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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .
COMMISSION FILE NUMBER: 0-24085
AMERICAN XTAL TECHNOLOGY, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 94-3031310
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
4311 SOLAR WAY, FREMONT, CALIFORNIA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (510) 683-5900
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, $.001
PAR VALUE
Indicate by checkmark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by checkmark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of
the registrant, based upon the closing sale price of the common stock on
December 31, 1998 as reported on the Nasdaq National Market, was approximately
$115,515,000. Shares of common stock held by each officer, director and by each
person who owns 5% or more of the outstanding common stock have been excluded in
that such persons may be deemed to be affiliates. This determination of
affiliate status is not a conclusive determination for other purposes.
As of December 31, 1998, 16,116,675 shares, $.001 par value, of the
registrant's common stock was outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement for the registrant's 1999 annual
meeting of stockholders to be filed with the Commission pursuant to Regulation
14A not later than 120 days after the end of the fiscal year covered by this
form are incorporated by reference into Part III of this Form 10-K report.
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PART I
This report includes forward-looking statements which reflect our current
views with respect to future events and our potential financial performance.
These forward-looking statements are subject to certain risks and uncertainties,
including those discussed in "Business", "Management's Discussion and Analysis
of Financial Condition and Results of Operations", and elsewhere in this report,
that could cause actual results to differ materially from historical results or
those anticipated. In this report, the words "anticipates," "believes,"
"expects," "intends," "future" and similar expressions identify forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of this report.
ITEM 1. BUSINESS
GENERAL
We use a proprietary vertical gradient freeze, commonly referred to as
"VGF," technique to produce high-performance compound semiconductor substrates
which are used in a variety of electronic and opto-electronic applications such
as wireless and fiber optic telecommunications, lasers, LEDs, satellite solar
cells and consumer electronics. We primarily manufacture and sell gallium
arsenide, called GaAs, substrates. Sales of GaAs substrates accounted for
approximately 81.8% of our product revenues in 1998. We also manufacture and
sell indium phosphide, or InP, and germanium, or Ge, substrates and are
currently developing other high-performance compound substrates including
gallium phosphide, or GaP, and gallium nitride, or GaN. Our customers include:
- EMCORE,
- Hewlett Packard,
- Motorola,
- NEC,
- Nortel,
- Siemens,
- Sony,
- Spectrolab, and
- TRW.
BACKGROUND
Recent advances in communications and information technologies have created
a growing need for power efficient, high-performance electronic systems that
operate at very high frequencies, have increased computational and display
capabilities, and can be produced cost-effectively in commercial volumes. In the
past, electronic systems manufacturers have relied on advances in silicon
semiconductor technology to meet many of these demands. Silicon-based
semiconductor devices, however, have performance limitations in power efficient,
high-performance electronic applications. In addition, silicon-based
semiconductor devices currently do not possess the electrical properties
necessary to be used effectively in most opto-electronic applications such as
LEDs and lasers.
As a result of the limitations of silicon, semiconductor device
manufacturers are increasingly utilizing alternative substrates to improve the
performance of semiconductor devices or to enable new applications. These
alternative substrates may be composed of a single element, such as Ge, or
multiple elements which may include:
- gallium,
- aluminum,
- indium,
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- arsenic,
- phosphorus, and
- nitrogen.
Substrates that consist of more than one element are commonly referred to
as "compound substrates" and include GaAs, InP, GaP and GaN. GaAs is currently
the most widely used compound substrate. In comparison to silicon, compound
substrates have electrical properties that allow semiconductor devices to
operate at much higher speeds or at the same speed with lower power consumption.
For example, electrons move up to five times faster in GaAs than in silicon.
Compound substrates also have better opto-electronic characteristics than
silicon which allow them to convert energy into light and lasers, or to detect
light and convert light into electrical energy. The GaAs substrate market is
divided into two segments, semi-insulating and semi-conducting.
Semi-insulating GaAs substrates. The market for semi-insulating GaAs
substrates is the fastest growing segment of the GaAs market. According to
projections by Dataquest, IDC and Strategies Unlimited, the market for
semi-insulating GaAs substrates was estimated at $125 million in 1998 and is
expected to grow to approximately $400 million by the year 2002. This growth is
being driven by increasing demand for semi-insulating GaAs substrates in a
variety of power-efficient, high-performance applications, including cellular
phones, radars, satellite communication systems and direct broadcast systems.
Manufacturers integrate semi-insulating GaAs substrates into devices using
either an ion implantation or epitaxial process. Ion implantation is the process
of implanting ions directly into the semi-insulating GaAs substrate to modify
the electrical parameters of the substrate so that it can be used to manufacture
many of today's high-performance electronic devices. This process requires the
electrical parameters of the substrate to be as uniform as possible. Epitaxy, a
more recently developed process, involves the growth of layers of other
materials onto the semi-insulating GaAs substrate. While generally more
expensive than the ion implantation process, the epitaxial process enables
devices to achieve even greater performance advantages. The epitaxial process
requires that the GaAs substrate have an extremely smooth surface, few physical
imperfections, uniform electrical properties and low dislocation density, which
is a measurement of the crystalline perfection of the substrate material.
Traditionally, crystals for semi-insulating GaAs substrates for the ion
implantation and epitaxy markets have been grown using the liquid-encapsulated
czochralski, or LEC technique. The LEC technique requires a high temperature
gradient in the manufacturing process. Because the temperature gradient in the
LEC technique is high, the resulting crystals have a relatively high dislocation
density which weakens a crystal's physical structure and increases the risk of
breakage of the GaAs substrate during device manufacturing. In addition, as
semi-insulating GaAs substrates continue to grow in size to support increasingly
complex devices, the manufacturing challenges facing the LEC technique increase.
Semi-conducting GaAs substrates. We believe that the market for
semi-conducting GaAs substrates, based on 1998 market data and annual growth
rates projected by Dataquest, IDC and Strategies Unlimited, was approximately
$90 million in 1998 and we expect that the market will continue to grow. The
market for semi-conducting GaAs substrates is being driven by increasing demand
for a number of opto-electronic applications such as LEDs and lasers, which are
incorporated into a variety of products including:
- traffic lights,
- digital versatile discs, more commonly known as DVD players,
- CD players,
- CD-ROMs,
- laser printers,
- automobile lights and
- electronic displays.
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In contrast to semi-insulating GaAs substrates which undergo either an ion
implantation or epitaxial process, semi-conducting GaAs substrates only undergo
an epitaxial process. As with semi-insulating GaAs substrates, semi-conducting
GaAs substrates that undergo the epitaxial process must have a smooth surface,
few physical imperfections, uniform electrical properties and a low dislocation
density. The traditional method of growing crystals for producing
semi-conducting GaAs substrates is the Horizontal Bridgeman, or HB, technique.
With the HB technique, the crystal is grown in a semi-cylindrical container
which results in a semi-circular, or D-shaped, substrate. In order to produce a
round semi-conducting GaAs substrate, the HB technique requires that the
D-shaped substrate be cut into a circle, resulting in a large amount of
discarded substrate. In addition, crystals grown using the HB technique
generally have a relatively high dislocation density and less uniform electrical
properties. These and other inherent technical difficulties limit the ability of
the HB technique to be used to cost-effectively produce high-quality substrates
greater than three inches in diameter.
Other high-performance substrates. We believe there are significant growth
opportunities in manufacturing other high-performance substrates. For example,
we believe that the markets for InP and GaP substrates, based on 1997 market
data and annual growth rates projected by Dataquest, IDC and Strategies
Unlimited, were an aggregate of approximately $150 million in 1998 and we expect
that these markets will continue to grow. Semi-insulating InP substrates are
used in power-efficient, high-performance electronic applications such as
wireless and high-bandwidth communications and semi-conducting InP substrates
are used in such applications as fiber optic communications and lasers. GaP
substrates are used by manufacturers of LEDs. The traditional method for growing
crystals for InP and GaP substrates has been the LEC, technique. In addition to
compound substrates, the market for the element Ge is developing in response to
the growing demand for solar cells in satellite communications. We believe that
the market for Ge substrates used to manufacture solar cells was approximately
$60 million in 1998 and we expect that the market will continue to grow. This
application requires the use of Ge substrates which must be manufactured with
few defects and minimal breakage. We believe the further development of these
markets depends on the ability of suppliers to cost-effectively manufacture
power-efficient, high-performance compound and single-element substrates.
THE AXT SOLUTION
We use a proprietary VGF technique to produce high-performance GaAs and
other substrates for use in a variety of electronic and opto-electronic
applications. We believe that our VGF technique, which we have developed over
the past 12 years, provides certain significant advantages over traditional
manufacturing methods for growing crystals used in the production of
semi-insulating and semi-conducting GaAs substrates. We believe that we are
currently the only high-volume supplier of GaAs substrates manufactured by using
the VGF technique and are positioned to become a leading manufacturer and
supplier of other compound and Ge substrates.
In the GaAs substrate market, crystals grown using our proprietary VGF
technique have a dislocation density that is significantly lower than crystals
grown using either the LEC or HB technique. As a result, we believe our GaAs
substrates have greater mechanical strength which often results in reduced
breakage during the ion implantation and epitaxial growth processes.
Furthermore, we believe the low dislocation density of our semi-insulating and
semi-conducting GaAs substrates translates into fewer defects in the materials
layered onto the substrate during the epitaxy process. In addition,
semi-insulating GaAs substrates produced using our VGF technique have more
uniform electrical properties than LEC-produced GaAs substrates, which is
important for the ion implantation process. In the semi-conducting GaAs
substrate market, VGF-grown crystals, unlike those grown using the traditional
HB technique, can be processed into round substrates with minimal wasted
material. Using our VGF technique, we have been able to produce GaAs substrates
as large as six inches in diameter.
In addition to the GaAs substrate market, we believe we can leverage our
expertise in the VGF technique to manufacture and produce commercial volumes of
other compound and single-element substrates. For example, in 1998, we shipped
Ge and InP substrates to customers and qualified our wafers with many more
potential customers.
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STRATEGY
Our strategy is to be the leading developer and supplier of
high-performance GaAs substrates for both the semi-insulating and
semi-conducting markets, and to continue to expand into the development and
supply of other substrates. The key elements of our strategy include:
Advance VGF technology leadership. We pioneered the commercial use of the
VGF technique and have continued to develop and enhance our technology over the
course of 12 years through substantial investments in research and development.
Our efforts have led to significant improvements in the dislocation density,
mechanical strength and uniformity of the electrical properties of GaAs
substrates. We believe that our experience and expertise in VGF technology
provides us with a competitive advantage over more recent market entrants who
are utilizing variations of the VGF technology. We intend to continue to advance
our VGF technology through continued investment in research and development and
participation in certain government sponsored research programs.
Extend leadership in GaAs market. We are currently one of the largest
suppliers of GaAs substrates worldwide. Historically, we have been a leading
supplier of GaAs substrates in the epitaxy segment of the semi-insulating market
and in the semi-conducting market for GaAs substrates for lasers. We intend to
increase our share of these markets by continuing to provide high-quality,
price-competitive substrates. In addition, in the semi-insulating GaAs substrate
market, we intend to leverage our demonstrated success in the epitaxy segment to
further penetrate the ion implantation segment. In the semi-conducting GaAs
substrate market, we also intend to capitalize on our leadership to further
penetrate the high-volume, cost-sensitive LED market.
Leverage VGF technology to manufacture additional substrates. We believe
our VGF technology is a platform which we can leverage to rapidly develop and
cost-effectively manufacture additional high-quality compound substrates for
emerging applications in markets such as wireless and fiber optic
communications. For example, we recently began shipping InP and Ge substrates
developed using our VGF technique to customers. Unlike the more traditional
methods of growing crystals, we can use our VGF technology to grow the crystals
for these other substrates without having to make a significant investment in
new capital equipment.
Increase manufacturing capacity to target high-volume markets. We increased
our manufacturing capacity by approximately 30,000 square feet in the fourth
quarter of 1998. In addition, in June 1998, we have purchased an additional
58,000 square foot facility in Fremont, California. In January 1999, we
announced we had received a business license for operations in Beijing, China
and had purchased a 30,000 square foot facility in a major tax-free industrial
park in Beijing. These new facilities provide us with additional manufacturing
capacity. We believe that this increased manufacturing capacity will enable us
to further lower unit production costs and provide our high-performance
substrates at competitive prices for high-volume markets such as LEDs.
Leverage existing customer relationships. We currently sell our GaAs
substrates to over 200 customers, including:
- EMCORE,
- Hewlett Packard,
- Motorola,
- NEC,
- Nortel,
- Siemens,
- Sony,
- Spectrolab, and
- TRW.
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We believe our past success in providing high-quality GaAs substrates to
these customers will provide us with a competitive advantage in supplying them
additional substrates as their needs develop. For example, we recently began
shipments of InP substrates to TRW, which currently purchases a significant
portion of its GaAs substrates from us. In addition, we intend to establish
alliances and joint development arrangements with customers to develop new
products, increase manufacturing efficiencies and more effectively serve our
customers' needs.
CUSTOMERS
We sold our products to over 200 customers during 1998. Each of the
customers listed below purchased substrates in excess of $500,000 during 1998:
Alpha Industries Picogiga
Alpha Photonics Quantum Epitaxial Designs
Electronics & Materials, Inc. RF Micro Devices
Epitaxial Products International SDL, Inc.
EMCORE Co. Siemens
Hewlett Packard Sony
Motorola Spectrolab
Nortel Sumitomo Chemical
Opto Power TRW Space & Defense
We have historically entered into significant contracts with a number of
government agencies and customers for the development of certain products. For
more information regarding our development efforts, see " Research and
Development."
In the twelve months ended December 31, 1998, one customer accounted for
13.7% of our total revenues. No customer accounted for more than 10.0% of our
total revenues in 1996 and 1997. In 1996, 1997 and 1998, our five largest
customers accounted for 35.5%, 34.9% and 39.5%, respectively, of our total
revenues. Generally, we do not have long-term or other non-cancelable
commitments from our customers and usually sell products pursuant to customer
purchase orders. The loss of any major customer could have a material adverse
effect on our business and operating results.
TECHNOLOGY
AXT's VGF technique. Our proprietary VGF technique produces high-quality
crystals from which we produce high-performance compound and single-element
substrates for use in a variety of electronic and opto-electronic applications.
Our VGF technique is designed to control the crystal-growth process with
minimal temperature variation. Unlike traditional techniques, our VGF technique
places the hot GaAs melt above the cool crystal, thereby reducing the turbulence
of the GaAs melt which results when the melt and crystal are inverted. The
temperature gradient between the melt and the crystal in the VGF technique is
significantly lower than in traditional techniques. These aspects of the VGF
technique enable us to grow crystals that have a relatively low dislocation
density and high uniformity. One of the benefits of these characteristics is
that the crystal, and the substrate into which the crystal is manufactured, are
mechanically strong. The mechanical strength often results in substrates with
lower breakage rates during a customer's manufacturing process.
Under the VGF technique, the GaAs melt and growing crystal are contained in
a closed chamber. A number of benefits result from the use of this closed
system. Because the VGF system is sealed and the crystal growth is isolated,
both semi-insulating and semi-conducting crystals can be grown in the same
system without the time consuming and expensive process of completely
reconfiguring the system. The closed system isolates the crystal from the
outside environment during growth and significantly reduces potential
contamination of the crystal by impurities. The closed system also allows for
more precise control of the gallium-to-arsenic ratio which results in better
consistency and uniformity of the crystals. Therefore, crystals grown using the
VGF technique are consistently of a high quality. In addition, the use of
cylindrical crucibles, which are sized to
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meet a customer's requirements, enables us to produce circular substrates with a
minimum amount of discarded material.
The VGF technique is highly automated and the temperature gradient is
controlled electronically rather than by physically moving the crystal or
furnace. As a result, there is no physical movement to disturb the sensitive
crystal. The entire crystal growth process is run under computer control with
minimal operator intervention. A single operator can supervise the control of
many VGF furnaces which results in significant cost savings.
We believe the VGF technology is a platform which we can leverage to
rapidly develop and cost-effectively manufacture additional high-quality
substrates. Unlike the more traditional methods of growing crystals, we can use
the VGF technology to grow crystals from these other substrates without having
to make a significant investment in new capital equipment. For example, we use
the proprietary VGF technique to manufacture InP and Ge substrates.
VGF compared to traditional techniques for producing GaAs substrates. We
believe our proprietary VGF technique provides significant advantages over the
traditional crystal growth techniques. The LEC technique is the traditional
method for producing semi-insulating GaAs substrates. Unlike the VGF technique,
the LEC technique is designed so that the hotter GaAs melt is located beneath
the cooler crystal, which results in greater turbulence in the melt. The LEC
technique requires a temperature gradient between the GaAs melt and the cool
crystal which is approximately 50 to 200 times higher than the temperature
gradient of the VGF technique. The turbulence and the high temperature gradient
cause LEC-grown crystals to have a higher dislocation density than VGF-grown
crystals. This characteristic results in a higher rate of breakage of the
LEC-developed substrate during the device manufacturing process. In addition,
the LEC technique is essentially an open process whereby the melt and growing
crystal are exposed to the environment for the entire duration of the crystal
growth process. This exposure results in greater propensity for impurity
contamination as well as difficulty in controlling the ratio of gallium to
arsenic. Because the crystal is not contained in a crucible, fluctuations in
temperature cause the diameter of the crystal to vary. Thus, to ensure proper
size with the LEC technique, the crystal must be grown significantly larger than
the desired size of the resulting substrate. During the LEC process, the crystal
is grown by dipping a seed crystal through molten boric oxide into a melt and
slowly pulling the seed up into the cool zone above the boric oxide where the
crystal hardens. As the GaAs melt is consumed, the crucible containing the
remaining liquid must be raised in coordination with the pulling of the crystal.
These moving parts and the relative complexity of the system result in higher
maintenance costs. Unlike the VGF technique, the LEC technique uses large,
complex electro-mechanical systems that are expensive to acquire and require
highly skilled personnel to operate.
The HB technique is the traditional method for producing semi-conducting
GaAs substrates. The HB technique holds the GaAs melt in a semi-cylindrical
"boat." Because of the semi-cylindrical shape of the boat, semi-conducting GaAs
crystals grown using the HB technique have a semi-circular cross-section. As a
result of this semi-circular shape, more crystal material must be discarded to
cut the crystal ingot into a cylindrical shape from which round substrates can
be produced. Furthermore, crystals grown using the HB technique have a higher
dislocation density than VGF-grown crystals. These and other inherent technical
difficulties limit the ability of the HB technique to be used to
cost-effectively produce high-quality substrates greater than three inches in
diameter. Since the HB technique uses a quartz crucible during the growth
process which can contaminate the GaAs melt with silicon impurities, the HB
technique is also unsuitable for making semi-insulating GaAs substrates.
PRODUCTS
We currently sell the compound substrates GaAs and InP, and the
single-element substrate Ge. We supply various sizes of substrates in 2, 3, 4,
and 6 square inches according to our customers' specifications and work closely
with our customers to ensure that we manufacture substrates to each customer's
particular specifications.
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The table below sets forth our products, their available sizes and selected
applications:
SUBSTRATE MATERIAL DIAMETER (IN INCHES) APPLICATIONS
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GaAs semi-insulating 2,3,4,6 - Cellular phones
- Direct broadcast television
- High-performance transistors
- Satellite communications
GaAs semi-conducting 2,3,4 - LEDs
- Lasers
- Optical couplers
- Displays
InP semi-insulating 2,3 - Fiber optic communications
- Satellite communications
- High-performance transistors
- Automotive collision avoidance radars
InP semi-conducting 2 - Fiber optic communications
- Lasers
Ge 4 - Satellite solar cells
MANUFACTURING
Our manufacturing operations, which include crystal growth, slicing,
testing, edge grinding, polishing, inspecting and packaging the substrates for
shipment, are located at our headquarters in Fremont, California. Our Fremont
facilities are ISO 9002 certified. Many of our manufacturing operations are
computer monitored or controlled, enhancing reliability and yield.
We depend on a single or limited number of suppliers for certain critical
materials, including gallium, for use in the production of substrates. We
generally purchase these materials through standard purchase orders and not
pursuant to long-term supply contracts. We seek to maintain sufficient levels of
inventory for certain materials to guard against interruptions in supply and to
meet our near term needs. To date, we have been able to obtain sufficient
supplies of materials in a timely manner. However, a stoppage or delay in
supply, receipt of defective or contaminated materials, or increases in the
pricing of such raw materials could materially adversely affect our operating
results.
In the third quarter of 1998, we completed the expansion of our
approximately 50,000 square feet facility located in Fremont, California by
approximately 30,000 square feet to meet anticipated production needs through
1999. Because we currently perform all steps in our manufacturing process at our
Fremont facility, any interruption resulting from earthquake, fire, equipment
failures or other causes would have a material adverse effect on our results of
operations. For more information regarding the risks relating to our
manufacturing process and our new facility, see "Factors Affecting Future
Results -- If we do not achieve acceptable yields of crystals and the successful
and timely production of substrates, the shipment of our products would be
delayed and our business adversely affected." and "Factors Affecting Future
Results -- We are subject to additional risks as a result of the recent
completion of a new manufacturing facility," respectively.
Additionally, in connection with further expanding our manufacturing
capacity, we purchased an additional 58,000 square foot facility in Fremont,
California and a 30,000 square foot facility in Beijing, China in 1998.
SALES AND MARKETING
We sell our products worldwide through our direct sales force as well as
through independent international sales representatives. Our direct sales force
consists of highly trained, technically sophisticated sales engineers who are
knowledgeable in the manufacturing and use of compound and single-element
substrates. Our direct sales force operates out of our corporate office in
Fremont, California and our Japanese subsidiary. Our sales engineers work with
customers during all stages of the substrate manufacturing process, from
developing the precise composition of the substrate through manufacturing and
processing the substrate
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to the customer's exact specifications. We believe that maintaining a close
relationship with customers and providing customers with ongoing technical
support improves customer satisfaction and will provide us with a competitive
advantage in selling other substrates to our customers.
International sales, excluding Canada, as a percentage of total revenues in
1996, 1997 and 1998 were 35.0%, 34.1% and 28.8%, respectively. In addition to
our direct sales force in Japan, we have independent sales representatives in
France, Japan, South Korea, Taiwan and the United Kingdom. Except for sales by
our Japanese subsidiary, which are denominated in yen, we receive all payments
for products in U.S. dollars.
In order to raise market awareness of our products, we advertise in trade
publications, distribute promotional materials, publish technical articles,
conduct marketing programs and participate in industry trade shows and
conferences. For more information regarding the risks relating to our
international operations, see "Factors Affecting Future Results -- We derive a
significant portion of our revenues from international sales and our ability to
sustain and increase our international sales involve significant risks".
RESEARCH AND DEVELOPMENT
Our research and development efforts are focused on developing new
substrates, improving the performance of existing products and processes, and
reducing costs in the manufacturing process. We have assembled a
multi-disciplinary team of highly skilled scientists, engineers and technicians
to meet our research and development objectives. Among other projects, we have
research and development projects involving the development of GaN and high
purity GaAs epitaxy substrates.
Our research and development expenses in 1996, 1997 and 1998 were $592,000,
$1.3 million and $2.5 million, respectively. In addition to internally funded
research and development, we have also funded a significant portion of our
research and development efforts through contracts with the U.S. government and
customer funded research projects. In 1996, 1997 and 1998, we received $2.0
million, $2.3 million and $1.8 million, respectively, from U.S. government
agencies and customer funded research contracts. Under our contracts, we retain
rights to the VGF and wafer fabrication technology which we develop. The U.S.
government retains rights to utilize the technologies we develop for government
purposes only.
Our total research and development costs, including both contract funded
and internally funded research and development expenses, for 1996, 1997 and 1998
totaled $1.4 million, $2.8 million and $3.3 million, respectively. We expect to
continue to expend substantial resources on research and development. The
development of compound and single-element substrates is highly complex. There
can be no assurance that we will successfully develop and introduce new products
in a timely and cost-effective manner or that our development efforts will
successfully permit our products to meet changing market demands. For more
information regarding the risks relating to our research and development
efforts, see "Factors Affecting Future Results -- We must effectively respond to
rapid technological changes by continually introducing new products that achieve
broad market acceptance."
COMPETITION
The markets for GaAs substrates are intensely competitive. Our principal
competitors in the market for semi-insulating GaAs substrates currently include:
- Freiberger;
- Hitachi Cable;
- Litton Airtron; and
- Sumitomo Electric.
In the semi-conducting GaAs substrate market, our principal competitors
currently are Sumitomo Electric and Hitachi Cable. We also face competition from
manufacturers that produce GaAs substrates for their own use. In addition, we
face competition from companies, such as IBM, that are actively developing
alternative materials to GaAs. As we enter new markets, such as the Ge and InP
substrate markets, we expect
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to face competitive risks similar to those for its GaAs substrates. Many of our
competitors and potential competitors have been in the business longer than us
and have greater manufacturing experience, more established technologies than
our VGF technique, broader name recognition and significantly greater financial,
technical and marketing resources than us. We cannot assure you that we will
compete successfully against these competitors in the future or that our
competitors or potential competitors will not develop enhancements to the LEC,
HB or VGF techniques that will offer price and performance features that are
superior to ours. Increased competitive pressure could also lead to intensified
price-based competition, resulting in lower prices and margins, which would
materially adversely affect our business, financial condition and results of
operations.
We believe that the primary competitive factors in the markets in which our
products compete are:
- quality,
- price,
- performance,
- customer support and satisfaction, and
- customer commitment to competing technologies.
Our ability to compete in target markets also depends on factors such as:
- the timing and success of the development and introduction of new
products by us and our competitors,
- the availability of adequate sources of raw materials, and
- protection of our products by effective utilization of intellectual
property laws and general economic conditions.
In order to remain competitive, we believe we must invest significant
resources in developing new substrates and in maintaining customer satisfaction
worldwide. There can be no assurance that our products will continue to compete
favorably or that we will be successful in the face of competition from existing
competitors or new companies entering our target markets. If we fail to compete
successfully, our financial condition and results of operation would be
materially adversely affected.
PROTECTION OF OUR INTELLECTUAL PROPERTY
Our success and competitive position for our VGF technique depends
materially on our ability to maintain trade secrets, patents and other
intellectual property protections. To protect our trade secrets, we take certain
measures to ensure their secrecy, such as executing non-disclosure agreements
with our employees, customers and suppliers. Despite our efforts, we cannot
assure you that others will not gain access to our trade secrets, or that we can
meaningfully protect our intellectual property. In addition, effective trade
secret protection may be unavailable or limited in certain foreign countries.
Although we intend to protect our rights vigorously, these measures may not be
successful.
We rely primarily on the technical and creative ability of our personnel,
rather than on patents, to maintain our competitive position. To date, we have
been issued one U.S. patent, which relates to our VGF technique, and have two
patent applications, one of which relates to our VGF technique, pending. We have
one pending application for a Japanese patent but no issued foreign patents.
There can be no assurance that our pending applications or any future U.S. or
foreign patent applications will be approved, that any issued patents will
protect our intellectual property or will not be challenged by third parties, or
that the patents of others will not have an adverse effect on our ability to do
business. Moreover, the laws of certain foreign countries may not protect our
intellectual property rights to the same extent as the laws of the United
States. We believe that, due to the rapid pace of technological innovation in
the GaAs and other substrate markets, our ability to establish and maintain a
position of technology leadership in the industry depends more on the skills of
our development personnel than upon the legal protections afforded our existing
technologies.
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Although there are currently no pending material lawsuits against us or
unresolved notices that we are infringing intellectual property rights of
others, we may be notified in the future that we are infringing the patent
and/or other intellectual property rights of others. Litigation may be necessary
in the future to enforce our patents and other intellectual property rights, to
protect our trade secrets, to determine the validity and scope of the
proprietary rights of others, or to defend against claims of infringement or
invalidity. We cannot assure you that we would prevail in any future litigation.
Any litigation, whether or not determined in our favor or settled by us, would
be costly and would divert the efforts and attention of our management and
technical personnel from normal business operations, which would have a material
adverse effect on our business, and results of operations. Adverse
determinations in litigation could result in the loss of our proprietary rights,
subject us to significant liabilities, require us to seek licenses from third
parties or prevent us from licensing our technology, any of which could have a
material adverse effect on our business and results of operations.
ENVIRONMENTAL REGULATIONS
We are subject to federal, state and local laws and regulations concerning
the use, storage, handling, generation, treatment, emission, release, discharge
and disposal of certain materials used in our research and development and
production operations, as well as laws and regulations concerning environmental
remediation and employee health and safety. The growing of crystals and the
production of substrates involve the use of certain hazardous raw materials,
including, but not limited to, arsenic. We cannot guarantee that our control
systems will be successful in preventing a release of these materials or other
adverse environmental conditions. Any release or other failure to comply with
present or future environmental laws and regulations could result in the
imposition of significant fines against us, the suspension of production or a
cessation of operations. In addition, there can be no assurance that existing or
future changes in laws or regulations will not require expenditures or
liabilities to be incurred by us, or in restrictions on our operations. At
December 31, 1998, we believe we were in substantial compliance with all
applicable environmental regulations.
BACKLOG
We include in backlog only those customer orders which have been accepted
by us and which shipment is generally expected within 12 months. As of December
31, 1998, our backlog was approximately $8.7 million. Backlog can fluctuate
greatly based upon, among other matters, the timing of orders. In addition,
purchase orders in our backlog are subject to changes in delivery schedules or
to reduction in size or cancellation at the option of the purchaser without
significant penalty. We have experienced, and may continue to experience,
cancellation, reduction and rescheduled delivery of orders in our backlog. Our
backlog may vary significantly from time to time depending upon the level of
capacity available to satisfy unfilled orders. Accordingly, although useful for
scheduling production, backlog as of any particular date may not be a reliable
indicator of sales for any future period.
EMPLOYEES
As of December 31, 1998, we had 314 full-time employees, of whom 263 were
principally engaged in manufacturing, 32 in sales, general and administration
and 19 in research and development. Our success is in part dependent on our
ability to attract and retain highly skilled workers, who are in high demand in
the Silicon Valley area. None of our employees is represented by a union and we
have never experienced a work stoppage. Management considers its relations with
its employees to be good.
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EXECUTIVE OFFICERS
As of December 31, 1998, our executive officers and directors were as
follows:
NAME AGE POSITION
---- --- --------
Morris S. Young, Ph.D. ... 53 Chairman of the Board of Directors, President and Chief
Executive Officer
Theodore S. Young, 58 Senior Vice President, Marketing and Director
Ph.D. ..................
Davis Zhang............... 42 Senior Vice President, Production
Gary S. Young............. 55 Vice President, Sales
Guy D. Atwood............. 56 Vice President and Chief Financial Officer, Treasurer and
Secretary
Xiao Gordon Liu........... 34 Vice President, Engineering and Development
Jesse Chen(1)(2).......... 40 Director
B.J. Moore(1)(2).......... 62 Director
Donald L. Tatzin(1)(2).... 46 Director
- ------------------------
(1) Member of the compensation committee.
(2) Member of the audit committee.
Morris S. Young, Ph.D. co-founded AXT in 1986 and has served as our
Chairman of the Board of Directors since February 1998 and President and Chief
Executive Officer, as well as a director since 1989. Dr. Young holds a B.S. in
Metallurgical Engineering from Chengkung University, Taiwan, an M.S. in
Metallurgy from Syracuse University and a Ph.D. in Metallurgy from Polytechnic
University.
Theodore S. Young, Ph.D. co-founded AXT in 1986 and has served as our
Senior Vice President, Marketing since 1989 and served as President from 1987 to
1989. He has also acted as a director since our inception, including as the
Chairman of the Board of Directors from January 1987 to January 1998. Dr. Young
holds a B.S. in Physics from National Taiwan University, an M.S. in Geophysics
from the University of Alaska and a Ph.D. in Plasma Physics from the
Massachusetts Institute of Technology.
Davis Zhang co-founded AXT in 1986 and has served as our Senior Vice
President, Production since January 1994. From 1987 to 1993, Mr. Zhang served as
our Senior Production Manager. Mr. Zhang holds a B.S. in Mechanical Engineering
from Northern Communication University, Beijing, China.
Gary S. Young joined us in 1991 and has served as our Vice President, Sales
since July 1993. From 1991 to 1993, Mr. Young served as our Sales and
Administrative Manager. From 1973 to 1991, Mr. Young worked in various
capacities with several companies, including as a Systems Engineer for IBM and
as a software engineer for Boole & Babbage, Inc., an independent software
vendor. Mr. Young holds a B.S. in Mathematics from National Taiwan Normal
University, an M.A. in Mathematics from Northeast Missouri State University and
an M.S. in Operations Research from Purdue University.
Guy D. Atwood joined us in August 1997 as our Vice President and Chief
Financial Officer and has served as our Treasurer and Secretary since February
1998. From 1991 to August 1997, Mr. Atwood served at various times as Chief
Financial Officer for several private companies, most recently the alumni
association for the University of California at Berkeley and AvenuSoftware, a
film and video software company, of which he was also its President. Mr. Atwood
was self-employed as a financial consultant from 1994 to 1995, and also provided
services in such capacity to the Company from June to September 1995. Mr. Atwood
holds a B.S. in Accounting from the University of California at Berkeley.
Xiao Gordon Liu joined us in 1995 as Senior Engineer and was promoted to
Vice President, Engineering and Development in November 1998. Prior to joining
us, Mr. Liu was a postdoctoral fellow and associate specialist at University of
California at Berkeley and a research associate at the University of Lund,
Sweden. Mr. Liu holds a Ph.D. in Physics from the University of Lund, Sweden and
has published more than 30 scientific papers.
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Jesse Chen has served as a director of AXT since February 1998. Since May
1997, Mr. Chen has served as a Managing Director of Maton Venture, an investment
company. Prior to that, Mr. Chen co-founded BusLogic, Inc., a computer
peripherals company and served as its Chief Executive Officer from 1990 to 1996.
Mr. Chen serves on the Board of Directors of several private companies. Mr. Chen
has a B.S. degree in Aeronautical Engineering from Chenkung University, Taiwan
and an M.S. in Electrical Engineering from Loyola Marymount University.
B.J. Moore has served as a director of AXT since February 1998. Since 1991,
Mr. Moore has been self-employed as a consultant and has served as a director to
several technology-based companies. Mr. Moore currently serves on the Board of
Directors for Adaptec, Inc., a computer peripherals company and Dionex
Corporation, an ion chromatography systems company, as well as several private
companies. From 1986 to 1991, Mr. Moore served as President and Chief Executive
Officer of Outlook Technology, an electronics test equipment company. Mr. Moore
holds a B.S. and an M.S. degree in Electrical Engineering from the University of
Tennessee.
Donald L. Tatzin has served as a director of AXT since February 1998. Since
1993, Mr. Tatzin has served as Executive Vice President of Showboat, Inc., a
gaming company. In addition, Mr. Tatzin served as a director for Sydney Harbour
Casino, an Australian gaming company from 1995 to 1996 and as its Chief
Executive Officer from April to October 1996. Prior to that, Mr. Tatzin was a
director and consultant with Arthur D. Little, Inc., from 1976 to 1993. Mr.
Tatzin holds an S.B. in Economics and an S.B. and masters degrees in City
Planning from the Massachusetts Institute of Technology and an M.S. in Economics
from Australian National University.
ITEM 2. PROPERTIES
In the third quarter of 1998, we completed the expansion of our
approximately 50,000 square foot facility located in Fremont, California by
approximately 30,000 square feet to meet anticipated production needs through
1999. Additionally, in connection with further expanding our manufacturing
capacity, we purchased an additional 58,000 square foot facility in Fremont,
California and a 30,000 square foot facility in Beijing, China in 1998.
ITEM 3. LEGAL PROCEEDINGS
In October 1998, a vendor submitted a claim against us to the Arbitration
Commission in Shenzhen, China, alleging that we failed to honor our obligation
to take delivery of the full quantity of Ge under a purchase contract with the
vendor. We believe that this action is without merit and will continue to
vigorously defend our position. We expect the cost of defending this matter will
not materially adversely affect our operating results through fiscal 1999.
However, there can be no assurance that our defense of this matter will be
successful.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
AXT common stock has been trading publicly on the Nasdaq National Market
under the symbol "AXTI" since May 20, 1998, the date we consummated our initial
public offering. The following table sets forth, for the periods indicated, the
range of quarterly high and low closing sales prices for AXT's common stock on
the Nasdaq National Market.
HIGH LOW
------- -------
FISCAL 1998
January 1, 1998 through May 19, 1998..................... Not Applicable
May 20, 1998 through June 30, 1998....................... $15.000 $10.125
Third Quarter ended September 30, 1998................... 15.500 7.000
Fourth Quarter ended December 31, 1998................... 10.813 6.000
As of December 31, 1998, there were 181 holders of record of our common
stock. Because many shares of AXT's common stock are held by brokers and other
institutions on behalf of stockholders, we are unable to estimate the total
number of stockholders represented by these record holders.
We have never paid or declared any cash dividends on our common stock and
do not anticipate paying cash dividends in the foreseeable future.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
YEARS ENDED DECEMBER 31,
----------------------------------------------
1994 1995 1996 1997 1998
------ ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
STATEMENT OF OPERATIONS DATA:
Revenues:
Product revenues................................ $5,666 $11,520 $14,222 $23,014 $41,493
Contract revenues............................... 1,791 2,958 2,005 2,321 1,797
------ ------- ------- ------- -------
Total revenues.......................... 7,457 14,478 16,227 25,335 43,290
Cost of revenues:
Cost of product revenues........................ 3,091 6,030 9,270 13,674 24,550
Cost of contract revenues....................... 1,422 2,234 795 1,553 804
------ ------- ------- ------- -------
Total cost of revenues.................. 4,513 8,264 10,065 15,227 25,354
------ ------- ------- ------- -------
Gross profit...................................... 2,944 6,214 6,162 10,108 17,936
Operating expenses:
Selling, general and administrative............... 921 1,716 2,033 2,959 5,016
Research and development.......................... 149 448 592 1,289 2,504
------ ------- ------- ------- -------
Total operating expenses................ 1,070 2,164 2,625 4,248 7,520
------ ------- ------- ------- -------
Income from operations............................ 1,874 4,050 3,537 5,860 10,416
Interest expense.................................. (3) (12) (170) (570) (781)
Interest and other income (expense)............... 65 282 (72) (34) 568
------ ------- ------- ------- -------
Income before provision for income taxes.......... 1,936 4,320 3,295 5,256 10,203
Provision for income taxes........................ 775 1,581 1,249 1,998 3,877
------ ------- ------- ------- -------
Net income........................................ $1,161 $ 2,739 $ 2,046 $ 3,258 $ 6,326
====== ======= ======= ======= =======
Basic net income per share........................ $ 0.44 $ 0.97 $ 0.71 $ 1.11 $ 0.42
====== ======= ======= ======= =======
Diluted net income per share...................... $ 0.10 $ 0.23 $ 0.17 $ 0.25 $ 0.42
====== ======= ======= ======= =======
Shares used in basic net income per share
calculations.................................... 2,634 2,821 2,882 2,938 14,928
Shares used in diluted net income per
share calculations.......... 11,676 11,813 11,811 12,839 15,177
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DECEMBER 31,
----------------------------------------------
1994 1995 1996 1997 1998
------ ------- ------- ------- -------
(IN THOUSANDS)
BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments..................................... $1,446 $ 835 $ 756 $ 3,054 $16,122
Working capital................................... 2,859 3,760 5,542 14,209 41,068
Total assets...................................... 5,757 11,316 17,384 30,613 75,023
Long-term debt, net of current portion............ -- 2,350 5,582 7,728 16,347
Stockholders' equity.............................. 4,213 7,005 8,999 18,591 51,168
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ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and
Results of Operations includes a number of forward-looking statements which
reflect current views with respect to future events and financial performance.
These forward-looking statements are subject to certain risks and uncertainties,
including those discussed in the "Factors Affecting Future Results" and
elsewhere in this report that could cause actual results to differ materially
from historical results or those anticipated. In this report, the words
"anticipates," "believes," "expects," "future," "intends," and similar
expressions identify forward-looking statements. Readers are cautioned not to
place undue reliance on these forward-looking statements, which speak only as of
the date hereof.
RESULTS OF OPERATIONS
Overview
We use a proprietary VGF technique to produce high-performance compound
semiconductor substrates for use in a variety of electronic and opto-electronic
applications. We were founded in 1986 and commenced product sales in 1990. We
currently sell GaAs, InP and GaN substrates to manufacturers of semiconductor
devices for use in applications such as wireless and fiber optic
telecommunications, lasers, LEDs, and consumer electronics. We also sell Ge
substrates for use in satellite solar cells.
We have been profitable on an annual basis since 1990 and our total
revenues were $16.2 million, $25.3 million and $43.3 million for the years ended
December 31, 1996, 1997 and 1998, respectively. Total revenues consist of
product revenues and contract revenues. Our product revenues were $14.2 million,
$23.0 million and $41.5 million for the years ended December 31, 1996, 1997 and
1998, respectively. Product revenues are generally recognized upon shipment of
products to customers. Historically, virtually all of our product revenues have
been derived from sales of GaAs substrates, which, in the years ended December
31, 1997 and 1998, accounted for 95.0% and 81.8%, respectively, of the our
product revenues. We began selling InP and Ge substrates to our customers in
late 1997 and GaN substrates in late 1998.
Our contract revenues were $2.0 million, $2.3 million and $1.8 million for
the years ended December 31, 1996, 1997 and 1998, respectively. Contract
revenues are recognized under the percentage of completion method and related
research costs are included in cost of contract revenues. Contract revenues
consist of research and development contracts with U.S. government agencies and
customer-funded research projects. The largest of the government contracts was a
four-year U.S. Department of Defense Title III Program for development of GaAs
substrates (the "Title III GaAs contract"), which was awarded to us in March
1994 and under which we were paid an aggregate of $6.1 million. The Title III
GaAs contract was completed in 1998. We retain rights to the VGF and wafer
fabrication technology developed under these government and customer-funded
research contracts and are therefore able to leverage these programs to continue
to broaden our product and technology offerings.
In 1995, we established a wholly-owned subsidiary in Japan to distribute
our products. This subsidiary serves primarily as a direct sales and support
office for our customers in Japan. We also utilize independent sales
representatives in France, Japan, South Korea, Taiwan and the United Kingdom.
Domestic sales are generated by our direct sales force. International sales,
excluding Canada, accounted for 35.0%, 34.1% and 28.8% of total revenues for the
years ended December 31, 1996, 1997 and 1998, respectively. Except for sales in
Japan, which are denominated in yen, we denominate and collect our international
sales in U.S. dollars. Doing business in Japan subjects us to fluctuations in
exchange rates between the U.S. dollar and the Japanese yen. We incurred foreign
exchange losses of $114,000, $186,000 and $24,000 for the years ended December
31, 1996, 1997 and 1998, respectively. During the year ended December 31, 1998,
we bought foreign exchange contracts to hedge against certain trade accounts
receivable in Japanese yen. The outstanding commitments with respect to such
foreign exchange contracts had a total value of approximately $1.6 million as of
December 31, 1998.
Since July 1996, we have conducted all of our operations in a 50,000 square
foot office and production facility located in Fremont, California. Prior to
transitioning our manufacturing operations to this facility, we
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leased a 20,000 square foot manufacturing facility in Dublin, California. In
late 1998, we expanded the size of our current manufacturing facility by
approximately 30,000 square feet to meet our anticipated future production needs
through 1999. In June 1998, we purchased an additional 58,000 square foot
facility in Fremont, California directly across the street from our existing
manufacturing facility and moved marketing, sales, engineering and
administrative personnel into a portion of the building. We believe that this
new facility will not be used for production of substrates prior to the end of
1999. In January 1999, we announced we had received a business license for
operations in Beijing, China and had purchased a 30,000 square foot facility in
a major tax-free industrial park in Beijing. This facility is expected to be
operational during the second quarter of 1999. We expect that our proprietary
VGF crystal growth operations will continue to be housed in Fremont, California,
and our other manufacturing operations will be conducted in both Fremont and
Beijing.
In connection with the granting of stock options, we recorded aggregate
deferred compensation of $322,000 and $203,000, representing the difference
between the deemed fair value of the Common Stock for accounting purposes and
the option exercise price at the date of grant for the years ended December 31,
1997 and 1998, respectively. This deferred compensation will be amortized over
the vesting period of the applicable options of which $102,000 and $96,000 was
amortized during the years ended December 31, 1997 and 1998, respectively.
RESULTS OF OPERATIONS
The following table sets forth certain operating data as a percentage of
total revenues for the periods indicated.
YEARS ENDED DECEMBER 31,
--------------------------
1996 1997 1998
------ ------ ------
Revenues:
Product revenues.......................................... 87.6% 90.8% 95.8%
Contract revenues......................................... 12.4 9.2 4.2
----- ----- -----
Total revenues.................................... 100.0 100.0 100.0
Cost of revenues:
Cost of product revenues.................................. 57.1 54.0 56.7
Cost of contract revenues................................. 4.9 6.1 1.9
----- ----- -----
Total cost of revenues............................ 62.0 60.1 58.6
----- ----- -----
Gross margin................................................ 38.0 39.9 41.4
Operating expenses:
Selling, general and administrative....................... 12.5 11.7 11.5
Research and development.................................. 3.6 5.1 5.8
----- ----- -----
Total operating expenses.......................... 16.1 16.8 17.3
----- ----- -----
Income from operations...................................... 21.9 23.1 24.1
Interest expense............................................ (1.0) (2.2) (1.8)
Interest and other income (expense)......................... (0.5) (0.1) 1.3
----- ----- -----
Income before provision for income taxes.................... 20.4 20.8 23.6
Provision for income taxes.................................. 7.7 7.9 9.0
----- ----- -----
Net income.................................................. 12.7% 12.9% 14.6%
===== ===== =====
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The following table sets forth product and contract gross profits and gross
margins for the periods indicated.
YEARS ENDED DECEMBER 31,
---------------------------
1996 1997 1998
------ ------ -------
(DOLLARS IN THOUSANDS)
Product gross profit.................................... $4,952 $9,340 $16,943
Product gross margin.................................... 34.8% 40.6% 40.8%
Contract gross profit................................... $1,210 $ 768 $ 993
Contract gross margin................................... 60.3% 33.1% 55.3%
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1998
Revenues. Total revenues increased 70.9% from $25.3 million for the year
ended December 31, 1997 to $43.3 million for year ended December 31, 1998.
Product revenues increased 80.3% from $23.0 million for the year ended December
31, 1997 to $41.5 million for the year ended December 31, 1998. The increase in
product revenues reflected an increase in the volume of sales of GaAs and InP
substrates to existing domestic and international customers, the addition of new
customers and the introduction of Ge substrates in the fourth quarter of 1997.
Ge substrates totaled 15.6% of product revenues for the year ended December 31,
1998 compared to only 3.6% in 1997.
International revenues, excluding Canada, decreased from 34.1% of total
revenues for the year ended December 31, 1997 to 28.8% of total revenues for the
year ended December 31, 1998, primarily reflecting the introduction of Ge
substrates in late 1997, which are currently sold only to domestic customers. We
believe that Ge substrates will be sold only to U.S. customers for the
foreseeable future, which is expected to cause our international revenues to
decline as a percentage of total revenues.
Contract revenues decreased 22.6% from $2.3 million for the year ended
December 31, 1997 to $1.8 million for the year ended December 31, 1998. Contract
revenues in 1997 were higher than in 1998 primarily because we recognized
significant revenue from a $1.2 million customer-funded Ge substrates research
contract that was completed in June 1997. Contract revenues declined from 9.2%
of total revenues for the year ended December 31, 1997 to 4.2% for the year
ended December 31, 1998 as a result of product revenue growth combined with a
decline in contract revenues. In future periods, we expect contract revenues to
continue to decline as a percentage of total revenues.
Gross margin. Gross margin increased from 39.9% for the year ended December
31, 1997 to 41.4% for the year ended December 31, 1998. Product gross margin
increased slightly from 40.6% for the year ended December 31, 1997 to 40.8% for
the year ended December 31,1998, reflecting the higher yields achieved in GaAs
and InP production, partially offset by lower margins from Ge substrates.
Contract gross margins increased from 33.1% for the year ended December
31,1997 to 55.3% for the year ended December 31, 1998. This increase was due to
a shift in contract revenue mix from a lower margin customer-funded contract for
Ge substrates research completed in June 1997 to higher margin government
contracts.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased 69.5% from $3.0 million for the year ended
December 31, 1997 to $5.0 million for the year ended December 31, 1998. This
increase resulted primarily from increased personnel and administrative expenses
required to support additional sales volume. Selling, general and administrative
expenses as a percentage of total revenues decreased slightly from 11.7% for the
year ended December 31,1997 to 11.5% for the year ended December 31, 1998.
Research and development expenses. Research and development expenses
increased 94.3% from $1.3 million for the year ended December 31, 1997 to $2.5
million for the year ended December 31, 1998. This increase resulted primarily
from the hiring of additional engineers and the purchase of materials to develop
new products and to enhance existing products. In addition to our funded
research and development, we incurred research and development expenses relating
to government and customer-funded research contracts, which are included in the
cost of contract revenues. For the year ended December 31, 1998, total research
and
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development costs, including both contract funded and internally funded research
and development expenses, totaled $3.3 million, or 7.6% of total revenues.
Interest expense. Interest expense increased from $570,000 for the year
ended December 31, 1997 to $781,000 for the year ended December 31, 1998. This
increase was primarily the result of additional borrowings in 1998 we incurred
to finance the purchase of the our new building and to finance expansion of
production facilities and related equipment purchases.
Interest and other income (expense). Interest and other income (expense)
increased from $34,000 of expense for the year ended December 31, 1997 to
$568,000 of income for the year ended December 31, 1998. This increase was
primarily the result of interest income earned on the $25.8 million in net
proceeds raised from our initial public offering in May 1998.
Provision for Income Taxes. Income tax expense remained at 38.0% of income
before provision for income taxes for the years ended December 31, 1997 and
1998.
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Revenues. Total revenues increased 56.1% from $16.2 million for the year
ended December 31, 1996 to $25.3 million for the year ended December 31, 1997.
Product revenues increased 61.8% from $14.2 million for the year ended December
31, 1996 to $23.0 million for the year ended December 31, 1997. The increase in
product revenues reflected an increase in the volume of sales of GaAs substrates
to existing domestic and international customers, sales to new customers and the
introduction of Ge substrates in the fourth quarter of 1997.
International revenues, excluding Canada, decreased from 35.0% of total
revenues for the year ended December 31, 1996 to 34.1% of total revenues for the
year ended December 31, 1997, primarily reflecting the introduction of Ge
substrates in late 1997, which were sold only to U.S. customers.
Contract revenues increased 15.8% from $2.0 million for the year ended
December 31, 1996 to $2.3 million for the year ended December 31, 1997. This
increase was primarily due to revenues recognized from a $1.2 million
customer-funded Ge substrates research contract that was completed in 1997. This
increase was partially offset by a reduction in government contract revenues.
Contract revenues declined from 12.4% of total revenues for the year ended
December 31, 1996 to 9.2% for the year ended December 31, 1997 as a result of
product revenue growth exceeding contract revenue growth.
Gross margin. Gross margin increased from 38.0% for the year ended December
31, 1996 to 39.9% for the year ended December 31, 1997. Product gross margin
increased from 34.8% for the year ended December 31, 1996 to 40.6% for the year
ended December 31, 1997. The lower product gross margin in 1996 resulted
primarily from duplicate expenses of approximately $500,000 due to simultaneous
operations of two facilities and manufacturing inefficiencies relating to the
transition to our new production facility.
Contract gross margin declined from 60.3% for the year ended December 31,
1996 to 33.1% for the year ended December 31, 1997. This decrease was due to a
shift in contract revenue mix from higher margin government research contracts
in 1996 to a lower margin customer-funded contract for Ge substrates research.
In addition, in 1996 gross margin was favorably impacted by large incentive
awards which we were paid upon completion of certain milestones of the Title III
GaAs contract.
Selling, general and administrative expenses Selling, general and
administrative expenses increased 45.5% from $2.0 million for the year ended
December 31, 1996 to $3.0 million for the year ended December 31, 1997. This
increase resulted primarily from increased domestic and international sales
personnel and administrative expenses required to support increased sales
volume.
Research and development expenses. Research and development expenses
increased 117.7% from $592,000 for the year ended December 31, 1996 to $1.3
million for the year ended December 31, 1997. This increase resulted primarily
from the hiring of additional engineers to develop new products and to enhance
existing products. For the year ended December 31, 1997, total research and
development costs, including
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both contract funded and internally funded research and development expenses,
totaled $2.8 million, or 11.2% of total revenues.
Interest expense. Interest expense increased from $170,000 for the year
ended December 31, 1996 to $570,000 for the year ended December 31, 1997. This
increase resulted primarily from additional borrowings incurred in 1996 to
finance our new manufacturing facility, the expansion of production facilities
in 1997 and related equipment purchases.
Interest and other income (expense). Interest and other income (expense)
decreased from $72,000 of expense for the year ended December 31, 1996 to
$34,000 of expense for the year ended December 31, 1997. This decrease was due
to higher interest income generated on investments from the proceeds of a $5.9
million private equity financing completed in March 1997, partially offset by
foreign currency transaction losses incurred due to the increase in the value of
the U.S. dollar compared to the Japanese yen.
Provision for income taxes. Income tax expense was virtually unchanged from
37.9% of income before provision for income taxes for the year ended December
31, 1996 to 38.0% of income before provision for income taxes for the year ended
December 31, 1997.
SELECTED QUARTERLY RESULTS OF OPERATIONS
The following table sets forth unaudited quarterly results in dollars for
the eight quarters ended December 31, 1998. 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
---------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1997 1997 1997 1997 1998 1998 1998 1998
-------- -------- --------- -------- -------- -------- --------- --------
(IN THOUSANDS)
Revenues:
Product revenues.............. $4,494 $5,360 $6,060 $7,100 $9,238 $10,293 $10,887 $11,074
Contract revenues............. 600 842 447 432 492 497 508 301
------ ------ ------ ------ ------ ------- ------- -------
Total revenues......... 5,094 6,202 6,507 7,532 9,730 10,790 11,395 11,375
Cost of revenues:
Cost of product revenues...... 2,805 3,167 3,604 4,098 5,460 6,139 6,684 6,267
Cost of contract revenues..... 498 654 210 191 265 218 157 164
------ ------ ------ ------ ------ ------- ------- -------
Total cost of 3,303 3,821 3,814 4,289 5,725 6,357 6,841 6,431
revenues.............
------ ------ ------ ------ ------ ------- ------- -------
Gross profit.................... 1,791 2,381 2,693 3,243 4,005 4,433 4,554 4,944
Operating expenses:
Selling, general and 642 674 703 940 966 1,119 1,110 1,821
administrative..............
Research and development...... 222 296 306 465 640 669 736 459
------ ------ ------ ------ ------ ------- ------- -------
Total operating 864 970 1,009 1,405 1,606 1,788 1,846 2,280
expenses.............
------ ------ ------ ------ ------ ------- ------- -------
Income from operations.......... 927 1,411 1,684 1,838 2,399 2,645 2,708 2,664
Interest expense................ (115) (151) (158) (146) (181) (157) (169) (273)
Interest and other income (91) 77 (8) (12) 21 (25) 206 365
(expense).....................
------ ------ ------ ------ ------ ------- ------- -------
Income before provision for 721 1,337 1,518 1,680 2,239 2,463 2,745 2,756
income taxes..................
Provision for income taxes...... 274 508 577 639 854 943 1,037 1,043
------ ------ ------ ------ ------ ------- ------- -------
Net income...................... $ 447 $ 829 $ 941 $1,041 $1,385 $ 1,520 $ 1,708 $ 1,713
====== ====== ====== ====== ====== ======= ======= =======
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The following table sets forth selected consolidated financial information
as a percentage of total revenues for each of our last eight quarters.
QUARTERS ENDED
---------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1997 1997 1997 1997 1998 1998 1998 1998
-------- -------- --------- -------- -------- -------- --------- --------
Revenues:
Product revenues.............. 88.2% 86.4% 93.1% 94.3% 94.9% 95.2% 95.5% 97.4%
Contract revenues............. 11.8 13.6 6.9 5.7 5.1 4.8 4.5 2.6
------ ------ ------ ------ ------ ------- ------- -------
Total revenues......... 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Cost of revenues:
Cost of product revenues...... 55.0 51.1 55.4 54.4 56.1 56.9 58.6 55.1
Cost of contract revenues..... 9.8 10.5 3.2 2.5 2.7 2.0 1.4 1.4
------ ------ ------ ------ ------ ------- ------- -------
Total cost of 64.8 61.6 58.6 56.9 58.8 58.9 60.0 56.5
revenues.............
------ ------ ------ ------ ------ ------- ------- -------
Gross margin.................... 35.2 38.4 41.4 43.1 41.2 41.1 40.0 43.5
Operating expenses:
Selling, general and 12.6 10.8 10.8 12.5 9.9 10.4 9.7 16.0
administrative..............
Research and development...... 4.4 4.8 4.7 6.2 6.6 6.2 6.5 4.0
------ ------ ------ ------ ------ ------- ------- -------
Total operating 17.0 15.6 15.5 18.7 16.5 16.6 16.2 20.0
expenses.............
------ ------ ------ ------ ------ ------- ------- -------
Income from operations.......... 18.2 22.8 25.9 24.4 24.7 24.5 23.8 23.5
Interest expense................ (2.3) (2.4) (2.4) (1.9) (1.9) (1.5) (1.5) (2.4)
Interest and other income (1.7) 1.2 (0.2) (0.2) 0.2 (0.2) 1.8 3.2
(expense).....................
------ ------ ------ ------ ------ ------- ------- -------
Income before provision for 14.2 21.6 23.3 22.3 23.0 22.8 24.1 24.3
income taxes..................
Provision for income taxes...... 5.4 8.2 8.9 8.5 8.8 8.7 9.1 9.2
------ ------ ------ ------ ------ ------- ------- -------
Net income...................... 8.8% 13.4% 14.4% 13.8% 14.2% 14.1% 15.0% 15.1%
====== ====== ====== ====== ====== ======= ======= =======
The following table sets forth product and contract gross profits and gross
margins for the eight quarters ended December 31, 1998.
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1997 1997 1997 1997 1998 1998 1998 1998
-------- -------- --------- -------- -------- -------- --------- --------
(DOLLARS IN THOUSANDS)
Product gross profit............ $1,689 $2,193 $2,456 $3,002 $3,778 $ 4,154 $ 4,203 $ 4,807
Product gross margin............ 37.6% 40.9% 40.5% 42.3% 40.9% 40.4% 38.6% 43.4%
Contract gross profit........... $ 102 $ 188 $ 237 $ 241 $ 227 $ 279 $ 351 $ 137
Contract gross margin........... 17.0% 22.3% 53.0% 55.8% 46.1% 56.1% 69.1% 45.5%
Our total revenues have increased in each of the eight quarters ended
December 31, 1998, except for the quarter ended December 31, 1998, which was
comparable to the prior quarter. These quarterly increases reflect increased
product shipments to both the semi-insulating and semi-conducting GaAs and InP
markets and the introduction of Ge substrates in the quarter ended December 31,
1997. In the quarter ended December 31, 1998, revenues from the sales of Ge
substrates declined by $1.2 million from the prior quarter as a result of a
major customer having excess inventory and deferring shipments. This decline in
revenues was offset by a $1.2 million increase in GaAs shipments due primarily
to increased orders from Southeast Asia for semi-conducting substrates. Contract
revenues increased in the quarters ended March 31 and June 30, 1997 primarily as
a result of revenues recognized from a $1.2 million customer-funded Ge
substrates research contract. Contract revenues decreased in the quarter ended
December 31, 1998 due primarily to the temporary reduction in the level of work
performed on contracts in progress.
We experienced higher product gross margins in the four quarters of 1997
primarily as a result of better product yields achieved from the new production
facility completed in 1996 and improved manufacturing efficiencies from larger
production volumes. In addition, due to a recycling program implemented in the
quarter ended December 31, 1997, we were able to recycle scrapped inventory that
had accumulated over prior quarters. This recycling program had a significant
positive impact on the product gross margin for the quarter ended December 31,
1997. While we will continue the recycling program, we expect the program to
have a less significant impact on product gross margins in the future as
evidenced by the decline in product gross
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margins for March 31, 1998. The increase in the overall product gross margin in
the quarter ended December 31, 1997 was partially offset by lower product gross
margins from sales of Ge substrates, which have lower gross margins than GaAs
and InP substrates. The decrease in the overall product gross margins for the
first three quarters of 1998 was primarily due to an increase in sales of Ge
substrates. We experienced significantly lower contract gross margins for the
quarters ended March 31, 1997 and June 30, 1997 due to a shift in contract
revenue mix from higher margin government research contracts in prior quarters
to a lower margin customer-funded contract for Ge substrates research. The
decrease in contract gross margin from the quarter ended December 31, 1997 to
the quarter ended March 31, 1998 was due to a shift in contract revenue mix from
higher margin government research contracts in prior quarters to a lower margin
cost sharing contract for InP substrates research. Contract gross margin in the
quarter ended September 30, 1998 was favorably impacted by the recognition of
certain performance incentives under the Title III GaAs contract. The lower
contract gross margin in the quarter ended December 31, 1998 was primarily due
to the lower margin on the cost sharing contract for InP substrates research.
Selling, general and administrative expenses for the quarter ended December
31, 1997 were higher than the quarters ended June 30 and September 30, 1997, as
we built our management infrastructure to support its increased sales volume.
Selling, General and administrative expenses for the quarter ended December 31,
1998 were significantly higher than the previous three quarters due primarily to
increases in our bad debt allowance to cover exposure from increased
international sales and for legal expenses in connection with an arbitration
case.
Research and development expenses for the four quarters ended September 30,
1998 significantly increased over the prior three quarters ended September 30,
1997, primarily due to increased new product research and materials purchased
for research on InP substrates. Research and development expenses for the
quarter ended December 31, 1998 decreased primarily due to lower material
purchases for three research projects.
We believe that our quarterly and annual revenues, expenses and operating
results could vary significantly in the future and that period-to-period
comparisons should not be relied upon as indications of future performance.
There can be no assurance that our revenues will grow in future periods or that
it will sustain its level of total revenues or its rate of revenue growth on a
quarterly or annual basis. We may, in some future quarter, have operating
results that will be below the expectations of stock market analysts and
investors. In such event, the price of the our common stock could be materially
adversely affected.
LIQUIDITY AND CAPITAL RESOURCES
During the past five years, we have funded our operations primarily from
cash provided by operations, short-term and long-term borrowings and a private
financing of $5.9 million for preferred stock completed in March 1997. We
completed our initial public offering in May 1998, and raised net proceeds of
approximately $25.8 million. As of December 31, 1998, we had working capital of
$40.8 million, including cash and cash equivalents of $16.1 million, compared to
working capital at December 31, 1997 of $14.2 million, including cash of $3.1
million, and compared to working capital at December 31, 1996 of $5.5 million,
including cash of $756,000.
During the year ended December 31, 1996, net cash provided by operations of
$474,000 was due primarily to net income of $2.0 million, depreciation of
$867,000 and an increase in accounts payable and accrued liabilities of
$629,000, offset in part by increases in inventory of $2.3 million, and accounts
receivable and other assets of $727,000. The increase in inventory was primarily
due to increases in raw material and work-in-process inventory to provide an
adequate supply of material in anticipation of large orders for the upcoming
year. These inventory increases resulted in a decrease in the inventory turnover
ratio from 4.5 turns per year at December 31, 1995 to 3.3 turns per year at
December 31, 1996. The increase in accounts receivable was primarily a result of
increased sales in Japan, which generally have longer payment cycles. The
increase in sales to Japan also adversely impacted days sales outstanding, which
increased from 49 days at December 31, 1995 to 60 days at December 31, 1996.
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During the year ended December 31, 1997, net cash used in operations of
$1.2 million was primarily due to increases in inventory of $4.4 million and
accounts receivable of $3.0 million, offset in part by net income of $3.3
million, depreciation of $1.2 million and increases in accounts payable and
accrued liabilities of $1.6 million. The increase in inventory during this
period included additional Ge inventory, which primarily resulted in a decrease
in the inventory turnover ratio from 3.3 turns per year at December 31, 1996 to
2.2 turns per year at December 31, 1997. The increases in accounts payable and
accrued liabilities, accounts receivable and inventory were primarily the result
of a 56.1% increase in revenues from the prior year. In addition, accounts
receivable increased due to the increase in international revenues, which
historically have longer payment cycles. This increase in payment cycles
resulted in an increase in days sales outstanding from 60 days at December 31,
1996 to 64 days at December 31, 1997.
During the year ended December 31, 1998, net cash used in operations of
$6.3 million was primarily due to increases in inventory of $12.2 million,
accounts receivable of $2.9 million and prepaid and other assets of $1.6
million, offset in part by net income of $6.3 million, depreciation of $2.0
million, and increases in accounts payable of $1.7 million and accrued
liabilities of $496,000. The increases in accounts receivable, inventory and
accounts payable were primarily the result of the 70.9% increase in total
revenues from the prior year. In addition, inventory increased due to our
decision to maintain the Ge substrates production line during the fourth quarter
of 1998 in anticipation of future large orders, although shipments to a large
customer had been deferred. Accordingly, the inventory turnover ratio declined
from 2.2 turns per year at December 31, 1997 to 1.7 turns per year at December
31, 1998. The increase in prepaid and other assets was due primarily to deposits
on manufacturing equipment and materials for our new Beijing, China facility and
U.S. operations and for increases in prepaid insurance, taxable bond fees and
bank fees. The increase in accrued liabilities was the result of an increase in
legal expenses in connection with an arbitration case, and higher vacation and
payroll expenses due to the increased number of personnel. Days sales
outstanding decreased from 64 days at December 31, 1997 to 62 days at December
31, 1998, reflecting improved collection efforts.
Net cash used in investing activities was $3.9 million, $4.9 million, and
$16.4 million for the years ended December 31, 1996, 1997 and 1998,
respectively, which amounts were attributed in each period to the purchase of
property, plant and equipment. For the year ended December 31, 1998, the
property acquired included our new 58,000 square foot building at a cost of $9.0
million and the 30,000 square foot addition for $2.0 million.
Net cash provided by financing activities was $3.5 million, $8.4 million
and $35.5 million for the years ended December 31, 1996, 1997 and 1998,
respectively. For the year ended December 31, 1996, net cash provided by
financing activities resulted primarily from long-term borrowings of $3.5
million to complete our manufacturing facility. For the year ended December 31,
1997, net cash provided by financing activities resulted primarily from the
issuance of $5.9 million of preferred stock and $2.7 million for long-term bank
borrowings, partially offset by the repayment of $300,000 of short-term
borrowings. For the year ended December 31, 1998, net cash provided by financing
activities consisted primarily of net proceeds of $25.8 million from our initial
public offering and long-term net borrowings of $9.6 million. Long-term net
borrowings reflected the issuance of $11.6 million in taxable variable rate
revenue bonds in November 1998 and equipment loans in the amount of $2.3 million
less repayment of existing long-term debts in the amount of $4.3 million.
Long-term borrowings were used for the purchase of the new 58,000 square foot
facility, for construction of the additional 30,000 square foot manufacturing
space and related equipment.
We have generally financed our equipment purchases through secured
equipment loans over five-year terms at interest rates ranging from 6.0% to 9.0%
per annum. Our manufacturing facilities have been financed by long-term
borrowings, which were repaid by the taxable variable rate revenue bonds in
1998, except for a $1.0 million SBA loan. The SBA loan has an interest rate of
7.3% per annum, matures in 2016 and is subordinated to the taxable variable rate
revenue bonds. The taxable variable rate revenue bonds have a term of 25 years
and mature in 2023 with an interest rate at 200 basis points below the prime
rate and are traded in the public market. Repayment of principal and interest
under the bonds is secured by a letter of credit from our bank and is paid on a
quarterly basis. We have the option to redeem in whole or in part the bonds
during their term. At December 31, 1998, $11.6 million was outstanding under the
taxable variable rate revenue bonds.
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We currently have a $15.0 million line of credit with a commercial bank at
an interest rate equal to the prime rate plus one-half percent. This line of
credit is secured by all business assets, less equipment, and expires in May
1999. This line of credit is subject to certain financial covenants regarding
current financial ratios and cash flow requirements, which were met as of
December 31, 1998. We must obtain the lender's approval to obtain additional
borrowings or to further pledge our assets, except for borrowings secured by the
pledge of equipment or obtained in the normal course of business. At December
31, 1998, no amount was outstanding under the $15.0 million line of credit.
We anticipate that the combination of existing working capital and the
borrowings available under current credit agreements will be sufficient to fund
working capital and capital expenditure requirements for the next 12 months. Our
future capital requirements will depend on many factors, including the rate of
revenue growth, our profitability, the timing and extent of spending to support
research and development programs, the expansion of selling and marketing and
administrative activities, and market acceptance of our products. We expect that
we may need to raise additional equity or debt financing in the future, although
we are not currently negotiating for additional financing nor do we have any
plans to obtain additional financing at this time. There can be no assurance
that additional equity or debt financing, if required, will be available on the
acceptable terms or at all. If we are unable to obtain such additional capital,
if needed, we may be required to reduce the scope of our planned product
development and selling and marketing activities, which would have a material
adverse effect on our business, financial condition and results of operations.
In the event that we do raise additional equity financing, further dilution to
our investors will result.
YEAR 2000 READINESS
Some computers, software, and other equipment include computer code in
which calendar year data is abbreviated to only two digits. As a result of this
design decision, some of these systems could fail to operate or fail to produce
correct results if "00" is interpreted to mean 1900, rather than 2000. These
problems are widely expected to increase in frequency and severity as the year
2000 approaches, and are commonly referred to as the "year 2000 problem."
Assessment. The year 2000 problem affects the computers, software and other
equipment that we use, operate or maintain for our operations. Accordingly, we
have organized a program team responsible for monitoring the assessment and
remediation status of our year 2000 projects and reporting such status to our
board of directors. This project team is currently assessing the potential
effect and costs of remediating the year 2000 problem for our internal systems.
To date, we have obtained verification or validation from our significant
equipment and system vendors that the software programs and applications and
related hardware that we use, operate or maintain for our operations are
compliant with the year 2000.
Internal infrastructure. We believe that we have identified and evaluated
all of the major computers, software applications and related equipment used in
connection with our internal operations to determine if they must be modified,
upgraded or replaced to minimize the possibility of a material disruption to our
business. We are in the process of modifying, upgrading, and replacing major
systems that have been assessed as adversely affected, and expect to complete
this process before the end of fiscal 1999. As of December 31, 1998, we have
incurred approximately $300,000 in this process.
Systems other than information technology systems. In addition to computers
and related systems, the operation of office and facilities equipment, such as
fax machines, telephone switches, security systems, and other common devices may
be affected by the year 2000 problem. We are currently assessing the potential
effect and costs of remediating the year 2000 problem on our office equipment at
our facilities in Fremont, California. We estimate the total cost to us of
completing any required modifications, upgrades or replacements of our internal
systems will not exceed $100,000, almost all of which we believe will be
incurred during 1999. This estimate is being monitored and we will revise it as
additional information becomes available.
Based on the activities described above, we do not believe that the year
2000 problem will have a material adverse effect on our business or operating
results.
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Suppliers. We are in the process of contacting third-party suppliers of
components used in the manufacture of our products to identify and, to the
extent possible, resolve issues involving the year 2000 problem. However, we
have limited or no control over the actions of these third-party suppliers.
Thus, while we expect that we will be able to resolve any significant year 2000
problems with these third parties, there can be no assurance that these
suppliers will resolve any or all year 2000 problems before the occurrence of a
material disruption to the operation of our business. Any failure of these third
parties to timely resolve year 2000 problems with their systems could have a
material adverse effect on our business, operating results and financial
condition.
Most likely consequences of year 2000 problems. We expect to identify and
resolve all year 2000 problems that could materially adversely affect our
business operations. However, we believe that it is not possible to determine
with complete certainty that all year 2000 problems affecting us have been
identified or corrected. The number of devices that could be affected and the
interactions among these devices are simply too numerous. In addition, no one
can accurately predict how many year 2000 problem-related failures will occur or
the severity, duration, or financial consequences of these perhaps inevitable
failures. As a result, we believe that the following consequences are possible:
- a significant number of operational inconveniences and inefficiencies for
us, our contract manufacturers and our customers that will divert
management's time and attention and financial and human resources from
ordinary business activities;
- business disputes and claims for pricing adjustments or penalties due to
year 2000 problems by our customers, which we believe will be resolved in
the ordinary course of business; and
- business disputes alleging that we failed to comply with the terms of
contracts or industry standards of performance, some of which could
result in litigation or contract termination.
Contingency plans. We are currently developing contingency plans to be
implemented if our efforts to identify and correct year 2000 problems affecting
our internal systems are not effective. We expect to complete our contingency
plans by the end of August 1999. Depending on the systems affected, these plans
could include:
- accelerated replacement of affected equipment or software; short- to
medium-term use of backup equipment and software; increased work hours
for our personnel; and use of contract personnel to correct on an
accelerated schedule any year 2000 problems that arise or to provide
manual workarounds for information systems.
Our implementation of any of these contingency plans could have a material
adverse effect on our business, operating results and financial condition.
Disclaimer. The discussion of our efforts and expectations relating to year
2000 compliance are forward-looking statements. Our ability to achieve year 2000
compliance and the level of incremental costs associated therewith, could be
adversely affected by, among other things, the availability and cost of
programming and testing resources, third party suppliers' ability to modify
proprietary software, and unanticipated problems identified in the ongoing
compliance review.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"). SFAS 133 established a new model for
accounting for derivatives and hedging activities and supersede and amend a
number of existing accounting standards. SFAS 133 requires that all derivative
be recognized in the balance sheet at their fair market value. In addition,
corresponding derivative gains and losses should be either reported in the
statement of operations or stockholders' equity, depending on the type of
hedging relationship that exists with respect to such derivatives. Adopting the
provisions of SFAS 133, which will be effective in fiscal year 2000, is not
expected to have a material effect on the Company's consolidated financial
statements.
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FACTORS AFFECTING FUTURE RESULTS
In addition to the other information in this report, the following factors
should be considered carefully in evaluating our business before purchasing
shares of our stock.
A number of factors could cause our quarterly financial results to be worse
than expected, resulting in a decline in our stock price. Although we have been
profitable on an annualized basis since 1990, due to the foregoing factors, we
believe that period-to-period comparisons of our operating results cannot be
relied upon as an indicator of our future performance. It is likely that in some
future quarter, our operating results may be below the expectations of public
market analysts or investors. If this occurs, the price of our common stock
would likely decrease. For more information regarding our results, see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations".
Our quarterly and annual revenues and operating results have varied
significantly in the past and may vary significantly in the future due to a
number of factors, including:
- fluctuations in demand for our substrates due to reduction in the value
of Asian currencies and the turmoil in the Asian financial markets;
- our expense levels and expected research and development requirements;
- our ability to develop and bring to market new products on a timely
basis;
- the volume and timing of orders from our customers;
- the availability of raw materials;
- fluctuations in manufacturing yields;
- our manufacturing expansion in Beijing, China;
- changes in the unit of products sold;
- introduction of products and technologies by our competitors; and
- costs relating to possible acquisitions and integration of technologies
or businesses.
For more information regarding our results, see "Management's Discussion
and Analysis of Financial Condition and Results of Operations."
VGF is a new technique for producing substrates which must achieve
widespread acceptance if we are to succeed. We believe that our competitors
principally utilize the traditional LEC or HB crystal growing processes for
producing semi-insulating and semi-conducting GaAs substrates. We further
believe that we are the only high-volume supplier of semi-insulating and
semi-conducting GaAs substrates which utilize the VGF technique, a newer
technology than either the LEC or HB techniques. We cannot assure you that our
current customers will continue to use our VGF-produced substrates or that
additional companies will purchase our products manufactured from the VGF
technique. Failure to gain increased market acceptance of our VGF technique by
either current or prospective customers could materially adversely affect our
operating results.
A significant portion of our prospective customers are wireless
communications manufacturers, fiber optic communications manufacturers and
manufacturers of other high-speed semiconductor devices that use GaAs substrates
produced using either the LEC or HB techniques. To establish the VGF technique
as a preferred process for producing substrates for prospective customers, we
must offer products with superior prices and performance on a timely basis and
in sufficient volumes. We must also overcome the reluctance of these customers
to purchase our GaAs substrates due to possible perceptions of risks relating to
concerns about the quality and cost-effectiveness of our GaAs substrates when
compared to substrates produced by the traditional LEC or HB techniques. In
addition, potential GaAs substrate customers may be reluctant to rely on a
relatively small company for critical materials used to manufacture their
semiconductor devices.
If we do not achieve acceptable yields of crystals and the successful and
timely production of substrates, the shipment of our products would be delayed
and our business adversely affected. The highly complex
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processes of growing crystals as well as other steps involved in manufacturing
substrates which we engage in can be adversely affected by a number of factors,
including the following:
- chemical or physical defects in the crystals;
- contamination of the manufacturing environment;
- substrate breakage;
- equipment failure; and
- performance of personnel involved in the manufacturing process.
We have been adversely affected in the past due to the occurrence of a
combination of these factors which resulted in product shipment delays and
adversely affected our business.
A significant portion of our manufacturing costs are fixed. As a result, we
must increase the production volume of substrates and improve yields in order to
reduce unit costs, increase margins and maintain and improve our results of
operations. Such decreases in production volume and yields could materially
adversely affect our business, financial condition and results of operations.
In the past, we have sometimes manufactured substrates which have not met
certain customers' manufacturing process requirements. We have fixed such
occurrences through minor changes to the substrates or the manufacturing
process. Recurrence of such problems and our inability to solve them may
materially hurt our performance.
We have begun producing and shipping Ge and InP substrates in commercial
volume. We also understand that we must achieve the same manufacturing
capability for six inch GaAs wafers. We cannot assure you that we will be able
to manufacture the Ge and InP substrate or the larger GaAs substrates in
commercial volumes with acceptable yields. Our business, financial condition and
results of operations would be materially adversely affected if we experience
low yields of these substrates.
Because substantially all of our revenue is derived from sales of our GaAs
substrates, we are dependent on widespread market acceptance of these
products. We currently derive substantially all of our revenues from sales of
our GaAs substrates. We expect that revenue from GaAs substrates will account
for a significant majority of our revenues for the next several years. GaAs
substrates are primarily used in electronic applications such as wireless
communications, fiber optic communications and other high-speed semiconductor
devices, as well as in opto-electronic applications such as lasers and LEDs. If
there is a decrease in demand for GaAs substrates by semiconductor device
manufacturers or if new substrates for these electronic and opto-electronic
applications are developed and successfully introduced by competitors, our
revenues may decline and our business will be materially adversely affected.
Further, other companies, including IBM, are actively involved in
developing other devices which could provide the same high-performance, low
power capabilities as GaAs-based devices at competitive prices, such as
silicon-germanium based devices for use in certain wireless applications. If
these silicon-germanium based devices are successfully developed and are adopted
by semiconductor device manufacturers, demand for GaAs substrates could
decrease. This development could cause our revenues to fall, which could
adversely affect our business, financial condition and results of operations.
In order to be successful, we must develop and introduce in a timely manner
new substrates and continue to improve our current substrates to address
customer requirements and compete effectively on the basis of price and
performance. Recently, we have begun commercial shipments of Ge and InP
substrates and are currently developing other substrates, including gallium
phosphide and gallium nitride. Factors that may affect the success of product
improvements and product introductions include the development of markets for
such improvements and substrates, achievement of acceptable yields, price and
market acceptance. Many of these factors are beyond our control. We cannot
assure you that our product development efforts will be successful or that our
new products will achieve market acceptance. To the extent that product
improvements and new product introductions do not achieve market acceptance, our
business, financial condition and results of operations would be materially
adversely affected.
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Our limited ability to protect our intellectual property may adversely
affect our ability to compete. We rely on a combination of patents, copyrights,
trademarks and trade secret laws and contractual restrictions on employees,
consultants and third parties from disclosure to protect our intellectual
property rights. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use our
products or technology. Policing unauthorized use of our products is difficult,
and we cannot be certain that the steps we have taken will prevent
misappropriation of our technology, particularly in foreign countries where the
laws may not protect our proprietary rights as fully as in the United States. We
believe that, due to the rapid pace of technological innovation in the GaAs and
other substrate markets, our ability to establish and maintain a position of
technology leadership in the industry depends more on the skills of our
development personnel than upon the legal protections afforded our existing
technologies.
To date, we have been issued one U.S. patent, which relates to the VGF
technique, and have two U.S. patent applications pending, one which relates to
the VGF technique. Additionally, we have one pending application for a Japanese
patent but no issued foreign patents. We cannot assure you that:
- the pending or any future U.S. or foreign patent applications will be
approved;
- any issued patents will protect our intellectual property;
- third parties will not challenge the ownership rights of the patents or
the validity of the patent applications;
- the patents owned by others will not have an adverse effect on our
ability to do business; or
- others will not independently develop similar or competing technology or
design around any patents issued to us.
Moreover, the laws of certain foreign countries may not lend protection to
our patents to the same extent as the laws of the United States. See
"Business-Intellectual property" for more information regarding risks relating
to protecting our intellectual property rights.
If we infringe the proprietary rights of others, we may be forced to enter
costly royalty or licensing agreements. We could in the future receive a claim
that we are infringing the patent, trademark, copyright or other proprietary
rights of other third parties. If any claims were asserted against us for
violation of patent, trademark, copyright or other similar laws as a result of
the use by us, our customers or other third parties of our products, those
claims would be costly and time-consuming to defend, would divert our
management's attention and could cause product delays. In addition, if we
discovered we violated other third party rights, we could be required to enter
into costly royalty or licensing agreements as a result of such claims. These
royalty or licensing agreements may adversely affect our operating results.
If we fail to comply with stringent environmental regulations, we may be
subject to significant fines or the cessation of our operations. We are subject
to federal, state and local environmental laws and regulations. Any failure to
comply with present or future environmental laws and regulations could result in
the imposition of significant fines on us, the suspension of production or a
cessation of operations. In addition, existing or future changes in laws or
regulations may require us to incur further significant expenditu