003, options to purchase 1,114,000 shares at a weighted averageexercise price of $3.40 and 1,060,000 shares at a weighted average exerciseprice of $9.80, respectively, of our common stock were exercisable.

***Employee Stock Purchase Plan***

In February 1998, ourboard of directors approved the 1998 Employee Stock Purchase Plan (1998Purchase Plan). Our stockholders approved the 1998 Purchase Plan in March 1998.A total of 900,000 shares of our common stock were reserved for issuance underthe 1998 Purchase Plan, of which a total of approximately 845,000 shares werepurchased as of December 31, 2005. The 1998 Purchase Plan permitedeligible employees to acquire shares of our common stock through payrolldeductions. The common stock purchase price was 85% of the lower of the marketprice of the common stock at the purchase date or the date of offer to theemployee. A total of approximately 55,000, 106,000 and 404,000 shares,respectively, of common stock have been issued under the 1998 Purchase Plan forthe years ended December 31, 2005, 2004, and 2003, respectively. Wesuspended the 1998 Purchase Plan in February 2005.

***Retirement Savings Plan***

We have a 401(k) SavingsPlan (Savings Plan) which qualifies as a thrift plan under Section 401(k) ofthe Internal Revenue Code. All full-time U.S. employees are eligible toparticipate in the Savings Plan after 90 days from the date of hire. In 2005 weamended the savings plan to allow all full-time participants (as defined) tocontribute up to 10% of their earnings to the Savings Plan with a discretionarymatching amount provided by us. Our contributions to the Savings Plan were$289,000, $177,000, and $191,000 for the years ended December 31, 2005,2004 and 2003, respectively.

**Note 12. Guarantees**

***Indemnification Agreements***

We enter into standard indemnification arrangements inthe ordinary course of business. Pursuant to these arrangements, we indemnify,hold harmless, and agree to reimburse the indemnified parties for lossessuffered or incurred by the indemnified party, generally their businesspartners or customers, in connection with any U.S. patent, or any copyright orother intellectual property infringement claim by any third party with respectto our products. The term of these indemnification agreements is generallyperpetual anytime after the execution of the agreement. The maximum potentialamount of future payments we could be required to make under these agreementsis unlimited. We have never incurred costs to defend lawsuits or settle claimsrelated to these indemnification agreements. As a result, we believe theestimated fair value of these agreements is minimal.

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We have entered intoindemnification agreements with our directors and officers that may require usto indemnify our directors and officers against liabilities that may arise byreason of their status or service as directors or officers, other than liabilitiesarising from wilful misconduct of a culpable nature; to advance their expensesincurred as a result of any proceeding against them as to which they could beindemnified; and to obtain directors’ and officers’ insurance if available onreasonable terms, which we currently have in place.

***Product Warranty***

Wewarrant our products for a specific period of time, generally twelve months,against material defects. We provide for the estimated future costs of warrantyobligations in cost of sales when the related revenue is recognized. Theaccrued warranty costs represents the best estimate at the time of sale of thetotal costs that we expect to incur to repair or replace product parts, whichfail while still under warranty. The amount of accrued estimated warranty costsare primarily based on historical experience as to product failures as well ascurrent information on repair costs. On a quarterly basis, we review theaccrued balances and updates the historical warranty cost trends. The followingtable reflects the change in our warranty accrual during 2005 and 2004 (inthousands):

| ** **                                    | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Beginning accrued  warranty and related costs |       | $                                       | 135        |   | $ | 135 |   |
| Charged to cost  of revenue                   |       | 54                                      |       | — |   |
| Actual warranty  expenditures                 |       | (69                                     | )          | — |   |
| Ending accrued warranty  and related costs    |       | $                                       | 120        |   | $ | 135 |   |

 

***Sales Returns***

In March 2004, we increased our reserve forrepair and replacement costs by $745,000. Approximately $487,000 of the$745,000 sales returns reserve has been utilized and approximately $205,000 hasbeen reversed to revenue as of December 31, 2005 as we favorably resolvedan outstanding matter with a customer. We will continue to monitor the returnsfor this specific reserve.

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**Note 13. Income Taxes**

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

| ** **                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current:                            |       |                                        |       |   |   |   |   |   |   |   |   |
| Federal                             |       | $                                           | (1,099     | ) |   | $ | — |   |   |   | $ | — |   |   |
| Foreign                             |       | 149                                         |       |   | 71 |   |   |   | — |   |   |
| Total current                       |       | (950                                        | )          |   | 71 |   |   |   | — |   |   |
| Deferred:                           |       |                                        |       |   |   |   |   |   |   |   |   |
| Federal                             |       | —                                      |       |   | — |   |   |   | — |   |   |
| State                               |       | —                                      |       |   | — |   |   |   | — |   |   |
| Total deferred                      |       | —                                      |       |   | — |   |   |   | — |   |   |
| Total net benefit  for income taxes |       | $                                           | (950       | ) |   | $ | 71 |   |   |   | $ | — |   |   |

 

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

| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Statutory federal  income tax rate               |       | (35.0                                       | )%         | (35.0 | )% | (35.0 | )% |
| State income  taxes, net of federal tax benefits |       | (1.8                                        | )          | (1.7 | ) | (1.7 | ) |
| Change in valuation  allowance                   |       | 30.9                                        |       | 30.1 |   | 35.8 |   |
| Other                                            |       | (1.3                                        | )          | 7.1 |   | 0.9 |   |
| Effective tax rate                               |       | (7.2                                        | )%         | 0.5 | % | 0.0 | % |

 

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

| ** **                               | ** ** | **As of December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|
| ** **                               | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Deferred tax assets:                     |       |                                  |       |   |   |
| Net operating loss                       |       | $                                     | 42,546     |   | $ | 32,605 |   |
| Accruals and reserves not yet deductible |       | 5,345                                 |       | 5,491 |   |
| Credits                                  |       | 4,329                                 |       | 4,329 |   |
|                                     |       | 52,220                                |       | 42,425 |   |
| Deferred tax  liabilities:               |       |                                  |       |   |   |
| State taxes                              |       | (72                                   | )          | (151 | ) |
| Unrepatriated foreign earnings           |       | (1,239                                | )          | (1,239 | ) |
| Depreciation                             |       | —                                |       | (2,270 | ) |
|                                     |       | (1,311                                | )          | (3,660 | ) |
| Net deferred tax assets                  |       | 50,909                                |       | 38,765 |   |
| Valuation allowance                      |       | (50,909                               | )          | (38,765 | ) |
| Net deferred tax  assets                 |       | $                                     | —     |   | $ | — |   |

 

As of December 31, 2005, we had federal and statenet operating loss carryforwards of approximately $117.4 million and $45.1million, respectively, which will expire beginning in 2020 and 2007,respectively. In addition, we had federal tax credit carryforwards ofapproximately $1.6 million, which will expire beginning in 2019. We also hadstate tax credit carryforwards of approximately $2.7 million which will expirebeginning 2007.

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In 2005, the Internal Revenue Service closed its examinationof our tax return for the 2002 tax year, including the calculation of our 1999and 2000 net operating loss carry back. As a result of this, we reversed approximately$1.1 million of income tax payable accrued for potential exposuresrelating to those years. This amount is shown as a benefit from income taxes onour consolidated statement of operations.

The deferred tax assets valuation allowance as of December 31,2005 is attributed to U.S. federal, and state deferred tax assets, which resultprimarily from future deductible accruals, reserves, net operating losscarryforwards, and tax credit carryforwards. We believe that, based on a numberof factors, the available objective evidence creates sufficient uncertaintyregarding our ability to realize the deferred tax assets such that a fullvaluation allowance has been recorded. These factors include our history oflosses, and the lack of carryback capacity to realize deferred tax assets.

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

**Note 14. Net loss per Share**

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

| ** **                                                                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator:                                                                       |       |                                        |       |   |   |   |   |
| Loss from continuing operations                                                  |       | $                                           | (12,759    | ) | $ | (14,524 | ) | $ | (11,093 | ) |
| Gain (loss) from discontinued operations                                         |       | 544                                         |       | 891 |   | (15,638 | ) |
| Less: Preferred stock dividends                                                  |       | (177                                        | )          | (177 | ) | (177 | ) |
| Net loss to common stockholders                                                  |       | $                                           | (12,392    | ) | $ | (13,810 | ) | $ | (26,908 | ) |
| Denominator:                                                                     |       |                                        |       |   |   |   |   |
| Denominator for basic net loss per share—weighted  average common shares    |       | 23,047                                      |       | 23,063 |   | 22,781 |   |
| Effect of  dilutive securities:                                                  |       |                                        |       |   |   |   |   |
| Common stock options                                                             |       | —                                      |       | — |   | — |   |
| Denominator for  dilutive net loss per share                                     |       | 23,047                                      |       | 23,063 |   | 22,781 |   |
| Basic and diluted income  (loss) per share:                                      |       |                                        |       |   |   |   |   |
| Loss from continuing operations                                                  |       | $                                           | (0.56      | ) | $ | (0.64 | ) | $ | (0.49 | ) |
| Gain (loss) from discontinued operations                                         |       | 0.02                                        |       | 0.04 |   | (0.69 | ) |
| Net loss to common stockholders                                                  |       | $                                           | (0.54      | ) | $ | (0.60 | ) | $ | (1.18 | ) |
| Options excluded from  diluted net loss per share as the impact is anti-dilutive |       | 2,917                                       |       | 2,310 |   | 2,588 |   |

 

**Note15. Segment Information and Foreign Operations**

***Segment Information***

We operate in one segmentfor the design, development, manufacture and distribution of high-performancecompound semiconductor substrates and sale of materials. In accordance withSFAS No. 131, *“Disclosures aboutSegments of an Enterprise and Related Information,”* our chiefoperating decision-maker has been identified as the Chief Executive Officer,who reviews operating results to make decisions about allocating resources andassessing performance for the company. All material operating units qualify for

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aggregationunder SFAS No. 131 due to their identical customer base andsimilarities in economic characteristics, nature of products and services, andprocurement, manufacturing and distribution processes. Since we operate in onesegment, all financial segment and product line information required bySFAS No. 131 can be found in the consolidated financial statements.

***Geographical Information***

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

| ** **                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Product revenue:                           |       |                                        |       |   |   |   |   |
| North America*                             |       | $                                           | 5,168      |   | $ | 7,514 |   | $ | 12,009 |   |
| Europe                                     |       | 6,186                                       |       | 6,840 |   | 5,638 |   |
| Japan                                      |       | 2,854                                       |       | 5,156 |   | 4,167 |   |
| Taiwan                                     |       | 3,843                                       |       | 8,397 |   | 7,055 |   |
| Asia Pacific  (excluding Japan and Taiwan) |       | 8,485                                       |       | 7,547 |   | 5,844 |   |
|                                       |       | $                                           | 26,536     |   | $ | 35,454 |   | $ | 34,713 |   |

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*                    Primarily theUnited States

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

| ** **         | ** ** | **As of December 31,** | ** ** |
|--------------------|------------|---------------------------------------|------------|
| ** **         | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Long-lived assets: |       |                                  |       |   |   |
| North America      |       | $                                     | 6,547      |   | $ | 7,163 |   |
| Asia Pacific       |       | 10,759                                |       | 11,882 |   |
|               |       | $                                     | 17,306     |   | $ | 19,045 |   |

 

***Significant Customers***

Two customers representedgreater than 10% of revenue, totaling 20.7% for the year ended December 31,2005. No customer represented greater than 10% of product revenues for theyears ended December 31, 2004 and 2003. Our top five customers represented37.5%, 30.1%, and 28.9% of product revenue for the years ended December 31,2005, 2004, and 2003, respectively.

**Note16. Foreign Exchange Contracts and Transaction Gains/Losses**

We use short-term forward exchange contracts forhedging purposes to reduce the effects of adverse foreign exchange ratemovements. We have purchased foreign exchange contracts to hedge againstcertain trade accounts receivable denominated in Japanese yen. The change inthe fair value of the forward contracts is recognized as part of the relatedforeign currency transactions as they occur. As of December 31, 2005, wehad no outstanding commitments with respect to foreign exchange contracts.

We incurred foreigncurrency transaction exchange losses (gains) of $222,000, ($60,000), and($110,000) for the years ended December 31, 2005, 2004, and 2003,respectively.

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**Note 17. Related Party Transactions**

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

We entered into anoperating lease in July 2001 for warehouse space in Fremont, CA with 4160 BusinessCenter, LLC, a real estate holding company, in which Davis Zhang, president ofour joint venture operations, was the sole shareholder. Lease payments to 4160Business Center, LLC were approximately $484,000 for the year ended December 31,2002 and $121,000 for the three months ended March 31, 2003. In April of2003, Mr. Zhang sold this warehouse to a party unrelated to us. We beganleasing this warehouse from the new owner on the date of sale. Mr. Zhangcontinued to hold a $3.7 million note on the property as of December 31,2005.

**Note18. Commitments and Contingencies**

***Legal Matters***

On October 15, 2004, a purported securities classaction lawsuit was filed in the United States Court for the Northern Districtof California. City of Harper Woods Employees Retirement System v. AXT, Inc.et al., No. C 04 4362 MJJ. The Court consolidated the case with asubsequent related case and appointed a lead plaintiff. On April 5, 2005,the lead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc.et al., No. C 04 4362 MJJ. The lawsuit complaint names AXT, Inc. andour chief technology officer, as defendants, and is brought on behalf of aclass of all purchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during this periodthat were false and misleading. No specific amount of damages is claimed. On September 23,2005, the Court granted our motion to dismiss the complaint, with leave toamend*.*Lead plaintiff filed an amendedcomplaint, which we have moved to dismiss. We believe that there aremeritorious defenses against this litigation and intend to vigorously defendit. However, due to the inherent uncertainties of litigation, we cannotaccurately predict the ultimate outcome of the litigation. Any unfavorableoutcome of the litigation could have an adverse impact on our business,financial condition and results of operations.

On June 1, 2005, a lawsuit was filed in theSuperior Court of California, County of Alameda, *Zhao et. Al.vs. American Xtal Technology, et. al.*, No. R 605215713. Thelawsuit complaint names as defendants AXT, its chief technology officer, itsformer interim chief executive officer, a former safety department employee anda supplier to AXT. The lawsuit is brought on behalf of two former employees andtheir minor child. The complaint alleges personal injury, general negligence,intentional tort, wage loss and other damages, including punitive damages, as aresult of exposure to the child while in utero to high levels of galliumarsenide and methanol used in the production of gallium arsenide wafers. Webelieve that there are meritorious defenses against this litigation and intendto vigorously defend it. AXT’s commercial general liability insurance carrierhas agreed to fund AXT’s defense of the case, but has reserved the right todeny coverage, in whole or in part, in the future under selected policyprovisions and applicable law. There is $21 million in available limits underthe policies in question. Due to the inherent uncertainties of litigation, we cannotaccurately predict the ultimate outcome of the litigation. Any unfavorableoutcome of the litigation could have an adverse impact on our business,financial condition and results of operations.

***Leases***

Welease certain office space, manufacturing facilities and property underlong-term operating leases expiring at various dates through March 2013.Total rent expenses under these operating leases were $1.3 million, $1.3million and $1.2 million for the years ended December 31, 2005, 2004 and2003, 

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respectively. Total minimum lease payments under theseleases as of December 31, 2005 are summarized below (in thousands):

| ** ** | ** ** | **Lease Payment** | ** ** |
|------------|------------|------------------------|------------|
| 2006       |       |                   | $          | 940 |   |   |
| 2007       |       |                   | 644        |   |   |
| 2008       |       |                   | 712        |   |   |
| 2009       |       |                   | 735        |   |   |
| 2010       |       |                   | 754        |   |   |
| Thereafter |       |                   | 1,732      |   |   |
|       |       |                   | $          | 5,517 |   |   |

 

***Contract Commitmenst***

We had entered intocontracts to supply several large customers with GaAs wafers. The contractsguaranteed delivery of a certain number of wafers between January 1, 2001and December 31, 2004. The contract sales prices were subject to reviewquarterly and could be adjusted in the event that raw material prices changed.In the event of non-delivery of the determined wafer quantities in any monthlydelivery period, we could be subject to non-performance penalties of between 5%and 10% of the value of the delinquent monthly deliveries. We have not receivedany claims for non-performance penalties due to non-delivery. As of December 31,2005, we have met all of our current delivery obligations under thesecontracts. Partial prepayments received for these supply contracts totaling$125,000 and $130,000 are included in accrued liabilities in the accompanyingcondensed consolidated balance sheets as of December 31, 2005 and 2004,respectively.

**Note19. Unaudited Quarterly Consolidated Financial Data**

| ** **                             | ** ** | **Quarter**                                                        | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                             | ** ** | **First**                                                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| ** **                             | ** ** | **(in thousands, except per share data)** | ** ** |
| **2004:**                              |       |                                                               |       |   |   |   |   |   |   |
| Revenue                                |       | $                                                                  | 9,776      |   | $ | 9,524 |   | $ | 8,531 |   | $ | 7,623 |   |
| Gross profit  (loss)                   |       | 533                                                                |       | 829 |   | (2,236 | ) | 623 |   |
| Net loss                               |       | (2,560                                                             | )          | (3,847 | ) | (4,964 | ) | (2,262 | ) |
| Net loss per  share, basic and diluted |       | $                                                                  | (0.11      | ) | $ | (0.17 | ) | $ | (0.21 | ) | $ | (0.10 | ) |
| **2005:**                              |       |                                                               |       |   |   |   |   |   |   |
| Revenue                                |       | $                                                                  | 6,634      |   | $ | 6,032 |   | $ | 6,153 |   | $ | 7,717 |   |
| Gross profit                           |       | 279                                                                |       | 127 |   | 1,145 |   | 648 |   |
| Net loss                               |       | (4,123                                                             | )          | (3,279 | ) | (2,082 | ) | (2,731 | ) |
| Net loss per share,  basic and diluted |       | $                                                                  | (0.18      | ) | $ | (0.14 | ) | $ | (0.09 | ) | $ | (0.12 | ) |

 

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereto duly authorized.

AXT, Inc.

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

 

Date: March 30, 2006

**POWER OF ATTORNEY**

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

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

|                      | **Signature** | ** **                                                        | ** ** |                     | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|----------------------|---------------|-------------------------------------------------------------------|------------|---------------------|-----------|------------|------------|--|----------|------------|
| /s/ PHILIP  C.S. YIN |          | Chief Executive Officer and Director                              |       | March 30, 2006 |
| Philip  C.S. Yin     |          | *(Principal Executive Officer)*                                   |       |                |
| /s/ WILSON W. CHEUNG |          | Chief Financial Officer                                           |       | March 30, 2006 |
| Wilson  W. Cheung    |          | *(Principal Financial Officer and  Principal Accounting Officer)* |       |                |
| /s/ JESSE CHEN       |          | Chairman of the Board of Directors                                |       | March 30, 2006 |
| Jesse  Chen          |          |                                                              |       |                |
| /s/ MORRIS S. YOUNG  |          | Chief Technology Officer and Director                             |       | March 30, 2006 |
| Morris  S. Young     |          |                                                              |       |                |
| /s/ DAVID C. CHANG   |          | Director                                                          |       | March 30, 2006 |
| David  C. Chang      |          |                                                              |       |                |
| /s/ LEONARD LEBLANC  |          | Director                                                          |       | March 30, 2006 |
| Leonard LeBlanc      |          |                                                              |       |                |

 

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**AXT, Inc.**

**EXHIBITSTOFORM 10-K ANNUAL REPORT**

**Forthe Year Ended December 31, 2005**
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                          | ** ** | **Description** | ** ** |
|-----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|
| ** **3.1(3)      |       | Restated  Certificate of Incorporation                                                                                                                                                                                                                                                                              |       |
| ** **3.2(4)      |       | Certificate  of Designation, Preferences and Rights of Series A Preferred Stock  (which is incorporated herein by reference to Exhibit 2.1 to the  registrant’s form 8-K dated May 28, 1999).                                                                                                   |       |
| ** **3.3(5)      |       | Second  Amended and Restated By Laws                                                                                                                                                                                                                                                                                |       |
| ** **4.2(5)      |       | Rights  Agreement dated April 24, 2001 by and between AXT, Inc. and  ComputerShare Trust Company, Inc.                                                                                                                                                                                               |       |
| 10.1(1)               |       | Form of  Indemnification Agreement for directors and officers.*                                                                                                                                                                                                                                                |       |
| 10.2(1)               |       | 1993  Stock Option Plan and forms of agreements thereunder.*                                                                                                                                                                                                                                                        |       |
| 10.3(1)               |       | 1997  Stock Option Plan and forms of agreements thereunder.*                                                                                                                                                                                                                                                        |       |
| 10.5(1)               |       | 1998  Employee Stock Purchase Plan and forms of agreements thereunder.*                                                                                                                                                                                                                                             |       |
| 10.7(2)               |       | Purchase  and Sale Agreement by and between Limar Realty Corp #23 and AXT, Inc.  dated April 1998.                                                                                                                                                                                                        |       |
| 10.10(3)              |       | Bond  Purchase Contract between Dain Rauscher Incorporated and AXT, Inc. dated  December 1, 1998.                                                                                                                                                                                                         |       |
| 10.11(3)              |       | Remarketing  Agreement between Dain Rauscher Incorporated and AXT, Inc. dated  December 1, 1998.                                                                                                                                                                                                          |       |
| 10.15(7)              |       | Reimbursement  Agreement between Wells Fargo Bank National Association and AXT, Inc.  dated April 7, 2003.                                                                                                                                                                                                |       |
| 10.16(8)              |       | Asset  purchase agreements dated September 4, 2003 by and between Dalian Luming  Science and Technology Group, Ltd and AXT, Inc. and by and between Lumei  Optoelectronics Corp., AXT, Inc., Lyte Optronics, Inc., Beijing Tongmei  Xtal Technology and Xiamen Advanced Semiconductor Co., Ltd. |       |
| 10.17(9)              |       | Offer  letter to Mr. Philip C.S. Yin.*                                                                                                                                                                                                                                                                         |       |
| 10.18(10)             |       | Offer  letter to Mr. Minsheng Lin.*                                                                                                                                                                                                                                                                            |       |
| 10.19(11)             |       | Employement  agreement between the Company and Mr. Wilson W. Cheung.*                                                                                                                                                                                                                                          |       |
| 10.20(12)             |       | Agreement  respecting severance payment between the Company and Dr. Morris S.  Young.*                                                                                                                                                                                                                         |       |
| 10.21(13)             |       | Employement  agreement between the Company and Mr. Davis Zhang.*                                                                                                                                                                                                                                               |       |
| 21.1(1)               |       | List  of Subsidiaries.                                                                                                                                                                                                                                                                                              |       |
| 23.1                  |       | Consent  of Independent Registered Public Accounting Firm, Burr, Pilger, Mayer LLP.                                                                                                                                                                                                                                 |       |
| 23.2                  |       | Consent  of Independent Registered Public Accounting Firm, PricewaterhouseCoopers LLP.                                                                                                                                                                                                                              |       |
| 24.1                  |       | Power  of Attorney (see signature page).                                                                                                                                                                                                                                                                            |       |
| 31.1                  |       | Certification  by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                          |       |
| 31.2                  |       | Certification  by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                          |       |
| 32.1                  |       | Certification  by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                      |       |
| 32.2                  |       | Certification by Chief  Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                      |       |

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(1)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in ourRegistration Statement on Form S-1 on March 17, 1998.

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(2)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in ourRegistration Statement on Amendment No. 2 to Form S-1 on May 11,1998.

(3)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in ourAnnual Report on Form 10-K for the year ended December 31,1998.

(4)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in our Form 8-Kon June 14, 1999.

(5)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in our Form 8-Kon May 30, 2001.

(6)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in our Form 10-Qon November 12, 2002.

(7)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in our Form 10-Qon May 9, 2003.

(8)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in our Form 10-Qon November 13, 2003.

(9)          Incorporated byreference to exhibit 99.1 to registrant’s Form 8-K filed with theSEC on March 17, 2005.

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

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

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

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

*                    Managementcontract or compensatory plan.

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