|
|
 | | | |
- close
- close
- close
- close
AXT 10-Q 2005
UNITED STATES Washington, DC. 20549
FORM 10-Q
(Mark One)
Commission File Number 000-24085
AXT, INC. (Exact name of registrant as specified in its charter)
4281 Technology Drive, Fremont, California 94538 (Address of principal executive offices) (Zip code)
(510) 683-5900 (Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities 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 ý NO o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO ý
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
AXT, INC.
2
AXT, INC.
See accompanying notes to condensed consolidated financial statements.
3
AXT, INC.
See accompanying notes to condensed consolidated financial statements.
4
AXT, INC.
See accompanying notes to condensed consolidated financial statements.
5
AXT, INC.
Note 1. Basis of Presentation
The accompanying condensed consolidated financial statements of AXT, Inc. (“AXT”, “Company”, we,” “us,” and “our” refer to AXT, Inc. and all of its consolidated subsidiaries) are unaudited, and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary to present fairly the financial position, results of operations and cash flows of AXT and its subsidiaries for all periods presented.
Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ materially from those estimates.
The results of operations are not necessarily indicative of the results to be expected in the future or for the full fiscal year. It is recommended that these condensed consolidated financial statements be read in conjunction with our consolidated financial statements and the notes thereto included in our 2004 Annual Report on Form 10-K and our Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on March 18, 2005 and May 6, 2005, respectively.
Revenues from continuing operations decreased for the three month period ended June 30, 2005 compared to the same period of fiscal 2004. In response to continued net losses, we have taken measures including the shifting of production to China to reduce costs and control cash flows. As of June 30, 2005, we had available cash, cash equivalents and short-term investments of $25.0 million, excluding restricted deposits. We believe that our existing cash and cash equivalents and short-term investments, together with additional efforts to reduce expenditures in support of the continuing substrate business will be sufficient to meet working capital requirements for the next twelve months. However, existing cash and cash equivalents and short-term investments could decline during the remainder of 2005 due to a weakening of the economy, a loss in revenue, an unanticipated increase in expenses, or changes in our planned cash outlay.
If our performance fails to improve, we will continue to use cash and may at some time be forced to seek additional capital. There can be no assurance that additional capital will be available or, if available to us, that it will be at terms acceptable to us.
Note 2. Discontinued Operations and related Assets Held for Sale
In June 2003, we announced the discontinuation of our opto-electronics division, which we had established as part of our May 1999 acquisition of Lyte Optronics, Inc.. The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs) for the illumination markets, including full-color displays, wireless handset backlighting and traffic signals, and also manufactured vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in our condensed consolidated statements of operations for all periods presented.
In September 2003, we completed the sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. A portion of the purchase price equal to $1.0 million was held in escrow to satisfy any claims that the purchasers might make for breaches of representations or warranties by us. Of this total escrow, $750,000 could be released after the one year anniversary of the sale of the opto-electronics business and the remainder could be released after the second anniversary of the sale. Given the difficult negotiations we encountered with the acquiring company when negotiating the sale of the opto-electronics business, as well as the historical operating problems of the business, we determined there was significant uncertainty regarding the recoverability of the escrowed amounts. Accordingly, we did not recognize the cash held in escrow in recording the sale of the opto-electronics division, and have only recorded amounts as and when they are received. To date, we have resolved all claims made against the first $750,000 held in escrow, and have
6
received approximately $719,000 from the escrow. Accordingly, we recorded a gain on discontinued operations for the six month period ended June 30, 2005 of $300,000. We also recorded a gain on discontinued operations of $58,000 in property tax refunds for the same period. The remaining $250,000 held in escrow will not be released until September 2005, if the buyer makes no claims against it by such date.
In June 2005, we completed the sale of a building located in Monterey Park, California. This asset had been classified as “assets held for sale” in the amount of $1.25 million on the condensed consolidated balance sheets as of December 31, 2004. We received net proceeds on the sale of the property of approximately $1.3 million and accordingly recorded a gain on sale of $53,000 for the quarter ended June 30, 2005.
Our condensed consolidated financial statements have been presented to reflect the opto-electronics business as a discontinued operation for all periods presented. Operating results of the discontinued operation are as follows (in thousands):
The carrying value of the assets and liabilities of the discontinued opto-electronics business included in the condensed consolidated balance sheets are as follows (in thousands):
Note 3. Accounting for Stock-Based Compensation
We account for stock-based employee compensation arrangements using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations thereof. Accordingly, compensation cost for stock options is measured as the excess, if any, of the market price of AXT’s stock at the date of grant over the stock option exercise price. The following table illustrates the effect on our net loss and net loss per share if we had applied the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure,” to options granted under our stock option plans. For purposes of this pro forma disclosure, the value of the options is estimated using the Black-Scholes option pricing model and amortized to expense over the options’ vesting periods. Because the estimated value is determined as of the date of grant, the actual value ultimately
7
realized by the employee may be significantly different.
Had compensation cost for our options been determined based on the fair value at the grant dates, as prescribed in SFAS 123 and SFAS 148, our pro forma net loss and net loss per share would have been as summarized below (in thousands except per share data):
We calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model as prescribed by SFAS 123 using the following assumptions:
The weighted average grant date fair value of options granted during the six month period ended June 30, 2005 and 2004 were $0.86 and $1.97 per share, respectively.
An analysis of historical information is used to determine the above assumptions, to the extent that historical information is relevant, based on the terms of the grants being issued in any given period. Assumptions related to the Employee Stock Purchase Plan are not presented as the related compensation expense amounts are insignificant.
8
Note 4. Cash, Cash Equivalents and Short-Term Investments
Our cash, cash equivalents and short term investments are classified as follows (in thousands):
The short-term investments amounts include $8.2 million recorded as restricted deposits on the condensed consolidated balance sheets as of June 30, 2005 and December 31, 2004, respectively.
We manage our short-term investments as a single portfolio of highly marketable securities that is intended to be available to meet our current cash requirements. As of June 30, 2005 and December 31, 2004, we had no gross realized gains or losses on sales of our available-for-sale securities.
The gross unrealized losses related to our portfolio of available-for-sale securities were primarily due to a decrease in the fair value of debt and equity securities as a result of an increase in interest rates during 2004 and the first half of 2005. We have determined that the gross unrealized losses on our available-for-sale securities as of June 30, 2005 are temporary in nature. We reviewed our investment portfolio to identify and evaluate investments that have indications of possible impairment. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value. The following table provides a breakdown of our available-for-sale securities with unrealized losses as of June 30, 2005 (in thousands):
9
Note 5. Inventories, Net
The components of inventories are summarized below (in thousands):
Note 6. Restructuring Charges
Our restructuring accrual is as follows (in thousands):
On March 14, 2005, we announced that we would be reducing the workforce at our Beijing, China manufacturing facility by approximately 100 positions or approximately 15%. This measure was taken as part of our ongoing effort to reduce our cost structure and bring capacity in line with current market demand. In March 2005, we recorded a restructuring charge of $86,000 relating to the reduction in work force, which we completed in June 2005. On an annual basis, we anticipate payroll and related expense savings of approximately $0.3 million relating to this reduction in force.
For the three and six month periods ended June 30, 2005 we recorded restructuring charges of $169,000 and $208,000, respectively, related to lease costs associated with facilities located in California that are no longer required to support production. The remaining restructuring accrual for future lease payments related to abandoned U.S. facilities of $487,000, is expected to be paid out through 2006, and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.
10
On April 28, 2005, we closed our Japan office as part of our ongoing effort to reduce our cost structure. In the three month period ended June 30, 2005 we recorded a restructuring charge of $98,000 relating to the closure of our Japan office of which $17,000 is in the restructuring accrual balance at June 30, 2005. On an annual basis, we anticipate payroll and related expense savings of approximately $0.3 million relating to the closure of our Japan office. The remaining restructuring accrual for our Japan office closure of $17,000 is expected to be paid out through 2005, and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.
Note 7. Net Loss Per Share
Basic net loss per common share is calculated by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net loss per common and common equivalent shares include the dilutive effect of common stock equivalents outstanding during the period calculated using the treasury stock method. Common stock equivalents consist of the shares issueable upon the exercise of stock options.
A reconciliation of the numerators and denominators of the basic and diluted net loss per share calculations is as follows (in thousands, except per share data):
Note 8. Comprehensive Loss
The components of comprehensive loss are as follows (in thousands):
Note 9. Segment Information and Foreign Operations
Segment Information
We operate in one segment for the design, development, manufacture and distribution of high-performance compound semiconductor substrates and sale of materials. In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” our chief operating decision-maker has been identified as the Chief Executive Officer, who reviews operating results to make decisions about allocating resources and assessing performance for the Company. All material operating units qualify for aggregation under SFAS No. 131 due to their identical customer base and similarities in economic characteristics, nature of products and services, and procurement, manufacturing and distribution processes. Since we operate in one segment, all financial segment and product line information required by SFAS No. 131 can be found in the
11
condensed consolidated financial statements.
Geographical Information
The following table represents revenue amounts (in thousands) reported for products shipped to customers in the corresponding geographic region:
* Primarily the United States
Long-lived assets consist primarily of property, plant and equipment, and are attributed to the geographic location in which they are located. Long-lived assets by geographic region were as follows (in thousands):
Significant Customers
One customer represented 14.6% and 9.6% of revenues for the three month periods ended June 30, 2005 and 2004, respectively. One customer represented 12.2% and 9.5% of revenues for the six month periods ended June 30, 2005 and 2004, respectively. Our top five customers represented 38.7% and 35.6% of revenue for the three month periods ended June 30, 2005, and 2004, respectively. Our top five customers represented 39.8% and 34.6% of revenue for the six month periods ended June 30, 2005, and 2004, respectively.
Note 10. Corporate Affiliates
We have made strategic investments in private companies located in China in order to gain access to raw materials at a competitive cost that are critical to our substrate business. Our investments in these private corporate affiliates are summarized below (in thousands):
The investment balances for the two affiliates accounted for under the equity method are included in other assets in the condensed consolidated balance sheets. We own 25% of the ownership interests in each of these affiliates. These two affiliates are not considered variable interest entities because:
• both affiliates have sustainable businesses of their own;
• our voting power is proportionate to our ownership interests;
12
• we only recognize our respective share of the losses and/or residual returns generated by the affiliates if they occur, or both and
• we do not have controlling financial interests in either affiliate, do not maintain operational or management control, nor control of the board of directors, and are not required to provide additional investment or financial support to either affiliate.
Undistributed retained earnings relating to our corporate affiliates were $1.8 million and $1.4 million as of June 30, 2005 and 2004, respectively. Net income recorded from our corporate affiliates were $243,000 and $382,000 for the three month periods ended June 30, 2005 and 2004, respectively. Net income recorded from our corporate affiliates were $332,000 and $612,000 for the six month periods ended June 30, 2005 and 2004, respectively.
The minority interest for those affiliates that are consolidated is included within “Other long-term liabilities” in the condensed consolidated balance sheets and within “Other expense (income)” on the condensed consolidated statements of operations.
We have considered investments in other joint ventures, including a new joint venture investment in China for a germanium business opportunity. If agreement is reached with the other parties concerning the formation of this joint venture, we may, upon the fulfillment of certain conditions, invest up to $1.0 million in the new joint venture in 2005.
Note 11. Commitments and Contingencies
Legal Matters
On October 15, 2004, a purported securities class action lawsuit was filed in the United States Court for the Northern District of California. City of Harper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The Court consolidated the case with a subsequent related case and appointed a lead plaintiff. On April 5, 2005, the lead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc. et al., No. C 04 4362 MJJ. The lawsuit complaint names AXT, Inc. and our chief technology officer, as defendants, and is brought on behalf of a class of all purchasers of our securities from February 6, 2001 through April 27, 2004. The complaint alleges that we announced financial results during this period that were false and misleading. No specific amount of damages is claimed. We believe that there are meritorious defenses against this litigation and intend to vigorously defend it. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operations.
On June 1, 2005, a lawsuit was filed in the Superior Court of California, County of Alameda, Zhao et. Al. vs. American Xtal Technology, et. Al., No. R 605215713. The lawsuit complaint names AXT and its chief technology officer and former interim chief executive officer, and is brought on behalf of two former employees and their minor child. The complaint alleges personal injury, general negligence, intentional tort, wage loss and other damages, including punitive damages, as a result of exposure of defendants, including the minor child in utero, to high levels of gallium arsenide in gallium arsenide wafers, and methanol. The complaint seeks damages of $10 million each for pain, suffering and inconvenience, and for emotion distress, special damages to be determined, and punitive damages in the amount of $10 million. We believe that there are meritorious defenses against this litigation and intend to vigorously defend it. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operations.
Contract Commitment
We have entered into contracts to supply several large customers with GaAs wafers. The contracts guaranteed delivery of a certain number of wafers between January 1, 2001 and December 31, 2004 with a current contract value of $130,000. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, we could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. We have not received any claims for non-performance penalties due to non-delivery. Partial prepayments received for these supply contracts totaling $125,000 and $130,000 are included in accrued liabilities in the accompanying condensed consolidated balance sheets as of June 30, 2005 and December 31, 2004, respectively. As of June 30, 2005, we have met all of our current delivery obligations under these contracts and expect to continue to meet delivery requirements during the remainder of the contract terms.
13
Indemnification Agreements
We enter into standard indemnification arrangements in the ordinary course of business. Pursuant to these arrangements, we indemnify, hold harmless, and agree to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, generally their business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual anytime after the execution of the agreement. The maximum potential amount of future payments we could be required to make under these agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal.
We have entered into indemnification agreements with our directors and officers that may require us to indemnify our directors and officers against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from willful misconduct of a culpable nature; to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified; and to obtain directors’ and officers’ insurance if available on reasonable terms, which we currently have in place.
Product Warranty
We warrant our products for a specific period of time, generally twelve months, against material defects. We provide for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that we expect to incur to repair or replace product parts that fail while still under warranty. The amount of accrued estimated warranty costs are primarily based on historical experience as to product failures as well as current information on repair costs. On a quarterly basis, we review the accrued balances and update these based on the historical warranty cost trends. The following table reflects the change in our warranty accrual during the three month and six month periods ended June 30, 2005 and 2004 (in thousands):
Sales Returns
In March 2004, we increased our reserve for repair and replacement costs by $745,000, after determining that we had not followed certain requirements for testing of products and provision of testing data and information relating to customer requirements for certain shipments made over the past several years. Approximately $487,000 of the $745,000 sales returns reserve has been utilized as of June 30, 2005. We will continue to monitor the returns for this specific reserve.
Note 12. Foreign Exchange Contracts and Transaction Gains/Losses
We use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. We have purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of June 30, 2005, we had no outstanding commitments with respect to foreign exchange contracts.
We incurred a foreign currency transaction exchange loss of $29,000 for the three month period ended June 30, 2005, and a foreign currency exchange loss of $75,000 for the three month period ended June 30, 2004. We incurred a foreign currency transaction exchange loss of $49,000 for the six month period ended June 30, 2005, and a foreign currency exchange loss of $11,000 for the six month period ended June 30, 2004.
Note 13. Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment,” which requires companies to measure and recognize compensation expense for all stock-based payments at fair value. SFAS 123R was originally effective for all interim periods beginning after June 15, 2005. Early adoption is encouraged and retroactive application of the provisions of SFAS 123R to
14
the beginning of the fiscal year that includes the effective date is permitted, but not required.
In March 2005, the U.S. Securities and Exchange Commission, (“ SEC”), released Staff Accounting Bulletin 107 (“SAB107”), “Share-Based Payments” . The interpretations in SAB 107 express views of the SEC staff, regarding the interaction between SFAS 123R and certain SEC rules and regulations, and provide the staff’s views regarding the valuation of share-based payment arrangements for public companies. In particular, SAB 107 provides guidance related to share-based payment transactions with nonemployees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of SFAS 123R in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS 123R, the modification of employee share options prior to adoption of SFAS 123R and disclosures in Management’s Discussion and Analysis subsequent to adoption of SFAS 123R.
In April 2005, the SEC approved a new rule that delays the effective date of SFAS 123R to the first annual or interim reporting period for fiscal years beginning on or after June 15, 2005. SFAS123R will be effective for us beginning with the first quarter of fiscal 2006. We are currently evaluating the impact of SFAS 123R on our financial position and results of operations. See Note 3. Accounting for Stock-Based Compensation for information related to the pro forma effects on our reported net loss and net loss per share when applying the fair value recognition provisions of the previous SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “…under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges....” This Statement requires that those items be recognized as current period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of this Statement is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 153 (SFAS 153), “Exchanges of Nonmonetary Assets—An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.” SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces it with an exception for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for the fiscal periods beginning after June 15, 2005. We do not expect the adoption of SFAS 153 to have a material impact on our consolidated financial position, results of operations or cash flows.
15
ITEM 2. 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 made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based upon management’s current views with respect to future events and financial performance, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. Such risks and uncertainties include those set forth under “Risks Related to our Business” below. Forward-looking statements may be identified by the use of terms such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” and similar expressions. Statements concerning our future or expected financial results and condition, business strategy and plans or objectives for future operations are forward-looking statements.
These forward-looking statements are not guarantees of future performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2004 and the condensed consolidated financial statements included elsewhere in this report.
Overview
We were founded in 1986 to commercialize and enhance our proprietary vertical gradient freeze (VGF) technique for producing high-performance compound semiconductor substrates. As a result of the discontinuance of our opto-electronics division, and the sale of substantially all of the assets of this business in 2003, we now have one operating segment: our substrate division. We made our first substrate sales in 1990 and our substrate division currently sells gallium arsenide (GaAs) and indium phosphide (InP) substrates to manufacturers of semiconductor devices for use in applications such as fiber optic and wireless telecommunications, light emitting diodes (LEDs) and lasers. We also sell raw materials including gallium and germanium through our participation in majority- and minority-owned joint ventures. We have the capability to manufacture germanium substrates for use in satellite solar cells but withdrew from this business during 2000 so that we could more profitably use our then constrained capacity. We are now trying to re-qualify our germanium substrates with the few existing satellite solar cell system manufacturers.
Discontinued Opto-Electronics Business
In June 2003, we announced the discontinuation of our opto-electronics division, which we had established as part of our acquisition of Lyte Optronics, Inc. in May 1999. The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs) for the illumination markets, and also manufactured vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in our condensed consolidated statements of operations for all periods presented. See Note 2 to our condensed consolidated financial statements for details regarding the accounting for discontinued operations.
In September 2003, we completed the sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. A portion of the purchase price equal to $1.0 million was held in escrow to satisfy any claims that the purchaser might make for breaches of representations or warranties by us. Of this total escrow $750,000 could be released after the one year anniversary of the sale of the opto-electronics business and the remainder could be released after the second anniversary of the sale. Given the difficult negotiations we encountered with the acquiring company when negotiating the sale of the opto-electronics business, as well as the historical operating problems of the business, we determined there was significant uncertainty regarding the recoverability of the escrowed amounts. Accordingly, we did not recognize the cash held in escrow in recording the sale of the opto-electronics division, and have only recorded amounts as and when they are received. As of June 30, 2005, we have resolved all claims made against the first $750,000 held in escrow by the acquiring company, and have received all but $31,000 of the first $750,000 held in escrow. As of June 30, 2005, we have $250,000 in escrow which will not be eligible for release until September 2005.
In June 2005, we completed the sale of a building located in Monterey Park, California. This asset had been classified as “assets held for sale” in the amount of $1.25 million on the condensed consolidated balance sheets as of December 31, 2004. We received net proceeds on the sale of the property of approximately $1.3 million and accordingly recorded a gain on sale of $53,000 in the quarter ended June 30, 2005.
16
Restructuring Charges
During the second quarter of 2004, we announced plans to cease all production activities in the United States and to manufacture our products only in China. In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down our remaining manufacturing facilities in the United States. In the third and fourth quarter of 2004, we incurred additional restructuring charges of $231,000 for a total of $1.3 million in 2004. These charges comprised costs related to the reduction in work force effected in June 2004, and lease costs associated with the facilities located in California that are no longer required to support production. In aggregate, we eliminated 50 positions, 47 of which were production workers. On an annual basis, we anticipate payroll and related expense savings of $1.5 million. On March 14, 2005, we announced a reduction of our workforce at our Beijing, China manufacturing facility of approximately 100 positions or approximately 15%. This measure was taken as part of our ongoing effort to reduce our cost structure and bring capacity in line with current market demand. We recorded a restructuring charge of $56,000 in the six month period ended June 30, 2005 relating to the reduction in force, which we completed in March 2005. On an annual basis, we anticipate payroll and related expense savings of approximately $0.3 million relating to this reduction in force.
For the three and six month periods ended June 30, 2005, we recorded restructuring charges of $169,000 and $208,000, respectively, related to lease costs associated with facilities located in California that are no longer required to support production. The remaining restructuring accrual for future lease payments related to abandoned U.S. facilities of $487,000, is expected to be paid out through 2006, and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.
In April, 2005, we closed our Japan office as part of our ongoing effort to reduce our cost structure. In the three month period ended June, 2005 we recorded a restructuring charge of $98,000 relating to the closure of our Japan office of which $17,000 is in the restructuring accrual balance at June 30, 2005. On an annual basis, we anticipate payroll and related expense savings of approximately $0.3 million relating to the closure of our Japan office. The remaining restructuring accrual for our Japan office closure of $17,000 is expected to be paid out through 2005 and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.
For the remainder of 2005, we will continue to reduce costs by qualifying new lower cost suppliers, moving more of our administrative functions to China where our costs are lower, and streamlining our organization structure and costs in the United States and China to bring them in line with our current business.
Critical Accounting Policies and Estimates
We have prepared our condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. As such, we have had to make estimates, assumptions and judgments that affect the amounts reported on our financial statements. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that are believed to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. The discussion and analysis of our results of operations and financial condition are based upon these condensed consolidated financial statements. We have identified the policies below as critical to our business operations and understanding of our financial condition and results of operations. A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations. They may require us to make assumptions about matters that are highly uncertain at the time of the estimate, and different estimates that we could have used, or changes in the estimate that are reasonably likely to occur, may have a material impact on our financial condition or results of operations.
We believe that the following are our critical accounting policies:
Revenue Recognition
We manufacture and sell high-performance compound semiconductor substrates and sell certain raw materials including gallium, germanium dioxide, and pBN crucibles. After we ship our products, there are no remaining obligations or customer acceptance requirements that would preclude recognition of the revenue earned on the sale. Our products are typically sold pursuant to a purchase order placed by our customers, and our terms and conditions of sale do not require customer acceptance. We recognize revenue upon shipment and transfer of title of products to our customers, which is either upon
17
shipment from our dock, receipt at the customer’s dock, or removal from consignment inventory at the customer’s location, provided that we have received a signed purchase order, the price is fixed or determinable, title and risk of ownership have transferred, collection of resulting receivables is probable, and product returns are reasonably estimable. We do not provide training, installation or commissioning services. Additionally, we do not provide discounts or other incentives to customers except for one customer with whom we agreed in the fourth quarter of 2004 to provide a certain amount of cumulative discounts on future product purchases from us. We will recognize these discounts in future periods as a reduction in revenue as products are sold to this customer.
We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized. In the first quarter of 2004, we recorded a reserve for sales returns of $745,000 related to our failure to follow certain testing requirements and provision of testing data and information to certain customers. This reserve was based on discussions with some of the affected customers and review of specific shipments. Approximately $487,000 of the $745,000 sales returns reserve had been utilized as of June 30, 2005. We will continue to monitor the returns for this specific reserve.
Allowance for Doubtful Accounts
We periodically review the likelihood of collection on our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We provide a 100% allowance for U.S. receivables in excess of 90 days and for foreign receivables in excess of 120 days. We assess the probability of collection based on a number of factors, including the length of time a receivable balance has been outstanding, our past history with the customer and their credit worthiness.
As of June 30, 2005 and December 31, 2004, our accounts receivable balance was $5.0 million and $4.0 million, respectively, which was net of an allowance for doubtful accounts of $0.5 million and $1.1 million, respectively. If actual uncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could have a material impact on our financial results for the period.
Warranty Reserve
We maintain a warranty reserve based upon our claims experience during the prior twelve months. Warranty costs are accrued at the time revenue is recognized. As of June 30, 2005, accrued product warranties totaled $82,000. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financial condition and results of operations.
Inventory Valuation
Inventories are stated at the lower of cost or market. Cost is determined using the weighted average cost method. Our inventory consists of raw materials as well as finished goods and work-in-process that include material, labor and manufacturing overhead costs. Given the nature of our substrate products, and the materials used in the manufacturing process, the wafers and ingots comprising work-in-process may be held in inventory for up to two years and three years, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory and provide a valuation allowance for certain inventories based upon the age and quality of the product and the projections for sale of the completed products. As of June 30, 2005, we had an inventory reserve of $17.5 million for excess and obsolete inventory. The majority of this inventory has not been scrapped. If actual demand for our products were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results of operations.
Impairment of Investments
We classify our investments in debt and equity securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” All available-for-sale securities with a quoted market value below cost (or adjusted cost) are reviewed in order to determine whether the decline is other-than-temporary. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value.
18
We invest in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee’s management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in our carrying value.
Impairment of Long-Lived Assets
We evaluate the recoverability of property, equipment, and intangible assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” When events and circumstances indicate that long-lived assets may be impaired, we compare the carrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to such assets. In the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the asset’s fair value.
Employee Stock Options
We grant options to substantially all management employees and believe that this broad-based program helps us to attract, motivate, and retain high quality employees, to the ultimate benefit of our stockholders. We currently account for share-based payments to employees using the intrinsic value method under APB Opinion No. 25 and, as such, generally recognize no compensation cost for employee stock options. Statement of Financial Accounting Standards No. 123 (revised), “Share-Based Payment” (SFAS 123R) will be effective for us beginning with the first quarter of fiscal 2006. The adoption of SFAS No. 123R is expected to result in a material increase in expense during fiscal 2006 based on unvested options outstanding as of June 30, 2005 and current compensation plans. While the effect of adoption depends on the level of share-based payments granted in the future and unvested grants on the date we adopt SFAS 123(R), the effect of this accounting standard on our prior operating results would approximate the effect of SFAS 123 as described in the disclosure of pro forma net loss and net loss per share. See Note 3 to our condensed consolidated financial statements.
Income Taxes
We account for income taxes in accordance with SFAS No. 109 (SFAS 109), “Accounting for Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized.
We provide for income taxes based upon the geographic composition of worldwide earnings and tax regulations governing each region, particularly China. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws, particularly in foreign countries such as China.
Results of Operations
Revenue
Revenue from continuing operations decreased $3.5 million, or 36.7%, to $6.0 million for the three month period ended June 30, 2005 compared with $9.5 million for the three month period ended June 30, 2004.
19
Total GaAs substrate revenue decreased $3.0 million, or 40.2%, to $4.5 million for the three month period ended June 30, 2005 compared with $7.5 million for the three month period ended June 30, 2004. Sales of 2 inch and 3 inch diameter GaAs substrates were $2.5 million for the three month period ended June 30, 2005 compared with $4.3 million for the three month period ended June 30, 2004. The decrease in GaAs substrate revenue is due to existing quality issues, the continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers and a decline in orders from customers who are qualifying our China-grown products. InP substrate revenue decreased $253,000, or 47.5%, to $280,000 for the three month period ended June 30, 2005 compared with $533,000 for the three month period ended June 30, 2004. The decrease in InP substrate revenue was due to a decline in orders from customers who are qualifying our China-grown products.
Revenue from continuing operations decreased $6.6 million, or 34.4%, to $12.7 million for the six month period ended June 30, 2005 compared with $19.3 million for the six month period ended June 30, 2004.
Total GaAs substrate revenue decreased $5.9 million, or 37.7%, to $9.7 million for the six month period ended June 30, 2005 compared with $15.5 million for the six month period ended June 30, 2004. Sales of 2 inch and 3 inch diameter GaAs substrates were $6.3 million for the six month period ended June 30, 2005 compared with $9.3 million for the six month period ended June 30, 2004. The decrease in GaAs substrate revenue is due to existing quality issues, the continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers and a decline in orders from customers who are qualifying our China-grown products. InP substrate revenue decreased $632,000, or 60.2%, to $417,000 for the six month period ended June 30, 2005 compared with $1.0 million for the six month period ended June 30, 2004. The decrease in InP substrate revenue was due to a decline in orders from customers who are qualifying our China-grown products.
Revenue by Geographic Region
* Primarily the United States
Asia Pacific revenue increased to 32% of total revenue from continuing operations for the three month period ended June 30, 2005 compared with 16% of total revenue from continuing operations for the three month period ended June 30, 2004. The increase was primarily due to increased sales of GaAs substrates to customers in China and Singapore which are being
20
used in opto-electronics applications. The overall decrease in other geographic areas for our GaAs substrates is due to existing quality issues, continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers, and delays in orders from customers who are qualifying our China-grown products.
* Primarily the United States
International revenue increased to 82% of total revenue from continuing operations for the six month period ended June 30, 2005 compared with 78% of total revenue from continuing operations for the six month period ended June 30, 2004. Asia Pacific revenue increased to 31% of total revenue from continuing operations for the six month period ended June 30, 2005 compared with 17% of total revenue from continuing operations for the six month period ended June 30, 2004. The increase was primarily due to increased sales of GaAs substrates to customers in China and Singapore which are being used in opto-electronics applications. The overall decrease in other geographic areas for our GaAs substrates is due to existing quality issues, continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers, and delays in orders from customers who are qualifying our China-grown products.
Gross Margin
Gross margin. Gross margin decreased to 2.1% of total revenue for the three month period ended June 30, 2005 compared with 8.7% of total revenue for the three month period ended June 30, 2004. Gross margin in the three month period ended June 30, 2005 was negatively impacted by a $765,000 charge to cost of revenues as a result of an inventory valuation adjustment. There was no such adjustment in the three month period ended June 30, 2004. The impact of the charge in the three month period ended June 30, 2005 was to reduce gross margin from 14.8% to 2.1%. Our average selling prices have dropped, our revenue is down, and given our current excess capacity, our gross margins are not expected to improve significantly for the remainder of 2005.
21
Gross margin. Gross margin decreased to 3.2% of total revenue for the six month period ended June 30, 2005 compared with 7.1% of total revenue for the six month period ended June 30, 2004. Gross margin for the six month period ended June 30, 2005 was negatively impacted by a $765,000 charge to cost of revenues as a result of an inventory valuation adjustment. There was no such adjustment for the six month period ended June 30, 2004. The impact of the charge in the six month period ended June 30, 2005 was to reduce gross margin from 9.2% to 3.2%. Our average selling prices have dropped, our revenue is down, and given our current excess capacity, our gross margins are not expected to improve significantlyfor the remainder of 2005.
Selling, General and Administrative Expenses
Selling, general and administrative expenses decreased $487,000 to $2.7 million for the three month period ended June 30, 2005 compared with $3.2 million for the three month period ended June 30, 2004. The reasons for this decrease was that the three month period ended June 30, 2004 included $350,000 of legal fees related to the investigation by our Audit Committee into product testing and compliance practices and $300,000 of audit and Sarbanes-Oxley related expenses. For the three month period ended June 30, 2005 we had $548,000 of expenses relating to the decommissioning of our Fremont, California facilities, which was partially offset by a reduction in the allowance for doubtful accounts of $270,000.
Selling, general and administrative expenses increased $995,000 to $7.0 million for the six month period ended June 30, 2005 compared with $6.0 million for the six month period ended June 30, 2004. The increase was primarily due to $1.8 million of expenses for the six month period ended June 30, 2005 relating to the decommissioning of our Fremont, California facilities, offset by $350,000 of legal fees related to the investigation by our Audit Committee into product testing and compliance practices and $300,000 of audit and Sarbanes-Oxley related expenses for the six month period ended June 30, 2004.
Research and Development
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||