AXT
Annual Report 2006

Plain-text annual report

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549Form 10-K(Mark One)xx ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934For the fiscal year ended December 31, 2006ORoo TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934For the transition period from toCommission file number: 000-24085AXT, Inc.(Exact name of registrant as specified in its charter)Delaware94-3031310(State or other jurisdiction of(I.R.S. Employerincorporation or organization)Identification No.)4281 Technology Drive, Fremont, California94538(Address of principal executive offices)(Zip Code) Registrant’s telephone number, including area code: (510) 683-5900Securities registered pursuant to Section 12(b) of the Act:Title of each className of each exchange on which registeredCommon Stock, $0.001 par valueThe NASDAQ Stock Market LLC Securities registered pursuant to Section 12(g) of the Act:NoneIndicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes x NoIndicate by checkmark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes x NoIndicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding12 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. x Yes o NoIndicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, tothe best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. oIndicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer inRule 12b-2 of the Act. (Check one):Large accelerated filer o Accelerated filer o Non-accelerated filer xIndicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). o Yes x NoThe aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing sale price of the common stock on June 30, 2006 as reported on theNasdaq National Market, was approximately $55,603,853. Shares of common stock held by each officer, director and by each person who owns 5% or more of the outstanding commonstock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not a conclusive determination for other purposes.As of February 28, 2007, 29,894,949 shares, $0.001 par value, of the registrant’s common stock were outstanding.DOCUMENTS INCORPORATED BY REFERENCEPortions of the definitive proxy statement for the registrant’s 2007 annual meeting of stockholders to be filed with the Commission pursuant to Regulation 14A not later than 120days after the end of the fiscal year covered by this form are incorporated by reference into Part III of this Form 10-K report. Except for those portions specifically incorporated by referenceherein, such document shall not be deemed to be filed with the Commission as part of this Form 10-K. TABLE OF CONTENTSPART IItem 1.Business2Item 1A.Risk Factors12Item 1B.Unresolved Staff Comments27Item 2.Properties27Item 3.Legal Proceedings28Item 4.Submission of Matters to a Vote of Security Holders28PART IIItem 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities29Item 6.Selected Consolidated Financial Data31Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations33Item 7A.Quantitative and Qualitative Disclosures About Market Risk53Item 8.Consolidated Financial Statements and Supplementary Data54Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure54Item 9A.Controls and Procedures54Item 9B.Other Information54PART IIIItem 10.Directors, Executive Officers, and Corporate Governance55Item 11.Executive Compensation55Item 12.Security Ownership of Certain Beneficial Owners and Management and Related StockholderMatters55Item 13.Certain Relationships and Related Transactions and Director Independence55Item 14.Principal Accountant Fees and Services56PART IVItem 15.Exhibits and Financial Statement Schedules57 1PART IThis Annual Report (including the following section regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations)contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,”“intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements,but are not the exclusive means of identifying forward-looking statements in this Annual Report. Additionally, statements concerning future matters such as thedevelopment of new products, enhancements or technologies, sales levels, expense levels and other statements regarding matters that are not historical areforward-looking statements.Although forward-looking statements in this Annual Report reflect the good faith judgment of our management, such statements can only be based onfacts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results andoutcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause orcontribute to such differences in results and outcomes include without limitation those discussed under the heading “Risk Factors” in Item 1A below, as wellas those discussed elsewhere in this Annual Report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as ofthe date of this Annual Report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance thatmay arise after the date of this Annual Report. Readers are urged to carefully review and consider the various disclosures made in this Annual Report, whichattempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.Item 1. BusinessAXT, Inc. (“AXT”, “we,” “us,” and “our” refer to AXT, Inc. and all of its subsidiaries) is a leading developer and producer of high-performancecompound and single element semiconductor substrates, including substrates made from gallium arsenide (GaAs), indium phosphide (InP) and germanium(Ge). We currently sell the following substrate products in the sizes and for the applications indicated:SubstratesSubstrateDiameterApplicationsGaAs (semi-insulating)2”, 3”, 4”, 5”, 6”· Power amplifiers and radio frequency integrated circuitsfor wireless handsets (cell phones)· Direct broadcast television· High-performance transistors· Satellite communicationsGaAs (semi-conducting)2”, 3”, 4”· High brightness light emitting diodes· Lasers· Optical couplersInP2”, 3”, 4”· Broadband and fiber optic communicationsGe2”, 4”· Satellite and terrestrial solar cells We manufacture all of our semiconductor substrates using our proprietary vertical gradient freeze (VGF) technology, which enables us to add capacityquickly and cost effectively. Most of our revenue is from sales of GaAs substrates. We manufacture all of our products in the People’s Republic of China(PRC or China), which generally has favorable costs for facilities and labor. We also have five joint ventures in China that provide us favorable pricing,reliable supply and shorter lead-times for raw materials central to our final manufactured products. We consolidate, for accounting purposes, three of thesejoint ventures and have equity interests of 25% in each of the other two. We use our direct sales2force in the United States and independent sales representatives in Europe and Asia to market our substrates. Our ten largest customers for 2006 were: AvagoTechnologies Manufacturing (Singapore) Pte. Ltd., Freescale Semiconductor, Inc., MBE Technology Pte. Ltd., Ningbo Ker Ning Da Ri Fang Magnet Co.,Ltd., Osram Opto Semiconductors GmbH, Picogiga International SAS, IQE, plc., Sumika Epi Solution Co., Ltd., Visual Photonics Epitaxy Co., Ltd., andRecapture Metals Limited. We believe that, as the demand for compound semiconductor substrates is expected to increase, we are positioned to leverage ourPRC-based manufacturing capabilities and access to favorably priced raw materials to increase our market share.In 2005, we made a number of important changes to our management team. Philip C.S. Yin, Ph.D., joined the company in March 2005 as chief executiveofficer and restructured the organization from the top down. In June 2005, two new positions were created: chief operating officer and chief technology officer.Also, the former president of AXT’s China operations became president of joint venture operations. In September 2005, our new vice president of global salesand marketing joined us. This new structure enables us to maximize the expertise and skill sets of our team while placing enhanced emphasis onmanufacturing, production and quality, and quality systems improvement.With the new management team in place, quality, quality systems and revenue began to improve beginning in the third quarter of 2005. InDecember 2005, we reduced the workforce at our Fremont, California facility by 15 full-time equivalent positions that we no longer required to supportproduction and operations, or approximately 29% of the workforce based at this facility.We were incorporated in California in December 1986 and reincorporated in Delaware in May 1998. We changed our name from American XtalTechnology, Inc. to AXT, Inc. in July 2000. Our corporate office is located at 4281 Technology Drive, Fremont, California 94538, and our telephone numberat this address is (510) 683-5900. Our web site is www.axt.com; however, the information on our web site does not constitute a part of this Annual Report onForm 10-K and is not incorporated herein. We make available, free of charge, on or through our web site, our annual, quarterly and current reports, and anyamendments to those reports.Industry BackgroundCertain electronic and opto-electronic applications have performance requirements that exceed the capabilities of conventional silicon substrates and oftenrequire high-performance compound or single element substrates. Examples of higher performance non-silicon based substrates include GaAs, InP, galliumnitride (GaN), silicon carbide (SiC) and Ge.For example, power amplifiers and radio frequency integrated circuits for wireless handsets are made with semi-insulating GaAs substrates. Semi-conducting GaAs substrates are used to create opto-electronic products including high brightness light emitting diodes (HBLEDs) which are often used tobacklight wireless handsets and liquid crystal display (LCD) TVs and for automotive and general illumination applications. InP is a high performancesemiconductor substrate used in broadband and fiber optic applications. Ge substrates are used in emerging applications such as solar cells for space andterrestrial photovoltaic applications.The total market for high performance GaAs, InP and Ge substrates is expected to grow from $529 million in 2005 to $1.1 billion in 2010, a compoundannual growth rate of approximately 16%, according to Strategy Analytics, an independent research firm.The primary costs of manufacturing compound semiconductor substrates are labor, raw materials and manufacturing equipment such as crystalgrowing furnaces. Substrate manufacturers are shifting production to larger wafers to reduce manufacturing costs. Strategy Analytics estimates that demandfor 6” wafers will grow at a compound annual growth rate of approximately 28% from 2005 through 2010.3Suppliers of compound semiconductor substrates typically compete on product quality, product lead-time, price, device performance, meeting customerspecifications and providing customer support. A compound semiconductor substrate customer typically has two or three substrate suppliers that it hasqualified for the production of its products. These qualified suppliers must meet industry-standard specifications for quality, on-time delivery and customersupport. Once a substrate supplier has qualified with a customer, price, consistent quality and current and future product delivery lead times become the mostimportant competitive factors. A supplier that cannot meet customers’ current lead times or that a customer perceives will not be able to meet future demandand provide consistent quality can lose current market share.The AXT AdvantageWe believe that we benefit from the following advantages:· Low-cost manufacturing operation in the PRC. Since 2004, we have manufactured all of our products in China, which generally has favorablecosts for facilities and labor. Approximately 983 of our 1,022 employees are in China. Our primary competitors have their manufacturing operationsin Germany or Japan.· Favorable access to raw materials. Our joint ventures provide us favorable pricing, reliable supply and shorter lead-times for raw materials centralto our final manufactured products. These materials include gallium, arsenic, germanium, germanium dioxide, paralytic boron nitride crucibles andboron oxide. As a result, we believe that our joint ventures will enable us to meet potential increases in demand from our customers.· Flexible manufacturing infrastructure. Our total manufacturing space in China is approximately 190,000 square feet, 90,000 square feet of whichwe currently use and the remainder of which we have configured for relatively rapid expansion. We believe that our competitors typically purchasecrystal growing furnaces from original equipment manufacturers. In contrast, we design and build our own VGF crystal growing furnaces, whichshould allow us to increase our production capacity more quickly and cost effectively.Given these advantages, we believe that, as the demand for compound semiconductor substrates increases, we are positioned to leverage our PRC-basedmanufacturing capabilities and access to favorably priced raw materials to increase our market share. As an example, we are currently working to addsignificant additional capacity in 6” GaAs substrates to meet expected increasing market demands. In addition, each of our five joint ventures are alsoincreasing capacity.StrategyOur goal is to become the leading worldwide supplier of high-performance compound and single element semiconductor substrates. Key elements of ourstrategy include:Continue to provide customers high and consistent quality products and service. We seek to improve our manufacturing processes continually inorder to meet and exceed our customers’ high product quality standards, ensure on-time delivery of our products and optimize the cost of ownership. Inaddition, we plan to continue to enhance our support functions, including service and applications engineering.Increase market share.We intend to leverage our product quality, competitive pricing and lead times both to establish relationships with new customersand to increase our market share with current customers in the integrated circuits for wireless handsets and HBLED markets.4Add capacity to meet customers’ increasing demand for substrates. We believe that the markets for our substrates are currently capacityconstrained. We intend to add additional capacity in order to meet our customers’ current and anticipated increased demands, specifically in 6” GaAssubstrates.Establish leadership in emerging substrate applications. We intend to expand our served markets by exploring new opportunities for our substrates.For example, due to Ge’s inherent high efficiency and the increasing supply constraints of traditional poly-silicon, some customers have begun to research theuse of Ge substrates for terrestrial solar cell applications.TechnologyOur core technologies include our proprietary VGF technique used to produce high quality crystals that are processed into compound substrates, and thetechnologies of our joint venture companies, which enable us to manufacture a range of products that are used in the manufacture of compound semiconductorsubstrates or can be sold as raw materials to third parties.Our VGF technique is designed to control the crystal-growth process with minimal temperature variation and is the technique we use to produce ourGaAs, InP and Ge substrates. Unlike traditional techniques, our VGF technique places the hot compound melt above the cool crystal, and minimizes thetemperature gradient between the crystal and the melt which reduces the turbulence at the interface of the melt and the solid crystal. In comparison, in theLiquid Encapsulation Czochralski (LEC) technique the melt and crystal are inverted, there is a higher temperature gradient between the melt and the crystal,and more turbulence at the interface of the melt and solid crystal. These aspects of the VGF technique enable us to grow crystals that have a relatively lowdefect density and high uniformity. The crystal and the resulting substrate are mechanically strong, resulting in lower breakage rates during a customer’smanufacturing process. Since the temperature gradient is controlled electronically rather than by physical movement, the sensitive crystal is not disturbed as itmay be during some competitors’ VGF-like growth processes. In addition, the melt and growing crystal are contained in a closed chamber, which isolates thecrystal from the outside environment to reduce potential contamination. This substrate isolation allows for more precise control of the gallium-to-arsenic ratio,resulting in better consistency and uniformity of the crystals.Our VGF technique offers several benefits when compared to traditional crystal growing technologies. The Horizontal Bridgman (HB) technique is thetraditional method for producing semi-conducting GaAs substrates for opto-electronic applications. The HB technique holds the GaAs melt in a semi-cylindrical5container, causing crystals grown using the HB method to have a semi-circular, or D-shaped, cross-section. Accordingly, more crystal material is discardedwhen the D-shaped substrate is subsequently trimmed to a round shape. In addition, crystals grown using the HB technique have a higher defect density thanVGF-grown crystals. The HB technique cannot be used cost-effectively to produce substrates greater than three inches in diameter. The HB technique housesthe GaAs melt in a quartz container during the growth process, which can contaminate the GaAs melt with silicon impurities, making it unsuitable forproducing semi-insulating GaAs substrates.Our VGF technique also offers advantages over the LEC technique for producing semi-insulating GaAs substrates for electronic applications. During theLEC process, the crystal is grown by dipping a seed crystal through molten boric oxide into a melt of gallium and arsenic poly-crystal material and slowlypulling the seed up into the cool zone above the boron oxide where the crystal hardens. Unlike the VGF technique, the LEC technique is designed so that thehotter GaAs melt is located beneath the cooler crystal, resulting in greater turbulence in the melt, and at a temperature gradient that is significantly higher thanthe VGF technique. The turbulence and high temperature gradient cause LEC-grown crystals to have a higher dislocation density than VGF-grown crystals,resulting in a higher rate of breakage during the device manufacturing process. As an open process, the LEC technique also results in greater propensity forcontamination and difficulty controlling the ratio of gallium to arsenic. It requires large, complex electro-mechanical systems that are expensive and requirehighly skilled personnel to operate.The following table provides a comparison of these three techniques:VGFHBLECSubstrate applicationsElectronic andopto-electronicOpto-electronicElectronicLargest wafer size in commercial use6”3”6”Stress/defect levelsVery LowLowHighCrystal purityGoodPoorGoodApplicability to multiple materialsGaAs, InP, GeGaAsGaAs, InP, GaPEquipment and labor costVery LowLowHighAmount of waste materialVery LowHighLowEquipment flexibilityVersatileLimitedLimitedEquipment downtimeMinimalModerateHighNumber of competitorsSeveralDecliningDecliningProductsWe design, develop, manufacture and distribute high-performance semiconductor substrates. The table below sets forth our products and selectedapplications:ProductApplicationsSubstratesElectronicOpto-electronicGaAs· Cellular phones· LEDs· Direct broadcast television· Lasers· High-performance transistors· Optical couplers· Satellite communicationsInP· Fiber optic communications· Lasers· Satellite communications· High-performance transistors· Automotive collision avoidance radarGe· Satellite solar cells6Substrates. We currently sell compound substrates manufactured from GaAs and InP, as well as single-element substrates manufactured from Ge. Wesupply GaAs substrates in two-, three-, four-, five- and six-inch diameters. We manufacture InP substrates in two-, three- and four-inch diameters and Gesubstrates in two- and four-inch diameters.Materials. We participate in five joint ventures in China that sell raw materials used by us in substrate manufacturing and by others. These jointventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, and germanium, germanium dioxide, paralytic boronnitride (pBN) crucibles, and boron oxide (B2O3). In 2006 and 2005, sales of raw materials to parties other than us were approximately $5.3 million and $4.8million, respectively, which comprised of all of these products.CustomersWe sell our compound semiconductor substrates and materials worldwide. Our top revenue producing customers include:·Avago Technologies Manufacturing(Singapore) Pte. Ltd.· Intelligent Epitaxy Technology· Picogiga International SAS·Bookham· IQE (Europe) Limited· Recapture Metals Limited·China Electronics Technology Group· IQE, plc.· Sumika Epi Solution Co., Ltd.·Continental Metals, Inc.· Ningbo Ker Ning Da Ri FangMagnet Co., Ltd.· Visual Photonics Epitaxy Co.,Ltd.·Epitech Technology Corporation· MBE Technology Pte. Ltd.· Xiamen Sanan Electronics Co.,Ltd.·Epiworks, Inc.· MCP, UK.· Xiamen Xinde Co., Ltd.·Freescale Semiconductor, Inc.· Osram Opto SemiconductorsGmbH Historically, we have sold a significant portion of our products in any particular period to a limited number of customers. One customer, VisualPhotonics Epitaxy Co., Ltd., represented greater than 10% of revenue, totaling 12.8%, for the year ended December 31, 2006, two customers, Osram OptoSemiconductors GmbH, and MBE Technology Pte. Ltd., represented greater than 10% of revenue, totaling 20.7%, for the year ended December 31, 2005,while no customers represented greater than 10% of revenue for the year ended December 31, 2004. Our top five customers represented 40.0% of revenue for theyear ended December 31, 2006, 37.5% of revenue for the year ended December 31, 2005, and 30.1% of revenue for the year ended December 31, 2004. Weexpect that sales to a small number of customers will continue to comprise a significant portion of our revenue in the future.The third party customers for our raw materials products are in many instances the same as our customers for substrates. There have been no thirdparty customers for our raw materials that account for greater than 10% of revenue for the years ended December 31, 2006, 2005 and 2004. Our joint venturesare a key strategic benefit for us as they give us a strong competitive advantage of allowing our customers to work with one supplier for all their substrate andraw material requirements.Manufacturing, Raw Materials and SuppliesWe believe that our results are partially due to our manufacturing efficiency and high product yields and we continually emphasize quality and processcontrol throughout our manufacturing operations. We perform our substrate manufacturing operations at our facilities in Beijing, China. During 2004, wediscontinued our manufacturing and research and development activities at our Fremont, California7facility. We believe that our capital investment and subsequent operating costs are lower for our manufacturing facilities in China relative to the U.S. Many ofour manufacturing operations are fully automated and computer monitored or controlled, enhancing reliability and yield. We use proprietary equipment in oursubstrate manufacturing operations to protect our intellectual property and control the timing and pace of capacity additions. All of our manufacturing facilitiesare ISO 9001 or 9002 certified. In January 2006, our Beijing facility successfully passed the ISO 14001 certification audit.Although we purchase supply parts, components and raw materials from several domestic and international suppliers, we depend on a single or limitednumber of suppliers for certain critical materials used in the production of our substrates, such as quartz tubing, and polishing solutions. We generallypurchase these materials through standard purchase orders and not pursuant to long-term supply contracts. Although we seek to maintain sufficient inventorylevels of certain materials to guard against interruptions in supply and to meet our near term needs, and have to date been able to obtain sufficient supplies ofmaterials in a timely manner, there may be shortages of certain key materials, such as gallium. Accordingly, to help ensure continued supply of materials, weformed five joint ventures with and made investments in some suppliers of key raw materials required to manufacture our products, including gallium,arsenic, germanium, germanium dioxide, pyrolitic boron nitride crucibles, and boron oxide. We believe that these joint ventures and investments will beadvantageous in procuring materials to support our growth and cost management goals.Sales and MarketingWe advertise in trade publications, distribute promotional materials, conduct marketing and sales programs, and participate in industry trade shows andconferences in order to raise market awareness of our products. We sell our substrate products through our direct sales force in the U.S. and throughindependent sales representatives in France, Germany, Japan, South Korea, Taiwan and the United Kingdom. Our direct sales force is knowledgeable in theuse of compound and single-element substrates. Our applications engineers work with customers during all stages of the substrate manufacturing process,from developing the precise composition of the substrate through manufacturing and processing the substrate to the customer’s specifications. We believe thatmaintaining a close relationship with customers and providing them with ongoing engineering support improves customer satisfaction and will provide us witha competitive advantage in selling other substrates to our customers. The substrate division launched a program in late 2000 with selected customers in whichwe guaranteed that certain volumes of six-inch GaAs and other substrates would be delivered on specific dates and the customer made a prepayment for part ofthe value of the entire order. Several major customers participated in this program. We did not continue this program. As of December 31, 2006, there were noremaining unearned pre-payments under this program.International Sales. International sales are an important part of our business. For the year ended December 31, 2006, sales to customers outside NorthAmerica (primarily United States) accounted for 71% of our revenue, as compared with 81% in 2005 and with 79% in 2004. The primary markets for salesof our substrate products outside of the United States include countries in Asia and Western Europe.In 2006, through our joint ventures we expanded our raw material offering that included 4N, 6N, and 7N gallium, boron oxide, germanium, arsenic,germanium dioxide, paralytic boron nitride crucibles used in crystal growth and parts for MBE (Molecular Beam Epitaxy). Our joint ventures are a keystrategic benefit for us as they give us a strong competitive advantage of allowing our customers to work with one supplier for all their substrate and rawmaterial requirements.8Research and DevelopmentTo maintain and improve our competitive position, we focus our research and development efforts on designing new proprietary processes and products,improving the performance of existing products and reducing manufacturing costs. We have assembled a multi-disciplinary team of skilled scientists,engineers and technicians to meet our research and development objectives.Our current substrate research and development activities focus on continued development and enhancement of GaAs, InP and Ge substrates, includinghaze reduction, improved yield, enhanced surface and electrical characteristics and uniformity, greater substrate strength and increased crystal length. During2006, we continued to spend some research and development resources to reduce surface quality problems we experienced with our GaAs and InP substratesfor some customers, particularly related to surface morphology. We continue to work on issues related to surface quality.Research and development expenses were $2.4 million in 2006, compared with $1.7 million in 2005 and $1.5 million in 2004. We expect to maintain ourrate of expenditure on research and development costs in 2007.Research and development at our joint ventures will remain at a minimal level.CompetitionThe semiconductor substrate industry is characterized by rapid technological change and price erosion, as well as intense foreign and domesticcompetition. We believe we currently have a leading position in the market for GaAs substrates for HBLED applications primarily as a result of our expertisein VGF technology, overall product quality, response times and prices. However, we face actual and potential competition from a number of establisheddomestic and international companies who have advantages not available to us.We believe that the primary competitive factors in the markets in which our substrate products compete are:· quality;· price;· performance;· meeting customer specifications; and· customer support and satisfaction.Our ability to compete in target markets also depends on factors such as:· the timing and success of the development and introduction of new products and product features by us and our competitors;· the availability of adequate sources of raw materials;· protection of our products by effective use of intellectual property laws; and· general economic conditions.Our primary competition in the market for compound semiconductor substrates includes Crystal Technologies, Freiberger Compound Materials, JapanEnergy, Mitsubishi Chemical Corporation, and Sumitomo Electric Industries. We believe that at least two of our competitors are shipping high volumes ofGaAs substrates manufactured using a technique similar to our VGF technique. In addition, as a result of quality problems that we have experienced, webelieve that some customers have allocated some of their9requirements for VGF grown substrates across more competitors and we believe that we may have lost revenue and market share as a result of these customerdecisions. In addition, we also face competition from compound semiconductor device manufacturers that produce substrates for their own internal use,including Hitachi, and from companies such as IBM that are actively developing alternative compound semiconductor materials.We are the only compound semiconductor substrate supplier to offer a full suite of raw materials and we believe that it gives us a strong competitiveadvantage in our marketplace.Protection of our Intellectual PropertyOur success and the competitive position of our VGF technique depend on our ability to maintain trade secrets and other intellectual property protections.We rely on a combination of patents, trademark and trade secret laws, non-disclosure agreements and other intellectual property protection methods to protectour proprietary technology. We believe that, due to the rapid pace of technological innovation in the markets for our products, our ability to establish andmaintain a position of technology leadership depends as much on the skills of our development personnel as upon the legal protections afforded our existingtechnologies. To protect our trade secrets, we take certain measures to ensure their secrecy, such as executing non-disclosure agreements with our employees,customers and suppliers. However, reliance on trade secrets is only an effective business practice insofar as trade secrets remain undisclosed and a proprietaryproduct or process is not reverse engineered or independently developed.To date, we have been issued three U.S. patents which relate to our VGF products and processes. We have six patent applications pending, (in PatentCooperation Treaty (“PCT”)/national stage process) in Europe, Canada, China, Japan and South Korea which are based on our U.S. patents that relate to ourVGF processes. We have one issued foreign patent.In connection with a final settlement of litigation, we entered into a global intellectual property cross-licensing agreement with Sumitomo ElectricIndustries, Ltd. (SEI). Under the terms of the settlement, we will make on-going royalty payments through 2012 on certain products sold by us in Japan.In the normal course of business, we periodically receive and make inquiries regarding possible patent infringement. In dealing with such inquiries, itmay become necessary or useful for us to obtain or grant licenses or other rights. However, there can be no assurance that such licenses or rights will beavailable to us on commercially reasonable terms. If weare not able to resolve or settle claims, obtain necessary licenses on commercially reasonable termsand/or successfully prosecute or defend its position, our business, financial condition and results of operations could be materially and adversely affected.Environmental RegulationsWe are subject to federal, state and local environmental laws and regulations, including laws in China as well as the U.S. These laws, rules andregulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development and salesdemonstrations. We maintain a number of environmental, health and safety programs that are primarily preventive in nature. As part of these programs, weregularly monitor ongoing compliance. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or cessation of our operations.EmployeesAs of December 31, 2006, we had 1,022 employees, of whom 819 were principally engaged in manufacturing, 119 in sales and administration, and 84in research and development. Of these employees, 39 are located in the U.S., and 983 in China. As of December 31, 2005, we had 842 employees, of whom10680 were principally engaged in manufacturing, 116 in sales and administration, and 46 in research and development. Of these employees, 55 were locatedin the U.S., and 787 in China.In December 2005, as part of our ongoing effort to reduce our Fremont, California facility headcount, we reduced the workforce at the facility by 15 full-time equivalent positions that we no longer required to support production and operations, or approximately 29% of the workforce based at this facility. Someof our employees in China are represented by a union, but we have never experienced a work stoppage. Although morale has been affected by our workforcereductions in California, we consider our relations with our employees to be good.Available of InformationOur principal executive offices are located at 4281 Technology Drive, Fremont, CA 94538, and our main telephone number is (510) 683-5900. Thepublic may read and copy any material we file with the Securities and Exchange Commission, or SEC, at the SEC’s Public Reference Room at 450 FifthStreet, N.W., Washington D.C., 20549. The public may obtain information on the operations of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site, http://www.sec.gov, that contains reports, proxy and information statements and other information regardingissuers that file electronically with the SEC.11Item 1A. Risk FactorsFor ease of reference, we have divided these risks and uncertainties into the following general categories:· Risks related to our general business;· Risks related to international aspects of our business;· Risks related to our financial results and capital structure;· Risks related to our intellectual property; and· Risks related to compliance and other legal matters.Risks Related to Our General BusinessDefects in our products could diminish demand for our products.Our products are complex and may contain defects. We have experienced quality control problems with many of our products, which caused customersto return products to us, reduce orders for our products, or both. Although our quality has improved, resulting in some increases in product sales, we believethat we continue to experience some reduction in orders as a result of our prior product quality problems. If we continue to experience quality control problems,or experience these or other problems in new products, customers may cancel or reduce orders or purchase products from our competitors, we may be unableto maintain or increase sales to our customers and sales of our products could decline. Defects in our products could cause us to incur higher manufacturingcosts and suffer product returns and additional service expenses, all of which could adversely impact our operating results.If new products developed by us contain defects when released, our customers may be dissatisfied and we may suffer negative publicity or customerclaims against us, lose sales or experience delays in market acceptance of our new products.Decreases in average selling prices of our products may reduce gross margins.The market for compound semiconductor substrates is characterized by pressures on average selling prices resulting from factors such as increasedcompetition or overcapacity. We have experienced and expect to continue to experience price pressures on our products, and if average selling prices decline inthe future, our revenue and gross margins could decline. We may be unable to reduce the cost of our products sufficiently to offset the effect of lower sellingprices and allow us to keep pace with competitive pricing pressures, and our margins could be adversely affected.The loss of one or more of our key substrate customers would significantly hurt our operating results.A small number of substrate customers have historically accounted for a substantial portion of our total revenue. Our top five customers represented40.0% of revenues for the year ended December 31, 2006, 37.5% of revenue for the year ended December 31, 2005, and 30.1% of revenue for the year endedDecember 31, 2004. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate customers. Ourcustomers are not obligated to purchase a specified quantity of our products or to provide us with binding forecasts of product purchases. In addition, ourcustomers may reduce, delay or cancel orders at any time without any significant penalty. In the past, we had experienced slower bookings, significant push-outs and cancellation of orders from customers. If we lose a major customer or if a customer cancels, reduces or delays orders, our revenue would decline. Inaddition, customers that have accounted for significant revenue in the past may not continue to generate revenue for us in any future period. Any delay inscheduled shipments of our products could cause revenue12to fall below our expectations and the expectations of market analysts or investors, causing our stock price to decline.Our results of operations may suffer if we do not effectively manage our inventory.We must manage our inventory of component parts, work-in-process and finished goods effectively to meet changing customer requirements, whilekeeping inventory costs down and improving gross margins. Some of our products and supplies have in the past and may in the future become obsolete whilein inventory due to changing customer specifications, or become excess inventory due to decreased demand for our products and an inability to sell theinventory within a foreseeable period. Furthermore, if current costs of production increase or sales prices drop below the standard prices at which we valueinventory, we may need to take a charge for a reduction in inventory values. We have in the past had to take inventory valuation and impairment charges. Anyfuture unexpected changes in demand or increases in costs of production that cause us to take additional charges for un-saleable, obsolete or excess inventory,or to reduce inventory values, could adversely affect our results of operations.If we have low product yields, or if there is a deliberate sabotage of our products, the shipment of our products may be delayed and our operatingresults may be adversely impacted.Our products are manufactured using complex technologies, and the number of usable substrates we produce can fluctuate as a result of many factors,including:· impurities in the materials used;· contamination of the manufacturing environment;· substrate breakage;· equipment failure, power outages or variations in the manufacturing process; and· performance of personnel involved in the manufacturing process.If our yields decrease, our revenue could decline if we are unable to produce needed product on time. At the same time, our manufacturing costs couldremain fixed, or could increase. We have experienced product shipment delays and difficulties in achieving acceptable yields on both new and older products,and delays and poor yields have adversely affected our operating results. We may experience similar problems in the future and we cannot predict when theymay occur or their severity. In particular, many of our manufacturing processes are new and are still being refined, which can result in lower yields.If there is deliberate sabotage of our products making them unfit for use by our customers, our products would be rejected, resulting in compensationcosts paid to our customers, and possible disqualification. This could lead to revenue loss and market share loss.If we do not successfully develop new products to respond to rapidly changing customer requirements, our ability to generate revenue, obtain newcustomers, and retain existing customers may suffer.Our success depends on our ability to offer new products and product features that incorporate leading technology and respond to technological advances.In addition, our new products must meet customer needs and compete effectively on quality, price and performance. The life cycles of our products aredifficult to predict because the markets for our products are characterized by rapid technological change, changing customer needs and evolving industrystandards. If our competitors introduce products employing new technologies or performance characteristics, our existing products could become obsolete andunmarketable. During the past three years, we have seen our competitors selling more substrates manufactured using a crystal growth technology similar toours, which has eroded our technological differentiation. Other companies, including Triquent, are actively developing substrate materials that could13be used to manufacture devices that could provide the same high-performance, low-power capabilities as GaAs- and InP-based devices at competitive prices. Ifthese substrate materials or VGF-derived products are successfully developed and semiconductor device manufacturers adopt them, demand for our GaAssubstrates could decline and our revenue could suffer.The development of new products can be a highly complex process, and we may experience delays in developing and introducing new products. Anysignificant delays could cause us to fail to timely introduce and gain market acceptance of new products. Further, the costs involved in researching,developing and engineering new products could be greater than anticipated. If we fail to offer new products or product enhancements or fail to achieve higherquality products, we may not generate sufficient revenue to offset our development costs and other expenses or meet our customers’ requirements.Intense competition in the markets for our products could prevent us from increasing revenue and sustaining profitability.The markets for our products are intensely competitive. We face competition for our substrate products from other manufacturers of substrates, such asFreiberger Compound Materials, Hitachi Cable and Sumitomo Electric, from semiconductor device manufacturers that produce substrates for their own use,and from companies, such as Triquent, that are actively developing alternative materials to GaAs and marketing semiconductor devices using these alternativematerials. We believe that at least two of our major competitors are shipping high volumes of GaAs substrates manufactured using a technique similar to ourVGF technique. Other competitors may develop and begin using similar technology. If we are unable to compete effectively, our revenue may not increase andwe may be unable to become profitable. We face many competitors that have a number of significant advantages over us, including:· greater experience in the business;· more manufacturing experience;· extensive intellectual property;· broader name recognition; and· significantly greater financial, technical and marketing resources.Our competitors could develop new or enhanced products that are more effective than our products are.The level and intensity of competition has increased over the past year and we expect competition to continue to increase in the future. Competitivepressures caused by the current economic conditions have resulted in reductions in the prices of our products, and continued or increased competition couldreduce our market share, require us to further reduce the prices of our products, affect our ability to recover costs and result in reduced gross margins.In addition, new competitors have and may continue to emerge, such as a small crystal growing company established by a former employee of ours inChina that is supplying ingots to the market. While new competitors such as this company currently do not appear to be fully competitive, competition fromsources such as this could increase, particularly if these competitors are able to obtain large capital investments.14Demand for our products may decrease if our customers experience difficulty manufacturing, marketing or selling their products.Our products are used as components in our customers’ products. Accordingly, demand for our products is subject to factors affecting the ability of ourcustomers to introduce and market their products successfully, including:· the competition our customers face in their particular industries;· the technical, manufacturing, sales and marketing and management capabilities of our customers;· the financial and other resources of our customers; and· the inability of our customers to sell their products if they infringe third-party intellectual property rights.If demand for the end-user applications for which our products are used decreases, or our customers are unable to develop, market and sell theirproducts, demand for our products will decrease.The financial condition of our customers may affect their ability to pay amounts owed to us.Many of our customers are facing business downturns that have reduced their cash balances and their prospects. We frequently allow our customers topay for products we ship to them within 30 to 120 days after delivery. Subsequent to our shipping a product, some customers have been unable to makepayments as due, reducing our cash balances and causing us to incur charges to allow for a possibility that some accounts might not be paid. Customers mayalso be forced to file for bankruptcy. If our customers do not pay their accounts when due, we will be required to incur charges that would reduce our earnings.We purchase critical raw materials and parts for our equipment from single or limited sources, and could lose sales if these sources fail to fill ourneeds.We depend on a limited number of suppliers for certain raw materials, components and equipment used in manufacturing our products, including keymaterials such as quartz tubing, polishing solutions and paralytic boron nitride. Although several of these raw materials are purchased from suppliers inwhich we hold an ownership interest, we generally purchase these materials through standard purchase orders and not pursuant to long-term supply contractsand no supplier guarantees supply of raw materials or equipment to us. If we lose any of our key suppliers, our manufacturing efforts could be significantlyhampered and we could be prevented from timely producing and delivering products to our customers. Prior to investing in our raw material joint ventures, wesometimes experienced delays obtaining critical raw materials and spare parts, including gallium, due to shortages of these materials and could experience suchdelays again in the future due to shortages of materials and may be unable to obtain an adequate supply of materials. These shortages and delays could resultin higher materials costs and cause us to delay or reduce production of our products. If we have to delay or reduce production, we could fail to meet customerdelivery schedules and our revenue and operating results could suffer.We have made and may continue to make strategic investments in raw materials suppliers, which may not be successful and may result in the lossof all or part of our investment.We have made investments through our five joint ventures in raw material suppliers in China, which provide us with opportunities to gain supplies ofkey raw materials that are important to our substrate business. These affiliates each have a market beyond that provided by us. We do not have influence overall of these companies, each of which is located in China, and in some we have made only a strategic, minority investment. We may not be successful inachieving the financial, technological or commercial15advantage upon which any given investment is premised, and we could end up losing all or part of our investment.Our substrate products have a long qualification cycle that makes it difficult to plan our expenses and forecast our results.Customers typically place orders with us for our substrate products three months to a year or more after our initial contact with them. The sale of ourproducts may be subject to delays due to our customers’ lengthy internal budgeting, approval and evaluation processes. During this time, we may incursubstantial expenses and expend sales, marketing and management efforts while the customers evaluate our products. These expenditures may not result insales of our products. If we do not achieve anticipated sales in a period as expected, we may experience an unplanned shortfall in our revenue. As a result, wemay not be able to cover expenses, causing our operating results to vary. In addition, if a customer decides not to incorporate our products into its initialdesign, we may not have another opportunity to sell products to this customer for many months or even years. In the current competitive and economicclimate, the average sales cycle for our products has lengthened even further and is expected to continue to make it difficult to forecast our future salesaccurately. We anticipate that sales of any future substrate products will also have lengthy sales cycles and will, therefore, be subject to risks substantiallysimilar to those inherent in the lengthy sales cycles of our current substrate products.Risks Related to International Aspects of Our BusinessChanges in tariffs, import restrictions, export restrictions or other trade barriers may reduce gross margins.We may incur increases in costs due to changes in tariffs, import or export restrictions, or other trade barriers, or unexpected changes in regulatoryrequirements, any of which could reduce our gross margins. For example, in September 2006 and November 2006, tax authorities in the People’s Republic ofChina (PRC) changed the treatment of refunds of value-added taxes that companies pay when they purchase certain raw materials, including gallium andarsenic. The cumulative effect is that our PRC joint venture companies no longer receive a refund of value-added tax for exports of gallium or arsenic,including certain shipments to our wholly-owned PRC subsidiary that are treated as exports under PRC tax regulations. However, our PRC joint venturecompanies sell only a portion of their gallium in transactions that are considered exports, and none of those PRC joint venture companies currently exportsarsenic. Therefore, after having conducted further analysis on our consolidated financial results, which include a portion of the financial impact of these taxreleases on our PRC joint venture companies, we believe that our consolidated financial results will not be materially affected. However, given the relativelyfluid regulatory environment in the PRC, there could be additional tax or other regulatory changes in the future. Any such changes could directly andmaterially adversely impact our financial results and general business condition.Our operating results depend in large part on continued customer acceptance of our substrate products manufactured in China and continuedimprovements in product quality.We manufacture all of our products in China, and source most of our raw materials in China. Accordingly, we continue to seek customer qualification ofour China-manufactured products. In addition, we have in the past experienced quality problems with our China-manufactured products. Our previousquality problems caused us to lose market share to our competitors, as some customers reduced their orders from us until our surface quality was as good andconsistent as that offered by competitors and customers allocated their requirements for compound semiconductor substrates across more competitors. If weare unable to continue to achieve customer qualifications for our products, or if we again experience quality problems, customers may not increase purchasesof our products, our China facility will become underutilized, and we will be unable to achieve expected revenue growth. We may again lose sales of our16products to competitors and experience loss of market share. If we are unable to recover and retain our market share, we may be unable to grow our business.Problems incurred by our joint ventures or venture partners could result in a material adverse impact on our financial condition or results ofoperationsWe have invested in five joint venture operations in China that produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic,germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles and boron oxide. We purchase a portion of the materials produced by these venturesfor our use and sell the remainder of their production to third parties. Our ownership interest in these entities ranges from 25% to 83%. We consolidate the threeventures in which we own a majority or controlling financial interest and employ equity accounting for the two joint ventures in which we have a 25% interest.Several of these ventures occupy space within larger facilities owned and/or operated by one of the other venture partners. Several of these venture partners areengaged in other manufacturing activities at or near the same facility. In some facilities, we share access to certain functions, including water, hazardous wastetreatment or air quality treatment. If any of our joint venture partners in any of these five ventures experiences problems with its operations, disruptions of ourjoint venture operations could result, having a material adverse effect on the financial condition and results of operation of our joint ventures, andcorrespondingly on our financial condition or results of operations.In addition, if any of our joint ventures or venture partners with which our joint ventures share facilities is deemed to have violated applicable laws,rules or regulations governing the use, storage, discharge or disposal of hazardous chemicals during manufacturing, research and development, or salesdemonstrations, the operations of our joint ventures could be adversely affected and we could be subject to substantial liability for clean-up efforts, personalinjury and fines or suspension or cessation of our joint venture operations as a result of the actions of the joint ventures or other venture partners. Employeesworking for our joint ventures or any of the other venture partners could bring litigation against us as a result of actions taken at the joint venture or venturepartner facilities, even though we are not directly controlling the operations, including actions for exposure to chemicals or other hazardous materials at thefacilities of our joint ventures or the facilities of any venture partner that are shared by our joint ventures. If litigation is brought against us, litigation isinherently uncertain and, while we would expect to defend ourselves vigorously, it is possible that our business, financial condition, results of operations orcash flows could be affected in any particular period by any litigation if brought against us, particularly if litigation with us, as a non-Chinese company, isdeemed advantageous. Even if we are not deemed responsible for the actions of the joint ventures or venture partners, litigation could be costly, time consumingto defend and divert management attention; in addition, pursuit of us could occur if we are deemed to be the most financially viable of the partners.Going forward, we believe that investing in additional joint ventures will be important to remaining competitive in our marketplace and ensuring a supplyof critical raw materials. However, we may not be able to identify complementary joint venture opportunities or, even once opportunities are identified, we maynot be able to reach agreement on the terms of the venture with the other venture partners. Additional joint ventures could cause us to incur contingent liabilitiesor other expenses, any of which could adversely affect our financial condition and operating results.Since all of our joint venture activity is expected to occur in China, these activities could subject us to a number of risks associated with conductingoperations internationally, including:· difficulties in managing geographically disparate operations;· difficulties in enforcing agreements through non-U.S. legal systems;17· unexpected changes in regulatory requirements that may limit our ability to export the venture products or sell into particular jurisdictions or imposemultiple conflicting tax laws and regulations;· political and economic instability, civil unrest or war;· terrorist activities that impact international commerce;· difficulties in protecting our intellectual property rights, particularly in countries where the laws and practices do not protect proprietary rights to asgreat an extent as do the laws and practices of the United States;· changing laws and policies affecting economic liberalization, foreign investment, currency convertibility or exchange rates, taxation or employment;and· nationalization of foreign-owned assets, including intellectual property.The impact of changes in global economic conditions on our customers may cause us to fail to meet expectations, which would negatively impactthe price of our stock.Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. The revenue growth andprofitability of our business depends on the overall demand for our substrates, and we are particularly dependent on the market conditions for the wireless,solid-state illumination, fiber optics and telecommunications industries. Because our sales are primarily to major corporate customers whose businessesfluctuate with general economic and business conditions, a softening of demand for products that use our substrates, caused by a weakening economy, mayresult in decreased revenue. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing productsdue to the downturn in their business and in the general economy.We derive a significant portion of our revenue from international sales, and our ability to sustain and increase our international sales involvessignificant risks.Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 71%, 81% and 79% of ourtotal revenue for the years ended December 31, 2006, 2005 and 2004, respectively. We expect that sales to customers outside the U.S., particularly sales tocustomers in Asia, will continue to represent a significant portion of our revenue.Currently, an increasing percentage of our sales is to customers headquartered in Asia. All of our manufacturing facilities and some of our suppliers arealso located outside the U.S. Managing our overseas operations presents challenges, including periodic regional economic downturns, trade balance issues,varying business conditions and demands, political instability, variations in enforcement of intellectual property and contract rights in different jurisdictions,differences in the ability to develop relationships with suppliers and other local businesses, changes in U.S. and international laws and regulations includingU.S. export restrictions, fluctuations in interest and currency exchange rates, the ability to provide sufficient levels of technical support in different locations,cultural differences, shipping delays and terrorist acts or acts of war, among other risks. Many of these challenges are present in China, which represents alarge potential market for semiconductor devices and where we anticipate significant opportunity for growth. Global uncertainties with respect to: (i) economicgrowth rates in various countries; (ii) sustainability of demand for electronics products; (iii) capital spending by semiconductor manufacturers; (iv) priceweakness for certain semiconductor devices; and (v) political instability in regions where we have operations may also affect our business, financial conditionand results of operations.18Our dependence on international sales involves a number of risks, including:· changes in tariffs, import restrictions, export restrictions, or other trade barriers;· unexpected changes in regulatory requirements;· longer periods to collect accounts receivable;· changes in export license requirements;· political and economic instability;· unexpected changes in diplomatic and trade relationships; and· foreign exchange rate fluctuations.Our sales are denominated in U.S. dollars, except for sales to our Japanese and some Taiwanese customers, which are denominated in Japanese yen.Thus, increases in the value of the U.S. dollar could increase the price of our products in non-U.S. markets and make our products more expensive thancompetitors’ products in these markets.Also, denominating some sales in Japanese yen subjects us to fluctuations in the exchange rates between the U.S. dollar and the Japanese yen. Thefunctional currency of our Chinese subsidiary and joint ventures is the local currency. We incur transaction gains or losses resulting from consolidation ofexpenses incurred in local currencies for these entities, as well as in translation of the assets and liabilities of their assets at each balance sheet date. If we do noteffectively manage the risks associated with international sales, our revenue, cash flows and financial condition could be adversely affected.Because of power shortages in the PRC, we may have to temporarily close our China operations, which would adversely impact our ability tomanufacture our products and meet customer orders, and would result in reduced revenue.The Chinese government faced a power shortage over the summer of 2004 and reported that power demand in 24 provinces outstripped supply in peakperiods during January to April of 2004. Instability in electrical supply caused sporadic outages among residential and commercial consumers. As a result, theChinese government implemented tough measures in 2004 to ease the energy shortage. Provinces imposed power brownouts during 2004 to reduce electricitydemand, and some companies in Beijing were ordered to give their employees a week off to ease the pressure on power supply. Plants, most of which are state-owned, were closed and reopened on a staggered schedule to reduce power consumption during the capital’s hottest months during 2004. As a result, we closedmost of our operations for a week in late July 2004 in conformance with this policy.In 2006 we were able to switch the electrical supply for our manufacturing facility onto the same power grid as that used by vital PRC governmentservices such as hospitals and police. However, if even despite this switch we are required to make temporary closures of our subsidiary and joint ventureoperations, we may be unable to manufacture our products, and would then be unable to meet customer orders except from inventory on hand. As a result, ourrevenue could be adversely impacted, and our relationships with our customers could suffer, impacting our ability to generate future revenue. In addition, ifpower is shut off at our Beijing subsidiary at any time, either voluntarily or as a result of unplanned brownouts, during certain phases of our manufacturingprocess including our crystal growth phase, the work in process may be ruined and rendered unusable, causing us to incur expense that will not be covered byrevenue, and negatively impacting our cost of revenue and gross margins.19Changes in China’s political, social and economic environment may affect our financial performance.Our financial performance may be affected by changes in China’s political, social and economic environment. The role of the Chinese central and localgovernments in the Chinese economy is significant. Chinese policies toward economic liberalization, and laws and policies affecting technology companies,foreign investment, currency exchange rates and other matters could change, resulting in greater restrictions on our ability to do business and operate ourmanufacturing facilities in China. Any imposition of surcharges or any increase in Chinese tax rates could hurt our operating results. The Chinese governmentcould revoke, terminate or suspend our license for national security and similar reasons without compensation to us. If the government of China were to takeany of these actions, we would be prevented from conducting all or part of our business. Any failure on our part to comply with governmental regulationscould result in the loss of our ability to manufacture our products in China.China from time to time has experienced instances of civil unrest and hostilities. Confrontations have occurred between the military and civilians. Eventsof this nature could influence the Chinese economy, result in nationalization of foreign-owned operations such as ours, and negatively affect our ability tooperate our facilities in China.We may face additional risks as a result of the revaluation of the Chinese currency.In July 2005, China agreed to a shift in Chinese currency policy. It established a 2% revaluation of the renminbi and referenced the renminbi to a basketof currencies, with a daily trading band of +/-0.3%. Depending on market conditions and the state of the Chinese economy, it is possible that China will makemore adjustments in the future. Over the next five to ten years, China may move to a managed float system, with opportunistic interventions. This reservediversification may negatively impact the United States dollar and U.S. interest rates, which, in turn, could negatively impact our operating results andfinancial condition. The functional currency of our Chinese subsidiary, including our joint ventures, is the local currency; since most of our operations areconducted in China, most of our costs are incurred in Chinese currency, which subjects us to fluctuations in the exchange rates between the U.S. dollar andthe Chinese renminbi. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for these subsidiaries, as wellas in translation of the assets and liabilities of these assets at each balance sheet date. These risks may be increased by the fluctuation and revaluation of theChinese renminbi. If we do not effectively manage the risks associated with this currency risk, our revenue, cash flows and financial condition could beadversely affected.A reoccurrence of Severe Acute Respiratory Syndrome (SARS) or the outbreak of a different contagious disease such as the Avian Flu mayadversely impact our manufacturing operations and some of our key suppliers and customers.All of our substrate manufacturing activities are conducted in China. In addition, we acquire key raw materials, including gallium, from our jointventures and other suppliers in China. The 2003 SARS outbreak was most notable in China and a small number of cases were reported in 2004. One employeeat our LED production facility in China contracted SARS in late April 2003 prompting us to close the facility for ten days. There was no significant impact toour ability to fill customer orders. If there were to be another outbreak of SARS or a different contagious disease, such as Avian Flu, and if our employeescontracted the disease, we might be required to temporarily close our manufacturing operations. Similarly, if one of our key suppliers is required to close foran extended period, we might not have enough raw material inventory to continue manufacturing operations. In addition, while we possess management skillsamong our China staff that enable us to maintain our manufacturing operations with minimal on-site supervision from our US-based staff, our businesscould also be harmed if travel to or from Asia and the United States is restricted or inadvisable, as it was during parts of 2003. None of our substratecompetitors is as dependent on manufacturing facilities in China as we are. If our manufacturing operations were20closed for a significant period, we could lose revenue and market share during that period, which would depress our financial performance and could bedifficult to recapture. Finally, if one of our key customers is required to close for an extended period, we might not be able to ship product to them, our revenuewould decline and our financial performance would suffer.Risks Related to Our Financial Results and Capital StructureThe compound semiconductor industry is cyclical and has experienced a downturn which has adversely impacted our operating results.Our continuing business depends in significant part upon manufacturers of electronic and opto-electronic compound semiconductor devices, as well asthe current and anticipated market demand for these devices and products using these devices. As a supplier to the compound semiconductor industry, we aresubject to the business cycles that characterize the industry. The timing, length and volatility of these cycles are difficult to predict. The compoundsemiconductor industry has historically been cyclical because of sudden changes in demand, the amount of manufacturing capacity and changes in thetechnology employed in compound semiconductors. The rate of changes in demand, including end demand, is high, and the effect of these changes upon usoccurs quickly, exacerbating the volatility of these cycles. These changes have affected the timing and amounts of customers’ purchases and investments innew technology. These industry cycles create pressure on our revenue, gross margin and net income (loss).The industry has in the past experienced periods of oversupply that result in significantly reduced demand and prices for compound semiconductordevices and components, including our products, both as a result of general economic changes and overcapacity. When these periods occur and our operatingresults and financial condition are adversely affected, oversupply creates pressure on our revenue, gross margins and net income (loss). Inventory buildups intelecommunications products and slower than expected sales of computer equipment resulted in overcapacity and led to reduced sales by our customers, andtherefore reduced purchases of our products. During periods of weak demand such as those experienced historically, customers typically reduce purchases,delay delivery of products and/or cancel orders of component parts such as our products. Increased price competition has resulted, causing pressure on our netsales, gross margin and net income (loss). We experienced cancellations, price reductions, delays and push-outs of orders, which have resulted in reducedrevenue. If the economic downturn occurred again, further order cancellations, reductions in order size or delays in orders could occur and would materiallyadversely affect our business and results of operations. Actions to reduce our costs, such as those we have recently taken, may be insufficient to align ourstructure with prevailing business conditions. We may be required to undertake additional cost-cutting measures, and may be unable to invest in marketing,research and development and engineering at the levels we believe are necessary to maintain our competitive position. Our failure to make these investmentscould seriously harm our business.During periods of increasing demand for compound semiconductor devices, we must have sufficient manufacturing capacity and inventory to meetcustomer demand, and must be able to attract, hire, train and retain qualified employees to meet demand. If we are unable to effectively manage our resourcesand production capacity during an industry upturn, there could be a material adverse effect on our business, financial condition and results of operations.If we fail to manage periodic contractions, we may utilize our cash balances and our existing cash and cash equivalents and investment balancescould decline.We anticipate that our existing cash resources will fund any anticipated operating losses and purchases of capital equipment, as well as provide adequateworking capital for the next twelve months. However, our liquidity is affected by many factors including, among others, the extent to which we pursueadditional21capital expenditures, the level of our production, and other factors related to the uncertainties of the industry and global economies. If we fail to manage ourcontractions successfully we may draw down our cash reserves, which would adversely affect our operating results and financial condition, reduce our valueand possibly impinge our ability to raise debt and equity funding in the future, at a time when we might be required to raise additional cash. Accordingly, therecan be no assurance that events in the future will not require us to seek additional capital or, if required, that such capital would be available on termsacceptable to us, if at all. As part of our effort to reduce costs, we may lose key staff, production resources and technology that we will need to grow when endmarkets recover. These events could reduce our ability to grow profitably as markets recover.Unpredictable fluctuations in our operating results could disappoint analysts or our investors, which could cause our stock price to decline.We have not been able to sustain growth for any significant period in the last five years, and may not be able to return to historic growth levels in thecurrent economic environment. Our net loss in 2002 was the largest in our history and our losses continued during 2003, 2004, 2005, and the first twoquarters of 2006. We recorded net income in the third and fourth quarters of 2006.We have experienced and may continue to experience significant fluctuations in our revenue and earnings. Our quarterly and annual revenue andoperating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including:· our ability to develop, manufacture and deliver high quality products in a timely and cost-effective manner;· decline in general economic conditions or downturns in the industry in which we compete;· fluctuations in demand for our products;· expansion of our manufacturing capacity;· expansion of our operations in China;· limited availability and increased cost of raw materials;· the volume and timing of orders from our customers, and cancellations, push-outs and delays of customer orders once made;· fluctuation of our manufacturing yields;· decreases in the prices of our or our competitors’ products;· costs incurred in connection with any future acquisitions of businesses or technologies; and· increases in our expenses, including expenses for research and development.Due to these factors, we believe that period-to-period comparisons of our operating results may not be meaningful indicators of our future performance.A substantial percentage of our operating expenses is fixed in the short term, and we may be unable to adjust spending to compensate for an unexpectedshortfall in revenue. As a result, any delay in generating revenue could cause our operating results to be below the expectations of market analysts or investors,which could also cause our stock price to fall.Our stock price has been and may continue to be volatile.Our stock price has fluctuated significantly since we began trading on the NASDAQ Global Market. For the year ended December 31, 2006, the highand low closing sales prices of our common stock were22$5.37 and $1.98, respectively. A number of factors could cause the price of our common stock to continue to fluctuate substantially, including:• actual or anticipated fluctuations in our quarterly or annual operating results;• changes in expectations about our future financial performance or changes in financial estimates of securities analysts;• announcements of technological innovations by us or our competitors;• new product introduction by us or our competitors;• large customer orders or order cancellations; and• the operating and stock price performance of comparable companies.In addition, the stock market in general has experienced extreme volatility that often has been unrelated to the operating performance of particularcompanies. These broad market and industry fluctuations may adversely affect the trading price of our common stock, regardless of our actual operatingperformance.We have adopted certain anti-takeover measures that may make it more difficult for a third party to acquire us.Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges ofthose shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adverselyaffected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock could have the effect ofmaking it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue additional shares ofpreferred stock.We have adopted a preferred stock purchase rights plan intended to guard against certain takeover tactics. The adoption of this plan was not in responseto any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could also have the effect of making it more difficultfor a third party to acquire a majority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation may have the effect ofdelaying or preventing a change of control, which could adversely affect the market price of our common stock.In addition, provisions in our amended and restated certificate of incorporation and amended and restated bylaws may have the effect of delaying orpreventing a merger, acquisition or change of control of us, or changes in our management, including:· the division of our board of directors into three separate classes, each with three-year terms;· the right of our board to elect a director to fill a space created by a board vacancy or the expansion of the board;· the ability of our board to alter our amended and restated bylaws; and· the requirement that only our board or the holders of at least 10% of our outstanding shares may call a special meeting of our stockholders.23Furthermore, because we are incorporated in Delaware, we are subject to the provisions of Section 203 of the Delaware General Corporation Law. Theseprovisions prohibit large stockholders, in particular those owning 15% or more of the outstanding voting stock, from consummating a merger or combinationwith a corporation unless:· 663% of the shares of voting stock not owned by these large stockholders approve the merger or combination, or· the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of ouroutstanding voting stock.Risks Related to Our Intellectual PropertyIntellectual property infringement claims may be costly to resolve and could divert management attention.Other companies may hold or obtain patents on inventions or may otherwise claim proprietary rights to technology necessary to our business. Themarkets in which we compete are comprised of competitors that in some cases hold substantial patent portfolios covering aspects of products that could besimilar to ours. We could become subject to claims that we are infringing patent, trademark, copyright or other proprietary rights of others. For example, wehave previously been involved in two separate lawsuits alleging patent infringement, and could in the future be involved in similar litigation.If we are unable to protect our intellectual property, we may lose valuable assets or incur costly litigation.We rely on a combination of patents, copyrights, trademark and trade secret laws, non-disclosure agreements and other intellectual property protectionmethods to protect our proprietary technology. However, we believe that, due to the rapid pace of technological innovation in the markets for our products, ourability to establish and maintain a position of technology leadership also depends on the skills of our development personnel. Despite our efforts to protect ourintellectual property, third parties can develop products or processes similar to ours. Our means of protecting our proprietary rights may not be adequate, andour competitors may independently develop similar technology, duplicate our products or design around our patents. We believe that at least two of ourcompetitors have begun to ship GaAs substrates produced using a process similar to our VGF technique. Our competitors may also develop and patentimprovements to the VGF technology upon which we rely, and thus may limit any exclusivity we enjoy by virtue of our patents or trade secrets.It is possible that pending or future United States or foreign patent applications made by us will not be approved, that our issued patents will not protectour intellectual property, or that third parties will challenge the ownership rights or the validity of our patents. In addition, the laws of some foreign countriesmay not protect our proprietary rights to as great an extent as do the laws of the United States and it may be more difficult to monitor the use of our intellectualproperty. Our competitors may be able to legitimately ascertain non-patented proprietary technology embedded in our systems. If this occurs, we may not beable to prevent the development of technology substantially similar to ours.We may have to resort to costly litigation to enforce our intellectual property rights, to protect our trade secrets or know-how or to determine their scope,validity or enforceability. Enforcing or defending our proprietary technology is expensive, could cause us to divert resources and may not prove successful.Our protective measures may prove inadequate to protect our proprietary rights, and if we fail to enforce or protect our rights, we could lose valuable assets.242For example, in the past we have been involved in litigation with Sumitomo Electric Industries, Ltd. (“SEI”) in Japan as well as interference actions in theUnited States. We and SEI approved a settlement of this litigation during the fourth quarter of 2004 and the litigation was withdrawn and we abandoned theinterference proceeding. We made an initial payment of approximately $1.4 million and will have to pay ongoing royalties to SEI on certain of our products.Risks Related to Compliance and Other Legal MattersWe need to continue to improve or implement our systems, procedures and controls and may not receive a favorable attestation report on ourinternal control systems by our independent registered public accounting firm.The requirements adopted by the Securities and Exchange Commission, or SEC, in response to the passage of the Sarbanes-Oxley Act of 2002, willrequire annual review and evaluation of our internal control systems, and an attestation of these systems by our independent registered public accounting firmbeginning with our fiscal year ending December 31, 2007. We are currently reviewing our internal control procedures and considering further documentation ofthese procedures that may be necessary. We are currently evaluating the extent to which any of our joint ventures may also be required to comply, if at all. Wecan give no assurances that our systems will satisfy these requirements of the SEC or, if required, that any of the systems of our joint ventures will meet theserequirements, or that we will receive a favorable review and attestation by our independent registered public accounting firm.In addition, the shift of our manufacturing operations to China has placed and continues to place a significant strain on our operations and managementresources. We have upgraded our inventory control systems and may implement additional systems relating to consolidation of our financial results, butcontinue to rely on certain manual processes in our operations and in connection with consolidation of our financial results. If we fail to manage these changeseffectively, our operations may be disrupted.To manage our business effectively, we may need to implement additional and improved management information systems, further develop ouroperating, administrative, financial and accounting systems and controls, add experienced senior level managers, and maintain close coordination among ourexecutive, engineering, accounting, marketing, sales and operations organizations.If we fail to comply with environmental and safety regulations, we may be subject to significant fines or forced to cease our operations; inaddition, we could be subject to suits for personal injuries caused by hazardous materials.We are subject to federal, state and local environmental and safety laws and regulations in all of our operating locations, including laws and regulationsof China, such as laws and regulations related to the development, manufacture and use of our products, the operation of our facilities, and the use of our realproperty. These laws and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research anddevelopment, and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or be forced to cease our operations, and/or suspend or terminate the development, manufacture or use of certain of ourproducts, the use of our facilities, or the use of our real property, each of which could have a material adverse effect on our business, financial condition andresults of operations.In March 2001, we settled a claim made by the California Occupational Safety and Health Administration, or Cal-OSHA, in an investigation primarilyregarding impermissible levels of potentially hazardous materials in certain areas of our manufacturing facility in Fremont, California for $200,415, andduring 2004 we were the target of press allegations and correspondence purportedly on behalf of current and/or former employees concerning our environmentalcompliance programs and exposure of our25employees to hazardous materials. In June 2005, a complaint was filed against us and a current and former officer, alleging personal injury, generalnegligence, intentional tort, wage loss and other damages, including punitive damages, as a result of exposure of plaintiffs, who are former employees of AXT,including a minor child in utero, to high levels of gallium arsenide in gallium arsenide wafers, and methanol. There is a possibility that other current and/orformer employees may bring additional litigation against us. Although we have put in place engineering, administrative and personnel protective equipmentprograms to address these issues, our ability to expand or continue to operate our present locations could be restricted or we could be required to acquire costlyremediation equipment or incur other significant expenses. Existing or future changes in laws or regulations in the United States and China may require us toincur significant expenditures or liabilities, or may restrict our operations. In addition, our employees could be exposed to chemicals or other hazardousmaterials at our facilities and we may be subject to lawsuits seeking damages for wrongful death or personal injuries allegedly caused by exposure to chemicalsor hazardous materials at our facilities.Litigation is inherently uncertain and while we would expect to defend ourselves vigorously, it is possible that our business, financial condition, resultsof operations or cash flows could be affected in any particular period by litigation pending and any additional litigation brought against us.Existing or future litigation could result in significant judgments against us, or cause us to incur costly settlements.In June 2005, a complaint was filed against us and a current and former officer, alleging personal injury, general negligence, intentional tort, wage lossand other damages, including punitive damages, as a result of exposure of plaintiffs, who are former employees of AXT, including a minor child in utero, tohigh levels of gallium arsenide in gallium arsenide wafers, and methanol. In addition, we are defendants in an ongoing securities litigation matter. Litigation isinherently uncertain and while we would expect to defend ourselves vigorously, it is possible that our business, financial condition, results of operations orcash flows could be affected in any particular period by litigation now pending and any additional litigation brought against us. In addition, response to thislitigation could divert management’s attention from our business and operations, causing our business and financial results to suffer. We could incur defenseor settlement costs in excess of the insurance covering these litigation matters, or that could result in significant judgments against us or cause us to incurcostly settlements, in excess of our insurance limits.Legislative actions, higher insurance costs and potential new accounting pronouncements are likely to cause our general and administrativeexpenses to increase and impact our future financial position and results of operations.In order to comply with rules and regulations adopted pursuant to the Sarbanes-Oxley Act of 2002 by the SEC, as well as changes to listing standardsadopted by the NASDAQ Stock Market, and accounting changes adopted affecting accounting for stock-based compensation, we may be required to increaseour internal controls and hire additional personnel and outside legal, accounting and advisory services, all of which will cause our general and administrativecosts to increase. Insurers may increase premiums as a result of the high claims rates they incurred over the past year. Changes in accounting rules, includinglegislative and other rules to account for employee stock options as a compensation expense among others, could materially increase the expense that we reportunder generally accepted accounting principles and adversely affect our operating results.The effect of terrorist threats and actions on the general economy could decrease our revenue.The United States continues to be on alert for terrorist activity. The potential near- and long-term impact terrorist activities may have in regards to oursuppliers, customers and markets for our products and the U.S. economy is uncertain. There may be embargos of ports or products, or destruction of26shipments or our facilities, or attacks that affect our personnel. There may be other potentially adverse effects on our operating results due to a significantevent that we cannot foresee. Since we perform all of our manufacturing operations in China, and a significant portion of our customers are located outside ofthe Untied States, terrorist activity or threats against US-owned enterprise are a particular concern to us.If any of our facilities is damaged by occurrences such as fire, explosion, or natural disaster, we might not be able to manufacture our products.The ongoing operation of our manufacturing and production facilities in China is critical to our ability to meet demand for our products. If we are notable to use all or a significant portion of our facilities for prolonged periods for any reason, we would not be able to manufacture products for our customers.For example, a fire or explosion caused by our use of combustible chemicals and high temperatures during our manufacturing processes could render some orall of our facilities inoperable for an indefinite period of time. Actions outside of our control, such as earthquakes or other natural disasters, could also damageour facilities, rendering them inoperable. If we are unable to operate our facilities and manufacture our products, we would lose customers and revenue and ourbusiness would be harmed.Item 1B. Unresolved Staff CommentsNone.Item 2. PropertiesOur principal properties as of February 21, 2007 are as follows:LocationSquareFeetPrincipal UseOwnershipFremont, CA80,000VacantOwnedFremont, CA55,000Production andAdministrationOperating lease, expires March 2013Beijing, China31,000Production andAdministrationOwnedBeijing, China31,000ProductionOwnedBeijing, China32,000ProductionOwnedBeijing, China16,000HousingOwnedBeijing, China34,000ProductionOwnedBeijing, China48,000ProductionOwnedBeijing, China22,000Production andAdministrationOwnedBeijing, China53,000ProductionOwnedXianxi, China56,500ProductionOwned by Beijing Ji Ya Semiconductor Material, Co., Ltd.*Xianxi, China7,500AdministrationOwned by Beijing Ji Ya Semiconductor Material, Co., Ltd.*Xianxi, China1,000AdministrationOwned by Beijing Ji Ya Semiconductor Material, Co., Ltd.*Nanjing, China22,000ProductionOwned by Nanjing Jin Mei Gallium Co., Ltd.*Nanjing, China5,700R&D andAdministrationOwned by Nanjing Jin Mei Gallium Co., Ltd.*Nanjing, China3,900ProductionOwned by Nanjing Jin Mei Gallium Co., Ltd.*Beijing, China7,600Production andAdministrationOwned by Beijing BoYu SemiconductorVessel Craftwork Technology Co., Ltd.** Joint ventures in which we hold an interest. We hold a 46% interest in Beijing Ji Ya Semiconductor Material Co., Ltd., a 83% interest in Nanjing Jin MeiGallium Co., Ltd., and a 70% interest in Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd (BoYu).27We consider each facility to be in good operating condition and adequate for its present use, and believe that each facility has sufficient plant capacity tomeet its current and anticipated operating requirements.Item 3. Legal ProceedingsFrom time to time we may be involved in judicial or administrative proceedings concerning matters arising in the ordinary course of business. We do notexpect that any of these matters, individually or in the aggregate, will have a material adverse effect on our business, financial condition, cash flows or resultsof operation.On October 15, 2004, a purported securities class action lawsuit was filed in the United States Court for the Northern District of California, City ofHarper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The Court consolidated the case with a subsequent related case andappointed a lead plaintiff. On April 5, 2005, the lead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc. et al., No. C 04 4362 MJJ.The lawsuit complaint names AXT, Inc. and our former chief technology officer as defendants, and is brought on behalf of a class of all purchasers of oursecurities from February 6, 2001 through April 27, 2004. The complaint alleges that we announced financial results during this period that were false andmisleading. No specific amount of damages is claimed. On September 23, 2005, the Court granted our motion to dismiss the complaint, with leave to amend.The lead plaintiff filed an amended complaint, which we have moved to dismiss. We believe that there are meritorious defenses against this litigation andintend to vigorously defend it. Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Anyunfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operations.On June 1, 2005, a lawsuit was filed in the Superior Court of California, County of Alameda, Zhao et al. v. American Xtal Technology, et al., No. R605215713. The lawsuit complaint names as defendants AXT, Inc., our former chief technology officer and one of our suppliers. The lawsuit is brought onbehalf of two former employees and their minor child. The complaint alleges personal injury, general negligence, intentional tort, wage loss and other damages,including punitive damages, as a result of exposure of the child while in utero to high levels of gallium arsenide and methanol used in the production ofgallium arsenide wafers. We believe that there are meritorious defenses against this litigation and intend to vigorously defend it. Our commercial generalliability insurance carrier has agreed to fund our defense of the case, but has reserved the right to deny coverage, in whole or in part, in the future underselected policy provisions and applicable law. The plaintiffs have made an initial settlement demand within our insurance limits. Due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of the litigation could have an adverseimpact on our business, financial condition and results of operations.Item 4. Submission of Matters to a Vote of Security HoldersNone.28PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesOur common stock has been trading publicly on the NASDAQ Global Market, (NASDAQ) under the symbol “AXTI” since May 20, 1998, the datewe consummated our initial public offering. The following table sets forth the range of high and low sales prices of the common stock for the periodsindicated, as reported by NASDAQ. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarilyrepresent actual transactions.HighLow2006First Quarter$3.87$1.98Second Quarter$4.47$2.84Third Quarter$4.26$2.84Fourth Quarter$5.37$4.192005First Quarter$1.57$1.10Second Quarter$1.42$1.08Third Quarter$1.65$1.14Fourth Quarter$2.47$1.21 As of December 31, 2006, there were 91 holders of record of our common stock. Because many shares of AXT’s common stock are held by brokers andother institutions on behalf of stockholders, we are unable to estimate the total number of stockholders.We have never paid or declared any cash dividends on our common stock and do not anticipate paying cash dividends in the foreseeable future.Dividends accrue on our outstanding Series A preferred stock at the rate of $0.20 per annum per share of Series A preferred stock.Issuer Purchases of Equity SecuritiesDuring the year ended December 31, 2006, we did not repurchase any shares of our common stock. During the year ended December 31, 2005, werepurchased the following shares of our common stock:PeriodTotal Numberof SharesPurchasedAverage PricePaid PerShareTotal Number ofSharesPurchased asPart of a PubliclyAnnounced Planor Program(1)ApproximateDollar Valueof Shares ThatMay Yet BePurchasedUnder thePlan orProgramJan. 1, 2005 through Mar. 31, 200523,383$1.2323,383$1,971,313Apr. 1, 2005 through Jun. 30, 2005134,7001.22134,7001,807,145Jul 1, 2005 through Sep. 30, 200543,4331.2243,4331,754,160Oct 1, 2005 through Dec. 31, 2005———1,754,160Total201,516$1.22201,516$1,754,160(1) Pursuant to a Plan publicly announced on August 25, 2004 and extended in July, 2005, in accordance with Rule 10b5-1 of the Securities Exchange Actof 1934 to provide for the repurchase of up to $2 million of the Company’s common stock. Repurchases were made from time to time in the open marketduring the twelve-month period ended July 31, 2006, at prevailing market prices. Repurchases were made under the program using the Company’s owncash resources. As of December 31, 2005, we had 22,977,301 shares of common stock outstanding and 201,516 were repurchased in 2005 under thisprogram. No repurchases were made during 2006.29Use of ProceedsIn December 2006, we received net proceeds of $24.1 million from the public offering of 5,750,000 shares of our common stock we sold. The netproceeds will be used for corporate and joint venture capacity expansion, research and development, working capital requirements, and potential acquisitionsof complementary products, technologies or businesses.Comparison of Stockholder ReturnSet forth below is a line graph comparing the annual percentage change in the cumulative total return to the stockholders of the Company on our commonstock with the CRSP Total Return Index for the Nasdaq Stock Market (U.S. Companies) and the Nasdaq Electronic Components Index for the periodcommencing December 31, 2001, and ending December 31, 2006.COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*Among AXT, Inc., The NASDAQ Composite IndexAnd The NASDAQ Electronic Components Index* $100 invested on 12/31/01 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.Other consolidated financial statements and supplementary data required by this item are set forth at the pages indicated at Item 15(a).30Item 6. Selected Consolidated Financial DataThe following selected consolidated financial data is derived from and should be read in conjunction with our consolidated financial statements andrelated notes set forth in Item 8 below, and in our previously filed reports on Form 10-K. See also Item 7. “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” for further information relating to items reflecting our results of operations and financial condition.Years Ended December 31,20062005200420032002(in thousands, except per share data)Statements of OperationsRevenue$44,445$26,536$35,454$34,713$44,865Cost of revenue31,70924,33735,70532,47853,758Gross profit (loss)12,7362,199(251)2,235(8,893)Operating expenses:Selling, general, and administrative12,65012,95511,56110,47513,860Research and development2,3511,7231,4791,3372,339Impairment charges1,417—210—14,632Restructuring charge (benefit)(2)8361,308——Total operating expenses16,41615,51414,55811,81230,831Loss from continuing operations(3,680)(13,315)(14,809)(9,577)(39,724)Interest income, net4435162621722,746Other income (expense), net2,709(910)94(1,688)(15,886)Loss from continuing operations before provision(benefit) for income taxes(528)(13,709)(14,453)(11,093)(52,864)Provision (benefit) for income taxes(1,454)(950)71—2,119Income (loss) from continuing operations926(12,759)(14,524)(11,093)(54,983)Discontinued operations:Gain (loss) from discontinued operations, net of tax18(59)472(6,163)(34,625)Gain (loss) from disposal, net of tax—603419(9,475)—Benefit for income taxes————(8,427)Gain (loss) from discontinued operations18544891(15,638)(26,198)Net income (loss)$944$(12,215)$(13,633)$(26,731)$(81,181)Basic income (loss) per share:Income (loss) from continuing operations$0.03$(0.56)$(0.64)$(0.49)$(2.46)Gain (loss) from discontinued operations, net of tax—0.020.04(0.69)(1.17)Net loss$0.03$(0.54)$(0.60)$(1.18)$(3.63)Diluted income (loss) per share:Income (loss) from continuing operations$0.03$(0.56)$(0.64)$(0.49)$(2.46)Gain (loss) from discontinued operations, net of tax—0.020.04(0.69)(1.17)Net income (loss)$0.03$(0.54)$(0.60)$(1.18)$(3.63)Shares used in per share calculations:Basic23,30323,04723,06322,78122,433Diluted24,60023,04723,06322,78122,433 31 Years Ended December 31,20062005200420032002(in thousands)Balance Sheet Data:Cash and cash equivalents$16,116$17,472$12,117$24,339$13,797Short-term investments19,4285,55520,06214,6698,205Working capital66,35936,34746,14157,33565,375Restricted deposits7,1507,4508,2159,30211,150Long-term investments————3,657Total assets98,33274,79887,540107,023145,667Long-term capital lease, net of current portion————4,847Long-term debt, net of current portion6,8397,4207,8808,84213,289Stockholders’ equity81,20055,61868,01782,298105,657 All periods have been restated to reflect the accounting for discontinued operations. As a result, the discontinued opto-electronics and consumer productsdivisions have been eliminated from continuing operations in the statements of operations.32Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsIn addition to historical information, the following discussion contains forward-looking statements that are subject to risks and uncertainties. Actualresults may differ substantially from those referred to herein due to a number of factors, including but not limited to risks described in the section entitledItem 1A. “Risk Factors” and elsewhere in this Annual Report. This discussion should be read in conjunction with Item 6. “Selected Consolidated FinancialData” and our consolidated financial statements and related notes included elsewhere in this Form 10-K.Critical Accounting Policies and EstimatesWe 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 historicalexperience and on other assumptions that are believed to be reasonable under the circumstances. These estimates may change as new events occur or additionalinformation 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 aprolonged 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. Acritical accounting policy is one that is both material to the presentation of our consolidated financial statements and requires us to make difficult, subjectiveor complex judgments that could have a material impact on our consolidated financial statements. Different estimates that we could have used, or changes inthe estimates that are reasonably likely to occur, may have a material impact on our financial condition or results of operations. We also refer you to our “TheCompany and Summary of Significant Accounting Policies” discussed in the accompanying notes to our consolidated financial statements included elsewherein this Form 10-K.Revenue RecognitionWe 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 revenuerecognition. Our products are typically sold pursuant to a purchase order placed by our customers, and our terms and conditions of sale do not requirecustomer 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, theprice is fixed or determinable, title and risk of ownership have transferred, collection of resulting receivables is probable, and product returns are reasonablyestimable. We do not provide training, installation or commissioning services. Additionally, we do not provide discounts or other incentives to customersexcept for one customer with whom we agreed in the fourth quarter of 2004 to provide a certain amount of cumulative discounts on future product purchasesfrom us. We recognize these discounts as a reduction in revenue as products are sold to this customer.We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized.In the first quarter of 2004, we recorded a reserve for sales returns of $0.7 million related to our failure to follow certain testing requirements and provision oftesting data and information to certain customers. This reserve was based on discussions with some of the affected customers and review of specificshipments. As of December 31, 2006, this reserve was zero since approximately $0.5 million had been utilized and approximately $0.2 million had beenreversed to revenue as we favorably resolved an outstanding matter with a customer.33Allowance for Doubtful AccountsWe periodically review the likelihood of collection on our accounts receivable balances and provide an allowance for doubtful accounts receivableprimarily based upon the age of these accounts. We provide a 100% allowance for U.S. receivables in excess of 90 days and for foreign receivables in excess of120 days. We assess the probability of collection based on a number of factors, including the length of time a receivable balance has been outstanding, ourpast history with the customer and their credit worthiness.From our allowance for doubtful accounts of $4.0 million at December 31, 2003, we wrote off $3.5 million of fully reserved accounts receivable resultingin the allowance for doubtful accounts of $0.5 million at December 31, 2004. From our allowance for doubtful accounts of $0.5 million at December 31, 2004,we wrote off $0.1 million of fully reserved accounts receivable for a Korean customer and decreased the allowance by $0.3 million due to improved collectionsmainly from a Japanese customer, while increasing the allowance for a large customer in China of $0.4 million, resulting in the allowance for doubtfulaccounts of $0.5 million at December 31, 2005. During 2006, we increased our collection efforts and collected the entire amount from this large customer inChina requiring us to reverse this $0.4 million allowance resulting in the allowance for doubtful accounts of $0.1 million at December 31, 2006. As ofDecember 31, 2006, our accounts receivable balance was $9.7 million, which was net of an allowance for doubtful accounts of $0.1 million. As ofDecember 31, 2005, our accounts receivable balance was $5.2 million, which was net of an allowance for doubtful accounts of $0.5 million. If actualuncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could havea material impact on our financial results for the period.The allowance for sales returns is also deducted from gross accounts receivable. From our allowance for sales returns of $0.5 million as of December 31,2003, we increased the reserve for sales returns resulting in the allowance for sales returns of $0.6 million as of December 31, 2004. From our allowance forsales returns of $0.6 million as of December 31, 2004, we utilized $0.5 million for investigation related returns, resulting in the allowance for sales returns of$0.1 million as of December 31, 2005. During 2006, the allowance for sales returns remained at approximately $0.1 million. The total allowances deductedfrom gross accounts receivable as of December 31, 2006 is $0.1 million, compared to $0.6 million as of December 31, 2005.Warranty ReserveWe maintain a warranty reserve based upon our claims experience during the prior twelve months. Warranty costs are accrued at the time revenue isrecognized. As of December 31, 2006 and 2005, accrued product warranties totaled $0.5 million and $0.1 million, respectively. If actual warranty costs differsubstantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financialcondition and results of operations.Inventory ValuationInventories are stated at the lower of cost or market. Cost is determined using the weighted average cost method. Our inventory consists of raw materialsas well as finished goods and work-in-process that include material, labor and manufacturing overhead costs. Given the nature of our substrate products, andthe 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 threeyears, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditionsin order to identify excess and obsolete inventory and provide a valuation allowance for certain inventories based upon the age and quality of the product andthe projections for sale of the completed products. If actual demand for our products were to be substantially lower than estimated, additional inventory34adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results ofoperations.Impairment of InvestmentsWe classify our investments in debt and equity securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards(SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” All available-for-sale securities with a quoted market value belowcost (or adjusted cost) are reviewed in order to determine whether the decline is other-than-temporary. Factors considered in determining whether a loss istemporary 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, andour 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 for business and strategic purposes. These investments are classified as other assets and areaccounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments forimpairment 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, thelength 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, fundamentalchanges 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 timesufficient to allow for any anticipated recovery in our carrying value. In the third quarter of 2004, we recorded an impairment charge of $0.2 million to writedown the value of our investment in a private company. We made the decision to write down the investment as a result of the declining financial position of theinvestee, evidenced by an audit opinion with a going concern explanatory paragraph received by the investee. The $0.2 million was the remaining balance ofthis investment. No further write-downs were recorded in 2006 or 2005.Impairment of Long-Lived AssetsWe evaluate the recoverability of property, plant and equipment, and intangible assets in accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” When events and circumstances indicate that long-lived assets may be impaired, we compare the carryingvalue of the long-lived assets to the projection of future undiscounted cash flows attributable to such assets. In the event that the carrying value exceeds thefuture undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the asset’s fair value. Fair valueis generally determined by calculating the discounted future cash flows using a discount rate based upon our weighted average cost of capital, and specificappraisal in certain instances. Significant judgments and assumptions are required in the forecast of future operating results used in the preparation of theestimated future cash flows, including long-term forecasts of the amounts and timing of overall market growth and our percentage of that market, groupings ofassets, discount rate and terminal growth rates. Changes in these estimates could have a material adverse effect on the assessment of long-lived assets, therebyrequiring us to write down the assets. In the third quarter of 2006, we incurred an impairment charge of $1.4 million to write down our U.S. property inFremont, California, which has been decontaminated and is being prepared for sale. This property has been classified as “Assets held for sale” in the amountof $4.7 million on the consolidated balance sheet as of December 31, 2006.35Stock Based CompensationWe grant options to substantially all management employees and believe that this program helps us to attract, motivate and retain high quality employees,to the ultimate benefit of our stockholders. Effective January 1, 2006, we adopted the provisions of SFAS No. 123 (revised 2004), “Share-Based Payment,”(“SFAS No. 123(R)”) using the modified prospective transition method. Under this transition method, stock compensation expense for fiscal 2006 includescompensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair valueestimated in accordance with the original provision of SFAS No. 123,”Accounting for Stock-Based Compensation” (“SFAS No. 123”). Stock compensationexpense for all stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with theprovisions of SFAS No. 123(R). We recognize these compensation costs net of an estimated forfeiture rate over the requisite service period of the award, whichis generally the vesting term of four years for stock options.In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS No. 123(R) and thevaluation of share-based payments for public companies. We have applied the provisions of SAB 107 in the adoption of SFAS No. 123(R). Stockcompensation expense recorded in cost of revenue, research and development, and selling, general and administrative expenses is the amortization of the fairvalue of share-based payments made to employees and members of our board of directors, primarily in the form of stock options as we adopted the provisionof SFAS No. 123(R) on January 1, 2006 (see Note 1—Summary of Significant Accounting Policies—Stock-Based Compensation). All of our stockcompensation is accounted for as an equity instrument.We account for stock compensation costs in accordance with SFAS No. 123(R)and apply the provisions of SAB 107. We utilize the Black-Scholesoption pricing model to estimate the grant date fair value of employee stock compensation awards, which requires the input of highly subjective assumptions,including expected volatility and expected life. Historical and implied volatility were used in estimating the fair value of our stock compensation awards, whilethe expected life for our options was estimated based on historical trends. Further, as required under SFAS No. 123(R), we now estimate forfeitures for stockcompensation awards that are not expected to vest. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of ourstock compensation. We charge the estimated fair value to earnings on a straight-line basis over the vesting period of the underlying awards, which is generallyfour years for our stock option awards.The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and arefully transferable. As our stock option awards have characteristics that differ significantly from traded options, and as changes in the subjective assumptionscan materially affect the estimated value, our estimate of fair value may not accurately represent the value assigned by a third party in an arms-lengthtransaction. There currently is no market-based mechanism to verify the reliability and accuracy of the estimates derived from the Black-Scholes optionpricing model or other allowable valuation models, nor is there a means to compare and adjust the estimates to actual values. While our estimate of fair valueand the associated charge to earnings materially affects our results of operations, it has no impact on our cash position.The guidance in SFAS No. 123(R) and SAB 107 is relatively new and the application of these principles may be subject to further interpretation andguidance. There are significant variations among allowable valuation models, and there is a possibility that we may adopt a different valuation model or refinethe inputs and assumptions under our current valuation model in the future resulting in a lack of consistency in future periods. Our current or futurevaluation model and the inputs and assumptions we make may also lack comparability to other companies that use different models, inputs, or assumptions,and the resulting differences in comparability could be material.36Prior to the adoption of SFAS No. 123(R), we measured compensation expense for stock compensation made to our employee and members of our boardof directors, primarily in the form of stock options and purchases under the employee stock purchase plan, using the intrinsic value method provided byAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. We applied the disclosure provisions of SFAS No. 123, asamended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosures” as if the fair-value-based method had been applied inmeasuring compensation expense. We recorded employee stock compensation expense prior to fiscal 2006 for options granted to employees with an exerciseprice less than the market value of the underlying common stock on the date of grant.On November 10, 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Accounting Position No. FAS 123 (R)-3“TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards.” We have elected to adopt the alternative transition methodprovided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS No. 123(R). The alternative transitionmethod includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employeestock-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of theemployee stock-based compensation awards that are outstanding upon adoption of SFAS No. 123(R).Income TaxesWe account for income taxes in accordance with SFAS No. 109 (SFAS 109), “Accounting for Income Taxes,” which requires that deferred tax assetsand liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities.SFAS 109 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 notbe realized.We provide for income taxes based upon the geographic composition of worldwide earnings and tax regulations governing each region, particularly China.The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws, particularly inforeign countries such as China.Results of OperationsOverviewWe were founded in 1986 to commercialize and enhance our proprietary vertical gradient freeze (VGF) technique for producing high-performancecompound semiconductor substrates. We have one operating segment: our substrate business, with limited additional raw materials sales. We recorded ourfirst substrate sales in 1990 and our substrate division currently sells gallium arsenide (GaAs) and indium phosphide (InP) substrates to manufacturers ofsemiconductor devices for use in applications such as fiber optic and wireless telecommunications, light emitting diodes (LEDs) and lasers. We also sell rawmaterials including gallium and germanium through our participation in majority- and minority-owned joint ventures. We had the capability to manufacturegermanium substrates for use in satellite solar cells but withdrew from this business during 2000 so that we could more profitably use our then constrainedcapacity. We are now trying to qualify our germanium substrates with the few existing satellite solar cell system manufacturers.Continuing OperationsOur sales of substrate products is dependant on the semiconductor industry, which is highly cyclical and has historically experienced downturns both asa result of economic changes and overcapacity.37In March 2004, we learned of certain failures to comply with requirements for product testing and the provision of testing data and information relating torequirements of certain customers. Specifically, we determined that in some cases we had not provided accurate data to customers confirming that productsshipped were compliant with all specifications provided by the customer, or had been manufactured at the location specified by the customer. As a result ofour conclusions, we reorganized our production and quality control procedures, established quality control and assurance as a direct reporting group to thechief executive officer, and implemented measures, including additional employee training, statistical sampling of product shipments during the quarter, andreview of our satisfaction of customer specifications each quarter, to ensure adherence to operational controls. We also implemented certain executivemanagement changes.As a result of the weaknesses identified, in the first quarter of 2004 we increased our sales return reserve by $0.7 million, based on our best estimate offuture returns related to this matter. Approximately $0.5 million of the $0.7 million sales returns reserve had been utilized and approximately $0.2 million hasbeen reversed to revenue as of December 31, 2005 as we favorably resolved an outstanding matter with a customer. This reserve was based, in part, ondiscussion with affected customers. The amount of the reserve was determined in part based upon the amount of our historical product returns, paymenthistory of prior period receivables, discussions with customers concerning the non-compliant product and testing data, and estimated levels of our productmaintained by customers, and likelihood that products previously shipped would be returned to us.During the second quarter of 2004, we announced plans to cease all production activities in the United States and to manufacture our products only inChina.In 2005, we made a number of important changes to our management team. Philip C.S. Yin, Ph.D., joined the company in March 2005 as chief executiveofficer and restructured the organization from the top down. In June 2005, two new positions were created: chief operating officer and chief technology officer.Also, the former president of AXT’s China operations became president of joint venture operations. In September 2005, our new vice president of global salesand marketing joined the company. This new structure enabled us to maximize the expertise and skill sets of our team while placing enhanced emphasis onmanufacturing, production and quality, and quality systems improvement.With the new management team in place, quality, quality systems and revenue began to improve beginning the third quarter of 2005. In December 2005,we continued to execute our workforce reduction in our Fremont, California facility and accordingly we eliminated approximately 15 positions in California.See further discussion under “Restructuring Charges” below.During 2006 we sold all of our shares of common stock of Finisar Corporation generating net proceeds of $4.4 million and recording a gain of$3.3 million. In December 2006, we received net proceeds of $24.1 million from the public offering of 5,750,000 shares of our common stock. During thefourth quarter of 2006 we completed an increase in our production capacity for 6 inch diameter GaAs substrates by fifty percent and are currently in theprocess of an additional forty percent increase by the middle of 2007.Discontinued Opto-Electronics BusinessIn June 2003, we announced the discontinuation of our opto-electronics division, which we had established as part of our acquisition of LyteOptronics, Inc. in May 1999. The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes(HBLEDs) for the illumination markets, including full-color displays, wireless handset backlighting and traffic signals, and also manufactured verticalcavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks. Accordingly, the results of operations ofthe opto-electronics division have been segregated from continuing operations and are reported separately as38discontinued operations in our consolidated statements of operations for all periods presented. See Note 2 to our consolidated financial statements for detailsregarding the accounting for discontinued operations.In September 2003, we completed the sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) andDalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. A portion of the purchase price equalto $1.0 million was held in escrow to satisfy any claims that the purchasers might make for breaches of representations or warranties by us. Of this totalescrow, $0.8 million could be released after the one year anniversary of the sale of the opto-electronics business and the remainder could be released after thesecond anniversary of the sale. To date, we have resolved all claims made against the $1.0 million that was held in escrow. For the year ended December 31,2005 we recorded $0.6 million gains from escrow, $0.1 million in property tax refunds and interest.In June 2005, we completed the sale of a building located in Monterey Park, California. This asset had been classified as “assets held for sale” in theamount of $1.25 million on the consolidated balance sheet as of December 31, 2004. We received net proceeds on the sale of the property of approximately$1.3 million and accordingly recorded a gain on disposal of approximately $0.1 million.Revenue2005 to 20062004 to 2005Year Ended Dec. 31,IncreaseIncrease($ in thousands)200620052004(Decrease)% Change(Decrease)% ChangeGaAs$36,511$20,831$27,272$15,68075.3%$(6,441)(23.6)%InP1,7059061,58879988.2(682)(42.9)Ge909421008672,064.3(58)(58.0)Raw Materials5,2934,7526,39954111.4(1,647)(25.7)Other2759522440.0(90)(94.7)Total revenue$44,445$26,536$35,454$17,90967.5%$(8,918)(25.2)% Revenue increased $17.9 million or 67.5%, to $44.4 million in 2006 from $26.5 million in 2005. Total GaAs substrate revenue increased$15.7 million, or 75.3%, to $36.5 million in 2006 from $20.8 million in 2005. Sales of 5 inch and 6 inch diameter GaAs substrates were $16.7 million in2006 compared with $4.8 million in 2005. The increase in larger diameter substrate revenue was due to the fact that, while the GaAs device market grew instrength for both cellular and the WLAN (Wide Local Area Network) markets, the compound semiconductor industry has been experiencing capacityconstraints; with our excess capacity and our ability to increase capacity in a timely and cost efficient manner, we were able to benefit from the overflowbusiness from our competition.Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates were $19.7 million in 2006 compared with $15.9 million in 2005. The increase in revenuefrom smaller diameter substrates was generally due to the continued market growth of LED laser diodes and commercial epitaxy.InP substrate revenue increased $0.8 million, or 88.2%, to $1.7 million in 2006 from $0.9 million in 2005. While overall demand for InP has increasedover the past year, the higher than expected increase in InP substrate revenue was due to the receipt of one large customer order for a government contract,which is not expected to repeat. While we are beginning to see evidence of renewed growth in the optical networking industry, which uses InP to manufacturetelecom lasers and may result in growth in InP substrate sales, we have not yet seen a large movement in this direction.Ge substrate revenue increased $0.9 million, or 2,064.3%, to $0.9 million in 2006 from $42,000 in 2005. The increase in Ge substrate revenue was dueto an increase in customers in the PRC that have now qualified our product, as demand for photovoltaic applications is strong in the PRC.39Raw materials revenue increased $0.5 million, or 11.4%, to $5.3 million in 2006 from $4.8 million in 2005. The increase in raw materials revenue wasprimarily due to sales of germanium dioxide to a new customer, and increased sales of gallium to existing customers. The new customer for germanium dioxideis located in North America, and has been purchasing consistently in 2006. We expect this trend to continue. Our raw materials business is increasinglybecoming an important part of our business, both in terms of providing us protection against raw materials pricing increases and supply constraints, and inopportunities for sales of raw materials. Accordingly, we expect to continue to expand our raw materials sales efforts and explore new and additional investmentopportunities.Revenue decreased $8.9 million or 25.2%, to $26.5 million in 2005 from $35.5 million in 2004. Total GaAs substrate revenue decreased $6.4 million,or 23.6%, to $20.8 million in 2005 from $27.3 million in 2004. Overall sales of smaller diameter GaAs substrates decreased $7.2 million due to the earlierquality issues, the continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers and a decline inorders from customers who were qualifying our China-grown products. On the other hand, sales of larger diameter GaAs substrates, which were usedexclusively to manufacture electronic devices, increased $1.4 million compared to 2004 due to an increase in orders from customers who have qualified ourChina-grown products. InP substrate revenue decreased $0.7 million, or 42.9%, to $0.9 million in 2005 from $1.6 million in 2004. InP substrates were usedalmost exclusively for telecommunications applications. The decrease in GaAs and InP substrate revenue was due to the pricing pressures causing prices todecline and overall lesser demand from our telecommunications and wireless application customers. Raw material sales decreased $1.7 million, or 25.7%, to$4.8 million in 2005 from $6.4 million in 2004. The decrease in raw material sales was due to customers’ lower demand, particularly for raw gallium andgermanium dioxide.Only one customer represented greater than 10% revenue, totaling 12.8% for the year ended December 31, 2006. Two customers represented greater than10% of revenue, totaling 20.7% for the year ended December 31, 2005, while no customer represented greater than 10% of revenue for the year endedDecember 31, 2004. Our top five customers represented 40.0%, 37.5%, and 30.1% of revenue for the years ended December 31, 2006, 2005, and 2004,respectively.Revenue by Geographic Region2005 to 20062004 to 2005Years Ended Dec. 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)North America*$13,029$5,168$7,514$7,861152.1%$(2,346)(31.2)%% of total revenue29%19%21%Europe8,3656,1866,8402,17935.2(654)(9.6)% of total revenue19%23%19%Japan3,3472,8545,15649317.3(2,302)(44.6)% of total revenue8%11%15%Taiwan7,6473,8438,3973,80499.0(4,554)(54.2)% of total revenue17%15%24%Asia Pacific (excludingJapan and Taiwan)12,0578,4857,5473,57242.193812.4% of total revenue27%32%21%Total revenue$44,445$26,536$35,454$17,90967.5%$(8,918)(25.2)%* Primarily the United States.40Sales to customers outside of North America represented approximately 71%, 81%, and 79% of our revenue during 2006, 2005 and 2004, respectively.North America revenue increased by $7.9 million, or 152.1%, to $13.0 million in 2006 from $5.2 million in 2005. We believe our quality has improvedas shown by customers that have qualified our products manufactured in the PRC as sales to existing customers for larger diameter wafers increased by$4.7 million, while sales to existing customers for smaller diameter wafers increased by $1.9 million. Raw material sales increased by $1.3 million.Revenue from customers in Europe increased by $2.2 million, or 35.2%, to $8.4 million in 2006 from $6.2 million in 2005. This increase resulted from$1.9 million increased sales to customers in France, mainly in larger diameter wafers, $0.4 million increased sales to customers in Germany, mainly insmaller diameter wafers, partially offset by a $0.1 million decrease in sales to customers in Switzerland, mainly in smaller diameter wafers.Japan revenue increased by $0.5 million, or 17.3%, to $3.3 million in 2006 from $2.9 million in 2005. Increased sales to existing customers accountedfor $0.4 million, mainly in larger diameter wafers, while sales to new customers accounted for $0.1 million.Taiwan revenue increased by $3.8 million, or 99.0%, to $7.7 million in 2006 from $3.8 million in 2005. The increase was due to sales to existingcustomers of $3.8 million mainly in large diameter wafers.Asia Pacific (excluding Japan and Taiwan) revenue increased by $3.6 million, or 42.1%, to $12.1 million in 2006 from $8.5 million in 2005. Of thisincrease, sales to customers in Malaysia and Singapore accounted for $2.1 million of the increase, mainly in larger diameter wafers, while sales to customersin the PRC increased by $1.0 million, and sales to customers in Korea increased by $0.5 million.Asia Pacific (excluding Japan and Taiwan) revenue increased to 32% of total revenue in 2005 compared with 21% of total revenue in 2004. The increasewas primarily due to increased sales of GaAs substrates to customers in China and Singapore, which products are being used in opto-electronics applications.The Taiwan revenue decreased by $4.6 million or 54.2%, to $3.8 million in 2005 from $8.4 million in 2004. The decrease in Taiwan and other geographicareas for our GaAs substrates was due to continuing pricing pressures causing average sales prices to decline, overall lower demand from our wirelessapplication customers, and delays in orders from customers who had not yet qualified our China-grown products.Gross Margin2005 to 20062004 to 2005Years Ended Dec. 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)Gross profit (loss)$12,736$2,199$(251)$10,537479.2%$2,450976%Gross Margin %28.7%8.3%(0.7)% Gross margin increased to 28.7% of total revenue in 2006 from 8.3% of total revenue in 2005. Gross margin in 2006 was positively impacted by sales ofapproximately $2.9 million of GaAs wafers that were previously fully reserved, and by approximately $0.1 million as a result of a reversal of a sales returnreserve established in 2004 as we favorably resolved an outstanding matter with a customer. In addition, we sold a greater amount of InP substrates and largerdiameter GaAs wafers in 2006, which contributed higher gross margins. In December 2005, we reduced the workforce at our Fremont, California facility toeliminate positions that we no longer required to support production, and this reduction accounted for approximately 1.5 percentage points to gross margin in2006. In addition, we had manufacturing equipment that became fully depreciated in 2006, and the absence of depreciation expense for this41equipment contributed approximately 1.5 percentage points to gross margin in 2006. Finally, higher substrates gross margins were also achieved through betterslicing techniques, longer length ingot growth, shorter runtimes, and higher production volumes, partially offset by higher prices of raw materials for galliumand arsenic.Gross margin increased to 8.3% of total revenue in 2005 from negative 0.7% of total revenue in 2004. In 2004, our gross margin was negatively impactedby the following factors: (i) a $2.1 million charge for excess and obsolete inventory in the third quarter of 2004, (ii) an approximately $1.4 million chargeincurred in connection with our settlement of our patent dispute with Sumitomo Electric Industries, Ltd. in the third quarter of 2004, and (iii) the establishmentof a sales return reserve of $0.7 million in the first quarter of 2004 related to our failure to follow certain testing requirements, which reduced revenues withoutaffecting costs of revenues. The improvement in gross margin in 2005 was due to the increased sales in the larger diameter wafers as demand increased, andthe sales of fully reserved wafers which accounted for revenue of approximately $2.1 million in 2005.Selling, General and Administrative Expenses2005 to 20062004 to 2005Years Ended Dec. 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)Selling, general andadministrative expenses$12,650$12,955$11,561$(305)(2.4)%$1,39412.1%% of total revenue28.5%48.8%32.6% Selling, general and administrative expenses decreased $0.3 million to $12.7 million for 2006 compared to $13.0 million for 2005. The decrease wasprimarily due to decreases of $1.3 million for decontamination expenses as we prepare our U.S. property in Fremont, California for sale, $0.8 million for baddebt expenses as we collected on past due accounts and improved aging, $0.3 million for legal fees reimbursed by our insurance company for fees incurred inconnection with ongoing litigation as described in Note 18 of the consolidated financial statements, $0.2 million for legal and professional fees,and$0.1 million for recruiting fees, partially offset by increases of $0.5 million for compensation related payments, $0.5 million for stock-based compensationexpense, $0.4 million for consulting fees for compliance with the Sarbanes-Oxley Act of 2002, $0.3 million for customer compensation costs, $0.3 million forsales commissions and other miscellaneous expenses, $0.2 million for consulting fees for corporate design and human resources, and $0.2 million for jointventure labor related costs.Selling, general and administrative expenses increased $1.4 million to $13.0 million for 2005 compared with $11.6 million for 2004. The increase inabsolute dollars and as a percentage of revenue was primarily due to $2.0 million of decontamination expenses for our Fremont, California facilities, highertravel expenses of $0.3 million as operations have moved resulting in more travel to China, higher recruiting expenses of $0.1 million mainly in recruiting ournew chief executive officer, partially offset by $0.6 million lower insurance costs as operations have moved to China where rates are lower, $0.2 million indecreased Delaware franchise taxes, $0.1 million lower sales commissions due to lower sales and lower rates, and $0.1 million lower bad debt expenses ascollections and aging improved.42Research and Development Expenses2005 to 20062004 to 2005Years Ended Dec. 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)Research and developmentexpenses$2,351$1,723$1,479$62836.4%$24416.5%% of total revenue5.3%6.5%4.2% Research and development expenses increased $0.6 million, or 36.4%, to $2.4 million for 2006, from $1.7 million for 2005. During 2006, we incurred$0.4 million in severance payments to Dr. Morris Young, our chief technology officer who retired on December 31, 2006. We also incurred $0.2 million forstock-based compensation expense.Research and development expenses increased $0.2 million, or 16.5%, to $1.7 million for 2005, from $1.5 million for 2004. The increase was due to thetransition of Dr. Morris Young as our chief technology officer from his former position, and by severance payments to employees that had been performingresearch and development activities.We believe that continued investment in product development is critical to attaining our strategic objectives of maintaining and enhancing our technologyleadership. As a result, we expect research and development expenses to remain at the levels of recent quarters, excluding severance payments.Impairment and Restructuring Charges2005 to 20062004 to 2005Years Ended Dec. 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)Impairment charge$1,417$—$210$1,417NM$210NM% of total revenue3.2%—%0.6%Restructuring charge (benefit)$(2)$836$1,308$(838)(100.2)%$(472)(36.1)%% of total revenue0.0%3.2%3.7%NM: percentage not meaningfulImpairment ChargesIn the third quarter of 2006, we incurred an impairment charge of $1.4 million to write down our U.S. property in Fremont, California, which has beendecontaminated and is being prepared for sale. This property has been classified as “Assets held for sale” in the amount of $4.7 million on the consolidatedbalance sheet as of December 31, 2006.In the third quarter of 2004, we recorded an impairment charge of $0.2 million to write down the value of our investment in a private company. We madethe decision to write down the investment as a result of the declining financial position of the investee, evidenced by an audit opinion with a going concernexplanatory paragraph received by the investee. The $0.2 million was the remaining balance of this investment. No further write-downs were recorded in 2006or 2005.Restructuring ChargesIn 2006, we recognized a $2,000 benefit related to an adjustment to a prior accrual.43In March 2005, we announced that we would be reducing the workforce at our Beijing, China manufacturing facility by approximately 100 positions orapproximately 15%. This measure was taken as part of our ongoing effort to reduce our cost structure and bring capacity in line with current market demand.Accordingly, we recorded a restructuring charge of $56,000 in March 2005 relating to the reduction in work force, which we completed in June 2005. Wesaved approximately $0.3 million in payroll and related expense relating to this reduction in force.In April 2005, we closed our Japan office as part of our ongoing effort to reduce our cost structure. Accordingly, we recorded restructuring charges of$98,000 and $9,000, in the second and third quarters of 2005, respectively, relating to the closure of our Japan office. We saved approximately $0.3 millionin payroll and related expense.In December 2005, we further reduced the workforce at our Fremont, California facility by approximately 15 positions that were longer required tosupport production and operations, or approximately 29 percent. This measure was being taken as part of our ongoing effort to downsize our Fremont,California facility headcount. Accordingly, we recorded a restructuring charge of approximately $0.3 million in December 2005 related to the reduction in forcefor severance-related expenses from the reduction in force, all of which will be cash expenditures. The cash outflow from this charge was incurred over the firsttwo quarters of 2006. We saved approximately $0.9 million annually in payroll and related expenses. Also in December 2005, we recorded an additionalrestructuring charge of approximately $0.2 million, primarily related to the final liquidation procedures of AXT’s Japan office so as to eliminate the remainingassets. There was no further cash outflow from this charge.Overall for the year ended December 31, 2005, we recorded restructuring charges of $0.2 million relating to lease costs associated with facilities located inCalifornia that are no longer required to support production. The remaining restructuring accrual for future lease payments related to abandoned U.S. facilitiesof $0.3 million was paid out through 2006, and was included on the accompanying consolidated balance sheet as accrued restructuring. Refer to Note 8 to ourconsolidated financial statements.In 2004 in the second quarter, we announced plans to cease all production activities in the United States and to manufacture our products only in China.In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down our remaining manufacturing facilities in the UnitedStates. In the third and fourth quarter of 2004, we incurred additional restructuring charges of $0.2 million for a total of $1.3 million in 2004. These chargescomprised costs related to the reduction in work force effected in June 2004, and lease costs associated with the facilities located in California that are no longerrequired to support production. In aggregate, we eliminated 50 positions, 47 of which were production workers. As of December 31, 2004, we savedapproximately $0.6 million in annual payroll and related expenses.Interest Income, Net2005 to 20062004 to 2005Years Ended Dec. 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)Interest income, net$443$516$262$(73)(14.1)%$25496.9%% of total revenue1.0%1.9%0.7% Interest income, net decreased $0.1 million to $0.4 million for 2006 from $0.5 million for 2005 as a result of higher interest rates earned on ourinvestments, partially offset by higher interest rates on our debt, which we have continued to pay down. We also had lower cash balances.44Interest income, net increased $0.3 million to $0.5 million for 2005 from $0.3 million for 2004 as a result of our lower debt levels as we continued to paydown our debt.Other Income and (Expense), Net2005 to 20062004 to 2005Years Ended Dec. 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)Other income and (expense), net$2,709$(910)$94$3,619397.7%$(1,004)(1,068.1)%% of total revenue6.1%(3.4)%0.3% Other income and expense, net, was $2.7 million in 2006 compared to other expense, net, of $0.9 million in 2005. Other income, net was $2.7 millionfor 2006 primarily due to a realized gain of $3.3 million on the sale of all of our shares of common stock of Finisar Corporation, partially offset by minorityinterests in our joint ventures. Other expense was $0.9 million for 2005 due to $0.7 million for minority interests in our joint ventures, and $0.2 million forforeign exchange losses primarily related to the Japanese yen.Other expense was $0.9 million for 2005 compared with other income of $0.1 million for 2004. The $1.0 million change from other income to otherexpense was mainly due to $0.4 million increase in minority interest’s share in our joint ventures, $0.3 million increase in foreign exchange losses primarilyrelated to the Japanese yen and to the Chinese renminbi, $0.2 million other income in 2004 received from a customer to terminate a supply guarantee contract,and $0.1 million losses on asset and marketable security disposals.Minority interest in earnings of consolidated subsidiaries is included in other income and (expense), net and for the years ended December 31, 2006,2005, and 2004 were ($1.0 million) ($0.7 million), and ($0.3 million), respectively, as the consolidated subsidiaries’ profitability increased.Provision (benefit) for Income Taxes2005 to 20062004 to 2005Years Ended Dec. 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)Provision (benefit) for incometaxes$(1,454)$(950)$71$(504)(53.1)%$(1,021)(1,438)%% of total revenue3.3%3.6%(0.2)% In 2005, the Internal Revenue Service closed its examination of our tax return for the 2002 tax year, including the calculation of our 1999 and 2000 netoperating loss carry back. As a result, we reversed approximately $2.1 million and $1.1 million of income tax payable accrued for potential exposures relatingto 2006 and 2005, respectively. These amounts are shown as benefits from income taxes in 2006 and 2005. The other amounts in 2006 and 2005 relate toprovisions for income taxes related to our foreign subsidiaries. Provision for income taxes for 2004 was $71,000, which was related to our foreign subsidiaries.Due to our continuing operating losses and uncertainty regarding our future profitability, we recorded a full valuation allowance against our net deferred taxassets of $49.9 million in 2006, and $50.9 million in 2005.45Gain or Loss from Discontinued Operations2005 to 20062004 to 2005Years Ended December 31,IncreaseIncrease200620052004(Decrease)% Change(Decrease)% Change($ in thousands)Gain (loss) from discontinuedoperations, net of tax$18$544$891$(526)(96.7)%$(347)(38.9)% In 2006, we recorded $18,000 in interest income on cash balances held in discontinued operations.In 2005, the $0.5 million gain from discontinued operations was made up of a gain of $0.6 million, which was the remaining portion of the first$0.8 million held in escrow due to us from the sale of our opto-electronics business, and partially offset by $0.1 million in expenses for consulting fees, rentand tax payments.In 2004, we realized a $0.4 million gain on discontinued opto-electronics operations as a result of the partial release of escrow funds. Also in 2004, weentered into an agreement with a real estate developer for the purchase of our discontinued opto-electronics’ property held for sale and realized a gain of$0.3 million reflecting an adjustment to the realizable market value of the property. The remaining gain of $0.2 million was a result of our reversal of accruedliabilities of general and administrative expenses no longer required.Liquidity and Capital ResourcesYears Ended December 31,200620052004($ in thousands)Net cash provided by (used in):Operating activities$(10,263)$(7,746)$(340)Investing activities(15,809)13,886(7,846)Financing activities24,248(792)(4,216)Effect of exchange rate changes4687180Net change in cash and cash equivalents(1,356)5,355(12,222)Cash and cash equivalents—beginning period17,47212,11724,339Cash and cash equivalents—end of period16,11617,47212,117Short-term investments—end of period19,4285,55520,062Total cash, cash equivalents and short-term investments$35,544$23,027$32,179 We consider cash and cash equivalents, and short-term investments as liquid and available for use. Short-term investments are comprised of governmentbonds and high-grade commercial debt instruments. Also historically included in short-term investments was our investment in common stock of FinisarCorporation, a United States publicly-traded company. During 2006 we sold all of our shares of common stock of Finisar Corporation generating net proceedsof $4.4 million and recording a gain of $3.3 million, which is included in other income and (expense). As of December 31, 2006, our principal sources ofliquidity were $35.5 million in cash and cash equivalents and short-term investments, excluding restricted deposits.Cash and cash equivalents and short-term investments, increased $14.9 million to $35.5 million as of December 31, 2006 from $20.6 million as ofDecember 31, 2005, excluding $2.4 million for our investment in Finisar common stock as of December 31, 2005. The combined increase in cash and cashequivalents and short-term investments was primarily due to the net proceeds of $24.1 million received from the public offering of 5,750,000 shares of ourcommon stock in December 2006, net proceeds of $4.4 million from the sale of all of our shares of common stock of Finisar, partially offset by the purchaseof machinery and46equipment of $4.5 million, payments of long-term debt of $0.4 million, and the continual funding of our operations.Net cash used in operating activities of $10.3 million for 2006 was primarily comprised of our net income of $0.9 million, adjusted for non-cash itemsof depreciation of $2.6 million, an asset impairment charge of $1.4 million, stock-based compensation of $0.8 million, and a loss on disposal of property,plant and equipment of $0.1 million, partially offset by a realized gain on sale of investments of $3.3 million, and by a net increase of $12.8 million in assetsand liabilities. The net increase in assets and liabilities of $12.8 million resulted from a $4.4 million increase in accounts receivable, net, a $4.1 millionincrease in inventories, net, a $2.2 million increase in prepaid expenses, primarily from foreign taxes prepaid and prepayments to vendors, a $2.3 milliondecrease in income taxes payable, primarily from the reversal of approximately $2.1 million of income tax payable accrued for potential exposures that haveexpired, a $0.6 million decrease in accrued liabilities, primarily for restructuring costs and decommissioning expenses, a $0.5 million increase in other assets,and partially offset by a $0.7 million increase in accounts payable and a $0.6 million increase in other long-term liabilities, primarily minority interests.Accounts receivable, net, increased by $4.4 million, or 84.8%, to $9.7 million as of December 31, 2006 from $5.2 million as of December 31, 2005. Theincrease was primarily a result of our increased sales, as well as decreased accounts receivable allowances of $0.1 million as of December 31, 2006 comparedto $0.6 million as of December 31, 2005 reflecting continuous improvements in our collection efforts from customers. Our days sales outstanding was 68days as of December 31, 2006 compared to 62 days as of December 31, 2005. Inventories, net, increased $4.1 million, or 25.4% to $20.3 million as ofDecember 31, 2006 from $16.2 million as of December 31, 2005, as we increased inventory in raw materials, work in process and finished goods to increaseproduction in anticipation of increased forecast sales.Net cash used in operating activities increased $7.4 million from $0.3 million in 2004 to $7.7 million in 2005, and was primarily comprised of our netloss of $12.2 million, adjusted for non-cash items of depreciation of $3.7 million, restructuring charge $0.7 million, amortization of marketable securities$0.2 million, stock-based compensation of $0.2 million, a loss on disposal of property, plant and equipment of $0.3 million, and by a net increase of$0.6 million in assets and liabilities.Net cash used in investing activities of $15.8 million for the year ended December 31, 2006 included net purchases of investment securities totaling$11.8 million, net purchases of property and equipment of $4.3 million, partially offset by a decrease in our restricted deposits of $0.3 million.Net cash provided by investing activities of $13.9 million for the year ended December 31, 2005 included proceeds from the sale of our Monterey Park,CA property of $1.3 million, net sales of high grade investment securities totaling $14.1 million and a decrease in our restricted deposits of $0.8 million,partially offset by purchases of property and equipment of $2.3 million.We are currently expanding capacity at our China facilities and we expect to invest up to approximately $4.9 million in capital expansion and otherprojects in 2007 related to our China facilities. We believe that the expansion will be sufficient to fulfill expected future orders.Net cash provided by financing activities of $24.2 million for the year ended December 31, 2006 consisted of $24.1 million net proceeds from theissuance of 5,750,000 shares of common stock as a result of our December 2006 follow-on stock offering, $0.6 million from the proceeds from the exercise ofemployee stock options, partially offset by payments of $0.4 million related to long-term borrowings.Net cash used in financing activities of $0.8 million for the year ended December 31, 2005 consisted of payments of $0.7 million related to long-termborrowings and $0.2 million for the repurchase of our common stock under our 10b5-1 plan, and partially offset by $0.1 million proceeds from the issuanceof common stock under our employee stock purchase plan.47In December 2004, we reached a final settlement of our litigation with Sumitomo Electric Industries, Ltd. (SEI), which includes a global intellectualproperty cross-licensing agreement. We recorded a charge of approximately $1.4 million in the quarter ended September 30, 2004 in connection with thissettlement. Under the terms of the settlement, we made a payment to SEI in the amount of Japanese Yen one hundred and forty-seven million (¥147,000,000) onJanuary 4, 2005, and we will make on-going royalty payments through 2012 on certain products sold by AXT in Japan. Subsequent to that payment, SEIdropped the litigation in Japan and we abandoned the interference proceedings in the U.S.We believe that we have adequate cash and investments to meet our needs over the next 12 months. If our sales decrease, however, our ability to generatecash from operations will be adversely affected which could adversely affect our future liquidity, require us to use cash at a more rapid rate than expected, andrequire us to seek additional capital. There can be no assurance that such additional capital will be available or, if available it will be at terms acceptable to us.Cash from operations could be affected by various risks and uncertainties, including, but not limited to those set forth below under Item 1A. “Risk Factors”above.Off-Balance Sheet ArrangementsWe have never entered into any off-balance sheet financing arrangements and have never established any special purpose entities. We have not entered intoany options on non-financial assets.We had entered into contracts to supply several large customers with GaAs wafers. The contracts guaranteed delivery of a certain number of wafersbetween January 1, 2001 and December 31, 2004. The contract sales prices were subject to review quarterly and could be adjusted in the event that rawmaterial prices changed. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, we could be subject to non-performancepenalties of between 5% and 10% of the value of the delinquent monthly deliveries. We have not received any claims for non-performance penalties due to non-delivery. As of December 31, 2006, we had met all of our current delivery obligations under these contracts and do not show any amount owing. Partialprepayments received for these supply contracts totaling $125,000 was included in customer prepayments in the accompanying consolidated balance sheet asof December 31, 2005.We indemnify certain customers for attorney fees and damages and costs awarded against these parties in certain circumstances if our products are foundto infringe certain patents and they are sued by the patent holder and awarded damages. There are limits on and exceptions to our potential liability forindemnification relating to intellectual patent infringement claims. We cannot estimate the amount of potential future payments, if any, that we might berequired to make as a result of these agreements. To date, we have not paid any claim or been required to defend any action related to our indemnificationobligations, and accordingly, we have not accrued any amounts for such indemnification obligations. However, we may record charges in the future as a resultof these indemnification obligations.Contractual ObligationsAs of December 31, 2006, the credit facility maintained by us with a bank included a letter of credit supporting repayment of our industrial bonds withan outstanding amount of approximately $7.2 million. We have pledged and placed certain investment securities with an affiliate of the bank as additionalcollateral for this facility. We have also pledged certain investments for a credit facility for our workers compensation insurance policy for portions of 2003.Accordingly, $7.2 million of our cash and short-term investments are restricted.48We lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through March 2013. OnMarch 11, 2003, we completed the sale of our property located at 4281 Technology Drive, Fremont, California, for $6.3 million. Net cash proceeds from thesale were $5.2 million. The gain incurred by us on this transaction was less than $15,000. Under the terms of the sale agreement, we have agreed to leaseback the property for a ten-year period. Accordingly, on March 11, 2003, we signed an operating lease for this property through March 2013. Total rentexpense under these operating leases were approximately $0.9 million, $1.3 million and $1.3 million for years ended December 31, 2006, 2005 and 2004,respectively.The following table summarizes our contractual obligations as of December 31, 2006 (in thousands):Payments due by periodContractual ObligationsTotalLess than1 year1-3years3-5yearsMore than5 yearsLong-term debt$7,289$450$1,039$900$4,900Operating leases4,5776451,4461,530956Total$11,866$1,095$2,485$2,430$5,856 49Selected Quarterly Results of OperationsThe following table sets forth unaudited quarterly results for the eight quarters ended December 31, 2005. We believe that all necessary adjustments,consisting only of normal recurring adjustments, have been included in the amounts stated below to present fairly such quarterly information. The operatingresults for any quarter are not necessarily indicative of results for any subsequent period.Quarters EndedDec. 31,2006Sept. 30,2006June 30,2006Mar. 31,2006Dec. 31,2005Sept. 30,2005June 30,2005Mar. 31,2005Revenue$13,072$12,547$10,355$8,471$7,717$6,153$6,032$6,634Cost of revenue8,0849,0687,5966,9617,0695,0085,9056,355Gross profit4,9883,4792,7591,5106481,145127279Operating expenses:Selling, general and administrative2,9262,6413,8533,2303,0892,8982,7164,252Research and development854392571534466472423362Impairment charge—1,417——————Restructuring charge (benefit)———(2)46014237125Total operating expenses3,7804,4504,4243,7624,0153,3843,3764,739Income (loss) from continuingoperations1,208(971)(1,665)(2,252)(3,367)(2,239)(3,249)(4,460)Interest income, net101103111128130136131119Other income and (expense), net1,016641814238416193196105Income (loss) from continuingoperations before provision (benefit)for income taxes2,325(227)(740)(1,886)(3,653)(2,296)(3,314)(4,446)Provision (benefit) for income taxes(1,048)(862)138318(1,048)451835Income (loss) from continuingoperations3,373635(878)(2,204)(2,605)(2,341)(3,332)(4,481)Discontinued operations:Gain (loss) from discontinuedoperations, net of tax11421(126)9—58Gain from disposal, net of tax—————25053300Gain (loss) from discontinuedoperations, net of tax11421(126)25953358Net income (loss)$3,384$639$(876)$(2,203)$(2,731)$(2,082)$(3,279)$(4,123) Recent Accounting PronouncementsIn November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151,“Inventory Costs—An Amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “InventoryPricing”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among otherprovisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight and re-handling costs must be recognized ascurrent-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, SFAS 151 requires that theallocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The adoption of SFAS 151,effective January 1, 2006, did not have a material impact on our consolidated financial position, results of operations or cash flows.50In December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets—An Amendment of APB Opinion No. 29” (“SFAS 153”).SFAS 153 eliminates the exception from fair value measurement for non-monetary exchanges of similar productive assets in paragraph 21(b) of APB OpinionNo. 29, “Accounting for Non-monetary Transactions,” and replaces it with the exception for exchanges that do not have commercial substance. SFAS 153specifies that a non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of theexchange. The adoption of SFAS 153, effective January 1, 2006, did not have a material impact on our consolidated financial position, results of operationsor cash flows.In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”). SFAS 123(R) requires that all share-based payments to employees, including grants of stock options, be recognized in the financial statements based on their fair value. Refer to Note 1 of the notesto consolidated financial statements for further discussion.In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3” (“SFAS 154”). SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle, and applies toall voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that thepronouncement does not include specific transition provisions. This statement requires retrospective application to prior periods’ financial statements ofchanges in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. The adoption ofSFAS 154, effective January 1, 2006, did not have a material impact on our consolidated financial position, results of operations or cash flows.In November 2005, the FASB issued FASB Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments” (“FSP FAS 115-1”), which provides guidance on determining when investments in certain debt and equity securities areconsidered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP FAS 115-1 also includes accountingconsiderations subsequent to the recognition of an other-than temporary impairment and requires certain disclosures about unrealized losses that have not beenrecognized as other-than-temporary impairments. The adoption of FSP FAS 115-1, effective January 1, 2006, did not have a material impact on ourconsolidated financial position, results of operations or cash flows.In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Instruments—an amendment of FASB Statements No. 133 and140” (“SFAS 155”). SFAS 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and SFASNo. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). SFAS 155 allows entities theoption of applying fair value accounting to certain hybrid financial instruments in their entirety if they contain embedded derivatives that would otherwiserequire bifurcation under SFAS 133. SFAS 155 will be effective for us as of January 1, 2007. We are currently assessing the impact that the adoption ofSFAS 155 may have on our consolidated financial position, results of operations or cash flows.In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets” (SFAS 156”). This statement amends SFASNo. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, (“SFAS 140”) with respect to the accountingfor separately recognized servicing assets and servicing liabilities. SFAS 156 will be effective for us as of January 1, 2007. We are currently assessing theimpact that the adoption of SFAS 156 may have on our consolidated financial position, results of operations or cash flows.In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting For Uncertain Tax Positions—An Interpretation of FASB StatementNo. 109” (“FIN 48”). FIN 48 clarifies the accounting for51uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”.It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to betaken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure andtransition. FIN 48 is effective for fiscal years beginning after Decemeber 15, 2006. We are currently assessing the impact that the adoption of FIN 48 mayhave on our consolidated financial position, results of operations or cash flows.In June 2006, the FASB ratified the consensus reached by the Emerging Issues Task Force (“EITF”) on Issue No. 06-3, “How Taxes Collected fromCustomers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)”, (“ EITF06-3”). EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and acustomer and may include, but is not limited to, sales, use, value added, and some excise taxes. EITF 06-3 concludes that the presentation of taxes on either agross (included in revenues and costs) or a net (excluded from revenues) basis is an accounting policy decision that should be disclosed. In addition, for anysuch taxes that are reported on a gross basis, a company should disclose the amounts of those taxes in interim and annual financial statements for each periodfor which an income statement is presented if those amounts are significant. The provisions of EITF 06-3 should be applied to financial reports for interimand annual reporting periods beginning after December 15, 2006, with earlier adoption permitted. We are currently assessing the impact that the adoption ofEITF 06-3 may have on our consolidated financial position, results of operations or cash flows.In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides a new single authoritativedefinition of fair value and provides enhanced guidance for measuring the fair value of assets and liabilities and requires additional disclosures related to theextent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements onearnings. SFAS 157 is effective for us as of January 1, 2008. We are currently assessing the impact that the adoption of SFAS 157 may have on ourconsolidated financial position, results of operations or cash flows.In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—anamendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”). SFAS 158 requires balance sheet recognition of the overfunded orunderfunded status of pension and postretirement benefit plans. Under SFAS 158, actuarial gains and losses, prior service costs or credits, and anyremaining transition assets or obligations that have not been recognized under previous accounting standards must be recognized as a component ofaccumulated other comprehensive income (loss) within stockholders’ equity, net of tax effects, until they are amortized as a component of net periodic benefitcost. In addition, the measurement date and the date at which plan assets and the benefit obligation are measured, are required to be the company’s fiscal year-end. SFAS 158 is effective for us as of December 31, 2007, except for the measurement date provisions, which are effective December 31, 2009. We arecurrently assessing the impact that the adoption of SFAS 158 may have on our consolidated financial position, results of operations or cash flows.In September 2006, the United States Securitires and Exchange Commission (“SEC”) released Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 providesinterpretative guidance on how public companies quantify financial statement misstatements. There have been two common approaches used to quantify sucherrors. Under an income statement approach, the “roll-over” method, the error is quantified as the amount by which the current year income statement ismisstated. Alternatively, under a balance sheet approach, the “iron curtain” method, the error is quantified as the cumulative amount by which the current yearbalance sheet is misstated. In SAB 108, the SEC established an approach that requires quantification of financial statement misstatements based on the effectsof the52misstatements on each of the company’s financial statements and the related financial statement disclosures. This model is commonly referred to as a “dualapproach” because it requires quantification of errors under both the roll-over and iron curtain methods. SAB 108 was effective for us as of December 31,2006. The adoption of SAB 108 did not have a material impact on our consolidated financial position, results of operations or cash flows.In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets andLiabilities” (“SFAS 159”). SFAS 159 provides entities with the option to report selected financial assets and liabilities at fair value. Business entitiesadopting SFAS 159 will report unrealized gains and losses in earnings at each subsequent reporting date on items for which fair value option has been elected.SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributesfor similar types of assets and liabilities. SFAS 159 requires additional information that will help investors and other financial statement users to understandthe effect of an entity’s choice to use fair value on its earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with earlieradoption permitted. We are currently assessing the impact that the adoption of SFAS 159 may have on our consolidated financial position, results ofoperations or cash flows.Item 7A. Quantitative and Qualitative Disclosures about Market RiskForeign Currency RiskSince 2004 we no longer use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements.We had previously purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fairvalue of the forward contracts was recognized as part of the related foreign currency transactions as they occur. As of December 31, 2006, and 2005, we hadno outstanding commitments with respect to foreign exchange contracts.Interest Rate RiskCash and cash equivalents earning interest and certain variable rate debt instruments are subject to interest rate fluctuations. The following table setsforth the probable impact of a 10% change in interest rates (in thousands):InstrumentBalance as ofDecember 31,2006CurrentInterestRateProjected AnnualInterestIncome/(Expense)Proforma 10%Interest RateDeclineIncome/(Expense)Proforma 10%Interest RateIncreaseIncome/(Expense)Cash$6,8920.50%$34$31$38Cash equivalents9,2245.23482434531Investment in debt and equityinstruments26,5784.521,2011,0811,321Long-term debt(7,289)5.47(399)(359)(439)$1,318$1,187$1,451 Equity RiskWe maintain minority investments in privately-held companies. These investments are reviewed for other than temporary declines in value on a quarterlybasis. These investments are classified as other assets in the consolidated balance sheets and are accounted for under the cost method as we do not have theability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when eventsor changes in circumstances indicate that the carrying53value may not be recoverable. Reasons for other than temporary declines in value include whether the related company would have insufficient cash flow tooperate for the next twelve months, significant changes in the operating performance and changes in market conditions. As of December 31, 2006 and 2005,the minority investments totaled $0.4 million for both years. In 2004, we recorded a $0.2 million charge related to impairment in one of the U.S. privatecompanies.Item 8. Consolidated Financial Statements and Supplementary DataThe consolidated financial statements, related notes thereto and financial statement schedule required by this item are listed and set forth beginning onpage 57, and is incorporated by reference here. Supplementary financial information regarding quarterly financial information required by this item is setforth under the caption “Quarterly Results of Operations” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” and is incorporated by reference here.Item 9. Changes in and Disagreements with Accountants on Accounting and Financial DisclosureNone.Item 9A. Controls and ProceduresEvaluation of disclosure controls and procedures. Under the supervision and with the participation of our management, our Chief ExecutiveOfficer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Chief Executive Officer and our Chief FinancialOfficer concluded that the our disclosure controls and procedures were effective as of the end of the period covered by this report.Changes in internal control over financial reporting. As required by Rule 13a-15(d), our management, including our Chief Executive Officer andChief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during theperiod covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based onthat evaluation, there has been no such change during the period covered by this report.Limitations of the effectiveness of internal control. A control system, no matter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the internal control system are met. Because of the inherent limitations of any internal control system, no evaluationof controls can provide absolute assurance that all control issues, if any, within a company have been detected. Notwithstanding these limitations, ourdisclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives. Our Chief Executive Officer and Chief FinancialOfficer have concluded that our disclosure controls and procedures are, in fact, effective at the “reasonable assurance” level.Item 9B. Other InformationNone.54PART IIIThe United States Securities and Exchange Commission (“SEC”) allows us to include information required in this report by referring to other documentsor reports we have already or will soon be filing. This is called “Incorporation by Reference.” We intend to file our definitive proxy statement pursuant toRegulation 14A not later than 120 days after the end of the fiscal year covered by this report, and certain information therein is incorporated in this report byreference.Item 10. Directors, Executive Officers and Corporate GovernanceThe information required by this item pursuant to Item 401 of Regulation S-K concerning directors is incorporated by reference to the information in thesection entitled “Proposal No. 1, Election of Directors” in the Proxy Statement.The information required by this item pursuant to Item 401 of Regulation S-K concerning executive officers is incorporated by reference to the sectionentitled “Proposal No.1 Election of Directors” and “Executive Compensation and Other Matters” in the Proxy Statement.The information required by this item pursuant to Item 405 of Regulation S-K concerning compliance with Section 16(a) of the Securities Exchange Actof 1934, as amended, is incorporated by reference to information in the section entitled “Security Ownership of Certain Holders—Section 16(a) BeneficialOwnership Reporting Compliance” in the Proxy Statement.The Board of Directors of AXT, Inc. has adopted a code of ethics that applies to our principal executive officers, principal financial officer, andcorporate controller, as well as other employees. A copy of this code of ethics has been posted on our Internet website at www.axt.com. Any amendments to, orwaivers from, a provision of our code of ethics that applies to our principal executive officer, principal financial officer, controller, or persons performingsimilar functions and that relates to any element of the code of ethics enumerated in paragraph (b) of Item 406 of Regulation S-K shall be disclosed by postingsuch information on our website.Item 11. Executive CompensationThe information required by this Item is incorporated herein by reference to information set forth in our definitive Proxy statement to be filed inconnection with our annual meeting of stockholders to be held on May 22, 2007, under the section entitled “Executive Compensation and Other Matters.”Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersThe information required by this Item is incorporated herein by reference to information set forth in our definitive Proxy statement to be filed inconnection with our annual meeting of stockholders to be held on May 22, 2007, under the section entitled “Security Ownership of Certain Beneficial Ownersand Management and Equity Compensation Plan Information.”Item 13. Certain Relationships and Related Transactions and Director IndependenceSince January 2002, there has not been, nor is there currently proposed, any transaction or series of similar transactions to which we were or are to be aparty in which the amount involved exceeds $60,000, and in which any director, executive officer or holder of more than 5% of any class of our votingsecurities or members of that person’s immediate family had or will have a direct or indirect material interest other than the transactions described below.We entered into an operating lease in July 2001 for warehouse space in Fremont, CA with 4160 Business Center, LLC, a real estate holding company, inwhich Davis Zhang, president of our joint55venture operations, was the sole shareholder. Lease payments to 4160 Business Center, LLC were approximately $484,000 for the year ended December 31,2002 and $121,000 for the three months ended March 31, 2003. In April of 2003, Mr. Zhang sold this warehouse to a party unrelated to us. We began leasingthis warehouse from the new owner on the date of sale up to the end of the lease expiration in July, 2006. Mr. Zhang no longer holds a $3.7 million note on theproperty as of December 31, 2006.Item 14. Principal Accountant Fees and ServicesThe information required by this Item is incorporated herein by reference to information set forth in our definitive Proxy statement to be filed inconnection with our annual meeting of stockholders to be held on May 22, 2007, under the section entitled “Principal Accounting Firm Fees.”56PART IVItem 15. Exhibits and Financial Statement Schedules(a) The following documents are filed as part of this report:(1) Financial Statements:INDEX TO CONSOLIDATED FINANCIAL STATEMENTSReport of Independent Registered Public Accounting Firm, Burr, Pilger & Mayer LLP58Consolidated Balance Sheets59Consolidated Statements of Operations60Consolidated Statements of Stockholders’ Equity61Consolidated Statements of Cash Flows62Notes to Consolidated Financial Statements63 (2) Financial Statement SchedulesAll schedules have been omitted because the required information is not applicable or because the information required is included in the consolidatedfinancial statements or notes thereto.(b) ExhibitsSee Index to Exhibits attached elsewhere to this Form 10-K. The exhibits listed in the accompanying Index to Exhibits are filed as part of, or incorporatedby reference into, this report on Form 10-K.57REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Stockholders and Board of Directors of AXT, Inc.:We have audited the accompanying consolidated balance sheets of AXT, Inc. and its subsidiaries (the Company) as of December 31, 2006 and 2005,and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006.These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company isnot required to have, nor have we been engaged to perform, an audit of the Company’s internal control over financial reporting. Our audits includedconsideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for thepurpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. Anaudit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of AXT, Inc. and itssubsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period endedDecember 31, 2006 in conformity with accounting principles generally accepted in the United States of America.As discussed in Note 1 to the consolidated financial statements, on January 1, 2006 the Company changed its method of accounting for stock-basedcompensation as a result of adopting Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” applying the modifiedprospective method./s/ BURR, PILGER & MAYER LLPSan Jose, California March 21, 200758AXT, INC.CONSOLIDATED BALANCE SHEETSDecember 31,20062005(In thousands, exceptper share data)ASSETSCurrent assetsCash and cash equivalents$16,116$17,472Short-term investments19,4285,555Accounts receivable, net of allowances of $140 and $619 as of December 31, 2006and 2005, respectively9,6585,226Inventories, net20,26316,156Prepaid expenses and other current assets3,9851,801Assets held for sale4,659—Total current assets74,10946,210Property, plant and equipment, net12,77517,306Restricted deposits7,1507,450Other assets4,2983,832Total assets$98,332$74,798LIABILITIES AND STOCKHOLDERS’ EQUITYCurrent liabilitiesAccounts payable$3,764$3,070Accrued liabilities1,7972,562Accrued compensation and related charges1,102726Accrued product warranty459120Accrued restructuring costs—465Customer prepayments—125Current portion of long-term debt450300Income taxes payable1782,495Total current liabilities7,7509,863Long-term debt, net of current portion6,8397,420Other long-term liabilities2,5431,897Total liabilities17,13219,180Commitments and contingencies (Note 18)Stockholders’ equity:Preferred stock, $0.001 par value; 2,000 shares authorized; 883 shares issued andoutstanding as of December 31, 2006 and 2005, respectively3,5323,532Common stock, $0.001 par value; 70,000 shares authorized; 29,011 and 22,977shares issued and outstanding as of December 31, 2006 and 2005, respectively2923Additional paid-in-capital180,936155,441Accumulated deficit(103,832)(104,776)Other comprehensive income5351,398Total stockholders’ equity81,20055,618Total liabilities and stockholders’ equity$98,332$74,798 The accompanying notes are an integral part of these consolidated financial statements.59AXT, INC.CONSOLIDATED STATEMENTS OF OPERATIONSYears Ended December 31,200620052004(In thousands, except per share data)Revenue$44,445$26,536$35,454Cost of revenue31,70924,33735,705Gross profit (loss)12,7362,199(251)Operating expenses:Selling, general and administrative12,65012,95511,561Research and development2,3511,7231,479Impairment charge1,417—210Restructuring charge (benefit)(2)8361,308Total operating expenses16,41615,51414,558Loss from continuing operations(3,680)(13,315)(14,809)Interest income, net443516262Other income and (expense), net2,709(910)94Loss from continuing operations before provision (benefit) for income taxes(528)(13,709)(14,453)Provision (benefit) for income taxes(1,454)(950)71Income (loss) from continuing operations926(12,759)(14,524)Discontinued operations:Gain (loss) from discontinued operations, net of tax18(59)472Gain from disposal, net of tax—603419Gain from discontinued operations, net of tax18544891Net income (loss)$944$(12,215)$(13,633)Basic income (loss) per share:Income (loss) from continuing operations$0.03$(0.56)$(0.64)Gain from discontinued operations, net of tax—0.020.04Net income (loss)$0.03$(0.54)$(0.60)Shares used in computing basic net income (loss) per share23,30323,04723,063Diluted income (loss) per share:Income (loss) from continuing operations$0.03$(0.56)$(0.64)Gain from discontinued operations, net of tax—0.020.04Net income (loss)$0.03$(0.54)$(0.60)Shares used in computing diluted net income (loss) per share24,60023,04723,063 The accompanying notes are an integral part of these consolidated financial statements.60AXT, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYCommon StockOtherPreferred StockAdditionalAccumulatedComprehensiveComprehensiveSharesAmountSharesAmountPaid In CapitalDeficitIncome/(loss)TotalIncome/(loss)(In thousands)Balance as ofDecember 31, 2003883$3,53222,957$23$155,155$(78,928)$(2,516)$82,298Common stock optionsexercised56153153Issuance of Employee StockPurchase Plan stock106117117Compensation related to stockoptions66Comprehensive loss:Net loss(13,633)(13,633)$(13,633)Unrealized gain (loss) onmarketable securities(1,104)(1,104)(1,104)Currency translationadjustment180180180Balance as ofDecember 31, 20048833,53223,11923155,431(92,561)1,59268,017(14,557)Common stock optionsexercised555Issuance of Employee StockPurchase Plan stock555959Common stock repurchased(202)(246)(246)Compensation related to stockoptions192192Comprehensive loss:Net loss(12,215)(12,215)(12,215)Unrealized (loss) gain onmarketable securities(201)(201)(201)Currency translationadjustment777Balance as ofDecember 31, 20058833,53222,97723155,441(104,776)1,39855,618(12,409)Common stock optionsexercised284556556Stock-based compensation822822Issuance of common stock, netof stock issuance costs of$1,7525,750624,11724,123Comprehensive loss:Net income944944944Unrealized (loss) gain onmarketable securities(1,331)(1,331)(1,331)Currency translationadjustment468468468Balance as ofDecember 31, 2006883$3,53229,011$29$180,936$(103,832)$535$81,200$81 The accompanying notes are an integral part of these consolidated financial statements.61AXT, INC.CONSOLIDATED STATEMENTS OF CASH FLOWSYears Ended December 31,200620052004(In thousands)Cash flows from operating activities:Net income (loss)$944$(12,215)$(13,633)Adjustments to reconcile net income (loss) to cash (used in) providedby operations:Depreciation2,6253,7454,869Amortization of marketable securities premium/discount(79)192307Stock-based compensation8221926Non-cash restructuring charge—7361,308Impairment of investments——210Impairment of property, plant and equipment1,417——Realized gain on sale of investments3,301——Loss on disposal of property, plant and equipment11529010Gain on disposal of discontinued operations—(53)(472)Changes in assets and liabilities:Accounts receivable, net(4,432)(1,192)2,263Inventories(4,107)3067,621Prepaid expenses(2,184)722(948)Other assets(466)—(77)Accounts payable6941,175(743)Accrued liabilities(640)(1,775)(1,001)Income taxes(2,317)(430)(140)Other long-term liabilities64656180Net cash (used in) provided by operating activities(10,263)(7,746)(340)Cash flows from investing activities:Purchases of property, plant and equipment(4,458)(2,329)(2,139)Proceeds from disposal of property, plant and equipment1733310Purchases of marketable securities(27,346)(10,227)(25,876)Proceeds from sale of marketable securities15,52224,34119,072Proceeds from sale of assets held for sale—1,303—Decrease (increase) in restricted deposits300765(1,087)Net cash provided by (used in) investing activities(15,809)13,886(7,846)Cash flows from financing activities:Proceeds from issuance of common stock24,67964270Repurchase of common stock—(246)—Proceeds from long-term debt borrowings—49—Long-term debt payments(431)(659)(4,486)Net cash provided by (used in) financing activities24,248(792)(4,216)Effect of exchange rate changes4687180Net increase (decrease) in cash and cash equivalents(1,356)5,355(12,222)Cash and cash equivalents at the beginning of the period17,47212,11724,339Cash and cash equivalents at the end of the period$16,116$17,472$12,117Supplemental Disclosures:Interest paid$372$266$271Income taxes paid$1,978$111$197 The accompanying notes are an integral part of these consolidated financial statements.62AXT, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSNote 1. The Company and Summary of Significant Accounting PoliciesThe CompanyAXT, Inc. (“AXT”, “we,” “us,” and “our” refer to AXT, Inc. and all of its subsidiaries) designs, develops, manufactures and distributes high-performance compound semiconductor substrates. Our substrate products are used primarily in wireless communications, lighting display applications, andfiber optic communications. We believe our vertical gradient freeze, or VGF, technique for manufacturing semiconductor substrates provides significantbenefits over other methods and enabled us to become a leading manufacturer of such substrates. We pioneered the commercial use of VGF technology tomanufacture gallium arsenide (GaAs) substrates and subsequently used VGF technology to manufacture substrates from indium phosphide (InP), andgermanium (Ge). We also manufacture and sell raw materials related to our substrate business through five joint ventures located in China. These jointventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, and germanium, germanium dioxide, paralytic boronnitride (pBN) crucibles, and boron oxide. AXT’s ownership interest in these entities ranges from 25 percent to 83 percent. We consolidate the three ventures inwhich we own a majority share and employ equity accounting for the two joint ventures in which we have a 25 percent interest. We purchase the materialsproduced by these ventures for our use and sell other portions of their production to third parties.On June 24, 2003, our Board of Directors approved management’s plan to exit our unprofitable Opto-electronics business. Substantially all of the assetsof this division were sold in September 2003. The decision to dispose of the business was due to continuing operating losses and negative cash flows from thedivision and significant uncertainty regarding future profitability.Use of EstimatesThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires managementto make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from these estimates.Principles of ConsolidationThe consolidated financial statements include the accounts of AXT and our majority-owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated. Investments in business entities in which we do not have control, but have the ability to exercise significant influence overoperating and financial policies (generally 20-50% ownership), are accounted for by the equity method.Fair Value of Financial InstrumentsThe carrying amounts of certain of our financial instruments including cash and cash equivalents, accounts receivable, short-term investments,accounts payable and accrued liabilities approximate fair value due to their short maturities. The carrying amounts of short-term and long-term debtapproximate fair value due to the market interest rates that these debts bear, and interest rates currently available to us.63ReclassificationsCertain reclassifications have been made to the prior years’ consolidated financial statements to conform to current year presentation. Thesereclassifications had no impact on previously reported total assets, stockholders’ equity or net loss.Foreign Currency TranslationThe functional currencies of our Japanese and Chinese subsidiaries are the local currencies. Transaction gains and losses resulting from transactionsdenominated in currencies other than the U.S. dollar or in the functional currencies of our subsidiaries are included in other income and (expense) and income,net for the periods presented.The assets and liabilities of the subsidiaries are translated at the rates of exchange on the balance sheet date. Revenue and expense items are translated atthe average rate of exchange for the period. Gains and losses from foreign currency translation are included in other comprehensive income (loss) instockholders’ equity.Revenue RecognitionWe recognize revenue upon the shipment of our products to customers when:· we have received a signed purchase order placed by our customers,· the price is fixed or determinable,· title and risk of ownership has transferred to our customers upon shipment from our dock, receipt at customer’s dock, or removal from consignmentinventory at customer’s location,· collection of resulting receivables is probable, and· product returns are reasonably estimable.We do not provide training, installation or commissioning services. Our terms and conditions of sale do not require customer acceptance. We assess theprobability of collection based on a number of factors including past history with the customer and credit worthiness. We provide for future returns based onhistorical experience, current economic trends and changes in customer demand at the time revenue is recognized. Additionally, we do not provide discounts orother incentives to customers except for one customer with whom we agreed in the fourth quarter of 2004 to provide a certain amount of cumulative discountson future product purchases from us. We will recognize these discounts in future periods as a reduction in revenue as products are sold to this customer.Concentration of Credit RiskOur business is very dependant on the semiconductor industry, which is highly cyclical and has historically experienced downturns as a result ofeconomic changes, overcapacity, and technological advancements. Significant technological changes in the industry or customer requirements, or theemergence of competitive products with new capabilities or technologies, could adversely affect operating results. In addition, a significant portion of ourrevenues and net income (loss) is derived from international sales. Fluctuations of the United States dollar against foreign currencies and changes in localregulatory or economic conditions, particularly in an emerging market such as China, could adversely affect operating results.We depend on a single or limited number of suppliers for certain critical materials used in the production of our substrates, such as quartz tubing, andpolishing solutions. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts.64Financial instruments that potentially subject us to concentration of credit risk consist primarily of cash equivalents, short-term investments, and tradeaccounts receivable. We invest primarily in money market accounts, commercial paper instruments, and investment grade securities. We are exposed to creditrisks in the event of default by the issuers to the extent of the amount recorded on the consolidated balance sheets.We perform ongoing credit evaluations of our customers’ financial condition, and limit the amount of credit extended when deemed necessary, butgenerally do not require collateral. The credit risk in our accounts receivable is substantially mitigated by our credit evaluation process, reasonably shortcollection terms and the geographical dispersion of sales transactions. One customer represented greater than 10% of revenue, totaling 12.8%, for the yearended December 31, 2006, two customers represented greater than 10% of revenue, totaling 20.7%, for the year ended December 31, 2005, while no customersrepresented greater than 10% of revenue for the year ended December 31, 2004. Our top five customers represented 40.0% of revenues for the year endedDecember 31, 2006, 37.5% of revenue for the year ended December 31, 2005, and 30.1% of revenue for the year ended December 31, 2004. We expect thatsales to a small number of customers will continue to comprise a significant portion of our revenue in the future. Two customers each accounted for 10% ormore of our trade accounts receivable balance as of December 31, 2006 at 20.4% and 13.7%, respectively. Two customers each accounted for 10% or more ofour trade accounts receivable balance as of December 31, 2005 at 30.0% and 18.8%, respectively.Cash Equivalents and Short-Term InvestmentsWe classify our investments in debt and equity securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards(“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” We consider investments in highly liquid instruments purchasedwith an original maturity of three months or less to be cash equivalents. Our short-term investments are reported at fair value as of the respective balance sheetdates with unrealized gains and losses included in accumulated other comprehensive income (loss) within stockholders’ equity on the consolidated balancesheets. The amortized cost of securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in otherincome and (expense) and income, net in the consolidated statements of operations. Realized gains and losses and declines in value judged to be other thantemporary on available-for-sale securities are also included in other income and (expense) and income, net in the consolidated statements of operations. The costof securities sold is based upon the specific identification method.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 themarket 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 forany anticipated recovery in market value.We maintain in restricted deposits an amount approximately equal to the amount of the taxable bond.Accounts Receivable and Allowance for Doubtful AccountsAccounts receivable are recorded at the invoiced amount and are not interest bearing. We maintain an allowance for doubtful accounts to reserve forpotentially uncollectible trade receivables. We also review our trade receivables by aging category to identify specific customers with known disputes orcollectibility issues. We exercise judgment when determining the adequacy of these reserves as we evaluate historical bad debt trends, general economicconditions in the United States and internationally, and changes in customer financial conditions. Uncollectible receivables are recorded as bad debt expensewhen all efforts to collect have been exhausted and recoveries are recognized when they are received. From our65allowance for doubtful accounts of $4.0 million at December 31, 2003, we wrote off $3.5 million of fully reserved accounts receivable resulting in theallowance for doubtful accounts of $0.5 million at December 31, 2004. From our allowance for doubtful accounts of $0.5 million at December 31, 2004, wewrote off $0.1 million of fully reserved accounts receivable for a Korean customer and decreased the allowance by $0.3 million due to improved collectionsmainly from a Japanese customer, while increasing the allowance for a large customer in China of $0.4 million, resulting in the allowance for doubtfulaccounts of $0.5 million at December 31, 2005. During 2006, we increased our collection efforts and collected the entire amount from this large customer inChina requiring us to reverse this $0.4 million allowance resulting in the allowance for doubtful accounts of $0.1 million at December 31, 2006. As ofDecember 31, 2006, our accounts receivable balance was $9.7 million, which was net of an allowance for doubtful accounts of $0.1 million. As ofDecember 31, 2005, our accounts receivable balance was $5.2 million, which was net of an allowance for doubtful accounts of $0.5 million. If actualuncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could havea material impact on our financial results for the period.The allowance for sales returns is also deducted from gross accounts receivable. From our allowance for sales returns of $0.5 million as of December 31,2003, we increased the reserve for sales returns by $0.1 million resulting in the allowance for sales returns of $0.6 million as of December 31, 2004. From ourallowance for sales returns of $0.6 million as of December 31, 2004, we utilized $0.5 million for investigation related returns, resulting in the allowance forsales returns of $0.1 million as of December 31, 2005. During 2006, the allowance for sales returns remained at approximately $0.1 million. The totalallowances deducted from gross accounts receivable as of December 31, 2006 is $0.1 million, compared to $0.6 million as of December 31, 2005.InventoriesInventories are stated at the lower of cost (approximated by standard cost) or market. Cost is determined using the weighted average cost method. Ourinventory consists of raw materials as well as finished goods and work-in-process that include material, labor and manufacturing overhead costs. Provisionfor potentially obsolete or slow moving inventory is made based on management’s analysis of inventory levels and sales forecasts.Property, Plant and EquipmentProperty, plant and equipment are stated at cost less accumulated depreciation computed using the straight-line method over the estimated economic livesof the assets, which vary from 3 to 27.5 years. Leasehold improvements are amortized over the shorter of the estimated useful life or the term of the lease. Wegenerally depreciate computers and software over 3 years, office equipment, furniture and fixtures over 3 years, automobiles over 5 years, leaseholdimprovements over 10 years, and buildings over 27.5 years. Repairs and maintenance costs are expensed as incurred.Impairment of Long-Lived AssetsWe evaluate the recoverability of property, plant and equipment, and intangible assets in accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” When events and circumstance indicate that long-lived assets may be impaired, management compares thecarrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to such assets and in the event that the carrying valueexceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the asset’s fair value.In the third quarter of 2006, we incurred an impairment charge of $1.4 million to write down our U.S. property in Fremont, California, which has beendecontaminated and is being prepared for sale. This property has66been classified as “Assets held for sale” in the amount of $4.7 million on the consolidated balance sheet as of December 31, 2006.Segment ReportingOur business is conducted in a single operating segment. Our chief executive officer reviews a single set of financial data that encompasses our entireoperations for purposes of making operating decisions and assessing financial performance.InvestmentsWe invest in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets and areaccounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments forimpairment 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, thelength 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, fundamentalchanges 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 timesufficient to allow for any anticipated recovery in our carrying value. In the third quarter of 2004, we recorded an impairment charge of $0.2 million to writedown the value of our investment in a private company. We made the decision to write down the investment as a result of the declining financial position of theinvestee, evidenced by an audit opinion with a going concern explanatory paragraph received by the investee. The $0.2 million was the remaining balance ofthis investment. No further write-downs were recorded in 2006 or 2005.Stock-Based CompensationWe have employee stock option plans, which are described more fully in Note 11—Employee Benefit Plans. Effective January 1, 2006, we adopted theprovisions of SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”). SFAS 123(R) establishes accounting for stock-based awardsexchanged for employee services. Accordingly, stock-based compensation cost is measured at each grant date, based on the fair value of the award, and isrecognized as expense over the employee’s requisite service period of the award. All of the Company’s stock compensation is accounted for as an equityinstrument. The Company previously applied Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” andrelated interpretations and provided the required pro forma disclosures of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).We have elected the modified prospective application transition method for adopting SFAS 123(R). Under this method, the provisions of SFAS123(R) apply to all awards granted or modified after the date of adoption. The unrecognized expense of awards not yet vested at the date of adoption will berecognized in net income (loss) in the periods after the date of adoption using the same Black-Scholes valuation method and assumptions determined under theoriginal provisions of SFAS 123, as disclosed in our previous quarterly and annual reports.Prior to the Adoption of SFAS 123(R)Prior to the adoption of SFAS 123(R), we provided the disclosures required under SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosures.” SFAS 123(R) requires us to present pro forma information for the comparative period prior to adoptionas if we had accounted for all our employee stock options under the fair value method of the original67SFAS 123. The following table illustrates the effect on net loss and net loss per share if we had applied the fair value recognition provisions of SFAS 123 tostock-based employee compensation to the prior-year periods (in thousands, except per share data):Year EndedDecember 31,2005Year EndedDecember 31,2004Net loss:As reported$(12,392)$(13,810)Add: Stock-based employee compensation expense included in netloss as reported1926Less: Stock-based compensation expense using the fair value basedmethod, net of related tax(1,035)(1,330)Pro forma net loss$(13,235)$(15,134)Basic and diluted net loss per common shareAs reported$(0.54)$(0.60)Pro forma$(0.57)$(0.66)Shares used in computing basic and diluted net loss per share23,04723,063Impact of the Adoption of SFAS 123 (R)We elected to adopt the modified prospective application transition method as provided by SFAS 123(R), and we recorded $822,000 in our consolidatedstatements of operations for year ended December 31, 2006. We elected not to capitalize any stock-based compensation to inventory as of January 1, 2006when the provisions of SFAS 123(R) were initially adopted. We utilized the Black-Scholes valuation model for estimating the fair value of the stockcompensation granted both before and after the adoption of SFAS 123(R). In accordance with the modified prospective application transition method, ourconsolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). The following tablesummarizes compensation costs related to our stock-based compensation awards (in thousands, except per share data):Year EndedDecember 31,2006Stock-based compensation in the form of employee stock options, included in:Cost of revenue$96Selling, general and administrative539Research and development187Total stock-based compensation$822Tax effect on stock-based compensation—Net effect on net income or loss$822Shares used in computing basic net income (loss) per share23,303Shares used in computing diluted net income (loss) per share24,600Effect on basic net income per share$(0.04)Effect on diluted net income per share$(0.03)As of December 31, 2006, the total compensation cost related to unvested stock-based awards granted to employees under our stock option plan but notyet recognized was approximately $1,167,000, net of68estimated forfeitures of $31,000. This cost will be amortized on a straight-line basis over a weighted-average period of approximately 2.59 years and will beadjusted for subsequent changes in estimated forfeitures. We elected not to capitalize any stock-based compensation to inventory as of December 31, 2006, dueto the immateriality of the amount.The amortization of stock compensation under SFAS 123(R) for the period after our January 1, 2006 adoption is based on the single-option approach.We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS 123(R), Securities andExchange Commission Staff Accounting Bulletin No. 107 and our prior period pro forma disclosures of net loss, including stock-based compensation(determined under a fair value method as prescribed by SFAS 123). The weighted-average grant date fair value of our stock options granted to employeesduring 2006, 2005, and 2004 was $2.89, $0.89, and $1.17 per share, respectively. The fair value of options granted was estimated at the date of grant usingthe following weighted-average assumptions:Years Ended December 31,200620052004Risk-free interest rate4.7%4.3%3.6%Expected life (in years)3.95.05.0Dividend yield———Estimated forfeitures12.4%——Volatility78.2%89.7%103.0% The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends.Expected volatility is based on the combination of historical volatility of the Company’s common stock and the expected future volatility over the periodcommensurate with the expected life of the options. The risk-free interest rates are taken from the Daily Federal Yield Curve Rates as of the grant dates aspublished by the Federal Reserve and represent the yields on actively traded Treasury securities for terms equal to the expected term of the options. Theexpected term calculation for stock options is based on the observed historical option exercise behavior and post-vesting forfeitures of options by theCompany’s employees. Assumptions related to the Employee Stock Purchase Plan are not presented as the related compensation expense amounts areinsignificant. The Employee Stock Purchase Plan was suspended in February 2005.Research and DevelopmentResearch and development costs consisting primarily of salaries including stock compensation expense and related personnel costs, depreciation andproduct testing are expensed as incurred.Advertising CostsAdvertising costs, included in selling, general and administrative, are expensed as incurred. Advertising costs for the years ended December 31, 2006,2005, and 2004 were $52,000, $22,000 and $51,000, respectively.Shipping and Handling costsWe include fees billed to customers and costs incurred for shipping and handling as a component of cost of sales.69Income TaxesWe account for deferred income taxes using the liability method, under which the expected future tax consequences of timing differences between the bookand tax basis of assets and liabilities are recognized as deferred tax assets and liabilities. Valuation allowances are established when necessary to reduce netdeferred tax assets when management estimates, based on available objective evidence, that it is more likely than not that the future income tax benefitrepresented by the net deferred tax asset will not be realized.Comprehensive Income(Loss)We report comprehensive income or loss in accordance with the provisions of SFAS No. 130, “Reporting Comprehensive Income,” which establishesstandards for reporting comprehensive income and its components in the financial statements. The components of other comprehensive income (loss) consistof unrealized gains and losses on marketable securities and foreign currency translation adjustments. Comprehensive income (loss) and the components ofaccumulated other comprehensive income (loss) are presented in the accompanying consolidated statements of stockholders’ equity.Net Income (Loss) Per ShareBasic net income (loss) per share is computed using the weighted average number of common shares outstanding during the periods. Diluted net income(loss) per share is computed using the weighted average number of common shares outstanding and potentially dilutive common shares outstanding during theperiods. Potentially dilutive common shares consist of common shares issuable upon the exercise of stock options. Potentially dilutive common shares areexcluded in net loss periods, as their effect would be anti-dilutive.Recent Accounting PronouncementsIn November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, “Inventory Costs—An Amendment of ARB No. 43,Chapter 4” (“SFAS 151”). SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing”, to clarify the accounting for abnormal amountsof idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facilityexpense, excessive spoilage, double freight and re-handling costs must be recognized as current-period charges regardless of whether they meet the criterion of“so abnormal” as stated in ARB No. 43. Additionally, SFAS 151 requires that the allocation of fixed production overheads to the costs of conversion be basedon the normal capacity of the production facilities. The adoption of SFAS 151, effective January 1, 2006, did not have a material impact on our consolidatedfinancial position, results of operations or cash flows.In December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets—An Amendment of APB Opinion No. 29” (“SFAS 153”).SFAS 153 eliminates the exception from fair value measurement for non-monetary exchanges of similar productive assets in paragraph 21(b) of APB OpinionNo. 29, “Accounting for Non-monetary Transactions,” and replaces it with the exception for exchanges that do not have commercial substance. SFAS 153specifies that a non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of theexchange. The adoption of SFAS 153, effective January 1, 2006, did not have a material impact on our consolidated financial position, results of operationsor cash flows.In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3” (“SFAS 154”). SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle, and applies toall voluntary changes in accounting principle. It also applies to changes required by an accounting70pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires retrospectiveapplication to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects orthe cumulative effect of the change. The adoption of SFAS 154, effective January 1, 2006, did not have a material impact on our consolidated financialposition, results of operations or cash flows.In November 2005, the FASB issued FASB Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments” (“FSP FAS 115-1”), which provides guidance on determining when investments in certain debt and equity securities areconsidered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP FAS 115-1 also includes accountingconsiderations subsequent to the recognition of an other-than temporary impairment and requires certain disclosures about unrealized losses that have not beenrecognized as other-than-temporary impairments. The adoption of FSP FAS 115-1, effective January 1, 2006, did not have a material impact on ourconsolidated financial position, results of operations or cash flows.In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Instruments—anamendment of FASB Statements No. 133 and 140” (“SFAS 155”). SFAS 155 amends SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities” (“SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”(“SFAS 140”). SFAS 155 allows entities the option of applying fair value accounting to certain hybrid financial instruments in their entirety if they containembedded derivatives that would otherwise require bifurcation under SFAS 133. SFAS 155 will be effective for us as of January 1, 2007. We are currentlyassessing the impact that the adoption of SFAS 155 may have on our consolidated financial position, results of operations or cash flows.In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets”(SFAS 156”). This statement amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”,(“SFAS 140”) with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 will be effective for us as ofJanuary 1, 2007. We are currently assessing the impact that the adoption of SFAS 156 may have on our consolidated financial position, results of operationsor cash flows.In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting For Uncertain Tax Positions—An Interpretation of FASB StatementNo. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance withFASB Statement No. 109, “Accounting for Income Taxes”. It prescribes a recognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after Decemeber 15, 2006. We arecurrently assessing the impact that the adoption of FIN 48 may have on our consolidated financial position, results of operations or cash flows.In June 2006, the FASB ratified the consensus reached by the Emerging Issues Task Force (“EITF”) on Issue No. 06-3, “How Taxes Collected fromCustomers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)”, (“EITF06-3”). EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and acustomer and may include, but is not limited to, sales, use, value added, and some excise taxes. EITF 06-3 concludes that the presentation of taxes on either agross (included in revenues and costs) or a net (excluded from revenues) basis is an accounting policy decision that should be disclosed. In addition, for anysuch taxes that are reported on a gross basis, a company should disclose the amounts of those taxes in interim and annual financial statements for each periodfor which an income71statement is presented if those amounts are significant. The provisions of EITF 06-3 should be applied to financial reports for interim and annual reportingperiods beginning after December 15, 2006, with earlier adoption permitted. We are currently assessing the impact that the adoption of EITF 06-3 may have onour consolidated financial position, results of operations or cash flows.In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157provides a new single authoritative definition of fair value and provides enhanced guidance for measuring the fair value of assets and liabilities and requiresadditional disclosures related to the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and theeffect of fair value measurements on earnings. SFAS 157 is effective for us as of January 1, 2008. We are currently assessing the impact that the adoption ofSFAS 157 may have on our consolidated financial position, results of operations or cash flows.In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”). SFAS 158 requires balance sheetrecognition of the overfunded or underfunded status of pension and postretirement benefit plans. Under SFAS 158, actuarial gains and losses, prior servicecosts or credits, and any remaining transition assets or obligations that have not been recognized under previous accounting standards must be recognized as acomponent of accumulated other comprehensive income (loss) within stockholders’ equity, net of tax effects, until they are amortized as a component of netperiodic benefit cost. In addition, the measurement date and the date at which plan assets and the benefit obligation are measured, are required to be thecompany’s fiscal year-end. SFAS 158 is effective for us as of December 31, 2007, except for the measurement date provisions, which are effectiveDecember 31, 2009. We are currently assessing the impact the adoption of SFAS 158 may have on our consolidated financial position, results of operations orcash flows.In September 2006, the United States Securities and Exchange Commission (“SEC”) released Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 providesinterpretative guidance on how public companies quantify financial statement misstatements. There have been two common approaches used to quantify sucherrors. Under an income statement approach, the “roll-over” method, the error is quantified as the amount by which the current year income statement ismisstated. Alternatively, under a balance sheet approach, the “iron curtain” method, the error is quantified as the cumulative amount by which the current yearbalance sheet is misstated. In SAB 108, the SEC established an approach that requires quantification of financial statement misstatements based on the effectsof the misstatements on each of the company’s financial statements and the related financial statement disclosures. This model is commonly referred to as a“dual approach” because it requires quantification of errors under both the roll-over and iron curtain methods. SAB 108 was effective for us as ofDecember 31, 2006. The adoption of SAB 108 did not have a material impact on our consolidated financial position, results of operations or cash flows.In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets andLiabilities” (“SFAS 159”). SFAS 159 provides entities with the option to report selected financial assets and liabilities at fair value. Business entitiesadopting SFAS 159 will report unrealized gains and losses in earnings at each subsequent reporting date on items for which fair value option has been elected.SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributesfor similar types of assets and liabilities. SFAS 159 requires additional information that will help investors and other financial statement users to understandthe effect of an entity’s choice to use fair value on its earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with earlieradoption permitted. We are currently assessing the impact that the adoption of SFAS 159 may have on our consolidated financial position, results ofoperations or cash flows.72Note 2. Discontinued Operations and Related Assets Held for SaleIn June 2003, we announced the discontinuation of our opto-electronics division, which we had established as part of our acquisition of LyteOptronics, Inc. in May 1999. The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes(HBLEDs) for the illumination markets, including full-color displays, wireless handset backlighting and traffic signals, and also manufactured verticalcavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks. Accordingly, the results of operations ofthe opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in our consolidatedstatements of operations for all periods presented.In September 2003, we completed the sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) andDalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. A portion of the purchase price equalto $1.0 million was held in escrow to satisfy any claims that the purchasers might make for breaches of representations or warranties by us. Of this totalescrow, $0.8 million could be released after the one year anniversary of the sale of the opto-electronics business and the remainder could be released after thesecond anniversary of the sale. To date, we have resolved all claims made against the $1.0 million that was held in escrow. For the year ended December 31,2005, we recorded a $0.6 million gain from escrow refund, a $0.1 million gain in property tax refunds and gain on disposal of properties, offset by$0.2 million in expenses totaling a net gain of $0.5 million. Of the $0.8 million escrow amount, approximately $0.2 million was received in 2004, while theremaining $0.6 million was received in 2005.In June 2005, we completed the sale of a building located in Monterey Park, California. This asset had been classified as “assets held for sale” in theamount of $1.25 million on the consolidated balance sheet as of December 31, 2004. We received net proceeds on the sale of the property of approximately$1.3 million and accordingly recorded a gain on disposal of $0.1 million.Our consolidated financial statements have been presented to reflect the opto-electronics business as a discontinued operation for all periods presented.Operating results of the discontinued operation are as follows (in thousands):Years Ended December 31,200620052004Revenue$—$—$—Cost of revenue———Gross loss———Operating expenses:Selling, general and administrative—(59)(222)Total operating expenses—(59)(222)Gain (loss) from operations—59222Other income (expense), net18—250Gain (loss) from discontinued operations before gain on disposal18(59)472Gain on disposal—603419Net gain from discontinued operations$18$544$891 73The carrying value of the assets and liabilities of the discontinued opto-electronics business included in the consolidated balance sheets are as follows (inthousands):As ofDecember 31,20062005Current assets:Cash$395$472Total current assets395472Other assets——Total assets$395$472Current liabilities:Accrued liabilities$—$95Total liabilities—95Net assets395377Total liabilities and net assets$395$472 74Note 3. Cash, Cash Equivalents and InvestmentsOur cash, cash equivalents and investments are classified as follows (in thousands):December 31, 2006December 31, 2005AmortizedCostGrossUnrealizedGainGrossUnrealized(Loss)FairValueAmortizedCostGrossUnrealizedGainGrossUnrealized(Loss)FairValueClassified as:Cash$6,892$—$—$6,892$12,803$—$—$12,803Cash equivalents:Money marketfund7,045——7,0451,729——1,729US Treasury andagency securities2,179——2,179————Commercial paper————2,940——2,940Total cash equivalents9,224——9,2244,669——4,669Total cash and cashequivalents16,116——16,11617,472——17,472Investments:US Treasury andagencysecurities12,277—(39)12,2384,460—(12)4,448Asset-backedsecurities809—(1)8083,285—(11)3,274Commercial paper500——500————Corporate bonds13,035—(3)13,0322,504—(13)2,491Corporate equitysecurities————1,4681,324—2,792Total investments26,621—(43)26,57811,7171,324(36)13,005Total cash, cashequivalents andinvestments$42,735—$(43)$42,694$29,189$1,324$(36)$30,477Contractualmaturities oninvestments:Due within1 year$13,767$13,727$8,384$9,682Due after 1through5 years12,85412,8513,3333,323$26,621$26,578$11,717$13,005 The investments include $7.2 million and $7.5 million recorded as restricted deposits on the consolidated balance sheets as of December 31, 2006 and2005, respectively, as a result of the outstanding principal amount on our industrial revenue bonds.75We manage our investments as a single portfolio of highly marketable securities that is intended to be available to meet our current cash requirements. Forthe year ended December 31, 2006, we had $3.3 million of gross realized gains on sales of our available-for-sale securities. For the year ended December 31,2005, we had no gross realized gain or loss on sales of our available-for-sale securities.The gross unrealized losses related to our portfolio of available-for-sale securities were primarily due to a decrease in the fair value of debt securities as aresult of an increase in interest rates during 2006. We have determined that the gross unrealized losses on our available-for-sale securities as of December 31,2006 are temporary in nature. We reviewed our investment portfolio to identify and evaluate investments that have indications of possible impairment. Factorsconsidered 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 belowcost (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 inmarket value. The following table provides a breakdown of our available-for-sale securities with unrealized losses as of December 31, 2006 and 2005 (inthousands):In Loss Position< 12 monthsIn Loss Position> 12 monthsTotal InLoss Position2006FairValueGrossUnrealized(Loss)FairValueGrossUnrealized(Loss)FairValueGrossUnrealized(Loss)Investments:US Treasury and agency securities$10,841$(38)$1,397$(1)$12,238$(39)Asset-backed securities——809(1)809(1)Corporate bonds1,387(3)296—1,683(3)Total in loss position$12,228$(41)$2,502$(2)$14,730$(43) In Loss Position< 12 monthsIn Loss Position> 12 monthsTotal InLoss Position2005FairValueGrossUnrealized(Loss)FairValueGrossUnrealized(Loss)FairValueGrossUnrealized(Loss)Investments:US Treasury and agency securities$2,757$(9)$1,691$(3)$4,448$(12)Asset-backed securities1,642(4)1,632(7)3,274(11)Corporate bonds2,491(13)——2,491(13)Total in loss position$6,890$(26)$3,323$(10)$10,213$(36) Note 4. Inventories, NetThe components of inventory are summarized below (in thousands):As of December 31,20062005Inventories:Raw materials$8,419$6,667Work in process11,2229,141Finished goods622348$20,263$16,156 76Note 5. Property, Plant and Equipment, NetThe components of our property, plant and equipment are summarized below (in thousands):As of December 31,20062005Property, plant and equipment:Land$—$1,120Building10,01916,421Machinery and equipment19,52317,798Leasehold improvements769868Construction in progress2,36362332,67436,830Less: accumulated depreciation and amortization(19,899)(19,524)$12,775$17,306 Depreciation expense was $2.6 million, $3.7 million, and $4.9 million for the years ended 2006, 2005, and 2004, respectively.Note 6. Investments in Privately-held CompaniesWe have made strategic investments in private companies located in China in order to gain access to raw materials at competitive cost that are critical toour substrate business.Our investments are summarized below (in thousands) :Investment BalanceAs of December 31,AccountingOwnershipCompany20062005MethodPercentageBeijing Ji Ya Semiconductor Material Co., Ltd$996$996Consolidated46%Nanjing Jin Mei Gallium Co., Ltd592592Consolidated83Beijing BoYu Semiconductor Vessel CraftworkTechnology Co., Ltd410410Consolidated70Xilingol Tongli Germanium Co. Ltd1,304864Equity25Emeishan Jia Mei High Purity Metals Co., Ltd670596Equity25 Our ownership of Beijing Ji Ya Semiconductor Material Co., Ltd. (Ji Ya) at inception was 51%. During 2005, our ownership share was reduced to 46%as 5% of our ownership was given to Ji Ya’s management upon fulfillment of working at Ji Ya for at least four years. There are no further outstandingcommitments. We will continue to consolidate Ji Ya as we have significant influence in management and have a majority control of the board. Our chieffinancial officer is chairman of the board, while our chief executive officer, our chief operating officer, and our president of joint venture operations aremembers of the board.We have a similar arrangement with Nanjing Jin Mei Gallium Co., Ltd. (Jin Mei) where our ownership at inception was 88%. During 2005, ourownership share was reduced to 83% as 5% of our ownership was given to Jin Mei’s management upon fulfillment of working at Jin Mei for at least threeyears. There are no further outstanding commitments. We will continue to consolidate Jin Mei as we have significant influence in management and have amajority control of the board. Our chief operating officer is chairman of the board, while our chief executive officer and our president of joint ventureoperations are members of the board.77We have significant influence in management over Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd (BoYu), have a controllingfinancial interest of 70%, and have a majority control of the board. Our chief executive officer is chairman of the board, while our chief operating officer andour president of joint venture operations are members of the board.The investment balances for the two companies accounted for under the equity method are included in other assets in the consolidated balance sheets andtotaled $2.0 million and $1.5 million at December 31, 2006 and 2005, respectively. We own 25% of the ownership interests in each of these companies. Thesetwo companies are not considered variable interest entities because:· both companies have sustainable businesses of their own;· our voting power is proportionate to our ownership interests;· we only recognize our respective share of the losses and/or residual returns generated by the companies if they occur; and· we do not have controlling financial interest in, do not maintain operational or management control of, do not control the board of directors of, and arenot required to provide additional investment or financial support to either company.Undistributed retained earnings relating to our investments in these privately-held companies were $4.4 million and $2.6 million as of December 31,2006 and 2005, respectively. Net income recorded from our investments was $1.8 million, $1.1 million, and $0.7 million, for the years ended December 31,2006, 2005, and 2004, respectively.Note 7. InvestmentsAs of December 31, 2006 we only maintain minority investments in private companies. During 2006 we sold all of our shares of common stock of theonly publicly traded company we held, Finisar Corporation, generating net proceeds of $4.4 million and recording a gain of $3.3 million, which is included inother income and (expense). Our investments in private companies are reviewed for other than temporary declines in value on a quarterly basis. Theseinvestments are classified as other assets in the consolidated balance sheets and are accounted for under the cost method as we do not have the ability toexercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changesin circumstances indicate that the carrying value may not be recoverable. Reasons for other than temporary declines in value include whether the relatedcompany would have insufficient cash flow to operate for the next twelve months, significant changes in the operating performance and changes in marketconditions. As of December 31, 2006 and 2005, the minority investments totaled approximately $0.4 million for both years.Note 8. Restructuring CostsAs of December 31, 2006 and 2005, our restructuring accruals are as follows (in thousands):2006RestructuringAccrual as ofDecember 31, 2005Reversals/AdditionsPaymentsRestructuringAccrual as ofDecember 31, 2006Future lease payments related to abandoned facilities$250$—$(250)$—Workforce reduction215(2)(213)—Total$465$(2)$(463)$— 78 2005RestructuringAccrual as ofDecember 31, 2004AdditionsPaymentsRestructuringAccrual as ofDecember 31, 2005Future lease payments related to abandoned facilities$552$236$(538)$250Workforce reduction—329(114)215Japan office closure—271(271)—Total$552$836$(923)$465 2004RestructuringAccrual as ofDecember 31, 2003AdditionsPaymentsRestructuringAccrual as ofDecember 31, 2004Future lease payments related to abandoned facilities$—$845$(293)$552Workforce reduction—463(463)—Total$—$1,308$(756)$552 In March 2005, we announced that we would be reducing the workforce at our Beijing, China manufacturing facility by approximately 100 positions orapproximately 15%. This measure was taken as part of our ongoing effort to reduce our cost structure and bring capacity in line with current market demand.Accordingly, we recorded a restructuring charge of $0.1 million in March 2005 relating to the reduction in work force, which we completed in June 2005. Weanticipate annual savings of $0.3 million relating to this reduction in force.In April 2005, we closed our Japan office as part of our ongoing effort to reduce our cost structure. Accordingly, we recorded restructuring charges of$0.1 million in the second and third quarters of 2005, respectively, relating to the closure of our Japan office. We also anticipate payroll and related expenseannual savings of approximately $0.3 million.In December 2005, we further reduced the workforce at our Fremont, California facility by approximately 15 positions that are no longer required tosupport production and operations, or approximately 29 percent, over the next 120 days. This measure was being taken as part of our ongoing effortto downsize our Fremont, California facility headcount. Accordingly, we recorded a restructuring charge of approximately $0.3 million in December 2005related to the reduction in force for severance-related expenses from the reduction in force, all of which will be cash expenditures. We anticipate that the cashoutflow from this charge to be incurred over the two quarters commencing in the first quarter of 2006 and we expect to save $0.9 million annually in payrolland related expenses. Also in December 2005, we recorded an additional restructuring charge of approximately $0.2 million, primarily related to the finalliquidation procedures of AXT’s Japan office so as to eliminate the remaining assets. There is no expected cash outflow of this charge.Overall for the year ended December 31, 2005, we recorded restructuring charges of $0.2 million relating to lease costs associated with facilities located inCalifornia that are no longer required to support production. The remaining restructuring accrual for future lease payments related to abandoned U.S. facilitiesof $0.3 million was paid out during 2006, and was included on the accompanying consolidated balance sheet as accrued restructuring.For 2004, we announced plans to cease all production activities in the United States and to manufacture our products only in China during the secondquarter. In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down our remaining manufacturing facilities in theUnited States. In the third and fourth quarter of 2004, we incurred additional restructuring charges of $231,000 for a total of $1.3 million in 2004. Thesecharges comprised costs related to the79reduction in work force effected in June 2004, and lease costs associated with the facilities located in California that are no longer required to supportproduction. In aggregate, we eliminated 50 positions, 47 of which were production workers. As of December 31, 2004, we saved approximately $560,000 inpayroll and related expenses.Note 9. DebtCredit FacilityAs of December 31, 2006, the credit facility maintained by us with a bank included a letter of credit supporting repayment of our industrial bonds withan outstanding amount of $7.2 million. We have pledged and placed cash and certain investment securities with the trust department of the bank as additionalcollateral for this facility. Accordingly, $7.2 million of cash and short-term investments are restricted.Long-Term DebtThe components of long-term debt are summarized below (in thousands):As of December 31,20062005Taxable revenue bonds, collateralized by a letter of credit from a bank, bearing interest at the H1530 day bond yield for commercial paper which was 5.47% as of December 31, 2006, maturingDecember 2023$7,150$7,450Joint venture long term debt by outside shareholder at zero% interest maturing in 20081392707,2897,720Less current portion(450)(300)$6,839$7,420Maturities of long-term debt as of December 31, 2006 were as follows:2007$4502008589200945020104502011450Thereafter4,900$7,289 Note 10. Stockholders’ EquityIn August 2004, we announced the adoption of a stock repurchase program in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934 toprovide for the repurchase of up to $2 million of our common stock. This plan was extended for one year in July 2005. Repurchases were made from time totime in the open market during the twelve-month period ended July 31, 2006, at prevailing market prices using our own cash resources. As of December 31,2005, we had 22,977,301 shares of common stock outstanding and 201,516 shares were repurchased in 2005 under this program. As of December 31,2006, we had 29,010,546 shares of common stock outstanding and no shares were repurchased in 2006 under this program, which has now expired.The 883,000 shares of $0.001 par value Series A preferred stock issued and outstanding at December 31, 2006, and 2005, valued at $3,532,000 arenon-voting and non-convertible preferred stock with a 5.0% cumulative annual dividend rate payable when declared by the board of directors and $4 per80share liquidation preference over common stock. These preferred shares were issued when we completed our acquisition of Lyte Optronics, Inc. on May 28,1999.Note 11. Employee Benefit PlansStock Option PlansIn March 1993, our board of directors approved the 1993 Stock Option Plan (1993 Plan), which provided for granting of incentive and non-qualifiedstock options to our employees and directors. Under the 1993 Plan, 880,000 shares of common stock were authorized for issuance. Options granted under the1993 Plan were generally for periods not to exceed ten years and were granted at the fair market value of the stock at the date of grant as determined by theboard of directors. Options granted under the 1993 Plan generally vested 25% upon grant and 25% each year thereafter, with full vesting occurring on thethird anniversary of the grant date. This plan terminated on March 12, 2003.In July 1997, our board of directors approved the 1997 Stock Option Plan (1997 Plan), which provides for granting of incentive and non-qualifiedstock options to our employees and directors. Under the 1997 Plan, 5,423,583 shares of common stock have been authorized for issuance. Options grantedunder the 1997 Plan are generally for periods not to exceed ten years (five years if the option is granted to a 10% stockholder) and are granted at the fair marketvalue of the stock at the date of grant as determined by the board of directors. Options granted under the 1997 Plan generally vest 25% at the end of one yearand 2.1% each month thereafter, with full vesting after four years.The following summarizes our stock option activity under the 1993 Plan and the 1997 Plan, and related weighted average exercise price within eachcategory for each of the years ended December 31, 2004, 2005, and 2006 (in thousands, except per share data):Availablefor GrantNumber ofOptionsOutstandingWeighted-averageExercisePriceWeighted-averageRemainingContractualLifeAggregateIntrinsicValue(in years)Options outstanding as of December 31, 20032,3982,588$10.79Granted(600)6001.51Exercised—(56)2.73Canceled822(822)15.47Options outstanding as of December 31, 20042,6202,3102.70Granted(866)8661.27Exercised—(5)1.28Canceled254(254)2.45Options outstanding as of December 31, 20052,0082,9172.30Granted(180)1804.52Exercised—(284)1.96Canceled85(85)1.50Options outstanding as of December 31, 20061,9132,728$2.516.37$7,091Options vested and expected to vest as of December 31,20062,516$2.556.20$6,508Options exercisable as of December 31, 20061,857$2.745.41$4,715 81The options outstanding and exercisable as of December 31, 2006 were in the following exercise price ranges (in thousands, except per share data):Options Outstanding as ofDecember 31, 2006Options Vested andExercisable as ofDecember 31, 2006Range ofExercise PriceSharesWeighted-averageExercise PriceWeighted-averageRemainingContractual LifeSharesWeighted-AverageExercise Price$1.17 - $ 1.381,475$1.297.01851$1.30$1.39 - $ 1.4411$1.418.394$1.41$1.45 - $ 2.24620$2.175.68556$2.18$2.25 - $ 5.00504$3.996.17328$3.65$5.01 - $41.50118$13.412.77118$13.412,728$2.516.371,857$2.74 The total intrinsic value of options exercised for the year ended December 31, 2006 was $0.4 million. Cash received from option exercises for the yearended December 31, 2006 was $0.6 million. The total fair value of options vested for the year ended December 31, 2006 was $2.0 million.As of December 31, 2005 and 2004, options to purchase 1,536,000 shares and 1,114,000 shares at weighted average exercise prices of $3.03 and $3.40per share were vested and exerciseable, respectively.Employee Stock Purchase PlanIn February 1998, our board of directors approved the 1998 Employee Stock Purchase Plan (1998 Purchase Plan). Our stockholders approved the1998 Purchase Plan in March 1998. A total of 900,000 shares of our common stock were reserved for issuance under the 1998 Purchase Plan, of which atotal of approximately 845,000 shares were purchased as of December 31, 2005. The 1998 Purchase Plan permited eligible employees to acquire shares of ourcommon stock through payroll deductions. The common stock purchase price was 85% of the lower of the market price of the common stock at the purchasedate or the date of offer to the employee. A total of approximately 55,000 and 106,000 shares, respectively, of common stock have been issued under the 1998Purchase Plan for the years ended December 31, 2005 and 2004, respectively. We suspended the 1998 Purchase Plan in February 2005.Retirement Savings PlanWe have a 401(k) Savings Plan (Savings Plan) which qualifies as a thrift plan under Section 401(k) of the Internal Revenue Code. All full-time U.S.employees are eligible to participate in the Savings Plan after 90 days from the date of hire. In 2005 we amended the savings plan to allow all full-timeparticipants (as defined) to contribute up to 10% of their earnings to the Savings Plan with a discretionary matching amount provided by us. Ourcontributions to the Savings Plan were $0.4 million, $0.3 million, and $0.2 million for the years ended December 31, 2006, 2005 and 2004, respectively.Note 12. GuaranteesIndemnification AgreementsWe enter into standard indemnification arrangements in the ordinary course of business. Pursuant to these arrangements, we indemnify, hold harmless,and agree to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, generally their business partners or customers, inconnection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The termof these indemnification agreements is generally perpetual anytime after the execution of the agreement. The maximum potential amount of future82payments we could be required to make under these agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal.We have entered into indemnification agreements with our directors and officers that may require us to indemnify our directors and officers againstliabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from wilful 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 WarrantyWe warrant our products for a specific period of time, generally twelve months, against material defects. We provide for the estimated future costs ofwarranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represents the best estimate at the time of sale of thetotal costs that we expect to incur to repair or replace product parts, which fail while still under warranty. The amount of accrued estimated warranty costs areprimarily based on historical experience as to product failures as well as current information on repair costs. On a quarterly basis, we review the accruedbalances and update the historical warranty cost trends. The following table reflects the change in our warranty accrual during 2006 and 2005 (in thousands):Years EndedDecember 31,20062005Beginning accrued warranty and related costs$120$135Charged to cost of revenue66854Actual warranty expenditures(329)(69)Ending accrued warranty and related costs$459$120 Sales ReturnsIn March 2004, we recorded a reserve for sales returns of $0.7 million related to our failure to follow certain testing requirements and provision of testingdata and information to certain customers. This reserve was based on discussions with some of the affected customers and review of specific shipments. As ofDecember 31, 2006, this reserve was zero since approximately $0.5 million had been utilized and approximately $0.2 million had been reversed to revenue in2005 as we favorably resolved an outstanding matter with a customer.83Note 13. Income TaxesThe components of the provision (benefit) for income taxes are summarized below (in thousands):Years Ended December 31,200620052004Current:Federal$(2,064)$(1,099)$—State4——Foreign60614971Total current(1,454)(950)71Deferred:Federal———State———Total deferred———Total net benefit for income taxes$(1,454)$(950)$71 A reconciliation of the effective income tax rates and the U.S. statutory federal income tax rate is summarized below:Years Ended December 31,200620052004Statutory federal income tax rate35.0%(35.0)%(35.0)%State income taxes, net of federal tax benefits0.5(1.8)(1.7)Change in valuation allowance50.330.930.1Stock compensation60.8——Foreign rate differences(470.7)(2.2)5.4Dividend from PRC investee45.0——Net loss from privately-held PRC investments(15.3)——Other3.40.91.7Effective tax rate(291.0)%(7.2)%0.5% Deferred tax assets and liabilities are summarized below (in thousands):As of December 31,20062005Deferred tax assets:Net operating loss$43,149$42,546Accruals and reserves not yet deductible4,6485,345Credits3,3594,32951,15652,220Deferred tax liabilities:State taxes—(72)Unrepatriated foreign earnings(1,239)(1,239)(1,239)(1,311)Net deferred tax assets49,91750,909Valuation allowance(49,917)(50,909)Net deferred tax assets$—$— 84As of December 31, 2006, we had federal and state net operating loss carryforwards of approximately $120.1 million and $46.8 million, respectively,which will expire beginning in 2020 and 2007, respectively. In addition, we had federal tax credit carryforwards of approximately $1.6 million, which willexpire beginning in 2019. We also had state tax credit carryforwards of approximately $2.7 million which will expire beginning 2007.In 2005, the Internal Revenue Service closed its examination of our tax return for the 2002 tax year, including the calculation of our 1999 and 2000 netoperating loss carry back. As a result of this, we reversed approximately $2.1 million in 2006 and $1.1 million in 2005 of income taxes payable accrued forpotential exposures relating to those years. This amount is shown as a benefit from income taxes on our consolidated statements of operations.The deferred tax asset valuation allowance as of December 31, 2006 is attributed to U.S. federal, and state deferred tax assets, which result primarilyfrom future deductible accruals, reserves, net operating loss carryforwards, and tax credit carryforwards. We believe that, based on a number of factors, theavailable objective evidence creates sufficient uncertainty regarding our ability to realize the deferred tax assets such that a full valuation allowance has beenrecorded. These factors include our history of losses, and the lack of carryback capacity to realize deferred tax assets. The valuation allowance decreased by$1.0 million, increased by $12.1 million, and increased by $4.2 million for the years ended December 31, 2006, 2005 and 2004, respectively.In accordance with Section 382 of the Internal Revenue Code, the amounts of and benefits from net operating loss and tax credit carryforwards may beimpaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses or credits that we may utilize in any oneyear include, but are not limited to, a cumulative ownership change of more than 50% as defined, over a three year period.85Note 14. Net loss per ShareA reconciliation of the numerators and denominators of the basic and diluted net loss per share calculations is as follows (in thousands, except per sharedata):Years Ended December 31,200620052004Numerator:Income (loss) from continuing operations$926$(12,759)$(14,524)Gain from discontinued operations, net of tax18544891Less: Preferred stock dividends(177)(177)(177)Net income (loss) to common stockholders$767$(12,392)$(13,810)Denominator:Denominator for basic net income (loss) per share—weighted average common shares23,30323,04723,063Effect of dilutive securities:Common stock options1,297——Denominator for dilutive net income (loss) per share24,60023,04723,063Basic net income (loss) per share:Income (loss) from continuing operations$0.03$(0.56)$(0.64)Gain from discontinued operations, net of taxes—0.020.04Net income (loss) to common stockholders$0.03$(0.54)$(0.60)Diluted net income (loss) per share:Income (loss) from continuing operations$0.03$(0.56)$(0.64)Gain from discontinued operations, net of taxes—0.020.04Net income (loss) to common stockholders$0.03$(0.54)$(0.60)Options excluded from diluted net income (loss) per shareas the impact is anti-dilutive3622,9172,310 Note 15. Segment Information and Foreign OperationsSegment InformationWe operate in one segment for the design, development, manufacture and distribution of high-performance compound semiconductor substrates and saleof materials. In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” our chief operating decision-maker has been identified as the Chief Executive Officer, who reviews operating results to make decisions about allocating resources and assessingperformance for the company. All material operating units qualify for aggregation due to their identical customer base and similarities in economiccharacteristics, nature of products and services, and procurement, manufacturing and distribution processes. Since we operate in one segment, all financialsegment and product line information can be found in the consolidated financial statements. 86Geographical InformationThe following table represents revenue amounts (in thousands) reported for products shipped to customers in the corresponding geographic region:Years Ended December 31,200620052004Product revenue:North America*$13,029$5,168$7,514Europe8,3656,1866,840Japan3,3472,8545,156Taiwan7,6473,8438,397Asia Pacific (excluding Japan and Taiwan)12,0578,4857,547$44,445$26,536$35,454* Primarily the United StatesLong-lived assets consist primarily of property, plant and equipment, and are attributed to the geographic location in which they are located. Long-livedassets by geographic region were as follows (in thousands):As of December 31,20062005Long-lived assets:North America$426$6,547Asia Pacific12,34910,759$12,775$17,306 Note 16. Foreign Exchange Contracts and Transaction Gains/LossesWe discontinued the use of short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movementssince 2004. As of December 31, 2006, and 2005, we had no outstanding commitments with respect to foreign exchange contracts.We incurred foreign currency transaction exchange losses (gains) of $123,000, $222,000, and ($60,000) for the years ended December 31, 2006, 2005,and 2004, respectively.Note 17. Related Party TransactionsSince January 2002, there has not been, nor is there currently proposed, any transaction or series of similar transactions to which AXT was or is to be aparty in which the amount involved exceeds $60,000, and in which any director, executive officer or holder of more than 5% of any class of our votingsecurities or members of that person’s immediate family had or will have a direct or indirect material interest other than the transactions described below.We entered into an operating lease in July 2001 for warehouse space in Fremont, CA with 4160 Business Center, LLC, a real estate holding company, inwhich Davis Zhang, our president of joint venture operations, was the sole shareholder. Lease payments to 4160 Business Center, LLC were approximately$484,000 for the year ended December 31, 2002 and $121,000 for the three months ended March 31, 2003. In April of 2003, Mr. Zhang sold this warehouse toa party unrelated to us. We began leasing this warehouse from the new owner on the date of sale. Mr. Zhang no longer holds a $3.7 million note on the propertyas of December 31, 2006.87Note 18. Commitments and ContingenciesLegal MattersOn October 15, 2004, a purported securities class action lawsuit was filed in the United States Court for the Northern District of California, City ofHarper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The Court consolidated the case with a subsequent related case andappointed a lead plaintiff. On April 5, 2005, the lead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc. et al., No. C 04 4362 MJJ.The lawsuit complaint names AXT, Inc. and our former chief technology officer as defendants, and is brought on behalf of a class of all purchasers of oursecurities from February 6, 2001 through April 27, 2004. The complaint alleges that we announced financial results during this period that were false andmisleading. No specific amount of damages is claimed. On September 23, 2005, the Court granted our motion to dismiss the complaint, with leave to amend.The lead plaintiff filed an amended complaint, which we have moved to dismiss. We believe that there are meritorious defenses against this litigation andintend to vigorously defend it. Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Anyunfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operations.On June 1, 2005, a lawsuit was filed in the Superior Court of California, County of Alameda, Zhao et al. v. American Xtal Technology, et al., No. R605215713. The lawsuit complaint names as defendants AXT, Inc., our former chief technology officer and one of our suppliers. The lawsuit is brought onbehalf of two former employees and their minor child. The complaint alleges personal injury, general negligence, intentional tort, wage loss and other damages,including punitive damages, as a result of exposure of the child while in utero to high levels of gallium arsenide and methanol used in the production ofgallium arsenide wafers. We believe that there are meritorious defenses against this litigation and intend to vigorously defend it. Our commercial generalliability insurance carrier has agreed to fund our defense of the case, but has reserved the right to deny coverage, in whole or in part, in the future underselected policy provisions and applicable law. The plaintiffs have made an initial settlement demand within our insurance limits. Due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of the litigation could have an adverseimpact on our business, financial condition and results of operations.LeasesWe lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through March 2013. Totalrent expenses under these operating leases were $0.9 million, $1.3 million and $1.3 million for the years ended December 31, 2006, 2005 and 2004,respectively. Total minimum lease payments under these leases as of December 31, 2006 are summarized below (in thousands):Lease Payment2007$6452008712200973420107542011776Thereafter956$4,577 88Contract CommitmentsWe had entered into contracts to supply several large customers with GaAs wafers. The contracts guaranteed delivery of a certain number of wafersbetween January 1, 2001 and December 31, 2004. The contract sales prices were subject to review quarterly and could be adjusted in the event that rawmaterial prices changed. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, we could be subject to non-performancepenalties of between 5% and 10% of the value of the delinquent monthly deliveries. We have not received any claims for non-performance penalties due to non-delivery. As of December 31, 2006, we had met all of our current delivery obligations under these contracts and do not show any amount owing. Partialprepayments received for these supply contracts totaling $125,000 was included in customer prepayments in the accompanying consolidated balance sheet asof December 31, 2005.Note 19. Unaudited Quarterly Consolidated Financial DataQuarterFirstSecondThirdFourth(in thousands, except per share data)2005:Revenue$6,634$6,032$6,153$7,717Gross profit2791271,145648Net loss(4,123)(3,279)(2,082)(2,731)Net loss per share, basic and diluted$(0.18)$(0.14)$(0.09)$(0.12)2006:Revenue$8,471$10,355$12,547$13,072Gross profit1,5102,7593,4794,988Net income (loss)(2,203)(876)6393,384Net income (loss) per share, basic$(0.10)$(0.04)$0.03$0.14Net income (loss) per share, diluted$(0.10)$(0.04)$0.02$0.13 Note 20. Subsequent EventsOn January 9, 2007 we announced the closing of the sale of an additional 862,500 shares of common stock from our December 19, 2006 publicoffering pursuant to the underwriter’s exercise of their over-allotment option at a price of $4.50 per share. We received additional net proceeds from the exerciseof the over-allotment option of approximately $3.6 million, after deducting the underwriting discount and estimated offering expenses.On February 27, 2007, we entered into an agreement with Recapture Metals Limited of Ontario, Canada (“Recapture”), pursuant to which Recapture willsupply our subsidiary in the PRC with one thousand kilograms per month of 99.99999% pure gallium, during the eighteen month period beginning July 1,2007. Under the terms of the agreement, we are required to purchase a minimum of eighteen thousand kilograms of gallium, unless the agreement is terminatedprior to the expiration of the eighteen month period on December 31, 2008.89SIGNATURESPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by theundersigned, thereto duly authorized.AXT, Inc.By:/s/ PHILIP C.S. YINPhilip C.S. YinChief Executive Officer(Principal Executive Officer)/s/ WILSON W. CHEUNGWilson W. CheungChief Financial Officer(Principal Financial and Accounting Officer)Date: March 23, 2007 POWER OF ATTORNEYKNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Philip C.S. Yin and Wilson W.Cheung, and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution, each with power to act alone, to sign and execute on behalf of theundersigned any and all amendments to this Report on Form 10-K, and to perform any acts necessary in order to file the same, with all exhibits thereto and other documents inconnection therewith with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every actand thing requested and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming allthat said attorney-in-fact and agent, or their or his or her substitutes, shall do or cause to be done by virtue hereof.Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.SignatureTitleDate/s/ PHILIP C.S. YINChief Executive Officer and DirectorMarch 23, 2007Philip C.S. Yin(Principal Executive Officer)/s/ WILSON W. CHEUNGChief Financial OfficerMarch 23, 2007Wilson W. Cheung(Principal Financial Officer and PrincipalAccounting Officer)/s/ RAYMOND A. LOWVice President, Corporate ControllerMarch 23, 2007Raymond A. Low/s/ JESSE CHENChairman of the Board of DirectorsMarch 23, 2007Jesse Chen/s/ DAVID C. CHANGDirectorMarch 23, 2007David C. Chang/s/ LEONARD LEBLANCDirectorMarch 23, 2007Leonard LeBlanc/s/ MORRIS S. YOUNGDirectorMarch 23, 2007Morris S. Young 90AXT, Inc.EXHIBITSTOFORM 10-K ANNUAL REPORTFor the Year Ended December 31, 2006Exhibit NumberDescription 3.1(3)Restated Certificate of Incorporation 3.2(4)Certificate of Designation, Preferences and Rights of Series A Preferred Stock (which is incorporated herein by reference to Exhibit 2.1 to the registrant’sform 8-K dated May 28, 1999). 3.3(5)Second Amended and Restated By Laws 4.2(5)Rights Agreement dated April 24, 2001 by and between AXT, Inc. and ComputerShare Trust Company, Inc.10.1(1)Form of Indemnification Agreement for directors and officers.*10.2(1)1993 Stock Option Plan and forms of agreements thereunder.*10.3(1)1997 Stock Option Plan and forms of agreements thereunder.*10.5(1)1998 Employee Stock Purchase Plan and forms of agreements thereunder.*10.7(2)Purchase and Sale Agreement by and between Limar Realty Corp #23 and AXT, Inc. dated April 1998.10.10(3)Bond Purchase Contract between Dain Rauscher Incorporated and AXT, Inc. dated December 1, 1998.10.11(3)Remarketing Agreement between Dain Rauscher Incorporated and AXT, Inc. dated December 1, 1998.10.15(7)Reimbursement Agreement between Wells Fargo Bank National Association and AXT, Inc. dated April 7, 2003.10.16(8)Asset purchase agreements dated September 4, 2003 by and between Dalian Luming Science and Technology Group, Ltd and AXT, Inc. and by andbetween Lumei Optoelectronics Corp., AXT, Inc., Lyte Optronics, Inc., Beijing Tongmei Xtal Technology and Xiamen Advanced Semiconductor Co., Ltd.10.17(9)Offer letter to Mr. Philip C.S. Yin.*10.18(10)Offer letter to Mr. Minsheng Lin.*10.19(11)Employement agreement between the Company and Mr. Wilson W. Cheung.*10.20(12)Agreement respecting severance payment between the Company and Dr. Morris S. Young.*10.21(13)Employement agreement between the Company and Mr. Davis Zhang.*10.22(14)Agreement dated February 27, 2007 by and between AXT, Inc. and Recapture Metals Limited. **21.1(15)List of Subsidiaries.23.1Consent of Independent Registered Public Accounting Firm, Burr, Pilger & Mayer LLP.24.1Power of Attorney (see signature page).31.1Certification by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2Certification by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1Certification by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2Certification by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(1) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Registration Statement on Form S-1 on March 17, 1998.(2) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Registration Statement on Amendment No. 2 to Form S-1 on May 11, 1998.(3) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Annual Report on Form 10-K for the year ended December 31, 1998.(4) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 8-K on June 14, 1999.(5) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 8-K on May 30, 2001.(6) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10-Q on November 12, 2002.(7) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10-Q on May 9, 2003.(8) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10-Q on November 13, 2003.(9) Incorporated by reference to exhibit 99.1 to registrant’s Form 8-K filed with the SEC on March 17, 2005.(10) Incorporated by reference to exhibit 99.1 to registrant’s Form 8-K filed with the SEC on June 30, 2005.(11) Incorporated by reference to exhibit 99.2 to registrant’s Form 8-K filed with the SEC on June 30, 2005.(12) Incorporated by reference to exhibit 99.1 to registrant’s Form 8-K filed with the SEC on March 30, 2005.(13) Incorporated by reference to exhibit 99.1 to registrant’s Form 8-K filed with the SEC on January 17, 2006.(14) Incorporated by reference to exhibit 10.22 to registrant’s Form 8-K filed with the SEC on March 5, 2007.(15) Incorporated by reference to exhibit 21.1 to registrant’s Form S-3/A (333-135474) filed with the SEC on July 28, 2006.* Management contract or compensatory plan.** Confidential treatment has been requested of the SEC for portions of the exhibit.Exhibit 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe hereby consent to the incorporation by reference in the Registration Statements on Form S-3 (No.333-135474) and Form S-8 (Nos. 333-38858 and 333-67297) of AXT, Inc. of our report dated March 21, 2007 relating to the consolidated financial statements, which appears in this Form 10-K./s/ BURR, PILGER & MAYER LLPSan Jose, CaliforniaMarch 21, 2007Exhibit 31.1CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Philip C.S. Yin, Chief Executive Officer of AXT, Inc., certify that:1. I have reviewed this annual report on Form 10-K of AXT, Inc.;2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport;3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;4. The registrant’s other certifying officer and I am responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))for the registrant and have:(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within thoseentities, particularly during the period in which this report is being prepared;(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recentfiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely tomaterially affect, the registrant’s internal control over financial reporting; and5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting.Date: March 23, 2007By:/s/ PHILIP C.S. YINPhilip C.S. YinChief Executive Officer Exhibit 31.2CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Wilson W. Cheung, Chief Financial Officer of AXT, Inc., certify that:1. I have reviewed this annual report on Form 10-K of AXT, Inc.;2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport;3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;4. The registrant’s other certifying officer and I am responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))for the registrant and have:(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within thoseentities, particularly during the period in which this report is being prepared;(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recentfiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely tomaterially affect, the registrant’s internal control over financial reporting; and5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting.Date: March 23, 2007By:/s/ WILSON W. CHEUNGWilson W. CheungChief Financial Officer Exhibit 32.1CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEYACT OF 2002In connection with the Annual Report of AXT, Inc. (the “Company”) on Form 10-K for the year ending December 31, 2006 as filed with the Securitiesand Exchange Commission on the date hereof (the “Report”), the undersigned hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002, that, to the best of my knowledge:(1) The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78m); and(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.Date: March 23, 2007By:/s/ PHILIP C.S. YINPhilip C.S. YinChief Executive Officer Exhibit 32.2CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEYACT OF 2002In connection with the Annual Report of AXT, Inc. (the “Company”) on Form 10-K for the year ending December 31, 2006 as filed with the Securitiesand Exchange Commission on the date hereof (the “Report”), the undersigned hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002, that, to the best of my knowledge:(1) The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78m); and(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.Date: March 23, 2007By:/s/ WILSON W. CHEUNGWilson W. CheungChief Financial Officer 

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