**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-K**

**(MarkOne)**

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

**Forthe fiscal year ended December 31, 2004**

**OR**

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

**Forthe transition period from                          to                         **

**Commissionfile number:  000-24085**

**AXT, Inc.**

(Exact name of registrantas specified in its charter)

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

 

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

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

|        | **Title of each class** | ** ** | ** ** | **Name of each exchange on which registered** | ** ** |
|--------|----------------------------------------|------------|------------|-----------------------------------------------------------------------------|------------|
|   |                                   |

 

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

**Common Stock, $0.001 parvalue**

(Title of class)

Indicate by checkmarkwhether the registrant (1) has filed all reports required to be filed by Section 13or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. x Yes     oNo

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

Indicate by checkmarkwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act.). o Yes     xNo

The aggregate market valueof the voting stock held by non-affiliates of the registrant, based upon theclosing sale price of the common stock on June 30, 2004 as reported on theNasdaq National Market, was approximately $35,305,807. Shares of common stockheld by each officer, director and by each person who owns 5% or more of theoutstanding common stock have been excluded in that such persons may be deemedto be affiliates. This determination of affiliate status is not a conclusivedetermination for other purposes.

As of March 10, 2005,23,175,126 shares, $0.001 par value, of the registrant’s common stock wereoutstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portionsof the definitive proxy statement for the registrant’s 2005 annual meeting ofstockholders to be filed with the Commission pursuant to Regulation 14A notlater than 120 days after the end of the fiscal year covered by this form areincorporated by reference into Part III of this Form 10-Kreport.

 

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**TABLEOF CONTENTS**
| **PART I**   |
|-------------------|
| Item 1.           |   | Business |   | 2 |
| Item 2.           |   | Properties |   | 11 |
| Item 3.           |   | Legal Proceedings |   | 11 |
| Item 4.           |   | Submission of Matters to a Vote of  Security Holders |   | 12 |
| **PART II**  |
| Item 5.           |   | Market for Registrant’s Common  Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |   | 13 |
| Item 6.           |   | Selected Consolidated Financial  Data |   | 14 |
| Item 7.           |   | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |   | 16 |
| Item  7A.         |   | Quantitative and Qualitative  Disclosures About Market Risk |   | 45 |
| Item 8.           |   | Consolidated Financial Statements  and Supplementary Data |   | 46 |
| Item 9.           |   | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure |   | 47 |
| Item  9A.         |   | Controls and Procedures |   | 47 |
| Item  9B.         |   | Other Information |   | 48 |
| **PART III** |
| Item  10.         |   | Directors and Executive Officers  of the Registrant |   | 49 |
| Item  11.         |   | Executive Compensation |   | 49 |
| Item  12.         |   | Security Ownership of Certain  Beneficial Owners and Management and Related Stockholder Matters |   | 49 |
| Item  13.         |   | Certain Relationships and Related  Transactions |   | 49 |
| Item  14.         |   | Principal Accountant Fees and  Services |   | 50 |
| **PART IV**  |
| Item  15.         |   | Exhibits and Financial Statement  Schedules |   | 51 |

 

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**PART I**

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

Although forward-lookingstatements in this Annual Report reflect the good faith judgment of ourmanagement, such statements can only be based on facts and factors currentlyknown by us. Consequently, forward-looking statements are inherently subject torisks and uncertainties and actual results and outcomes may differ materiallyfrom the results and outcomes discussed in or anticipated by the forward-lookingstatements. Factors that could cause or contribute to such differences inresults and outcomes include without limitation those discussed under theheading “Risks Related to Our Business” below, as well as those discussedelsewhere in this Annual Report. Readers are urged not to place undue relianceon these forward-looking statements, which speak only as of the date of thisAnnual Report. We undertake no obligation to revise or update anyforward-looking statements in order to reflect any event or circumstance thatmay arise after the date of this Annual Report. Readers are urged to carefullyreview and consider the various disclosures made in this Annual Report, whichattempt to advise interested parties of the risks and factors that may affectour business, financial condition, results of operations and prospects.

**Item1**.   *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 enabled us to become a leading manufacturer of such substrates. Wepioneered the commercial use of VGF technology to manufacture GaAs substratesand subsequently used VGF technology to manufacture substrates from InP and Ge.Some of our competitors followed our lead by developing their own versions ofVGF technology. Customers for our substrates include United Epitaxy Company,Agilent Technologies, 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 88percent. 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.

OnJune 24, 2003, our Board of Directors approved management’s plan to exitour unprofitable opto-electronics business. The disposition was a resultof continuing operating losses and negative cash flows from the division andsignificant uncertainty regarding its future profitability.

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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. Our web siteis *www.axt.com*; however, theinformation on our web site does not constitute a part of this annual report onForm 10-K and is not incorporated herein. We make available, free ofcharge, on or through our web site, our annual, quarterly and current reports,and any amendments to those reports.

**Industry Background**

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. Theproducts made 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,including full color displays, automobile lighting, traffic lights, and channellighting; and

·       satellite communicationssystems.

The marketsfor several of these end-user applications are expected to grow; for example,iSuppli Corporation, an independent research firm, expects worldwide mobiletelephone production to grow from approximately 510 million units in 2003 toapproximately 740 million units in 2005.

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

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·       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, or HB,technique. We believe two trends reduced the appeal of these techniques: moresemiconductor 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 introduced our VGF technique in 1986 to respond to thelimitations inherent in the LEC and HB techniques, and, in recent years, someof our competitors who previously relied on the LEC or HB methods have alsodeveloped their own versions of VGF. We believe that a majority of thesubstrates sold commercially since 2003 for electronic device applications weremanufactured using VGF or similar techniques.

**The AXT Advantage**

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.**  *We pioneered the commercialuse of VGF technology to manufacture GaAs substrates and we believe thatthrough the use of VGF we became a leading worldwide supplier of GaAssubstrates, particularly for HBLED applications. Our VGF process producessubstrates with high mechanical strength and physical and chemical uniformity,as well as low crystal defect densities.

While we sold relatively few substrates for wireless andother electronic device applications in 2004, our VGF technology helps qualifyus to compete for these markets because changes in customers’ technologies areincreasing the share of substrates sold that are manufactured using VGF orcomparable 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 competitors able to deliver large volumes of six-inchdiameter VGF substrates and retain a significant amount of manufacturingcapacity for this product. Although we encountered surface morphology problemscausing our 2004 sales of six-inch diameter GaAs substrates to be lower than inprevious years, we believe that we are well-positioned to take advantage of thegrowth in 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 

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each customer, can be a barrier to entry for a new materialor supplier. Furthermore, certain of our customers now effectively specify thatthey 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 independence protects us fromdependence 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 their deviceson 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.

**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 

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low defect density and high uniformity. The crystal and theresulting substrate are mechanically strong, resulting in lower breakage ratesduring a customer’s manufacturing process. Since the temperature gradient iscontrolled 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 better consistencyand uniformity of the crystals.

Our VGFtechnique offers several benefits when compared to traditional crystal growingtechnologies. The Horizontal-Bridgeman, or HB, technique is the traditionalmethod for producing semi-conducting GaAs substrates for opto-electronicapplications. The HB technique holds the GaAs melt in a semi-cylindricalcontainer, causing crystals grown using the HB method to have a semi-circular,or D-shaped, cross-section. Accordingly, more crystal material isdiscarded when the D-shaped substrate is subsequently trimmed to a round shape.In addition, crystals grown using the HB technique have a higher defect densitythan VGF-grown crystals. The HB technique cannot be used cost-effectively toproduce substrates greater than three inches in diameter. The HB techniquehouses the GaAs melt in a quartz container during the growth process, which cancontaminate the GaAs melt with silicon impurities, making it unsuitable forproducing semi-insulating GaAs substrates.

Our VGFtechnique also offers advantages over the Liquid Encapsulated Czochralski, orLEC, technique for producing semi-insulating GaAs substrates for electronicapplications. During the LEC process, the crystal is grown by dipping a seedcrystal through molten boric oxide into a melt of gallium and arsenicpoly-crystal material and slowly pulling the seed up into the cool zone abovethe boron oxide where the crystal hardens. Unlike the VGF technique, the LECtechnique is designed so that the hotter GaAs melt is located beneath thecooler crystal, resulting in greater turbulence in the melt, and at atemperature gradient that is significantly higher than the VGF technique. Theturbulence and high temperature cause LEC-grown crystals to have a higherdislocation density than VGF-grown crystals, resulting in a higher rate ofbreakage during the device manufacturing process. As an open process, the LECtechnique also results in greater propensity for contamination and difficultycontrolling the ratio of gallium to arsenic. It requires large, complexelectro-mechanical systems that are expensive and require highly skilledpersonnel to operate. Strategy Analytics, a third-party market research firm,estimated that approximately 60 percent of the GaAs substrates sold in 2003 byall competitors to customers that manufacture electronic devices weremanufactured using VGF or similar techniques. They projected that VGF’s sharewould increase to approximately 70 percent by 2007.

The following table provides a comparison of these threetechniques: in 2003, LEC retains about 40% of the semi-insulating market and HBis still present in the semi-conducting or opto-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      |

 

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**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.

*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. In 2004, sales of gallium to parties other than us wereapproximately $3.3 million.

**Customers**

Wesell our compound semiconductor substrates and materials worldwide. Ourcustomers include:
| Advanced Epitaxy Technology |   | EMCORE             |   | Sogem                     |
|-----------------------------|--------|--------------------|--------|---------------------------|
| Agilent Technologies        |   | IQE, Inc.     |   | Sumika                    |
| Arima Optoelectronic Corp.  |   | MCP                |   | United Epitaxy Company    |
| Bookham                     |   | Motorola           |   | Visual Photonics Epitaxy  |
| Coherent Tutcore            |   | Nippon Sheet Glass |   | Xiamen Shanan Electronics |
| Dowa                        |   | Osram              |   |                      |

 

Historically, we have sold a significant portion ofour products in any particular period to a limited number of customers. No customerrepresented greater than 10% of revenues for the years ended December 31,2004, 2003, and 2002. The company’s top five customers represented 30.1% ofrevenue for the year ended December 31, 2004, 28.9% of revenue for theyear ended December 31, 2003, and 31.4% of revenue for the year endedDecember 31, 2002. We expect that sales to a small number of customerswill continue to comprise a significant portion of our revenue in the future.

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**Manufacturing, RawMaterials and Supplies**

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

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 these materialsthrough 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. Accordingly, to help ensure continued supply of materials, we formedfive joint ventures with and made investments in some suppliers of key rawmaterials required to manufacture our products, including gallium, arsenic,germanium, germanium dioxide, paralytic boron nitride crucibles, and boronoxide. We believe that these joint ventures and investments will beadvantageous in procuring materials to support our growth and cost managementgoals.

**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 Japan and through independent sales representatives in France,Germany, Japan, South Korea, Taiwan and the United Kingdom. Our direct salesforce is knowledgeable in the use of compound and single-element substrates.Our applications engineers work with customers during all stages of thesubstrate manufacturing process, from developing the precise composition of thesubstrate through 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, 2004, theunearned pre-payments we retained under this program equaled $130,000. We donot expect to continue this program after the pre-payments currently in handare utilized by customers.

*International Sales.**  *International sales are animportant part of our business. For the year ended December 31, 2004,sales to customers outside of the United States accounted for 79.2% of ourrevenue, as compared with 65.9% in 2003, and with 43.9% in 2002. The primarymarkets for sales of our products outside of the United States includecountries in Asia and Western Europe.

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**Research andDevelopment**

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

Our current substrate research and developmentactivities focus on continued development and enhancement of GaAs, InP and Gesubstrates, including haze reduction, improved yield, enhanced surface andelectrical characteristics and uniformity, greater substrate strength andincreased crystal length. In addition, during 2004 we spent 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 developmentexpenses were $1.5 million in 2004, compared with $1.3 million in 2003 and with$2.3 million in 2002. We expect to increase our rate of expenditure on researchand development costs by approximately 15% in 2005.

**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 to compete intarget markets also depends on factors such as:

·       the timing and success of thedevelopment and introduction of new products and product features by us and ourcompetitors;

·       the availability ofadequate sources of raw materials;

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

·       general economic conditions.

Our primary competition inthe market for compound semiconductor substrates includes Crystal Technologies,Freiberger Compound Materials, Japan Energy, Mitsubishi Chemical Corporation,and Sumitomo Electric Industries. We believe that at least two of ourcompetitors are shipping high volumes of GaAs substrates manufactured using atechnique similar to our VGF technique. In addition, as a result of qualityproblems that we have experienced, we believe that some customers haveallocated some of their requirements for VGF grown substrates across morecompetitors and we believe that we may have lost revenue and market share as aresult of these customer decisions. In addition, we also face competition 

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fromcompound semiconductor device manufacturers that produce substrates for theirown internal use, including Hitachi, and from companies such as IBM that areactively developing alternative compound semiconductor materials.

**Protection of ourIntellectual Property**

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

To date, we have beenissued four U.S. patents and have four U.S. patent applications pending, whichrelate to our VGF products and processes. We have fifteen patent applicationspending (in PCT/national stage process) in Europe, Canada, China, Japan andSouth Korea which are based on our U.S. patents that relate to our VGFprocesses. We have one issued foreign patent.

**EnvironmentalRegulations**

We are subject to federal,state and local environmental laws and regulations, including laws in China aswell as the U.S. These laws, rules and regulations govern the use,storage, discharge and disposal of hazardous chemicals during manufacturing,research and development and sales demonstrations. If we fail to comply withapplicable regulations, we could be subject to substantial liability forclean-up efforts, personal injury and fines or suspension or cessation of ouroperations.

**Employees**

As of December 31,2004, we had 1,010 employees, of whom 854 were principally engaged inmanufacturing, 112 in sales and administration, and 44 in research anddevelopment. Of these employees, 65 are located in the U.S., 943 in China and 2in Japan. As a result of shifting more of our substrate manufacturing to China,we reduced our headcount in our Fremont, California facilities, and expectfurther reductions during 2005. Some of our employees in China are representedby a union, but we have never experienced a work stoppage. Although morale hasbeen affected by our workforce reductions in California, we consider ourrelations with our employees to be good.

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**Item2**.   *Properties*

Ourprincipal properties as of March 10, 2005 are as follows:
| **Location**      | ** ** | ** ** | ** ** | **Square  Feet**               | ** ** | **Principal Use**                                                                 | ** ** | **Ownership** |
|-------------------|------------|------------|------------|--------------------------------|------------|-----------------------------------------------------------------------------------|------------|---------------|
| Fremont, CA       |       | 80,000     |       | Vacant                         |       | Owned                                                                             |
| Fremont, CA       |       | 14,441     |       | Vacant                         |       | Operating lease, expires  May 2005                                           |
| Fremont, CA       |       | 9,280      |       | Warehouse                      |       | Operating lease, expires  June 2005                                          |
| Fremont, CA       |       | 24,100     |       | Warehouse                      |       | Operating lease, expires  July 2006                                          |
| Fremont, CA       |       | 55,000     |       | Production and  Administration |       | Operating lease, expires  March 2013                                         |
| Monterey Park, CA |       | 22,000     |       | Vacant                         |       | Owned; accepted offer to  purchase, expected to complete sale in 2nd quarter 2005 |
| 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                                                                             |
| Xianshee, China   |       | 56,500     |       | Production                     |       | Owned by Beijing Ji Ya  Semiconductor Materials, Co., Ltd.*                       |
| Xianshee, China   |       | 7,500      |       | Administration                 |       | Owned by Beijing Ji Ya  Semiconductor Materials, Co., Ltd.*                       |
| Xianshee, China   |       | 1,000      |       | Administration                 |       | Owned by Beijing Ji Ya  Semiconductor Materials, Co., Ltd.*                       |
| Nanjing, China    |       | 22,000     |       | Production                     |       | Owned by Nanjing Jin Mei  Gallium Co., Ltd.*                                      |
| Nanjing, China    |       | 5,700      |       | R&D and  Administration    |       | Owned by Nanjing Jin Mei  Gallium Co., Ltd.*                                      |
| Nanjing, China    |       | 3,900      |       | Production                     |       | Owned by Nanjing Jin Mei  Gallium Co., Ltd.*                                      |
| Beijing, China    |       | 7,600      |       | Production and Administration  |       | Owned by Beijing Bo Yu Semiconductor  Vessel Craftwork Technology*           |

----

*                    Joint venturesin which we hold an interest of between 25 percent and 88 percent.

We consider each facilityto be in good operating condition and adequate for its present use, and believethat each facility has sufficient plant capacity to meet its current andanticipated operating requirements. We do not intend to renew the operatingleases of properties in Fremont and El Monte, California, that expire in 2005and 2006, respectively, as we are no longer using such facilities.

**Item3**.   *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 lawsuit names AXT, Inc. and our chiefexecutive officer, China operations, as defendants, and is brought on behalf ofa class of all purchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during thisperiod that 

11

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were false and misleading.No specific amount of damages is claimed. On February 4, 2005, the Courtconsolidated the case with a related case making similar allegations, andappointed a lead plaintiff, who will file a consolidated complaint. We believethat there are meritorious defenses against this litigation and intends tovigorously defend it. However, due to the inherent uncertainties of litigation,we cannot accurately predict the ultimate outcome of the litigation. Anyunfavorable outcome of the litigation could have an adverse impact on ourbusiness, financial condition and results of operations.

On December 2, 2004,we executed an agreement with Sumitomo Electric Industries, Ltd. (“SEI”), aJapanese corporation, to settle litigation commenced by SEI against AXT inJapan alleging infringement of certain SEI patents, and an interference actionbetween an AXT patent and an SEI reissue application brought in the UnitedStates. We and SEI entered into a four-year cross-licensing agreement for allintellectual property used by either company related to compound semiconductorsubstrates, which will expire on December 31, 2008, with the exception ofthe patents that were the basis for the litigation in Japan and theinterference in the U.S. where the license agreement shall last for the life ofthese patents. Under the terms of the settlement, we made a payment to SEI inthe amount of Japanese Yen one hundred and forty-seven million (¥147,000,000)on January 4, 2005, and we will make on-going royalty payments through2012 on certain products sold by us in Japan. Subsequent to that payment, SEIdropped the litigation in Japan and we abandoned the interference proceedingsin the U.S.

**Item4**.   *Submission of Matters to a Vote of Security Holders*

None

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**PART II**

**Item5**.   *Market for Registrant’sCommon Equity, Related Stockholder Matters and Issuer Purchases of EquitySecurities*

Our common stock has beentrading publicly on the Nasdaq National Market, (NASDAQ) under the symbol “AXTI”since May 20, 1998, the date we consummated our initial public offering.The following table sets forth the range of high and low sales prices on NASDAQof the common stock for the periods indicated, as reported by NASDAQ. Suchquotations represent inter-dealer prices without retail markup, markdown orcommission and may not necessarily represent actual transactions.
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| 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 |   |
| 2003           |       |     |       |    |       |
| First Quarter  |       | $        | 1.95       |    | $          | 0.67 |   |
| Second Quarter |       | $        | 1.65       |    | $          | 0.68 |   |
| Third Quarter  |       | $        | 3.12       |    | $          | 1.20 |   |
| Fourth Quarter |       | $        | 3.42       |    | $          | 1.89 |   |

 

As of December 31, 2004, there were 107 holdersof record of our common stock. Because many shares of AXT’s common stock areheld by brokers and other institutions on behalf of stockholders, we are unableto estimate the total number of stockholders.

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

**Issuer Purchases ofEquity Securities**

In August 2004, weannounced the adoption of a stock repurchase program in accordance with Rule 10b5-1of the Securities Exchange Act of 1934 to provide for the repurchase of up to$2 million of our common stock. Repurchases may be made from time to time inthe open market during the twelve-month period ending July 31, 2005, atprevailing market prices using our own cash resources. As of December 31,2004, we had 23.1 million shares of common stock outstanding and none wererepurchased in 2004 under this program. In January 2005, 10,000 shareswere repurchased.

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**Item6**.   *Selected ConsolidatedFinancial Data*

Thefollowing selected consolidated financial data are 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,**                        | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                  | ** ** | **(in thousands, except per share data)** | ** ** |
| **Income Statement Data:**                                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue                                                                     |       | $                                                                  | 35,454     |   | $ | 34,713 |   | $ | 44,865 |   | $ | 108,800 |   | $ | 113,374 |   |
| Cost of revenue                                                             |       | 35,705                                                             |       | 32,478 |   | 53,758 |   | 67,494 |   | 61,361 |   |
| Gross profit  (loss)                                                        |       | (251                                                               | )          | 2,235 |   | (8,893 | ) | 41,306 |   | 52,013 |   |
| Operating expenses:                                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Selling, general, and administrative                                        |       | 11,561                                                             |       | 10,475 |   | 13,860 |   | 17,208 |   | 13,619 |   |
| Research and development                                                    |       | 1,479                                                              |       | 1,337 |   | 2,339 |   | 3,876 |   | 4,307 |   |
| Impairment charges                                                          |       | 210                                                                |       | — |   | 14,632 |   | — |   | — |   |
| Restructuring costs                                                         |       | 1,308                                                              |       | — |   | — |   | — |   | — |   |
| Total operating expenses                                                    |       | 14,558                                                             |       | 11,812 |   | 30,831 |   | 21,084 |   | 17,926 |   |
| Income (loss)  from operations                                              |       | (14,809                                                            | )          | (9,577 | ) | (39,724 | ) | 20,222 |   | 34,087 |   |
| Interest expense                                                            |       | 290                                                                |       | 466 |   | 437 |   | 831 |   | 2,357 |   |
| Other (income)  and expense, net                                            |       | (646                                                               | )          | 1,050 |   | 12,703 |   | 13,379 |   | (28,463 | ) |
| Income (loss)  from continuing operations before provision for income taxes |       | (14,453                                                            | )          | (11,093 | ) | (52,864 | ) | 6,012 |   | 60,193 |   |
| Provision for  income taxes                                                 |       | 71                                                                 |       | — |   | 2,119 |   | 2,164 |   | 22,874 |   |
| Income (loss) from  continuing operations                                   |       | (14,524                                                            | )          | (11,093 | ) | (54,983 | ) | 3,848 |   | 37,319 |   |
| Discontinued operations:                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Gain (loss) from discontinued operations                                    |       | 472                                                                |       | (6,163 | ) | (34,625 | ) | (13,818 | ) | (22,264 | ) |
| Gain (loss) on disposal                                                     |       | 419                                                                |       | (9,475 | ) | — |   | — |   | (1,341 | ) |
| Benefit for income taxes                                                    |       | —                                                             |       | — |   | (8,427 | ) | (4,974 | ) | (7,896 | ) |
| Gain (loss) from  discontinued operations                                   |       | 891                                                                |       | (15,638 | ) | (26,198 | ) | (8,844 | ) | (15,709 | ) |
| Net income (loss)                                                           |       | $                                                                  | (13,633    | ) | $ | (26,731 | ) | $ | (81,181 | ) | $ | (4,996 | ) | $ | 21,610 |   |
| Basic income (loss) per  share:                                             |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations                                    |       | $                                                                  | (0.64      | ) | $ | (0.49 | ) | $ | (2.46 | ) | $ | 0.17 |   | $ | 1.90 |   |
| Gain (loss) from discontinued operations                                    |       | 0.04                                                               |       | (0.69 | ) | (1.17 | ) | (0.40 | ) | (0.80 | ) |
| Net income (loss)                                                           |       | $                                                                  | (0.60      | ) | $ | (1.18 | ) | $ | (3.63 | ) | $ | (0.23 | ) | $ | 1.10 |   |
| Diluted income (loss)  per share:                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations                                    |       | $                                                                  | (0.64      | ) | $ | (0.49 | ) | $ | (2.46 | ) | $ | 0.17 |   | $ | 1.77 |   |
| Gain (loss) from discontinued operations                                    |       | 0.04                                                               |       | (0.69 | ) | (1.17 | ) | (0.39 | ) | (0.75 | ) |
| Net income (loss)                                                           |       | $                                                                  | (0.60      | ) | $ | (1.18 | ) | $ | (3.63 | ) | $ | (0.23 | ) | $ | 1.03 |   |
| Shares used in per share  calculations:                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                       |       | 23,063                                                             |       | 22,781 |   | 22,433 |   | 22,278 |   | 19,677 |   |
| Diluted                                                                     |       | 23,063                                                             |       | 22,781 |   | 22,433 |   | 22,879 |   | 21,059 |   |

 

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| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                     | ** ** |
| **Balance Sheet Data:**                          |       |                                        |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                       |       | $                                           | 12,117     |   | $ | 24,339 |   | $ | 13,797 |   | $ | 37,538 |   | $ | 68,585 |   |
| Short-term  investments                          |       | 20,062                                      |       | 14,669 |   | 8,205 |   | 25,673 |   | 30,852 |   |
| Working capital                                  |       | 45,861                                      |       | 57,335 |   | 65,375 |   | 125,295 |   | 140,387 |   |
| Restricted  deposits                             |       | 8,215                                       |       | 9,302 |   | 11,150 |   | — |   | — |   |
| Long-term  investments                           |       | —                                      |       | — |   | 3,657 |   | 6,552 |   | — |   |
| Total assets                                     |       | 87,540                                      |       | 107,023 |   | 145,667 |   | 243,359 |   | 250,220 |   |
| Long-term capital  lease, net of current portion |       | —                                      |       | — |   | 4,847 |   | 10,002 |   | 7,278 |   |
| Long-term debt,  net of current portion          |       | 7,600                                       |       | 8,842 |   | 13,289 |   | 14,342 |   | 15,123 |   |
| Stockholders’ equity                        |       | 68,017                                      |       | 82,298 |   | 105,657 |   | 186,322 |   | 185,347 |   |
|                                                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 Risks Related to OurBusiness and elsewhere in this Annual Report. This discussion should be read inconjunction with *“Selected ConsolidatedFinancial Data”* and our consolidated financial statements andrelated notes included elsewhere in this Form 10-K.

**Critical Accounting Policies and Estimates**

We have prepared ourconsolidated financial statements in accordance with accounting principlesgenerally accepted in the United States of America. Accordingly, we have had tomake estimates, assumptions and judgments that affect the amounts reported onour consolidated financial statements. These estimates, assumptions andjudgments about future events and their effects on our results cannot bedetermined with certainty, and are made based upon our historical experienceand on other assumptions that are believed to be reasonable under thecircumstances. These estimates may change as new events occur or additionalinformation is obtained, and we may periodically be faced with uncertainties,the outcomes of which are not within our control and may not be known for aprolonged 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 sellhigh-performance compound semiconductor substrates and sell certain rawmaterials including gallium, germanium dioxide, and pBN crucibles. After weship our products, there are no remaining obligations or customer acceptancerequirements that would preclude revenue recognition. Our products aretypically sold pursuant to a purchase order placed by our customers, and ourterms and conditions of sale do not require customer acceptance. We recognizerevenue upon shipment and transfer of title of products to our customers, whichis either upon shipment from our dock, receipt at the customer’s dock, orremoval from consignment inventory at the customer’s location, provided that wehave received a signed purchase order, the price is fixed or determinable,title and risk of ownership have transferred, collection of resultingreceivables is probable, and product returns are reasonably estimable. We donot provide training, installation or commissioning services. Additionally, wedo not provide discounts or other incentives to customers except for onecustomer with whom we agreed in the fourth quarter of 2004 to provide acertain amount of cumulative discounts on future product purchases from us. Wewill recognize these discounts in future periods as a reduction in revenue asproducts 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 $285,000 of the $745,000 sales returns reserve had been utilizedas of December 31, 2004. See further discussion in “Results of Operations”below.

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***Allowance forDoubtful Accounts***

We periodically review thelikelihood of collection on our accounts receivable balances and provide anallowance for doubtful accounts receivable primarily based upon the age ofthese accounts. We provide a 100% allowance for U.S. receivables in excess of 90days and for foreign receivables in excess of 120 days. We assess theprobability of collection based on a number of factors, including the length oftime a receivable balance has been outstanding, our past history with thecustomer and their credit worthiness.

In previous years, threeof our customers had filed for bankruptcy protection. Upon notification of thebankruptcy, we immediately stopped shipping orders to these customers otherthan on payment in advance. At that time, the outstanding balances of thesecustomers had been fully reserved. The related accounts receivable balances andreserve were subsequently written off in November 2004 when we finallydetermined that the balances were uncollectible. This determination was made asa result of our unsuccessful efforts to collect these accounts receivable, thesignificant length of time that the receivables balance was outstanding, andthe unlikelihood that we would collect the balances from the bankrupt’s estate.As of December 31, 2004 and 2003, our accounts receivable balance was $4.0million and $6.3 million, respectively, which was net of an allowance fordoubtful accounts of $1.1 million and $4.3 million, respectively. During 2004,we wrote off $3.5 million of fully reserved accounts receivable and increasedthe allowance for doubtful accounts by $0.3 million. If actual uncollectibleaccounts differ substantially from our estimates, revisions to the estimatedallowance for doubtful accounts would be required, which could have a materialimpact on our financial results for the period.

***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 31,2004, accrued product warranties totaled $135,000. 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 themanufacturing process, the wafers and ingots comprising work-in-process may beheld in inventory for up to two years and three years, respectively, as therisk of obsolescence for these materials is low. We routinely evaluate thelevels of our inventory in light of current market conditions in order toidentify excess and obsolete inventory and provide a valuation allowance forcertain inventories based upon the age and quality of the product and theprojections for sale of the completed products. During the third quarter of2004, it became apparent that our revenues were likely to continue to declinein the fourth and subsequent quarters due to the need to re-qualify ourproducts with several customers. Furthermore, many new orders were for productswith specifications that differed from the features of the products held ininventory. In accordance with our policy, we evaluated the levels of ourinventory, and determined that in light of current market conditions, we hadexcess and obsolete inventory based upon its age and quality, and that theinventory exceeded the sales projections as revised. Accordingly, we establisheda reserve for the excess. As of December 31, 2004 and 2003, we had aninventory reserve of $6.1 million and $7.2 million, respectively. The majorityof this inventory has not been scrapped. If actual demand for our products wereto be substantially lower than estimated, additional inventory adjustments forexcess or obsolete inventory might be required, which could have a materialimpact on our business, financial condition and results of operations.

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***Impairment ofInvestments***

We classify ourinvestments in debt and equity securities as available-for-sale securities asprescribed by Statement of Financial Accounting Standards (SFAS) No. 115, *“Accounting for Certain Investments in Debt andEquity Securities.”* All available-for-sale securities with a quotedmarket value below cost (or adjusted cost) are reviewed in order to determinewhether the decline is other-than-temporary. Factors considered in determiningwhether a loss is temporary include the magnitude of the decline in marketvalue, the length of time the market value has been below cost (or adjustedcost), credit quality, and our ability and intent to hold the securities for aperiod of time sufficient to allow for any anticipated recovery in marketvalue.

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 ofLong-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.

***Employee StockOptions***

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 APB Opinion No. 25 and, as such,generally recognize no compensation cost for employee stock options. Theadoption of Statement of Financial Accounting Standards No. 123 (revised),“Share-Based Payment” (SFAS 123R) is expected to result in a material increasein expense during the second half of 2005 based on unvested options outstandingas of December 31, 2004 and current compensation plans. While the effectof adoption depends on the level of share-based payments granted in the futureand unvested grants on the date we adopt SFAS 123(R), the effect of thisaccounting standard on our prior operating results would approximate the effectof SFAS 123 as described in the disclosure of pro forma net loss and net lossper share. See “Note 1—The Company and Summary of Significant AccountingPolicies” of the notes to consolidated financial statements.

***Income Taxes***

We account for incometaxes in accordance with SFAS No. 109 (SFAS 109), *“Accounting for Income Taxes,”* whichrequires that deferred tax assets and liabilities be recognized using enactedtax rates for the effect of temporary differences between the book and taxbases of recorded assets and liabilities. SFAS 109 

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alsorequires that deferred tax assets be reduced by a valuation allowance if it ismore likely than not that a portion of the deferred tax asset will not berealized.

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

**Results 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. Asa result of the discontinuance of our opto-electronics division, and the saleof substantially all of the assets of this business in 2003, we now have oneoperating segment: our substrate business. We recorded our first substratesales in 1990 and our substrate division currently sells gallium arsenide(GaAs) and indium phosphide (InP) substrates to manufacturers of semiconductordevices for use in applications such as fiber optic and wirelesstelecommunications, light emitting diodes (LEDs) and lasers. We also sell rawmaterials including gallium and germanium through our participation inmajority- and minority-owned joint ventures. We had the capability tomanufacture germanium substrates for use in satellite solar cells but withdrewfrom this business during 2000 so that we could more profitably use our thenconstrained capacity. We are now trying to re-qualify our germanium substrateswith the few existing satellite solar cell system manufacturers.

***ContinuingOperations***

Our continuing business,primarily sales of our substrate products, is dependant on the semiconductorindustry, which is highly cyclical and has historically experienced downturnsboth as a result of economic changes and overcapacity.

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

In 2003, we believe thatthe wireless communications and HBLED markets grew, but our revenue did notincrease until the fourth quarter of 2003 due to continued reductions inprices, and time required to improve our substrate surface quality and regainsome lost customers. Revenue for 2003 fell by $10.2 million, or 22.6% comparedwith 2002. We recorded net losses in each quarter of 2003. During 2003, wecontinued to shift more of our manufacturing operations to China and reducedour costs incurred in the United States.

In 2004, our revenueincreased $0.7 million as compared to 2003, primarily as a result of increaseddemand for HBLEDs.

In March 2004, welearned of certain failures to comply with requirements for product testing andthe provision of testing data and information relating to requirements ofcertain customers. Specifically, we 

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determinedthat in some cases we had not provided accurate data to customers confirmingthat products shipped were compliant with all specifications provided by thecustomer, or had been manufactured at the location specified by the customer.As a result of our conclusions, we reorganized our production and qualitycontrol procedures, established quality control and assurance as a directreporting group to the chief executive officer, and implemented measures,including additional employee training, statistical sampling of productshipments during the quarter, and review of our satisfaction of customerspecifications each quarter, to ensure adherence to operational controls. Wealso implemented certain executive management changes.

As a result of theweaknesses identified, in the first quarter of 2004 we increased our salesreturn reserve by $745,000, based on our best estimate of future returnsrelated to this matter. Approximately $285,000 of the $745,000 sales returnsreserve had been utilized as of December 31, 2004. This reserve was based,in part, on discussion with affected customers. The amount of the reserve wasdetermined in part based upon the amount of our historical product returns,payment history of prior period receivables, discussions with customersconcerning the non-compliant product and testing data, and estimated levels ofour product maintained by customers, and likelihood that products previouslyshipped would be returned to us.

During the second quarterof 2004, we announced plans to cease all production activities in the United Statesand to manufacture our products only in China. See further discussion under “Impairmentand Restructuring Charges” below.

***DiscontinuedOpto-Electronics Business***

In June 2003, weannounced the discontinuation of our opto-electronics division, which we hadestablished as part of our acquisition of Lyte Optronics, Inc. in May 1999.The discontinued opto-electronics division manufactured blue, cyan, andgreen high-brightness light emitting diodes (HBLEDs) for the illuminationmarkets, including full-color displays, wireless handset backlighting andtraffic signals, and also manufactured vertical cavity surface emitting lasers(VCSELs) and laser diodes for fiber optic communications and storage areanetworks. Accordingly, the results of operations of the opto-electronicsdivision have been segregated from continuing operations and are reportedseparately as discontinued operations in our consolidated statements ofoperations for all periods presented. See Note 2 to our consolidated financialstatements for details regarding the accounting for discontinued operations.

In September 2003, wecompleted the sale of substantially all of the assets of our opto-electronicsbusiness to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science andTechnology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6million. A portion of the purchase price equal to $1.0 million was held inescrow to satisfy any claims that the purchaser might make for breaches ofrepresentations or warranties by us. Of this total escrow $750,000 could bereleased after the one year anniversary of the sale of the opto-electronicsbusiness and the remainder could be released after the second anniversary ofthe sale. Given the difficult negotiations we encountered with the acquiringcompany when negotiating the sale of the opto-electronics business, as well asthe historical operating problems of the business, we determined there wassignificant uncertainty regarding the recoverability of the escrowed amounts.Accordingly, we did not recognize the cash held in escrow in recording the saleof the opto-electronics division. We will only record amounts as and whenthey are received. To date, we have resolved all claims made against the first$750,000 held in escrow by the acquiring company, and expect to receive all but$31,000 of the first $750,000 held in escrow. As of December 31, 2004,approximately $419,000 was released from escrow and accordingly we recorded again on discontinued operations in 2004. In February 2005, we received anadditional $300,000 from escrow, leaving $250,000 in escrow, which will not beeligible for release until September 2005.

In addition, we retain abuilding located in Monterey Park, California that we have listed on the marketfor sale. This asset has been classified as held for sale on the consolidatedbalance sheets as of 

20

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December 31,2004 and 2003. We recorded in the fourth quarter 2004 a $0.25 million marketvalue adjustment after we accepted an offer in January 2005 from a real estatedeveloper to purchase the property for net proceeds of approximately $1.25million, after deducting estimated commission and selling expenses. We expectthe sale to be completed in the second quarter of 2005.

***Impairment andRestructuring Charges***

***Inventory Impairment***

Prior to 2001, our markets had steadily increased,causing us to build inventory to meet demand. In the second half of 2001, weexperienced a 58.5% decrease in revenue as a result of a rapid decline in themobile and fiber optic telecommunications markets. We experienced lowerrevenues and slower bookings than forecast, as well as postponements andcancellations of orders. The market decline continued into 2002, as significantexcess capacity developed in the substrate industry, sales prices declined, andour revenues fell, resulting in a higher ratio of inventory levels to revenue.In addition, two competitors had developed and were successfully sellingproducts with technologies similar to ours, capturing a significant portion ofour market share. With this unexpected loss in market share, we determined thatit would be harder to recover even once the market improved. As our revenuecontinued to decline, and the industry continued to experience excess capacity,it became apparent by the fourth quarter of 2002 that the amount of inventorywe would be able to utilize was significantly less than previously projectedand that the amount of inventory on hand exceeded the then current salesprojections for those products. As a result, we wrote down $9.6 million ofobsolete inventory in 2002, none of which has been subsequently sold. Of thisamount, inventory valued at $1.2 million and $1.7 million were scrapped in thesecond and fourth quarter of 2003, respectively.

In September 2004, wewrote down an additional $2.1 million of obsolete inventory. The wafers andingots comprising the written-down inventory had been manufactured within theprior two and three years, respectively. During the third quarter of 2004, itbecame apparent that our revenues were likely to continue to decline in thefourth and subsequent quarters due to the need to re-qualify our products withseveral customers. Furthermore, many new orders were for products withspecifications that differed from the features of the products held ininventory. In accordance with our policy, we evaluated the levels of ourinventory, and determined that in light of current market conditions, we hadexcess and obsolete inventory based upon its age and quality, and that theinventory exceeded the sales projections as revised. Accordingly, weestablished a reserve for the excess. The majority of this inventory has notbeen scrapped.

***Reduction in Long-LivedAssets***

Also as a result of thisdecline and the adverse impact on our revenues, during the second quarter of2002 we revised our financial forecast and initiated an aggressive effort toreduce our substrate manufacturing costs. This included moving more of oursubstrate manufacturing to China beginning in the second quarter of 2002, andultimately shutting down our Fremont, California facility. Given the loweredsales projections and the expectation to close down our Fremont manufacturingfacility, we undertook a review of the long-lived assets of our substratebusiness in order to determine whether the expected undiscounted, future cashflows were sufficient to recover the carrying values of the related assets.This review undertaken in the second quarter of 2002 indicated that animpairment charge of $14.6 million was required to write down these long-livedassets to their estimated fair market value. In order to determine the fairvalue of these assets, we calculated the present value of expected cash flowsof the substrate operations. The estimated cash flows were based on our updatedrevenue outlook, and accordingly we revised our operating budget and relatedcash flows discounted at the rate reflecting our average cost of capital.

21

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***Opto-Electronics Business***

During the third quarterof 2002, we recorded an additional impairment charge of $24.5 million relatedto our opto-electronics division. The primary business of this divisionwas the manufacture of light-emitting diodes (“LED’s”). Our business inthis division was heavily dependent on one customer. In the third quarter of2002, we experienced a significant quality problem which ultimately resulted inthis customer canceling all current and future orders. Given the uncertainty ofresolving the quality issue and the significance of this customer to theoperations, we undertook an impairment review in the third quarter whichindicated that the undiscounted cash flows were not sufficient to recover thecarrying value of the related long-lived assets. Accordingly, an impairmentcharge was recorded to write down the assets to their estimated fair market value.The estimated fair market value was based on management’s estimate of the fairvalue, with management making this determination based in part on anindependent valuation of the assets.

As a result of ourdecision to discontinue the opto-electronics business in 2003, the $24.5million charge related to the opto-electronics business was reclassified into “lossfrom discontinued operations” in 2003.

***RestructuringCharges***

During the second quarterof 2004, we announced plans to cease all production activities in the UnitedStates and to manufacture our products only in China. In June 2004, weincurred a restructuring charge of $1.1 million as a result of our decision toclose down our remaining manufacturing facilities in the United States. In thethird and fourth quarter of 2004, we incurred additional restructuring chargesof $231,000 for a total of $1.3 million in 2004. These charges comprised costsrelated to the 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 payroll and related expenses. On an annualbasis, we anticipate payroll and related expense savings of $1.5 million. In2005, we will continue to reduce costs by qualifying new lower cost suppliers,moving more of our administrative functions to China where our costs are lower,and streamlining our organization structure and costs in the United States andChina to bring them in line with with our current business. Refer to Note 8 toour consolidated financial statements.

***Other Impairment***

Also in the third quarterof 2004, we recorded an impairment charge of $210,000 to write down the valueof our 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.

***Revenue***
| ** **    | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|---------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **    | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**              | ** ** |
| GaAs          |       | $                                           | 27,272     |                       | $          | 28,354                     |       | $ | 32,892 |   |   | $ | (1,082 | ) |   |   | (3.8 | )% |   | $ | (4,538 | ) |   | (13.8 | )% |   |
| InP           |       | 1,588                                       |       | 2,075                      |       | 6,491                      |       |   | (487 | ) |   |   | (23.5 | ) |   | (4,416 | ) |   | (68.0 | ) |   |
| Raw Materials |       | 6,499                                       |       | 4,118                      |       | 4,485                      |       |   | 2,381 |   |   |   | 57.8 |   |   | (367 | ) |   | (8.2 | ) |   |
| Other         |       | 95                                          |       | 166                        |       | 997                        |       |   | (71 | ) |   |   | (42.8 | ) |   | (831 | ) |   | (83.4 | ) |   |
| Total revenue |       | $                                           | 35,454     |                       | $          | 34,713                     |       | $ | 44,865 |   |   | $ | 741 |   |   |   | 2.1 | % |   | $ | (10,152 | ) |   | (22.6 | )% |   |

 

22

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Revenue from continuingoperations increased $741,000, or 2.1%, to $35.5 million in 2004 compared to$34.7 million in 2003. Total GaAs substrate revenue decreased $1.1 million, or3.8%, to $27.3 million in 2004 compared to $28.4 million in 2003. Sales of 5inch and 6 inch diameter GaAs substrates, which were used exclusively tomanufacture electronic devices, decreased $1.9 million, or 36.1%, to $3.5million in 2004 compared to $5.4 million in 2003. InP substrate revenuedecreased $0.5 million, or 23.5%, to $1.6 million in 2004 compared to $2.1million in 2003. InP substrates were used almost exclusively fortelecommunications applications. The decrease in GaAs and InP substrate revenuewas due to the pricing pressures causing prices to decline and overall lesserdemand from our telecommunications and wireless application customers. Rawmaterial sales increased $2.4 million, or 57.8%, to $6.5 million in 2004compared to $4.1 million in 2003. The increase in raw material sales was due tocustomers’ higher demand, particularly for raw gallium and germanium dioxide.

Revenue from continuingoperations decreased $10.2 million, or 22.6%, to $34.7 million in 2003 comparedto $44.9 million in 2002. Total GaAs substrate revenue decreased $4.5 million,or 13.8%, to $28.4 million in 2003 compared to $32.9 million in 2002. Sales of5 inch and 6 inch diameter GaAs substrates, which were used exclusively tomanufacture electronic devices, decreased $3.4 million, or 38.5% to $5.4 millionin 2003 compared to $8.8 million in 2002. InP substrate revenue decreased $4.4million, or 68.0%, to $2.1 million in 2003 compared to $6.5 million in 2002.InP substrates were used almost exclusively for telecommunicationsapplications. The decrease in GaAs and InP substrate revenue was due todecreased volume and lower average sales prices as a result of the slowdown inour target markets including telecommunications, high speed electronic devices,and short wavelength lasers, and the introduction of VGF-like substrates fromour competitors that caused some customers to purchase substrates from ourcompetitors rather than from us.

***Revenue byGeographic Region***
| ** **                                 | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                 | ** ** | **($ in thousands)**              | ** ** |
| North America*                             |       | $                                           | 7,514      |                       | $          | 12,009                     |       | $ | 26,208 |   |   | $ | (4,495 | ) |   |   | (37.4 | )% |   | $ | (14,199 | ) |   | (54.2 | )% |   |
| *% of  total revenue*                      | * *   | *21*                                        | *%*        | *35*                       | *%*        | *59*                       | *%*        |   |   |   |   |   |   |   | * * | * * | * * |   |   |   |   |
| Europe                                     |       | 6,840                                       |       | 5,638                      |       | 5,508                      |       |   | 1,202 |   |   |   | 21.3 |   |   | 130 |   |   | 2.4 |   |   |
| *% of  total revenue*                      | * *   | *19*                                        | *%*        | *16*                       | *%*        | *12*                       | *%*        |   |   |   |   |   |   |   | * * | * * | * * |   |   |   |   |
| Japan                                      |       | 5,156                                       |       | 4,167                      |       | 3,000                      |       |   | 989 |   |   |   | 23.7 |   |   | 1,167 |   |   | 38.9 |   |   |
| *% of  total revenue*                      | * *   | *15*                                        | *%*        | *12*                       | *%*        | *7*                        | *%*        |   |   |   |   |   |   |   | * * | * * | * * |   |   |   |   |
| Taiwan                                     |       | 8,397                                       |       | 7,055                      |       | 4,246                      |       |   | 1,342 |   |   |   | 19.0 |   |   | 2,809 |   |   | 66.2 |   |   |
| *% of  total revenue*                      | * *   | *24*                                        | *%*        | *20*                       | *%*        | *9*                        | *%*        |   |   |   |   |   |   |   | * * | * * | * * |   |   |   |   |
| Asia Pacific (excluding  Japan and Taiwan) |       | 7,547                                       |       | 5,844                      |       | 5,903                      |       |   | 1,703 |   |   |   | 29.1 |   |   | (59 | ) |   | (1.0 | ) |   |
| *% of  total revenue*                      | * *   | *21*                                        | *%*        | *17*                       | *%*        | *13*                       | *%*        |   |   |   |   |   |   |   | * * | * * | * * |   |   |   |   |
| Total revenue                              |       | $                                           | 35,454     |                       | $          | 34,713                     |       | $ | 44,865 |   |   | $ | 741 |   |   |   | 2.1 | % |   | $ | (10,152 | ) |   | (22.6 | )% |   |

----

*                    Primarily theUnited States.

Sales to customers outside of North Americarepresented approximately 79%, 65% and 41% of our revenue during 2004, 2003 and2002, respectively. International revenue continued to increase during 2004 ascompared to 2003 primarily due to sales growth of $1.2 million and$4.0 million in Europe and Asia Pacific including Japan and Taiwan,respectively. The increase was the result of our continued penetration into theAsian markets, particularly Taiwan and China.

International revenueincreased during 2003 as compared to 2002 primarily due to sales growth of $0.1million, $1.2 million, and $2.8 million in Europe, Japan, and Taiwan,respectively. The increase was 

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drivenby greater share of our GaAs substrates being used in opto-electronicsapplications and the majority of our customers requiring these applicationswere in Asia.

***Gross Margin***
| ** **           | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|----------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**              | ** ** |
| Gross profit  (loss) |       | $                                           | (251       | )                          | $          | 2,235                      |       | $ | (8,893 | ) |   | $ | (2,486 | ) |   |   | (111 | )% |   |   | $ | 11,128 |   |   |   | 125 | % |   |
| *Gross  Margin %*    | * *   | *(0.7*                                      | *)%*       | *6.4*                      | *%*        | *(19.8*                    | *)%*       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                      |            |                                             |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 during 2004: (i) a $2.1 million charge for excess andobsolete inventory in the third quarter, (ii) an approximately $1.4million settlement charge with Sumitomo Electric Industries, Ltd. in the thirdquarter, and (iii) the establishment of a sales return reserve of $745,000in the first quarter related to our failure to follow certain testingrequirements, which reduced revenues without affecting costs of revenues.

Gross margin increased to6.4% of revenue in 2003 compared to negative 19.8% in 2002. The increase wasprimarily due to reduced costs associated with moving most of our production toChina. In addition, we incurred a charge of $9.7 million in 2002 related to thewrite-down of certain inventory that we concluded was obsolete.

***Selling, Generaland Administrative Expenses***
| ** **            | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|-----------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **            | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**              | ** ** |
| SG&A expenses     |       | $                                           | 11,561     |                       | $          | 10,475                     |       | $ | 13,860 |   |   | $ | 1,086 |   |   |   | 10.4 | % |   |   | $ | (3,385 | ) |   |   | (24.4 | )% |   |
| *% of  total revenue* | * *   | *32.6*                                      | *%*        | *30.2*                     | *%*        | *30.9*                     | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                       |            |                                             |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Selling, general and administrative expenses increased$1.1 million, or 10.4%, to $11.6 million in 2004 compared to $10.5 million in2003. As a percentage of total revenue, selling, general and administrativeexpenses were 32.6% in 2004 compared to 30.2% in 2003. The increase in selling,general and administrative expenses is primarily the result of increased legaland professional fees with respect to our product testing investigation, theSumitomo litigation settlement, and implementation of Section 404 of theSarbanes-Oxley Act of 2002.

Selling, general andadministrative expenses decreased $3.4 million, or 24.4%, to $10.5 million in2003 compared to $13.9 million in 2002. As a percentage of total revenue,selling, general and administrative expenses were 30.2% in 2003 compared to30.9% in 2002. The decrease in selling, general and administrative expenses isthe result of our efforts to adjust costs in line with our current business andof our ability to shift some of these activities to China where our costs arelower.

***Research andDevelopment Expenses***
| ** **            | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|-----------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **            | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**              | ** ** |
| R&D expenses      |       | $                                           | 1,479      |                       | $          | 1,337                      |       | $ | 2,339 |   |   | $ | 142 |   |   |   | 10.6 | % |   |   | $ | (1,002 | ) |   |   | (42.8 | )% |   |
| *% of  total revenue* | * *   | *4.2*                                       | *%*        | *3.9*                      | *%*        | *5.2*                      | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                       |            |                                             |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

24

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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. We expect research and development expenses to increase byapproximately 15% in 2005.

Research and developmentexpenses decreased $1.0 million or 42.8%, to $1.3 million in 2003 compared to$2.3 million in 2002. As a percentage of total revenue, research anddevelopment expenses were 3.9% in 2003 compared to 5.2% in 2002. Research anddevelopment efforts during 2003 were focused primarily on improving the yieldand surface quality of our GaAs substrates.

***Impairment andRestructuring Charges***
| ** **           | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|----------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**              | ** ** |
| Impairment  charges  |       | $                                           | 210        |                       | $          | —                     |       | $ | 14,632 |   |   | $ | 210 |   |   |   | NM |   |   | $ | (14,632 | ) |   | NM |   |   |
| *% of total revenue* | * *   | *0.6*                                       | *%*        | *—*                   | * *   | *32.6*                     | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Restructuring  costs |       | $                                           | 1,308      |                       | $          | —                     |       | $ | — |   |   | $ | 1,308 |   |   |   | NM |   |   | $ | — |   |   | NM |   |   |
| *% of total revenue* | * *   | *3.7*                                       | *%*        | *—*                   | * *   | —                     | * *   |   |   |   |   |   |   |   | * * | * * | * * |   |   |   |   |

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NM: percentage not meaningful

In the third quarter of 2004, we recorded animpairment charge of $210,000 to write down the value of our investment in aprivate company. We made the decision to write down the investment as a resultof the declining financial position of the investee, evidenced by an auditopinion with a going concern explanatory paragraph received by the investee.The $210,000 was the remaining balance of this investment.

***Interest Expense***
| ** **           | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|----------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**              | ** ** |
| Interest expense     |       | $                                           | 290        | * *                   | $          | 466                        | * *   | $ | 437 | * * |   | $ | (176 | ) |   |   | (37.8 | )% |   |   | $ | 29 |   |   |   | 6.6 | % |   |
| *% of total revenue* | * *   | *0.8*                                       | *%*        | *1.3*                      | *%*        | *1.0*                      | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                      |            |                                             |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest expense decreased $176,000, or 37.8%, to$290,000 in 2004 compared to $466,000 in 2003. The decrease in interest expensereflected the absence of equipment financing charges. By the end of 2003, wehad repaid $10.1 million in equipment lease and loan debt.

Interest expense increased$29,000, or 6.6%, to $466,000 in 2003 compared to $437,000 in 2002.

***Other Income andExpense, Net***
| ** **                        | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                        | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **($ in thousands)**              | ** ** |
| Other income  (expense), net |       | $                                           | 646        |                       | $          | (1,050                     | )          | $ | (12,703 | ) |   | $ | 1,696 |   |   |   | 161.5 | % |   |   | $ | 11,653 |   |   |   | 91.7 | % |   |
| *% of  total revenue*             | * *   | *1.8*                                       | *%*        | *(3.0*                     | *)%*       | *(28.3*                    | *)%*       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                   |            |                                             |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income was $0.6 million in 2004 compared toother expense of $1.1 million in 2003. Other income (expense) comprises foreignexchange gain (loss) and minority interests from our China joint ventures.Other income in 2004 also included a gain of $237,000 as a result of a customer’sforfeiture of 

25

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deposits originally madein connection with the program we launched in late 2000 with selected customersto guarantee volume delivery of substrates. We terminated all remainingobligations under the program with this customer by mutual consent.

Other expense was $1.1million in 2003 compared to $12.7 million in 2002. The amount in 2003 includeda charge of $2.1 million related to the write-down of our investments in twoprivately held U.S. companies. The amount in 2002 included non-cash charges of$10.8 million related to the write-down of our investment in FinisarCorporation’s common stock to its market value and $3.1 million related to thewrite-down of a building held for sale to its net realizable value as of December 31,2002.

***Provision forIncome Taxes***
| ** **                  | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                  | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **                  | ** ** | **($ in thousands)**              | ** ** |
| Provision for  income taxes |       | $                                           | 71         | * *                   | $          | —                     |       | $ | 2,119 |   |   | $ | 71 |   |   |   | NM |   |   |   | $ | (2,119 | ) |   |   | NM |   |   |
| *% of total revenue*        | * *   | *0.2*                                       | *%*        | *—*                   |       | *4.7*                      | *%*        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                             |            |                                             |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

NM: percentage not meaningful

Provision for income taxeswas $71,000 for 2004, all of which related to our foreign subsidiaries. Due toour continuing operating losses and uncertainty regarding future profitability,we recorded a full valuation allowance against our net deferred tax assets of$38.8 million in 2004.

***Gain or Loss fromDiscontinued Operations***
| ** **                                     | ** ** | **Years Ended December 31,** | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                     | ** ** | **2004**                                    | ** ** | **2003**                   | ** ** | **2002**                   | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                     | ** ** | **($ in thousands)**              | ** ** |
| Gain (loss) from discontinued  operations |       | $                                           | 891        |                       | $          | (15,638                    | )          | $ | (26,198 | ) |   | $ | 16,529 |   |   |   | 105.7 | % |   |   | $ | 10,560 |   |   |   | 40.3 | % |   |
|                                                |            |                                             |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 $250,000reflecting an adjustment to the realizable market value of the property. Theremaining gain of $222,000 was a result of our reversal of accrued liabilitiesof general and administrative expenses no longer required. Loss from ourdiscontinued opto-electronics division for 2003 was $15.6 million, whichincluded a loss on disposal of $9.5 million and the operating loss of $6.1million. Loss from our discontinued opto-electronics division for 2002 was$26.2 million, which included the operating loss and certain impairment chargesfor a total of $34.6 million, partially offset by a benefit for income taxes of$8.4 million. See further discussion under “Results of Operations—Overview”elsewhere in Management’s Discussion and Analysis of Financial Condition andResults of Operations of this Form 10-K.

**American JobsCreation 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 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 

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company’s board ofdirectors. Certain other criteria in the Jobs Act must be satisfied as well. Wemay elect to apply this provision to qualifying earnings repatriations ineither fiscal 2005 or fiscal 2006. We are in the process of evaluating whetherwe will repatriate foreign earnings under the repatriation provisions of theJobs 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 either fiscal 2005 or fiscal 2006,the amount of our indefinitely reinvested foreign earnings, or the amount ofour deferred tax liability with respect to foreign earnings.

**Liquidity and Capital Resources**
| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                               | ** ** | **($ in thousands)**              | ** ** |
| Net cash provided by  (used in):                         |       |                                        |       |   |   |   |   |
| Operating activities                                     |       | $                                           | (340       | ) | $ | 6,269 |   | $ | 725 |   |
| Investing activities                                     |       | (7,846                                      | )          | 13,723 |   | (16,037 | ) |
| Financing activities                                     |       | (4,216                                      | )          | (9,647 | ) | (8,116 | ) |
| Effect of  exchange rate changes                         |       | 180                                         |       | 197 |   | (313 | ) |
| Net change in  cash and cash equivalents                 |       | (12,222                                     | )          | 10,542 |   | (23,741 | ) |
| Cash and cash  equivalents—beginning period         |       | 24,339                                      |       | 13,797 |   | 37,538 |   |
| Cash and cash  equivalents—end of period            |       | 12,117                                      |       | 24,339 |   | 13,797 |   |
| Short-term  investments—end of period               |       | 20,062                                      |       | 14,669 |   | 8,205 |   |
| Total cash, cash  equivalents and short-term investments |       | $                                           | 32,179     |   | $ | 39,008 |   | $ | 22,002 |   |

 

We consider cash and cashequivalents, and short-term investments as liquid and available for use.Short-term investments are comprised of government bonds and high-gradecommercial debt instruments. Also included in short-term investments is ourinvestment in common stock of Finisar Corporation, a United Statespublicly-traded company. As of December 31, 2004, our principal sources ofliquidity were $32.2 million in cash and cash equivalents and short-terminvestments, excluding restricted deposits.

Cash and cash equivalentsand short-term investments, excluding $2.7 million and $3.7 million for ourinvestment in Finisar common stock as of December 31, 2004 and December 31,2003, respectively, decreased $5.8 million to $29.5 million as of December 31,2004 compared with $35.3 million as of December 31, 2003. The combineddecrease in cash and cash equivalents and short-term investments was primarilydue to payments of long-term debt of $4.5 million, purchase of machinery andequipment of $0.9 million, and the continual funding of our operations.

The decrease in operatingcash flow in 2004, as compared with 2003, was primarily the result of theabsence during 2003 of certain non-cash charges of $9.5 million on the disposalof our discontinued opto-electronics business and $2.1 million on impairment ofinvestments, a slower rate of decrease in inventories of $3.9 million,partially offset by an improvement to our net loss of $13.6 million.

Net accounts receivabledecreased by $2.3 million, or 35.9%, to $4.0 million as of December 31,2004 compared with $6.3 million as of December 31, 2003. The decreasereflects lower fourth quarter 2004 sales compared with the same period in 2003,better collections from customers and an establishment of a sales returnsreserve of $745,000 recorded in the first quarter of 2004.

Net inventories decreased$7.6 million, or 31.6% to $16.5 million as of December 31, 2004 comparedwith $24.1 million as of December 31, 2003. We adopted a strategy of usinginventory to conserve cash beginning in 2001. During 2004, we had a $2.1million inventory valuation charge due to excess and obsolete inventory. We donot expect to maintain the same rate of net inventory decrease in 2005 as weexperienced in 2004.

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Net cash used by investingactivities of $7.8 million for the year ended December 31, 2004 includedpurchases of property and equipment of $2.1 million primarily used to transferproduction capacity to China for the substrate division, and purchases of highgrade investment securities with maturities of less than two years totaling$25.9 million. This was partially offset by sales of high grade investmentsecurities totaling $19.1 million and a decrease in our restricted deposits of$1.1 million

We do not have any plans toinitiate any major new capital spending projects in 2005. We are currentlycompleting certain projects at our China facilities. We expect to investapproximately $5.0 million in capital projects in 2005. We believe that ourexisting and planned facilities and equipment are sufficient to fulfill currentand expected future orders.

Net cash used in financing activities of $4.2 millionfor the year ended December 31, 2004 consisted of payments of $4.5 millionrelated to long-term borrowings, partially offset by proceeds of $270,000 as aresult of purchases of our common stock by employees under our employee stockcompensation programs.

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 weabandoned the 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 “Risks Related to Our Business.”

***Off-Balance SheetArrangements***

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 have 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 with acurrent contract value of $130,000. The contract sales prices are subject toreview quarterly and can be adjusted in the event that raw material prices change.In the event of non-delivery of the determined wafer quantities in any 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 31,2004, we have met all of its current delivery obligations under these contractsand expects to continue to meet delivery requirements during the remainder ofthe contract terms.

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

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***Contractual Obligations***

Our main Fremont,California manufacturing facility is financed by long-term borrowings, whichwere refinanced by taxable variable rate revenue bonds in 1998. These bondsmature in 2023 and bear interest at a variable rate that was 2.49% as of December 31,2004. The bonds are traded in the public market. Repayment of principal andinterest under the bonds is supported by a letter of credit from our bank andis paid on a quarterly basis. We have the option to redeem the bonds in wholeor in part during their term. As of December 31, 2004, $8.05 million wasoutstanding under these bonds.

As of December 31,2004, the credit facility maintained by us with a bank included a letter ofcredit supporting repayment of our industrial bonds with an outstanding amountof approximately $8.2 million. We have pledged and placed certain investmentsecurities with an affiliate of the bank as additional collateral for thisfacility. We have also pledged certain investments for a credit facility forour workers compensation insurance policy for portions of 2003. Accordingly,$8.2 million of our cash and short-term investments are restricted.

We lease certain officespace, manufacturing facilities and property under long-term operating leasesexpiring at various dates through March 2013. On March 11, 2003, wecompleted the sale of our property located at 4281 Technology Drive, Fremont,California, for $6.3 million. Net cash proceeds from the sale were $5.2million. The gain incurred by us on this transaction was less than $15,000.Under the terms of the sale agreement, we have agreed to lease back theproperty for a ten-year period. Accordingly, on March 11, 2003, we signedan operating lease for this property through March 2013. Total rentexpenses under these operating leases were approximately $1.3 million, $1.2million and $0.9 million for years ended December 31, 2004, 2003 and 2002,respectively. We have a purchase obligation with a third party vendor topurchase $1.3 million of equipment towards which we have paid a deposit of$300,000, leaving a net purchase obligation of $1.0 million.

Thefollowing table summarizes our contractual obligations as of December 31,2004 (in thousands):
| ** **                       | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3  years** | ** ** | **4-5  years** | ** ** | **More than  5 years** | ** ** |
| Long-term debt  obligations      |       | $                                         | 8,050      |   |   | $ | 450 |   |   | $ | 1,420 |   | $ | 900 |   |   | $ | 5,280 |   |   |
| Operating lease  obligations     |       | 6,837                                     |       |   | 1,319 |   |   | 2,299 |   | 1,486 |   |   | 1,733 |   |   |
| Purchase  obligations            |       | 1,017                                     |       |   | 1,017 |   |   | — |   | — |   |   | — |   |   |
| Total                            |       | $                                         | 15,904     |   |   | $ | 2,786 |   |   | $ | 3,719 |   | $ | 2,386 |   |   | $ | 7,013 |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We have made strategicinvestments in private companies located in China in order to gain access toraw materials at competitive costs that are critical to our substrate business.We are currently negotiating a new joint venture investment in China for aGermanium business opportunity, and upon the fulfillment of certain conditions,we may invest up to $1.0 million in the new joint venture in 2005.

**Risks Related to Our Business**

***We may incur claimsor other liabilities or obligations related to our failure to followrequirements for testing of products and provision of testing data andinformation relating to customer requirements. Additionally, customers maycancel or reduce future shipments in response to these failures.***

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 customerrequirements. We notified affected customers concerning our findings, however,there can be no assurance that we will not incur customer claims or otherliabilities or obligations in connection with this matter, nor, if we receiveany such claims, that we will not have to restate results from prior periods.In addition, revenue in future periods 

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may beadversely impacted if customers decide not to order from us as a result of thisdisclosure. We experienced several cancellations of future orders by customerspending further information regarding enhancements to our product testing andquality control systems. In addition, some customers are requiring additionalqualification of our China operations before placing future orders with us. Wecannot be sure that we will not receive additional cancellations of orders byother customers, or fail to win expected future orders from customers, as aresult of our disclosure of our investigation conclusions, or that ourcustomers will qualify our China operations and place future orders with us.

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

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 which isexpected to last at least through 2005. Provinces imposed power brownoutsduring 2004 to reduce electricity demand and some companies in Beijing wereordered to give their employees a week off to ease the pressure on powersupply. The plants, most of which are state-owned, were closed and reopened ona staggered schedule to reduce power consumption during the capital’s hottestmonths during 2004. As a result we closed most of our operations for a week inlate July 2004 in conformance with this policy. Some shortages havealready been reported in 2005 and the power shortages may be more severe thanduring 2004. If we are required to make additional temporary closures of ourBeijing and joint venture operations during 2005, we may be unable tomanufacture our products, and would then be unable to meet customer ordersexcept from inventory on hand. As a result, we could lose sales, adverselyimpacting our revenues, and our relationships with our customers could suffer,impacting our ability to generate future sales. In addition, if power is shutoff at our Beijing operations at any time, either voluntarily or as a result ofunplanned brownouts, during certain phases of our manufacturing processincluding our crystal growth phase, the work in process may be ruined andrendered unusable, causing us to incur expense that will not be covered byrevenue, and negatively impacting our cost of goods sold and gross margins. Weare attempting to partially mitigate the potential effects of power outages bybuilding inventory during early 2005 in anticipation of power outages duringthe summer. This inventory build is prepared to accommodate forecast demandrather specific customer orders. If the inventory we build is not ordered bycustomers, we may have to scrap these products and incur a cost which willreduce our gross margins.

***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 achieve qualifications for these products, our China facility will beunderutilized, our investments in China will not be recouped and we will beunable to lower our costs by moving to China. We may lose sales of our productsto competitors who are not manufacturing in China, or whose operations in Chinahave already been qualified by customers. If customers do not fully qualify ourChina production, we may lose additional customers and fail to achieve revenuegrowth.

Furthermore, somecustomers have reduced their orders from us until our surface quality is asgood and consistent as that offered by competitors. As a result, some customersare now allocating their requirements for compound semiconductor substratesacross more competitors and we believe that we have lost revenue and marketshare as a result of these customer decisions, which we may be unable torecover. If we are unable to retain our market share, our revenue andperformance will decline.

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***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 88percent. 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 ourjoint ventures or venture partners with whom our joint ventures sharefacilities are deemed to have violated applicable laws, rules orregulations governing the use, storage, discharge or disposal of hazardouschemicals during manufacturing, research and development, or salesdemonstrations, the operations of our joint ventures could be adverselyaffected and we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or cessation of our joint ventureoperations as a result of the actions of the joint ventures or other venturepartners. Employees working at the operations of our joint ventures or theoperations of any of the other venture partners could bring litigation againstus as a result of actions taken at the joint venture or venture partnerfacilities, even though we are not directly controlling the operations,including actions for exposure to chemicals or other 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, litigationis inherently uncertain and while we would expect to defend ourselvesvigorously, it is possible that our business, financial condition, results ofoperations or cash flows could be affected in any particular period by suchlitigation if brought against us, particularly if, as a non-Chinese company,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:

·       Difficultiesin managing geographically disparate operations;

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

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

·       Politicaland economic instability, civil unrest or war;

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·       Terroristactivities that impact international commerce;

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

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

·       Nationalizationof foreign owned assets, including intellectual property.

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

Other companies may hold or obtain patents oninventions or may otherwise claim proprietary rights to technology necessary toour business. The markets in which we compete are comprised of competitors whoin some cases hold substantial patent portfolios covering aspects of productsthat could be similar to ours. We could become subject to claims that we areinfringing patent, trademark, copyright or other proprietary rights of others.For example, we have previously been involved in two separate lawsuits allegingpatent infringement.

On June 11, 2003, Cree, Inc. filed acomplaint in the United States Court for Northern District of Californiaagainst us alleging patent infringement. The complaint sought damages andinjunction against infringement. On July 23, 2003, we filed a countercomplaint in the United States Court for Northern District of California,denying any patent infringement and alleging that Cree’s actions wereintentionally designed to interfere with our prospective businessrelationships. We reached an agreement with Cree resolving the disputes betweenus and signed a settlement agreement on March 5, 2004. The resolution ofthe disputes did not have a material adverse impact on the Company’sconsolidated financial position or results of operations.

On October 8, 2004,we announced that we had reached a tentative settlement of the litigation inJapan and interference actions in the United States with Sumitomo ElectricIndustries, Ltd. (“SEI”), which includes a global intellectual propertycross-licensing agreement. AXT and SEI finalized this agreement onDecember 2, 2004. Accordingly, we recorded a charge of approximately $1.4million for the quarter ended September 2004 in connection with thissettlement, and are expected to make royalty payments on future sales ofcertain products. The litigation was withdrawn in January, 2005 and weabandoned the interference proceeding.

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***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. These laws, rules andregulations govern the use, storage, discharge and disposal of hazardouschemicals during manufacturing, research and development, and salesdemonstrations. If we fail to comply with applicable regulations, we could besubject to substantial liability for clean-up efforts, personal injury andfines or suspension or cessation of our operations. In March 2001, wesettled a claim made by the California Occupational Safety and HealthAdministration, or Cal-OSHA, in an investigation primarily regardingimpermissible levels of potentially hazardous materials in certain areas of ourmanufacturing facility in Fremont, California for $200,415, and during 2004 wewere the target of press allegations and correspondence purportedly on behalfof current and/or former employees concerning our environmental complianceprograms and exposure of our employees to hazardous materials, and there is apossibility that current and/or former employees may bring litigation againstus. Although we have put in place engineering, administrative and personnelprotective equipment programs to address these issues, our ability to expand orcontinue to operate our present locations could be restricted or we could berequired to acquire costly remediation equipment or incur other significantexpenses. Existing or future changes in laws or regulations in the UnitedStates and China may require us to incur significant expenditures orliabilities, or may restrict our operations. In addition, our employees couldbe exposed to chemicals or other hazardous materials at our facilities and wemay be subject to lawsuits seeking damages for wrongful death or personalinjuries allegedly caused by exposure to chemicals or hazardous materials atour facilities.

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

***The 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 semiconductordevices, as well as the current and anticipated market demand for such devicesand products using such devices. As a supplier to the semiconductor industry,we are subject to the business cycles that characterize the industry. Thetiming, length and volatility of these cycles are difficult to predict. Thesemiconductor industry has historically been cyclical because of sudden changesin demand for semiconductors, the manufacturing capacity of thesesemiconductors and changes in the technology employed in the semiconductors.The rate of changes in demand, including end demand, is high, and the effect ofthese changes upon us occurs quickly, exacerbating the volatility of thesecycles. These changes have affected the timing and amounts of customers’purchases and investments in new technology. These industry cycles createpressure on our revenue, gross margin and net income (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 createpressure on our revenue, gross margins and net income. 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. We experiencedcancellations, price reductions, delays and push outs of orders, which haveresulted in reduced revenues. If the economic downturn occurred again, furtherorder cancellations, 

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reductions in order sizeor delays in orders could occur and would materially adversely affect ourbusiness and results of operations. Actions to reduce our costs, such as thosewe have recently taken, may be insufficient to align our structure withprevailing business conditions. We may be required to undertake additionalcost-cutting measures, and may be unable to invest in marketing, research anddevelopment and engineering at the levels we believe are necessary to maintainour competitive position. Our failure to make these investments could seriouslyharm our business.

During periods ofincreasing demand for semiconductor devices, we must have sufficientmanufacturing capacity and inventory to meet customer demand, and must be ableto attract, hire, train and retain qualified employees to meet demand. Itappears that the semiconductor industry experienced increased demand during 2004.However, we cannot predict neither the sustainability nor rate of a recovery,if any. If we are unable to effectively manage our resources and productioncapacity during an industry upturn, there could be a material adverse effect onour business, financial condition and results of operations.

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

We must manage our inventory of component parts,work-in-process, and finished goods effectively to meet changing customerrequirements, while keeping inventory costs down and improving gross margins.Some of our products and supplies have in the past and may in the future becomeobsolete while in inventory due to changing customer specifications, or becomeexcess inventory due to decreased demand for our products and an inability tosell the inventory within a foreseeable period. Furthermore, if current costsof production increase or sales prices drop below the standard prices at whichwe value inventory, we may need to take a charge for a reduction in inventoryvalues. We have in the past, including during 2004, had to take inventoryvaluation and impairment charges. If we are not able to manage successfully ourinventory in the future, we may again need to write off un-saleable, obsoleteor excess inventory, which could adversely affect our results of operations.

During early 2005 we willincrease work-in-process inventory in order to avoid the effects of probablepower shortages in China. We will prepare this inventory in accordance with ourforecast of demand rather than against specific customer orders. If we do notforecast correctly, customers may not order the inventory we manufacture, andwe will incur a cost with no offsetting revenue. Ultimately, we would have toincur a charge for the value of unused inventory.

***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. Wemay experience price pressures on our products, and if average selling pricesdecline in the future, our revenues and gross margins could decline. We may beunable to reduce the cost of our products sufficiently to counter the effect oflower selling prices and allow us to keep pace with competitive pricingpressures and our margins could be adversely affected.

***The 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. More specifically, the macro-economic environmentthat we faced since late 2000 was more uncertain than in some prior periods,the downturn which began in 2001 lasted longer than expected and materially andadversely affected us and our operating results. The revenue growth andprofitability of our business depends on the overall demand for our substrates,and we are particularly dependant on the market conditions for the wireless,solid-state illumination, fiber optics and 

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telecommunicationsindustries. Because our sales are primarily to major corporate customers whosebusinesses fluctuate with general economic and business conditions, a softeningof demand for products that use our substrates, caused by a weakening economymay result in decreased revenues. Customers may find themselves facing excessinventory from earlier purchases, and may defer or reconsider purchasingproducts due to the downturn in their business and in the general economy.

***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. If we continue to experience quality control problems, or experiencethese or other problems in new products, customers may cancel or reduce ordersor purchase products from our competitors and sales of our products coulddecline. Defects in our products could cause us to incur higher manufacturingcosts and suffer product returns and additional service expenses, all of whichcould 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 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:

·       impuritiesin the materials used;

·       contaminationof the manufacturing environment;

·       substratebreakage;

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

·       performanceof personnel involved in the manufacturing process.

If our yields decrease,our revenue could decline 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 

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be used to manufacturedevices that could provide the same high-performance, low-power capabilities asGaAs- and InP-based devices at competitive prices. If these substrate materialsor VGF-derived products are successfully developed and semiconductor devicemanufacturers adopt them, demand for our GaAs substrates could decline and ourrevenue could suffer.

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

***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:

·       greaterexperience in the business;

·       moremanufacturing experience;

·       extensiveintellectual property;

·       broadername recognition; and

·       significantlygreater financial, technical and marketing resources.

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

The level and intensity 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:

·       thecompetition our customers face in their particular industries;

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

·       thefinancial and other resources of our customers; and

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

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

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

Many of our customers arefacing business downturns that have reduced their cash balances and theirprospects. We frequently allow our customers to pay for products we ship tothem within 30 to 120 days after delivery. Subsequent to our shipping aproduct, some customers have been unable to make payments as due, reducing ourcash balances and causing us to incur charges to allow for a possibility thatsome accounts might not be paid. During 2004, a customer of one agent filed forbankruptcy protection. We incurred a charge equal to the amount owed us andbelieve that there is a substantial likelihood that we will be able to recouplittle, if any, of the this amount. Other customers may also be forced to filefor bankruptcy. If our customers do not pay their accounts when due, we will berequired to incur charges that would reduce our earnings.

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

We depend on a limitednumber of suppliers for certain raw materials, components and equipment used inmanufacturing our products, including key materials such as quartz tubing,polishing solutions, and paralytic boron nitride. Although several of these rawmaterials are purchased from suppliers in 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.***

Through fiscal 2004, wehave recorded investments in raw material suppliers in China, that provide uswith opportunities to gain supply of key raw materials that are important toour substrate business. These affiliates each have a market beyond thatprovided by us. We do not have influence over all of these companies, each ofwhich is located in China, and in some we have made only a strategic, minorityinvestment. We may not be successful in achieving the financial, technologicalor commercial advantage upon which any given investment is premised, and wecould end up losing all or part of our investment.

***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 30.1%, 28.9%, and 31.4%of product revenue for the years ended December 31, 2004, 2003, and 2002,respectively. We expect that a significant portion of our future revenue willcontinue to be derived from a limited number of substrate customers. Ourcustomers 

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are notobligated to purchase a specified quantity of our products or to provide uswith binding forecasts of product purchases. In addition, our customers mayreduce, delay or cancel orders at any time without any significant penalty, andduring the past year, we have experienced slower bookings, significant pushouts and cancellation of orders from some customers. In addition, several ofour previously large customers have stopped operations entirely. If we lose amajor customer or if a customer cancels, reduces or delays orders, our revenuewould decline. In addition, customers that have accounted for significantrevenue in the past may not continue to generate revenue for us in any futureperiod. Any delay in scheduled shipments of our products could cause revenue tofall below our expectations and the expectations of market analysts orinvestors, causing our stock price to decline.

***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.

***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 ourproducts or design around our patents. We believe that at least two of ourcompetitors have begun to ship GaAs substrates produced using a process similarto our VGF technique. Our competitors may also develop and patent improvementsto the VGF technology upon which we rely, and thus may limit any exclusivity weenjoy by virtue 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.

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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 andSEI approved a settlement of this litigation during the fourth quarter of 2004and the litigation was withdrawn and we abandoned the interference proceeding.We incurred an initial charge of approximately $1.4 million and will have topay ongoing 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 79% and66% of our total revenue for fiscal years ended December 31, 2004 and2003, respectively. We expect that sales to customers outside the U.S. willcontinue to represent a significant portion of our revenue, particularly salesto customers 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 represents a large potential market forsemiconductor equipment and where we anticipate significant opportunity forgrowth. Global uncertainties with respect to: (i) economic growth rates invarious countries; (ii) sustainability of demand for electronics products;(iii) capital spending by semiconductor manufacturers; (iv) priceweakness for certain semiconductor devices; and (v) political instabilityin regions where we have operations may also affect our business, financialcondition and results of operations.

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

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

·       unexpectedchanges in regulatory requirements;

·       longerperiods to collect accounts receivable;

·       changesin export license requirements;

·       politicaland economic instability;

·       unexpectedchanges in diplomatic and trade relationships; and

·       foreignexchange rate fluctuations.

Our sales are denominatedin U.S. dollars, except for sales to our Japanese and some Taiwanese customers,which are denominated in Japanese yen. Thus, increases in the value of the U.S.dollar could increase the price of our products in non-U.S. markets and makeour products more expensive than competitors’ products in these markets. Also,denominating some sales in Japanese yen subjects us to fluctuations in theexchange rates between the U.S. dollar and the Japanese yen. The functionalcurrencies 

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of ourJapanese and Chinese subsidiaries are the local currencies. We incurtransaction gains or losses resulting from consolidation of expenses incurredin local currencies for these subsidiaries, as well as in translation of theassets and liabilities of these assets at each balance sheet date. If we do noteffectively manage the risks associated with international sales, our revenue,cash flows and financial condition could be adversely affected.

***We need to continue to improve or implement oursystems, procedures and controls and may not receive favorable attestation ofour internal control systems by our independent registered public accountingfirm.***

The new requirements adopted by the Securities andExchange Commission in response to the passage of the Sarbanes-Oxley Act of2002 will require annual review and evaluation of our internal control systems,and attestation of these systems by our independent accountants. We arecurrently reviewing our internal control procedures and considering furtherdocumentation of such procedures that may be necessary. Although the guidelinesfor the evaluation and attestation of internal control systems have beenfinalized, the evaluation and attestation processes are new and untested.Therefore, we can give no assurances that our systems will satisfy the newrequirements of the Securities and Exchange Commission or that we will receivea favorable review and attestation by our independent registered publicaccounting firm.

In the past, periods of rapid growth and expansion hasstrained our management and other resources. The expansion of our manufacturingcapacity and the shift of manufacturing operations to China placed and continueto place a significant strain on our operations and management resources. Werecently upgraded our inventory control systems and may implement additionalsystems relating to 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 withrules and regulations adopted pursuant to the Sarbanes-Oxley Act of 2002by the SEC, as well as changes to listing standards adopted by NASDAQ, andaccounting changes adopted affecting accounting for stock-based compensation wemay be required to increase our internal controls, hire additional personneland additional outside legal, accounting and advisory services, all of whichwill cause our general and administrative costs to increase. Insurers mayincrease premiums as a result of the high claims rates they incurred over thepast year. Changes in the accounting rules, including legislative and otherrules to account for employee stock options as a compensation expenseamong others, could materially increase the expense that we report undergenerally accepted accounting principles and adversely affect our operatingresults.

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

We anticipate that our existing cash resources willfund any anticipated operating losses, purchases of capital equipment andprovide adequate working capital for the next twelve months. However, ourliquidity is affected by many factors including, among others, the extent towhich we pursue additional capital expenditures, the level of our production,and other factors related to the uncertainties of the industry and globaleconomies. If we fail to manage our contractions successfully we may draw downour 

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cash reserves, which wouldadversely affect our operating results and financial condition, reduce ourvalue and may impinge our ability to raise debt and equity funding in thefuture, at a time when we may be required to raise additional cash.Accordingly, there can be no assurance that events in the future will notrequire us to seek additional capital, or, if so required, that such capitalwill be available on terms acceptable to us, if at all. As part of our effortto reduce costs, we may lose key staff, production resources, and technologythat we will need to grow when end markets recover. These events could reduceour ability to grow profitably as markets recover.

We anticipate that ourexisting cash resources will fund any anticipated operating losses, purchasesof capital equipment and provide adequate working capital for the next twelvemonths. Our liquidity is affected by many factors including, among others, theextent to which we pursue additional capital expenditures, the level of ourproduction efforts, and other factors related to the uncertainties of theindustry and global economies. Accordingly, there can be no assurance thatevents in the future will not require us to seek additional capital sooner, or,if so required, that such capital will be available on terms acceptable to usif at all.

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

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

China 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.

***A reoccurrence of Severe Acute Respiratory Syndrome(SARS) or the outbreak of a different contagious disease may adversely impactour manufacturing operations and some of our key suppliers and customers.***

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 and if our employees contracted the disease, wemay be required to temporarily close our manufacturing operations. Similarly,if one of our key suppliers is required to close for an extended period, we maynot have enough raw material inventory to continue manufacturing operations. Inaddition, while we possess management skills among our China staff that enableus to maintain our manufacturing operations with minimal on-site supervisionfrom our US-based staff, our business could also be harmed if travel to or fromAsia and the United States is restricted or inadvisable, as it was during partsof 2003. None of our substrate competitors is as dependent on manufacturingfacilities in China as we are. If our manufacturing operations were closed fora significant period, we could lose revenue and market share during that periodwhich would depress our financial performance and could be difficult torecapture. Finally, if one of our key customers is required 

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to closefor an extended period, we may not be able to ship product to them, our revenuewould decline and our financial performance would suffer.

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

The United States continues to be on alert forterrorist activity. The potential near- and long-term impact terroristactivities may have in regards to our suppliers, customers and markets for ourproducts and the U.S. economy are uncertain. There may be embargos of ports orproducts, or destruction of shipments or our facilities, or attacks that affectour personnel. There may be other potential adverse effects on our operatingresults due to a significant event that we cannot foresee. Since we performsubstantially all of our manufacturing operations in China, and a significantportion of our customers are located outside of the Untied States, terroristactivity or threats against US-owned enterprise are a particular concern to us.

***Any futureacquisitions may disrupt our business, dilute stockholder value or distractmanagement attention.***

Aspart of our strategy, we may consider acquisitions of, or significant investmentsin, businesses that offer products, services and technologies complementary toours. Acquisitions entail numerous risks, including:

·       wemay have difficulty assimilating the operations, products and personnel of theacquired businesses;

·       ourongoing business may be disrupted;

·       wemay incur unanticipated costs;

·       ourmanagement may be unable to manage the financial and strategic position ofacquired or developed products, services and technologies;

·       wemay be unable to maintain uniform standards, controls, procedures, andpolicies; and

·       ourrelationships with employees and customers may be impaired as a result of anyintegration.

For example, we incurredsubstantial costs in connection with our acquisition of Lyte Optronics in May 1999,including the assumption of approximately $10.0 million of debt, which wassubsequently repaid, resulting in a decline of cash available. We also incurredconsistent operating losses for the business following the acquisition, andhave discontinued all operations and sold the related assets acquired in ouracquisition of Lyte Optronics during 2003.

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

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

The ongoing operation of our manufacturing andproduction facilities in China is critical to our ability to meet demand forour products. If we are not able to use all or a significant portion of ourfacilities for prolonged periods for any reason, we will not be able tomanufacture products for our customers. For example, a natural disaster, fireor explosion caused by our use of combustible chemicals and high temperaturesduring our manufacturing processes would render some or all of our facilitiesinoperable for an indefinite period of time. Actions outside of our control,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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***Unpredictablefluctuations in our operating results could disappoint analysts or ourinvestors, which could cause our stock price to decline.***

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

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

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

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

·       fluctuationsin demand for our products;

·       expansionof our manufacturing capacity;

·       expansionof our operations in China;

·       limitedavailability and increased cost of raw materials;

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

·       fluctuationof our manufacturing yields;

·       decreasesin the prices of our competitors’ products;

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

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

Due to these factors, webelieve that period-to-period comparisons of our operating results may not bemeaningful indicators of our future performance. Our operating results haveover the past year at times been below the expectations of securities analystsor investors. If this occurs again in future periods, the price of our commonstock could decline or fluctuate.

A substantial percentage of our operating expenses arefixed in the short term and we may be unable to adjust spending to compensatefor an unexpected shortfall in revenues. As a result, any delay in generatingrevenue could cause our operating results to be below the expectations ofmarket analysts or investors, which could also cause our stock price to fall.

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

Ourstock price has fluctuated significantly since we began trading on the NASDAQNational Market. For the twelve months ended December 31, 2004, the highand low closing sales prices of our common stock were $4.68 and $1.05,respectively. A number of factors could cause the price of our common stock tocontinue to fluctuate substantially, including:

·       actualor anticipated fluctuations in our quarterly or annual operating results;

·       changesin expectations about our future financial performance or changes in financialestimates of securities analysts;

·       announcementsof technological innovations by us or our competitors;

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·       newproduct introduction by us or our competitors;

·       largecustomer orders or order cancellations; and

·       theoperating and stock price performance of comparable companies.

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

***We have adoptedcertain anti-takeover measures that may make it more difficult for a thirdparty to acquire us.***

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

On April 24, 2001,our board of directors adopted a preferred stock purchase rights plan intendedto guard against certain takeover tactics. The adoption of this plan was not inresponse to any proposal to acquire us, and the board is not aware of any sucheffort. The existence of this plan could also have the effect of making it moredifficult for a third party to acquire a majority of our outstanding votingstock. In addition, certain provisions of our certificate of incorporation mayhave the effect of delaying or preventing a change of control, which couldadversely affect the market price of our common stock.

Inaddition, provisions in our amended and restated certificate of incorporationand bylaws may have the effect of delaying or preventing a merger, acquisitionor change of control of us, or changes in our management, including:

·       thedivision of our board of directors into three separate classes, each with threeyear terms;

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

·       theability of our board to alter our bylaws;

·       theability of our board to authorize the issuance of up to 2,000,000 shares ofblank check preferred stock; and

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

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

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

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

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***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 adverse foreignexchange rate movements. We have purchased foreign exchange contracts to hedgeagainst certain trade accounts receivable denominated in Japanese yen. Thechange in the fair value of the forward contracts is recognized as part of therelated foreign currency transactions as they occur. As of December 31,2004, we had no outstanding commitments with respect to foreign exchangecontracts.

***Interest Rate Risk***

Cash and cash equivalentsearning interest and certain variable rate debt instruments are subject to interestrate fluctuations. The following table sets forth the probable impact of a 10%change in interest rates (in thousands):
| **Instrument**                  | ** ** | ** ** | ** ** | **Balance as of   December 31,  2004** | ** ** | **Current  Interest  Rate** | ** ** | **Projected  Annual Interest  Income/  (Expense)** | ** ** | **Proforma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|---------------------------------|------------|------------|------------|------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Cash and cash  equivalents      |       |       | $          | 12,117                                                     |       |                        |       | 0.50                                                    | %          |                                                                 |       | $                                                                     | 61         |   |   |   | $ | 55 |   |   |   | $ | 67 |   |   |
| Investment in  debt instruments |       |       | 25,322     |                                                       |       |                        | 1.40       |                                                    |       |                                                                 | 523        |                                                                  |       |   | 470 |   |   |   | 575 |   |   |
| Long-term debt                  |       |       | (8,050     | )                                                          |       |                        | 2.49       |                                                    |       |                                                                 | (200       | )                                                                     |       |   | (180 | ) |   |   | (220 | ) |   |
|                            |       |       |       |                                                       |       |                        |       |                                                    |       |                                                                 | $          | 384                                                                   |       |   |   | $ | 345 |   |   |   | $ | 422 |   |   |

 

***Equity Risk***

We also maintain minority investments in private andpublicly traded companies. These investments are reviewed for other thantemporary declines in value on a quarterly basis. Reasons for other thantemporary declines in value include whether the related company would haveinsufficient cash flow to operate for the next twelve months, significantchanges in the operating performance and changes in market conditions. In 2004,we recorded $210,000 in charges in connection with an impairment write-downof our investments. In 2003, we recorded $2.0 million in charges to write-downour investment in two private U.S. companies. As of December 31, 2004, theminority investments we continue to hold totaled $0.4 million.

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

***Selected QuarterlyResults of Operations***

The following table setsforth unaudited quarterly results in dollars and percentages for the eightquarters ended December 31, 2004. We believe that all necessaryadjustments, consisting only of normal recurring adjustments, have beenincluded in the amounts stated below to present fairly such quarterlyinformation. The operating results for any quarter are not necessarilyindicative of results for any subsequent period.
| ** **                                                         | ** ** | **Quarters Ended** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                         | ** ** | **Dec. 31,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **June 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** | **Dec. 31,  2003** | ** ** | **Sept. 30,  2003** | ** ** | **June 30,  2003** | ** ** | **Mar. 31,  2003** | ** ** |
| Revenue                                                            |       | $                       | 7,623      |   | $ | 8,531 |   | $ | 9,524 |   | $ | 9,776 |   | $ | 9,129 |   | $ | 8,529 |   | $ | 8,519 |   | $ | 8,536 |   |
| Cost of revenue                                                    |       | 7,000                   |       | 10,767 |   | 8,695 |   | 9,243 |   | 8,342 |   | 8,029 |   | 7,844 |   | 8,263 |   |
| Gross profit  (loss)                                               |       | 623                     |       | (2,236 | ) | 829 |   | 533 |   | 787 |   | 500 |   | 675 |   | 273 |   |
| Operating  expenses:                                               |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative                                |       | 3,120                   |       | 2,468 |   | 3,203 |   | 2,770 |   | 2,502 |   | 2,654 |   | 2,819 |   | 2,500 |   |
| Research and development                                           |       | 391                     |       | 397 |   | 350 |   | 341 |   | 289 |   | 301 |   | 368 |   | 379 |   |
| Impairment charges                                                 |       | —                  |       | 210 |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Restructuring costs                                                |       | 73                      |       | 158 |   | 1,077 |   | — |   | — |   | — |   | — |   | — |   |
| Total operating expenses                                           |       | 3,584                   |       | 3,233 |   | 4,630 |   | 3,111 |   | 2,791 |   | 2,955 |   | 3,187 |   | 2,879 |   |
| Loss from  operations                                              |       | (2,961                  | )          | (5,469 | ) | (3,801 | ) | (2,578 | ) | (2,004 | ) | (2,455 | ) | (2,512 | ) | (2,606 | ) |
| Interest expense                                                   |       | 63                      |       | 60 |   | 58 |   | 109 |   | 96 |   | 145 |   | 108 |   | 117 |   |
| Other (income)  and expense, net                                   |       | (212                    | )          | (380 | ) | 113 |   | (167 | ) | 15 |   | (3 | ) | 1,269 |   | (231 | ) |
| Loss from  continuing operations before provision for income taxes |       | (2,812                  | )          | (5,149 | ) | (3,972 | ) | (2,520 | ) | (2,115 | ) | (2,597 | ) | (3,889 | ) | (2,492 | ) |
| Provision  (benefit) for income taxes                              |       | (106                    | )          | 40 |   | 97 |   | 40 |   | — |   | — |   | — |   | — |   |
| Loss from  continuing operations                                   |       | (2,706                  | )          | (5,189 | ) | (4,069 | ) | (2,560 | ) | (2,115 | ) | (2,597 | ) | (3,889 | ) | (2,492 | ) |
| Discontinued  operations:                                          |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gain (loss) from discontinued operations                           |       | 250                     |       | — |   | 222 |   | — |   | — |   | (1,591 | ) | (2,747 | ) | (1,825 | ) |
| Gain (loss) on disposal                                            |       | 194                     |       | 225 |   | — |   | — |   | — |   | 1,625 |   | (11,100 | ) | — |   |
| Benefit for income taxes                                           |       | —                  |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Gain (loss) from  discontinued operations                          |       | 444                     |       | 225 |   | 222 |   | — |   | — |   | 34 |   | (13,847 | ) | (1,825 | ) |
| Net loss                                                           |       | $                       | (2,262     | ) | $ | (4,964 | ) | $ | (3,847 | ) | $ | (2,560 | ) | $ | (2,115 | ) | $ | (2,563 | ) | $ | (17,736 | ) | $ | (4,317 | ) |

 

Other consolidated financial statements andsupplementary data required by this item are set forth at the pages indicatedat Item 15(a).

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***Item 9******.*   Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

On June 23,2004 we dismissed PricewaterhouseCoopers LLP (“PwC”) as our independentregistered public accounting firm. The audit reports of PwC on our consolidatedfinancial statements for each of past two years did not contain an adverseopinion or a disclaimer of opinion and were not qualified or modified as touncertainty, audit scope or accounting principles. The decision to changeaccountants was approved by our Audit Committee of the Board of Directors. Inconnection with its audits for the two recent fiscal years ending on December 31,2003 and through June 18, 2004, there were no disagreements with PwC onany matter of accounting principles or practices, financial statementdisclosure or auditing scope or procedures which disagreements, if not resolvedto PwC’s satisfaction, would have caused PwC to make reference to suchdisagreement in their report on the financial statements for such years.

During the two fiscalyears ending on December 31, 2003 and through June 18, 2004, therewere no reportable events as defined in Item 304(a)(1)(v)(A), (B), (C) or(D) of Regulation S-K, except that, in its letter to the AuditCommittee Members dated June 7, 2004, in connection with the review of thefinancial statements for the quarter ended March 31, 2004, PwC noted thatas part of our implementation of our Code of Business Conduct and Ethics, welearned, and informed PwC, of certain failures to comply with requirements forproduct testing and the provision of testing data and information relating torequirements of certain customers. Our investigation into the product testingpractices and procedures conducted, with the assistance of outside counsel,confirmed that certain customer requirements were not being complied with.

PwC indicated that it believed that the condition thatenabled the deficiency to exist, including the lack of an effective monitoringand operational oversight function in this area, was a material weakness asdefined in AU 325, *Communication of InternalControl Related Matters Noted In An Audit*(AU 325) of the *AICPA Professional Standards.*PwCrecommended that we implement specific measures to ensure greater operationalcontrols and compliance with customer requirements. Company management did notdisagree with the suggestions made by PwC.

The Company engaged Burr,Pilger & Mayer LLP as its independent registered public accountingfirm as of June 23, 2004. During the two fiscal years ending on December 31,2003 and through the date of their engagement by us, we did not consult withBurr, Pilger & Mayer LLP regarding either (i) the application ofaccounting principles to a specified transaction, either completed or proposed,or the type of audit opinion that might be rendered on our financialstatements, and neither a written report was provided to us or oral advice wasprovided that Burr, Pilger & Mayer LLP concluded was an importantfactor considered by us in reaching a decision as to the accounting, auditingor financial reporting issue; or (ii) any matter that was either thesubject of a disagreement, as that term is defined in Item 304(a)(1)(iv) ofRegulation S-K and the related instructions to Item 304 ofRegulation S-K, or a reportable event, as that term is defined inItem 304(a)(1)(v) of Regulation S-K.

***Item 9A******.  *Controls and Procedures**

***Evaluation of disclosure controls and procedures.  ***Underthe supervision and with the participation of our management, our Interim ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof our disclosure 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 Interim 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 Interim ChiefExecutive Officer and Chief Financial Officer, also conducted an evaluation ofour internal control over financial reporting to determine whether any changesoccurred during the period covered by this report that have materiallyaffected, or are reasonably likely to materially affect, our 

47

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internal control overfinancial reporting. Based on that evaluation, there has been no such changeduring 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 Interim Chief Executive Officerand Chief Financial Officer have concluded that our disclosure controls andprocedures are, 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 June 28, 2005, under the sectionentitled “Executive Compensation and Other Matters.”

**Item 12**.   *Security Ownership of Certain Beneficial Owners and Management, and RelatedStockholder 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 June 28, 2005, 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 4160Business Center, LLC, a real estate holding company, in which Davis Zhang, thepresident of our China 

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Operations,is the sole shareholder. Lease payments to 4160 Business Center, LLC wereapproximately $484,000 for the year ended December 31, 2002 and $121,000for the three months ended March 31, 2003. In April of 2003, Mr. Zhangsold this warehouse to a party unrelated to us. We began leasing this warehousefrom the new owner on the date of sale. Mr. Zhang will continue to hold a$3.7 million note on the property through April 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 onJune 28, 2005, under the section entitled “Principal Accounting Firm Fees.”

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**PART IV**

***Item 15******.  *Exhibits and Financial StatementSchedules**

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

(1) Financial Statements:

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**
| Report of Independent  Registered Public Accounting Firm, Burr, Pilger & Mayer LLP |   | 52 |
|---------------------------------------------------------------------------------------------|--------|----|
| Report  of Independent Registered Public Accounting Firm, PricewaterhouseCoopers LLP        |   | 53 |
| Consolidated  Balance Sheets                                                                |   | 54 |
| Consolidated  Statements of Operations                                                      |   | 55 |
| Consolidated  Statements of Stockholders’ Equity                                       |   | 56 |
| Consolidated  Statements of Cash Flows                                                      |   | 57 |
| Notes to Consolidated Financial  Statements                                                 |   | 58 |

 

(2)         Financial StatementSchedules

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

(b)         Exhibits

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

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**REPORT**OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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

We have audited the accompanying consolidated balancesheet of AXT, Inc. and subsidiaries (the Company) as of December 31,2004, and the related consolidated statements of operations, stockholders’equity and cash flows for the year then ended. These consolidated financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audit.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of AXT, Inc. andsubsidiaries as of December 31, 2004, and the results of their operationsand their cash flows for the year then ended, in conformity with accountingprinciples generally accepted in the United States of America.

/s/ BURR, PILGER &MAYER LLP

Burr,Pilger & Mayer LLP

Palo Alto, CaliforniaFebruary 4, 2005

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**REPORT**OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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

In ouropinion, the accompanying consolidated balance sheet as of December 31,2003****and the related consolidatedstatements of operations, stockholders’ equity and cash flows for each of thetwo years in the period ended December 31, 2003 present fairly, in allmaterial respects, the financial position, results of operations and cash flowsof AXT, Inc. and its subsidiaries at December 31, 2003 and for eachof the two years in the period ended December 31, 2003, in conformity withaccounting principles generally accepted in the United States of America. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audits of these statements 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 of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

/s/ PRICEWATERHOUSECOOPERSLLP

PricewaterhouseCoopersLLP

San Jose, CaliforniaMarch 5, 2004

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**AXT, INC.CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                       | ** ** | **December 31,**                                          | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                                                                                       | ** ** | **2004**                                                       | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                       | ** ** | **(In thousands, except  per share data)** | ** ** |
| **ASSETS**                                                                                                                                                       |       |                                                           |       |   |   |
| Current assets                                                                                                                                                   |       |                                                           |       |   |   |
| Cash and cash equivalents                                                                                                                                        |       | $                                                              | 12,117     |   | $ | 24,339 |   |
| Short-term investments                                                                                                                                           |       | 20,062                                                         |       | 14,669 |   |
| Accounts receivable, net of allowance of $1,087 and  $4,304 as of December 31, 2004 and 2003, respectively                                                  |       | 4,034                                                          |       | 6,297 |   |
| Inventories, net                                                                                                                                                 |       | 16,462                                                         |       | 24,083 |   |
| Prepaid expenses and other current assets                                                                                                                        |       | 2,523                                                          |       | 1,575 |   |
| Assets held for sale                                                                                                                                             |       | 1,250                                                          |       | 1,000 |   |
| Total current assets                                                                                                                                             |       | 56,448                                                         |       | 71,963 |   |
| Property, plant  and equipment                                                                                                                                   |       | 19,045                                                         |       | 21,795 |   |
| Restricted  deposits                                                                                                                                             |       | 8,215                                                          |       | 9,302 |   |
| Other assets                                                                                                                                                     |       | 3,832                                                          |       | 3,963 |   |
| Total assets                                                                                                                                                     |       | $                                                              | 87,540     |   | $ | 107,023 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                    |       |                                                           |       |   |   |
| Current liabilities                                                                                                                                              |       |                                                           |       |   |   |
| Accounts payable                                                                                                                                                 |       | $                                                              | 1,895      |   | $ | 2,638 |   |
| Accrued liabilities                                                                                                                                              |       | 3,920                                                          |       | 3,227 |   |
| Accrued compensation and related charges                                                                                                                         |       | 715                                                            |       | 1,012 |   |
| Accrued restructuring costs                                                                                                                                      |       | 552                                                            |       | — |   |
| Customer prepayments                                                                                                                                             |       | 130                                                            |       | 994 |   |
| Current portion of long-term debt                                                                                                                                |       | 450                                                            |       | 3,694 |   |
| Income taxes payable                                                                                                                                             |       | 2,925                                                          |       | 3,063 |   |
| Total current liabilities                                                                                                                                        |       | 10,587                                                         |       | 14,628 |   |
| Long-term debt,  net of current portion                                                                                                                          |       | 7,600                                                          |       | 8,842 |   |
| Other long-term  liabilities                                                                                                                                     |       | 1,336                                                          |       | 1,255 |   |
| Total liabilities                                                                                                                                                |       | 19,523                                                         |       | 24,725 |   |
| 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, 2004  and 2003, respectively              |       | 3,532                                                          |       | 3,532 |   |
| Common stock, $0.001 par value; 70,000 shares  authorized; 23,119 and 22,957 shares issued and outstanding as of  December 31, 2004 and 2003,  respectively |       | 23                                                             |       | 23 |   |
| Additional paid-in-capital                                                                                                                                       |       | 155,431                                                        |       | 155,155 |   |
| Accumulated deficit                                                                                                                                              |       | (92,561                                                        | )          | (78,928 | ) |
| Other comprehensive income                                                                                                                                       |       | 1,592                                                          |       | 2,516 |   |
| Total stockholders’ equity                                                                                                                                  |       | 68,017                                                         |       | 82,298 |   |
| Total liabilities  and stockholders’ equity                                                                                                                 |       | $                                                              | 87,540     |   | $ | 107,023 |   |

 

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

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**AXT, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**
| ** **                                                         | ** ** | **Years Ended December 31,**                        | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                         | ** ** | **(In thousands, except per share data)** | ** ** |
| Revenue                                                            |       | $                                                                  | 35,454     |   | $ | 34,713 |   | $ | 44,865 |   |
| Cost of revenue                                                    |       | 35,705                                                             |       | 32,478 |   | 53,758 |   |
| Gross profit  (loss)                                               |       | (251                                                               | )          | 2,235 |   | (8,893 | ) |
| Operating expenses:                                                |       |                                                               |       |   |   |   |   |
| Selling, general and administrative                                |       | 11,561                                                             |       | 10,475 |   | 13,860 |   |
| Research and development                                           |       | 1,479                                                              |       | 1,337 |   | 2,339 |   |
| Impairment charges                                                 |       | 210                                                                |       | — |   | 14,632 |   |
| Restructuring costs                                                |       | 1,308                                                              |       | — |   | — |   |
| Total operating expenses                                           |       | 14,558                                                             |       | 11,812 |   | 30,831 |   |
| Loss from  operations                                              |       | (14,809                                                            | )          | (9,577 | ) | (39,724 | ) |
| Interest expense                                                   |       | 290                                                                |       | 466 |   | 437 |   |
| Other (income)  and expense, net                                   |       | (646                                                               | )          | 1,050 |   | 12,703 |   |
| Loss from  continuing operations before provision for income taxes |       | (14,453                                                            | )          | (11,093 | ) | (52,864 | ) |
| Provision for  income taxes                                        |       | 71                                                                 |       | — |   | 2,119 |   |
| Loss from  continuing operations                                   |       | (14,524                                                            | )          | (11,093 | ) | (54,983 | ) |
| Discontinued operations:                                           |       |                                                               |       |   |   |   |   |
| Gain (loss) from discontinued operations                           |       | 472                                                                |       | (6,163 | ) | (34,625 | ) |
| Gain (loss) on disposal                                            |       | 419                                                                |       | (9,475 | ) | — |   |
| Benefit for income taxes                                           |       | —                                                             |       | — |   | (8,427 | ) |
| Gain (loss) from  discontinued operations                          |       | 891                                                                |       | (15,638 | ) | (26,198 | ) |
| Net loss                                                           |       | $                                                                  | (13,633    | ) | $ | (26,731 | ) | $ | (81,181 | ) |
| Basic and diluted  income (loss) per share:                        |       |                                                               |       |   |   |   |   |
| Loss from continuing operations                                    |       | $                                                                  | (0.64      | ) | $ | (0.49 | ) | $ | (2.46 | ) |
| Gain (loss) from discontinued operations                           |       | 0.04                                                               |       | (0.69 | ) | (1.17 | ) |
| Net loss                                                           |       | $                                                                  | (0.60      | ) | $ | (1.18 | ) | $ | (3.63 | ) |
| Shares used in  computing basic and diluted net loss per share     |       | 23,063                                                             |       | 22,781 |   | 22,433 |   |

 

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

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**AXT,INC.**

**CONSOLIDATEDSTATEMENTS OF 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, 2001            |       |                     | 883        |                  |       |         | $          | 3,532          |       |                          | 22,383     |              |       | $                 | 22         |              |       |              | $          | 153,613 |   |   |   | $ | 28,984 |   |   |   | $ | 171 |   |   | $ | 186,322 |   |   |   |   |   |
| Common stock options exercised                  |       |                     |       |                  |       |         |       |           |       | 88                            |       |              |       |              |       |              | 684        |              |       |   |   |   |   |   |   |   |   | 684 |   |   |   |   |   |
| Issuance of Employee Stock Purchase Plan stock  |       |                     |       |                  |       |         |       |           |       | 24                            |       |              |       |              |       |              | 166        |              |       |   |   |   |   |   |   |   |   | 166 |   |   |   |   |   |
| Comprehensive loss:                             |       |                     |       |                  |       |         |       |           |       |                          |       |              |       |              |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                        |       |                     |       |                  |       |         |       |           |       |                          |       |              |       |              |       |              |       |              |       |   | (81,181 | ) |   |   |   |   |   | (81,181 | ) |   | $ | (81,181 | ) |   |
| Unrealized gain (loss) on marketable securities |       |                     |       |                  |       |         |       |           |       |                          |       |              |       |              |       |              |       |              |       |   |   |   |   |   | (21 | ) |   | (21 | ) |   | (21 | ) |   |
| Currency translation adjustment                 |       |                     |       |                  |       |         |       |           |       |                          |       |              |       |              |       |              |       |              |       |   |   |   |   |   | (313 | ) |   | (313 | ) |   | (313 | ) |   |
| Balance as of December 31, 2002            |       |                     | 883        |                  |       |         | 3,532      |           |       | 22,495                        |       |              | 22         |              |       |              | 154,463    |              |       |   | (52,197 | ) |   |   | (163 | ) |   | 105,657 |   |   | (81,515 | ) |   |
| 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 gain (loss) on marketable securities |       |                     |       |                  |       |         |       |           |       |                          |       |              |       |              |       |              |       |              |       |   |   |   |   |   | (1,104 | ) |   | (1,104 | ) |   | (1,104 | ) |   |
| Currency translation adjustment                 |       |                     |       |                  |       |         |       |           |       |                          |       |              |       |              |       |              |       |              |       |   |   |   |   |   | 180 |   |   | 180 |   |   | 180 |   |   |
| Balance as of  December 31, 2004           |       |                     | 883        |                  |       |         | $          | 3,532          |       |                          | 23,119     |              |       | $                 | 23         |              |       |              | $          | 155,431 |   |   |   | $ | (92,561 | ) |   |   | $ | 1,592 |   |   | $ | 68,017 |   |   | $ | (14,557 | ) |   |

 

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

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**AXT, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                | ** ** | **(In thousands)**                     | ** ** |
| **Cash flows from operating activities:**                                                 |       |                                        |       |   |   |   |   |
| Net loss                                                                                  |       | $                                           | (13,633    | ) | $ | (26,731 | ) | $ | (81,181 | ) |
| Adjustments to reconcile net loss to cash (used in)  provided by operations:         |       |                                        |       |   |   |   |   |
| Depreciation                                                                              |       | 4,869                                       |       | 5,782 |   | 9,493 |   |
| Deferred income taxes                                                                     |       | —                                      |       | — |   | 2,533 |   |
| Amortization of  marketable securities premium/discount                                   |       | 307                                         |       | 502 |   | 403 |   |
| Stock-based compensation                                                                  |       | 6                                           |       | 28 |   | — |   |
| Non-cash restructuring  charge                                                            |       | 1,308                                       |       | — |   | — |   |
| Impairment of property,  plant and equipment                                              |       | —                                      |       | — |   | 39,086 |   |
| Impairment of  investments                                                                |       | 210                                         |       | 2,128 |   | 10,577 |   |
| (Gain) loss on disposal  of property, plant and equipment                                 |       | 10                                          |       | (11 | ) | 3,404 |   |
| (Gain) loss on disposal  on discontinued operations                                       |       | (472                                        | )          | 9,475 |   | — |   |
| Changes in assets and liabilities:                                                        |       |                                        |       |   |   |   |   |
| Accounts receivable, net                                                                  |       | 2,263                                       |       | 232 |   | 8,489 |   |
| Inventories                                                                               |       | 7,621                                       |       | 11,541 |   | 17,989 |   |
| Prepaid expenses                                                                          |       | (948                                        | )          | 2,217 |   | (320 | ) |
| Other assets                                                                              |       | (77                                         | )          | (137 | ) | (362 | ) |
| Accounts payable                                                                          |       | (743                                        | )          | (1,590 | ) | 1,285 |   |
| Accrued liabilities                                                                       |       | (1,001                                      | )          | (5,493 | ) | (5,019 | ) |
| Income taxes                                                                              |       | (140                                        | )          | 8,783 |   | (6,091 | ) |
| Other long-term  liabilities                                                              |       | 80                                          |       | (457 | ) | 439 |   |
| Net cash (used in)  provided by operating activities                                      |       | (340                                        | )          | 6,269 |   | 725 |   |
| **Cash flows from investing activities:**                                                 |       |                                        |       |   |   |   |   |
| Purchases of property,  plant and equipment                                               |       | (2,139                                      | )          | (2,175 | ) | (14,238 | ) |
| Proceeds from disposal  of property, plant and equipment                                  |       | 10                                          |       | — |   | — |   |
| Purchases of marketable  securities                                                       |       | (25,876                                     | )          | (5,941 | ) | (17,869 | ) |
| Proceeds from sale of  marketable securities                                              |       | 19,072                                      |       | 13,885 |   | 17,070 |   |
| Proceeds from sale of  property and equipment from discontinued opto-electronics business |       | —                                      |       | 8,600 |   | — |   |
| Proceeds from sale of  property                                                           |       | —                                      |       | 5,172 |   | — |   |
| Decrease (increase) in  restricted deposits                                               |       | 1,087                                       |       | (5,818 | ) | (1,000 | ) |
| Net cash (used in)  provided by investing activities                                      |       | (7,846                                      | )          | 13,723 |   | (16,037 | ) |
| **Cash flows from financing activities:**                                                 |       |                                        |       |   |   |   |   |
| Proceeds from issuance  of common stock                                                   |       | 270                                         |       | 480 |   | 850 |   |
| Capital lease payments                                                                    |       | —                                      |       | (8,409 | ) | (5,965 | ) |
| Proceeds from long-term  debt borrowings                                                  |       | —                                      |       | — |   | 3,935 |   |
| Long-term debt payments                                                                   |       | (4,486                                      | )          | (1,718 | ) | (6,936 | ) |
| Net cash used in  financing activities                                                    |       | (4,216                                      | )          | (9,647 | ) | (8,116 | ) |
| Effect of exchange rate  changes                                                          |       | 180                                         |       | 197 |   | (313 | ) |
| Net (decrease) increase  in cash and cash equivalents                                     |       | (12,222                                     | )          | 10,542 |   | (23,741 | ) |
| Cash and cash  equivalents at the beginning of the period                                 |       | 24,339                                      |       | 13,797 |   | 37,538 |   |
| Cash and cash  equivalents at the end of the period                                       |       | $                                           | 12,117     |   | $ | 24,339 |   | $ | 13,797 |   |
| **Non-cash activity:**                                                                    |       |                                        |       |   |   |   |   |
| Purchases of property,  plant and equipment through financing                             |       | $                                           | —     |   | $ | — |   | $ | 577 |   |
| **Supplemental Disclosures:**                                                             |       |                                        |       |   |   |   |   |
| Interest paid                                                                             |       | $                                           | 271        |   | $ | 790 |   | $ | 1,326 |   |

 

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

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

**Note 1. The Companyand Summary 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 GaAs substrates and subsequently used VGF technologyto manufacture substrates from InP, and Ge. We also manufacture and sell rawmaterials related to our substrate business through five joint ventures locatedin China. These joint ventures produce products including 99.99% pure gallium(4N Ga), high purity gallium, arsenic, and germanium, germanium dioxide,paralytic boron nitride (pBN) crucibles, and boron oxide. AXT’s ownershipinterest in these entities ranges from 25 percent to 88 percent. We consolidatethe three ventures in which we own a majority share and employ equityaccounting for the two joint ventures in which we have a 25 percent interest.We purchase the materials produced by these ventures for our use and sell otherportions of their production 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 currentlyavailable to us.

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***Reclassifications***

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

***Foreign Currency Translation***

The functional currencies of our Japanese and Chinesesubsidiaries are the local currencies. Transaction gains and losses resultingfrom transactions denominated in currencies other than the U.S. dollar or inthe functional currencies of our subsidiaries are included in other (income)expense, 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 in thefourth quarter of 2004 to provide a certain amount of cumulative discountson future product purchases from us. We will recognize these discounts infuture periods as a reduction in revenue as products are sold to this 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 balance sheet.

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. No customer represented greaterthan 10% of product revenues for the years ended December 31, 2004, 2003and 2002. Our top five customers represented 30.1%, 28.9%, and 31.4% of productrevenue for the years ended December 31, 2004, 2003, and 2002,respectively. We expect that sales to certain customers will continue tocomprise a significant portion of our revenue in the future. Two customers eachaccounted for 10% or more of our trade accounts receivable balance as of December 31,2004 at 10.1% and 10.0%, and no customer accounted for 10% or more of our tradeaccounts receivable balance as of December 31, 2003.

***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 balancesheet. The amortized cost of securities is adjusted for amortization ofpremiums and accretion of discounts to maturity. Such amortization is includedin other (income) expense, net in the consolidated statements of operations.Realized gains and losses and declines in value judged to be other thantemporary on available-for-sale securities are also included in other (income)expense, net in the consolidated statements of operations. The cost ofsecurities sold is based upon the specific identification method.

All available-for-salesecurities with a quoted market value below cost (or adjusted cost) arereviewed in order to determine whether the decline is other-than-temporary.Factors considered in determining whether a loss is temporary include themagnitude of the decline in market value, the length of time the market valuehas been below cost (or adjusted cost), credit quality, and our ability andintent to hold the securities for a period of time sufficient to allow for anyanticipated recovery in market value.

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

Accounts receivable arerecorded at the invoiced amount and are not interest bearing. We maintain anallowance for doubtful accounts to reserve for potentially uncollectible tradereceivables. We also review our trade receivables by aging category to identifyspecific customers with known disputes or collectibility issues. We exercisejudgment when determining the adequacy of these reserves as we evaluatehistorical bad debt trends, general economic conditions in the United Statesand internationally, and changes in customer financial conditions.Uncollectible receivables are recorded as bad debt expense when all efforts tocollect have been exhausted and recoveries are recognized when they arereceived. During 2004, we wrote off $3.5 million of fully reserved accountsreceivable and increased the allowance for doubtful accounts by $0.3 million.

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***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.

***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 are chargedto expense 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 interim chief executive officer reviews asingle set of financial data that encompasses our entire operations for purposeof making operating 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 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.

***Stock-Based Compensation***

Wehave employee stock option plans, which are described more fully in Note11—Employee Benefit Plans. We account for stock-based employee compensationarrangements using the intrinsic value method as prescribed in AccountingPrinciples Board Opinion No. 25, *“Accountingfor Stock Issued 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 recognition provisionsof SFAS No. 123, *“Accounting forStock-Based Compensation,”* as amended by SFAS No. 148, *“Accounting for Stock-Based Compensation Transitionand Disclosure,”* to options granted 

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under our stock option plans. For purposes of this proforma disclosure, the value of the options is estimated using a Black-Scholesoption pricing model and amortized to expense over the options’ vestingperiods. Because the estimated value is determined as of the date of grant, theactual value ultimately realized by the employee may be significantlydifferent.
| ** **                                                                                    | ** ** | **Years Ended December 31,**                        | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                    | ** ** | **(in thousands, except per share data)** | ** ** |
| Net loss to common  stockholders:                                                             |       |                                                               |       |   |   |   |   |
| As reported                                                                                   |       | $                                                                  | (13,810    | ) | $ | (26,908 | ) | $ | (81,358 | ) |
| Add: Stock-based employee compensation expense  included in net loss as reported              |       | 6                                                                  |       | 28 |   | — |   |
| Less: Stock-based compensation expense using the fair  value based method, net of related tax |       | (1,330                                                             | )          | (7,323 | ) | (9,182 | ) |
| Pro forma net loss                                                                            |       | $                                                                  | (15,134    | ) | $ | (34,203 | ) | $ | (90,540 | ) |
| Basic and diluted net  loss per share:                                                        |       |                                                               |       |   |   |   |   |
| As reported                                                                                   |       | $                                                                  | (0.60      | ) | $ | (1.18 | ) | $ | (3.63 | ) |
| Pro forma                                                                                     |       | $                                                                  | (0.66      | ) | $ | (1.50 | ) | $ | (4.04 | ) |
| Shares used in computing  basic and diluted net loss per share                                |       | 23,063                                                             |       | 22,781 |   | 22,433 |   |

 

Theweighted average estimated value of employee stock options granted during 2004,2003, and 2002 was $1.17, $1.70, and $2.39, respectively. The value of optionsgranted was estimated at the date of grant using the following weighted averageassumptions:
| ** **                | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------|------------|---------------------------------------------|------------|
| ** **                | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Risk-free  interest rate  |       | 3.6                                         | %          | 2.9 | % | 3.0 | % |
| Expected life (in  years) |       | 5.0                                         |       | 5.0 |   | 5.0 |   |
| Dividend yield            |       | —                                      |       | — |   | — |   |
| Volatility                |       | 103.0                                       | %          | 109.0 | % | 101.0 | % |

 

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.

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.

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***Advertising Costs***

Advertising costs,included in selling and administrative, are expensed as incurred. Advertisingcosts for the years ended December 31, 2004, 2003, and 2002 were $51,000,$53,000 and $63,000, 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 ofstock options. Potentially dilutive common shares are excluded in net lossperiods, as their effect would be anti-dilutive.

***Recent Accounting Pronouncements***

In June 2004, the Financial Accounting StandardsBoard (FASB) ratified Emerging Issues Task Force Issue No. 03-1(EITF 03-1), *“The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments.”*EITF 03-1 includes new guidance for evaluating and recording impairmentlosses on debt and equity investments, as well as new disclosure requirementsfor investments that are deemed to be temporarily impaired. Adoption of therecognition and measurement guidance of EITF 03-1 has been temporarilydeferred by the FASB, but the disclosure requirements of EITF 03-1 areeffective for our 2004 annual consolidated financial statements. Accordingly,additional disclosures as required by EITF 03-1 are included inNote 3 to the consolidated financial statements.

In October 2004, the FASB issued Emerging IssuesTask Force Issue No. 04-1 (EITF 04-1), *“Accounting for Preexisting Relationships between the Parties to aBusiness Combination,”* which provides new guidance for theaccounting for preexisting relationships between the parties to a businesscombination. Additionally, EITF 04-1 includes additional disclosurerequirements for business combinations between parties with a preexistingrelationship. EITF 04-1 is effective for fiscal periods beginning after October 13,

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2004. We do not expect theadoption of EITF 04-1 to have a material impact on our consolidatedfinancial position, results of operations or cash flows.

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs*,*an amendment of ARB No. 43, Chapter 4.*This Statement amends the guidance in ARB No. 43, Chapter 4, “InventoryPricing,” to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material (spoilage). Paragraph 5of ARB 43, Chapter 4, previously stated that “...under some circumstances, itemssuch as idle facility expense, excessive spoilage, double freight, andrehandling costs may be so abnormal as to require treatment as current periodcharges....” This Statement requires that those items be recognized as currentperiod charges regardless of whether they meet the criterion of “so abnormal.”In addition, this Statement requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities. The provisions of this Statement are effective forinventory costs incurred during fiscal years beginning after June 15, 2005.The adoption of this Statement is not expected to have a material effect on ourconsolidated financial position, results of operations or cash flows.

In December 2004, the FASB issued SFAS No. 123revised 2004 (SFAS 123R), *“Share-BasedPayment,”* which requires companies to measure and recognizecompensation expense for all stock-based payments at fair value. SFAS 123Ris effective for all interim periods beginning after June 15, 2005 and,thus, will be effective for us beginning with the third quarter of fiscal 2005.Early adoption is encouraged and retroactive application of the provisions ofSFAS 123R to the beginning of the fiscal year that includes the effective dateis permitted, but not required. We are currently evaluating the impact of SFAS 123Ron our financial position and results of operations. See *Stock-Based Compensation* above forinformation related to the pro forma effects on our reported net loss and netloss per share when applying the fair value recognition provisions of theprevious SFAS No. 123, *“Accountingfor Stock-Based Compensation,”* to stock-based employee compensation.

In December 2004, theFASB issued SFAS No. 153 (SFAS 153), *“Exchangesof Nonmonetary Assets—An Amendment of APB Opinion No. 29, Accounting forNonmonetary Transactions.”* SFAS 153 eliminates the exceptionfrom fair value measurement for nonmonetary exchanges of similar productiveassets in paragraph 21(b) of APB Opinion No. 29, “Accounting forNonmonetary Transactions,” and replaces it with an exception for exchanges thatdo not have commercial substance. SFAS 153 specifies that a nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange. SFAS 153 iseffective for the fiscal periods beginning after June 15, 2005. We do notexpect the adoption of SFAS 153 to have a material impact on ourconsolidated financial position, results of operations or cash flows.

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

In June 2003, we announced the discontinuation ofour opto-electronics division, which we had established as part of ouracquisition of Lyte Optronics, Inc. in May 1999. The discontinuedopto-electronics division manufactured blue, cyan, and green high-brightness lightemitting diodes (HBLEDs) for the illumination markets, including full-colordisplays, wireless handset backlighting and 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 been segregatedfrom continuing operations and are reported separately as discontinuedoperations in our consolidated statements of operations for all periodspresented.

In September 2003, we completed the sale ofsubstantially all of the assets of our opto-electronics business to LumeiOptoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group,Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. A portionof the purchase price equal to $1.0 million was held in escrow to satisfy anyclaims that the purchaser might make for breaches of 

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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. Given thedifficult negotiations we encountered with the acquiring company whennegotiating the sale of the opto-electronics business, as well as thehistorical operating problems of the business, we determined there wassignificant uncertainty regarding the recoverability of the escrowed amounts.Accordingly, we did not recognize the cash held in escrow in recording the saleof the opto-electronics division. We will only record amounts as and when theyare received. To date, we have resolved all claims made against the first$750,000 held in escrow by the acquiring company, and will record amounts as theyare received from the escrow. As of December 31, 2004, approximately$419,000 was released from escrow and accordingly we recorded a gain ondiscontinued operations in 2004. In February 2005, we received anadditional $300,000 from escrow which was the remaining portion of the first$750,000 held in escrow due to us, as we had resolved a claim of approximately$31,000 in favor of the buyer. The remaining $250,000 held in escrow will notbe released until September 2005, if the buyer makes no claims against itby such date. In the second quarter of 2004, we recorded a gain of $222,000 asa result of our reversal of accrued liabilities of general and administrativeexpenses no longer required.

In addition, we retain a building located in MontereyPark, California that we have listed on the market for sale. This asset hasbeen classified as “Assets held for sale” on the consolidated balance sheets asof December 31, 2004 and 2003. In January 2005, we accepted an offerfrom a real estate developer to purchase the property for net proceeds ofapproximately $1.25 million, after deducting estimated commission and sellingexpenses. We expect the sale to complete by the second quarter of 2005.

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,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Revenue                                                                                                |       | $                                           | —     |   | $ | 7,245 |   | $ | 18,310 |   |
| Cost of revenue                                                                                        |       | —                                      |       | 9,972 |   | 20,273 |   |
| Gross loss                                                                                             |       | —                                      |       | (2,727 | ) | (1,963 | ) |
| Operating expenses:                                                                                    |       |                                        |       |   |   |   |   |
| Selling, general and administrative                                                                    |       | (222                                        | )          | 2,297 |   | 4,788 |   |
| Research and development                                                                               |       | —                                      |       | 814 |   | 2,529 |   |
| Impairment charges                                                                                     |       | —                                      |       | — |   | 24,454 |   |
| Total operating expenses                                                                               |       | (222                                        | )          | 3,111 |   | 31,771 |   |
| Gain (loss) from  operations                                                                           |       | 222                                         |       | (5,838 | ) | (33,734 | ) |
| Other (income)  expense, net                                                                           |       | (250                                        | )          | — |   | — |   |
| Interest expense                                                                                       |       | —                                      |       | 325 |   | 891 |   |
| Gain (loss) from  discontinued operations before benefit for income taxes and gain (loss) on  disposal |       | 472                                         |       | (6,163 | ) | (34,625 | ) |
| Income tax  benefit                                                                                    |       | —                                      |       | — |   | (8,427 | ) |
| Gain (loss) on  disposal                                                                               |       | 419                                         |       | (9,475 | ) | — |   |
| Net gain (loss) from  discontinued operations                                                          |       | $                                           | 891        |   | $ | (15,638 | ) | $ | (26,198 | ) |

 

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Thecarrying value of the assets and liabilities of the discontinuedopto-electronics business included in the consolidated balance sheets are asfollows (in thousands):
| ** **                        | ** ** | **As of December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|
| ** **                        | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Current assets:                   |       |                                  |       |   |   |
| Cash                              |       | $                                     | 537        |   | $ | 539 |   |
| Accounts receivable, net          |       | 19                                    |       | 250 |   |
| Assets held for sale              |       | 1,250                                 |       | 1,000 |   |
| Total current assets              |       | 1,806                                 |       | 1,789 |   |
| Other assets                      |       | 200                                   |       | 200 |   |
| Total assets                      |       | $                                     | 2,006      |   | $ | 1,989 |   |
| Current liabilities:              |       |                                  |       |   |   |
| Accounts payable                  |       | $                                     | —     |   | $ | 43 |   |
| Accrued liabilities               |       | 359                                   |       | 1,232 |   |
| Total liabilities                 |       | 359                                   |       | 1,275 |   |
| Net assets                        |       | 1,647                                 |       | 714 |   |
| Total liabilities and  net assets |       | $                                     | 2,006      |   | $ | 1,989 |   |

 

Assets held for saleconsist of a building and are carried at management’s estimated fair value lesscosts to sell, totaling $1.25 million and $1.0 million as of December 31,2004 and 2003, respectively. We recorded in the fourth quarter 2004 a $0.25million market value adjustment after we accepted an offer from a real estatedeveloper to purchase the property for net proceeds of approximately $1.25million, after deducting estimated commission and selling expenses in January 2005.We expect the sale to complete by the second quarter of 2005.

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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, 2004** | ** **    | **December 31, 2003** | ** ** |
|----------------------------------------------------------|------------|---------------------------------|---------------|---------------------------------|------------|
| ** **                                               | ** ** | **Amortized  Cost**             | ** **    | **Gross  Unrealized  Gain**     | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** |
| **Classified as:**                                       |       |                            |          |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash                                                     |       |                            | $ 8,638  |                            |       |   | $    — |   |   |   | $ — |   |   | $ 8,638 |   |   | $ 6,843 |   |   |   | $    — |   |   |   | $ — |   |   | $ 6,843 |   |
| Cash equivalents:                                        |       |                            |          |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market fund                                        |       |                            | 1,681         |                            |       |   | — |   |   |   | — |   |   | 1,681 |   |   | 2,961 |   |   |   | — |   |   |   | — |   |   | 2,961 |   |
| US Treasury and  agency securities                  |       |                            | —        |                            |       |   | — |   |   |   | — |   |   | — |   |   | 1,498 |   |   |   | — |   |   |   | — |   |   | 1,498 |   |
| Commercial paper                                         |       |                            | 398           |                            |       |   | — |   |   |   | — |   |   | 398 |   |   | 8,387 |   |   |   | — |   |   |   | — |   |   | 8,387 |   |
| Repurchase agreements                                    |       |                            | 1,400         |                            |       |   | — |   |   |   | — |   |   | 1,400 |   |   | 4,650 |   |   |   | — |   |   |   | — |   |   | 4,650 |   |
| Total cash  equivalents                                  |       |                            | 3,479         |                            |       |   | — |   |   |   | — |   |   | 3,479 |   |   | 17,496 |   |   |   | — |   |   |   | — |   |   | 17,496 |   |
| Total cash and  cash equivalents                    |       |                            | 12,117        |                            |       |   | — |   |   |   | — |   |   | 12,117 |   |   | 24,339 |   |   |   | — |   |   |   | — |   |   | 24,339 |   |
| Short-term investments:                                  |       |                            |          |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| US Treasury and agency  securities                       |       |                            | 10,468        |                            |       |   | — |   |   |   | (16 | ) |   | 10,452 |   |   | 14,567 |   |   |   | 18 |   |   |   | — |   |   | 14,585 |   |
| Asset-backed securities                                  |       |                            | 4,410         |                            |       |   | — |   |   |   | (25 | ) |   | 4,385 |   |   | 2,506 |   |   |   | 7 |   |   |   | — |   |   | 2,513 |   |
| Commercial paper                                         |       |                            | 1,708         |                            |       |   | — |   |   |   | (1 | ) |   | 1,707 |   |   | 1,300 |   |   |   | — |   |   |   | — |   |   | 1,300 |   |
| Corporate bonds                                          |       |                            | 8,737         |                            |       |   | — |   |   |   | (30 | ) |   | 8,707 |   |   | 1,890 |   |   |   | 8 |   |   |   | — |   |   | 1,898 |   |
| Corporate equity  securities                             |       |                            | 1,465         |                            |       |   | 1,561 |   |   |   | — |   |   | 3,026 |   |   | 1,115 |   |   |   | 2,560 |   |   |   | — |   |   | 3,675 |   |
| Total short-term  investments                       |       |                            | 26,788        |                            |       |   | 1,561 |   |   |   | (72 | ) |   | 28,277 |   |   | 21,378 |   |   |   | 2,593 |   |   |   | — |   |   | 23,971 |   |
| Total cash, cash  equivalents and short-term investments |       |                            | $ 38,905 |                            |       |   | $ 1,561 |   |   |   | $ (72 | ) |   | $ 40,394 |   |   | $ 45,717 |   |   |   |  

$2,593           |   |   |   | $ — |   |   | $ 48,310 |   |
| **Contractual maturities on  short-term investments:**   | ** ** |                            |          |                            |       |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| Due within 1 year                                        |       |                            | $ 21,879 |                            |       |   |   |   |   |   |   |   |   | $ 23,394 |   |   | $ 18,190 |   |   |   |   |   |   |   |   |   |   | $ 20,775 |   |
| Due after 1 through 5  years                             |       |                            | 4,909         |                            |       |   |   |   |   |   |   |   |   | 4,883 |   |   | 3,188 |   |   |   |   |   |   |   |   |   |   | 3,196 |   |
|                                                     |       |                            | $ 26,788 |                            |       |   |   |   |   |   |   |   |   | $ 28,277 |   |   | $ 21,378 |   |   |   |   |   |   |   |   |   |   | $ 23,971 |   |

 

The short-term investments amounts include $8.2million and $9.3 million recorded as restricted deposits on the consolidatedbalance sheets as of December 31, 2004 and 2003, 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, 2004and 2003, we had no gross realized gain or loss on sales of ouravailable-for-sale securities.

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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 2004. We havedetermined that the gross unrealized losses on our available-for-salesecurities as of December 31, 2004 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, 2004 (in thousands):
| ** **                        | ** ** | **In Loss Position  < 12 months** | ** ** | **Total in Loss Position** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **Fair  Value**                                          | ** ** | **Gross  Unrealized  (Loss)**             | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** |
| Short-term  investments:          |       |                                                     |       |                                      |       |   |   |   |   |   |   |   |   |
| US Treasury and agency securities |       | $ 9,452                                             |       |                                      | $ (16 | ) |   | $ 9,452 |   |   | $ (16 | ) |   |
| Assets-backed securities          |       | 4,385                                                    |       |                                      | (25        | ) |   | 4,385 |   |   | (25 | ) |   |
| Commercial paper                  |       | 1,312                                                    |       |                                      | (1         | ) |   | 1,312 |   |   | (1 | ) |   |
| Corporate bonds                   |       | 8,706                                                    |       |                                      | (30        | ) |   | 8,706 |   |   | (30 | ) |   |
| Total in loss  position           |       | $ 23,855                                            |       |                                      | $ (72 | ) |   | $ 23,855 |   |   | $ (72 | ) |   |

 

**Note 4.Inventories, Net**

Thecomponents of inventory are summarized below (in thousands):
| ** **      | ** ** | **As of December 31,** | ** ** |
|-----------------|------------|---------------------------------------|------------|
| ** **      | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Inventories:    |       |                                  |       |   |   |
| Raw materials   |       | $ 4,416                          |       | $ 7,086 |   |
| Work in process |       | 10,474                                |       | 16,027 |   |
| Finished goods  |       | 1,572                                 |       | 970 |   |
|            |       | $16,462                               |       | $ 24,083 |   |

 

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

Thecomponents of our property, plant and equipment are summarized below (inthousands):
| ** **                                       | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Property, plant and  equipment:                  |       |                                  |       |   |   |
| Land                                             |       | $   1,120              |       | $ 1,120 |   |
| Building                                         |       | 15,751                                |       | 17,180 |   |
| Machinery and  equipment                         |       | 16,176                                |       | 8,275 |   |
| Leasehold  improvements                          |       | 828                                   |       | 443 |   |
| Construction in  progress                        |       | 634                                   |       | 1,150 |   |
|                                             |       | 34,509                                |       | 28,168 |   |
| Less: accumulated  depreciation and amortization |       | (15,464                               | )          | (6,373 | ) |
|                                             |       | $ 19,045                         |       | $ 21,795 |   |

 

Depreciation expenses were$4.9 million, $5.8 million, and $9.5 million for the years ended 2004, 2003,and 2002, respectively.

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**Note 6. CorporateAffiliates**

Wehave made strategic investments in private companies located in China in orderto gain access to raw materials at competitive cost that are critical to oursubstrate business. We are currently negotiating a new joint venture investmentin China for a germanium business opportunity, and upon the fulfillment ofcertain conditions, we may invest up to $1.0 million in the new joint venturein 2005. Our corporate affiliates are summarized below (in thousands) :
| ** **                                     | ** ** | **Investment Balance**           | ** ** | ** **     | ** ** | ** **    | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|----------------|------------|---------------|------------|
| ** **                                     | ** ** | **As of December 31,** | ** ** | **Accounting** | ** ** | **Ownership** | ** ** |
| **Affiliate**                                  | ** ** | ** **                            | ** ** | **2004**       | ** ** | **2003**      | ** ** | **Method** | ** ** | **Percentage** | ** ** |
| Beijing Ji Ya  Semiconductor Material Co., Ltd |       | $ 1,071                          |       | $ 1,071   |       | Consolidated  |       |   | 51 | % |   |
| Nanjing Jin Mei  Gallium Co., Ltd              |       | 616                                   |       | 616            |       | Consolidated  |       |   | 88 |   |   |
| Beijing BoYu  Manufacturing Co., Ltd           |       | 409                                   |       | 409            |       | Consolidated  |       |   | 70 |   |   |
| Xilingol Tongli  Ge Co. Ltd                    |       | 863                                   |       | 822            |       | Equity        |       |   | 25 |   |   |
| Emeishan Jia Mei High  Pure Metals Co., Ltd    |       | 593                                   |       | 603            |       | Equity        |       |   | 25 |   |   |
|                                                |            |                                       |            |                |            |               |            |  |  |  |  |  |  |

 

The investmentbalances for the two affiliates accounted for under the equity method areincluded in other assets in the consolidated balance sheets. We own 25% of theownership interests in each of these affiliates. These two affiliates are notconsidered variable interest entities 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 $1.4 million and $769,000 asof December 31, 2004 and 2003, respectively. Net income (loss) recordedfrom our corporate affiliates were $668,000 and ($92,000) for the years ended December 31,2004 and 2003, respectively.

**Note 7. Investments**

We invest in equityinstruments of privately-held companies for business and strategic purposes.These investments are classified as other assets in the consolidated balancesheets and are accounted for under the cost method as we do not have theability to exercise 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. In 2004, we recorded a $210,000 charge related to impairment inone of these U.S. private companies. In 2003, we recorded $2.0 million incharges to write-down its investment in two private U.S. companies. As of December 31,2004, the investments we continue to hold totaled approximately $392,000.

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**Note 8.Restructuring Costs**

As of December 31,2004, our restructuring accrual is as follows (in thousands):
| **Description**                                        | ** ** | ** ** | ** **          | **Restructuring  Accrual as of  December 31,  2003** | ** ** | ** Addition ** | ** **       | **Payments** | ** ** | **Restructuring  Accrual as of   December 31,  2004** | ** **  |
|--------------------------------------------------------|------------|------------|---------------------|---------------------------------------------------------------------|------------|--------------------------|------------------|--------------|------------|---------------------------------------------------------------------------|-------------|
| Future lease  payments related to abandoned facilities |       |       | $ –– |                                                                |       |                     | $  845 |         |       |                                                                      | $ (327 | ) |   |   | $ 518 |   |   |
| Workforce  reduction                                   |       |       | —              |                                                                |       |                     | 463              |         |       |                                                                      | (429        | ) |   |   | 34 |   |   |
| Total                                                  |       |       | $ –– |                                                                |       |                     | $ 1,308     |         |       |                                                                      | $ (756 | ) |   |   | $ 552 |   |   |

 

During the second quarterof 2004, we announced plans to cease all production activities in the UnitedStates and to manufacture our products only in China. In June 2004, weincurred a restructuring charge of $1.1 million as a result of our decision toclose down our remaining manufacturing facilities in the United States. In thethird and fourth quarter of 2004, we incurred additional restructuring chargesof $231,000 for a total of $1.3 million in 2004. These charges comprised costsrelated to the 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 are production workers. The above accrued restructuring balance isincluded in accrued liabilities in the consolidated balance sheet. As of December 31,2004, we saved approximately $560,000 in payroll and related expenses. Onan annual basis, we anticipate payroll and related expense savings of $1.5 million.In 2005, we will continue to reduce costs by qualifying new lower costsuppliers, moving more of our administrative functions to China, andstreamlining our organization structure and costs in the United States andChina to bring them in line with market and product demand.

**Note 9. Debt**

***Credit Facility***

As of December 31,2004, the credit facility maintained by us with a bank included a letter ofcredit supporting repayment of our industrial bonds with an outstanding amountof $8.2 million. We have pledged and placed cash and certain investmentsecurities with the trust department of the bank as additional collateral forthis facility. Accordingly, $8.2 million of cash and short-term investments arerestricted.

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***Long-Term Debt***

Thecomponents of long-term debt are summarized below (in thousands):
| ** **                                                                                                                                                                                                     | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                                                                                                                     | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Debenture loan to  Bay Area Employment Development Company, guaranteed by the U.S. Small  Business Administration, bearing interest at a fixed rate of 7.27%, maturing  October 2016                      |       | $     — |       | $    788 |   |
| Taxable revenue  bonds, secured by a letter of credit from a bank, bearing interest at the H15  30 day bond yield for commercial paper which was 2.49% on December 31,  2004, maturing December 2023 |       | 8,050                                 |       | 8,450 |   |
| Notes payable to  a bank, secured by certain equipment in China, bearing interest at a fixed  rate of 5.49%, maturing December 2004                                                                       |       | —                                |       | 3,298 |   |
|                                                                                                                                                                                                           |       | 8,050                                 |       | 12,536 |   |
| Less current  portion                                                                                                                                                                                          |       | (450                                  | )          | (3,694 | ) |
|                                                                                                                                                                                                           |       | $7,600                                |       | $ 8,842 |   |
| Maturities of  long-term debt as of December 31, 2004 were as follows:                                                                                                                                    |       |                                  |       |   |   |
| 2005                                                                                                                                                                                                           |       | $  450                      |       |   |   |
| 2006                                                                                                                                                                                                           |       | 450                                   |       |   |   |
| 2007                                                                                                                                                                                                           |       | 450                                   |       |   |   |
| 2008                                                                                                                                                                                                           |       | 520                                   |       |   |   |
| 2009                                                                                                                                                                                                           |       | 450                                   |       |   |   |
| Thereafter                                                                                                                                                                                                     |       | 5,730                                 |       |   |   |
|                                                                                                                                                                                                           |       | $ 8,050                          |       |   |   |

 

**Note 10.Stockholders’ Equity**

In August 2004, weannounced the adoption of a stock repurchase program in accordance with Rule 10b5-1of the Securities Exchange Act of 1934 to provide for the repurchase of up to$2 million of our common stock. Repurchases may be made from time to time inthe open market during the twelve-month period ending July 31, 2005, atprevailing market prices using our own cash resources. As of December 31,2004, we had 23.1 million shares of common stock outstanding and none wererepurchased in 2004 under this program. In January 2005, 10,000 shareswere repurchased.

**Note 11. EmployeeBenefit Plans**

***Stock Option Plans***

In March 1993, our board of directors approvedthe 1993 Stock Option Plan (1993 Plan), which provided for granting ofincentive and non-qualified stock options to our employees and directors. Underthe 1993 Plan, 880,000 shares of common stock were authorized for issuance.Options granted under the 1993 Plan were generally for periods not to exceedten years and were granted at the fair market value of the stock at the date ofgrant as determined by the board of directors. Options granted under the 1993Plan generally vested 25% upon grant and 25% each year thereafter, with fullvesting occurring on the third anniversary of the grant date. This 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 1997 Plan are generally for periods not to exceed tenyears (five years if the option is granted to a 10% stockholder) and aregranted at the fair market value of the stock at the date of grant asdetermined by the 

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board of directors.Options granted under the 1997 Plan generally vest 25% at the end of one yearand 2.1% each month thereafter, 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 commonstock, representing approximately 48% of the options that were eligible to betendered in the offer as of May 27, 2003, were tendered and cancelled. Newoptions will vest at the same rate as the exchanged options and have anexercise price equal to the fair market value of our common stock at the newgrant date, which was $3.11 per share. On December 31, 2003, the Companygranted options to purchase an aggregate of 522,754 shares of our common stockin exchange for such tendered options. In 2004, several officers voluntarilycancelled 771,000 options 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, 2002, 2003, and 2004 (in thousands):
| ** **                            | ** ** | **Available  For Grant** | ** ** | **Number of  Options  Outstanding** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------|------------|-------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| Balance as of  December 31, 2001 |       |                          | 1,729      |                                     |       |                                   | 3,314      |   |   |   | $ 19.63 |   |   |
| Granted                               |       |                          | (1,137     | )                                        |       |                                   | 1,137      |   |   |   | 3.06 |   |   |
| Exercised                             |       |                          | —     |                                     |       |                                   | (24        | ) |   |   | 6.94 |   |   |
| Cancelled                             |       |                          | 863        |                                     |       |                                   | (863       | ) |   |   | 20.10 |   |   |
| 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 |   |   |

 

Informationabout stock options outstanding as of December 31, 2004 is summarizedbelow (in thousands):
| ** **                              | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $1.18 - $  1.37               |       |                         | 435        |                         |       |   | 9.58 |   |   |   | $ 1.24 |   |   |   | 1 |   |   |   | $ 1.34 |   |   |
| $1.38 - $  1.42               |       |                         | 463        |                         |       |   | 8.55 |   |   |   | 1.38 |   |   |   | 274 |   |   |   | 1.38 |   |   |
| $1.43 - $  2.23               |       |                         | 674        |                         |       |   | 8.04 |   |   |   | 2.15 |   |   |   | 330 |   |   |   | 2.18 |   |   |
| $2.24 - $  4.99               |       |                         | 529        |                         |       |   | 9.07 |   |   |   | 2.96 |   |   |   | 317 |   |   |   | 3.11 |   |   |
| $5.00 - $41.50                          |       |                         | 209        |                         |       |   | 3.91 |   |   |   | 9.78 |   |   |   | 192 |   |   |   | 8.86 |   |   |
|                                    |       |                         | 2,310      |                         |       |   | 8.29 |   |   |   | $ 2.70 |   |   |   | 1,114 |   |   |   | $ 3.40 |   |   |
|                                         |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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As of December 31,2004 options to purchase 1,059,533 shares of our common stock wereexerciseable.

***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.As of December 31, 2004, a total of 900,000 shares of our common stockwere reserved for issuance under the 1998 Purchase Plan. A total ofapproximately 789,000 shares were purchased as of December 31, 2004. The1998 Purchase Plan permits eligible employees to acquire shares of our commonstock through payroll deductions. The common stock purchase price was 85% ofthe lower of the market price of the common stock at the purchase date or thedate of offer to the employee. A total of 106,459, 206,375 and 74,262 shares,respectively, of common stock have been issued under the 1998 Purchase Plan forthe years ended December 31, 2004, 2003, and 2002, respectively.

***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 wechanged this to make all full-time Participants may contribute up to 10% oftheir earnings to the Savings Plan with a discretionary matching amountprovided AXT. Our contributions to the Savings Plan were $177,000, $191,000,and $315,000 for the years ended December 31, 2004, 2003 and 2002,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.

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

***Product Warranty***

Wewarrant our products for a specific period of time, generally twelve months,against material defects. We provide for the estimated future costs of warrantyobligations in cost of sales when the related revenue is recognized. Theaccrued warranty costs represents the best estimate at the time of sale of thetotal costs that we expect to incur to repair or replace product parts, whichfail while still under warranty. The amount of accrued estimated warranty costsare primarily based on historical experience as to product 

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failures as well as current information on repaircosts. On a quarterly basis, we review the accrued balances and updates thehistorical warranty cost trends. The following table reflects the change in ourwarranty accrual during fiscal year 2004 (in thousands):
| ** **                           | ** ** | **Amount** | ** **    |
|--------------------------------------|------------|------------|---------------|
| Warranty accrual,  beginning of year |       |       | $ — |   |   |
| Charged to cost  of sales            |       |       | 135           |   |   |
| Actual warranty  expenditures        |       |       | —        |   |   |
| Warranty accrual, end of  year       |       |       | $ 135    |   |   |

 

In March 2004, wedetermined that we had not followed certain requirements for testing ofproducts and provision of testing data and information relating to customerrequirements for certain shipments made over the past several years. Since April 2004,we have continued to notify the affected customers concerning our findings. Werecorded a reserve for sale returns of $745,000 and believed this was adequateto cover any product returns related to this matter. We are unable to assessthe impact that this matter might have, if any, on our future revenues or grossmargins. Approximately $285,000 of the $745,000 sales returns reserve has beenutilized as of December 31, 2004.

**Note 13. IncomeTaxes**

The components of the provision(benefit) for income taxes are summarized below (in thousands):
| ** **                          | ** ** | **Years Ended December 31,**              | ** **    |
|-------------------------------------|------------|----------------------------------------------------------|---------------|
| ** **                          | ** ** | **    2004    ** | ** **    | **    2003    ** | ** ** | **2002** | ** ** |
| Current:                            |       |                                                     |          |   |   |   |   |   |   |   |   |
| Federal                             |       |                                                     | $ — |   |   |   | $ — |   |   | $ (8,841 | ) |
| Foreign                             |       |                                                     | 71            |   |   |   | — |   |   | — |   |
| Total current                       |       |                                                     | 71            |   |   |   | — |   |   | (8,841 | ) |
| Deferred:                           |       |                                                     |          |   |   |   |   |   |   |   |   |
| Federal                             |       |                                                     | —        |   |   |   | — |   |   | 1,301 |   |
| State                               |       |                                                     | —        |   |   |   | — |   |   | 1,232 |   |
| Total deferred                      |       |                                                     | —        |   |   |   | — |   |   | 2,533 |   |
| Total net benefit  for income taxes |       |                                                     | $ 71     |   |   |   | $ — |   |   | $ (6,308 | ) |

 

A reconciliation of the effective income tax rates andthe U.S. statutory federal income tax rate is summarized below:
| ** **                                       | ** ** | **Years Ended December 31,**  | ** ** |
|--------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **   2004   ** | ** ** | **   2003   ** | ** ** | **   2002   ** | ** ** |
| Statutory federal  income tax rate               |       |                                         | (35.0      | )% |   |   | (35.0 | )% |   |   | (35.0 | )% |   |
| State income  taxes, net of federal tax benefits |       |                                         | (1.7       | ) |   |   | (1.7 | ) |   |   | (2.7 | ) |   |
| Unbenefited  losses and credits                  |       |                                         | 0.0        |   |   |   | 0.0 |   |   |   | 2.8 |   |   |
| Change in  valuation allowance                   |       |                                         | 30.1       |   |   |   | 35.8 |   |   |   | 29.9 |   |   |
| Other                                            |       |                                         | 7.1        |   |   |   | 0.9 |   |   |   | (2.2 | ) |   |
| Effective tax rate                               |       |                                         | 0.5        | % |   |   | 0.0 | % |   |   | (7.2 | )% |   |

 

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Deferredtax assets and liabilities are summarized below (in thousands):
| ** **                               | ** ** | **As of December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|
| ** **                               | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Deferred tax  assets:                    |       |                                  |       |   |   |
| Accruals and reserves not yet deductible |       | $                                     | 5,491      |   | $ | 7,624 |   |
| Net operating loss                       |       | 32,605                                |       | 28,170 |   |
| Credits                                  |       | 4,329                                 |       | 4,212 |   |
|                                     |       | 42,425                                |       | 40,006 |   |
| Deferred tax  liabilities:               |       |                                  |       |   |   |
| State taxes                              |       | (151                                  | )          | (526 | ) |
| Unrepatriated foreign earnings           |       | (1,239                                | )          | (1,239 | ) |
| Depreciation                             |       | (2,270                                | )          | (3,634 | ) |
|                                     |       | (3,660                                | )          | (5,399 | ) |
| Net deferred tax assets                  |       | 38,765                                |       | 34,607 |   |
| Valuation allowance                      |       | (38,765                               | )          | (34,607 | ) |
| Net deferred tax  assets                 |       | $                                     | —     |   | $ | — |   |

 

As of December 31,2004, we had federal and state net operating loss carryforwards ofapproximately $89.5 million and $39.4 million, respectively, which will expirebeginning in 2020 and 2007, respectively. In addition, we had federal taxcredit carryforwards of approximately $1.6 million, which will expire beginningin 2020. We also had state tax credit carryforwards of approximately $2.7million which will expire beginning 2008.

The deferred tax assets valuation allowance as of December 31,2004 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 382 of the InternalRevenue Code, the amounts of and benefits from net operating loss and taxcredit carryforwards may be impaired or limited in certain circumstances.Events which cause limitations in the amount of net operating losses or creditsthat we may utilize in any one year include, but are not limited to, acumulative ownership change of more than 50% as defined, over a three yearperiod.

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**Note 14.Net loss per Share**

A reconciliation ofthe numerators and denominators of the basic and diluted net loss per sharecalculations is as follows (in thousands, except per share data):
| ** **                                                                        | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Numerator:                                                                        |       |                                        |       |   |   |   |   |
| Loss from continuing operations                                                   |       | $                                           | (14,524    | ) | $ | (11,093 | ) | $ | (54,983 | ) |
| Gain (loss) from discontinued operations                                          |       | 891                                         |       | (15,638 | ) | (26,198 | ) |
| Less: Preferred stock dividends                                                   |       | (177                                        | )          | (177 | ) | (177 | ) |
| Net loss to common stockholders                                                   |       | $                                           | (13,810    | ) | $ | (26,908 | ) | $ | (81,358 | ) |
| Denominator:                                                                      |       |                                        |       |   |   |   |   |
| Denominator for basic net loss per share—weighted  average common shares     |       | 23,063                                      |       | 22,781 |   | 22,433 |   |
| Effect of dilutive securities:                                                    |       |                                        |       |   |   |   |   |
| Common stock options                                                              |       | —                                      |       | — |   | — |   |
| Denominator for  dilutive net loss per share                                      |       | 23,063                                      |       | 22,781 |   | 22,433 |   |
| Basic and diluted  income (loss) per share:                                       |       |                                        |       |   |   |   |   |
| Loss from continuing operations                                                   |       | $                                           | (0.64      | ) | $ | (0.49 | ) | $ | (2.46 | ) |
| Gain (loss) from discontinued operations                                          |       | 0.04                                        |       | (0.69 | ) | (1.17 | ) |
| Net loss to common stockholders                                                   |       | $                                           | (0.60      | ) | $ | (1.18 | ) | $ | (3.63 | ) |
| Options excluded from  diluted net loss per share  as the impact is anti-dilutive |       | 2,310                                       |       | 2,588 |   | 3,564 |   |

 

**Note 15. SegmentInformation and Foreign Operations**

***Segment Information***

We operate in one segmentfor the design, development, manufacture and distribution of high-performancecompound semiconductor substrates and sale of materials. In accordance withSFAS No. 131, *“Disclosures aboutSegments of an Enterprise and Related Information,”* our chiefoperating decision-maker has been identified as the Interim Chief ExecutiveOfficer, who reviews operating results to make decisions about allocatingresources and assessing performance for the company. All material operatingunits qualify for aggregation under SFAS No. 131 due to theiridentical customer base and similarities in economic characteristics, nature ofproducts and services, and procurement, manufacturing and distributionprocesses. Since we operate in one segment, all financial segment and productline information required by SFAS No. 131 can be found in theconsolidated financial statements.

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***Geographical Information***

The following tablerepresents revenue amounts (in thousands) reported for products shipped tocustomers in the corresponding geographic region:
| ** **                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Product revenue:                           |       |                                        |       |   |   |   |   |
| North America*                             |       | $                                           | 7,514      |   | $ | 12,009 |   | $ | 26,208 |   |
| Europe                                     |       | 6,840                                       |       | 5,638 |   | 5,508 |   |
| Japan                                      |       | 5,156                                       |       | 4,167 |   | 3,000 |   |
| Taiwan                                     |       | 8,397                                       |       | 7,055 |   | 4,246 |   |
| Asia Pacific  (excluding Japan and Taiwan) |       | 7,547                                       |       | 5,844 |   | 5,903 |   |
|                                       |       | $35,454                                     |       | $ | 34,713 |   | $ | 44,865 |   |
|                                            |            |                                             |            |  |  |  |  |  |  |  |

----

*                    Primarily theUnited States

Long-lived assets consist primarily of property, plantand equipment, and are attributed to the geographic location in which they arelocated. Long-lived assets by geographic region were as follows (in thousands):
| ** **          | ** ** | **As of December 31,** | ** ** |
|---------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Long-lived  assets: |       |                                  |       |   |   |
| North America       |       | $                                     | 7,163      |   | $ | 7,583 |   |
| Asia Pacific        |       | 11,882                                |       | 14,212 |   |
|                |       | $19,045                               |       | $ | 21,795 |   |
|                     |            |                                       |            |  |  |  |  |

 

***Significant Customers***

No customer representedgreater than 10% of product revenues for the years ended December 31,2004, 2003 and 2002. Our top five customers represented 30.1%, 28.9%, and 31.4%of product revenue for the years ended December 31, 2004, 2003, and 2002,respectively.

**Note 16. ForeignExchange 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, 2004, wehad no outstanding commitments with respect to foreign exchange contracts.

We incurred foreigncurrency transaction exchange gains of $60,000, $110,000, and $19,000 for theyears ended December 31, 2004, 2003, and 2002, respectively.

**Note 17. RelatedParty Transactions**

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

We entered into anoperating lease in July 2001 for warehouse space in Fremont, CA with 4160Business Center, LLC, a real estate holding company, in which Davis Zhang, thepresident of our China 

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Operations,is the sole shareholder. Lease payments to 4160 Business Center, LLC wereapproximately $484,000 for the year ended December 31, 2002 and $121,000for the three months ended March 31, 2003. In April of 2003, Mr. Zhangsold this warehouse to a party unrelated to us. We began leasing this warehousefrom the new owner on the date of sale. Mr. Zhang will continue to hold a$3.7 million note on the property through April 2005.

**Note 18.Commitments and Contingencies**

***Legal Matters***

On June 11, 2003, Cree, Inc. filed acomplaint in the United States Court for the Northern District of Californiaagainst AXT alleging patent infringement. The complaint sought damages andinjunction against infringement. On July 23, 2003, we filed a countercomplaint in the United States Court for the Northern District of California,denying any patent infringement and alleging that Cree’s actions wereintentionally designed to interfere with our prospective businessrelationships. We reached an agreement with Cree resolving the disputes betweenus and signed a settlement agreement on March 5, 2004. The resolution ofthe disputes did not have a material adverse impact on our consolidatedfinancial position or results of operations. All parties signed a final releaseregarding all disputes between them on April 15, 2004.

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 lawsuit names AXT, Inc. and our chiefexecutive officer, China operations, as defendants, and is brought on behalf ofa class of all purchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during thisperiod that were false and misleading. No specific amount of damages isclaimed. On February 4, 2005, the Court consolidated the case with arelated case making similar allegations, and appointed a lead plaintiff, whowill file a consolidated complaint. We believe that there are meritoriousdefenses against this litigation and intends to vigorously defend it. However,due to the inherent uncertainties of litigation, we cannot accurately predictthe ultimate outcome of the litigation. Any unfavorable outcome of thelitigation could have an adverse impact on our business, financial conditionand results of operations.

On December 2, 2004,we executed an agreement with Sumitomo Electric Industries, Ltd. (“SEI”), aJapanese corporation, to settle litigation commenced by SEI against AXT inJapan alleging infringement of certain SEI patents, and an interference actionbetween an AXT patent and an SEI reissue application brought in the UnitedStates. We and SEI entered into a four-year cross-licensing agreement for allintellectual property used by either company related to compound semiconductorsubstrates, which will expire on December 31, 2008, with the exception ofthe patents that were the basis for the litigation in Japan and theinterference in the U.S. where the license agreement shall last for the life ofthese patents. Under the terms of the settlement, we made a payment to SEI inthe amount of Japanese Yen one hundred and forty-seven million (¥147,000,000)on January 4, 2005, and we will make on-going royalty payments through2012 on certain products sold by us in Japan. Subsequent to that payment, SEIdropped the litigation in Japan and we abandoned the interference proceedingsin the U.S.

***Leases***

We lease certain officespace, manufacturing facilities and property under long-term operating leasesexpiring at various dates through March 2013. Total rent expenses underthese operating leases were $1.3 million, $1.2 million and $0.9 million for theyears ended December 31, 2004, 2003 and 2002, respectively. Total minimumlease payments under these leases as of December 31, 2004 are summarizedbelow (in thousands):

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| ** ** | ** ** | **Lease Payment** | ** ** |
|------------|------------|------------------------|------------|
| 2005       |       |                   | $          | 1,319 |   |   |
| 2006       |       |                   | 940        |   |   |
| 2007       |       |                   | 645        |   |   |
| 2008       |       |                   | 714        |   |   |
| 2009       |       |                   | 733        |   |   |
| Thereafter |       |                   | 2,486      |   |   |
|       |       |                   | $6,837     |   |   |

 

***Contract Commitment***

We have entered intocontracts to supply several large customers with GaAs wafers. The contracts guaranteeddelivery of a certain number of wafers between January 1, 2001 and December 31,2004 with a current contract value of $130,000. The contract sales prices aresubject to review quarterly and can be adjusted in the event that raw materialprices change. In the event of non-delivery of the determined wafer quantitiesin any monthly delivery period, we could be subject to non-performancepenalties of between 5% and 10% of the value of the delinquent monthlydeliveries. We have not received any claims for non-performance penalties dueto non-delivery. Partial prepayments received for these supply contractstotaling $130,000 and $994,000 are included in accrued liabilities in theaccompanying condensed consolidated balance sheets as of December 31, 2004and 2003, respectively. During the third quarter of 2004, the Company refundeda portion of a prepayment on future purchases of goods and recorded a $237,000gain for the amount of deposit forfeited by a private company, which investmentwas impaired by AXT. As of December 31, 2004, we have met all of ourcurrent delivery obligations under these contracts and expect to continue tomeet delivery requirements during the remainder of the contract terms.

We are currentlynegotiating a new joint venture investment in China for a germaniumbusiness opportunity, and upon the fulfillment of certain conditions, we mayinvest up to $1.0 million to the new joint venture in 2005.

**Note 19. Unaudited Quarterly Consolidated FinancialData**
| ** **                             | ** ** | **Quarter**                                                        | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                             | ** ** | **First**                                                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| ** **                             | ** ** | **(in thousands, except per share data)** | ** ** |
| **2003:**                              |       |                                                               |       |   |   |   |   |   |   |
| Revenue                                |       | $                                                                  | 8,536      |   | $ | 8,519 |   | $ | 8,529 |   | $ | 9,129 |   |
| Gross profit                           |       | 273                                                                |       | 675 |   | 500 |   | 787 |   |
| Net loss                               |       | (4,317                                                             | )          | (17,736 | ) | (2,563 | ) | (2,115 | ) |
| Net loss per  share, basic and diluted |       | $                                                                  | (0.19      | ) | $ | (0.78 | ) | $ | (0.11 | ) | $ | (0.09 | ) |
| **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 | ) |

 

**Note 20. Subsequent Event**

In January 2005, weaccepted an offer from a real estate developer to purchase our Monterey Parkfacility for net proceeds of approximately $1.25 million, after deductingestimated commission and selling expenses. This asset has been classified asheld for sale on the consolidated balance sheets as of December 31, 2004and 2003. We expect the sale to be completed in the second quarter of 2005.

79

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**SIGN**ATURES

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereto duly authorized.
|          |     | AXT, INC. |
|----------|----------|-----------|
|     |     | By:       |   | /s/  DONALD L. TATZIN |
|     |     |      |   | Donald L. Tatzin |
| * * | * * | * *  | * * | *Interim  Chief Executive Officer* |

Date: March 18, 2005

**POWER**OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below hereby constitutes and appoints Donald L. Tatzinand 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 to filethe 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 or hisor 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/ DONALD L.  TATZIN

Donald L. Tatzin |          | Interim  Chief Executive Officer and Director

*(Principal  Executive Officer)*          |       | March 18, 2005 |
| /s/ WILSON W. CHEUNG

Wilson W. Cheung  |          | Chief Financial Officer*(Principal Financial Officer and  Principal Accounting Officer)* |       | March 18, 2005 |
| /s/ JESSE CHEN

Jesse Chen              |          | Chairman  of the Board of Directors                                                      |       | March 18, 2005 |
| /s/ MORRIS S.  YOUNG

Morris S. Young   |          | Chief  Executive Officer, China Operations  and Director                                 |       | March 18, 2005 |
| /s/ DAVID C.  CHANG

David C. Chang     |          | Director                                                                                 |       | March 15, 2005 |
| /s/ LEONARD LEBLANC

Leonard LeBlanc    |          | Director                                                                                 |       | March 18, 2005 |

 

80

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**AXT, Inc.**

**EXHIBITSTOFORM 10-K ANNUAL REPORT**

**For the Year Ended December 31,2004**
| 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. |
| 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 Interim Chief Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |
| 31.2             |       | Certification by Chief Financial Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                           |
| 32.1             |       | Certification by Interim Chief Executive Officer  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |
| 32.2             |       | Certification by  Chief Financial Officer 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

   *           Indicatesa management contract

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