AXT Inc (AXTI) 2019 Q4 法說會逐字稿

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shift that occurred in Q1 of 2019.

In the fourth quarter of 2019, revenue from North America was 10%; Asia Pacific, 68%; and Europe 22%. In the fourth quarter, 2 customers reached 10% of revenue, and the top 5 customers generated approximately 42% of revenue.

Gross margin in the fourth quarter was 21%, down from 29% in the prior quarter. Approximately 4% of this decline or half the decline was due to lower manufacturing efficiencies and yields, primarily related to the ramp of 2 new products, 6-inch indium phosphide substrates and a new 6-inch germanium product configuration for a large customer. Both products address new market opportunities for AXT that we believe will contribute positively to our business later this year and for years to come.

Further, we view this decline in efficiency as temporary. Larger diameter substrates are inherently more challenging. We were already taking steps to refine the processes and expect to show improvement in the coming quarters.

The balance of the gross margin decline in Q4 came from the following: we had lower gross margins in each of our 2 consolidated raw material companies, and this accounted for 1.5% of the decline in gross margin. We also had a negative swing in adjustments to inventory in excess and obsolete, which accounted for 2.2% of the change from Q3. These items are formulary driven and the lower revenue impacted the formularies negatively.

As we look into Q1, we expect to show incremental improvement in our gross margin and will be focused throughout the year on improving our manufacturing efficiencies across all of our product lines.

Total operating expenses in Q4 were $6.7 million, up from $6.2 million in the prior quarter as a result of end of the year bonuses for employees at our raw material joint ventures, Jin Mei and Bo Yu that are part of our supply chain. These will not repeat in Q1, but we are seeing increases in other G&A areas such as insurance, payroll, taxes and legal. Q1 OpEx will likely be in the $6.4 million to $6.5 million range.

Total stock compensation expense for the fourth quarter of 2019 was $637,000. Operating loss for the fourth quarter of 2019 was $2.8 million, compared with an operating loss of $477,000 in the previous quarter and an operating loss of $638,000 for Q4 of 2018.

Interest income net of the fourth quarter -- for the fourth quarter of 2019 is a gain of $778,000. This included a de minimis gain in net interest income, a net loss of $226,000 from the partially owned companies in AXT supply chain accounted for under the equity method, a foreign exchange gain of $236,000 and other income of $766,000. The $766,000 includes 2 grants totaling $800,000 from provincial government agencies for a relocation. We expect this to continue in Q1, with a grant for approximately $1.1 million. Income tax for the fourth quarter of 2019 was a benefit that is a favorable adjustment at year-end of $241,000 compared with a charge of $23,000 in Q3. Q4 results included approximately $251,000 in tariffs as a result of the 25% tariff charge on importing wafers into the United States from China.

For Q4 2019, we had a net loss of $2.0 million or a loss of $0.05 per share. By comparison, we had a net loss of $0.9 million or a loss of $0.02 per share in the third quarter of 2019, and a net loss of $1.1 million or $0.03 per share in Q4 of 2018.

The basic share count in Q4 was 39.636 million shares. Cash, cash equivalents and investments were $36.3 million as of December 31. By comparison, at September 30, it was $38.5 million. A more interesting comparison is through December 31, 2018, when cash, cash equivalents and investments were $39.4 million. It means that our net cash burn in 2019 was only $3.1 million even though we spent almost $21 million on the relocation in 2019. This includes a bank loan of approximately $5.8 million in China, which we secured in Q3 of 2019.

We also have a line of credit at Wells Fargo Bank, which we have not utilized. We expect to spend approximately $5 million in CapEx for gallium arsenide in 2020 and we are considering additional investments in indium phosphide.

Depreciation and amortization in the fourth quarter was $5.5 million, and capital expenditures were just south of $7 million. Accounts receivables net of reserves were $19.0 million at December 31, 2019, compared with $17.4 million at September 30, 2019.

Net inventory at December 31 increased slightly by $81,000 to $49.2 million compared with $49.1 million in inventory at September 30. Again, a more interesting comparison is with December 31, 2018, when inventory was at $58.6 million. This is a reduction in 2019 of $9.4 million. Part of this reduction, approximately $5.8 million, was a result of no longer consolidating Jiya, one of our raw material supply chain companies. The remainder, $3.6 million is a result of operations and a focus on reducing inventory. Our goal was to average $1.0 million a quarter during the year, we got close to that, and given the lower revenue, it is a good result.

Ending inventory consisted of approximately 42% in raw materials, 51% in work in progress and only 7% in finished goods. This concludes the discussion of our quarterly financial results. Let me now briefly highlight the fiscal year.

For the fiscal year 2019, revenue was $83.3 million compared with $102.4 million in fiscal year 2018. It is important to keep in mind that our raw materials business declined by approximately $6 million in 2019 from 2018. The majority of this decline is attributed to the changes in our ownership positions in Q1 of 2019 that resulted in our consolidating 2 rather than 3 of the joint venture raw material companies in our revenue results for 2019. The balance of the decline came from gallium arsenide and germanium wafer substrate sales.

Gross margin for fiscal year 2019 was 29.8% of revenue compared with 36.2% of revenue for fiscal year 2018.

Net loss for the fiscal year 2019 was $2.6 million or $0.07 per share compared with a net profit of $9.7 million or $0.24 per diluted share for fiscal year 2018. Okay. This concludes the financial review.

I'll now turn the call over to Dr. Morris Young for a review of our business. Morris?

Thank you, Gary. Q4 capped off a turbulent year in the geopolitical and macroeconomic climate. Overall, the result was a weakened demand environment in 2019 that had a negative impact throughout the year on key applications and certain customers within AXT's gallium arsenide and germanium businesses. This impact made up the majority of our year-to-year revenue decline.

Despite these more challenging conditions, our indium phosphide business exceeded our expectation in Q4 and finished 2019 with modest growth over the prior year. In fact, 2019 was the first year in our history that total indium phosphide revenue surpassed total gallium arsenide revenue.

Why is this important? The fact that we saw growth in indium phosphide during a down year for a substrate market demonstrate the gathering momentum in a trend-driving indium phosphide demand. These trend, such as data center connectivity, 5G telecommunications and optical network expansions are powerful and substantial and they are developing as we speak.

In addition, there are significant new trend visible on the horizon, involving indium phosphide-based sensors, for new applications in health care, automotive and more. Collectively, these applications position indium phosphide as one of the most important material of this new decade.

AXT has developed considerable expertise and industry-leading (technical difficulty) for this highly specialized substrate. We're setting the pace in our market for technical innovation, and we are expanding facilities and additional equipment that will allow us to keep pace with the market demand.

As Gary mentioned, we are also bringing to market larger diameter indium phosphide substrates. This is a capability that both current and potential new customers are asking for. While the launch contributed to our gross margin decline in Q4, we believe this new capability will be essential to emerging large volume applications for indium phosphide.

We will also provide new barriers to entry for substrate manufacturers looking to move into this space. As we look ahead to year 2020 and beyond, we are excited by the opportunity we see, and we believe we are well situated to realize the benefit of the coming market expansion.

In Q1, our indium phosphide revenue is off to a good start. We believe our sales in the quarter will include a mix of applications, including data center, PON and 5G telecommunications. Our customer relationships remain strong, and we hope we can build upon our customer list more this year.

Now turning to gallium arsenide. Our business weathered a difficult year in 2019. The global demand environment in key applications such as LED lighting, automotive lighting and other high-performance applications was challenging. Though certain customers were predicting a pickup in Q4, it did not materialize. Wireless applications was also down from the prior year. Throughout the year, we focused on the completion of our relocation of our gallium arsenide manufacturing, which is and will be (inaudible) for our company.

Our new facilities give us tremendous capability and [state-of-the-art] manufacturing so that we are ready to meet requirements of these new decades. The relocation to Dingxing and Kazuo was involved and at times, challenging. It is a process that will be taxing even to companies much larger than AXT. We are proud of the achievements of our team in executing it successfully, and while supporting the need of our customers.

During Q4, we met a major milestone by completing the relocation of all gallium arsenide crystal growth to Kazuo, which opens many new doors for AXT. This facility was designed and built by us from the ground up and is optimized for innovation and best practice manufacturing.

Q1 also marks another important milestone in our relocation of our gallium arsenide wafer processing. We are making good progress with several customers regarding site qualification and results thus far have been positive, with final signing off expected later this quarter.

We'll be able to begin ramping our manufacturing in Dingxing to volume production. We also expect to be able to drive additional customer qualification in the coming months. We believe that demonstrating our capability for volume production is a key to our success, with both new and continuing customers of AXT.

The timing of our volume ramp in Kazuo and Dingxing is positive. While gallium arsenide had a difficult year in 2019, it is poised for renewed growth in year 2020 and beyond. This is likely to be driven by a recovery in our traditional applications of high-performance LEDs, used, for example, in automotive lighting, and lasers as well as a number of new and promising applications, such as mini and micro LEDs, laser-based sensing and over time, 5G wireless. We are excited to be able to open the doors on our new facilities at the time where gallium arsenide is experiencing its next wave of innovation, new applications and expansion.

Turning to germanium substrate. Coming off of a strong year in 2018, our sales took a meaningful step back in 2019. It is soft in a softer demand environment, particularly in China. As we move into 2020, the satellite solar cell market is poised for improvement. With the number of satellite launches expected to increase worldwide, we expect we will participate in that improvement. Still we believe that we underserved the market for germanium substrate.

As we talked to our customers over the last several quarters about their current and future requirement, we came to believe that our ability to offer a new configuration of our 6-inch germanium wafers can open up new opportunities for AXT.

It is a natural extension of our current capability and will allow us to support our high-volume demand. We are highly focused on driving manufacturing efficiency with this larger diameter product, and believe that we'll be able to bring the gross margin up to a more normalized level in the coming quarters.

Before we come through, I want to give you an update on the precautions AXT is taking for the coronavirus. Today, we are grateful that no AXT employees have become ill from this virus.

All 3 of our facilities are in operation and have strong local management teams providing oversight. We continue to be able to meet customer requirements and have the benefit of inventory and manufacturing redundancies between our locations should a need arise. Although the coronavirus has added another layer to the fear, uncertainty and doubt that characterize virtually all of year 2019, the demand environment to date is not as weak as we might have expected. Customers seem to be mixing a combination of caution with a sense that they have to return to running and growing their business.

Having said that, it is clearly a fluid situation, and we are winding our guidance range as a precaution. The biggest challenge we face currently are the travel restrictions, both to and from China and also within China.

These restrictions make it more difficult for our leadership to address certain issues that benefit from the hands-on problem solving, such as manufacturing efficiency and yield for the launch of our larger-diameter substrate. As a result, we expect the rate of improvement may be a bit slower than it would under normal circumstances.

We are also limited in the number of employees that are allowed to be in the factory on any given day. As such, productivity may not be quite as high until the government-mandated restriction are lifted.

Regarding health and safety precaution for our employees, we are adhering to all local laws and have implemented a number of personnel policies and procedures to limit employee risk of exposure. These include employee temperature screening every day, protected gears, including face masks, limited group meetings and changes in our cafeteria and food provision, among other precautions. The safety of our employees is our #1 concern.

In closing, coming off of a challenging year in which we got weathered one of the most difficult demand environment in recent years, the underlying end market needs for our wafer substrates are strong, compelling and growing. As a result, AXT is poised for growth and improvement in our financial results.

Our indium phosphide business is healthy, with exciting applications contributing to today and new ones on the horizon. Our gallium arsenide and germanium businesses are expected to benefit from recovering in 2020. We're excited to drive volume and better utilization in our new facilities. We believe our dynamic end market will open the door to incremental business opportunities from our new and continuing customers.

This year, we will be laser-focused on efficiency and delivering improvement in our financial structure. AXT has come a long way and overcome many challenges in the last several years. We believe that 2020 is lining up to be a beginning of a new chapter, one that delivers an opportunity for growth and success we've been working towards.

This conclude my proposed -- prepared comments. I'm now turning the call back to Gary for our first quarter guidance. Gary?

Thank you, Morris. As Morris discussed, we believe that 2020 will be a year of growth for AXT. We're taking an appropriately modest view of Q1, given that the market is recovering slowly. We're also widening our typical revenue range a bit to allow for unanticipated effects in the supply chain from the coronavirus. As such, we expect to see revenue in Q1 between $18.5 million to $20.5 million. We believe that loss per share in Q1 will be in the range of $0.03 to $0.06 based on 39.78 million shares outstanding.

This concludes our prepared comments. And Morris and I would be glad to answer your questions. Operator, Prince?

(Operator Instructions) And our first question is from Richard Shannon from Craig-Hallum.

A couple of them, I'll jump into first here. Gary, your commentary on sales growth for this year. If you can kind of spec out what you think between the revenue buckets, not only raw materials versus substrates, but also within the substrate business, if you could differentiate the revenue growth, maybe the path and speed of recovery if they're different between the substrate businesses?

Okay. I'll take the first crack. I think Morris probably has -- can add a lot more color, too. But this is just covering raw materials for the listening audience. In 2018, going backwards, we had 3 raw material companies that we consolidated. In the first part of 2019, we converted one to the equity method. So we have 2 now that we consolidate, and they're both doing quite well. So their revenue will definitely grow in 2020, don't know by how much. But their end markets are strong, and the companies are in good shape. So that should be an upward arrow.

And if you look at the substrate business, we definitely think indium phosphide will grow. We think germanium will grow. I'm going to leave it up to Morris if -- in terms of the timing, it's -- I'm not sure, we're a bit cautious at the Q1 because of the fear, uncertainty and doubt out there in the food chain due to the coronavirus. But we do hope, and I think the experts predict that, that should even out in Q2? Is it April 1 or is it June 30, to be determined. So Morris, do you want to comment?

Sure. I think, as I said in the prepared script, Q1 demand actually turns out to be fairly strong. We're seeing customers have a increased demand on PONs market. Actually, the PONs substrates is at all-time high right now. And when we talk to customers, they are saying, it's basically coming from the 5G base station build up. So we think that's very good news.

We're seeing data center demand is sort of flat, but poised to grow. We're talking to our customers, and they're saying the switch to 400G is still to come. When that comes, that should help us substantially. And we're also seeing other new applications on the horizon. Gallium arsenide, I think, LED should see the other recovery. However, to what extent or to what speed it is, is difficult to predict, especially with this coronavirus on the horizon. But germanium, we definitely believe that it should be better than 2019. So I didn't say anything quantitative. I think in our own budget, we think that indium phosphide is offering the best growth opportunity for us. And clearly, our size specifically, wireless is probably going to stay flat. LED is going to recover nicely and so is germanium.

Okay. Great. A question on gross margins. You talked about some issues in the fourth quarter of yield with a couple of products. Are these products actually shipping in any real volume? And if not, when do you expect that to happen?

Not so much on the indium phosphide. We spend a lot of effort on indium phosphide, but they're not shipping a large volume, but there's a great demand for it. And we are gearing up and speed up our development. And -- but unfortunately, we don't -- well, or fortunately, we don't break out that into R&D. So we bury it into the gross margin. Germanium, yes, we're shipping. And we have a 6-inch germanium product. But because of the big volume surge we undertake in Q4 of last year and we had a stumble in our start-up and -- mainly because, well, we increased the volume substantially in the quarter as well as, if you remember that we have to move our crystal growth from Tongmei to Kazuo. And that sort of split our management attention to the crystal growth yield issues. So we had a bad quarter as far as yield is concerned. We probably do expect -- well, I want to say, we do expect to improvement. But on the other hand, because of this travel restriction in China because of coronavirus, maybe the improvement is going to be slower than we expected. But it's not going to be a persistent yield hit or margin hit for us.

Okay. Fair enough. Last question from me. I'll jump out of the line. Regarding the new customer qualifications, maybe if you can give us a sense of a few different things. How long has the qualification been going on that you expect to finish this quarter? You're talking about major customers, how -- what kind of -- what percentage of your customer base could this potentially qualify for? And then, is this giving you any visibility into the rest of your customer base eventually moving to the new facility?

That's a good question. I think we are poised to qualify in the first quarter. In fact, we are seeing that people are giving us the good signal. But as far as the percentage of the customer who will qualify Dingxing facility is concerned, I think we have to run some numbers. I believe it could be as much as a good 50% to 60% by the end of Q1.

Okay. And then time frame for the rest of the customer base to move over, how fast do you think that could happen?

We think it could happen by 80%, 85% by the end of June, but provided we have to hope and pray that this coronavirus doesn't spread and give us a extra hiccup.

Next question is from Gus Richard from Northland.

Yes. In terms of gallium arsenide demand going into the back half of the year, do you expect any demand to come from VCSEL or display applications?

Yes, I think so. I think the opportunity absolutely brightens up more for year 2020, with our new facility opened up. And we are discussing with quite a few of our number of customers. However, we are trying to get into this market. I don't believe the volume will be substantial for 2020, but we believe that we should be able to get into the VCSEL market in 2020. Yes.

Okay. And then I think you mentioned you're doing the larger indium phosphide wafers. Is there a specific application that that is targeted for? And can you talk about what it might be?

Yes. The usual suspect for larger diameter actually is for electronic applications. Most of the electronic such as cell phone HPTs, et cetera and people demanded larger diameter because the processing line just fits perfectly for large 6-inch. However, we believe this application is for optical applications. So that's sort of a big surprise to us because optical, usually the device is smaller. But this particular device for -- at least from our customers telling us, this device is very large. We think it's some kind of a photo detector, but we don't quite know at this point what specific application it is. But they definitely require high-quality, low-defect density material, which fits our forte extremely well. As you know, that VGF can produce very low EPD material. So it's not only the larger diameter we can deliver, which will fit the customer requirement, but also the very low EPD and low strain, low defect density, which is required. So I think that fits our capability very well.

Okay. And then just shifting to the sort of complexity of the operating environment in China at the moment, can you just give us a sense of how much of your material is consumed in China? How much is shipped external to China? And then which is more difficult shipping intra countries or trying to get things in and out?

We don't have a supply issue. We start with gallium. We start with arsenic and we start with indium phosphide. And so the logistic of supply really is not a issue. We do have a issue about full -- I mean, face masks. Because in China, right now, if you don't provide employees with face mask for health protections, you are not allowed to operate. And as far as our customer is concerned, I believe that we have around 15% of volume to China customers?

No. I'm doing it from memory, but we do put it into the 10-K because it's required. It's a little bit north of 30%.

In China?

Yes.

Oh, really. Okay. So -- yes, but shipping product yes, we do have some logistics in shipping because a lot of airlines are cutting off their transport planes to China. So we may expect the cost of shipping to go up. But so far, we still can ship our product out.

Okay. And I guess the final one from me is, I think, you mentioned a health application for indium phosphide, could you talk about what that might be?

No, actually...

There's been a public discussion of...

Yes, there's a lot of public discussion. But in the Photonics West, people -- there are multiple sessions talking about using infrared laser to detect glucose in blood, but it's very speculative. And because the wavelength ranges from 1.5 nano -- 1.5 microns, up to 2.1 microns or 2.2 microns and that's a range that indium phosphide fit very well. But -- so we're expecting -- I mean, there's a lot of discussion about it. There's a lot of public speakers and people are focusing on it. But we don't know whether it's...

That's our only real source of information.

Yes, that's our source of the information.

(Operator Instructions) We have a question from Dave Kang from B. Riley FBR.

A couple of questions. Gary, I missed your comment about the number of shares for the first quarter. And also, how should we think about the tariffs for the current quarter?

The number of shares in the first quarter -- for the first quarter, is that you're asking about?

Yes.

There is some 39.78 million.

And then on tariffs?

Tariffs, it was about $250,000 in Q4. That actually was a little bit higher than normal. So I'd say that $200,000 is probably a decent guess. So...

Got it. And then on the -- your production status, can you tell us what that was, like, maybe you can give us a utilization before the outbreak and what is it now? And what do you think that will be maybe in 3, 4 weeks, or maybe April?

Sure. We came back to work almost 2 weeks ago. So we would -- after Chinese New Year. We actually closed off for Chinese New Year celebration. So we came back to work early, and we were very well prepared. We have all the procedures that the government approves. So once they are okay with our procedures, they -- so they allow us to work. However, that's not to say that you can operate at full force because the travel restrictions, for instance, if we have a employee who went back to home to visit their relatives during the holiday when they come back, they have to observe a 14 days quarantine. So such that our 3 locations, although they are all operating, but I would estimate the average operating percentage is around 60% to 65%.

As far as going forward, by April, heaven knows. I cannot predict. I think -- I watch the news as much as you do. And I think from the Chinese published new infections, it seems to be better. I mean, it seems to be declining. And there's a hope that with higher temperature in spring, the virus would decline. But on the other hand, there are other publications, which says this thing is tougher to eliminate. So...

And Dave, let me mention one thing that at the reduced utilization rate that Morris quoted, we still think that we can meet the revenue goal, okay? Now on the other hand, if our -- if we thought we could do $28 million in the coming quarter, then it might be a little bit trickier. But because the revenue isn't as high as we want it to be and has been in the past, even at this utilization rate, we should be okay.

Got it. Actually, I'm kind of thinking about how to think about actually second quarter. So I'm trying to figure out how much are you assuming for the first quarter? How much are you leaving on the table for first quarter that will be shifted to second quarter? So are you assuming maybe $1 million impact that could be -- that will be shifted to second quarter? How should we think about that? How should we think about second quarter, actually?

You guess it right. Actually, we are shifting some of the demand to second quarter.

Some of that is because the customer is shifting it. Some of it...

Some of them because we stretch it. But then on the other hand, our second quarter, the visibility is not that great. I mean, I think -- what's challenging, I think, is to say that the 5G base station, I think that's a very pleasant surprise. We're seeing the 2-inch demand for China market is almost like all-time high, as we said. However, the data center we haven't got a signal from a customer yet. I mean, there seems to be a still on the sort of level -- demand level. And whether they're going to bump up in second quarter or not is yet to be seen.

Actually, my final question is on the 5G -- China 5G because I've heard -- or yes, from multiple sources that 5G deployment has been pushed out or delayed because of the outbreak. But -- and yet, you are seeing pretty strong demand. So are customers just kind of building ahead in anticipation of whenever the ramp happens, whether it's second quarter or third quarter?

Well, actually, from our perspective, we only see -- because we categorize it as a PON because a certain size in the certain specification. So we think that's PON because data center usually use other type of specification for that market. So we are reasonably sure it's for PON, but whether they serve the China market or market elsewhere, we don't know. For that matter, they could just make the PON for the worldwide market.

And we have a follow-up question from Richard Shannon from Craig-Hallum.

A couple of quick numbers questions. Gary, on your OpEx line here, you had a number for the fourth quarter that was multiyear high, I guess, as far as back as I can see and you're guiding to probably close to a similar level for the first quarter. I guess, if you look back in the history here and understanding your factory move here, it's -- I think you've talked about some duplicative expenses. So I'm wondering to a degree to which we're seeing kind of a near-term high versus a new level? And should we expect the OpEx to come down as we move all the customers into the new facility?

Well, we do think that some of the duplicative expenses will continue to diminish. However, as we took a solid look at what's going on for 2020, we see at the beginning of the -- at least for Q1, we had some bigger legal expenses. We also saw our D&O insurance, like many other companies, go up. Payroll taxes spread over because you're going to pay social security and all that kind of stuff. So our expectation is we should at least settle down at $6 million, $6.5 million, but we would hope that we can get it to at least half of that, that's still a credible goal. But right now, it's -- for Q1, we're pretty sure it's going to be around $6.5 million.

Yes. Obviously, expenses is in your territory, Gary, but I would guess as we move our factory, and we were to consolidate more towards our new factory, things should decline. But I don't think it's going to happen very quickly, okay? I would expect the expenses to be around that number, but it doesn't increase, but hopefully, our revenue can more than -- climb faster than that.

Well, definitely, as we get back into revenue growth, we do not see a reciprocal growth in OpEx. So we will benefit when we enter that space.

Okay, fair enough. And last question on CapEx, Gary, I think in your remarks, you mentioned like $5 million for gallium arsenide, possibly some for indium phosphide. If we exclude the indium phosphide, should we think about CapEx just a little bit more than $5 million with some maintenance on top of that? Or should it be higher than that level?

Maybe $5 million to $7 million, but yes, the big punch is sort of finishing up all the little stuff for gallium arsenide. So...

I am showing no further questions at this time. I would now like to turn the conference back to Dr. Morris Young, Chief Executive Officer.

All right. Thank you for participating in our conference call. 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.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. You may all disconnect.