Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

(Mark One)

 

x

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the quarterly period ended March 31, 2010

 

Or

 

o

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 000-24085

 


 

AXT, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE

 

94-3031310

(State or other jurisdiction of
Incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

4281 Technology Drive, Fremont, California 94538

(Address of principal executive offices) (Zip code)

 

(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 x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer x

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  YES o NO x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding at April 30, 2010

Common Stock, $0.001 par value

 

30,997,701

 

 

 



Table of Contents

 

AXT, INC.

FORM 10-Q

TABLE OF CONTENTS

 

 

Page

PART I. FINANCIAL INFORMATION

3

Item 1. Financial Statements (unaudited)

3

Condensed Consolidated Balance Sheets as of March 31, 2010 and December 31, 2009

3

Condensed Consolidated Statements of Operations for the three months ended March 31, 2010 and 2009

4

Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2010 and 2009

5

Notes To Condensed Consolidated Financial Statements

6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

Item 3. Quantitative and Qualitative Disclosures About Market Risk

26

Item 4. Controls and Procedures

27

PART II. OTHER INFORMATION

28

Item 1. Legal Proceedings

28

Item 1A. Risk Factors

28

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

28

Item 3. Defaults Upon Senior Securities

28

Item 4. [Reserved]

28

Item 5. Other Information

28

Item 6. Exhibits

28

Signatures

30

 

2



Table of Contents

 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

AXT, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share data)

 

 

 

March 31,

 

December 31,

 

 

 

2010

 

2009 (1)

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

20,607

 

$

16,934

 

Short-term investments

 

15,120

 

18,469

 

Accounts receivable, net of allowances of $1,013 and $1,019 as of March 31, 2010 and December 31, 2009, respectively

 

15,166

 

15,362

 

Inventories, net

 

28,141

 

27,718

 

Prepaid expenses and other current assets

 

3,067

 

2,411

 

Total current assets

 

82,101

 

80,894

 

Long-term investments

 

3,614

 

 

Property, plant and equipment, net

 

20,293

 

20,853

 

Other assets

 

6,160

 

6,199

 

Total assets

 

$

112,168

 

$

107,946

 

 

 

 

 

 

 

Liabilities and stockholders’ equity:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

6,895

 

$

5,571

 

Accrued liabilities

 

4,975

 

4,566

 

Current portion of long-term debt

 

77

 

76

 

Total current liabilities

 

11,947

 

10,213

 

Long-term debt, net of current portion

 

401

 

420

 

Other long-term liabilities

 

29

 

62

 

Total liabilities

 

12,377

 

10,695

 

Commitments and contingencies (Note 10)

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.001 par value; 2,000 shares authorized; 883 shares issued and outstanding as of March 31, 2010 and December 31, 2009 (Liquidation preference of $5.4 million as of March 31, 2010 and December 31, 2009)

 

3,532

 

3,532

 

Common stock, $0.001 par value per share; 70,000 shares authorized; 30,971 and 30,880 shares issued and outstanding as of March 31, 2010 and December 31, 2009, respectively

 

30

 

30

 

Additional paid-in capital

 

188,117

 

187,871

 

Accumulated deficit

 

(98,550

)

(101,130

)

Accumulated other comprehensive income

 

4,076

 

4,300

 

Total AXT, Inc. stockholders’ equity

 

97,205

 

94,603

 

 

 

 

 

 

 

Noncontrolling interests

 

2,586

 

2,648

 

Total stockholders’ equity

 

99,791

 

97,251

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

112,168

 

$

107,946

 

 

See accompanying notes to condensed consolidated financial statements.

 


(1)   The condensed consolidated balance sheet at December 31, 2009 has been derived from the audited consolidated financial statements at that date.

 

3



Table of Contents

 

AXT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share data)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2010

 

2009

 

 

 

 

 

 

 

Revenue

 

$

18,641

 

$

7,654

 

Cost of revenue

 

11,909

 

7,891

 

Gross profit (loss)

 

6,732

 

(237

)

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

Selling, general and administrative

 

3,419

 

4,006

 

Research and development

 

451

 

460

 

Restructuring charge

 

 

507

 

Total operating expenses

 

3,870

 

4,973

 

Income (loss) from operations

 

2,862

 

(5,210

)

Interest income, net

 

15

 

44

 

Other income (loss), net

 

79

 

(422

)

 

 

 

 

 

 

Income (loss) before provision for income taxes

 

2,956

 

(5,588

)

Provision for income taxes

 

(246

)

(4

)

Net income (loss)

 

2,710

 

(5,592

)

Less: Net income (loss) attributable to noncontrolling interest

 

(130

)

76

 

Net income (loss) attributable to AXT, Inc.

 

$

2,580

 

$

(5,516

)

 

 

 

 

 

 

Net income (loss) attributable to AXT, Inc. per common share:

 

 

 

 

 

Basic

 

$

0.08

 

$

(0.18

)

Diluted

 

$

0.08

 

$

(0.18

)

 

 

 

 

 

 

Weighted average number of common shares outstanding:

 

 

 

 

 

Basic

 

30,743

 

30,434

 

Diluted

 

31,792

 

30,434

 

 

See accompanying notes to condensed consolidated financial statements.

 

4



Table of Contents

 

AXT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 

 

 

Three Months Ended
March 30,

 

 

 

2010

 

2009

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

2,710

 

$

(5,592

)

 

 

 

 

 

 

Adjustments to reconcile net income (loss) to net cash used in operating activities:

 

 

 

 

 

Depreciation

 

752

 

800

 

Accretion of marketable securities premium

 

 

(4

)

Loss on disposal of property, plant and equipment

 

1

 

1

 

Stock-based compensation

 

114

 

458

 

Restructuring charge

 

 

507

 

Realized loss (gain) on available for sale investments

 

(120

)

 

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable, net

 

196

 

3,108

 

Inventories

 

(505

)

1,583

 

Prepaid expenses and other current assets

 

(655

)

833

 

Other assets

 

38

 

58

 

Accounts payable

 

1,366

 

(2,454

)

Accrued liabilities

 

325

 

(544

)

Other long-term liabilities

 

9

 

(657

)

Net cash provided by (used in) operating activities

 

4,231

 

(1,903

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property, plant and equipment

 

(320

)

(135

)

Proceeds from sale of property, plant and equipment

 

4

 

 

Purchases of available for sale investments

 

(6,284

)

(13

)

Proceeds from sale of available for sale investments

 

6,120

 

 

Decrease in restricted deposits

 

 

13

 

Net cash used in investing activities

 

(480

)

(135

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from common stock options exercised

 

132

 

 

Dividends paid

 

(192

)

 

Long-term debt payments

 

(18

)

(30

)

Net cash used in financing activities

 

(78

)

(30

)

Effect of exchange rate changes on cash and cash equivalents

 

 

9

 

Net increase (decrease) in cash and cash equivalents

 

3,673

 

(2,059

)

Cash and cash equivalents at the beginning of the period

 

16,934

 

13,566

 

Cash and cash equivalents at the end of the period

 

$

20,607

 

$

11,507

 

 

See accompanying notes to condensed consolidated financial statements.

 

5



Table of Contents

 

AXT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1. Basis of Presentation

 

The accompanying condensed consolidated financial statements of AXT, Inc. (“AXT,” the “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, the year-end condensed consolidated balance sheet data was derived from our audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. In the opinion of our 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 our consolidated subsidiaries for all periods presented.

 

Our management 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 2009 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 22, 2010.

 

Certain reclassifications have been made to the prior period consolidated financial statements to conform to current period presentation.  These reclassifications had no impact on previously reported total assets, stockholders’ equity or net income (loss).

 

Note 2. Accounting for Stock-Based Compensation

 

We account for stock-based compensation in accordance with the provisions of FASB Accounting Standards Codification (“ASC”) topic 718, Compensation-Stock Compensation (“ASC 718”), which established accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at each grant date, based on the fair value of the award, and is recognized as expense over the employee’s requisite service period of the award. All of the Company’s stock compensation is accounted for as an equity instrument. The provisions of ASC 718 apply to all awards granted or modified after the date of adoption which was January 1, 2006. The unrecognized expense of awards not yet vested at the date of adoption will be recognized in net income (loss) in the periods after the date of adoption using the same Black-Scholes valuation method and assumptions determined under the original provisions of ASC 718.

 

We utilized the Black-Scholes valuation model for estimating the fair value of the stock compensation granted both before and after the adoption of ASC 718. The following table summarizes compensation costs related to our stock-based compensation awards (in thousands, except per share data):

 

 

 

Three Months Ended
March 31,

 

 

 

2010

 

2009

 

Stock-based compensation in the form of employee stock options, included in:

 

 

 

 

 

 

 

 

 

 

 

Cost of revenue

 

$

10

 

$

13

 

Selling, general and administrative

 

97

 

418

 

Research and development

 

7

 

27

 

 

 

 

 

 

 

Total stock-based compensation

 

114

 

458

 

Tax effect on stock-based compensation

 

 

 

 

 

 

 

 

 

Net effect on net income

 

$

114

 

$

458

 

Effect on net income (loss) attributable to AXT, Inc. per common share:

 

 

 

 

 

Basic

 

$

0.00

 

$

0.02

 

Diluted

 

$

0.00

 

$

0.02

 

 

6



Table of Contents

 

As of March 31, 2010 the total compensation costs related to unvested stock-based awards granted to employees under our stock option plan but not yet recognized was approximately $941,000, net of estimated forfeitures of $220,000. These costs will be amortized on a straight-line basis over a weighted-average period of approximately 3.19 years and will be adjusted for subsequent changes in estimated forfeitures. We elected not to capitalize any stock-based compensation to inventory as of March 31, 2010 due to the immateriality of the amount.

 

The amortization of stock compensation under ASC 718 for the period after our January 1, 2006 adoption is based on the single-option approach.

 

We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of ASC 718. There were no stock option grants made in the three months ended March 31, 2010 and 2009.

 

The following table summarizes the stock option transactions during the three months ended March 31, 2010 (in thousands, except per share data):

 

 

 

Shares

 

Weighted-
average
Exercise
Price

 

Weighted-
average
Remaining
Contractual
Life
(in years
)

 

Aggregate
Intrinsic
Value

 

 

 

 

 

 

 

 

 

 

 

Options outstanding as of January 1, 2010

 

2,880

 

$

2.46

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercised

 

(90

)

1.48

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Canceled and expired

 

(8

)

10.18

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Options outstanding as of March 31, 2010

 

2,782

 

$

2.47

 

5.47

 

$

3,542

 

 

 

 

 

 

 

 

 

 

 

Options vested and expected to vest as of March 31, 2010

 

2,675

 

$

2.49

 

5.31

 

$

3,405

 

 

 

 

 

 

 

 

 

 

 

Options exercisable as of March 31, 2010

 

1,829

 

$

2.67

 

3.50

 

$

2,333

 

 

As of December 31, 2009, options to purchase 1,900,000 shares at a weighted average exercise price of $2.64 per share were vested and exercisable.

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing price of $3.19 on March 31, 2010, which would have been received by the option holder had all option holders exercised their options on that date. The total number of in-the-money options exercisable as of March 31, 2010 was 1,148,000.

 

The options outstanding and exercisable as of March 31, 2010 were in the following exercise price ranges:

 

Options Outstanding as of March 31, 2010

 

Options Exercisable
as of March 31, 2010

 

Range of Exercise Price

 

Shares

 

Weighted-
average
Exercise Price

 

Weighted-
average
Remaining
Contractual Life

 

Shares

 

Weighted-
Average
Exercise Price

 

$1.17 - $1.18

 

340,000

 

$

1.17

 

2.34

 

340,000

 

$

1.17

 

$1.22 - $1.34

 

260,842

 

$

1.31

 

4.76

 

260,842

 

$

1.31

 

$1.38 - $1.38

 

305,400

 

$

1.38

 

3.44

 

305,400

 

$

1.38

 

$1.40 - $1.40

 

1,094

 

$

1.40

 

4.95

 

1,094

 

$

1.40

 

$1.59 - $1.59

 

566,901

 

$

1.59

 

7.56

 

162,346

 

$

1.59

 

$1.88 - $1.98

 

17,000

 

$

1.93

 

4.89

 

17,000

 

$

1.93

 

$2.04 - $2.04

 

488,700

 

$

2.04

 

9.57

 

0

 

$

0

 

$2.19 - $2.19

 

312,600

 

$

2.19

 

2.65

 

312,600

 

$

2.19

 

$3.11 - $6.31

 

440,219

 

$

4.90

 

4.88

 

380,797

 

$

4.76

 

$9.69 - $41.50

 

49,000

 

$

19.28

 

1.71

 

49,000

 

$

19.28

 

 

 

2,781,756

 

$

2.47

 

5.47

 

1,829,079

 

$

2.68

 

 

7



Table of Contents

 

There were 90,159 options exercised in the three months ended March 31, 2010. The total intrinsic value of options exercised for the three months ended March 31, 2010 was $164,568. Cash received from options exercised for the three months ended March 31, 2010 was $132,000. There were no options exercised in the three months ended March 31, 2009.

 

Restricted stock awards

 

A summary of activity related to restricted stock awards for the three months ended March 31, 2010 is presented below:

 

 

 

Shares

 

Weighted-Average
Grant Date Fair Value

 

Non-vested restricted stock shares outstanding as of January 1, 2010

 

170,660

 

$

1.21

 

Restricted stock shares granted

 

 

$

 

Restricted stock shares vested

 

 

$

 

Non-vested restricted stock shares outstanding as of March 31, 2010

 

170,660

 

$

1.21

 

 

As of March 31, 2010, we had $136,000 of unrecognized compensation expense, net of forfeitures, related to restricted stock awards, which will be recognized over the weighted average period of 1.78 years. During the three months ended March 31, 2010, no shares of restricted stock vested.

 

8



Table of Contents

 

Note 3. Investments and Fair Value Measurements

 

Our cash, cash equivalents and investments, and strategic investments in privately-held companies are classified as follows (in thousands):

 

 

 

March 31, 2010

 

December 31, 2009

 

 

 

 

 

Gross

 

Gross

 

 

 

 

 

Gross

 

Gross

 

 

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

 

 

Cost

 

Gain

 

(Loss)

 

Value

 

Cost

 

Gain

 

(Loss)

 

Value

 

Classified as:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash

 

$

20,520

 

$

 

$

 

$

20,520

 

$

16,790

 

$

 

$

 

$

16,790

 

Cash equivalents:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Money market fund

 

87

 

 

 

87

 

144

 

 

 

144

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total cash equivalents

 

87

 

 

 

87

 

144

 

 

 

144

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total cash and cash equivalents

 

20,607

 

 

 

20,607

 

16,934

 

 

 

16,934

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Certificates of Deposit

 

3,600

 

 

 

(9

)

3,591

 

 

 

 

 

 

 

 

 

US Treasury and agency securities

 

1,037

 

 

 

(7

)

1,030

 

 

 

 

 

 

 

 

 

Corporate bonds

 

13,945

 

186

 

(18

)

14,113

 

18,298

 

171

 

 

18,469

 

Total investments

 

18,582

 

186

 

(34

)

18,734

 

18,298

 

171

 

 

18,469

 

Total cash, cash equivalents and investments

 

$

39,189

 

186

 

$

(34

)

$

39,341

 

$

35,232

 

$

171

 

$

 

$

35,403

 

Contractual maturities on investments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Due within 1 year

 

$

14,941

 

 

 

 

 

$

15,120

 

$

18,298

 

 

 

 

 

$

18,469

 

Due after 1 through 5 years

 

3,641

 

 

 

 

 

3,614

 

 

 

 

 

 

 

 

 

$

18,582

 

 

 

 

 

$

18,734

 

$

18,298

 

 

 

 

 

$

18,469

 

 

We manage our investments as a single portfolio of highly marketable securities that is intended to be available to meet our current cash requirements. We have no investments in auction rate securities. For the three months ended March 31, 2010 we had $120,000 gross realized gains on sales of our available-for-sale securities. For the three months ended March 31, 2009 we had no 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 securities. We have determined that the gross unrealized losses on our available-for-sale securities as of March 31, 2010 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 March 31, 2010 (in thousands):

 

 

 

In Loss Position
< 12 months

 

Total In
Loss Position

 

 

 

 

 

Gross

 

 

 

Gross

 

 

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

 

 

Value

 

(Loss)

 

Value

 

(Loss)

 

Investments:

 

 

 

 

 

 

 

 

 

Certificates of Deposit

 

$

3,591

 

$

(9

)

$

3,591

 

$

(9

)

US Treasury and agency securities

 

1,030

 

(7

)

1,030

 

(7

)

Corporate bonds

 

1,628

 

(18

)

2,626

 

(18

)

Total in loss position

 

$

6,249

 

$

(34

)

$

7,248

 

$

(34

)

 

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Table of Contents

 

Investments in Privately-held Companies

 

We have made strategic investments in private companies located in China in order to gain access at a competitive cost to raw materials that are critical to our substrate business (see Note 9). The investment balances for the two companies accounted for under the equity method are included in “other assets” in the condensed consolidated balance sheets and totaled $4.3 million and $4.2 million as of March 31, 2010 and December 31, 2009, respectively. We have investments in three unconsolidated privately-held companies accounted for under the cost method. As of March 31, 2010 and December 31, 2009, our investments in the three unconsolidated privately-held companies accounted for under the cost method had a carrying value of $0.7 million and $0.7 million, respectively, and are included in “other assets” in the condensed consolidated balance sheets.

 

Fair Value Measurements

 

On January 1, 2008, we adopted ASC topic 820, Fair Value Measurements and Disclosures (“ASC 820”) which defines fair value, establishes a framework for using fair value to measure assets and liabilities, and expands disclosures about fair value measurements. ASC 820 applies whenever other statements require or permit assets or liabilities to be measured at fair value. ASC 820 applies to all financial assets and financial liabilities that are being measured and reported on a fair value basis and requires disclosure that establishes a framework for measuring fair value and expands disclosure about fair value measurements.

 

The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis in accordance with ASC 820 as of March 31, 2010 (in thousands):

 

 

 

Balance as of
March 31, 2010

 

Quoted Prices in
Active Markets of
Identical Assets
(Level 1)

 

Significant Other
Observable
Inputs
(Level 2)

 

Assets:

 

 

 

 

 

 

 

Cash and short-term investments:

 

 

 

 

 

 

 

Money market fund - Cash

 

$

87

 

$

87

 

$

 

Certificates of deposit

 

$

3,591

 

 

3,591

 

US Treasury and agency securities

 

$

1,030

 

 

1,030

 

Corporate bonds

 

14,113

 

 

14,113

 

Total

 

$

18,821

 

$

87

 

$

18,734

 

Liabilities

 

$

 

$

 

$

 

 

Our financial assets and liabilities are valued using market prices on both active markets (Level 1) and less active markets (Level 2). Level 1 instrument valuations are obtained from real-time quotes for transactions in active exchange markets involving identical assets. Level 2 instrument valuations are obtained from readily-available pricing sources for comparable instruments. As of March 31, 2010, we did not have any assets or liabilities without observable market values that would require a high level of judgment to determine fair value (Level 3 assets).

 

Items Measured at Fair Value on a Nonrecurring Basis

 

Certain assets that are subject to nonrecurring fair value measurements are not included in the table above. These assets include equity and cost method investments in private companies. We did not record other-than-temporary impairment charges for either of these investments during the first three months of 2010 or 2009.

 

Note 4. Inventories, Net

 

The components of inventories are summarized below (in thousands):

 

 

 

March 31,

 

December 31,

 

 

 

2010

 

2009

 

Inventories, net:

 

 

 

 

 

Raw materials

 

$

13,039

 

$

12,051

 

Work in process

 

11,675

 

11,947

 

Finished goods*

 

3,427

 

3,720

 

 

 

$

28,141

 

$

27,718

 

 


* Finished goods include $2.6 million and $2.1million of consigned inventory as of March 31, 2010 and December 31, 2009, respectively.

 

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Table of Contents

 

Note 5. Restructuring Charge

 

In March 2009, we reduced the workforce at our Fremont and Beijing facilities by approximately 11 positions that were no longer required to support certain production and administrative operations. This measure was being taken as part of our 2009 operating plan. Accordingly, we recorded a restructuring charge of $507,000 in March 2009 related to the reduction in force for severance-related expenses from the reduction in force, all of which were paid during the second quarter of 2009. We expect to save approximately $1.3 million annually in payroll and related expenses. We had no restructuring charge in the first three months of 2010.

 

Note 6. Net Income (Loss) Per Share

 

Basic net income (loss) per common share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net income (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 issuable upon the exercise of stock options.

 

A reconciliation of the numerators and denominators of the basic and diluted net income (loss) per share calculations is as follows (in thousands, except per share data):

 

 

 

Three Months Ended
March 31,

 

 

 

2010

 

2009

 

Numerator:

 

 

 

 

 

Net income (loss) attributable to AXT, Inc.

 

$

2,580

 

$

(5,516

)

Less: Preferred stock dividends

 

(44

)

(44

)

 

 

 

 

 

 

Net income (loss) available to common stockholders

 

$

2,536

 

$

(5,560

)

Denominator:

 

 

 

 

 

Denominator for basic net income (loss) per share - weighted average common shares

 

30,743

 

30,434

 

Effect of dilutive securities:

 

 

 

 

 

Common stock options

 

1,049

 

 

Denominator for dilutive net income (loss) per common share

 

31,792

 

30,434

 

Effect on net income (loss) attributable to AXT, Inc. per common share:

 

 

 

 

 

Basic

 

$

0.08

 

$

(0.18

)

Diluted

 

$

0.08

 

$

(0.18

)

Options excluded from diluted net income (loss) per share as the impact is anti-dilutive

 

366

 

2,753

 

 

The 883,000 shares of $0.001 par value Series A preferred stock issued on May 28, 1999 are non-voting and non-convertible preferred stock with a 5.0% cumulative annual dividend rate payable when declared by the board of directors, and a $4 per share liquidation preference over common stock, and must be paid before any liquidating distribution is made to common stockholders.

 

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Note 7. Stockholders’ Equity and Other Comprehensive Income (Loss)

 

Consolidated Statements of Changes in Equity

 

 

 

Preferred
Stock

 

Common
Stock

 

Additional
Paid In Capital

 

Accumulated
Deficit

 

Other
Comprehensive
Income/(loss)

 

AXT, Inc.
stockholders
equity

 

Noncontrolling
interests

 

Total
stockholders’
equity

 

Balance as of December 31, 2009

 

$

3,532

 

$

30

 

$

187,871

 

$

(101,130

)

$

4,300

 

$

94,603

 

$

2,648

 

$

97,251

 

Common stock options exercised

 

 

 

 

 

132

 

 

 

 

 

132

 

 

 

132

 

Stock-based compensation

 

 

 

 

 

114

 

 

 

 

 

114

 

 

 

114

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net (loss) income

 

 

 

 

 

 

 

2,580

 

 

 

2,580

 

130

 

2,710

 

Dividend declared

 

 

 

 

 

 

 

 

 

 

 

 

 

(192

)

(192

)

Change in unrealized (loss) gain on marketable securities

 

 

 

 

 

 

 

 

 

(19

))

(19

)

 

 

(19

)

Currency translation adjustment

 

 

 

 

 

 

 

 

 

(205

)

(205

)

 

 

(205

)

Balance as of March 31, 2010

 

$

3,532

 

$

30

 

$

188,117

 

$

(98,550

)

$

4,076

 

$

97,205

 

$

2,586

 

$

99,791

 

 

The components of comprehensive income (loss) are as follows (in thousands):

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2010

 

2009

 

 

 

 

 

 

 

Net income (loss) attributable to AXT, Inc

 

$

2,580

 

$

(5,516

)

Other comprehensive income, net of tax:

 

 

 

 

 

Change in foreign currency translation gain (loss), net of tax

 

(205

)

2

 

Change in unrealized gain (loss) on available-for-sale investments, net of tax

 

(19

)

187

 

Total other comprehensive income, net of tax

 

(224

)

189

 

Comprehensive income (loss)

 

2,356

 

(5,327

)

Comprehensive income attributable to the noncontrolling interest

 

 

1

 

Comprehensive income (loss) attributable to AXT, Inc.

 

$

2,356

 

$

(5,326

)

 

Note 8. 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 ASC topic 280, Segment Reporting, our chief operating decision-maker has been identified as the principal executive officer, who reviews operating results to make decisions about allocating resources and assessing performance for the Company. Since we operate in one segment, all financial segment and product line information can be found in the consolidated financial statements.

 

Product Information

 

 

 

Three Months Ended
March 31,

 

 

 

2010

 

2009

 

Revenue by product type:

 

 

 

 

 

GaAs substrates

 

$

13,434

 

$

5,012

 

InP substrates

 

875

 

490

 

Ge substrates

 

1,640

 

622

 

Raw materials and other

 

2,692

 

1,530

 

Consolidated

 

$

18,641

 

$

7,654

 

 

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Table of Contents

 

Geographical Information

 

The following table represents revenue amounts (in thousands) reported for products shipped to customers in the corresponding geographic region:

 

 

 

Three Months Ended
March 31,

 

 

 

2010

 

2009

 

Net revenues:

 

 

 

 

 

North America*

 

$

4,531

 

$

1,736

 

Europe

 

3,768

 

2,213

 

Japan

 

2,778

 

1,152

 

Taiwan

 

2,582

 

689

 

Asia Pacific

 

4,982

 

1,864

 

Consolidated

 

$

18,641

 

$

7,654

 

 


*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):

 

 

 

As of

 

 

 

March 31,

 

December 31,

 

 

 

2010

 

2009

 

Long-lived assets by geographic region:

 

 

 

 

 

North America

 

$

666

 

$

661

 

China

 

19,627

 

20,192

 

 

 

$

20,293

 

$

20,853

 

 

Significant Customers

 

One customer represented more than 10% of revenue for the three month period ended March 31, 2010 while two customers each represented more than 10% of revenue at 14.2% and 11.2% for the three month period ended March 31, 2009.  Our top five customers represented 39.6% and 43.9% of revenue for the three month periods ended March 31, 2010 and 2009, respectively.

 

We perform periodic credit evaluations of our customers’ financial condition and generally do not require collateral. Two customers each accounted for 10% or more of our trade accounts receivable balance as of March 31, 2010 at 27%, and 13%, respectively.

 

Note 9. Investments in Privately-held Companies

 

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 are summarized below (in thousands):

 

 

 

Investment Balance as of

 

 

 

 

 

 

 

March 31,

 

December 31,

 

Accounting

 

Ownership

 

Company

 

2010

 

2009

 

Method

 

Percentage

 

Beijing JiYa Semiconductor Material Co., Ltd

 

$

996

 

$

996

 

Consolidated

 

46

%

Nanjing Jin Mei Gallium Co., Ltd

 

592

 

592

 

Consolidated

 

83

%

Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd

 

410

 

410

 

Consolidated

 

70

%

Xilingol Tongli Germanium Co. Ltd

 

3,371

 

3,367

 

Equity

 

25

%

Emeishan Jia Mei High Purity Metals Co., Ltd

 

882

 

866

 

Equity

 

25

%

 

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Table of Contents

 

Our ownership of Beijing Ji Ya Semiconductor Material Co., Ltd. (JiYa) is 46%. We continue to consolidate JiYa as we have significant influence in management and have a majority control of the board. Our chief executive officer is chairman of the JiYa board, while our president of China operations and our vice president of China administration and our vice president of wafer production are also members of the JiYa board.

 

Our ownership of Nanjing Jin Mei Gallium Co., Ltd. (Jin Mei) is 83%. We continue to consolidate Jin Mei as we have significant influence in management and have a majority control of the board. Our chief executive officer is chairman of the Jin Mei board, while our president of China operations and our vice president of China administration are also members of the Jin Mei board.

 

Our ownership of Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd (BoYu), is 70%. We continue to consolidate Bo Yu as we have a significant influence over management and have a majority control of the board. Our chief executive officer is chairman of the BoYu board and our president of China operations and our vice president of China administration are members of the BoYu board.

 

Although we have representation on the boards of directors of each of these companies, the daily operations of each of these companies are managed by local management and not by us. Decisions concerning their respective short term strategy and operations, any capacity expansion and annual capital expenditures, and decisions concerning sales of finished product, are made by local management without input from us.

 

The investment balances for the two companies accounted for under the equity method are included in other assets in the consolidated balance sheets and totaled $4.3 million and $4.2 million as of March 31, 2010 and December 31, 2009, respectively. We own 25% of the ownership interests in each of these companies. These two companies are not considered variable interest entities because:

 

·                  both companies have sustainable businesses of their own;

 

·                  our voting power is proportionate to our ownership interests;

 

·                  we only recognize our respective share of the losses and/or residual returns generated by the companies if they occur; and

 

·                  we do not have controlling financial interest in, do not maintain operational or management control of, do not control the board of directors of, and are not required to provide additional investment or financial support to either company.

 

During the three months ended March 31, 2010 the three consolidated joint ventures had income of $0.5 million of which $0.1 million was allocated to minority interests, resulting in income of $0.4 million included in our net income. During the three months ended March 31, 2009 the three consolidated joint ventures lost $0.3 million of income of which $0.1 million was allocated to minority interests, resulting in a loss of $0.2 million included in our net loss. Our equity earnings from the two-minority owned joint ventures that are not consolidated are recorded as other income (loss), net and totaled $21,000 and $7,000 for the three months ended March 31, 2010 and 2009, respectively. Undistributed retained earnings relating to all our investments in these companies were $12.8 million and $12.4 million as of March 31, 2010 and December 31, 2009, respectively.

 

Our two minority-owned joint ventures that are not consolidated and accounted for under the equity method had the following summarized income information (in thousands) for the three months ended March 31, 2010 and 2009, respectively.

 

 

 

Three Months Ended
March 31,

 

 

 

2010

 

2009

 

 

 

 

 

 

 

Net Sales

 

$

3,338

 

$

2,104

 

Gross profit

 

895

 

687

 

Operating income

 

123

 

73

 

Net income

 

82

 

29

 

 

We have investments in three unconsolidated privately-held companies accounted for under the cost method. As of March 31, 2010 and December 31, 2009, our investments in the three unconsolidated privately-held companies accounted for under the cost method had a carrying value of $0.7 million and $0.7 million, respectively, and are included in “other assets” in the condensed consolidated balance sheets.

 

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Table of Contents

 

Note 10. Commitments and Contingencies

 

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 which is included in “accrued liabilities” on the condensed consolidated balance sheets, during the three months ended March 31, 2010 and 2009 (in thousands):

 

 

 

Three Months Ended
March 31,

 

 

 

2010

 

2009

 

 

 

 

 

 

 

Beginning accrued warranty and related costs

 

$

1,082

 

$

1,640

 

Charged (credited) to cost of revenue

 

60

 

76

 

Actual warranty expenditures

 

(56

)

(253

)

Ending accrued warranty and related costs

 

$

1,086

 

$

1,463

 

 

Purchase Obligations

 

Through the normal course of business, we purchase or place orders for the necessary materials of our products from various suppliers and we commit to purchase products where we may incur a penalty if the agreement was canceled. As of March 31, 2010, we do not have any outstanding material purchase obligations.

 

Legal Proceedings

 

From time to time we may be involved in judicial or administrative proceedings concerning matters arising in the ordinary course of business. We do not expect that any of these matters, individually or in the aggregate, will have a material adverse effect on our business, financial condition, cash flows or results of operation.

 

Note 11. Foreign Exchange Transaction Gains/Losses

 

We incurred foreign currency transaction exchange losses of $68,000 and $437,000 for the three month periods ended March 31, 2010, and 2009, respectively. These amounts are included in “Other income (expense), net” on the condensed consolidated statements of operations.

 

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Table of Contents

 

Note 12. Income Taxes

 

In July 2006, the Financial Accounting Standards Board (“FASB”) issued ASC topic 740, Income Taxes (“ASC 740”). ASC 740 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with ASC 740. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740 also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure, and transition. We adopted ASC 740 effective January 1, 2007. We recognize interest and penalties related to uncertain tax positions in income tax expense. As of March 31, 2010, we do not have any gross unrecognized tax benefits, nor any accrued interest and penalties related to uncertain tax positions. As a result of the implementation of ASC 740, we identified $16.4 million in the liability for unrecognized tax benefits. Of this amount, none was accounted for as a reduction to the January 1, 2007 balance of retained earnings. The amount decreased the tax loss carryforwards in the U.S. which are fully offset by a valuation allowance. We file income tax returns in the U.S. federal, various states and foreign jurisdictions. We have substantially concluded all U.S. federal and state income tax matters through December 31, 2008.

 

Note 13. Recent Accounting Pronouncements

 

With the exception of those stated below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the three months ended March 31, 2010, as compared to the recent accounting pronouncements described in the Annual Report that are of material significance, or have potential material significance, to the Company.

 

Effective April 1, 2009, the Company adopted the Financial Accounting Standards Board’s (“FASB’s”) updated guidance Accounting Standards Update (ASU) topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The updated guidance initially required the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date — that is, whether that date represents the date the financial statements were issued or were available to be issued. However, in February 2010, the FASB amended the guidance to remove the requirement to disclose the date through which subsequent events were evaluated. Adoption of the updated guidance did not have a material impact on the Company’s consolidated results of operations or financial condition.

 

In October 2009, the FASB issued ASU No. 2009-13, “Multiple-Deliverable Revenue Arrangements a Consensus of the FASB Emerging Issues Task Force” an update to Accounting Standards Codification (ASC) Topic 605, “Revenue Recognition.”  This update requires the allocation of consideration among separately identified deliverables contained within an arrangement, based on their related selling prices.  This update will be effective for annual reporting periods beginning January 1, 2011.  The Company is currently evaluating the impact of this update on its financial position, results of operations, cash flows, and disclosures.

 

In January 2010, the FASB issued ASU No. 2010-06, “Improving Disclosures about Fair Value Measurements” an update to ASC Topic 820, “Fair Value Measurements and Disclosures.” This update requires an entity to: (i) disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers and (ii) present separate information for Level 3 activity pertaining to gross purchases, sales, issuances, and settlements.  This update became effective for us in the quarter ended March 31, 2010, except that the disclosure on the roll forward activities for Level 3 fair value measurements will become effective for us with the reporting period beginning January 1, 2011. Other than requiring additional disclosures, adoption of this new guidance did not have a material impact on the Company’s financial statements.

 

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Table of Contents

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This quarterly report on Form 10-Q, including the following sections, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, particularly statements relating to our expectations regarding results of operations, customer demand, our ability to expand our markets and increase sales, customer qualifications of our products, gross margins, reliable supply and enhanced sourcing lead-times of raw materials, our reserve balances, our expected savings from our workforce reduction, the impact of the adoption of certain accounting pronouncements, our investments in capital projects, and our belief that we have adequate cash and investments to meet our needs over the next 12 months. 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 in such forward-looking statements. Such risks and uncertainties include those set forth under the section entitled “Risk Factors” below, which identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certain risk factors identified in this Form 10-Q and other filings we have made with the Securities and Exchange Commission. 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, 2009 and the condensed consolidated financial statements included elsewhere in this report.

 

Overview

 

We are a leading worldwide developer and producer of high-performance compound and single element semiconductor substrates comprising gallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge). We currently sell the following substrate products in the sizes and for the applications indicated:

 

Product

 

 

Substrates

 

Diameter

 

Applications

GaAs (semi-insulating)

 

2”, 3”, 4”, 5”, 6”

 

·  Power amplifiers and radio frequency integrated circuits for wireless handsets (cell phones)

 

 

 

 

·  Direct broadcast television

 

 

 

 

·  High-performance transistors

 

 

 

 

·  Satellite communications

 

 

 

 

 

GaAs (semi-conducting)

 

2”, 3”, 4”

 

·  High brightness light emitting diodes

 

 

 

 

·  Lasers

 

 

 

 

·  Optical couplers

 

 

 

 

 

InP

 

2”, 3”, 4”

 

·  Broadband and fiber optic communications

 

 

 

 

 

Ge

 

2”, 4”

 

·  Satellite and terrestrial solar cells

 

 

 

 

·  Optical applications

 

We manufacture all of our semiconductor substrates using our proprietary vertical gradient freeze (VGF) technology. Most of our revenue is from sales of GaAs substrates. We manufacture all of our products in the People’s Republic of China (PRC or China), which generally has favorable costs for facilities and labor compared to comparable facilities in the United States or Europe. We also have three majority-owned and two minority-owned joint ventures in China which provide us favorable pricing, reliable supply and enhanced sourcing lead-times for key raw materials which are central to our final manufactured products. These joint ventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles and boron oxide. AXT’s ownership interest in these entities ranges from 25% to 83%. We consolidate the three ventures in which we own a majority or controlling financial interest and employ equity accounting for the two joint ventures in which we have a 25% interest. We purchase portions of the materials produced by these ventures for our own use and the joint ventures sell the remainder of their production to third parties. We use our direct sales force in the United States and independent sales representatives in Europe and Asia to market our substrates. We believe that, as the demand for compound semiconductor substrates is expected to increase, we are positioned to leverage our PRC-based manufacturing capabilities and access to favorably priced raw materials to increase our market share.

 

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While the volatile business and financial markets are prompting us to continue to take a conservative approach to our business, we remain optimistic about our business. Positive industry trends in the first quarter of 2010, coupled with our competitive manufacturing and cost advantages give us confidence in our ability to continue to drive future business in 2010. Following very challenging industry conditions in the first half of 2009, we began to see stronger sales and improved gross margins in the second half of 2009. Our qualification efforts in both gallium arsenide and germanium substrates have been successful and we are pleased with our increasing diversification in these areas.

 

As of March 31, 2010, our principal sources of liquidity were $39.3 million in cash and cash equivalents and short-term investments. This increased by $3.9 million compared to cash and cash equivalents and short-term investments of $35.4 million at December 31, 2009.

 

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 revenue recognition. Our products are typically sold pursuant to a purchase order placed by our customers, and our terms and conditions of sale do not require customer acceptance. We recognize revenue upon shipment and transfer of title of products to our customers, which is either upon shipment from our dock, receipt at the customer’s dock, or removal from consignment inventory at the customer’s location, provided that we have received a signed purchase order, the price is fixed or determinable, title and risk of ownership have transferred, collection of resulting receivables is probable, and product returns are reasonably estimable. We do not provide training, installation or commissioning services. Additionally, we may provide discounts or other incentives to customers in order to secure business.

 

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

 

Accounts Receivable and Allowance for Doubtful Accounts

 

We periodically review the likelihood of collection on our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We provide a 100% allowance for receivables from U.S. customers in excess of 90 days and for receivables from customers located outside the U.S. 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 creditworthiness.

 

As of March 31, 2010 and December 31, 2009, our accounts receivable, net, balance was $15.2 million and $15.4 million, respectively, which was net of an allowance for doubtful accounts of $0.2 million and $0.2 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.

 

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The allowance for sales returns is also deducted from gross accounts receivable. As of March 31, 2010 and December 31, 2009, our allowance for sales returns was $0.8 million and $0.9 million, respectively.

 

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 March 31, 2010 and December 31, 2009, accrued product warranties totaled $1.1 million and $1.1 million, respectively. 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 we provide a valuation allowance for certain inventories based upon the age and quality of the product and the projections for sale of the completed products. As of March 31, 2010 and December 31, 2009, we had an inventory reserve of $9.9 million and $10.1 million, respectively, for excess and obsolete inventory. The majority of this inventory has not been scrapped, and accordingly, may be sold in future periods. 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 ASC topic 320, 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.

 

In addition to our five joint ventures, we have in the past invested 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.

 

Fair Value of Investments

 

In the current market environment, the assessment of the fair value of debt instruments can be difficult and subjective. The volume of trading activity of certain debt instruments has declined, and the rapid changes occurring in today’s financial markets can lead to changes in the fair value of financial instruments in relatively short periods of time. ASC 820 establishes three levels of inputs that may be used to measure fair value.

 

Level 1 instruments represent quoted prices in active markets. Therefore, determining fair value for Level 1 instruments does not require significant management judgment, and the estimation is not difficult. Level 2 instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments, including:

 

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·                  Determining which instruments are most similar to the instrument being priced requires management to identify a sample of similar securities based on the coupon rates, maturity, issuer, credit rating, and instrument type, and subjectively select an individual security or multiple securities that are deemed most similar to the security being priced.

 

·                  Determining whether a market is considered active requires management judgment. Our assessment of an active market for our marketable debt instruments generally takes into consideration activity during each week of the one-month period prior to the valuation date of each individual instrument, including the number of days each individual instrument trades and the average weekly trading volume in relation to the total outstanding amount of the issued instrument.

 

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

 

Level 3 instruments include unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities. The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. As of March 31, 2010, we did not have any assets or liabilities without observable market values that would require a high level of judgment to determine fair value (Level 3 assets).

 

Impairment of Long-Lived Assets

 

We evaluate the recoverability of property, equipment and intangible assets in accordance with ASC topic 360, Impairment of 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 these 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 assets’ fair value. Fair values are determined based on quoted market values, discounted cash flows or internal and external appraisals, as applicable. Assets held for sale are carried at the lower of carrying value or estimated net realizable value.

 

Employee Stock Options

 

We grant options to substantially all management employees and believe that this program helps us to attract, motivate and retain high quality employees, to the ultimate benefit of our stockholders. Effective January 1, 2006, we adopted the fair value recognition provisions of ASC 718, using the modified prospective application transition method. Under this transition method, stock-based compensation cost was recognized in the condensed consolidated financial statements for all share-based payments after January 1, 2006. Compensation cost recognized includes the estimated expense for the portion of the vesting period after January 1, 2006 for share-based payments prior to, but not vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of ASC 718. We recognize these compensation costs net of an estimated forfeiture rate over the requisite service period of the award, which is generally the vesting term of four years for stock options. Results for prior periods have not been restated, as provided for under the modified prospective application transition method.

 

Income Taxes

 

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

 

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

 

Effective January 1, 2007, we adopted ASC 740. See Note 12—“Income Taxes” in the notes to condensed financial statements for additional information.

 

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Table of Contents

 

Results of Operations

 

Revenue

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

 

 

($ in thousands)

 

 

 

 

 

GaAs

 

$

13,434

 

$

5,012

 

$

8,422

 

168.0

%

InP

 

875

 

490

 

385

 

78.6

%

Ge

 

1,640

 

622

 

1,018

 

163.7

%

Raw materials

 

2,692

 

1,530

 

1,162

 

75.9

%

Total revenue

 

$

18,641

 

$

7,654

 

$

10,987

 

143.5

%

 

Revenue increased $11.0 million, or 143.5%, to $18.6 million for the three months ended March 31, 2010 from $7.7 million for the three months ended March 31, 2009. Total GaAs substrate revenue increased $8.4 million, or 168.0%, to $13.4 million for the three months ended March 31, 2010 from $5.0 million for the three months ended March 31, 2009. The increase in revenue was primarily due to the stronger demand environment compared to the prior year, particularly for our GaAs product.

 

Sales of 5 inch and 6 inch diameter GaAs substrates were $5.3 million for the three months ended March 31, 2010 compared to $1.2 million for the three months ended March 31, 2009.

 

Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates were $8.1 million for the three months ended March 31, 2010 compared with $3.7 million for the three months ended March 31, 2009. The increase in revenue from smaller diameter substrates was due to the stronger demand environment compared to the worldwide economic slowdown we experienced in the prior year.

 

InP substrate revenue increased $385,000, or 78.6%, to $875,000 for the three months ended March 31, 2010 from $490,000 for the three months ended March 31, 2009 as demand from customers in the optical networking industry has increased.

 

Ge substrate revenue increased $1.0 million, or 163.7%, to $1.6 million for the three months ended March 31, 2010 from $0.6 million for the three months ended March 31, 2009. This increase came from our new European customer for germanium substrates that we did not have in the first quarter of 2009, as well as from an increase in overall demand for concentrated photovoltaic applications from our other Ge customers.

 

Raw materials revenue increased $1.2 million, or 75.9%, to $2.7 million for the three months ended March 31, 2010 from $1.5 million for the three months ended March 31, 2009. The increase in raw materials revenue was primarily due to the recovery in demand for 4N gallium.

 

Revenue by Geographic Region

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

North America *

 

$

4,531

 

$

1,736

 

$

2,795

 

161.0

%

% of total revenue

 

24

%

23

%

 

 

 

 

Europe

 

3,768

 

2,213

 

1,555

 

70.3

%

% of total revenue

 

20

%

29

%

 

 

 

 

Japan

 

2,778

 

1,152

 

1,626

 

141.1

%

% of total revenue

 

15

%

15

%

 

 

 

 

Taiwan

 

2,582

 

689

 

1,893

 

274.7

%

% of total revenue

 

14

%

9

%

 

 

 

 

Asia Pacific (excluding Japan and Taiwan)

 

4,982

 

1,864

 

3,118

 

167.3

%

% of total revenue

 

27

%

24

%

 

 

 

 

Total revenue

 

$

18,641

 

$

7,654

 

$

10,987

 

143.5

%

 


*Primarily the United States

 

Revenue from customers in North America increased by $2.8 million, or 161.0%, to $4.5 million for the three months ended March 31, 2010 from $1.7 million for the three months ended March 31, 2009 as the demand for substrates and for raw materials increased due to the stronger demand environment compared to the economic slowdown we experienced in the prior year.

 

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Revenue from customers in Europe increased by $1.6 million, or 70.3%, to $3.8 million for the three months ended March 31, 2010 from $2.2 million for the three months ended March 31, 2009. This increase came primarily from increased substrate sales to customers in Germany and to customers in France. In Germany, in the first quarter of 2010, we have a new customer for germanium substrates that we did not have in the first quarter of 2009.

 

Revenue from customers in Japan increased by $1.6 million, or 141.1%, to $2.8 million for the three months ended March 31, 2010 from $1.2 million for the three months ended March 31, 2009. The increase came primarily from increased substrate sales to major existing customers, in both small and large diameter wafers, and to a lesser extent increased raw material sales of 4N gallium to existing customers.

 

Revenue from customers in Taiwan increased by $1.9 million, or 274.7%, to $2.6 million for the three months ended March 31, 2010 from $0.7 million for the three months ended March 31, 2009. The increase came mainly from increased sales to five major customers as the demand for GaAs substrates in all sizes and for 4” germanium substrates increased due to the stronger demand environment compared to the economic slowdown we experienced in the prior year.

 

Revenue from customers in Asia Pacific (excluding Japan and Taiwan) increased by $3.1 million, or 167.3%, to $5.0 million for the three months ended March 31, 2010 from $1.9 million for the three months ended March 31, 2009. The increase came from several customers in China for both substrates and for raw materials, and from one major customer in Singapore who is part of the IQE group.

 

Gross Margin

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

Gross profit (loss)

 

$

6,732

 

$

(237

$

6,969

 

2,940.5

%

Gross Margin %

 

36.1

%

(3.1

)%

 

 

 

 

 

Gross margin increased to 36.1% of total revenue for the three months ended March 31, 2010 from negative 3.1% of total revenue for the three months ended March 31, 2009. Sales product mix, and process improvements in production such as longer ingots and first pass yield improvements in ingots contributed to higher gross profit for the three months ended March 31, 2010. During the three months ended March 31, 2010, our manufacturing facility in Beijing was operating at a higher utilization capacity compared to the same period in the prior year, which resulted in higher absorption rates. The negative 3.1 percent gross margin for the three months ended March 31, 2009 was primarily due to the low absorption rates as a result of reduced sales from the fourth quarter of 2008, and hence lower production volume.

 

Selling, General and Administrative Expenses

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

Selling, general and administrative expenses

 

$

3,419

 

$

4,006

 

$

(587

)

(14.7

)%

% of total revenue

 

18.3

%

52.3

%

 

 

 

 

 

Selling, general and administrative expenses decreased $0.6 million to $3.4 million for the three months ended March 31, 2010 from $4.0 million for the three months ended March 31, 2009. The $0.6 million decrease was from $0.5 million reduced legal fees, since in the prior year we had higher legal fees as a result of matters relating to the change in management in March 2009, in addition to $0.3 million in severance pay for our former chief executive officer, $0.3 million in related stock compensation expense for his stock option acceleration, and $0.1 million for a chief executive search fee. This was partially offset by a $0.4 million increase in the allowance for doubtful accounts and from a $0.2 million increase in sales commissions.

 

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Research and Development

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

Research and development

 

$

451

 

$

460

 

$

(9

)

(2.0

)%

% of total revenue

 

2.4

%

6.0

%

 

 

 

 

 

Research and development expenses decreased $9,000, or 2.0% to $451,000 for the three months ended March 31, 2010 from $460,000 for the three months ended March 31, 2009. The decrease was primarily due to $49,000 less labor costs mostly as a result of our restructuring in March 2009, partially offset by $40,000 higher new products testing costs.

 

Restructuring Charge

 

 

 

Three Months Ended 
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

Restructuring charge

 

$

 

$

507

 

$

(507

)

NM

 

% of total revenue

 

0.0

%

6.6

%

 

 

 

 

 

NM = % not meaningful

 

During the first quarter of 2009, we further reduced the workforce at our Fremont and Beijing facilities by approximately 11 positions that were no longer required to support certain production and administrative operations. This measure was being taken as part of our 2009 operating plan. Accordingly, we recorded a restructuring charge of $507,000 in March 2009 related to the reduction in force for severance-related expenses from the reduction in force, all of which were cash expenditures incurred in the second quarter of 2009. We expect to save approximately $1.3 million annually in payroll and related expenses. We had no restructuring charge for the first quarter of 2010.

 

Interest Income, net

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

Interest income, net

 

$

15

 

$

44

 

$

(29

)

(65.9

)%

% of total revenue

 

0.1

%

0.6

%

 

 

 

 

 

Interest income, net decreased $29,000 to $15,000 for the three months ended March 31, 2010 from $44,000 for the three months ended March 31, 2009. Interest income, net for the three months ended March 31, 2009 was higher since we had $59,000 of interest income on investment notes that matured, partially offset by $15,000 interest expense on our line of credit and tenant improvement loan. Interest income, net for the three months ended March 31, 2010 was lower as we did not have accrued interest on any notes maturing this quarter.

 

Other Income (Loss), net

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

Other income (loss), net

 

$

79

 

$

(422

$

501

 

(118.7

)%

% of total revenue

 

0.4

%

(5.5

)%

 

 

 

 

 

Other income, net was $79,000 for the three months ended March 31, 2010 primarily due a realized gain of $120,000 on the sale of short-term investments held by us, and $39,000, net, miscellaneous items, partially offset by unrealized foreign exchange losses of $80,000 on our Yen denominated accounts receivable and miscellaneous items. Other loss, net was $422,000 for the three months ended March 31, 2009 primarily due to unrealized foreign exchange losses of $409,000 on our Yen denominated accounts receivable, and $13,000, net, miscellaneous items.

 

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Provision for Income Taxes

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

Provision for income taxes

 

$

246

 

$

4

 

$

242

 

6050.0

% of total revenue

 

1.3

%

0.0

%

 

 

 

 

 

We provided for income taxes of $246,000 for our China operations for the three months ended March 31, 2010 compared to $4,000 for the three months ended March 31, 2009. The increase in tax provision was primarily due to increased sales and increased net income in the first quarter of 2010 compared to the our overall loss position for the same period last year.

 

Noncontrolling interest

 

 

 

Three Months Ended
March 31,

 

Increase

 

 

 

 

 

2010

 

2009

 

(Decrease)

 

% Change

 

 

 

($ in thousands)

 

 

 

 

 

Noncontrolling interest

 

$

(130

$

76

 

$

(206

(271.1

)%

% of total revenue

 

(0.7

)%

1.0

%

 

 

 

 

 

Net income (loss) attributable to noncontrolling interest changed $206,000 or 271.1% to an expense of $130,000 for the three months ended March 31, 2010 from a contribution of $76,000 for the three months ended March 31, 2009 as a result of higher profitability from our China joint venture operations as raw materials sales have increased due to increased demand compared to the same period last year.

 

Liquidity and Capital Resources

 

As of March 31, 2010, our principal sources of liquidity were $39.3 million in cash and cash equivalents and short-term investments. We consider cash and cash equivalents and short-term investments as liquid and available for use. Short-term investments are comprised of government bonds and high-grade commercial debt instruments. Approximately $12.3 million of our short-term investments in corporate bonds (see Note 3 to our condensed consolidated financial statements) are invested in Citigroup guaranteed instruments.

 

Cash and cash equivalents and short-term investments of $39.3 million increased by $3.9 million in the first quarter of 2010 compared to the fourth quarter of 2009.

 

Net cash provided by operating activities of $4.2 million for the three months ended March 31, 2010 was primarily comprised of our net income of $2.7 million, adjusted for non-cash items of depreciation of $0.8 million, stock-based compensation of $0.1 million, a net decrease of $0.7 million in assets and liabilities partially offset by a gain on sale of investments of $0.1 million. The $0.7 million net decrease in assets and liabilities primarily resulted from a $1.4 million increase in accounts payable, a $0.3 million increase in accrued liabilities, and a $0.2 million increase in accounts receivable, partially offset by a $0.7 million increase in prepaid expenses, and a $0.5 million increase in inventory.

 

Accounts receivable, net increased by $0.2 million as of March 31, 2010 compared to December 31, 2009 due to higher sales volume, which was offset by improved collections. Our days sales outstanding (DSO) is 73 days as of March 31, 2010 and was 79 days as of December 31, 2009.

 

Inventories, net, increased by $0.5 million as of March 31, 2010 compared to Decemeber 31, 2009, as raw materials increased by $1.0 million due to timing of purchases, and we decreased work-in-process and finished goods by $0.5 million due to sales.

 

Net cash used in operating activities of $1.9 million for the three months ended March 31, 2009 was primarily comprised of our net loss of $5.5 million, adjusted for non-cash items of depreciation of $0.8 million, stock-based compensation of $0.5 million, and a non-cash restructuring charge of $0.5 million, partially offset by a net decrease of $1.8 million in assets and liabilities. The $1.8 million net decrease in assets and liabilities primarily resulted from a $3.1 million decrease in accounts receivable, a $1.6 million decrease in inventories, and a $0.8 million decrease in prepaids and other assets, partially offset by a $2.5 million decrease in accounts payable, a $0.7 million decrease in other long-term liabilities, primarily minority interests, and a $0.5 million decrease in accrued liabilities.

 

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Accounts receivable, net decreased by $3.1 million as of March 31, 2009 due to the weaker demand environment which resulted in lower sales volume.

 

Inventories, net, decreased by $1.6 million as of March 31, 2009 as we decreased inventory in work-in-process and finished goods by $2.1 million and shipped these out as sales, partially offset by a $0.5 million increase in raw materials as demand for raw material fell.

 

Net cash used in investing activities of $0.5 million for the three months ended March 31, 2010 was primarily from the purchase of property, plant and equipment of $0.3 million and partially offset by the net purchases of marketable securities of $0.2 million.

 

Net cash used in investing activities of $0.1 million for the three months ended March 31, 2009 was primarily from the purchase of property, plant and equipment of $0.1 million.

 

We expect to invest up to approximately $8.7 million in capital projects at our China facilities for the remainder of 2010, having delayed certain expansion activities as a result of the impact of the 2009 worldwide economic conditions.

 

Net cash used in financing activities of $78,000 for the three months ended March 31, 2010 consisted of $192,000 dividends paid, and payments of $18,000 related to our tenant improvement loan, partially offset by net proceeds of $132,000 on the issuance of common stock.

 

Net cash used in financing activities of $30,000 for the three months ended March 31, 2009 consisted of payments of $30,000 related to our tenant improvement loan.

 

We believe that we have adequate cash and investments to meet our needs over the next 12 months. If our sales decrease, however, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity, require us to use cash at a more rapid rate than expected, and require us to seek additional capital. There can be no assurance that such additional capital will be available or, if available it will be at terms acceptable to us. Cash from operations could be affected by various risks and uncertainties, including, but not limited to those set forth below under Item 1A “Risks Factors.”

 

Outstanding contractual obligations as of March 31, 2010 are summarized as follows (in thousands):

 

 

 

Payments due by period

 

Contractual Obligations

 

Total

 

Less than 1 year

 

1-3
years

 

3-5
years

 

More than
5 years

 

Tenant improvement loan

 

$

478

 

$

77

 

$

161

 

$

174

 

$

66

 

Operating leases

 

1,663

 

307

 

554

 

594

 

208

 

Total

 

$

2,141

 

$

384

 

$

715

 

$

768

 

$

274

 

 

We lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through November 2013. On July 2, 2008, we entered into a new lease agreement with the landlord of the facility at 4281 Technology Drive, Fremont, California with approximately 27,760 square feet. The new lease commenced December 1, 2008 for a term of seven years, with an option by us to cancel the new lease after five years, upon forfeiture of the security deposit and payment of one-half of the fifth year’s rent. Total rent expenses under these operating leases were approximately $0.1 million and $0.1 million for the three months ended March 31, 2010 and 2009, respectively.

 

Recent Accounting Pronouncements

 

With the exception of those stated below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the three months ended March 31, 2010, as compared to the recent accounting pronouncements described in the Annual Report that are of material significance, or have potential material significance, to the Company.

 

Effective April 1, 2009, the Company adopted the Financial Accounting Standards Board’s (“FASB’s”) updated guidance Accounting Standards Update (ASU) topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The updated guidance initially required the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date — that is, whether that date represents the date the financial statements were issued or were available to be issued. However,

 

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in February 2010, the FASB amended the guidance to remove the requirement to disclose the date through which subsequent events were evaluated. Adoption of the updated guidance did not have a material impact on the Company’s consolidated results of operations or financial condition.

 

In October 2009, the FASB issued ASU No. 2009-13, “Multiple-Deliverable Revenue Arrangements a Consensus of the FASB Emerging Issues Task Force” an update to Accounting Standards Codification (ASC) Topic 605, “Revenue Recognition.”  This update requires the allocation of consideration among separately identified deliverables contained within an arrangement, based on their related selling prices.  This update will be effective for annual reporting periods beginning January 1, 2011.  The Company is currently evaluating the impact of this update on its financial position, results of operations, cash flows, and disclosures.

 

In January 2010, the FASB issued ASU No. 2010-06, “Improving Disclosures about Fair Value Measurements” an update to ASC Topic 820, “Fair Value Measurements and Disclosures.” This update requires an entity to: (i) disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers and (ii) present separate information for Level 3 activity pertaining to gross purchases, sales, issuances, and settlements.  This update became effective for us in the quarter ended March 31, 2010, except that the disclosure on the roll forward activities for Level 3 fair value measurements will become effective for us with the reporting period beginning January 1, 2011. Other than requiring additional disclosures, adoption of this new guidance did not have a material impact on the Company’s financial statements.

 

In various areas, including revenue recognition, stock option accounting, accounting standards and practices continue to evolve. Additionally, the SEC and the FASB’s Emerging Issues Task Force continue to address revenues, stock option accounting related accounting issues. We believe that we are in compliance with all of the rules and related guidance as they currently exist. However, any changes to accounting principles generally accepted in the United States of America in these areas could impact the future accounting of our operations.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Foreign Currency Risk

 

A significant portion of our business is conducted in currencies other than the U.S. dollar. The functional currency for our foreign operations is the renminbi, the local currency of China, where our operating expenses are predominantly in the local currency. Since most of our operations are conducted in China, most of our costs are incurred in Chinese currency, which subjects us to fluctuations in the exchange rates between the U.S. dollar and the Chinese renminbi. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for these subsidiaries, as well as in translation of the assets and liabilities of these assets at each balance sheet date. These risks may be increased by the fluctuations and revaluations of the Chinese renminbi. Our financial results could be adversely affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets, including the revaluation by China of the renminbi, and any future adjustments that China may make to its currency such as any move it might make to a managed float systems with opportunistic interventions. In the future we may experience foreign exchange losses on our non-functional currency denominated receivables and payables to the extent that we have not mitigated our exposure utilizing foreign currency forward exchange contracts. Foreign exchange losses could have a materially adverse effect on our operating results and cash flows.

 

We do not currently use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. We had previously 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 was recognized as part of the related foreign currency transactions as they occur. As of March 31, 2010, we had no outstanding commitments with respect to foreign exchange contracts.

 

During the first quarter of 2010, we recorded a net realized foreign exchange gain of $12,000, included as part of other income in our consolidated statements of operations. We incurred foreign currency transaction exchange gains and losses due to operations in general. It is uncertain whether these currency trends will continue. In the future we may experience foreign exchange losses on our non-functional currency denominated receivables and payables to the extent that we have not mitigated our exposure utilizing foreign currency forward exchange contracts. Foreign exchange losses could have a materially adverse effect on our operating results and cash flows. During the first quarter of 2010, we recorded unrealized foreign currency loss of $80,000, included in the balance of accumulated other comprehensive income on our consolidated balance sheet.

 

In July 2005, China agreed to a shift in Chinese currency policy. It established a 2% revaluation of the renminbi and referenced the renminbi to a basket of currencies, with a daily trading band of +/-0.3%. Depending on market conditions and the state of the Chinese economy, it is possible that China will make more adjustments in the future. Over the next five to ten years, China may move to a

 

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managed float system, with opportunistic interventions. This reserve diversification may negatively impact the United States dollar and U.S. interest rates, which, in turn, could negatively impact our operating results and financial condition. The functional currency of our Chinese subsidiary, including our joint ventures, is the local currency; since most of our operations are conducted in China, most of our costs are incurred in Chinese currency, which subjects us to fluctuations in the exchange rates between the U.S. dollar and the Chinese renminbi. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for these subsidiaries, as well as in translation of the assets and liabilities of these assets at each balance sheet date. These risks may be increased by the fluctuation and revaluation of the Chinese renminbi. If we do not effectively manage the risks associated with this currency risk, our revenue, cash flows and financial condition could be adversely affected.

 

Interest Rate Risk

 

Cash and cash equivalents earning interest and certain variable rate debt instruments are subject to interest rate fluctuations. The following table sets forth the probable impact of a 10% change in interest rates (in thousands):

 

Instrument

 

Balance as of
March 31,
2010

 

Current
Interest
Rate

 

Projected Annual
Interest
Income/(Expense)

 

Proforma 10%
Interest Rate
Decline
Income/(Expense)

 

Proforma 10%
Interest Rate
Increase
Income/(Expense)

 

Cash

 

$

20,520

 

0.50

%

$

103

 

$

92

 

$

113

 

Cash equivalents

 

87

 

2.15

 

2

 

2

 

2

 

Investment in debt and equity instruments

 

18,734

 

2.39

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