AXT, Inc. 2016 Q2 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. All manufacturing operations are in China, supported by a supply chain involving ten partially owned Chinese companies. The filing covers the three and six months ended June 30, 2016, compared with the corresponding 2015 periods. The financial statements are unaudited.
Financial performance and position
| Metric | Three months ended June 30, 2016 | Three months ended June 30, 2015 | Six months ended June 30, 2016 | Six months ended June 30, 2015 |
|---|---|---|---|---|
| Revenue | $20.5 million | $21.0 million | $39.2 million | $41.1 million |
| Gross profit | $6.0 million | $4.4 million | $11.3 million | $9.1 million |
| Gross margin | 29.4% | 20.9% | 28.8% | 22.2% |
| Income from operations | $0.9 million | $(0.8) million | $1.4 million | $(2.5) million |
| Net income attributable to AXT | $1.2 million | $(3 thousand) | $1.2 million | $(1.0) million |
| Diluted earnings per share | $0.03 | $(0.00) | $0.03 | $(0.03) |
| Operating cash flow | Not separately disclosed | Not separately disclosed | $3.0 million | $0.3 million |
Revenue declined 2.5% year over year in the quarter and 4.5% year to date, primarily because of lower raw-material sales and lower average gallium selling prices. Growth in indium phosphide and germanium substrates, supported by fiber-optic and data-connectivity applications, partially offset the decline.
Gross profit and margins improved because of product mix, higher yields, manufacturing efficiencies and higher production volume. Selling, general and administrative expense declined 9.4% in the quarter and 24.7% year to date, largely because of lower stock compensation, lower receivable provisions and the absence of 2015 professional fees related to a related-party investigation. Research and development expense increased 6.0% in the quarter and 8.5% year to date.
Equity losses from unconsolidated joint ventures were $0.4 million in the quarter and $0.9 million year to date, compared with equity earnings of $0.4 million and $0.6 million in the comparable 2015 periods. The decline reflected lower raw-material selling prices and volumes. Other income also decreased, primarily because of lower investment-sale gains and lower Chinese government subsidies.
At June 30, 2016, cash and cash equivalents were $26.1 million, short-term investments were $10.5 million and long-term investments were $8.4 million, for total cash and investments of approximately $45.0 million. Total assets were $151.4 million and total liabilities were $14.4 million. The filing reports no debt; liabilities primarily comprised accounts payable, accrued liabilities and royalty obligations. Contractual obligations totaled $1.9 million, including $1.4 million under a royalty agreement and $0.5 million of operating leases.
Cash flow, liquidity and capital allocation
- Operating cash flow was $3.0 million in the first six months of 2016, compared with $0.3 million in the first six months of 2015.
- Investing cash flow was $(1.3) million, including $1.7 million of equipment purchases and $7.9 million of investment purchases, partially offset by $8.3 million of investment sales and maturities.
- Financing cash flow was $(37 thousand); no common stock was repurchased during the first six months of 2016.
- Cash increased $1.2 million to $26.1 million during the first six months. Approximately $20.3 million of cash and investments were held in foreign bank accounts, and approximately $14.8 million would not be available for U.S. use without potential U.S. income taxes.
- Management stated that existing cash and investments are adequate for expected needs over the next twelve months. No estimate was provided for the cost of a potential China manufacturing relocation.
Material changes versus the prior comparable period
- Revenue declined despite higher substrate sales, reflecting weaker raw-material sales and gallium pricing.
- Gross margin expanded 8.5 percentage points in the quarter and 6.6 percentage points year to date.
- The Company returned to operating profitability and attributable net profitability.
- Unconsolidated joint ventures shifted from earnings to losses, while noncontrolling interests shifted from income to losses because of lower profitability at consolidated Chinese subsidiaries.
- AXT recorded a $226 thousand restructuring charge in the second quarter for a 28-position reduction in force at Beijing JiYa; the plan was completed by June 30, 2016.
- Accumulated other comprehensive income declined by $1.5 million year to date, primarily because of foreign-currency translation losses.
Guidance, outlook, risks and unusual items
The filing does not provide a clear numerical revenue, earnings or margin forecast. Management expects to maintain adequate liquidity over the next twelve months but cautions that lower sales could reduce operating cash flow and require additional capital.
- China manufacturing relocation: Government planning may require relocation of gallium arsenide and germanium production from Beijing. The timing and cost were undetermined at the filing date. Disruption or poor execution could materially affect revenue, margins and supply to customers. The Company was considering retaining indium phosphide production at the current site.
- Gallium arsenide permit: A required Chinese permit related to gallium arsenide manufacturing remained under review. Failure to obtain the permit could require production suspension or relocation, employee furloughs and potential customer loss.
- Pricing and demand: Oversupply and declining average selling prices for gallium, germanium and other raw materials could pressure revenue and margins. Semiconductor industry cyclicality, customer order delays and cancellations remain significant risks.
- Customer concentration: Landmark and IQE Group each represented 11% of year-to-date revenue; the top five customers represented 42%. One customer represented 19% of accounts receivable at June 30, 2016.
- Inventory: Inventory totaled $38.6 million and included reserves of $11.8 million for excess and obsolete inventory and $0.5 million for lower-of-cost-or-market exposure.
- Related parties and investments: The Company maintains strategic investments and transactions with Chinese joint ventures and related entities, including related-party notes receivable and purchases. It also disclosed a 2015 investigation into historical related-party transactions; the investigation found no intentional misconduct or financial-statement inaccuracies, but resulted in approximately $1.8 million of professional fees.
- Foreign exchange: The Company is exposed to the Japanese yen, Chinese renminbi and other currencies. It uses short-term yen hedges, but the program is partial and may not fully offset volatility.
- Taxes: The Company reported $14.6 million of unrecognized tax benefits, with no accrued interest or penalties at June 30, 2016. U.S. deferred tax assets were fully reserved.
- Controls and litigation: Management concluded that disclosure controls were effective at a reasonable assurance level, with no material changes to internal control over financial reporting. Ordinary-course legal matters were not expected to have a material adverse effect.
Most important facts for investors to verify
- Whether the improvement in gross margin is sustainable or primarily reflects temporary mix, yield and utilization benefits.
- The status, timing, cost and required scope of the Beijing manufacturing relocation.
- Whether the gallium arsenide manufacturing permit has been obtained and whether production remains uninterrupted.
- Trends in gallium, germanium and other raw-material prices, inventory reserves and joint-venture profitability.
- Customer concentration, order cancellations and the collectability of accounts receivable.
- Availability of cash held by Chinese subsidiaries and potential tax or regulatory restrictions on repatriation.
- Potential exposure from related-party transactions, the $14.6 million of unrecognized tax benefits and environmental or employee-related claims.