AXT INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) This quarterly report on Form 10-Q, including the following sections, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, particularly statements relating to our expectations regarding results of operations, customer demand, our ability to expand our markets and increase sales, industry trends, customer qualifications of our products, gross margins, the impact of the adoption of certain accounting pronouncements, our investments in capital projects, and our belief that we have adequate cash and investments to meet our needs over the next 12 months. These forward-looking statements are based upon management's current views with respect to future events and financial performance, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated in such forward-looking statements.

Such risks and uncertainties include those set forth under the section entitled "Risk Factors" below, which identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certain risk factors identified in this Form 10-Q and other filings we have made with the Securities and Exchange Commission. Forward-looking statements may be identified by the use of terms such as "anticipates," "believes," "estimates," "expects," "intends," and similar expressions. Statements concerning our future or expected financial results and condition, business strategy and plans or objectives for future operations are forward-looking statements.

These forward-looking statements are not guarantees of future performance.

Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2011 and the condensed consolidated financial statements included elsewhere in this report.

Overview We are a leading worldwide developer and producer of high-performance compound and single element semiconductor substrates comprising gallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge). We currently sell the following substrate products in the sizes and for the applications indicated: Product Substrates Diameter Applications GaAs (semi-insulating) 2", 3", 4", 5", 6" · Power amplifiers and radio frequency integrated circuits for wireless handsets (cell phones) · Direct broadcast television · High-performance transistors · Satellite communications GaAs (semi-conducting) 2", 3", 4" · High brightness light emitting diodes · Lasers · Optical couplers InP 2", 3", 4" · Broadband and fiber optic communications Ge 2", 4", 6" · Satellite and terrestrial solar cells · Optical applications We manufacture all of our semiconductor substrates using our proprietary vertical gradient freeze (VGF) technology. 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 compared to comparable facilities in the United States, Europe or Japan.

We also have joint ventures in China which provide us pricing advantages, reliable supply and enhanced sourcing lead-times for key raw materials which are central to our final manufactured products. These joint ventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, pyrolytic boron nitride (pBN) crucibles and boron oxide. AXT's ownership interest in these entities ranges from 25% to 83%. We consolidate, for accounting purposes, the joint ventures in which we have majority or controlling financial interest and significant influence on management, and employ equity accounting for the joint ventures in which we have a smaller ownership interest. We purchase portions of the materials produced by these ventures for our own use and the joint ventures sell the remainder of their production to third parties. We use our direct sales force in the United States and China and independent sales representatives in Europe and other parts of Asia to market our substrates. We believe that, as the demand for compound semiconductor substrates increases, we are positioned to leverage our PRC-based manufacturing capabilities and access to favorably priced raw materials to increase our market share.

20-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America. We make estimates, assumptions and judgments that can have significant impact on the amounts reported on our financial statements.

These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that we believe to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time.

We have identified the policies below as critical to our business operations and understanding of our financial condition and results of operations. Critical accounting policies are material to the presentation of our financial statements and require us to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations.

They may require us to make assumptions about matters that are highly uncertain at the time of the estimate, and different estimates that we could have used, or changes in the estimate that are reasonably likely to occur, may have a material impact on our financial condition or results of operations.

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

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

Accounts Receivable and Allowance for Doubtful Accounts We periodically review the likelihood of collection on our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We evaluate receivables from U.S.

customers in excess of 90 days and for receivables from customers located outside the U.S. in excess of 120 days and reserve allowance on the receivable balances if needed. We assess the probability of collection based on a number of factors, including the length of time a receivable balance has been outstanding, our past history with the customer and their creditworthiness.

As of September 30, 2012 and December 31, 2011, our accounts receivable, net, balance was $16.9 million and $18.0 million, respectively, with no allowance for doubtful accounts. If actual uncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could have a material impact on our financial results for the affected period.

The allowance for sales returns is also deducted from gross accounts receivable.

As of September 30, 2012 and December 31, 2011, our allowance for sales returns was $167,000 and $124,000, respectively.

Warranty Reserve We maintain a warranty reserve based upon our claims experience during the prior twelve months. Warranty costs are accrued at the time revenue is recognized. As of September 30, 2012 and December 31, 2011, accrued product warranties totaled $697,000 and $1.0 million, respectively. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financial condition and results of operations.

21-------------------------------------------------------------------------------- Table of Contents Inventory Valuation Inventories are stated at the lower of cost or market. Cost is determined using the weighted average cost method. Our inventory consists of raw materials as well as finished goods and work-in-process that include material, labor and manufacturing overhead costs. Given the nature of our substrate products, and the materials used in the manufacturing process, the wafers and ingots comprising work-in-process may be held in inventory for up to two years and three years, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory, and we provide a valuation allowance for certain inventories based upon the age and quality of the product and the projections for sale of the completed products.

As of September 30, 2012 and December 31, 2011, we had an inventory reserve of $6.9 million and $12.3 million, respectively, for excess and obsolete inventory.

If actual demand for our products were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results of operations.

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

We invest in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable.

Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee's management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in our carrying value. We had no write-downs for the three and nine months ended September 30, 2012 and 2011.

Fair Value of Investments In the current market environment, the assessment of the fair value of debt instruments can be difficult and subjective. The rapid changes occurring in today's financial markets can lead to changes in the fair value of financial instruments in relatively short periods of time. ASC 820 establishes three levels of inputs that may be used to measure fair value.

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

Level 2 instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments, including: · Determining which instruments are most similar to the instrument being priced requires management to identify a sample of similar securities based on the coupon rates, maturity, issuer, credit rating, and instrument type, and subjectively select an individual security or multiple securities that are deemed most similar to the security being priced.

· Determining whether a market is considered active requires management judgment. Our assessment of an active market for our marketable debt instruments generally takes into consideration activity during each week of the one-month period prior to the valuation date of each individual instrument, including the number of days each individual instrument trades and the average weekly trading volume in relation to the total outstanding amount of the issued instrument.

· Determining which model-derived valuations to use in determining fair value requires management judgment. When observable market prices for identical securities or similar securities are not available, we price our marketable debt instruments using non-binding market consensus prices that are corroborated with observable market data or pricing models, such as discounted cash flow models, with all significant inputs derived from or corroborated with observable market data.

22-------------------------------------------------------------------------------- Table of Contents Level 3 instruments include unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.

The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. As of September 30, 2012, we did not have any assets or liabilities without observable market values that would require a high level of judgment to determine fair value (Level 3 assets).

Impairment of Long-Lived Assets We evaluate the recoverability of property, equipment and intangible assets in accordance with ASC topic 360, Property, Plant and Equipment ("ASC 360"). When events and circumstances indicate that long-lived assets may be impaired, we compare the carrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to these assets. In the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the assets' fair value. Fair values are determined based on quoted market values, discounted cash flows or internal and external appraisals, as applicable.

Stock-based Compensation We 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. We account for stock-based compensation in accordance with ASC topic 718, Stock-based Compensation ("ASC 718"), using the modified prospective method. We utilize the Black-Scholes option 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 term. Historical volatility was used in estimating the fair value of our stock options awards, while the expected term for our options was estimated based on historical option exercise behavior and post-vesting forfeitures of options by our employees. Further, we estimate forfeitures for stock compensation awards that are not expected to vest. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of our stock compensation.

We recognize the compensation costs net of an estimated forfeiture rate over the requisite service period of the options award, which is generally the vesting term of four years. The cost of restricted stock awards is determined using the fair value of our common stock on the date of grant. Compensation expense for restricted stock awards is recognized over the vesting period, which is generally three years or four years. Stock-based compensation expense is recorded in cost of revenue, research and development, and selling, general and administrative expenses.

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

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 in foreign countries such as China.

See Note 13-"Income Taxes" in the notes to condensed financial statements for additional information.

Results of Operations Revenue Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) GaAs $ 12,901 $ 18,735 $ (5,834 ) (31.1 ) % InP 1,649 1,522 127 8.3 % Ge 2,007 2,954 (947 ) (32.1 ) % Raw materials and other 4,251 5,094 (843 ) (16.5 ) % Total revenue $ 20,808 $ 28,305 $ (7,497 ) (26.5 ) % Revenue decreased $7.5 million, or 26.5%, to $20.8 million for the three months ended September 30, 2012 from $28.3 million for the three months ended September 30, 2011. Total GaAs substrate revenue decreased $5.8 million, or 31.1%, to $12.9 million for the three months ended September 30, 2012 from $18.7 million for the three months ended September 30, 2011. The decrease in GaAs substrate revenue was primarily due to the softer demand environment worldwide in both the light emitting diode (LED) market that uses semi-conducting (SC) substrates and wireless devices market that uses semi-insulating (SI) substrates compared to the same period last year.

23-------------------------------------------------------------------------------- Table of Contents Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates, which are mainly used in LED applications, were $9.3 million for the three months ended September 30, 2012 compared with $11.8 million for the three months ended September 30, 2011. The decrease in revenue from smaller diameter substrates was primarily due to weaker demand in LED applications in all geographic regions except Taiwan. We expect revenue from semi-conducting GaAs substrates to decline next quarter primarily due to weaker demand from customers in China in consumer applications markets.

Sales of 5 inch and 6 inch diameter GaAs substrates, which are mainly used in wireless devices, were $3.6 million for the three months ended September 30, 2012 compared to $6.9 million for the three months ended September 30, 2011. The decrease in revenue from larger diameter substrates was primarily due to lower demand in the wireless devices market compared to the same period last year. We expect revenue from semi-insulating GaAs substrate to decline next quarter.

InP substrate revenue increased $127,000, or 8.3%, to $1.6 million for the three months ended September 30, 2012 from $1.5 million for the three months ended September 30, 2011 primarily due to increased demand in the optical networking industry. We expect InP revenue remain stable next quarter.

Ge substrate revenue decreased $947,000, or 32.1%, to $2.0 million for the three months ended September 30, 2012 from $3.0 million for the three months ended September 30, 2011 primarily due to fewer planned satellite launches particularly in Asia compared to the same period last year. We expect Ge substrate revenue to decline moderately due to customer mix in different geographic regions.

Raw materials revenue decreased $843,000, or 16.5%, to $4.3 million for the three months ended September 30, 2012 from $5.1 million for the three months ended September 30, 2011. The decrease in raw materials revenue was primarily due to fluctuation in demand for 4N raw gallium as well as from decreased selling prices. We expect our third party raw material revenue to continue to decline next quarter as a result of anticipated decreases in average selling prices.

Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) GaAs $ 39,994 $ 52,593 $ (12,599 ) (24.0 ) % InP 4,433 4,458 (25 ) (0.6 ) % Ge 7,078 8,645 (1,567 ) (18.1 ) % Raw materials and other 17,942 17,206 736 4.3 % Total revenue $ 69,447 $ 82,902 $ (13,455 ) (16.2 ) % Revenue decreased $13.5 million, or 16.2%, to $69.4 million for the nine months ended September 30, 2012 from $82.9 million for the nine months ended September 30, 2011. Total GaAs substrate revenue decreased $12.6 million, or 24.0%, to $40.0 million for the nine months ended September 30, 2012 from $52.6 million for the nine months ended September 30, 2011. The decrease in GaAs substrate revenue was primarily due to the softer demand environment worldwide in both the light emitting diode (LED) market and wireless devices market compared to the same period last year.

Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates were $27.7 million for the nine months ended September 30, 2012 compared with $34.9 million for the nine months ended September 30, 2011. The decrease in revenue from smaller diameter substrates was primarily due to weaker demand in LED market in all geographic regions except Taiwan.

Sales of 5 inch and 6 inch diameter GaAs substrates were $12.3 million for the nine months ended September 30, 2012 compared to $17.7 million for the nine months ended September 30, 2011. The decrease in revenue from larger diameter substrates was primarily due to lower demand for semi-insulating GaAs substrate from customers in the wireless devices market compared to the same period last year.

InP substrate revenue decreased slightly by $25,000, or 0.6%, to $4.4 million for the nine months ended September 30, 2012 from $4.5 million for the nine months ended September 30, 2011 and resulted from customer mix in the optical networking industry.

24-------------------------------------------------------------------------------- Table of Contents Ge substrate revenue decreased $1.6 million, or 18.1%, to $7.1 million for the nine months ended September 30, 2012 from $8.6 million for the nine months ended September 30, 2011 primarily due to fewer planned satellite launches particular in Asia compared to the same period last year.

Raw materials revenue increased $736,000, or 4.3%, to $17.9 million for the nine months ended September 30, 2012 from $17.2 million for the nine months ended September 30, 2011 primarily due to increased sales of pyrolytic boron nitride (pBN) crucibles, partially offset by decreased revenue from sales of 4N raw gallium resulting from decreased selling prices.

Revenue by Geographic Region Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) North America * $ 3,230 $ 6,049 $ (2,819 ) (46.6 ) % % of total revenue 15.5 % 21.4 % Europe 5,148 5,831 (683 ) (11.7 ) % % of total revenue 24.7 % 20.6 % Japan 2,404 3,951 (1,547 ) (39.2 ) % % of total revenue 11.6 % 14.0 % Taiwan 3,490 2,592 898 34.6 % % of total revenue 16.8 % 9.2 % Asia Pacific (excluding Japan and Taiwan) 6,536 9,882 (3,346 ) (33.9 ) % % of total revenue 31.4 % 34.9 % Total revenue $ 20,808 $ 28,305 $ (7,497 ) (26.5 ) % -------------------------------------------------------------------------------- *Primarily the United States Revenue from customers in North America decreased by $2.8 million, or 46.6%, to $3.2 million for the three months ended September 30, 2012 from $6.0 million for the three months ended September 30, 2011 primarily due to decreased sales from all substrates, partially offset by increased sales of 4N raw gallium.

Revenue from customers in Europe decreased by $683,000, or 11.7%, to $5.1 million for the three months ended September 30, 2012 from $5.8 million for the three months ended September 30, 2011 primarily due to decreased sales of substrates and raw materials to customers in Germany and United Kingdom, partially offset by increased substrates sales to customers in France.

Revenue from customers in Japan decreased by $1.5 million, or 39.2%, to $2.4 million for the three months ended September 30, 2012 from $4.0 million for the three months ended September 30, 2011 primarily due to decreased sales of GaAs substrates and InP substrate, partially offset by increased sales of 4N raw gallium and Ge substrates.

Revenue from customers in Taiwan increased by $898,000, or 34.6%, to $3.5 million for the three months ended September 30, 2012 from $2.6 million for the three months ended September 30, 2011 primarily due to increased sales of semi-conducting GaAs substrates and InP substrate, partially offset by decreased sales of semi-insulating GaAs substrates from a major customer. We expect revenue from customers in Taiwan to decline next quarter primarily due to decreased demand from a major customer for semi-conducting GaAs substrates.

Revenue from customers in Asia Pacific (excluding Japan and Taiwan) decreased by $3.3 million, or 33.9%, to $6.5 million for the three months ended September 30, 2012 from $9.9 million for the three months ended September 30, 2011 primarily due to decreased sales of 4N raw gallium, semi-conducting GaAs substrates and Ge substrates to customers in China, decreased sales of GaAs substrates to customers in Singapore, partially offset by increased sales of pyrolytic boron nitride (pBN) crucibles to customers in Korea.

25-------------------------------------------------------------------------------- Table of Contents Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) North America * $ 12,663 $ 16,253 $ (3,590 ) (22.1 ) % % of total revenue 18.2 % 19.6 % Europe 14,519 17,063 (2,544 ) (14.9 ) % % of total revenue 20.9 % 20.6 % Japan 7,196 11,358 (4,162 ) (36.6 ) % % of total revenue 10.4 % 13.7 % Taiwan 9,130 8,201 929 11.3 % % of total revenue 13.2 % 9.9 % Asia Pacific (excluding Japan and Taiwan) 25,939 30,027 (4,088 ) (13.6 ) % % of total revenue 37.3 % 36.2 % Total revenue $ 69,447 $ 82,902 $ (13,455 ) (16.2 ) % -------------------------------------------------------------------------------- *Primarily the United States Revenue from customers in North America decreased by $3.6 million, or 22.1%, to $12.7 million for the nine months ended September 30, 2012 from $16.3 million for the nine months ended September 30, 2011 primarily due to decreased sales from GaAs substrates and InP substrate, partially offset by increased sales of 4N raw gallium.

Revenue from customers in Europe decreased by $2.5 million, or 14.9%, to $14.5 million for the nine months ended September 30, 2012 from $17.1 million for the nine months ended September 30, 2011 primarily due to decreased sales of GaAs substrates and raw materials to customers in Germany and United Kingdom, partially offset by increased substrates sales to customers in France.

Revenue from customers in Japan decreased by $4.2 million, or 36.6%, to $7.2 million for the nine months ended September 30, 2012 from $11.4 million for the nine months ended September 30, 2011 primarily due to decreased sales of GaAs substrates and 4N raw gallium.

Revenue from customers in Taiwan increased by $929,000, or 11.3%, to $9.1 million for the nine months ended September 30, 2012 from $8.2 million for the nine months ended September 30, 2011 primarily due to increased sales of semi-conducting GaAs substrates and InP substrates, partially offset by decreased sales of semi-insulating GaAs substrates to a major customer.

Revenue from customers in Asia Pacific (excluding Japan and Taiwan) decreased by $4.1 million, or 13.6%, to $25.9 million for the nine months ended September 30, 2012 from $30.0 million for the nine months ended September 30, 2011 primarily due to decreased sales of 4N raw gallium, Ge substrates and semi-conducting GaAs substrates to customers in China, decreased sales of semi-conducting GaAs substrates to customers in Singapore, partially offset by increased sales of pyrolytic boron nitride (pBN) crucibles to customers in Korea.

Gross Margin Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Gross profit $ 5,466 $ 12,237 $ (6,771 ) (55.3 ) % Gross Margin % 26.3 % 43.2 % Gross margin decreased to 26.3% of total revenue for the three months ended September 30, 2012 from 43.2% of total revenue for the three months ended September 30, 2011. Higher priced raw material in our inventory and lower average selling prices due to product mix and customer mix, and lower volumes negatively impacted the gross margin for all substrates for the three months ended September 30, 2012. During the three months ended September 30, 2012, gross margins for raw material sales also decreased due to decreased selling prices of 4N raw gallium compared to the same period last year.

26-------------------------------------------------------------------------------- Table of Contents Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Gross profit $ 21,168 $ 36,923 $ (15,755 ) (42.7 ) % Gross Margin % 30.5 % 44.5 % Gross margin decreased to 30.5% of total revenue for the nine months ended September 30, 2012 from 44.5% of total revenue for the nine months ended September 30, 2011. Approximately $1.3 million, or 1.9% of total revenue for the nine months ended September 30, 2012 was expensed for supplemental and retroactive VATs levied by the tax authorities in the People's Republic of China (PRC) which was applicable for the period from July 1, 2011 to June 30, 2012. In addition, higher priced raw material in our inventory and lower average selling prices due to product mix and customer mix also negatively impacted the gross margins for all substrates for the nine months ended September 30, 2012. During the nine months ended September 30, 2012, gross margins for raw material sales also decreased due to decreased selling prices of 4N raw gallium compared to the same period last year.

Selling, General and Administrative Expenses Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Selling, general and administrative expenses $ 3,950 $ 3,555 $ 395 11.1 % % of total revenue 19.0 % 12.6 % Selling, general and administrative expenses increased $395,000 or 11.1% to $4.0 million for the three months ended September 30, 2012 from $3.6 million for the three months ended September 30, 2011. The increase was primarily due to higher labor related costs including salaries and retirement benefit from our joint ventures, higher sales commission expenses, and higher stock-based compensation expenses resulting from the new options and awards granted in 2011.

Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Selling, general and administrative expenses $ 11,709 $ 10,959 $ 750 6.8 % % of total revenue 16.9 % 13.2 % Selling, general and administrative expenses increased $750,000, or 6.8%, to $11.7 million for the nine months ended September 30, 2012 from $11.0 million for the nine months ended September 30, 2011. The increase was primarily due to higher labor related costs including salaries and retirement benefit from our joint ventures, higher stock-based compensation expenses resulting from the new options and awards granted in 2011, higher sales commission expenses and higher professional fees.

Research and Development Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Research and development $ 844 $ 612 $ 232 37.9 % % of total revenue 4.1 % 2.2 % Research and development expenses increased $232,000, or 37.9%, to $844,000 for the three months ended September 30, 2012 from $612,000 for the three months ended September 30, 2011. The increase was primarily due to higher labor related costs including salaries and bonus and higher stock-based compensation expenses mainly related to the hiring of a Chief Scientist in March 2012 and higher product testing costs.

27-------------------------------------------------------------------------------- Table of Contents Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Research and development $ 2,593 $ 1,816 $ 777 42.8 % % of total revenue 3.7 % 2.2 % Research and development expenses increased $777,000, or 42.8%, to $2.6 million for the nine months ended September 30, 2012 from $1.8 million for the nine months ended September 30, 2011. The increase was primarily due to higher labor related costs including salaries and bonus and higher stock-based compensation expenses mainly related to the hiring of a Chief Scientist in March 2012, higher product testing costs and higher health insurance expenses.

Interest Income, net Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands)Interest income, net $ 52 $ 103 $ (51 ) (49.5 ) % % of total revenue 0.2 % 0.4 % Interest income, net decreased $51,000 to $52,000 for the three months ended September 30, 2012 from $103,000 for the three months ended September 30, 2011. Interest income, net for the three months ended September 30, 2012 was lower compared to the same period last year primarily due to lower interest rates from investments.

Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Interest income, net $ 202 $ 259 $ (57 ) (22.0 ) % % of total revenue 0.3 % 0.3 % Interest income, net decreased $57,000 to $202,000 for the nine months ended September 30, 2012 from $259,000 for the nine months ended September 30, 2011. Interest income, net for the nine months ended September 30, 2012 was lower compared to the same period last year primarily due to lower interest rates from investments.

Other Income, net Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Other income, net $ 492 $ 356 $ 136 38.2 % % of total revenue 2.4 % 1.3 % Other income, net increased $136,000 to $492,000 for the three months ended September 30, 2012 from $356,000 for the three months ended September 30, 2011 primarily due to higher investment income from our minority-owned joint ventures that are not consolidated, partially offset by lower net foreign exchange gains on our Yen denominated accounts receivable and transactions realized by our joint ventures in China.

Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Other income, net $ 314 $ 443 $ (129 ) (29.1 ) % % of total revenue 0.5 % 0.5 % Other income, net decreased $129,000 to $314,000 for the nine months ended September 30, 2012 from $443,000 for the nine months ended September 30, 2011 primarily due to higher withholding tax on foreign dividends, a loss on disposal of equipments from our joint ventures, offset by agency commission recognized by one of our joint ventures and higher investment income from our minority-owned joint ventures that are not consolidated.

28-------------------------------------------------------------------------------- Table of Contents Provision for (Benefit from) Income Taxes Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Provision for (benefit from) income taxes $ (228 ) $ 667 (895 ) NM % of total revenue (1.1 ) % 2.4 % NM = % not meaningful Provision for (benefit from) income taxes for three months ended September 30, 2012 and 2011 was mostly related to our China subsidiary and our China joint venture operations, with income tax benefits in the three months ended September 30, 2012 compared to income tax provisions in the three months ended September 30, 2011 primarily due to tax refunds expected for state income taxes as well as tax refunds received by one of our China joint ventures, and decreased sales and decreased net income in the three months ended September 30, 2012 compared to the same period last year. Besides the state taxes liabilities, no federal income taxes have been provided for U.S. operations due to our available net operating loss carryforwards.

Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Provision for income taxes $ 559 $ 2,633 $ (2,074 ) (78.8 ) % % of total revenue 0.8 % 3.2 % Provision for income taxes for nine months ended September 30, 2012 and 2011 was mostly related to our China subsidiary and our China joint venture operations, with the decrease in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011 primarily due to decreased sales and decreased net income in the nine months of 2012 compared to the same period last year and tax refunds expected in 2012 for state income taxes as well as tax refunds received by one of our China joint ventures. Besides the state taxes liabilities, no federal income taxes have been provided for U.S. operations due to our available net operating loss carryforwards. Our estimated tax rate can vary greatly from period to period because of the change in the mix of taxable income between the U.S. and China based operations.

Noncontrolling interest Three Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Noncontrolling interest $ 512 $ 1,378 $ (866 ) (62.8 ) % % of total revenue 2.5 % 4.9 % Noncontrolling interest decreased $866,000 to $512,000 for the three months ended September 30, 2012 from $1.4 million for the three months ended September 30, 2011 as a result of lower profitability from our China joint venture operations as raw materials sales have decreased due to decreased selling prices compared to the same period last year.

Nine Months Ended September 30, Increase 2012 2011 (Decrease) % Change ($ in thousands) Noncontrolling interest $ 2,957 $ 4,463 $ (1,506 ) (33.7 ) % % of total revenue 4.3 % 5.4 % Noncontrolling interest decreased $1.5 million to $3.0 million for the nine months ended September 30, 2012 from $4.5 million for the nine months ended September 30, 2011 as a result of lower profitability from our China joint venture operations as profits from raw materials sales have decreased due to decreased selling prices compared to the same period last year.

Liquidity and Capital Resources We consider cash and cash equivalents, short-term investments and long-term investments as liquid and available for use within two years in our current operations. Short-term investments and long-term investments are comprised of U.S. government securities and investment-grade corporate notes and bonds. As of September 30, 2012, our principal sources of liquidity were $51.4 million of which $14.9 million was held by our consolidated joint ventures, consisting of cash and cash equivalents of $35.5 million, short-term investments of $10.6 million and long-term investments of $5.4 million.

29-------------------------------------------------------------------------------- Table of Contents Cash and cash equivalents increased $9.3 million and short-term investments and long-term investments increased $1.5 million during the nine months ended September 30, 2012. Cash and cash equivalents increased $677,000 and short-term investments and long-term investments decreased $2.5 million during the nine months ended September 30, 2011.

Net cash provided by operating activities of $19.6 million for the nine months ended September 30, 2012 was primarily comprised of our net income of $6.8 million, adjusted for non-cash items of depreciation of $2.8 million, stock-based compensation of $873,000, amortization of marketable securities premium of $220,000, and loss on disposal of property, plant and equipment of $176,000, and a net change of $8.6 million in assets and liabilities. The $8.6 million net change in assets and liabilities primarily resulted from a $6.1 million decrease in inventories, a $1.9 million decrease in prepaid expenses, a $1.1 million decrease in accounts receivable, a $1.3 million increase in accounts payable, partially offset by a $824,000 decrease in other long-term liabilities, a $795,000 decrease in accrued liabilities and a $97,000 increase in other assets.

Net cash provided by operating activities of $12.0 million for the nine months ended September 30, 2011 was primarily comprised of our net income of $22.2 million, adjusted for non-cash items of depreciation of $2.5 million, amortization of marketable securities premium of $279,000, stock-based compensation of $638,000, realized loss on sales of investments of $8,000 and a net change of $13.6 million in assets and liabilities, partially offset by gain on disposal of property, plant and equipment of $30,000. The $13.6 million net change in assets and liabilities primarily resulted from a $8.2 million increase in inventories, $3.0 million increase in prepaid expenses, a $1.4 million increase in other assets, a $1.2 million decrease in accounts payable and accrued liabilities and a $848,000 decrease in other long-term liabilities, partially offset by a $1.1 million decrease in accounts receivable.

Net cash used in investing activities of $6.5 million for the nine months ended September 30, 2012 was primarily from the purchase of property, plant and equipment of $5.0 million and the purchase of investments totaling $8.2 million offset by the sale of investments totaling $6.7 million.

Net cash used in investing activities of $11.0 million for the nine months ended September 30, 2011 was primarily attributable to the purchase of property, plant and equipment of $9.6 million, investments in new joint ventures of $2.6 million, loan from one of our consolidated joint ventures to its equity investment entity of $775,000 and the purchase of investments totaling $14.0 million offset by the sale of investments totaling $15.9 million.

In January 2012, we agreed with the Administrative Commission of Tianjin Economy and Technology Development Zone to establish a second manufacturing facility in Tianjin, China. The arrangement provides us with land use rights for approximately 32 acres of industrial land located in Yixian Scientific and Industrial Park to construct a compound semiconductor substrate manufacturing facility that would be completed in phases by 2017. We agreed to provide $12.5 million in the first phase of the construction of the facility and have an understanding with our BoYu joint venture that it will provide the RMB 32.0 million, or approximately $5.0 million, that is anticipated to be required for the portion of the project devoted to crystal support, in exchange for land use rights, enterprise and individual income tax rebates, employee hiring and development subsidies, and other benefits. Our funding of the project is dependent upon the completion of environmental studies and the grant of permits.

We expect to fund the first phase of the construction of the facility with cash flow generated by our normal operations supplemented by our existing line of credit. The investment of $5.0 million will be funded by our BoYu joint venture.

In January 2012, we increased the credit facility line of credit maintained by us with UBS Bank USA from $3.0 million to $10.0 million at an annual interest rate of 1.65% above the current 30-day LIBOR (London Interbank Offered Rate). As of September 30, 2012 and December 31, 2011, we had not used any portion of this line of credit.

Net cash used in financing activities of $3.8 million for the nine months ended September 30, 2012 consisted of $4.1 million net dividends paid by our joint ventures partially offset by net proceeds of $276,000 on the issuance of common stock pursuant to stock option exercises.

Net cash used in financing activities of $999,000 for the nine months ended September 30, 2011 consisted of dividend payments of $1.6 million by our joint ventures, partially offset by net proceeds of $637,000 on the issuance of common stock pursuant to stock option exercises.

30-------------------------------------------------------------------------------- Table of Contents 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 generate cash 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, and require us to seek additional capital. There can be no assurance that such additional capital will be available or, if available it will be on terms acceptable to us. On September 13, 2011, our registration statement on Form S-3 was declared effective by the Securities and Exchange Commission (SEC). We may from time to time offer up to $60.0 million of common stock, preferred stock, depositary shares, warrants, debt securities and/or units in one or more offerings and in any combination. We intend to use the net proceeds from any sale of securities under the shelf registration statement for general corporate purposes, which may include capital expenditures in connection with our planned expansion of our manufacturing facilities in China. The timing of any offering will be at our discretion and will depend on many factors, including the prevailing market conditions. Specific terms and share prices of any future offering under the registration statement will be established at the time of any such offering, and will be described in a prospectus supplement that we will file with the SEC.

Cash from operations could be affected by various risks and uncertainties, including, but not limited to those set forth below under Item 1A "Risks Factors." We lease certain office space, manufacturing facilities and equipment under long-term operating leases expiring at various dates through February 2016. The lease agreement for the facility at Fremont, California with approximately 27,760 square feet commenced on December 1, 2008 for a term of seven years, with an option by us to cancel the lease after five years, upon forfeiture of the security deposit and payment of one-half of the fifth year's rent. Total rent expenses under these operating leases were approximately $107,000 and $121,000 for the three months ended September 30, 2012 and 2011, respectively and $334,000 and $365,000 for the nine months ended September 30, 2012 and 2011, respectively.

We entered into a royalty agreement with a vendor effective December 3, 2010 with a term of eight years, terminating December 31, 2018. We and our related companies are granted a worldwide, nonexclusive, royalty bearing, irrevocable license to certain patents for the term on the agreement.

Outstanding contractual obligations as of September 30, 2012 are summarized as follows (in thousands): Payments due by period 1-3 3-5 More than Contractual Obligations Total Less than 1 year years years 5 years Operating leases $ 1,114 $ 395 $ 664 $ 55 $ - Royalty agreement 4,439 913 1,600 1,207 719 Total $ 5,553 $ 1,308 $ 2,264 $ 1,262 $ 719 Recent Accounting Pronouncements There have been no new accounting pronouncements during the nine months ended September 30, 2012, as compared to the recent accounting pronouncements described in our Annual Report on Form 10-K for the year ended December 31, 2011, that are of material significance, or potential significance, to us.

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