AXT Inc (AXTI) 2018 Q3 法說會逐字稿

Good afternoon, everyone, and welcome to AXT's Third Quarter 2018 Financial Conference Call. Leading the call today is Dr. Morris Young, Chief Executive Officer; and Gary Fischer, Chief Financial Officer.

My name is Lauren, and I will be your coordinator today. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn the call over to Leslie Green, Investor Relations for AXT. You may begin.

Thank you, Lauren, and good afternoon, everyone. Before we begin, I would like to remind you that during the course of this conference call, including comments made in response to your questions, we will provide projections or make other forward-looking statements regarding, among other things, the future financial performance of the company and our ability to control costs, improve efficiency, increase orders in succeeding quarters, improve our competitive position in the market, our schedule and timeliness regarding our relocation plan, our thoughts on air pollution in Beijing, global, economic, and political conditions including trade tariffs and restrictions, our ability to meet market demands for our products, as well as other market conditions and trends, including expected growth in the markets we serve.

We wish to caution you that such statements deal with future events, are based on management's current expectations, and are subject to risks and uncertainties that could cause actual results or events or results to differ materially.

These uncertainties and risks include, but are not limited to, overall conditions in the markets in which the company competes, global financial conditions and uncertainties, potential tariffs and trade restrictions, increased environmental regulations in China, market acceptance and demand for the company's products and the impact of delays by our customers on the timing of sales of products.

In addition to the factors that may be discussed in this call, we refer you to the company's periodic reports filed with the Securities and Exchange Commission and available online by link from our website for additional information on Risk Factors that could cause actual results to differ materially from our current expectations.

This conference call will be available on our website at axt.com through July 25, 2019.

Also, before we begin I want to note that shortly following the close of market today, we issued a press release reporting financial results for the third quarter. This information is available on the Investor Relations portion of our website at axt.com.

I would now like to turn the call over to Gary Fischer for a review of our third quarter results. Gary?

Thank you, Leslie, and good afternoon, everyone.

Total revenue for the third quarter of 2018 was $28.6 million. This compares with $27.1 million in the second quarter of 2018 and $28.2 million for the third quarter of 2017. This represents year to date growth of approximately 9% over the same period in 2017.

Of our total revenue, substrate sales were $22.8 million compared with $21.6 million in the prior quarter. Revenue from our raw material joint ventures was $5.8 million in Q3 compared with $5.5 million in Q2.

In the third quarter of 2018, revenue from North America was 11%, Asia Pacific was 72%, and Europe was 17%.

In the third quarter, one customer reached 10% of revenue and the top 5 customers generated approximately 39% of total revenue. Gross margin in the third quarter was 37.1%, compared with 40.6% in the prior quarter. Our substrate products held their own in terms of gross margin but our 3 consolidated raw material companies each had a quarter-to-quarter decline. That plus the fact that Q2 had about a 1% incremental upside from the sale of material previously written off account for the change from Q2 to Q3.

Total operating expenses in Q3 were $6.3 million compared with $6.5 million in Q2. Operating expenses continue to be in line with our run rate expectations for the year. Total stock compensation expense for the third quarter was $461,000. Operating profit for the third quarter of 2018 was $4.3 million compared with $4.5 million in the previous quarter and $5.2 million for Q3 of 2017.

Interest and other income for the third quarter was a net gain of $200,000. This number consists of 3 categories: 1, net interest, which we earned $100,000; 2, equity accounting on our unconsolidated joint venture companies, which broke even; and 3, a foreign exchange gain of $100,000.

The tax provision in the third quarter was $410,000 compared to $367,000 in Q2. I do want to take a moment to talk about the U.S. tariffs with China. In the tariff list that was released by the United States government on September 24, 2018, it included wafer substrates that we manufacture and import to the United States. Therefore, our Q4 2018 forecast will include approximately $150,000 for tariffs of 10% charged on importing wafers into the United States from China.

It has been said that president Trump might raise the rate to 25% in 2019. These amounts are not what we would consider to be dramatic hits. Nevertheless, they are real and will have an impact going forward unless the 2 countries can sort out and resolve the trade war issues.

For Q3 2018, we had a net profit of $3.9 million or $0.10 per share. By comparison, we had a net profit of $3.9 million or $0.10 per share in the second quarter of 2018 and $4.4 million or $0.11 per share in Q3 2017. The diluted share count in Q3 was 40.331 million shares.

Cash, cash equivalents, and investments closed at $42 million as of September 30. By comparison, on June 30, it was $54 million. The primary reason for the decline was the new facility and equipment.

Depreciation and amortization in the third quarter was $1.2 million and capital expenditures were $12.7 million.

Accounts receivables net of reserves were $23.3 million as of September 30, 2018, compared with $22.4 million as of June 30.

Net inventory at September 30 was $58.7 million compared with $57.0 million in inventory at June 30. Ending inventory consisted of approximately 51% in raw materials, 44% in work in process, and only 5% in finished goods.

Okay, this concludes the financial comments. I'll turn the call now over to Dr. Morris Young for a view of our business. Morris?

Thank you, Gary and good afternoon everybody. We continue to execute solidly in Q3. Our revenue and profitability came in at the high end of our expectations, highlighting demand for our products across a diverse set of applications and our ongoing effort to drive efficiencies in our business.

Many of the key applications into which we sell appear to be in the early stages of a long and promising lifecycle. We're also encouraged to see new emerging applications that are likely to contribute to our growth for years to come.

As such, the relocation of our gallium arsenide germanium manufacturing lines is providing us the opportunity to plan for growth in our industry and to prepare our business to meet increasing customer demand.

Now, turning to our markets. We achieved another record quarter in indium phosphide revenue in Q3 with relative strength in all of its primary applications. In particular, demand for silicon photonics based applications such as datacenter connectivity grew from the prior quarter.

This is coming as a result of a substantial increase in the volume of global network and datacenter traffic that is driving the need for a more cost effective, energy efficient, and higher bandwidth solution.

We believe that the continued adoption of silicon photonics technology in hybrid center, hybrid scale, and enterprise datacenters as well as the transition over time to 100g and 400g technologies will fuel the need for indium phosphide for years to come.

In addition to datacenter connectivity, the current infrastructure upgrade cycle in preparation for 5G in telecommunication applications are providing opportunities in short haul, long haul, and metro deployments. As another data point for the expected growth in this application, Intel announced in Q3 that it has become sampling a new portfolio of 100 gigabit per second silicon photonics transceivers that are optimized to meet the bandwidth requirement and the front haul environment conditions of 5G communication infrastructure.

The industry move to 5G along with a ramp in existing network traffic for services such as video streaming is likely to strain the existing communication infrastructure. As a result, it will need to support expanded spectrum range over time, driving demand for more efficient solutions.

Beyond silicon photonics, power applications contributed meaningfully to our record Q3 indium phosphide revenue. As expected, PON sales were down from Q2 following a very strong first half and this is likely to continue through Q4.

This market trend tends to be somewhat lumpy quarter-over-quarter. The power applications should provide significant opportunities for our indium phosphide over many years.

Driving the demand is the ongoing need for faster broadband networks and increasing fiber to the home requirements. In a report published in August, [Elorio] indicated that it believed the global PON market to be on track to grow at a 5-year compounded annual growth rate of nearly 40% by 2017 to 2022, driven by the adoption of next generation PON technology such as 10 gigabit per second EPON and AXT is now well positioned in this market and supplies virtually all the major customers.

Q3 was also a growth quarter overall for our gallium arsenide business, driven by increased revenue by semi-insulating substrates. While wireless application streaming has been remarkable, we saw contributions from the emerging use of thin film gallium arsenide based solar cells. The reduced weight and ongoing progress in energy efficiency making these solar cells effective for extending the flight time of drones and other types of unmanned aerial vehicles.

This technology is similar to what we have seen used in certain automobiles to expand battery life. Our experience with the emerging solar cell application is that this demand is lumpy but the expansion of its use in multiple industries such as that its adoption will likely to grow over time.

Growth in the semiconducting gallium arsenide substrates are offset somewhat in Q3 by weaker demand conditions in LEDs. Based on the discussion with customers in this space, we expect a softness in our traditional lighting, signage, and display applications to persist in Q4. It's worth noting that we're beginning to see more meaningful contribution from Android based 3D sensing. To date, this year, our revenue have reached nearly $1 million from 3D sensing programs in Asia. Though the commercialization of the technology in the Android ecosystem is still in its early stages.

We expect that revenue will ramp slowly over the course of 2019 and into 2020 as new devices come to market. In addition, with the technology performance of our wafer and the solid progress we are making in relocating our gallium arsenide production line, we're positioning ourselves to expand beyond Android in the coming years.

Given the many applications of 3D sensing technology, we believe that it will represent a great opportunity for all high-end substrate manufacturers for years to come.

Broadly speaking, gallium arsenide is continuing to experience a period of renewed innovation with a number of new applications being developed to take advantage of its new unique opportunities, applications such as augmented and virtual reality, 5G wireless, LIDAR for other autonomous cars, (inaudible) and many others are emerging and will require the performance characteristics and adaptability that gallium arsenide offers.

Most recently, we have seen rising demand for gallium arsenide in high-powered fiber lasers that supplement traditional cutting, welding, and drilling tools for industries, micro fabrication, aerospace, and defense applications. The stringent technical specifications for these high-end applications continue to serve to severely limit the number of companies that can provide substrate in enough volume to meet global demand.

And importantly, as demand for these applications increases, AXT will be uniquely positioned through our current capacity expansion to accommodate the growing requirement of our customers.

As an update on our relocation, I'm proud of the work our team is doing to execute this significant undertaking efficiently, while ensuring that the need of our current customers remain the forefront of our focus. Every quarter, we put behind us it diminishes our execution risk and moves us closer to the supporting the next leg of industry growth with new, modern facilities and plenty of room for expansion.

As we have said, our ongoing strategy is to complete the move in a measured and incremental way in order to provide a seamless transition for our customers while ramping up to meet the increasing demand. For the end of this year, we expect to have relocated approximately 60% of our wafer production and expect to be close to completion by the middle of 2019.

We are now well under way with customer qualifications, including all of our major customers. Further, our internal qualification results to date demonstrate consistent specification across of our sites, which gives us the confidence that those remaining customers who require qualification will find quality levels that are on part with substrates made from our current facility.

Turning to germanium substrates, as expected, this area of our business was a bit down in Q3 coming off several strong quarters. Overall, the (inaudible) industry is expected to continue its positive trend, providing us with upside opportunities in the quarters to come.

And finally, raw material revenue increased modestly in Q3 with raw prices holding relatively stable. The continued relative health of our partially owned raw material companies allow us to be breakeven with the 7 that we account for using the equity method. The additional 3 that were consolidated contribute to our profitability in Q3.

It is important to note that the benefit to rising raw material prices for our joint ventures is offset somewhat on the substrate side of our business by higher cost of our cost of goods sold. But on balance, this unique vertical integration provided tremendous value in managing the market dynamics for the materials that are critical to our manufacturing and offers certain volume and cost advantage that will aid in our competitiveness.

Now, in closing, 2018 has been a critical year of execution for AXT. Our success to date in driving growth and profitability in our business while undertaking the construction of 2 new facilities and the relocation of our gallium arsenide and germanium production lines demonstrates the talent and dedication of the AXT team. And though our work is still underway, we look forward to the coming quarters for measured optimism and a firm belief that we are positioning ourselves to benefit from the numerous opportunities that are taking shape in front of us.

This concludes my prepared comments. I will now turn the call back to Gary for our fourth quarter guidance. Gary?

Thank you, Morris. We expect to see revenue in Q4 of between $26.5 million to $27.5 million. We remain confident in a gross margin going forward of around 37.5%. However, in this Q4, we believe we will be lower than that as a result of a drag from the 3 raw material companies that we consolidate as well as some yearend inventory adjustments.

As a result, we believe our profit per share in Q4 will be in the range of $0.05 to $0.07 based on 40.431 million diluted common shares outstanding. Okay. This concludes our prepared comments. Morris and I will be glad to answer your questions now. Lauren, the operator?

(Operator Instructions) Our first question comes from Richard Shannon with Craig-Hallum.

Maybe I'll ask a question on the fourth quarter sales guidance here. A little bit down sequentially. I wonder if maybe at a high level, Gary, can you help us understand the moving parts here by the 3 major substrates as well as raw materials?

The substrate guys -- I mean the raw material guys will probably be flat plus or minus a little bit. No big change there in the revenue side. On the wafer substrate side, Morris could chime in here to help out but generally, as you know, Richard, Q4 is typically a bit down from Q3 and we were hoping that this year might be different, but it's not going to be.

So it is a general softness. On the LED side, we've seen some softness and generally, we're just -- we think that the revenue for no big specific reasons, but it's going to be less in Q4 -- less in Q3.

Just a volatile category I think in substrates are down slightly. Indium phosphide, we were hoping for it to continue to grow but then we had a very good quarter in Q3 and so we're a bit cautious on its continued growth. And in semi-insulating, I think things are bit soft as well and Gary just said about semiconducting.

So just about every category. Other than the JV business I think it's going to be sort of flat. Otherwise, everybody is down slightly.

Would you attribute this to similar reasons we've seen a lot of other quarters reporting so far this season about general macro weakness? Or Gary, I think you said you're not seeing any specific customers. I just want to make clear that there's no specific customers and/or geographies that you are seeing some of this weakness from.

Right, I think that's accurate. It's a general softness and you could say at least part of it is macroeconomic but part of it is cyclical and seasonal for AXT because we generally don't have a strong Q4 revenue number.

And I think the other thing is this. We do have our own way of coming up to this guidance number. They do change is -- we collected data from our sales people and as they start to see some industry softness, they need to be slightly lower in their forecast. Everything, if it is down 5% then that's what contributes to the softness in the overall.

Okay. Let me ask a question on gross margins. Gary, I heard your comments about the confidence in 37.5 overall here, but this quarter you got dragged down here. I didn't have enough time to try to run this through my model real quickly. So wonder if you can give us a sense of how much lower you're expecting that.

And then how much of it are you expecting from the tariffs that you mentioned earlier in your comments?

Okay, so --

Hello, Gary, are you still there?

Are we cut off?

Guys, can you hear me? This is Richard.

We can hear you. Can you hear us?

Okay. You went blank for about 25 seconds. I didn't hear a thing after my question.

Can you hear me now, Richard?

I can hear you now, Gary.

Okay. Let me repeat. We didn't touch anything in this room so it must be the gremlins for Halloween out there playing tricks on people. So for gross margin, we're saying for this quarter --

Guys, I don't know if you can hear me. The gremlins are active to say the least. You just came back in again.

How about now?

I can hear you now but as soon as you started to answer my question, it went out for 10 seconds.

Must be my voice is haunting the ghost. Okay. So about Q4 gross margin and about Q4 tariffs. Gross margin will be around 35% on my model plus or minus something and then on the tariffs, I'm using $150,000 each quarter if it's 10%. We don't know what the President will do in 2019 but it's reported that he has said he's considering to raise it to 25%. So neither of those numbers --

(technical difficulty)

And pardon me, this is the operator. We are experiencing some technical difficulties. Please stand by. Your conference will begin momentarily. Once again, we are experiencing technical difficulties. Please stand by.

And pardon me, speakers, are you able to hear and speak now?

I can hear you fine. Can you hear me?

Yes, I can hear you as well.

And Gary, I can hear you too.

Morris, you wanted to say a test.

Okay. Test 1, 2, 3, Morris. Can you hear me okay?

I can hear you Morris. Thanks.

I can hear everyone okay as well and Richard, you are still in the queue. Can you still hear us all as well?

I can hear you as well operator. Thanks.

Okay, perfect.

Okay. So I think I covered gross margin but let me just repeat on the tariffs. At 10%, we estimate it will cost us $150,000 a quarter and that will be charged to cost of goods sold. And it's been said that the President will possibly increase the tariffs to 25% so that's a wildcard and of course, it's out of our control. Neither number, 10% or 25%, is a killer issue but they are real numbers and it's detrimental to us.

So we can complain or bang our head against the wall, or whatever, but that's the way it is. Okay, next question.

(Operator Instructions) Our next question comes from Hamed Khorsand. Your line is now open.

What happened in Q3 with indium phosphide that all of a sudden you saw positive traction but now you're saying that that's not happening again in Q4. You were trying to be conservative. What was that one time event that caused indium phosphide to increase in Q3?

There wasn't any one-time event. It was just strong demand the demand has kind of leveled off for Q4. So instead of growing, it's relatively flat. But it wasn't a one-off or anything. It was just generally the silicon photonics part was strong. The PON was still okay but wasn't as strong as Q2 and we think that PON will remain soft in Q4. And then we don't have a prediction yet about what happens to PON in Q1.

Do you have any insight if this is more inventory related at your customers or you don't have that kind of a visibility?

Well, Hamed, I think the way we run our projection, again, is such that, again, this early stage of the quarter we obviously take our customers' advice of how strongly they think the growth is.

But on the other hand, when we give guidance, we have to take what's in the dialogue and what our customer is telling us that they expect to order from us. And those are the (inaudible). And as Gary said, it's not going to be drastically down but we don't think it's going to grow significantly next quarter. But it's still holding its own.

And Hamed, I want to say that we're attributing -- there have been times when we've had some inventory corrections for indium phosphide in the food chain. I'm not so sure that our guys have told us that specifically this time. They're just forecasting relatively flat Q-to-Q for indium phosphide. But it's probably based on the customers end market demand as opposed to the customer having too much inventory. Because that hasn't been said.

But the other thing is that our customer in indium phosphide probably has 2 levels of inventory. One is our [EPI] grower customer and the end customer also has a potential inventory if they were to grow. So if they were to build inventory then they'd probably pull very strongly. And if they think that they have enough inventory, they may stay flat or if they want to consume some inventory then they may be down.

But I think overall, the trend is we're confident it will continue to grow. But quarter-to-quarter that's what we see.

Just from an inside standpoint on the solar cell commentary, do you know where that -- your product is ending up on the wafer side? Is it ending up in solar or is it ending up in being used for car batteries?

We think it's mostly for the solar cells.

The drones.

Our next question comes from Gus Richard with Northland.

In terms of OpEx, do you feel like that is peaking in terms of the cost of moving facilities and going to start to level out and come down?

That's a very good question, Gus. We've been looking at it. We have some people in the -- our corporate controller actually is over in Beijing this week and one of my requests was for her to drill down on that looking forward.

We're pretty much at what our expectations were for the run rate right now and we have a track record historically of having multiple quarters where it stays pretty stable. I don't really think it's going to go back down. I think it's going to stay up. So I would caution you to not take it down below $6 million and we haven't put the numbers together yet for next year but I think it's going to be somewhere in the mid 6s when we finish putting it together.

Morris, I think you mentioned you'd done about $1 million worth of substrates for VCSELs at this point. Is that pre-production volume? Can you give a little more color on that?

Yes, from what we know it's mostly pre-production volume. I mean customers are buying some 100s and some 50s for sampling and for development work and nobody has given us any consistent volume -- production volume yet at this point.

But we do have multiple customers taking volume samples from us.

In aggregate, it's close to $1 million. We don't view it as production yet but we view it as planting seeds and as the Android community begins to ramp in production, which we all know that's not quite yet but it's on the horizon, then we would expect some of those seeds are going to grow and become volume production. But we're not baking it into our numbers at this point.

And then on the LED weakness, is that broad-based one customer? Any color that?

It's generally broad-based. Our customers are telling us although future looks bright but then they do see softness going forward and in the last quarter as well.

Our next question comes from Richard Shannon with Craig-Hallum. Your line is now open.

Maybe I'll hold up on 3D sensing. I guess the first question is the customers that you're doing pre-production volumes with so far for Android, are those also customers that are currently supplying the one main guy that's out in the market with 3D sensing today?

I think the answer is no.

And is this with 4-inch or 6-inch or what size wafer are you supplying there?

The sample that we supply mainly are 6-inch but when it comes to the $1 million VCSEL revenue, I know there are some, which is 3-inch. But those are the timer flight VCSELs.

A couple other questions on a different topic here. JV profitability. I think you're viewing this a little less favorably in the fourth quarter. Can you give us a sense of what that is, that (inaudible) pricing, lower volumes in certain product areas, or can you help us out understanding that please?

Let me try on the pricing first. I don't think there's any particular pricing pressure we experience. Although, Richard, every year with major customers, we do negotiate new pricing. But we don't see any particular pressure on pricing. I think we have, as Gary commented, I think one big item was our JVs. 3 of our JVs are having the environmental issues with China government and they have some orders from the local government. They have to shut down for a short period of time during Q4 to reorganize themselves to re-qualify for production again. That's why they have a one-time cost issue. I mean they're going to lose money in the fourth quarter.

And what was the second part, Gary?

I think that the raw material companies that Morris is describing, there's government-mandated improvements that they have to install for safety and environmental reasons. And so their efficiency and productivity rate is going to be down or zero for part of the quarter.

And there was a second part in the gross margin decrease in your prepared comment. I forgot what it was.

The comment about Q3 was that it was entirely because of 3 raw material companies that would consolidate and we expect them to continue to be a drag in Q4.

And to follow-up on that last comment, Gary, is there an inflection point or a reversal that you expect ending some of these one-time situations that JV, both the consolidated and the equity ones can return to profitability>?

I think as far as JV is concerned, I think I can answer definitely it's going to be one-time issue. Once they get -- they comply to this and pollution and safety issues then they will come back in production and they will reverse back to the normal pattern.

Last question. Give us your thought process on CapEx going forward? I think you mentioned $12 plus million spending in the third quarter. I know you've got a little bit more elevated spending. If you can give us a sense of what your expectations are for fourth quarter and then when we get back down to the more historical level you've shown prior to the FAB move.

I think Q4 is going to be somewhere between $10 million and $20 million depending on when certain things are executed and the triggers are pulled. I think Q1 will have a little bit more CapEx for the facility and then the rest of next year I think will be just modest amounts for equipment. We have bought some extra equipment in this process sort of above and beyond what we normally would be buying for both growth and upgrades. And that's basically to be able to facilitate the relocation more easily.

So we bought ahead and that means depreciation is going to -- we're charging ourselves a little bit sooner than we would have. But I think we probably will end up with a little bit less in Qs 2, 3, and 4 next year because of that. Again, we haven't worked all the numbers out yet with our team yet for the 2019 budget but that's what we've sort of discussed in meetings and stuff. We could have a little bit lighter acquisition of equipment.

I think overall, if you count the amount of money that we spent so far, we expect to spend about between $30 million to $35 million to complete our new construction as far as new equipment we need to buy. And beyond that, then, we have our 2 brand new factory as well as increase equipment for more production.

And we were just over there, Morris and I were, and in fact, Leslie joined us. And so we toured the new sites and it was very encouraging. Looks very good.

I am not showing any further questions at this time. I would now like to turn the call back over to Dr. Morris Young for any closing remarks.

Thank you for participating in our conference call. During Q4, we'll be participating in the Craig-Hallum Alpha Select Conference on November 15 in New York City. We look forward to seeing many of you there. As always, please feel free to contact me, Gary Fischer, or Leslie Green directly if you would like to meet with us. We look forward to speaking with you in the near future.

Happy Halloween.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a wonderful day.