AXT INC quarterly report, Q3 FY2017

AXT, Inc. 2017 Third-Quarter Form 10-Q Summary

Business context and reporting period

AXT develops and manufactures compound and single-element semiconductor substrates, including indium phosphide, gallium arsenide and germanium wafers, and sells related raw materials and pyrolytic boron nitride crucibles. Manufacturing is conducted in China through AXT and controlled subsidiaries and joint ventures. The filing covers the three and nine months ended September 30, 2017; amounts are unaudited and presented in thousands unless otherwise noted.

Financial performance and liquidity

Metric	Q3 2017	Q3 2016	9M 2017	9M 2016
Revenue	$28.2 million	$21.9 million	$72.3 million	$61.1 million
Gross profit	$11.1 million	$7.6 million	$24.7 million	$18.9 million
Gross margin	39.5%	34.6%	34.1%	30.9%
Operating income	$5.2 million	$2.7 million	$8.9 million	$4.1 million
Net income attributable to AXT	$4.4 million	$2.2 million	$7.0 million	$3.4 million
Diluted EPS	$0.11	$0.07	$0.18	$0.10
Net cash from operations	Not provided for quarter	Not provided for quarter	$8.0 million	$5.5 million

Q3 operating margin was approximately 18.6% and net margin attributable to AXT was approximately 15.7%. Nine-month operating margin was approximately 12.3% and net margin attributable to AXT was approximately 9.7%.

Substrate revenue increased 31.2% in Q3 and 17.1% for the nine-month period. Raw materials and other revenue increased 20.1% and 24.4%, respectively.
Management attributed revenue growth primarily to higher demand across wafer products, data-center connectivity demand for indium phosphide, satellite-related germanium demand and stronger purified gallium sales. Units increased while average selling prices were generally flat or slightly lower.
Gross-margin expansion reflected favorable product mix, higher volume, improved yields and manufacturing efficiencies, and lower raw-material costs. These benefits were partly offset by higher excess and obsolete inventory charges and, for the nine-month period, costs associated with the March 2017 Beijing facility fire.
SG&A increased 35.3% in Q3 and 20.9% for nine months, driven by higher commissions, consulting and professional fees, and personnel costs. R&D declined 10.0% in Q3 and 19.6% for nine months.
Other expense was $349,000 in Q3 and $403,000 for nine months, compared with income in the prior-year periods, primarily because realized gains from sales of GHI stock were lower. AXT sold the remainder of its GHI investment during the first quarter of 2017.

At September 30, 2017, cash and cash equivalents were $48.1 million, short-term investments were $20.5 million and long-term investments were $9.7 million, for total cash and investments of $78.3 million. Current assets were $136.0 million versus current liabilities of $18.8 million. Total liabilities were $19.2 million. The filing reports no debt financing; liabilities principally comprised accounts payable, accrued liabilities and royalty obligations.

Nine-month investing cash use was $29.2 million, including $16.6 million of equipment purchases and $26.1 million of investment purchases, partly offset by $13.3 million of investment maturities and sales. Financing cash provided was $32.9 million, including $31.9 million net proceeds from a March 2017 offering of 5.3 million common shares and approximately $1.5 million from option exercises. Capital expenditures increased substantially as AXT began developing its Dingxing facility.

Material changes versus the prior comparable period

Revenue rose 28.8% in Q3 and 18.4% for nine months, while gross margin improved 4.9 percentage points and 3.2 percentage points, respectively.
Net income attributable to AXT nearly doubled in Q3 and increased approximately 105% for nine months.
Accounts receivable increased to $20.9 million from $14.5 million at December 31, 2016; inventory was $40.8 million, including $12.9 million of excess and obsolete inventory reserves.
Property, plant and equipment increased to $42.3 million from $27.8 million, largely reflecting $17.7 million of construction in progress, including $13.6 million for the Dingxing buildings.
The March 15, 2017 electrical fire disrupted portions of the Beijing facility and increased manufacturing and business-interruption costs, but management used available capacity and equipment rotation to mitigate the impact.
Equity-method investments generated a $313,000 impairment charge during the first quarter, as one gallium investment was written down to zero. Equity-method losses were $1.4 million for both nine-month periods.
Common shares outstanding increased to 38.9 million at November 8, 2017 from 33.0 million at December 31, 2016, primarily because of the March offering and option exercises.

Guidance, outlook, commentary and risks

The filing does not provide a specific numerical revenue or earnings forecast. Management stated that cash and investments are adequate to meet operating needs over the next twelve months, while cautioning that lower sales could reduce operating cash flow and require additional capital.

AXT completed the purchase of a new Dingxing, China manufacturing facility and produced its first single-crystal growth ingot there in October 2017. The gallium arsenide relocation is expected to be completed by the end of 2018 or the first half of 2019.
Estimated Dingxing relocation and construction costs were $25 million to $35 million, including amounts already paid, but the estimate could increase as AXT considers a larger facility to support potential 3-D-sensing and other high-end demand. A separate Kazuo site is intended initially for gallium-arsenic synthesis.
Customer qualification of products made at the new site, environmental permits, regulatory approvals, zoning, employee relocation and execution of the staged move are material contingencies.
AXT faces semiconductor cyclicality, pricing pressure, competition from silicon and other technologies, customer concentration, lengthy qualification cycles, yield and quality risks, raw-material price declines, inventory exposure and dependence on Chinese operations and suppliers.
Foreign-exchange exposure remains significant. The company recorded foreign-currency transaction losses of $339,000 in Q3 and $414,000 for nine months. Japanese-yen hedges had a de minimis net effect during the quarter.
Preferred stock dividends have accumulated to approximately $2.9 million and have not been declared or paid. The Series A preferred stock has a 5% cumulative dividend and a $4 per-share liquidation preference.
Operating leases and royalty obligations totaled $1.4 million as of September 30, 2017, including $719,000 under the royalty agreement. The filing reports no off-balance-sheet financing arrangements.
Subsequent events included the October 2017 resignation of the Chief Operating Officer with $300,000 of cash severance and the November 2017 dilution of AXT’s Boyu ownership from 70% to 63% following a $2 million third-party investment.

Important facts for investors to verify

Whether the Dingxing and Kazuo facilities receive all required environmental, regulatory and zoning approvals on schedule.
Progress of gallium arsenide production relocation, customer qualifications, capacity expansion and total relocation spending versus the $25 million to $35 million estimate.
Whether demand for 3-D sensing, data-center connectivity, satellite and other end markets supports continued volume growth and offsets declining average selling prices.
Accounts receivable collection trends, inventory aging and the adequacy of the $12.9 million excess and obsolete inventory reserve.
Future performance and funding needs of consolidated and equity-method Chinese joint ventures, including exposure to gallium and germanium pricing.
Potential cash requirements related to cumulative Series A preferred dividends, capital expenditures, royalties and joint-venture relocation projects.
Exposure to Chinese environmental regulation, hazardous-material permits, foreign exchange, customer concentration and operational disruptions such as fires or power outages.