AXT Inc (AXTI) 2002 Q3 法說會逐字稿

Good afternoon, my name is Amanda and I'll be your conference facilitator today. At this time, I would like to welcome everyone to the AXT Inc third quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer period. If you would like to ask a question during this time, simply press star then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you.

Dr. Young, President and CEO, I would now like to turn the call - conference over.

Hello and welcome to AXT's third quarter 2002 conference call. I'd like to thank you for taking the time to be with us this afternoon. I'm Morris Young, President and CEO of AXT. With me today is Don Tatzin, our Chief Financial Officer.

Don will give you the financial results of the quarter. And then I will give you an update on current market conditions and the AXT strategy to addressing the challenges. Following that I will close the prepared comments with forward-looking guidance. And we will open the call to your questions. Don.

Thank you, Morris. Before I begin, I would like to remind you that during the course of this conference call, we will make projections or other forward-looking statements regarding among other things our financial performance and outlook for the fourth quarter. Expected cash flows, cash utilization and fair value of certain operating assets. And the size and impact of impairment charges on our financial results.

Market conditions and trends, the future financial performance of the company, new products, and the company's ability to bring them to market. We wish to caution you that such statements are subject to risk and uncertainties that may cause actual results to differ materially. We refer you to the company's latest 10-K and 10-Q filings made with the securities and exchange commission. For additional discussions of risk factors that could cause actual results to differ materially from our current expectations.

Now on to the results from the quarter. Revenue during the third quarter of 2002 was 14.9 million compared with 19.2 million in the second quarter of 2002 and the 22.8 million in the third quarter of 2001. Revenue from outdoor electronics division, which represented 22 percent of total revenue for the third quarter of 2002 was 3.2 million compared with 3.6 million in the second quarter of 2002 and compared with 2.3 million in third quarter of 2001.

Within the optical electronics division revenue for high brightness (ph) blue, green, and cyan (ph) light emitting diodes was 2.5 million. And for our laser diode products was 700,000. Reported revenue is inclusive of a product return reserve of $921,000 for the optical electronic segment.

Revenue from our substrate division which represented 78 percent of total revenue for the third quarter was 11.7 million compared with 12.9 million in the second quarter of 2002 and 20.5 million in the third quarter of 2001. Reported revenue is inclusive of a product return allowance of 573,000 for the substrate segment. Total gallium arsenide substrate revenue is 9.1 million for the third quarter of 2002 compared with 9.8 million in the second quarter of 2002 and 11.1 million in the third quarter of 2001.

Firing (ph) six inch diameter gallium arsenide substrate revenue was three million for the third quarter of 2002 compared with 3.4 million in the second quarter of 2002, and 1.6 million in the third quarter of 2001. The decrease in large diameter gallium arsenide revenue compared with the second quarter, was largely the result of price declines as the volume of wafers shipped declined only slightly.

Indium phosphide substrate revenue is 1.1 million for the third quarter of 2002, compared with 1.7 million and the second quarter of 2002 and 7.9 million in the third quarter of 2001. Indium phosphide substrate revenue remains heavily dependent on the fiber optics business. Sales of raw material and products were 1.6 million compared with 1.4 million in the second quarter.

In the third quarter of 2002 North America revenue was 46 percent, Asia Pacific was 44 percent. And Europe was 11 percent of total revenue. By comparison, in the third quarter of 2001, North America revenue was 61 percent, Asia Pacific was 21 percent. And Europe was 18 percent of total revenue. A shift has occurred because the vast majority of our optical electronics customers are in Asia Pacific and that business increased as a percentage of total revenue. One substrate customer provided 10 percent of our revenue for the third quarter.

Gross margin was negative 23.7 percent of revenue for the third quarter of 2002, compared with 15.3 percent for the second quarter of 2002 and the 23.5 percent for the third quarter of 2001. The decline in gross margin is attributable to the lower revenue in both our substrate and optical electronics businesses and charges taken to reserve product returns and aged inventory.

Gross margin for optical electronics products was negative 74 percent in the third quarter compared with positive 17.8 percent in the second quarter of 2002 as a result of reduced volume, lower yield, and charges taken to reserve product returns and the realizable value of inventory.

Gross margins in the substrate division was negative 9.9 percent in the third quarter of 2002 compared with positive 14 percent in the second quarter of 2002, and positive 31.6 percent in the third quarter of 2001. The reduction in gross margins from the second quarter is a result of a combination of lower revenue and charges reserved aged inventory.

Selling, general and administrative expenses were five million for the third quarter of 2002 compared with 4.7 million for the second quarter of 2002 and 5.8 million for the third quarter of 2001. The expense includes the charge of 434,000 for bad debt reserve.

Research and development costs were 1.3 million for the third quarter of 2002 compared with 1.1 million for the second quarter of 2002 and 1.7 million for the third quarter of 2001. The increase in R&D occurred in the optical electronics division as more emphasis was placed on product improvement. As a percent of total revenue R&D was 8.8 percent in the third quarter compared with 5.7 percent in the second quarter of 2002 and was (ph) 7.5 percent in the third quarter of last year.

During the third quarter of 2002 we recorded asset impairment charges of 13.1 million and a deferred tax asset valuation allowance of 15.3 million. The asset impairment charges include 12 million of machinery and equipment right downs of the optical electronics division and a 1.1 million right down of goodwill. The machinery and equipment impairment charge is based upon management's best estimate of recoverability of these assets as of the date of this press release.

However, we will continue to monitor the value of these assets until we file our 10-Q for the third quarter ended September 30, 2002. Sure our best estimate of the recoverability of these assets changed during this period. The amount of the impairment charge may increase or decrease from the amount reported above. And consequently, our results including net loss and net loss per share as finally reported in our third quarter 10-Q may differ materially from results we are announcing today.

Interest expense for the third quarter of 2002 is 364,000 compared with 365,000 in the second quarter of 2002 and 493,000 in the third quarter of 2001. Pro forma net loss for the third quarter 2002 excluding the active impairment charge discussed above was 5.9 million or 26 cents per share compared with a loss of 1.9 million or nine cents per share for the second quarter of 2002.

Net GAAP loss in the third quarter of 2002 was 26.7 million or $1.19 per share. In the third quarter, the company posted a year ago, the company posted a net loss of 1.4 million or six cents per diluted share.

Let's now turn to the balance sheet. Cash and cash equivalents with maturity's of less than three months, short term investments and other investments of high grade debt securities with maturity's of less than two years, were 33.6 million at September 30th, 2002, compared with 50.4 million a June 30th, 2002. Of this amount, 10.7 million is reported as restricted cash under our revised agreement for a credit facility with our bank. We now comply with all of the provisions of the credit facility.

During the quarter, we retired 7.7 million in debt which was compromised of 5.3 million of real estate debt and 2.4 million in capital leases. Of the total debt reduction 6.3 million was voluntarily paid in advance of its due date. Accounts receivable net of reserves was 11.9 million at September 30th, 2002, compared with 14.4 million in the prior quarter. We saw an increase in days sales out standing to 71 in September 30th, 2002 compared with 68 at June 30th, 2002.

Net inventory decreased 1.8 million from 52.3 million at June 30,2002 to 50.6 million at September 30th, 2002. Our total reduction of net inventory and our substrate division since June 30th, 2001 was 13.8 million. We expect the rate of inventory reduction to increase during the coming quarters as we launch a program to recycle slow moving products.

Capital expenditures for PP&E during the quarter were 4.4 million and depreciation was 2.4 million. We have substantially reduced our plans for capital expenditure during the rest of 2002 and into 2003 as part of our revised strategy which Morris will describe shortly. Net cash used by operating activities was five million for the quarter ended September 30th, 2002 compared with cash used by operating activities of 1.6 million for the quarter June 30th, 2002. The increase in cash used results primarily from the decline in revenue. Use of cash and cash equivalents with a maturity of less then three months, short term investments, and other investments in high grade debt security with maturity less than two years were 16.8 million for the quarter ended September 30th, 2002 compared with 5.8 million for the quarter June 30th, 2002.

At September 30th, 2002 we had 1,626 employees in total of whom 1,397 worked in production. Compared with 1,517 employees in total of whom 1,270 worked in production at June 30th, 2001. At September 30th, 2002 551 employees working in the U.S. and 1,071 worked abroad. By October 15th, we had reduced the number of employees in our U.S. facilities by 225.

This concludes our review of our recent financial performance, let me now turn the call back to Morris.

Thank you, Don. I want to begin by reviewing the major developments of the third quarter and then give you detailed strategy to address the current market challenges. Let me begin with our substrate division. Our shipment of large diameter (INAUDIBLE) substrates for applications such as HPT (ph) and PHAMP (ph) devices used in wireless handsets were consistent with the second quarter, and we approximately 60 percent greater than during the first quarter.

Average selling prices for these product declines, however, causing total gallium arsenide revenue to decrease in the third quarter compared with the second quarter. It was five and 16 inch diameter product generated 33 percent of total gallium arsenide revenue for the third quarter which is about highest we have recorded. Most of this product is purchased by our customers that manufacture devices for wireless handsets. Our growth for this segment coincides with general (ph) industry (ph) observations that the wireless market continues to grow. We expect the wireless market will continue to be our most attractive end use market for the foreseeable future.

We believe that the combination of our BGF technologies, coupled with our early investment in capacity enables us to lead market for six inch substrates in both availability and quality. Manufacturers of HPT and PHAMP (ph) devices used in today's handsets prefer to use BGF material. This preference is even more pronounced among manufacturers that use five and 16 (INAUDIBLE) production line.

We're seeing less growth in other parts of our gallium arsenide business. Early this year, we shipped increasing amount of semiconducting substrate used for applications such LEDs, CD, and DVD lasers. In Q3, the volume of semi conducting products were shipped - declined by about 10 percent compared with the second quarter, but we're still approximately 21 percent higher than during the first quarter. We believed that this occurred because some customers may have made excess orders during the second quarter.

Our indium phosphide business declined from revenue of $1.7 million in Q2 to 1.1 million in Q3. During this third quarter, some of our historically large indium phosphide customer announced further cutbacks in their telecommunication businesses which use indium phosphide substrate. When the indium phosphide substrate business rebounds, we believe we will remain the clear leader in providing this product.

Our joint venture in China through which we are a supplier gallium, germanium and recycled gallium are performing well. Our total investment in this joint ventures was less than $2 million and the provide us with low cost access to 40 tons of gallium, up to two tons of germanium annually. All of this revenue are making a small pocket. And none has required a recent cash outlay from us. As our market rebounds, we will have a secure source of supply for our own needs and current profits by selling the excess production on the market, open market.

During the third quarter, we continue to move more of our production capacity to China where we have a cost advantage over our competition. We're very product of this significant achievement. By then end of Q4, approximately 95 percent of our gallium arsenide production will occur in China compared with approximately 50 percent at the beginning of 2002.

Many customers comment that the product quality we achieved in China equals or exceeds that which we produce in the United States. And almost all of our customers have now qualified our China production. Also, we were recently awarded (INAUDIBLE) 2000 certificate for our China facility.

At our Freemont facility, we're making further cost reductions. Since September 30th, we have reduced our Freemont staff by approximately 35 percent primarily through the voluntary lay off program. These action has reduced our pre tax break even revenue for our substrate business to approximately $12 million per quarter at current price levels. We believe we can be cash flow positive, lower revenue, if we implement our clients to utilize inventory.

We remain confident in our strong position in the compound substrate business. Customers are increasingly switching to BGF product for manufacturing advanced XPT and PHAMP (ph) devices for cell phone and other applications. While we now have more BGF competition than before, we remain a leader particularly for 16 (INAUDIBLE) product. We're pleased that more gallium arsenide users have announced plans to develop 16 inch production lines.

We are also having discussions with two major purchasers of germanium substrates for (INAUDIBLE) applications. They are now testing our samples and we have sent them a proposal to begin shipping product in the early part of second quarter of 2003. Currently, the companies are securing all of their substrate supply from one vendor and are looking to add one additional supply.

Turning to our optical electronics division, we informed you during our last conference call that we expect to ship lower volume to our leading light emitting dial, customer Agilent during the third quarter as we work to meet their production product specification. We have recently provided them with samples of our new hybrid (ph) blue LED product that we announced in late September. We believe the 40 percent improvement in brightness provided by this product would exceed the requirements and the initial feedback we have received from them is positive. They are continuing their test and will make a decision regarding new orders after the tests are completed which should be in early December.

We remain convinced that over time the market for high brightness LED (ph) will continue to grow as LED technology improves and as cost declines. It is replacing existing source of light in an increasing number of applications. This is happening quickly with full color displays, (INAUDIBLE) back lighting and will overtime spread to other applications.

So with all of these challenges and opportunities for our business in mind we are taking definitive steps to improve our efficiency, preserve our market position and manage our cash flow carefully so we can most effectively managing our (INAUDIBLE).

For our substrate business as I mentioned, we have completed our transfer to China and now are performing virtually all phases of our manufacturing operation in Beijing. This has allowed us to reduce our three month staff (ph) to 134 people today compared to 530 at the peak in June of 2000. Our entire substrate payroll cost are now just 37 percent of their level a year ago.

Second, beginning this quarter were taking a more aggressive approach to utilizing our substrate inventory to conserve our cash balances. During past quarters, we have reduced the cost incurred in production by shipping product from our inventory where (ph) we (ph) met (ph) customer specifications.

We're now also recycling working process products for which we are unlikely to receive a near (ph) to (ph) order (ph) into other products for which there are orders. This action will meet customer requirements and conserve our cash.

Finally, we have reduced capital expenditure for the substrate business to approximately for Q4 and believe that our total substrate capital expenditure budget for 2003 will be less than two million.

Turning to the optical electronics. We're managing the business to minimize cash loss while we qualify our new product with customers. We're focused on product quality, cash flow and profitability. We're also making significant operating changes in this division. We recently reduced our operating cost have (ph) relieved (ph) it (ph) by approximately $1 million per quarter from the run rate in place at the end of the third quarter.

We have also implemented other actions to further reduce costs while our customers are testing our new products. Our planned capital expenditures are being cancelled and new ones are being strictly limited. As a result, we anticipate being able to reduce our total cash usage significantly during the fourth quarter compared with the third. As ordered for our new product receipts (ph) we intend to ramp up slowly to our second quarter revenue level of approximately $6 million by adding back expenses, in a manner that conserves cash.

The asset impairment charges that we took reflect the possibility that sometime may be required for us to rebuild our position in the LED business. As a result of the cash conserving strategies that we have put in place, we believe that the cash burn rate will be approximately 40 percent we used to in the third quarter.

But implementing these changes - strategies, we will conserve cash. And we expect we will not need to raise funds. Furthermore, we will place ourselves in a better position to grow and gain market share when the market recovery becomes more certain. In the meantime, AXT will continue to benefit from the strength of our technology from the breadth and depth of our customer relationships and from the experience of our management team. AXT's well positioned to participate in market growth across a wide variety of end user markets and to foster our strategic advantages of our lower cost manufacturing in excess to raw materials.

We'll look forward to reporting to our progress. I will now turn the call back to Don to give you our forward-looking guidance. Don.

Thank you, Morris. We anticipate that consolidated revenue will be 13.5. to 14.2 million for the fourth quarter of 2002. We project that optical electronics revenue will increase to 3.5 to 3.7 million and then substrate revenue will decline to 10 - between 10 and 10.5 million.

We anticipate that gross margins will be negative five to negative nine percent. G&A costs are expected to increase to approximately 5.5 million due to a planned allowance for aging accounts receivable. And R&D expenditures will decline to approximately 1.1 million. Operating loss will be 7.4 to 7.8 million.

Net interest expense an exchange gain in loss will be approximately 225,000. Our net loss will be 7.7 to eight million or 34 to 36 cents per share as we will use a zero percent tax rate. Capital expenditures during the fourth quarter will be approximately two million. Currently, we project that capital expenditures for 2003 will be approximately four million. Approximately 10 million lower than previously forecast for 2003.

Cash used to pay to principal due on out standing debt will be one million during the fourth quarter. We anticipate that we will use approximately 60 percent less cash and cash equivalent assets during the fourth quarter than during the third. Depending on the developments during the quarter and our outlook for Q1, we will be prepared to take further steps to conserve cash if required.

This concludes our prepared comments. Because of the amount of information we covered today, we will post a transcript of these comments on our Web site. We are now happy to answer your questions.

At this time, I would like to remind everyone, in order to ask a question, please press star, then the number one on your telephone key pad. We'll pause for just a moment to compile the Q&A roster.

Your first question comes from Earl Lum (ph).

Earl Lum (ph): Good afternoon, Don, Morris. A couple of quick questions with regards to the return allowances that you have for both the optical and the substrates. I guess we can understand that with some of the issues that you were having with your largest customer in the optical that there would be some allowances. But the substrate allowance, can you talk a little bit about what the issues are with that?

It's - some of it's just normal. I mean we always allow for some return allowances. It's built (ph) been (ph) there (ph) this time. There were some discussions with customers who no longer needed product. And the best way to ultimately resolve it was to allow them to return a portion of what they ordered.

Earl Lum (ph): It this due from supply guarantee contract? Or this is not related to that?

I don't think this is related to a supply guarantee agreement.

Earl Lum (ph): OK. And then if you - I missed a little bit on what you talked about with your debt reduction. You had 5.3 million. Was that for building leases? Or ...

Let me just go back to that section.

I think it was seven something.

I think the total debt reduction was - hang on - 7.7 million, which was 5.3 million of real estate debt and 2.4 million in capital leases.

Earl Lum (ph): OK. And then what is the current situation with your restricted cash? By what definition is that given? And if you look at that versus what your short term cash is that leaves you roughly with 23 million of non restricted cash. Is that correct?

Around that, about 22.

Earl Lum (ph): OK. And in terms of the right downs, the 12 million for your opt to (ph) is that reactors? Or what exactly are you writing down?

It's a general asset impairment charge. We may take a proportion against all of the assets.

Earl Lum (ph): OK.

As opposed to writing down specific assets.

Earl Lum (ph): OK. And then, if you look at where - right now you're currently going through, I'm assuming it's reliability testing through early December. During this time, are you not expecting to have any revenues from Agilent in Q4 until they finish their rail (ph) testing and then make the decision to decide if they want to take that product? What exactly is the situation there now with the new product?

That is true for Agilent.

But we are shipping to other people obviously.

Earl Lum (ph): OK. And then, you will find out then before the end of Q4 whether or not the rail (ph) testing passes and then you can start shipping again theoretically by Q1?

It's conceivable. Anyway, the timetable is really under the control of Agilent. We're estimating it's early December based upon what they've told us so far. It's conceivable that we could be making some shipments to them during Q4 obviously not in great volume.

Earl Lum (ph): OK. And what is the current - with the right downs and everything else that you're looking at you gave us kind of a break even level for the substrate division on an EBIT basis. What are you looking at for the opt to (ph) now?

For break even? It would be around six, probably a little higher.

Earl Lum (ph): Six to seven million.

Yes. I'd say more like six to six-and-a-half.

Earl Lum (ph): OK. And then my last question, and then I'll turn it over to the next person, you mentioned ASP declines kicking in. It seems like it had a pretty decent impact on substrates. Can you talk about what - are we expecting to see continued aggressive pricing into Q4 and into 2003? Or what exactly is going on in the substrate market as you see it?

Well I think the, as we commented on the - in the script that we believe the reduced in revenue was because of pricing pressure. The pricing pressure is, yes, it happened there. But we do expect going into the fourth quarter, it should be firming up because I think it's probably reached the bottom all ready. I mean it's very, very touch out there.

And is this pricing pressure across all different sizes? Or is more predominantly on the larger diameter?

It's probably more on the four inch.

Earl Lum (ph): OK.

Where it is more of a - more mature product.

Earl Lum (ph): But you think that things kind of bottomed out here. And you don't expect a continued erosion like you saw in Q3.

We hope so.

Earl Lum (ph): OK. And just - I'm sorry, Don, just one follow up. Your 12 million assumes that pricing remains stable. Is that correct for the breakeven for substrates?

Yes.

Yes.

Earl Lum (ph): So we - if there is continued to decline than ...

...pushing up.

Earl Lum (ph): ... would be higher right?

Correct.

Earl Lum (ph): OK. Thank you.

All right, thank you.

Your next question comes from Hans Mossesman (ph).

Susan Chin (ph): Hi, this is actually Susan Chin (ph) for Hans Mossesman (ph). I just had a few questions.

One who are the new competitors in BGF? And what is AXT's advantage in BGF versus new competitors?

I think our competitor in the substrate business Sumitomo has BGF product, yet another competitor Fi Burger (ph) from Germany has BGF product.

I believe our advantage over our competitor, first of all we have been in the BGF production for the longest time. We started BGF back in 1986. And we're the pioneers. So we probably gained more experience in production than our competitor. Especially on six inch, we believe we are clearly the leader in that segment of the market, the smaller sizes probably our competitor can probably learn how to do it. But I think in six inch we have better yields and better efficiencies.

Susan Chin (ph): OK. Great. And then I had a couple of more questions. One, were the problems with Agilent brightness related? And then just on a different note, could you tell us what the percentage of your opt to (ph) business is going into wireless handsets?

The - yes, it was brightness related. But the percentage of the product going into the wireless handset, I believe in Q2 while we're shipping the majority of product into Agilent, then the most of the Agilent product was going to wireless handsets.

I think now we believe that proportion has decreased substantially because we're not shipping to Agilent. And a lot of our green and cyan (ph) products are going to full color displays as well as traffic signals.

And we also ship blue products still but that may or may not get into handsets. But, you know, our customers when they are smaller it's difficult to track whether they are serving a specific segment of the market.

Susan Chin (ph): OK. Great. Thanks.

All right.

Your next question comes from Chris Versace (ph).

Hi, guys.

Hi, Chris.

Hi.

Chris Versace (ph): Just a couple of questions. I just wanted to revisit the ASP issue. If I did the math right, it looks like the ASPs were down roughly, nine to 10 percent third quarter versus second quarter. First of all is that correct?

And second of all, can you give us a sense of how, you know, ASPs 2Q versus 1Q for substrates?

Let's see, yes, the nine to 10 percent is correct for the semi - sort of semi insulating. They went down from the first to the second quarter. I'm trying to remember exactly how much. I don't think it was by nearly as much as they did from Q2 to Q3.

Chris Versace (ph): OK. So I'm just trying to get a handle on it here. You know, realizing that there's some ASP pressure here. But are you guys - is it possible that you guys have lost a couple of points in market share here recently in terms of the substrate position?

Well I think that's very hard to call (ph). You know that market is very - right now it's very competitive out there. And then, you know, most of our competitor don't really publish their results on an individual business segment.

Well, that could be an assumption. I mean I think, you know, we - it's hard for us to know.

Chris Versace (ph): OK. And then just, you know, in I guess trying to understand since the beginning of the year, you know, you've really ramped up the China facility. And are you guys internally starting to see the numbers, you know, the benefits? Because, you know, obviously we've seen increasing losses here. I'm realizing it's the revenue side of things. But can you kind of give us an update on the progress and the real benefits you're seeing with the migration of China for the substrate business?

I will let Don give you the numbers, but I can tell you the reduction in work force in Freemont obviously is benefiting us at least into the future. As you know, that labor costs in the United States is much higher in China. And without moving all of the work to China, you just cannot make this kind of a reduction in force, a workforce.

Secondly, I think throughout 2002 while we still have moved a lot of the production to China, but because of the inventory issue, we have to maintain in turn in Chin as well as the United States. So we have to sort of double up in the inventory.

Now virtually all of the move has completed to China, we are now recently shipping all of the inventory into one location that is giving us the confidence that we can more effectively burn (ph) our inventory into the future. I think that's clearly an advantage we can look forward to.

Chris Versace (ph): And you mentioned too Morris, I guess a substantial piece of your customers are now qualified for China.

Yes.

Chris Versace (ph): So we should se more revenue in the next six months than we did even the third quarter coming out of China.

Out of China, well yes, we think so.

Chris Versace (ph): OK. And then you mentioned the mine (ph), the gallium mine (ph) was a source of - you actually - sorry, used some cash there in the quarter. Could you kind of ...

No.

No. Not actually in the past quarter. It was in, I think the last investment there, small investments in Q2, it was probably more in Q1 and even in 2001.

Chris Versace (ph): OK. And then just one other question. Maybe I miss heard, but it sounded like you said that you might have to review your position in the LED business. And I apologize if I misheard what you had said.

What we said was we recorded an impairment charge today. If we get additional information between now and the time that we file our 10-Q that causes us to alter our estimate of the value of those assets, we'll reflect the revised number in the 10-K or the 10-Q, I mean.

Chris Versace (ph): OK. So it's not as if you're saying you might exit the LED business.

We did not say that.

Chris Versace (ph): OK. Just wanted to make sure. Is there any thought to migrating, start to migrate some of that business over to Asia in terms of the production?

Well we sort of have that strategy put in place early this year. But we have since put a stop to that because as, you know, migrating a business manufacturing process to China will take money. And because of the business it's turning to be more challenging. We realized that conserving cash is probably more of a challenge for us. So we - we're now delaying our move to China.

Chris Versace (ph): OK. And one last, I believe Axtron (ph) had announcement out this morning that they were going to be starting to use eight inch gallium arsenide MOCBD reactors. Are you - where are you guys in the eight inch platform?

Who is using?

Chris Versace (ph): They said that - Axtron (ph) says it's making available reactors that will work with eight inch substrates for gas. So I'm just ...

Well that's quite different than a device manufacturer having announced an eight inch production line. I think right now my take is that the majority of the device makers are slowly migrating to six inch. As you know that R&D (ph) doesn't - is not working on six inch yet, and they will migrate to six inch and so will Sky Work (ph). They probably delayed their migration to six inch.

So I think this generation of moving to six inch will take awhile. And as the industry is sort of recuperating from the downturn, I think migrating to eight inch, to my best estimate will take a while. I think it's going to be at least three to four years before we start to see some work starting on the eight inch.

Chris Versace (ph): OK. Thank you, gentlemen.

Thank you.

Your next question comes from John Lao (ph).

John Lao (ph): Hi, Morris.

Hi, John.

John Lao (ph): How are you doing? I wanted to know if you can give us some more color on what you feel the inventory in the channel is for your gallium arsenide wafers, given that indicating that you had a lot of that in the wireless application. Is it pretty clean out there? And I have a follow up on the LED. Thanks.

I believe the inventory is quite lean. As indicated by most of our customers when they want product they want it in a hurry. So we believe that's the case. While we commented to potentially down the LED side for the red and yellow LED the substrate may have an inventory issue but it was a very small one. I think the correction was only about 10 percent decline. But as you know perhaps we can categorize by saying it's not growing wildly. I mean those are products which are in general industry used.

So we believe the inventory is relatively lean.

John Lao (ph): And you had indicated that for the reds and the yellows, would that be the semiconducting wafers.

Yes, that's semi conducting gallium arsenide substrate.

John Lao (ph): A little bit of access over there. And then finally, if you can go through some - in terms of the greens that you have over there, you had indicated that a lot of that was for the traffic and the signs.

Yes.

John Lao (ph): How is that growth going from the other additional customers that you're having right now? Are you continuing to see growth in the traffic and sign markets?

Yes, we believe so. I mean we have great demand for the green product. In fact, I think we have been saying all along that our green product is actually among the leader in the whole industry. We not only have a very high brightness product in green, in cyan (ph) but also our product reliability really stands out among the industry leaders in the LED industry.

So we see we - our product is penetrating let's say the traffic sign in China very nicely. And also the food color display market in China is booming. And we believe a lot of our green product goes into those applications where not only the brightness - high brightness is needed but also the reliability. Because you don't want to build a very large sign where some of the LEDs doesn't work.

John Lao (ph): And the packagers for those green products to the Asia Pacific areas, also in Asia?

Yes.

John Lao (ph): OK. Thank you.

Thank you.

Thank you.

At this time, I would again like to remind everyone, if you do wish to ask a question please press star then the number one on your telephone keypad.

Your next question comes from Dave Cane (ph).

Dave Cane (ph): Yes, thank you. A couple of quick questions first. Can you talk about the availability of credit facility? I know you've paid it down but if things get a little dicey can you get one of those credit facilities? And any potential asset sales plan to raise cash? Thank you.

As we announced, I think it was in Q2, we retired our line of credit. And are not in negotiations at this point to renew one. We obviously do have assets particularly in Freemont we have real estate assets that we could sell if we thought the need was sufficient.

Dave Cane (ph): OK. Going back to the LDD operation, can you jus talk about your strategic plan going forward? What I mean by that is assume that Agilent doesn't came back in December and, you know, stick with whatever they have, you know, what is your plan then?

Dave, I think we are working very hard on, you know, improving our product quality, improving brightness. We are also working with other customers to qualify our product. We are also, of course, very much in mind, of aware that our cost and burning cash is the issue. So we have a reduced work force over there. But our foremost, most important thing is develop a high quality product which we have now (ph) managed (ph) that 40 percent by this improvement.

But, you know, it takes a little bit of time for our customer to qualify our product. But in the meantime we will conserve cash and it starting to develop other customer relationship and selling to other channels. If, you know, Agilent doesn't really come back in any time soon.

Dave Cane (ph): OK. Going back to the ASP situation, since you implied that ASP should firm up this quarter, and yet in your guidance you expect substrate business to decline, does that mean shipments will decline in the fourth quarter?

Yes, it could. But I think it's a combination, I think, you know, although we said the ASP will firm up, you know, in making production, you don't know which one is coming to hit you. But we think this is a very firm number all ready.

But Dave, we do believe that most of the decline in the substrate revenue is going to come from lower sales of raw materials as opposed to lower sales of substrates. I mean there will be some of that, but this is mostly a raw material sales reduction.

Dave Cane (ph): So do expect, you know, gas substrate revenues to be up? Or at least be flat this quarter then.

You know, flat to maybe slightly down.

Dave Cane (ph): OK.

But not as much probably as reflected in the overall percentage decline for the substrate business.

Dave Cane (ph): Right. What about maybe at the high end, like five, six inch. I mean even will that go down this quarter? Or will they be, you know, firmer than compared to like a four inch products? Or is it too much granularity there?

Yes.

Yes, well you know right now the orders are very much - the - business is the greater portion of our business. I mean I think we've managed to last for three quarters through. We think we have high confidence we will be able to achieve that. But there's really no - we don't have a firm ordering hand, let's put it this way.

Dave Cane (ph): OK. And just lastly a couple of more. I thought some of your competitors exited the market, so I guess that's where I'm - I guess I'm a little bit surprised to hear that there's so much competitive pressure. And lastly, on tax rate, why is it going to be zero this quarter? And why did you incur tax expenses rather than tax benefit in the last quarter that you just reported? Thank you.

Well the first thing, the competitor that went out of business last year was one of our relatively smaller competitors, the larger competitors, certainly Sumitomo certainly remain active.

With regards to the tax charge, we concluded that at this point there recoverability of the tax, the deferred tax asset we had been - we would otherwise have built this quarter, we couldn't be certain as to when we could recover it. So the appropriate accounting treatment is to take a - sort of to reverse the tax benefit we accrued in the last quarter and to go with a zero tax rate going forward.

Now the benefit this will have for us when we become profitable is that that tax - deferred tax benefit still remains on the books, it's just offset by an allowance. And as we become profitable we'll continue to have zero percent tax rate for some period of time.

Dave Cane (ph): Since you mentioned, you know, being profitable, any guess to, you know, in terms of time frame as to when you'll become profitable?

No, we've not given any guidance for that yet.

Dave Cane (ph): OK. At least I should've tried, you know. Thank you.

Your next question comes from Jason Sam (ph).

JASON Jason Sam (ph): Hey Don. Hey Morris.

Hi, Jason.

Hi, Jason.

Jason Sam (ph): Hey, just a couple of questions. First, I missed the indium phosphide for Q3. Was that 1.1 million? Was that right?

Yes, 1.1.

Yes.

Jason Sam (ph): OK. And what was your cash burn for Q3?

Inclusive of the relatively high amount of debt repayments it was 16.8 million.

Jason Sam (ph): OK. And, assuming that Agilent did qualify your new -, in early December what would - when do you think you would be able to ramp up? If, you know, they did reach the internal goal?

Well we believe that really depends about when do they tell us. I think if they tell us tomorrow or mid November.

Jason Sam (ph): I was assuming you said early December that you ...

Early December is when we expect them to tell us. But then, you know, if they tell us by early December. But if they don't give us any warning when they tell us then it will take us about a week or two to start ramping up the production for them. But usually, you know, if they have any inkling things were going OK, then probably they will give a heads up then we can probably shorten that timeframe. So then we have a whole month of shipment we can ship to Agilent.

Jason Sam (ph): I see. And, you know, obviously you expect to hear from them in December. I mean right now I, you know, kind of I assume that the products you give them they're sort of, you know, hitting whatever it is that they're testing. What does there remain to be test that ...

We believe they like the brightness. We believe the - perhaps one of the other gaining factor is reliability.

And that you can only test by essentially a lifetime test.

Right.

Or, you know, a time test.

Jason Sam (ph): OK. Is that the 1,000 hour kind of a thing?

Yes.

Yes.

Yes.

Jason Sam (ph): OK. Great. And just revisiting the ASP question real quick, I'm still having trouble sort of, you know, understanding the ASP drop for the quarter, if you could help me real quick. What I want to know is, you know, if inventory is not a major issue out there, you know, being driven by your competitors to lower prices so that you will lose business? Or are you actually lowering prices proactively so that as you're in the middle of blowing out some inventory that you're actually driving the price decline? Can you talk a little bit about that?

I think it's the former. I think, you know, in this very testing market, I mean there are customer who just keep on driving the price down. And, of course, we also here that one particular competitor is very aggressive in their pricing so that they can survive because they don't have a better technology than we do. But this is the rumor we here.

And they're - but our - some of our customer always show us and say, you know, this is the quote I got from the other guy. And so can you match it? If you don't, you know, see you next quarter. You know, obviously we need to either match that or we tell them, you know, we have a better quality product. We also have to make a profit. But, you know, this is a very challenging time.

But I believe, Jason, I think, you know, I think we realize this market is challenging. And we are making all of the moves to lower our costs. I think this is within our control. I think it's fortunate. We're proud to say that we have put the China facility in place. And with the increasing pressure from pricing we are making that move very definitive and very forcefully to make the move to China.

And let's face it, I mean as far as customer is concerned, they don't necessarily applaud (ph) to the action. They much rather we are still shipping from the United States and still give them a good price. So we are suffering a little bit from that. I mean if that's any, you know, customer sentiment.

But the bottom line is I think some of our customers are also telling us that China product quality is actually better because many reasons. You know, the quality of workforce over there is higher. And, you know, there are more room that we can manage our production environment better. And now we can also reduce our inventory better to move to China. So I think all of those moves is going to benefit AXT in the coming year. And we will be the most competitive manufacturer of compound semiconductor substrate period.

And, you know, and our competitor, although they started to learn BGF as well, and, you know, also we said BGF is now becoming the dominant technology. Everybody wants BGF technology nowadays. And now they've learned our trick a little bit, but hopefully we still have a lead over the on the six inch product. But they have no idea how to move to a low cost manufacturing center yet. As you remember, it took us a good three years to move all of these production facilities to China. It's a painful move, but we completely did it. And for our competitors to compete with us in equal footing they also have to do the same thing over - hopefully over three or four years.

Jason Sam (ph): OK. Now as you're sort of aggressively lowering your inventory for the coming quarters, are you going to be, you know, more proactive on price? Or are you, you know, are you pretty much sort of waiting to see what the market is going to do before doing anything?

In other words, are you going to put pressure on your competitors?

Well think the price is plenty good. It's a very good price all ready. And we think, you know, I think we should be able to - but of course, Jason, this is independent. We will have to meet our customer and then talk to them and see what we can do for them. I mean hopefully there we can have a win-win situation. Hopefully it's not only day (ph) we (ph) lose (ph).

Jason Sam (ph): OK. Last question, regarding the market share, I mean you give the notion that there might be possibility that you might lost some business. Are you seeing concrete evidence that you lost business in terms of losing orders to the competitors because of the pricing? And do you think that's temporary that you could get it back? Or is it, you know, pretty tough once you lose that business?

In wireless handsets market, I believe a number of our customers are - some of them are very much price driven. I mean our sales force will tell us, you know, end of quarter, and they say meet this price. And if you don't it will go to the competitor if they have - if the competitor also qualify in their facility.

For those businesses, if we were to lose it, we can obviously get it back if lower the price too. So it's tit-for-tat. One call (ph) we gain and the other call (ph) they gain. But I think the fortunate thing Jason is that, I think not everybody has the same BGF product. And I think other product differentiation mode is perhaps six inch we are stronger.

Jason Sam (ph): OK. Thank you.

Thank you.

Your next question comes from James Cue (ph).

James Cue (ph): Yes, good afternoon Morris and Don.

Hi, how are you?

Hi.

James Cue (ph): OK. I have a few questions. For the high brightness LED, you mentioned a 40 percent increase in the brightness. Right now, can you comment what are the yields? Is that yield is OK? Or is a pretty (ph) no (ph) for the moment?

The yield is quite good. I think what's the testing requirement for us is that we are migrating some of our MOCBD to the high brightness. We obviously achieved the high brightness in one or more CBD. We're moving all of the production to be able to manufacture high brightness LED of that same quality and same high brightness.

And I think last I know, we have qualified the second one. But we will obviously need more - a little bit more time to migrate that higher finance platform to all of the other production tools.

James Cue (ph): So what you say is a one machine, you can produce the high brightness LED from one of the machine? Now the second machine can do it.

Yes.

James Cue (ph): And how many more machines do you have?

We - well actually have never announced how many production tools we have. But I can tell you, I think the experience with HAP (ph) is that once you can do two then our confidence levels is quite high that we can migrate that process because we understand how that process works.

James Cue (ph): OK. So it's more like basically the other machine just use kind of copy exactly just like a recipe chain (ph).

Right. But - although it's not as simple as just copy otherwise LED would be very easy to make. I mean there are challenges in production.

James Cue (ph): OK. You mentioned earlier you will not move the LED production for maybe the testing to China. So in that way, your cost advantage here basically is the substrate. You don't - on the labor side you would be the same as other competitors, is that right?

Yes, unfortunately in that short time that's the case, because in moving all of this production will require a lot of resources which we think is going to be in short supply in the near future. So we will not embark in that move. Rather, we want to produce high quality product, although, perhaps a smaller quantity to begin with and conserve cash. And maybe seeking profitability first.

That is you can still do by the way because, you know, if you have brightness improvement you don't have to lower your price or potentially you can even increase your ASP. And that, you know, as you know high brightness LED the selling price really depends on what kind of brightness you can deliver. And also the color, green color and cyan (ph) color is more expensive than the blue. The blue seems to be the commodity of the LED product.

James Cue (ph): OK. That's good. Also, since there are, you know, some worries about your inventory can you, you know, break down say how much inventory right now you have in LED? How much of that is in say gallium arsenide? How much is in raw materials? How much is in indium phoshide?

Right. I don't have all of that information with me. I will tell you in summary that of the $50.6 million that we have in inventory probably no more than four is related to the LED business or the whole optical electronics business.

And of the remainder, the vast majority is for the gallium arsenide portion of our business. But I don't have the breakdown with me of how much is raw material, work in process and finished goods.

Something - I think roughly 40 percent is in raw material in the gallium arsenide.

James Cue (ph): OK. So the really - if there is anything, the only thing really we should worry is the full (ph) meaning (ph) in the LED?

Well and we think we've valued that quite conservatively. That's one of the reasons that their gross margin is appearing (ph) as (ph) negative because we took an above average reserve against those products.

James Cue (ph): OK. The other thing is, you know, a lot of questions is asked regarding the ASP. Can you just give us a simple idea, say in terms of volume, maybe it's clear (ph) inch (ph) of error. Say how much gallium arsenide you shipped in the second quarter? How much you shipped in the quarter? Or maybe jus give us say in terms of a percentage change?

Well we've talked about a percentage change for gallium arsenide prices. We don't disclose actual price levels.

James Cue (ph): I mean the change in the volume.

The change in volume, I thought we said the volume was about the same from Q2 to Q3. But the decline in revenue was caused mainly by the price decrease. I think now we also have an analysis saying the gallium arsenide substrate price dropped about 30 percent from the peak ...

From its peak in 2001.

Yes.

James Cue (ph): OK. The other one is a simple one. I just didn't get the number for the SGA for the fourth quarter. What is that number again, I'm sorry?

OK. We're projecting 5.5 million. And that includes a planned allowance for aging accounts receivable.

James Cue (ph): How much is there allowing for account receivable?

It's going to be probably about one-and-a-half million.

James Cue (ph): And why is that? Some customers cannot pay? Or what's the reason?

Well we think that a number of our customers may be having some difficulties or may pay late. And so we have a typical policy of reserving an account if it goes over a certain amount of aging.

James Cue (ph): So this almost - I mean it's all ready amount due?

No it's not yet, but it - we're working with our customers to pay it. But it would go over the level during Q4 if they don't pay us.

James Cue (ph): I see. OK. Thanks a lot.

Thank you.

Thank you.

Your next question comes from Pierre Macognos (ph).

Pierre Macognos (ph): Hi, Morris, Don.

Hi, Pierre.

Pierre Macognos (ph): My batteries in my cell phone might cut your communication, so if that happens, excuse me, OK. In terms of the substrate revenues what - at this point, what percent of it is it wireless and what percent of it is LED?

I thought the five inch, six inch was all wireless right.

And most of the four...

And most of the four.

It's probably more than 60 percent wireless related at this point Pierre.

Pierre Macognos (ph): OK. And would it be right to say that most of the ASP decline is coming from the wireless?

Yes.

Pierre Macognos (ph): OK. And in terms of the LED are you still continuing with you plans to increase capacity there?

No. We have, as we said in the script, we have cancelled orders. And we have put cap ex in to a very strict diet. We believe that we need to consolidate our business, and then try to see if we can improve our brightness. We can still, you know, improve our performance by reducing our cost not to spend too much money on new equipment. But the equipment we've got all ready should be able to allow us to deliver more than $16 (ph) of revenue as we said in our script, in the LED business as you know that we have all ready put those production equipment in place.

And that approximately should give us the break even operation in the LED business.

Pierre Macognos (ph): And right now, your utilization in the wafer and the LED business, what would that be?

Utilization for the substrate I would approximately say it could be around 25 percent, a little higher perhaps. But any (INAUDIBLE) lower maybe down to 15 percent. And in the LED business I think we should say around maybe 50 percent.

Pierre Macognos (ph): OK. Great. Thank you so much.

All right.

Thank you.

Your next question comes from Earl Lum (ph).

Earl Lum (ph): Yes, guys, I just had two quick follow ups. Morris, you said that by the end of Q4, 95 percent of your gas production will be based out of China. Does that mean that you've all ready transferred pullers - crystal growers over to China?

Yes, some of them have gone there all ready.

Earl Lum (ph): OK. And with regards to the turns business and your visibility can you give us an idea of what was in Q3 that was turns? And what do you expect in Q4? Are we expecting to see an increase in the turns business in Q4?

Not really the percentage.

Earl Lum (ph): And can you give us a percentage of what it was in Q3?

Probably 40 percent as the turns or 50 percent. Yes, 50 percent.

Earl Lum (ph): OK. So almost half. So at this point going in to Q4, then could we assume that you're kind of booked for half of your revenue. And the other half is assume that it's going to be turns.

Yes.

Earl Lum (ph): OK. And then finally, with the burn (ph) in (ph) that's going in on Agilent, have you all ready done your internal reliability qualification?

Yes.

Earl Lum (ph): Is that going on in parallel? Or can you let us know exactly what is going on with that? Or are you just waiting for the results to come back from Agilent?

Well, we obviously doing our burn (ph) in (ph) cash but we don't know exactly what do they do. I mean we think it's similar. But, you know, the internal qualification we believe the product is OK.

Earl Lum (ph): OK. So you pass your own internal qual and now you're waiting for Agilent to do their specific specs and everything for their qual.

Right. But they could have different specs.

Earl Lum (ph): OK. And then Don what do you expect - this is my final question - what do you expect the cash burn to be in Q4?

I probably said it would be about 60 percent less than it was in Q3.

Earl Lum (ph): OK. Great. Thank you, gentlemen.

Thank you.

Thank you.

Your last question comes from Chris Versace (ph).

Chris Versace (ph): Hi, guys. Just a couple of quick follow ups or nits (ph) here. I know we're going to have in the guidance you said a zero percent tax rate in the fourth quarter.

Right.

Chris Versace (ph): And early thoughts on what the tax rate is in '03?

Zero.

Chris Versace (ph): Zero percent for the whole year?

Right.

Chris Versace (ph): OK. And then just one other one, if we assume that ASPs and the substrate business are flat, we know it's 12 million break even there, what's the total break even level for the company now?

Well you assume that the optical electronics business is around six, that would put it at about $18 million at current price levels.

Chris Versace (ph): OK. And then as we look over the next one to two quarters, given everything you guys are working on, where would you hope to see the greater margin improvement or margin start to move up earlier, which of the two segments?

Probably opt to (ph). I think, you know, as we migrate into shipping more green product that will improve our profitability buy in. Also brightness, if you can ship high brightness product the price can go up.

Chris Versace (ph): OK. So I mean is it conceivable, and I don't want to put words in your mouth but it's possible the substrate business runs at a modest loss or almost break even in the next one, maybe two quarters?

Yes, but I think the opportunity for the substrate is that we think we have a lot of opportunity because the move to China is not complete, we can start really aggressively burn (ph) our inventory which will help our cash position very nicely. And also, you know, the efficiency as, you know, if you operate from both sides the efficiency is not high. I mean we - from Q4 onward we believe this is going to be the first opportunity we'll be operating in one location. We hope to see greater efficiency improvement in the substrate business too.

I mean there are still yield improvement we can gain from the substrate division. And so I think the challenge on the two business is actually different.

Chris Versace (ph): OK. Thanks, guys.

Thank you.

Thank you.

At this time, sir, there are no further questions.

Thank you for participating in our conference call. We look forward to speaking with you again, soon.

This concludes today's conference. You may now disconnect.