SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-Q

(Mark One)

☒

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

for the quarterly period ended June 30, 2015

Or

☐

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

for the transition period from                 to

Commission File Number 000-24085

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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)

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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 ☒ No ☐

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 ☒ No ☐

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 ☐	Accelerated filer ☒
Non-accelerated filer ☐	Smaller reporting company ☐
(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 ☐ NO ☒

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 August 3, 2015
Common Stock, $0.001 par value		32,631,249

 

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AXT, INC.

FORM 10-Q

TABLE OF CONTENTS

	Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)	3
Condensed Consolidated Balance Sheets as of June 30, 2015 and December 31, 2014	3
Condensed Consolidated Statements of Operations for the three months and six months ended June 30, 2015 and 2014	4
Condensed Consolidated Statements of Comprehensive Income (Loss) for the three months and six months ended June 30, 2015 and 2014	5
Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2015 and 2014	6
Notes To Condensed Consolidated Financial Statements	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 3. Quantitative and Qualitative Disclosures About Market Risk	32
Item 4. Controls and Procedures	34
PART II. OTHER INFORMATION
Item 1. Legal Proceedings	35
Item 1A. Risk Factors	35
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	49
Item 3. Defaults Upon Senior Securities	50
Item 4. Mine Safety Disclosures	50
Item 5. Other Information	50
Item 6. Exhibits	50
Signatures	51

 

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

AXT, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share data)

		June 30,				December 31,
		2015				2014
ASSETS
Current assets:
Cash and cash equivalents		$	28,640			$	28,814
Short-term investments			3,932				12,340
Accounts receivable, net of allowances of $1,041 and $823 as of June 30, 2015 and December 31, 2014			19,312				17,864
Inventories			38,901				38,574
Related party notes receivable - current			174				171
Prepaid expenses and other current assets			3,481				5,430
Total current assets			94,440				103,193
Long-term investments			13,699				7,783
Property, plant and equipment, net			33,366				33,862
Related party notes receivable – long-term			1,711				1,704
Other assets			15,000				14,975
Total assets		$	158,216			$	161,517
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	7,323			$	7,137
Accrued liabilities			6,043				7,634
Total current liabilities			13,366				14,771
Long-term portion of royalty payments			1,438				1,725
Other long-term liabilities			332				333
Total liabilities			15,136				16,829
Commitments and contingencies (Note 11)
Stockholders’ equity:
Preferred stock, $0.001 par value; 2,000 shares authorized; 883 shares issued and outstanding as of June 30, 2015 and December 31, 2014 (Liquidation preference of $6.4 million and $6.3 million as of June 30, 2015 and December 31, 2014.)			3,532				3,532
Common stock, $0.001 par value; 70,000 shares authorized; 32,631 and 32,837 shares issued and outstanding as of June 30, 2015 and December 31, 2014.			32				32
Additional paid-in-capital			194,714				195,419
Accumulated deficit			(69,420	)			(68,393	)
Accumulated other comprehensive income			7,586				7,673
Total AXT, Inc. stockholders’ equity			136,444				138,263
Noncontrolling interests			6,636				6,425
Total stockholders’ equity			143,080				144,688
Total liabilities and stockholders’ equity		$	158,216			$	161,517

See accompanying notes to condensed consolidated financial statements.

 

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share data)

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2015				2014				2015				2014
Revenue		$	21,010			$	21,449			$	41,074			$	40,794
Cost of revenue			16,625				17,289				31,940				33,916
Gross profit			4,385				4,160				9,134				6,878
Operating expenses:
Selling, general and administrative			3,775				3,688				9,026				7,124
Research and development			1,389				987				2,630				1,762
Restructuring charge			—				—				—				907
Total operating expenses			5,164				4,675				11,656				9,793
Loss from operations			(779	)			(515	)			(2,522	)			(2,915	)
Interest income, net			108				127				205				254
Equity in earnings of unconsolidated joint ventures			410				625				610				1,112
Other income, net			626				476				1,259				486
Income (loss) before provision for income taxes			365				713				(448	)			(1,063	)
Provision for income taxes			241				152				327				211
Net income (loss)			124				561				(775	)			(1,274	)
Less: Net income attributable to noncontrolling interests			(127	)			(242	)			(252	)			(447	)
Net income (loss) attributable to AXT, Inc.		$	(3	)		$	319			$	(1,027	)		$	(1,721	)
Net income (loss) attributable to AXT, Inc. per common share:
Basic		$	(0.00	)		$	0.01			$	(0.03	)		$	(0.06	)
Diluted		$	(0.00	)		$	0.01			$	(0.03	)		$	(0.06	)
Weighted average number of common shares outstanding:
Basic			32,242				32,381				32,399				32,407
Diluted			32,242				32,597				32,399				32,407

 

See accompanying notes to condensed consolidated financial statements.

 

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited, in thousands)

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2015				2014				2015				2014
Net income (loss)		$	124			$	561			$	(775	)		$	(1,274	)
Other comprehensive income (loss), net of tax:
Change in foreign currency translation gain (loss), net of tax			67				81				305				(440	)
Change in unrealized gain (loss) on available-for-sale investments, net of tax			(91	)			149				(350	)			139
Total other comprehensive income (loss), net of tax			(24	)			230				(45	)			(301	)
Comprehensive income (loss)			100				791				(820	)			(1,575	)
Less: Comprehensive income attributable to the noncontrolling interest			(137	)			(251	)			(294	)			(377	)
Comprehensive income (loss) attributable to AXT, Inc.		$	(37	)		$	540			$	(1,114	)		$	(1,952	)

 

See accompanying notes to condensed consolidated financial statements.

 

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 

		Six Months Ended
		June 30,
		2015				2014
Cash flows from operating activities:
Net loss		$	(775	)		$	(1,274	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization			2,808				2,819
Amortization of marketable securities premium			113				245
Stock-based compensation			740				589
Provision for doubtful accounts			211				9
Realized gain on sale of investments			(859	)			—
Loss (gain) on disposal of property, plant and equipment			9				(10	)
Loss (gain) on equity investments, net			(610	)			(1,112	)
Changes in assets and liabilities:
Accounts receivable, net			(1,630	)			(4,396	)
Inventories			(262	)			3,783
Prepaid expenses and other current assets			1,954				3,300
Other assets			258				386
Accounts payable			166				(1,500	)
Accrued liabilities			(1,602	)*			148	*
Other long-term liabilities			(269	)			(407	)
Net cash provided by operating activities			252				2,580
Cash flows from investing activities:
Purchases of property, plant and equipment			(2,174	)			(600	)
Proceeds from sales of property, plant and equipment			2				10
Purchases of available-for-sale securities			(8,664	)			(3,728	)
Proceeds from sales and maturities of available-for-sale securities			11,752				2,922
Investments in non-marketable equity investments			(162	)			—
Return of equity method investments			286				327
Net cash provided by (used in) investing activities			1,040				(1,069	)
Cash flows from financing activities:
Proceeds from common stock options exercised			76				6
Repurchases of the Company’s common stock, including commission			(1,521	)			—
Dividends paid by consolidated joint ventures			(80	)			(83	)
Net cash used in financing activities			(1,525	)			(77	)
Effect of exchange rate changes on cash and cash equivalents			59				(88	)
Net increase (decrease) in cash and cash equivalents			(174	)			1,346
Cash and cash equivalents at the beginning of the period			28,814				24,961
Cash and cash equivalents at the end of the period		$	28,640			$	26,307

 

* Dividend accrued but not paid by joint ventures of $566 and $647 was included in accrued liabilities as of June 30, 2015 and June 30, 2014, respectively.

See accompanying notes to condensed consolidated financial statements.

 

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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 2014 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 13, 2015 and our Quarterly Report on Form 10-Q for the three months ended March 31, 2015 filed with the SEC on May 8, 2015.

The consolidated financial statements include the accounts of AXT, our wholly-owned subsidiary, Beijing Tongmei Xtal Technology Co., Ltd., and our majority-owned subsidiaries, Beijing JiYa Semiconductor Material Co., Ltd., Nanjing Jin Mei Gallium Co., Ltd. and Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd. All significant inter‑company accounts and transactions have been eliminated. Investments in business entities in which we do not have control, but have the ability to exercise significant influence over operating and financial policies (generally 20-50% ownership), are accounted for by the equity method. For majority-owned subsidiaries, we reflect the noncontrolling interest of the portion we do not own on our condensed consolidated balance sheets in stockholders’ equity and in our condensed consolidated statements of operations.

 

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Note 2. Investments and Fair Value Measurements

Our cash and cash equivalents consist of cash and instruments with original maturities of less than 90 days. Our investments consist of instruments with original maturities of more than 90 days. As of June 30, 2015 and December 31, 2014, our cash, cash equivalents and investments are classified as follows (in thousands):

 

		June 30, 2015																December 31, 2014
		Amortized Cost				Gross Unrealized Gain				Gross Unrealized (Loss)				Fair Value				Amortized Cost				Gross Unrealized Gain				Gross Unrealized (Loss)				Fair Value
Classified as:
Cash		$	17,337			$	—			$	—			$	17,337			$	22,337			$	—			$	—			$	22,337
Cash equivalents:
Certificates of deposit 1			11,303				—				—				11,303				6,454				—				—				6,454
Money market fund			—				—				—				—				23				—				—				23
Total cash and cash equivalents			28,640				—				—				28,640				28,814				—				—				28,814
Investments (available for sale):
Certificates of deposit 2			8,105				1				(16	)			8,090				10,195				1				(13	)			10,183
Corporate bonds			9,006				—				(40	)			8,966				9,214				1				(29	)			9,186
Corporate equity securities			200				375				—				575				44				710				—				754
Total investments			17,311				376				(56	)			17,631				19,453				712				(42	)			20,123
Total cash, cash equivalents and investments		$	45,951			$	376			$	(56	)		$	46,271			$	48,267			$	712			$	(42	)		$	48,937
Contractual maturities on investments:
Due within 1 year		$	3,560											$	3,932			$	11,631											$	12,340
Due after 1 through 5 years			13,751												13,699				7,822												7,783
		$	17,311												17,631			$	19,453											$	20,123

 

1. Certificate of deposit with original maturities of less than 90 days.

2. Certificate of deposit with original maturities of more than 90 days.

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. Certificates of deposit and corporate bonds are typically held until maturity. Corporate equity securities have no maturity and may be sold at any time. Our holding of corporate equity securities consist of the common stock of Intelligent Epitaxy Technology, Inc. (“IntelliEpi”) and GCS Holdings, Inc. (“GHI”) (previously Global Communication Semiconductors, Inc), both Taiwan publicly-traded companies. We began classifying IntelliEpi stock as an available-for-sale security upon its initial public offering in 2013. During the three months ended June 30, 2015, we sold all of our remaining IntelliEpi stock. From this, our cash proceeds from sales of available-for-sale investments was $515,000. Our cost was $23,000 and our gross realized gain from sales of available-for-sale investments was $492,000. During the six months ended June 30, 2015, our cash proceeds from sales of available-for-sale investments was $902,000. Our cost was $43,000 and our gross realized gain from sales of available-for-sale investments was $859,000. During the three months and six months ended June 30, 2014, our cash proceeds was $346,000, our cost was $22,000 and our gross realized gain was $324,000.

Also included in available-for-sale investments at June 30, 2015 is our investment in the common stock of GHI. We began classifying this asset as an available-for-sale security during the three months ended June 30, 2015 when we determined that there was sufficient trading volume in the exchange for the stock to be deemed readily marketable. An unrealized gain of $375,000 net of tax was recorded as of June 30, 2015. These securities are valued at fair market value at June 30, 2015 and will be marked to market with changes through other comprehensive income until sold. There is no assurance that we will realize this value when the securities are sold in the future.

 

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The gross unrealized losses related to our portfolio of available-for-sale securities were primarily due to changes in interest rates and market and credit conditions of the underlying securities. We have determined that the gross unrealized losses on some of our available-for-sale securities as of June 30, 2015 are temporary in nature. We periodically review 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.

A portion of our investments would generate a loss if we sold them on June 30, 2015. The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of June 30, 2015 (in thousands):

 

As of June 30, 2015		In Loss Position < 12 months								In Loss Position > 12 months								Total In Loss Position
		Fair Value				Gross Unrealized (Losses)				Fair Value				Gross Unrealized (Losses)				Fair Value				Gross Unrealized (Losses)
Investments:
Certificates of deposit		$	6,410			$	(15	)		$	1,199			$	(1	)		$	7,609			$	(16	)
Corporate bonds			8,966				(40	)			—				—				8,966				(40	)
Total in loss position		$	15,376			$	(55	)		$	1,199			$	(1	)		$	16,575			$	(56	)

The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2014 (in thousands):

 

As of December 31, 2014		In Loss Position < 12 months								In Loss Position > 12 months								Total In Loss Position
		Fair Value				Gross Unrealized (Loss)				Fair Value				Gross Unrealized (Loss)				Fair Value				Gross Unrealized (Loss)
Investments:
Certificates of deposit		$	4,492			$	(13	)		$	—			$	—			$	4,492			$	(13	)
Corporate bonds			3,770				(27	)			4,309				(2	)			8,079				(29	)
Total in loss position		$	8,262			$	(40	)		$	4,309			$	(2	)		$	12,571			$	(42	)

 

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 6). The investment balances for all of these companies, including minority investments indirectly in privately-held companies made by our consolidated subsidiaries, accounted for under the equity method are included in “other assets” in the consolidated balance sheets and totaled $12.6 million and $12.1 million as of June 30, 2015 and December 31, 2014, respectively.

As noted above, in June, 2015, we re-classified our minority investment in one company, which was accounted for under the cost method, as available-for- sale short-term investments and written-up to market value. As of June 30, 2015, we no longer maintain any investments under the cost method. As of December 31, 2014, our investments in this unconsolidated company had a carrying value of $200,000 and were included in “other assets” in the condensed consolidated balance sheets.

Fair Value Measurements

ASC topic 820, Fair value measurement (“ASC 820”) establishes three levels of inputs that may be used to measure fair value. Level 1 instrument valuations are obtained from real-time quotes for transactions in active exchange markets of the asset or identical assets. Level 2 instrument valuations are obtained from readily-available pricing sources for comparable instruments. Level 3 instrument valuations are obtained from unobservable inputs in which there is little or no market data, which require us to develop our own assumptions. On a recurring basis, we measure certain financial assets and liabilities at fair value, primarily consisting of our short-term and long-term investments.

 

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The type of instrument valued based on quoted market prices in active markets include our money market funds, which are generally classified within Level 1 of the fair value hierarchy. Other than corporate equity securities which are based on quoted market prices and classified as Level 1, we classify our available-for-sale securities including certificates of deposit, corporate bonds as having Level 2 inputs. The valuation techniques used to measure the fair value of these financial instruments having Level 2 inputs were derived from quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency.

We place short-term foreign currency hedges that are intended to offset the potential cash exposure related to fluctuations in the exchange rate between the United States dollar and Japanese yen. We measure the fair value of these foreign currency hedges at each month end and quarter end using current exchange rates and in accordance with generally accepted accounting principles. At quarter end any foreign currency hedges not settled are netted in “accrued liabilities” on the consolidated balance sheet and classified as Level 3 assets and liabilities. As of June 30, 2015 the net change in fair value from the placement of the hedge to settlement at each month end during the quarter had a de minimis impact to the consolidated results.

There were no changes in valuation techniques or related inputs in the three months ended June 30, 2015. There have been no transfers between fair value measurements levels during the three months ended June 30, 2015.

The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis in accordance with ASC 820 as of June 30, 2015 (in thousands):

		Balance as of June 30, 2015				Quoted Prices in Active Markets of Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets:
Cash equivalents and investments:
Certificates of deposit		$	19,393			$	—			$	19,393			$	—
Corporate bonds			8,966				—				8,966				—
Corporate equity securities			575				575				—				—
Total		$	28,934			$	575			$	28,359			$	—
Liabilities:
Foreign currency hedge obligations		$	29			$	—			$	—			$	29

The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis in accordance with ASC 820 as of December 31, 2014 (in thousands):

		Balance as of December 31, 2014				Quoted Prices in Active Markets of Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets:
Cash equivalents and investments:
Money market fund		$	23			$	23			$	—			$	—
Certificates of deposit			10,183				—				10,183				—
Corporate bonds			9,186				—				9,186				—
Corporate equity securities			754				754				—				—
Total		$	20,146			$	777			$	19,369			$	—
Liabilities		$	—			$	—			$	—			$	—

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 investments in privately-held companies accounted for by equity and cost method (See Note 6). We did not record other-than-temporary impairment charges for either of these investments during the three months ended June 30, 2015 or 2014.

 

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Note 3. Inventories

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

 

		June 30, 2015				December 31, 2014
Inventories:
Raw materials		$	20,549			$	18,990
Work in process			15,847				16,222
Finished goods			2,505				3,362
		$	38,901			$	38,574

 

As of June 30, 2015 and December 31, 2014, carrying values of inventories were net of inventory reserve of $11.4 million and $11.2 million, respectively, for excess and obsolete inventory.

Note 4. Accrued Liabilities

 

The components of accrued liabilities are summarized below (in thousands):

 

		June 30, 2015				December 31, 2014
Accrued compensation and related charges		$	1,694			$	2,656
Current portion of royalty payments			688				800
Accrued product warranty			668				802
Accrued professional services			418				509
Dividends payable by consolidated joint ventures			566				563
Accrued income taxes			279				119
Other accrued liabilities			1,730				2,185
		$	6,043			$	7,634

Note 5. Related Party Transactions

In August 2011, our consolidated joint venture, Beijing JiYa Semiconductor Material Co., Ltd. (“JiYa”), entered into a non-interest bearing note agreement in the amount of $1.7 million for a loan to one of its equity investment entities.  The original term of the loan was for two years and ten months with three periodic principal payments required.  After various amendments to the terms of the note, in December 2013 the parties agreed to delay all principal repayment until December 2016. As of June 30, 2015, and December 31, 2014, we included $1.7 million in “Related party notes receivable – long term” in our condensed consolidated balance sheets.

JiYa also purchases raw materials from one of its equity investment entities for production in the ordinary course of business. As of June 30, 2015 and December 31, 2014, amounts payable of $2.0 million and $1.8 million, respectively, were included in “accounts payable” in our condensed consolidated balance sheets.

JiYa also sells raw materials to one of its equity investment entities for production in the ordinary course of business. As of June 30, 2015 and December 31, 2014, amounts receivable of $518,000 and 350,000, respectively, were included in “accounts receivable” in our condensed consolidated balance sheets.

Beginning in 2012, our consolidated joint venture, Nanjing Jin Mei Gallium Co., Ltd. (“Jin Mei”), is contractually obligated under an agency sales agreement to sell raw material on behalf of its equity investment entity. Jin Mei bills the customers and remits the receipts, net of its portions of sales commission, to this equity investment entity. For the three months ended June 30, 2015 and 2014, Jin Mei has recorded $0 and $10,000 income from agency sales, respectively, which were included in “other income (expense), net” in the consolidated statements of operations. For the six months ended June 30, 2015 and 2014, Jin Mei has recorded $1,000 and $16,000 income from agency sales, respectively, which were included in “other income (expense), net” in the condensed consolidated statements of operations.

In March 2012, our wholly-owned subsidiary, Beijing Tongmei Xtal Technology Co., Ltd. (“Tongmei”), entered into an operating lease for the land it owns with our consolidated joint venture Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd. The lease agreement for the land of approximately 22,081 square feet commenced on January 1, 2012 for a term of 10 years with annual lease payments of $24,000 subject to a 5% increase at each third year anniversary. The annual lease payment is due by January 31 of each year.

 

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Tongmei has paid $121,000 on behalf of Donghai County Dongfang High Purity Electronic Materials Co., Ltd.(“Dongfang”), its equity investment entity, to purchase materials. In 2014, an agreement was signed between Tongmei and Dongfang to set the date of repayment on December 31, 2015. As of June 30, 2015, this balance was included in “Related party notes receivable – short term” in our condensed consolidated balance sheets.

 

In April 2014, Tongmei loaned an additional of $49,000 to Dongfang. The loan bears interest at 6.15% per annum and the principal and interest totaling $53,000 as of June 30, 2015 is due on December 31, 2015. As of June 30, 2015, this balance, including both principal and interest, was included in “Related party notes receivable – short term” in our condensed consolidated balance sheets.

 

Tongmei also purchases raw materials from Dongfang for production in the ordinary course of business. As of June 30, 2015 and December 31, 2014, amounts payable of $117,000 and $0, respectively, were included in “accounts payable” in our condensed consolidated balance sheets.

 

Tongmei also purchases raw materials from one of our equity investment entities for production in the ordinary course of business. As of June 30, 2015 and December 31, 2014, amounts payable of $293,000 and $513,000, respectively, were included in “accounts payable” in our condensed consolidated balance sheets.

 

Beijing Kaide Quartz Co. Ltd. (“Kaide”) has been a supplier of customized quartz tubes to the Company since 2004. Beijing XiangHeMing Trade Co. Ltd., (“XiangHeMing”) is a significant shareholder of Kaide. XiangHeMing was previously owned by, among others, certain immediate family members of Davis Zhang, our former President, China Operations, until at least sometime in 2004, at which time the official Chinese government records indicate that Mr. Zhang’s immediate family members transferred their ownership of XiangHeMing to a third party. However, we are currently unable to conclusively determine whether Mr. Zhang’s immediate family members retained any economic interest in XiangHeMing after the transfer. As of June 30, 2015 and December 31 2014, amounts payable of $116,000 and $730,000, respectively, were included in “accounts payable” in our condensed consolidated balance sheets.

 

Our Related Party Transactions Policy seeks to prohibit all conflicts of interest in transactions between related parties and us, unless they have been approved by our Board of Directors. This policy applies to all of our employees and directors, our subsidiaries and our joint ventures. Our executive officers retain board seats on the board of directors of the companies in which we have invested in our China joint ventures. See Note 6 for further details.

Note 6. Investments in 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. These companies form part of our overall supply chain.

The investments are summarized below (in thousands):

 

		Investment Balance as of
Company		June 30, 2015				December 31, 2014			Accounting Method		Ownership Percentage
Beijing JiYa Semiconductor Material Co., Ltd.		$	3,331			$	3,331		Consolidated			46	%
Nanjing Jin Mei Gallium Co., Ltd.			592				592		Consolidated			83	%
Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd.			1,346				1,346		Consolidated			70	%
		$	5,269			$	5,269
Donghai County Dongfang High Purity Electronic Materials Co., Ltd.		$	1,652			$	1,723		Equity			46	%
Xilingol Tongli Germanium Co. Ltd.			5,556				5,351		Equity			25	%
Emeishan Jia Mei High Purity Metals Co., Ltd.			1,043				1,021		Equity			25	%
		$	8,251			$	8,095

 

Our ownership of Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd (“BoYu”) is 70%. We continue to consolidate BoYu as we have a significant influence in management and have majority control of the board. Our Chief Executive Officer is chairman of the BoYu board and we have appointed two other representatives to serve on the 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 with some inputs from us.

During the three months ended June 30, 2015 and 2014, the three consolidated joint ventures generated $0.6 million and $1.1 million of income, respectively, of which $127,000 and $242,000, respectively, were allocated to minority interests, resulting in $520,000 and $847,000 of income, respectively, to our net income (loss). During the six months ended June 30, 2015 and 2014, the three consolidated joint ventures generated $1.2 million and $1.8 million of income, respectively, of which $252,000 and $447,000, respectively, were allocated to minority interests, resulting in $947,000 and $1.4 million of income, respectively, to our net income (loss).

For the three minority investment entities that are not consolidated, the investment balances are included in “other assets” in our condensed consolidated balance sheets and totaled $8.3 million and $8.1 million as of June 30, 2015 and December 31, 2014. We own 46% of the ownership interests in one of these companies and 25% in each of the other two companies.  These three companies are not considered variable interest entities because:

·

all three 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 any of these companies.

We also maintain minority investments indirectly in privately-held companies through our consolidated joint ventures. These minority investments are accounted for under the equity method in the books of our consolidated joint ventures. As of June 30, 2015 and December 31, 2014, our consolidated joint ventures included these minority investments in “other assets” in the consolidated balance sheets with a carrying value of $4.4 million and $4.0 million, respectively.

 

The minority investment entities that are not consolidated are accounted for under the equity method and had the following summarized income information (in thousands) for the three and six months ended June 30, 2015 and 2014.

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2015				2014				2015				2014
Net revenue		$	11,004			$	13,466			$	20,329			$	26,946
Gross profit			3,625				8,124				5,920				12,087
Operating income			2,292				3,424				3,343				6,088
Net income			1,784				2,607				2,741				4,726

 

Our portion of the entity earnings from the minority investment entities that are not consolidated and are accounted for under the equity method were $410,000 and $625,000 for the three months ended June 30, 2015 and 2014, respectively, and $610,000 and $1.1 million for the six months ended June 30, 2015 and 2014, respectively.

During the three months ended June 30, 2015, we re-classified our minority investments under the cost method as an available-for- sale security when we deemed that there was sufficient trading volume in the exchange for the stock to be deemed readily marketable. As of June 30, 2015, we no longer maintain any investments under the cost method. As of December 31, 2014, our investments in this unconsolidated company had a carrying value of $200,000 and were included in “other assets” in the condensed consolidated balance sheets.

 

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Note 7. Stockholders’ Equity

Consolidated Statement of Changes in Equity

(in thousands)

 

		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, 2014		$	3,532			$	32			$	195,419			$	(68,393	)		$	7,673			$	138,263			$	6,425			$	144,688
Common stock options exercised											76												76								76
Common stock repurchased											(1,521	)											(1,521	)							(1,521	)
Stock-based compensation											740												740								740
Net (loss) income															(1,027	)							(1,027	)			252				(775	)
Dividends declared by joint ventures																											(83	)			(83	)
Change in unrealized (loss) gain on marketable securities																			(350	)			(350	)							(350	)
Currency translation adjustment																			263				263				42				305
Balance as of June 30, 2015		$	3,532			$	32			$	194,714			$	(69,420	)		$	7,586			$	136,444			$	6,636			$	143,080

 

There were no reclassification adjustments from accumulated other comprehensive income for the six months ended June 30, 2015 and 2014.

 Note 8. 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. 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 our stock compensation is accounted for as an equity instrument.

 

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The following table summarizes compensation costs related to our stock-based awards (in thousands, except per share data):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2015				2014				2015				2014
Cost of revenue		$	5			$	5			$	10			$	10
Selling, general and administrative			417				245				642				489
Research and development			44				47				88				90
Total stock-based compensation			466				297				740				589
Tax effect on stock-based compensation			—				—				—				—
Net effect on net income (loss)		$	466			$	297			$	740			$	589

 

 

		Three Months Ended June 30, 2015				Six Months Ended June 30, 2015
Expected term (in years)			1.0				1.0
Volatility			54.21	%			54.21	%
Expected dividend			0	%			0	%
Risk-free interest rate			1.86	%			1.86	%

 

The following table summarizes the stock option transactions during the six months ended June 30, 2015 (in thousands, except per share data):

 

Stock Options		Shares				Weighted- average Exercise Price				Weighted- average Remaining Contractual Life (in years)				Aggregate Intrinsic Value
Balance as of January 1, 2015			3,198			$	3.12				6.95			$	1,247
Granted			20				2.51
Exercised			(54	)			1.40
Canceled and expired			(62	)			3.86
Balance as of June 30, 2015			3,102			$	3.13				5.54			$	659
Options vested as of June 30, 2015 and unvested options expected to vest, net of forfeitures			3,102			$	3.13				5.54			$	659
Options exercisable as of June 30, 2015			1,998			$	3.44				4.38			$	547

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing price of $2.52 on June 30, 2015, which would have been received by the option holder had all option holders exercised their options on that date.

 

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Stock Awards		Shares				Weighted-Average Grant Date Fair Value
Non-vested as of January 1, 2015			261			$	2.71
Granted			336			$	2.56
Vested			(118	)		$	2.65
Forfeited			(13	)		$	2.34
Non-vested as of June 30, 2015			466			$	2.63

 

As of June 30, 2015, the unamortized compensation costs related to unvested restricted stock awards was approximately $1.1 million, which is to be amortized on a straight-line basis over a weighted average period of approximately 1.8 years.

Note 9. Net Income (Loss) Per Share

Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the periods less shares of common stock subject to repurchase and non-vested stock awards. Diluted net income (loss) per share is computed using the weighted-average number of common shares outstanding and potentially dilutive common shares outstanding during the periods. The dilutive effect of outstanding stock options and restricted stock awards is reflected in diluted earnings per share by application of the treasury stock method. Potentially dilutive common shares consist of common shares issuable upon the exercise of stock options. Potentially dilutive common shares are excluded in net loss periods, as their effect would be anti-dilutive.

 

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 June 30,								Six Months Ended June 30,
		2015				2014				2015				2014
Numerator:
Net income (loss) attributable to AXT, Inc.		$	(3	)		$	319			$	(1,027	)		$	(1,721	)
Less: Preferred stock dividends			(44	)			(44	)			(88	)			(88	)
Net income (loss) available to common stockholders		$	(47	)		$	275			$	(1,115	)		$	(1,809	)
Denominator:
Denominator for basic net income (loss) per share - weighted average common shares			32,242				32,381				32,399				32,407
Effect of dilutive securities:
Common stock options			—				195				—				—
Restricted stock awards			—				22				—				—
Denominator for dilutive net income (loss) per common share			32,242				32,597				32,399				32,407
Net income (loss) attributable to AXT, Inc. per common share:
Basic		$	(0.00	)		$	0.01			$	(0.03	)		$	(0.06	)
Diluted		$	(0.00	)		$	0.01			$	(0.03	)		$	(0.06	)
Options excluded from diluted net income (loss)  per share as the impact is anti-dilutive			3,102				1,782				3,102				2,645
Restricted stock excluded from diluted net income (loss) per share as the impact is anti-dilutive			466				93				466				266

 

The 883,000 shares of $0.001 par value Series A preferred stock issued and outstanding as of June 30, 2015 and December 31, 2014, valued at $3,532,000, 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, which must be paid before any distribution is made to common stockholders. These preferred shares were issued to Lyte Optronics, Inc. stockholders in connection with the completion of our acquisition of Lyte Optronics, Inc. on May 28, 1999.

 

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Note 10. 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 our Chief 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 condensed consolidated financial statements.

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

 

		Three Months Ended June 30,								Six Months Ended June 30
		2015				2014				2015				2014
Geographical region:
Europe (primarily Germany)		$	5,664			$	4,968			$	10,607			$	11,551
China			3,561				4,960				6,858				9,125
Taiwan			3,414				2,785				6,523				4,900
North America (primarily the United States)			2,850				2,829				6,322				4,609
Asia Pacific (excluding China, Taiwan and Japan)			2,768				2,450				5,527				4,839
Japan			2,753				3,457				5,237				5,770
Total		$	21,010			$	21,449			$	41,074			$	40,794

 

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
		June 30, 2015				December 31, 2014
Long-lived assets by geographic region:
North America		$	1,114			$	136
China			32,252				33,726
		$	33,366			$	33,862

 

Significant Customers

One customer represented more than 10% of our revenue for the three months ended June 30, 2015 while no customer represented more than 10% of our revenue for the three months ended June 30, 2014. No customer represented more than 10% of our revenue for the six months ended June 30, 2015 and 2014. Our top five customers, although not the same five customers for each period, represented 37% of our revenue for the three months ended June 30, 2015 and 2014. Our top five customers, although not the same five customers for each period, represented 36% and 35% of our revenue for the six months ended June 30, 2015 and 2014, respectively.

We perform ongoing credit evaluations of our customers’ financial condition, and limit the amount of credit extended when deemed necessary, but generally do not require collateral. Two customers, although not the same two customers, accounted for 11% and 10% of our accounts receivable balance as of June 30, 2015 and December 31, 2014.

 

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 Note 11. Commitments and Contingencies

Indemnification Agreements

We have entered into indemnification agreements with our directors and officers that 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 provide warranties for 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 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 and six months ended June 30, 2015 and 2014 (in thousands):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2015				2014				2015				2014
Beginning accrued warranty and related costs		$	392			$	1,227			$	802			$	1,048
Accruals for warranties issued			411				81				585				577
Adjustments related to pre-existing warranties including expirations and changes in estimates			42				(199	)			(252	)			(302	)
Cost of warranty repair			(177	)			(129	)			(467	)			343
Ending accrued warranty and related costs		$	668			$	980			$	668			$	980

 

Contractual Obligations

We lease certain office space, warehouse facilities and equipment under long-term operating leases expiring at various dates through December 2025. The majority of our lease obligations relates to our lease agreement for the facility in Fremont, California with approximately 19,467 square feet.

Outstanding contractual obligations as of June 30, 2015 are summarized as follows (in thousands):

 

		Payments due by period
Contractual Obligations		Total				Less than 1 year				1-3 years				4-5 years				More than 5 years
Operating leases		$	639			$	222			$	258			$	54			$	105
Royalty agreement			2,125				688				1,150				287				—
Total		$	2,764			$	910			$	1,408			$	341			$	105

 

Purchase Obligations with Penalties for Cancellation

In the normal course of business, we issue purchase orders to various suppliers. In certain cases, we may incur a penalty if we cancel the purchase order. As of June 30, 2015, we do not have any outstanding purchase orders that will incur a penalty if cancelled by the Company.

 

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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 operations.

Note 12. Foreign Exchange Transaction Gains/Losses

We incurred foreign currency transaction exchange gains of $30,000 and $158,000 for the three months ended June 30, 2015 and 2014, respectively. We incurred foreign currency transaction exchange gains of $210,000 and $175,000 for the six months ended June 30, 2015 and 2014, respectively. These amounts are included in “other income (expense), net” on our condensed consolidated statements of operations.

Note 13. Income Taxes

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

In accordance with Section 382 of the Internal Revenue Code, the amounts of and benefits from net operating loss and tax credit carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses or credits that we may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50% as defined, over a three year period. As a result of the implementation of Interpretation 48, we recognized $16.4 million of liability for unrecognized tax benefits. Of this amount, none was accounted for as a reduction to balance of retained earnings. The amount decreased tax loss carryforwards in the U.S., which are fully offset by a valuation allowance.

We recognize interest and penalties related to uncertain tax positions in income tax expense. Income tax expense for the three month ended June 31, 2015 includes no interest and penalties. As of June 31, 2015, we have no accrued interest and penalties related to uncertain tax positions. 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, 2013.

Provision for income taxes for three and six months ended June 30, 2015 and 2014 was mostly related to our wholly owned China subsidiary and our three partially owned subsidiaries in China. We have made a tax election in China whereby certain minimum foreign withholding taxes are treated as an expense and not a tax credit. Besides the state taxes liabilities, no federal income tax benefit or expense has been provided for the three and six months ended June 30, 2015 and 2014 due to our net loss, our valuation allowance being utilized and uncertainty of future profits in the U.S.

 

Note 15. Recent Accounting Pronouncements

In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards (“IFRS”), FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” The new guidance sets forth a new five-step revenue recognition model which replaces the prior revenue recognition guidance in its entirety and is intended to eliminate numerous industry-specific pieces of revenue recognition guidance that have historically existed in U.S. GAAP. The underlying principle of the new standard is that a business or other organization will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. The standard also requires more detailed disclosures and provides additional guidance for transactions that were not addressed completely in the prior accounting guidance. The ASU provides alternative methods of initial adoption and is effective for annual and interim periods beginning after December 15, 2016. We are currently evaluating the impact that this standard will have on our consolidated financial statements.

 

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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, industry trends, customer qualifications of our products, gross margins, the impact of the adoption of certain accounting pronouncements, our investments in capital projects, our belief that we have adequate cash and investments to meet our needs over the next 12 months, and our ability to continue to manufacture gallium arsenide substrate wafers. 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. We undertake no obligation to revise or update any forward‑looking statements in order to reflect any event or circumstance that may arise after the date of this report. Readers are urged to carefully review and consider the various disclosures made in this report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects. 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, 2014 and the condensed consolidated financial statements included elsewhere in this report.

 

Overview

AXT is a worldwide developer and producer of high-performance compound and single element semiconductor substrates, also known as wafers. The dominant substrates used in producing semiconductor chips are made from silicon. However, certain chips may become too hot or perform their function too slowly if silicon is used as the base material. Alternative or specialty materials are used to replace silicon as the preferred base for the electronic circuit in these situations. We provide such alternative or specialty materials in the form of substrates or wafers, including compound and single element substrates. Our compound substrates combine gallium with arsenic (GaAs) or combine indium with phosphorous (InP). Our single element substrates are made from germanium (Ge). Most of our revenue is from sales of GaAs substrates. We currently sell the following substrate products in the sizes and for the applications indicated:

Product
Substrates		Diameter		Applications
GaAs (semi-insulating)		1”, 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)		1”, 2”, 3”, 4”, 6”		·  High brightness light emitting diodes
				·  Lasers
				·  Optical couplers
InP		2”, 3”, 4”		·  Broadband and fiber optic communications
Ge		2”, 4”, 6”		·  Satellite and terrestrial solar cells
				·  Optical applications

 

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We manufacture all of our semiconductor substrates using our proprietary vertical gradient freeze (VGF) technology. 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 with comparable facilities in the United States, Europe or Japan. Our supply chain includes AXT subsidiaries and joint ventures in China. We believe this supply chain arrangement provides us pricing advantages, reliable supply and enhanced sourcing lead-times for key raw materials which are central to our final manufactured products. Our subsidiaries and joint ventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, pyrolytic boron nitride (pBN) crucibles and boron oxide (B2O3). Our ownership and the ownership by our consolidated subsidiaries in these entities range from 20% to 83%. We consolidate, for accounting purposes, the joint ventures in which we have majority or controlling financial interest and significant influence on management, and employ equity accounting for the joint ventures in which we have a smaller ownership interest. We purchase portions of the materials produced by these joint 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 China, and independent sales representatives in Europe and other parts of Asia to market and sell our substrates.

Critical Accounting Policies and Estimates

We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. Accordingly, we make estimates, assumptions and judgments that affect the amounts reported on our consolidated financial statements. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that are believed to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time.

We have identified the policies below as critical to our business operations and understanding of our financial condition and results of operations. Critical accounting policies are material to the presentation of our consolidated financial statements and require us to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations. They may require us to make assumptions about matters that are highly uncertain at the time of the estimate. 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.

Revenue Recognition

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

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

Accounts Receivable and Allowance for Doubtful Accounts

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

As of June 30, 2015 and December 31, 2014, our accounts receivable, net, balance was $19.3 million and $17.9 million, respectively, which was net of an allowance for doubtful accounts of $605,000 and $410,000, 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 future periods.

 

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The allowance for sales returns is also deducted from gross accounts receivable. As of June 30, 2015 and December 31, 2014, our allowance for sales returns was $436,000 and $413,000, 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 June 30, 2015 and December 31, 2014, accrued product warranties totaled $668,000 and $802,000, respectively. The decrease in accrued product warranties is primarily attributable to decreased claims for quality issues experienced by some customers. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financial condition and results of operations for future periods.

Inventory Valuation

Inventories are stated at the lower of cost or market. Cost is determined using the weighted-average cost method. Our inventory consists of raw materials as well as finished goods and work-in-process that include material, labor and manufacturing overhead costs. Given the nature of our substrate products, and the materials used in the manufacturing process, the wafers and ingots comprising work-in-process may be held in inventory for up to two years and three years, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory, and we provide a valuation allowance for certain inventories based upon the age and quality of the product and the projections for sale of the completed products. As of June 30, 2015 and December 31, 2014, we had an inventory reserve of $11.4 million and $11.2 million, respectively, for excess and obsolete inventory. If actual demand for our products were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results of operations.

Impairment of Investments

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

We invest in equity instruments of privately-held companies in China for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee’s management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in our carrying value. We had no write‑downs for the three months ended June 30, 2015 or 2014.

 

Fair Value of Investments

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

 

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

Level 2 instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments, including:

·

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

 

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·

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.

There have been no transfers between fair value measurement levels during the three and six months ended June 30, 2015.

Impairment of Long-Lived Assets

We evaluate the recoverability of property, equipment and intangible assets in accordance with ASC topic 360, Property, Plant and Equipment (“ASC 360”). When events and circumstances indicate that long-lived assets may be impaired, we compare the carrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to 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. We had no “Assets held for sale” on the condensed consolidated balance sheet as of June 30, 2015 or December 31, 2014.

Stock-based Compensation

Income Taxes

See Note 13—“Income Taxes” in the notes to condensed financial statements for additional information.

 

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Results of Operations

Revenue

 

		Three Months Ended June 30,								Increase
		2015				2014				(Decrease)				% Change
		($ in thousands)
Total revenue		$	21,010			$	21,449			$	(439	)			(2.0	%)

Revenue decreased $439,000, or 2.0%, to $21.0 million for the three months ended June 30, 2015 from $21.4 million for the three months ended June 30, 2014. The revenue decrease resulted from decreased demand for our substrate materials, particularly in the LED market. This decrease was partially offset by the increased demand for our InP substrates as a result of expanding applications in the marketplace, such as fiber optic lasers and data connectivity.

 

		Six Months Ended June 30,								Increase
		2015				2014				(Decrease)				% Change
		($ in thousands)
Total revenue		$	41,074			$	40,794			$	280				0.7	%

Revenue increased $280,000, or 0.7%, to $41.1 million for the six months ended June 30, 2015 from $40.8 million for the six months ended June 30, 2014.  The revenue increase was primarily the result of an increase in InP revenue in 2015 as compared to the same period in the prior year. The InP revenue increase was the result of expanding applications in the marketplace, such as fiber optic lasers and data connectivity. In addition, our raw materials revenue increased as a result of stronger demand and our ability to respond quickly to short lead time requirements. The increase of revenue from InP and raw materials sales, however, was partially offset by the decreased demand for other substrate materials, particularly from our GaAs LED substrates customers.

Revenue by Geographic Region

		Three Months Ended June 30,								Increase
		2015				2014				(Decrease)				% Change
		($ in thousands)
Europe (primarily Germany)		$	5,664			$	4,968			$	696				14	%
% of total revenue			27	%			23	%
China			3,561				4,960				(1,399	)			(28	%)
% of total revenue			17	%			23	%
Japan			2,753				3,457				(704	)			(20	%)
% of total revenue			13	%			16	%
North America (primarily the United States)			2,850				2,829				21				1	%
% of total revenue			14	%			13	%
Taiwan			3,414				2,785				629				23	%
% of total revenue			16	%			13	%
Asia Pacific (excluding China, Taiwan and Japan)			2,768				2,450				318				13	%
% of total revenue			13	%			11	%
Total revenue			21,010			$	21,449			$	(439	)			(2	%)

 Revenue by geographic region shows stronger growth in both Taiwan and Europe mainly from the increase in InP sales in the second quarter of 2015 as compared to same period in 2014. Revenue from customers in China and Japan decreased substantially primarily due to decreased in sales in our substrate revenue, particularly in the LED market.

 

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		Six Months Ended June 30,								Increase
		2015				2014				(Decrease)				% Change
		($ in thousands)
Europe (primarily Germany)		$	10,607			$	11,551				(944	)			(8	%)
% of total revenue			26	%			28	%
China			6,858				9,125				(2,267	)			(25	%)
% of total revenue			17	%			23	%
Japan			5,237				5,770				(533	)			(9	%)
% of total revenue			13	%			14	%
North America (primarily the United States)			6,322				4,609				1,713				37	%
% of total revenue			15	%			11	%
Taiwan			6,523				4,900				1,623				33	%
% of total revenue			16	%			12	%
Asia Pacific (excluding China, Taiwan and Japan)			5,527				4,839				688				14	%
% of total revenue			13	%			12	%
Total revenue		$	41,074			$	40,794			$	280				1	%