AXT INC quarterly report, Q1 FY2018

AXT, Inc. 10-Q Summary

Reporting period: Three months ended March 31, 2018; filed May 4, 2018. The interim financial statements are unaudited. AXT develops and manufactures compound and single-element semiconductor substrates, including indium phosphide, gallium arsenide and germanium, and sells related raw materials. Manufacturing is conducted in China.

Financial Performance and Position

Metric	Q1 2018	Q1 2017	Change
Revenue	$24.4 million	$20.6 million	Up 18.4%
Gross profit	$9.6 million	$6.3 million	Up 52.2%
Gross margin	39.2%	30.5%	Up 8.7 percentage points
Income from operations	$3.9 million	$1.4 million	Up $2.6 million
Net income	$3.2 million	$0.4 million	Up $2.8 million
Net income attributable to AXT	$2.9 million	$0.7 million	Up $2.2 million
Diluted EPS	$0.07	$0.02	Improved
Cash flow from operations	$1.6 million	$1.1 million	Up $0.5 million

• Substrate revenue was $19.4 million, up 16.6%; raw materials and other revenue was $5.1 million, up 26.2%.
• Management attributed revenue growth primarily to higher demand for indium phosphide and germanium substrates, increased unit volumes and stronger raw-material sales. Average selling prices were generally flat or slightly lower.
• Gross-margin expansion reflected favorable product mix, higher production volume, improved yields and manufacturing efficiencies.
• Operating expenses were $5.6 million, including $4.2 million of selling, general and administrative expense and $1.4 million of research and development expense.
• Equity losses from unconsolidated joint ventures declined to $0.3 million from $0.9 million. Q1 2017 included a $0.3 million impairment charge for a gallium investment; no comparable impairment was recorded in Q1 2018.
• Other expense was $0.2 million, primarily reflecting a $0.2 million foreign-exchange loss. Q1 2017 included a $77,000 realized gain from the sale of GHI stock.
• Inventories increased to $51.1 million from $45.8 million at December 31, 2017. Inventory reserves totaled approximately $14.0 million.
• Total assets were $216.3 million and total stockholders’ equity was $194.7 million at March 31, 2018.
• The filing reports no debt balances. Total liabilities were $21.6 million, including $21.2 million of current liabilities.
• Cash, cash equivalents and investments totaled $66.9 million at March 31, 2018, consisting of $39.2 million of cash, $15.2 million of short-term investments and $12.5 million of long-term investments.

Cash Flow, Capital Expenditures and Liquidity

• Operating cash flow was $1.6 million, despite a $4.6 million use of cash for increased inventories.
• Investing activities used $7.1 million, including $11.8 million for property, plant and equipment and $9.9 million for available-for-sale securities, partially offset by $14.7 million of investment maturities and sales.
• Property, plant and equipment increased to $58.8 million from $46.5 million, principally due to construction in progress. Construction in progress was $32.4 million, including facilities under development in Dingxing and Chaoyang.
• Cash and cash equivalents declined by $5.2 million during the quarter. Management stated that available cash and investments were sufficient to meet operating needs over the next twelve months.
• Approximately $16.7 million of cash and investments were held in Chinese bank accounts by the company and its consolidated joint ventures.

Material Changes Versus Q1 2017

• Revenue, gross profit, operating income and net income increased materially, with gross margin rising from 30.5% to 39.2%.
• Q1 2018 benefited from the absence of the $313,000 equity-investment impairment recorded in Q1 2017 and from improved performance by unconsolidated joint ventures.
• Q1 2017 financing cash flow included approximately $31.9 million of net proceeds from a common-stock offering; Q1 2018 financing cash flow was only $66,000 from option exercises.
• Capital expenditures increased sharply to $11.8 million from $268,000, reflecting manufacturing-site development and equipment purchases.
• Cash and investments declined from approximately $86.8 million at March 31, 2017 to $66.9 million at March 31, 2018, partly because the prior-year balance benefited from the equity offering.
• Revenue from China and Taiwan increased 62.4% and 52.2%, respectively, while Japan declined 21.8% and other Asia Pacific declined 27.9%.

Guidance, Outlook, Risks and Unusual Items

• AXT is relocating its gallium arsenide production line from Beijing to Dingxing and Kazuo, China, and is also relocating its germanium production line. Completion is expected by the end of 2018 or the first half of 2019.
• Estimated relocation and facility costs were $40 million to $50 million, including amounts already paid, with spending expected to extend into 2019. Management cautioned that costs could be higher.
• The Dingxing cooperation agreement contemplates an eventual investment of approximately $90 million in value, assets and capital; the Kazuo target is approximately $15 million. These amounts include non-cash and flexible valuation elements and are not presented as fixed contractual obligations.
• Customers may require qualification of wafers produced at the new facilities. Delays, failed qualifications, production disruption, employee-retention issues or permitting problems could reduce revenue and profitability.
• Severe air pollution caused intermittent government shutdowns affecting more than 300 manufacturers, including AXT, for a total of ten days from February 27 through March 31, 2018. Management stated that these disruptions prevented the company from achieving the revenue range included in its prior guidance.
• AXT expects future environmental shutdowns and remains exposed until the relocation is substantially complete. Additional environmental permits, regulatory approvals and zoning applications were still in process.
• Q1 2018 included a $295,000 inventory write-down at a consolidated raw-gallium company. The filing also highlights risks from raw-material pricing pressure, excess inventory and supply-chain joint ventures.
• Two customers each represented 12% of Q1 revenue, and the top five customers represented 38%. One customer represented 13% of accounts receivable.
• More than 85% of revenue is typically international, while all manufacturing operations are in China. Key risks include foreign-exchange volatility, tariffs and trade restrictions, Chinese regulatory changes, environmental compliance, customer concentration, semiconductor cycles, competitive pricing and technology substitution.
• Contractual obligations totaled $981,000 at March 31, 2018, consisting of $550,000 of operating leases and $431,000 under a royalty agreement. The company reported no off-balance-sheet financing arrangements.
• AXT adopted ASC 606 revenue recognition and several other accounting standards on January 1, 2018; management reported no significant impact on the financial statements.

Most Important Facts for Investors to Verify

• Progress, total cost and timing of the Dingxing and Kazuo relocation projects, including permitting and customer qualification status.
• Whether air-pollution shutdowns or other Chinese government restrictions continue to affect production, shipments and guidance.
• Inventory growth, reserve adequacy and exposure to gallium and other raw-material price declines.
• Sustainability of the 39.2% gross margin and whether improvements reflect recurring manufacturing gains or favorable product mix.
• Customer concentration, demand trends for InP, GaAs and Ge substrates, and the potential impact of silicon-based alternatives and semiconductor-cycle weakness.
• Liquidity after planned relocation and capital expenditures, including the portion of cash and investments held by Chinese subsidiaries and joint ventures.
• Foreign-exchange losses, Chinese tax and environmental compliance, and risks associated with related-party transactions and minority investments in the China supply chain.