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AXT INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations
[March 14, 2014]

AXT INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) In addition to historical information, the following discussion contains forward­looking statements that are subject to risks and uncertainties. Actual results may differ substantially from those referred to herein due to a number of factors, including but not limited to risks described in the section entitled Item 1A. "Risk Factors" and elsewhere in this Annual Report. This discussion should be read in conjunction with Item 6. "Selected Consolidated Financial Data" and our consolidated financial statements and related notes included elsewhere in this Form 10-K.



Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. Accordingly, we make estimates, assumptions and judgments that affect the amounts reported on our consolidated financial statements. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that are believed to be reasonable under the circumstances.

These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time.


We have identified the policies below as critical to our business operations and understanding of our financial condition and results of operations. Critical accounting policies are material to the presentation of our consolidated financial statements and require us to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations. They may require us to make assumptions about matters that are highly uncertain at the time of the estimate, and different estimates that we could have used, or changes in the estimate that are reasonably likely to occur, may have a material impact on our financial condition or results of operations. We also refer you to Note 1 to our consolidated financial statements included elsewhere in this Form 10-K.

Revenue Recognition We manufacture and sell high-performance compound semiconductor substrates and sell certain raw materials including gallium, germanium dioxide, and pBN crucibles. After we ship our products, there are no remaining obligations or customer acceptance requirements that would preclude revenue recognition. Our products are typically sold pursuant to a purchase order placed by our customers, and our terms and conditions of sale do not require customer acceptance. We recognize revenue upon shipment and transfer of title of products to our customers, which is either upon shipment from our dock, receipt at the customer's dock, or removal from consignment inventory at the customer's location, provided that we have received a signed purchase order, the price is fixed or determinable, title and risk of ownership have transferred, collection of resulting receivables is probable, and product returns are reasonably estimable. We do not provide training, installation or commissioning services.

We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized.

28 -------------------------------------------------------------------------------- Table of Contents Accounts Receivable and Allowance for Doubtful Accounts We periodically review the likelihood of collection on our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We evaluate receivables from U.S.

customers with an emphasis on balances in excess of 90 days and for receivables from customers located outside the U.S. with an emphasis on balances in excess of 120 days and reserve allowance on the receivable balances if needed. The reason for the difference in the evaluation of receivables between foreign and U.S. customers is that U.S. customers have historically made payments in a shorter period of time than foreign customers. Foreign business practices generally require us to allow customer payment terms that are longer than those accepted in the United States. We assess the probability of collection based on a number of factors, including the length of time a receivable balance has been outstanding, our past history with the customer and their creditworthiness.

As of December 31, 2013 and December 31, 2012, our accounts receivable, net, balance was $14.9 million and $17.9 million, respectively, which was net of an allowance for doubtful accounts of $869,000 and zero, respectively. During 2013 we increased our allowance for doubtful accounts by $869,000 because of the poor financial condition of a few customers in China. During 2011, we decreased our allowance for doubtful accounts by $99,000 compared to the amount as of December 31, 2010 primarily for improved collections worldwide. If actual uncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could have a material impact on our financial results for the future periods.

The allowance for sales returns is also deducted from gross accounts receivable.

During 2013, we utilized $189,000 and charged an additional $130,000 resulting in the allowance for sales returns of $186,000 as of December 31, 2013. During 2012, we utilized $426,000 and reserved an additional $547,000 resulting in the allowance for sales returns of $245,000 as of December 31, 2012. During 2011, we utilized $144,000 and reduced allowance of $194,000 from the beginning balance of $462,000 resulting in the allowance for sales returns of $124,000 as of December 31, 2011.

Warranty Reserve We maintain a warranty reserve based upon our claims experience during the prior twelve months. Warranty costs are accrued at the time revenue is recognized. As of December 31, 2013 and 2012, accrued product warranties totaled $1.0 million and $588,000, respectively. The increase in accrued product warranties is primarily attributable to increased claims for quality issues experienced by some customers. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financial condition and results of operations for future periods.

Inventory Valuation Inventories are stated at the lower of cost or market. Cost is determined using the weighted average cost method. Our inventory consists of raw materials as well as finished goods and work-in-process that include material, labor and manufacturing overhead costs. Given the nature of our substrate products, and the materials used in the manufacturing process, the wafers and ingots comprising work-in-process may be held in inventory for up to two years and three years, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory, and we provide a valuation allowance for certain inventories based upon the age and quality of the product and the projections for sale of the completed products.

As of December 31, 2013 and 2012, we had an inventory reserve of $11.0 million and $10.1 million, respectively, for excess and obsolete inventory. If actual demand for our products were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results of operations.

Impairment of Investments We classify our investments in debt and equity securities as available-for-sale securities in accordance with ASC topic 320, Investments-Debt and Equity Securities ("ASC 320"). All available-for-sale securities with a quoted market value below cost (or adjusted cost) are reviewed in order to determine whether the decline is other-than-temporary. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value.

29 -------------------------------------------------------------------------------- Table of Contents We invest in equity instruments of privately-held companies in China for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee's management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in our carrying value. We had no write­downs in 2013, 2012 and 2011.

Fair Value of Investments ASC topic 820, Fair Value Measurement ("ASC 820") establishes three levels of inputs that may be used to measure fair value.

Level 1 instruments represent quoted prices in active markets. Therefore, determining fair value for Level 1 instruments does not require significant management judgment, and the estimation is not difficult.

Level 2 instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments, including: · Determining which instruments are most similar to the instrument being priced requires management to identify a sample of similar securities based on the coupon rates, maturity, issuer, credit rating, and instrument type, and subjectively select an individual security or multiple securities that are deemed most similar to the security being priced.

· Determining which model-derived valuations to use in determining fair value requires management judgment. When observable market prices for identical securities or similar securities are not available, we price our marketable debt instruments using non-binding market consensus prices that are corroborated with observable market data or pricing models, such as discounted cash flow models, with all significant inputs derived from or corroborated with observable market data.

Level 3 instruments include unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.

The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. As of December 31, 2013 and 2012, we did not have any assets or liabilities without observable market values that would require a high level of judgment to determine fair value (Level 3 assets).

Impairment of Long-Lived Assets We evaluate the recoverability of property, equipment and intangible assets in accordance with ASC topic 360, Property, Plant and Equipment ("ASC 360"). When events and circumstances indicate that long-lived assets may be impaired, we compare the carrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to such assets. In the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the asset's fair value. Fair values are determined based on quoted market values, discounted cash flows or internal and external appraisals, as applicable. Assets held for sale are carried at the lower of carrying value or estimated net realizable value. We had no "Assets held for sale" on the consolidated balance sheet as of December 31, 2013 and 2012.

Stock Based Compensation We account for stock-based compensation in accordance with ASC topic 718, Stock-based Compensation ("ASC 718"). Share-based awards granted include stock options and restricted stock awards. We utilize the Black­Scholes option pricing model to estimate the grant date fair value of stock options, which requires the input of highly subjective assumptions, including estimating stock price volatility and expected term. Historical volatility was used while the expected term for our options was estimated based on historical option exercise behavior and post-vesting forfeitures of options, and the contractual term, the vesting period and the expected term of the outstanding options. Further, we apply an expected forfeiture rate in determining the amount of share-based compensation.

We use historical forfeitures to estimate the future forfeitures rates. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of our stock compensation. The cost of restricted stock awards is determined using the fair value of our common stock on the date of grant.

30 -------------------------------------------------------------------------------- Table of Contents We recognize the compensation costs net of an estimated forfeiture rate over the requisite service period of the options award, which is generally the vesting term of four years. Compensation expense for restricted stock awards is recognized over the vesting period, which is generally three years or four years. Stock-based compensation expense is recorded in cost of revenue, research and development, and selling, general and administrative expenses. (see Note 1-Summary of Significant Accounting Policies-Stock­Based Compensation).

Income Taxes We account for income taxes in accordance with ASC topic 740, Income Taxes ("ASC 740") which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. ASC 740 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized.

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

See Note 13-"Income Taxes" in the consolidated financial statements for additional information.

Results of Operations Overview We were founded in 1986 to commercialize and enhance our proprietary vertical gradient freeze (VGF) technique for producing high-performance compound semiconductor substrates. We have one operating segment: our substrate business, with limited additional raw materials sales. We recorded our first substrate sales in 1990 and our substrate division currently sells gallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge) substrates to manufacturers of semiconductor devices for use in applications such as fiber optic and wireless telecommunications, light emitting diodes (LEDs), lasers and for solar cells for space and terrestrial photovoltaic applications. We also sell raw materials including gallium and germanium through our participation in majority­ and minority­owned joint ventures.

Operating Results We manufacture all of our semiconductor substrates using our proprietary vertical gradient freeze (VGF) technology. Most of our revenue is from sales of GaAs substrates. We manufacture all of our products in the People's Republic of China (PRC or China), which generally has favorable costs for facilities and labor compared to comparable facilities in the United States or Europe. We also have joint ventures in China that provide us reliable supply and shorter lead-times for raw materials central to our final manufactured products.

Our business and operating results depend in significant part upon capital expenditures of semiconductor designers and manufacturers, which in turn depend upon the current and anticipated market demand for products incorporating semiconductors from these designers and manufacturers. Our business also depends in part on worldwide economic conditions. During 2013, we experienced some fluctuation in the customer demand for the semi-insulating GaAs substrates that are used for end-products in the wireless market and the semi-conducting GaAs substrate used in the light emitting diode (LED) market. We believe consolidation within the base of customers for our products was likely the reason for slower qualifications for our business, but may create more opportunities in the future. The increased adoption of SOI technology also impacted the overall industry. Ge substrate revenue increased primarily due to more planned satellite launches in 2013 compared to 2012 and from increased demand from concentrated photovoltaic applications for solar terrestrial cells.

We expect Ge substrate revenue to increase in the future as we are seeing increased demand from concentrated photovoltaic applications for solar terrestrial cells; however, we expect Ge raw material cost remains high in 2014.

Revenue from InP substrates increased as the demand from customers in the optical networking industry increased. Our raw materials revenue decreased primarily due to decreased selling prices of raw gallium.

31 -------------------------------------------------------------------------------- Table of Contents As we move into 2014, we expect that the demand for GaAs products will be continually driven by the proliferation of smart phones and tablets. These devices, which enable full performance of video, gaming and Internet browsing capabilities, are driving increases in wireless subscribers in major geographic areas around the world as well as an upgrade cycle for new devices. We expect the demand for semi-conducting GaAs substrates in the LED market will increase; however, we need to penetrate into a few key accounts in order to capture more market share. We also expect Ge substrates sales will improve in 2014 as there is increasing interest in the replacement of fossil fuel resources with sustainable alternatives such as solar power and solar modules and a renewed interest in renewable energy technology, particularly in Europe and China. At the same time, we believe that improvements in conversion efficiency for Ge has been occurring, which we believe will continue to enable this technology to become more affordable and therefore, more widely utilized, in the future. We also expect InP substrate sales, which currently represents a smaller portion of revenue, will increase due to growing demand in the optical networking industry.

For raw materials sales, we believe the selling price of gallium has slowed its decline and we expect this will favorably affect our raw material revenue in 2014.

Revenue 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change ($ in thousands, except percentages) GaAs $ 40,234 $ 51,368 $ 63,697 $ (11,134 ) (21.7 )% $ (12,329 ) (19.4 )% InP 7,128 6,024 5,182 1,104 18.3 % 842 16.2 % Ge 16,962 8,734 11,635 8,228 94.2 % (2,901 ) (24.9 )% Raw Materials and other 21,011 22,248 23,607 (1,237 ) (5.6 )% (1,359 ) (5.8 )% Total revenue $ 85,335 $ 88,374 $ 104,121 $ (3,039 ) (3.4 )% $ (15,747 ) (15.1 )% Revenue decreased by $3.0 million or 3.4%, to $85.3 million in 2013 from $88.4 million in 2012. Total GaAs substrate revenue decreased $11.1 million, or 21.7%, to $40.2 million in 2013 from $51.3 million in 2012. The decrease in revenue was primarily due to the softer demand from our current customer base in the LED market and reduced orders from a few big customers as demand fell in the wireless market compared to 2012.

Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates, which are mainly used in LED applications, decreased by $6.6 million to $27.7 million in 2013 compared to $34.3 million in 2012 primarily due to weaker demand from our current customers in LED applications in all geographic regions.

Sales of 5 inch and 6 inch diameter GaAs substrates, which are mainly used in wireless devices, decreased by $4.5 million to $12.6 million in 2013 compared to $17.0 million in 2012 primarily due to reduced orders from a few big customers as demand fell in the wireless market.

Revenue decreased by $15.7 million or 15.1%, to $88.4 million in 2012 from $104.1 million in 2011. Total GaAs substrate revenue decreased $12.3 million, or 19.4%, to $51.4 million in 2012 from $63.7 million in 2011. The decrease in revenue was primarily due to the softer demand from our customer base in both the LED market and wireless devices market compared to 2011. Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates, decreased by $8.7 million to $34.3 million in 2012 compared to $43.0 million in 2011 primarily due to weaker demand from our customers in LED applications in all geographic regions except Taiwan which was particularly strong in the first half of 2012. Sales of 5 inch and 6 inch diameter GaAs substrates decreased by $3.7 million to $17.0 million in 2012 compared to $20.7 million in 2011 primarily due to lower demand for semi-insulating GaAs substrate from our customers in the wireless devices market compared to prior year.

InP substrate revenue increased by $1.1 million, or 18.3%, to $7.1 million in 2013 compared to $6.0 million in 2012 as demand from customers in the optical networking industry increased. We continued and expect to see renewed demand for these substrates as investment in high-speed optical communications continue to increase worldwide in 2014. InP substrate revenue increased by $842,000, or 16.2%, to $6.0 million in 2012 compared to $5.2 million in 2011 as demand from customers in the optical networking industry increased.

Ge substrate revenue increased by $8.2 million, or 94.2%, to $17.0 million in 2013 from $8.7 million in 2012. Our Ge substrate revenue increased primarily due to more planned satellite launches in 2013 compared 2012 and from increased demand from concentrated photovoltaic applications for solar terrestrial cells.

Ge substrate revenue decreased by $2.9 million, or 24.9%, to $8.7 million in 2012 from $11.6 million in 2011 due to fewer planned satellite launches in 2012 particularly in Asia.

32 -------------------------------------------------------------------------------- Table of Contents Raw materials and other revenue decreased by $1.2 million, or 5.6%, to $21.0 million in 2013 from $22.2 million in 2012 primarily due to decreased selling prices which was partially offset by increased tonnage sold, as well as by increased revenue from pyrolytic boron nitride (pBN) crucibles due to increased demand. Raw materials and other revenue decreased by $1.4 million, or 5.8%, to $22.2 million in 2012 from $23.6 million in 2011 primarily due to decreased selling prices which was partially offset by increased tonnage sold, as well as by increased revenue from pyrolytic boron nitride (pBN) crucibles due to increased demand.

Although our raw materials revenue decreased in 2013 due to decreased selling prices, it remains an important part of our business, as it provides us protection against raw materials pricing increases and supply constraints. Since we are able to supply raw materials necessary for the production of our substrates at favorable prices, our ability to sell such materials in the open market, at market prices, also provides us with pricing protection. We expect to continue to expand our raw materials sales efforts Revenue by Geographic Region 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change ($ in thousands, except percentages) North America* $ 10,665 $ 15,391 $ 20,471 $ (4,726 ) (30.7 )% $ (5,080 ) (24.8 )% % of total revenue 12 % 17 % 20 % Europe 21,387 18,170 21,082 3,217 17.7 % (2,912 ) (13.8 )% % of total revenue 25 % 21 % 20 % Japan 9,041 9,346 13,749 (305 ) (3.3 )% (4,403 ) (32.0 )% % of total revenue 11 % 11 % 13 % Taiwan 10,131 10,985 9,813 (854 ) (7.8 )% 1,172 11.9 % % of total revenue 12 % 12 % 9 % China 24,946 19,815 25,181 5,131 25.9 % (5,366 ) (21.3 %) % of total revenue 29 % 22 % 24 % Asia Pacific (excluding China, Japan and Taiwan) 9,165 14,667 13,825 (5,502 ) (37.5 )% 842 6.1 % % of total revenue 11 % 17 % 14 % Total revenue $ 85,335 $ 88,374 $ 104,121 $ (3,039 ) (3.4 )% $ (15,747 ) (15.1 )% -------------------------------------------------------------------------------- * Primarily the United States.

Sales to customers located outside of North America represented approximately 88%, 83%, and 80% of our revenue during 2013, 2012 and 2011, respectively.

Revenue from customers located in North America decreased by $4.7 million, or 30.7%, to $10.7 million in 2013 from $15.4 million in 2012. This decrease in 2013 was primarily due to decreased demand for raw materials primarily from 4N raw gallium and decreased demand for GaAs substrates, reflecting the slower demand in the wireless market, which is partially offset by increased demand for InP substrates used in the optical networking industry. Revenue from customers located in North America decreased by $5.1 million, or 24.8%, to $15.4 million in 2012 from $20.5 million in 2011. This decrease in 2012 was primarily due to decreased sales of GaAs substrates partially offset by increased sales of 4N raw gallium.

Revenue from customers located in Europe increased by $3.2 million, or 17.7%, to $21.4 million in 2013 from $18.2 million in 2012. This increase in 2013 was primarily due to increased sales of Ge substrates and raw material sales to customers in Germany, partially offset by decreased demand for GaAs substrates from customers in Germany. Revenue from customers located in Europe decreased by $2.9 million, or 13.8%, to $18.2 million in 2012 from $21.1 million in 2011.

This decrease in 2012 was primarily due to decreased sales of GaAs substrates to customers in Germany and United Kingdom, decreased raw material sales to customers in Germany and Slovakia, partially offset by increased substrates sales to customers in France.

Revenue from customers located in Japan decreased by $305,000, or 3.3%, to $9.0 million in 2013 from $9.3 million in 2012. This decrease in 2013 was primarily due to decreased sales of GaAs substrates and 4N raw gallium, offset by increased sales from pyrolytic boron nitride (pBN) crucibles. Revenue from customers located in Japan decreased by $4.4 million, or 32.0%, to $9.3 million in 2012 from $13.7 million in 2011. This decrease in 2012 was primarily due to decreased sales of GaAs substrates and 4N raw gallium.

33 -------------------------------------------------------------------------------- Table of Contents Revenue from customers in Taiwan decreased by $854,000, or 7.8%, to $10.1 million in 2013 from $11.0 million in 2012. This decrease in 2013 was primarily due to decreased sales of semi-conducting GaAs substrates, partially offset by increased sales of semi-insulating GaAs substrates to a major customer. Revenue from customers in Taiwan increased by $1.2 million, or 11.9%, to $11.0 million in 2012 from $9.8 million in 2011. This increase in 2012 was primarily due to increased sales of semi-conducting GaAs substrates and InP substrates, partially offset by decreased sales of semi-insulating GaAs substrates to a major customer.

Revenue from customers in China increased by $5.1 million, or 25.9%, to $25.0 million in 2013 from $19.8 million in 2012. This increase in 2013 was contributed by increased sales from all of our products in China and the most noticeable increase came from Ge substrate sales. Revenue from customers in China decreased by $5.4 million, or 21.3%, to $19.8 million in 2012 from $25.2 million in 2011. This decrease in 2012 was primarily due to decreased sales of 4N raw gallium, Ge substrates and semi-conducting GaAs substrates.

Revenue from customers in the Asia Pacific region (excluding China, Japan and Taiwan) decreased by $5.5 million, or 37.5%, to $9.2 million in 2013 from $14.7 million in 2012. This decrease in 2013 was primarily due to decreased sales of semi-insulating GaAs substrates to customers in Singapore, partially offset by increased sales of Ge substrates to customers in Malaysia. Revenue from customers in the Asia Pacific region (excluding China, Japan and Taiwan) increased by $842,000, or 6.1%, to $14.7 million in 2012 from $13.8 million in 2011. This increase in 2012 was primarily due to increased sales of semi-insulating GaAs substrates, partially offset by decreased sales of semi-conducting to customers in Singapore.

Gross Margin 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change ($ in thousands, except percentages) Gross profit $ 11,828 $ 24,852 $ 44,782 $ (13,024 ) (52.4 )% $ (19,930 ) (44.5 )% Gross Margin % 13.9 % 28.1 % 43.0 % Gross margin decreased to 13.9% of total revenue in 2013 from 28.1% of total revenue in 2012. Lower revenue and lower average selling prices due to product mix and customer mix negatively impacted the gross margins for GaAs substrates for 2013. Although Ge substrate sales increased by $8.2 million, gross margins for Ge substrate was decreased due to higher priced raw material in our inventory and lower average selling prices in 2013. Gross margins for raw material sales also decreased due to decreased selling prices of 4N raw gallium compared to 2012. The 2013 quarter gross margin for the first quarter to the fourth quarter of 15.6%, 13.5%, 11.9% and 15.1%, respectively, also reflects the impact of lower rate of absorption of manufacturing overhead across lower production volume compared to last year.

Gross margin decreased to 28.1% of total revenue in 2012 from 43.0% of total revenue in 2011. Approximately $1.3 million, or 1.5% of total revenue for the year of 2012 was expensed for supplemental and retroactive VATs levied by the tax authorities in China which was applicable for the period from July 1, 2011 to June 30, 2012. In addition, higher priced raw material in our inventory and lower average selling prices due to product mix and customer mix also negatively impacted the gross margins for all substrates for 2012. Gross margins for raw material sales also decreased due to decreased selling prices of 4N raw gallium compared to 2011. The 2012 quarterly trend of gross margin for the first quarter to the fourth quarter of 34.9%, 29.8%, 26.3% and 19.5%, respectively, also reflects the impact of lower rate of absorption of manufacturing overhead across lower production volume compared to the prior year.

Selling, General and Administrative Expenses 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change($ in thousands, except percentages) Selling, general and administrative expenses $ 16,066 $ 15,419 $ 14,836 $ 647 4.2 % $ 583 3.9 % % of total revenue 18.8 % 17.4 % 14.2 % 34-------------------------------------------------------------------------------- Table of Contents Selling, general and administrative expenses increased $647,000 to $16.1 million for 2013 compared to $15.4 million for 2012. This increase in 2013 was primarily due to an increase in bad debt expense and higher rent expense primarily from early termination penalty of our lease for our U.S. office, partially offset by decreased sales commission expenses resulting from lower revenue and lower office supply expenses. We expect our selling, general administrative expenses may decrease in the future due to the implementation of our restructuring plan in our manufacturing facility in China in 2014.

Selling, general and administrative expenses increased $583,000 to $15.4 million for 2012 compared to $14.8 million for 2011. This increase in 2012 was primarily due to higher personnel related costs including salaries and retirement benefits for employees in our joint ventures, higher stock-based compensation expenses resulting from the new options and awards granted in 2011 and 2012, absence of bad debt reversal credit recorded in 2011, partially offset by lower bonus from unfavorable financial results and lower sales commission expenses from lower commissionable substrates sales.

Research and Development Expenses 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change ($ in thousands, except percentages) Research and development expenses $ 3,424 $ 3,468 $ 2,473 $ (44 ) (1.3 )% $ 995 40.2 % % of total revenue 4.0 % 3.9 % 2.4 % Research and development expenses decreased $44,000, or 1.3%, to $3.4 million for 2013 from $3.5 million for 2012. Research and development expenses decreased slightly primarily due to lower personnel related costs including the fact that no bonuses were paid due to lack of achievement of financial metrics and lower product development and testing costs, partially offset by higher consulting expenses for product testing. We expect our rate of expenditures on research and development costs in 2014 to be stable as our joint ventures continue to maintain their efforts in research and development.

Research and development expenses increased $995,000, or 40.2%, to $3.5 million for 2012 from $2.5 million for 2011. This increase in 2012 was primarily due to higher personnel related costs including salaries and bonuses and higher stock-based compensation expenses mainly related to the hiring of a Chief Scientist in March 2012, higher product testing costs and higher health insurance cost.

Interest Income, Net 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change ($ in thousands, except percentages) Interest income, net $ 408 $ 518 $ 449 $ (110 ) (21.2 )% $ 69 15.4 % % of total revenue 0.5 % 0.6 % 0.4 % Interest income, net decreased $110,000 to $408,000 for 2013 from $518,000 for 2012 primarily due to lower returns from various investment portfolio mix, lower investment balances and lower interest income earned by our consolidated joint ventures from their bank.

Interest income, net increased $69,000 to $518,000 for 2012 from $449,000 for 2011 primarily due to higher interest income earned by our consolidated joint ventures from their bank deposits and interest income on loan from one of our consolidated joint ventures to its equity investment entity.

35 -------------------------------------------------------------------------------- Table of Contents Equity in Earnings of Unconsolidated Joint Ventures 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change ($ in thousands, except percentages) Equity in earnings of unconsolidated joint ventures $ 1,377 $ 1,281 $ 741 $ 96 7.5 % $ 540 72.9 % % of total revenue 1.6 % 1.5 % 0.7 % Equity in earnings of unconsolidated joint ventures is primarily net income from our minority-owned joint ventures that are not consolidated. Equity in earnings of unconsolidated joint ventures increased $96,000 to $1.4 million for 2013 from $1.3 million for 2012 primarily due to higher net income recorded by our consolidated joint ventures from their minority investments.

Equity in earnings of unconsolidated joint ventures increased $540,000 to $1.3 million for 2012 from $741,000 for 2011 primarily due to higher net income recorded by our consolidated joint ventures from their new minority investments.

Other Income (Expense), Net 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change ($ in thousands, except percentages) Other income (expense), net $ (748 ) $ (761 ) $ (45 ) $ 13 1.7 % $ (716 ) (1,591.1 )% % of total revenue (0.9 )% (0.9 )% (0.0 )% Other expense, net decreased $13,000 to $748,000 for 2013 from $761,000 for 2012 primarily due to the gain recognized from the sale of our 35% ownership in our cost method investee in its pre-IPO placement in Taiwan, the absence of loss on disposal of equipment from the same period in the prior year, partially offset by higher foreign exchange losses in 2013.

Other expense, net increased $716,000 to $761,000 for 2012 from $45,000 for 2011 primarily due to higher net foreign exchange transaction losses mainly on our Yen denominated accounts receivable, higher withholding tax on foreign dividends from our consolidated joint ventures and higher losses on disposal of equipment.

Noncontrolling Interest 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change($ in thousands, except percentages) Noncontrolling interest $ 1,145 $ 3,040 $ 5,503 $ (1,895 ) (62.3 )% $ (2,463 ) (44.8 )% % of total revenue 1.3 % 3.4 % 5.3 % Noncontrolling interest in earnings of consolidated joint ventures for the years ended December 31, 2013, 2012 and 2011 were $1.1 million, $3.0 million, and $5.5 million, respectively. The decrease in noncontrolling interest from 2012 to 2013 and 2011 to 2012 was due to lower profitability from our China joint venture operations as profits from raw materials sales have decreased due to decreased selling prices.

36 -------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes 2012 to 2013 2011 to 2012 Years Ended Dec. 31, Increase Increase 2013 2012 2011 (Decrease) % Change (Decrease) % Change($ in thousands, except percentages) Provision for income taxes $ 188 $ 853 $ 2,795 $ (665 ) (78.0 )% $ (1,942 ) (69.5 )% % of total revenue 0.2 % 1.0 % 2.7 % Provision for income taxes for 2013 was $188,000, which was mostly related to our China subsidiary and our China joint venture operations. The decrease in provision for income taxes from 2012 to 2013 was due to decreased net income of our foreign subsidiaries as well as lower taxable income for state tax purposes in the U.S. Furthermore, the provision for income taxes was partially offset by tax refunds received by our China joint ventures. Besides the state tax liabilities, no income taxes or benefit have been provided for U.S. operations due to the loss in the U.S. and the uncertainty of generating future profit in the U.S. which has resulted in our deferred tax asset being fully reserved. Our estimated tax rate can vary greatly from year to year because of the change or benefit in the mix of taxable income between our U.S. and China based operations.

Provision for income taxes for 2012 was $853,000, which was mostly related to our China subsidiary and our China joint venture operations. The decrease in provision for income taxes from 2011 to 2012 was due to decreased sales and net income of our foreign subsidiaries as well as lower taxable income for state tax purposes in the U.S. Furthermore, the provision for income taxes was partially offset by tax refunds received for state income taxes in the U.S. and received by our China joint ventures. Besides the state taxes liabilities, no income taxes or benefit have been provided for U.S. operations due to the loss in U.S.

and the uncertainty of generating future profit in the U.S. which has resulted in our deferred tax asset being fully reserved.

Provision for income taxes for 2011 was $2.8 million, which was mostly related to our foreign subsidiaries. The increase in provision for income taxes from 2010 to 2011 was due to increased net income of our foreign subsidiaries as well as higher taxable income for state tax purposes in the U.S. Besides the state tax liabilities, no income taxes have been provided for U.S. operations due to the use of available federal net operating loss carryforwards.

Due to our uncertainty regarding our future profitability, we recorded a full valuation allowance against our net deferred tax assets of $58 million in 2013, $51 million in 2012 and $49.6 million in 2011.

Liquidity and Capital Resources Years Ended December 31, 2013 2012 2011 ($ in thousands) Net cash provided by (used in): Operating activities $ 2.509 $ 21,302 $ 18,132 Investing activities (6,212 ) (13,168 ) (15,430 ) Financing activities (2,513 ) (3,792 ) (999 ) Effect of exchange rate changes 543 136 729 Net change in cash and cash equivalents (5,673 ) 4,478 2,432 Cash and cash equivalents-beginning period 30,634 26,156 23,724 Cash and cash equivalents-end of period 24,961 30,634 26,156 Short and long-term investments-end of period 22,644 19,461 14,486 Total cash, cash equivalents and short-term and long-term investments $ 47,605 $ 50,095 $ 40,642 37-------------------------------------------------------------------------------- Table of Contents We consider cash and cash equivalents, short-term investments and long-term investments as liquid and available for use within two years in our current operations. Short-term investments and long-term investments are comprised of U.S. government securities and investment-grade corporate notes and bonds. Also included in short-term investments is our investment in common stock of Intelligent Epitaxy Technology, Inc (IntelliEPI), a Taiwan publicly-traded company. In 2013, we re-categorized our IntelliEPI investment from cost method to short-term investments as they completed their initial public offering in 2013. As of December 31, 2013, our principal sources of liquidity were $47.6 million of cash and investments of which $10.0 million of cash and cash equivalent was held by our consolidated joint ventures, which are not available for use in the United States without paying income taxes, consisting of cash and cash equivalents of $25.0 million, short-term investments of $12.5 million and long-term investments of $10.1 million, a decrease of $2.5 million from $50.1 million as of December 31, 2012. The $5.7 million combined decrease in cash and cash equivalents was primarily due to net cash provided by operating activities of $2.5 million, offset by net cash used in investing activities of $6.2 million and net cash used in financing activities of $2.5 million. Short-term and long-term investments increased by $3.2 million to $22.6 million from $19.5 million. As of December 31, 2013, we and our consolidated joint ventures held approximately $18.7 million in cash and investments in foreign bank accounts which are not available for use in the United States without paying income taxes.

Cash and cash equivalents and short-term and long-term investments increased $9.5 million to $50.1 million as of December 31, 2012 from $40.6 million as of December 31, 2011. The $4.5 million combined increase in cash and cash equivalents was primarily due to net cash provided by operating activities of $21.3 million, offset by net cash used in investing activities of $13.2 million and net cash used in financing activities of $3.8 million. Short-term and long-term investments increased by $5.0 million to $19.5 million from $14.5 million.

Net cash provided by operating activities of $2.5 million for 2013 was primarily comprised of our net loss of $6.8 million, adjusted for non-cash items of depreciation and amortization of $5.5 million, stock­based compensation of $1.3 million, provision for doubtful accounts of $869,000, amortization of marketable securities premium of $518,000, offset by gain on sale of cost method investment of $811,000, a gain on disposal of property, plant and equipment of $9,000 and a net change of $2.0 million in assets and liabilities. The $2.0 million net change in assets and liabilities primarily resulted from a $1.4 million decrease in inventories, a $645,000 increase in prepaid expenses and other current assets, a $2.2 million decrease in accounts receivable, a $1.9 million increase in other assets, a $2.2 million increase in accounts payable, a $899,000 decrease in accrued liabilities and a $373,000 decrease in other long-term liabilities.

Net cash provided by operating activities of $21.3 million for 2012 was primarily comprised of our net income of $6.2 million, adjusted for non-cash items of depreciation and amortization of $3.9 million, stock­based compensation of $1.2 million, amortization of marketable securities premium of $323,000, a loss on disposal of property, plant and equipment of $195,000 and a net change of $9.5 million in assets and liabilities. The $9.5 million net change in assets and liabilities primarily resulted from a $5.7 million decrease in inventories, a $1.8 million decrease in prepaid expenses and other current assets, a $54,000 decrease in accounts receivable, a $174,000 increase in other assets, a $2.6 million increase in accounts payable, a $461,000 increase in accrued liabilities and a $900,000 decrease in other long-term liabilities.

Net cash provided by operating activities of $18.1 million for 2011 was primarily comprised of our net income of $25.8 million, adjusted for non-cash items of depreciation and amortization of $3.4 million, stock­based compensation of $896,000, amortization of marketable securities premium of $368,000, a realized loss on sale of investments of $8,000 and a net change of $12.4 million in assets and liabilities. The $12.4 million net change in assets and liabilities primarily resulted from a $9.8 million increase in inventories, a $4.0 million decrease in accounts payable and accrued liabilities, a $3.3 million increase in prepaid expenses, other current assets and a $781,000 decrease in other long-term liabilities, a $5.2 million decrease in accounts receivable and a $426,000 decrease in other assets.

Net cash used in investing activities of $6.2 million for 2013 was primarily from the purchase of property, plant and equipment of $5.4 million mainly in our China facilities and the purchase of investments totaling $14.1 million offset by the sale of investments totaling $12.5 million.

Net cash used in investing activities of $13.2 million for 2012 was primarily from the purchase of property, plant and equipment of $7.1 million mainly in our China facilities, loan from our consolidated joint venture to its equity investment entity of $875,000 and the purchase of investments totaling $12.1 million offset by the sale of investments totaling $6.9 million.

Net cash used in investing activities of $15.4 million for 2011 was primarily from the purchase of property, plant and equipment of $13.1 million mainly in capital projects at our China facilities, investments in new joint ventures of $3.0 million, loans from our consolidated joint ventures to their equity investment entities of $1.6 million offset by net proceeds from investment securities totaling $2.2 million.

38 -------------------------------------------------------------------------------- Table of Contents In January 2012, we agreed with the Administrative Commission of Tianjin Economy and Technology Development Zone to establish a second manufacturing facility in Tianjin, China. The arrangement, if completed, would provide us with land use rights for approximately 32 acres of industrial land located in Yixian Scientific and Industrial Park to construct a compound semiconductor substrate manufacturing facility that would be completed in phases over a number of years.

We agreed to provide $12.5 million in the first phase of the construction of the facility and have an understanding with our BoYu joint venture that it will provide the RMB 32.0 million, or approximately $5.0 million, that is anticipated to be required for the portion of the project devoted to crystal support, in exchange for land use rights, enterprise and individual income tax rebates, employee hiring and development subsidies, and other benefits. We expect to fund the first phase of the construction of the facility with cash flow generated by our normal operations supplemented by our existing line of credit. However, we have delayed our participation in the project at this time due to the volatility in our substrate business. It is possible that the investment of $5.0 million will still be funded by our BoYu joint venture for crystal support.

In January 2012, we increased the credit facility line of credit, secured by the marketable securities, with a bank from $3.0 million to $10.0 million at an annual interest rate of 1.65% above the current 30-day LIBOR (London Interbank Offered Rate). As of December 31, 2013 and 2012, we had not used the line of credit.

Net cash used in financing activities was $2.5 million for 2013 consisted of $2.3 million net dividends paid by our consolidated joint ventures and $716,000 of repurchases of shares of our common stock, partially offset by net proceeds of $532,000 on the issuance of common stock pursuant to stock option exercises.

Net cash used in financing activities was $3.8 million for 2012 consisted of $4.1 million net dividends paid by our consolidated joint ventures partially offset by net proceeds of $294,000 on the issuance of common stock pursuant to stock option exercises.

Net cash used in financing activities was $999,000 for 2011 consisted of $1.6 million of dividends paid by joint ventures, offset by $637,000 from the proceeds from the exercise of employee stock options.

On September 13, 2011, our registration statement on Form S-3 was declared effective by the Securities and Exchange Commission (SEC). We may from time to time offer up to $60.0 million of common stock, preferred stock, depositary shares, warrants, debt securities and/or units in one or more offerings and in any combination. We intend to use the net proceeds from any sale of securities under the shelf registration statement for general corporate purposes, which may include capital expenditures in connection with our planned expansion of our manufacturing facilities in China. The timing of any offering will be at our discretion and will depend on many factors, including the prevailing market conditions. Specific terms and share prices of any future offering under the registration statement will be established at the time of any such offering, and will be described in a prospectus supplement that we will file with the SEC.

On February 21, 2013, our Board of Directors approved a stock repurchase program that complies with Rule 10b-18 of the Securities Exchange Act of 1934, as amended, authorizing us to purchase up to $6.0 million of our outstanding common stock. The timing, actual number and value of the shares that are repurchased under this program are dependent on market conditions and other corporate considerations, including price, corporate and regulatory requirements and alternative investment opportunities. The program is funded from existing cash balances and cash generated from operations. We are not obligated to repurchase any particular amount of common stock during any period and may choose to suspend or discontinue the repurchase program at any time. During 2013, we repurchased approximately 285,000 shares at an average price of $2.51 per share for a total purchase price of $716,000 under the stock repurchase program. As of December 31, 2013, approximately $5.3 million remained available for future repurchases under this program.

We believe that we have adequate cash and investments to meet our needs over the next 12 months. If our sales decrease, however, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity, require us to use cash at a more rapid rate than expected, and require us to seek additional capital. There can be no assurance that such additional capital will be available or, if available it will be on terms acceptable to us.

Cash from operations could be affected by various risks and uncertainties, including, but not limited to those set forth below under Item 1A. "Risk Factors" above.

Off-Balance Sheet Arrangements We do not have any off-balance sheet financing arrangements and have never established any special purpose entities. We have not entered into any options on non-financial assets.

39 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations We lease certain office space, manufacturing facilities and equipment under long-term operating leases expiring at various dates through February 2016. The lease agreement for the facility at Fremont, California with approximately 27,760 square feet commenced on December 1, 2008 for a term of seven years, with an option by us to cancel the lease after five years, upon forfeiture of the security deposit and payment of one-half of the fifth year's rent. On June 28, 2013, we sent a notice to terminate the lease effective November 30, 2013 with an early termination penalty of $142,000 which was recorded as an expense in the third quarter of 2013. On August 2, 2013, we signed a new lease agreement for the current facility with reduced footage of 20,767 square feet, which commenced on December 1, 2013 for a term of two years. The reduced square footage, the reduced rate per square foot, and the expected reduced operating costs, would save us approximately $382,000 during 2014 and 2015.Total rent expenses under these operating leases were approximately $638,000, $447,000 and $460,000 for the years ended December 31, 2013, 2012 and 2011, respectively.

We entered into a royalty agreement with a vendor effective December 3, 2010 with a term of eight years, terminating December 31, 2018. We and our related companies are granted a worldwide, nonexclusive, royalty bearing, irrevocable license to certain patents for the term on the agreement. We shall pay a total of $7.0 million royalty payment over eight years that began in 2011 based on future royalty bearing sales. This agreement contains a clause that allows us to claim for credit, starting in 2013, in the event that the royalty bearing sales for the year is lower than a pre-determined amount set forth in this agreement.

Royalty expense under this agreement for 2013 was $530,000, which was net of claim for credit of $270,000, $1.4 million and $1.3 million for the years ended December 31, 2012 and 2011, respectively, and was included in cost of revenue.

The following table summarizes our contractual obligations as of December 31, 2013 (in thousands): Payments due by period 1-3 3-5 More than Contractual Obligations Total Less than 1 year years years 5 years Operating leases $ 438 $ 174 $ 174 $ 38 $ 52 Royalty agreement 3,325 800 1,375 1,150 - Total $ 3,763 $ 974 $ 1,549 $ 1,188 $ 52 40-------------------------------------------------------------------------------- Table of Contents Selected Quarterly Results of Operations The following table sets forth unaudited quarterly results for the eight quarters ended December 31, 2013. The information for each of these quarters is unaudited but has been prepared on the same basis as the audited consolidated financial statements. We believe that all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to present fairly such quarterly information. The operating results for any quarter are not necessarily indicative of results for any subsequent period.

Quarters Ended (in thousands, except for per Dec. 31, Sept. 30, June 30, Mar. 31, Dec. 31, Sept. 30, June 30, Mar. 31, share amounts) 2013 2013 2013 2013 2012 2012 2012 2012 Revenue $ 18,603 $ 20,521 $ 23,831 $ 22,380 $ 18,927 $ 20,808 $ 25,153 $ 23,486 Cost of revenue 15,790 18,075 20,746 18,896 15,243 15,342 17,645 15,292 Gross profit 2,813 2,446 3,085 3,484 3,684 5,466 7,508 8,194 Operating expenses: Selling, general and administrative 3,631 4,303 4,207 3,925 3,710 3,950 3,974 3,785 Research and development 797 766 1,039 822 875 844 914 835 Total operating expenses 4,428 5,069 5,246 4,747 4,585 4,794 4,888 4,620 Income (loss) from operations (1,615 ) (2,623 ) (2,161 ) (1,263 ) (901 ) 672 2,620 3,574 Interest income, net 272 55 50 31 316 52 62 88 Equity in earnings of unconsolidated joint ventures 278 346 471 282 495 348 284 154 Other income (expense), net (257 ) (47 ) 381 (825 ) (289 ) 144 (127 ) (489 ) Income (loss) before provision for income taxes (1,322 ) (2,269 ) (1,259 ) (1,775 ) (379 ) 1,216 2,839 3,327 Provision for (benefit from) income taxes (134 ) (204 ) (342 ) 184 294 (228 ) 412 375 Net income (loss) (1,188 ) (2,065 ) (1,601 ) (1,959 ) (673 ) 1,444 2,427 2,952 Less: Net income attributable to noncontrolling interest (40 ) (230 ) (434 ) (441 ) (83 ) (512 ) (1,128 ) (1,317 ) Net income (loss) attributable to AXT, Inc $ (1,228 ) $ (2,295 ) $ (2,035 ) $ (2,400 ) $ (756 ) $ 932 $ 1,299 $ 1,635 Net income (loss) attributable to AXT, Inc. per common share: Basic $ (0.04 ) $ (0.07 ) $ (0.06 ) $ (0.08 ) $ (0.02 ) $ 0.03 $ 0.04 $ 0.05 Diluted $ (0.04 ) $ (0.07 ) $ (0.06 ) $ (0.08 ) $ (0.02 ) $ 0.03 $ 0.04 $ 0.05 Weighted average number of common shares outstanding: Basic 32,628 32,366 32,382 32,297 32,220 32,183 32,138 32,034 Diluted 32,628 32,366 32,382 32,297 32,220 32,769 32,944 33,018 Recent Accounting Pronouncements Recent accounting pronouncements are detailed in Note 1 to our Consolidated Financial Statements included in this Annual Report on Form 10-K.

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