Morris Young - Chief Executive Officer Gary Fischer - Chief Financial Officer.

Tom Sepenzis - Northland Capital Richard Shannon - Craig-Hallum Arthur Su - Needham Zach Houston - Footprint Asset Management.

Good afternoon everyone and welcome to AXT's third quarter 2016 financial conference call. Leading the call today is Dr. Morris Young, Chief Executive Officer; and Gary Fischer, Chief Financial Officer. My name is Terence and I will be the coordinator today. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the call over to Gary Fischer. Sir, you may begin..

number one, net interest earned on our cash of $105,000; number two, foreign exchange gains of $83,000; number three, equity accounting on our unconsolidated joint ventures, a loss of $581,000; and number four, other items equaling a gain of $81,000. For Q3 of 2016, we had a net profit of $2.2 million which is $0.07 per share.

This is north of our guidance, which is a range of profit of $0.03 to $0.05 per share. By comparison, we had a net profit of $1.2 million or $0.03 per share in the second quarter of 2016. Along with profits, cash increased nicely in the quarter by $2.4 million. Cash and cash equivalents increased to a total of $47.3 million as of September 30, 2016.

This compares with $45 million at June 30, 2016. Depreciation and amortization in the third quarter was $1.2 million and CapEx was $500,000. Accounts receivables, net of reserves, were $18.4 million at September 30 compared with $18.0 million at June 30.

Net inventory at September 30 was $38.7 million compared with $38.6 million in inventory at June 30. Ending inventory consisted of approximately 50% in raw materials, 43% in work in process and 7% in finished goods. The spread between the three buckets remains very consistent. So this concludes our financial review. I’ll now turn it over to Dr.

Morris Young for a review of our business..

Thank you, Gary. Q3 was a solid quarter that highlighted the success of our ongoing diversification and business model improvement. We achieved revenue and profitability above the high end of our guidance range and generated strong cash flow. In addition, our gross margin performance was the highest it has been since Q1 of 2012.

We continue to benefit from a positive product mix including phosphide substrate and other materials with high end applications. In addition, through the implementation of a number of programs, we are achieving improved deals for both ingots and wafer processing.

The benefit of this in progress and other cost reduction measures are becoming increasingly visible in our financial results. Now, let’s turn to our markets. The global build out of fiber optical connections continue to be the leading driver of our indium phosphide sales.

Fiber optic technology is helping to enable the fruition applications such as cloud computing, the Internet-of-Things and video streaming. Worldwide fiber deployment has 100 million connections in 2015 and is expected to continue to grow for the long term.

However, consistent with our recent report, we are seeing sound view to sharpness in the GPON and EPON market in China. We believe that these markets are taking a pause to rebalance following two years of strong growth. This softness caused modest decline in indium phosphide sales in Q3 and we expect that GPON and EPON will continue to be weak in Q4.

Nevertheless our overall indium phosphide atomic revenue will increase in Q4. In addition to fiber to the home deployment, data center connectivity continues to gain momentum as acquired of indium phosphide growth.

Cisco that by the end of 2016, six gigabytes of data will be validated through data centers driven by cloud computing, mobile data, video streaming, internet of things. And this number is expected to double by the year of 2020.

Further, networking bandwidth is doubling every two to three years with plenty transitioning to 25G and 40G ports evolving to 100G. Silicon photonics based solutions are expected to be a significant enabling factor for these transitions particularly in cloud and hyper scale computing environments.

All of this is part of it for our indium phosphide product line because to state it simply and concisely where you use laser light to transmit data, you need indium phosphide.

As evidenced that silicon photonics is moving from the research phase to market adoption during Q3, Intel launched its first silicon photonics product, a family of 100G optical transceiver for interconnecting data center networking switches.

These products further expand a growing ecosystem of silicon photonics based solutions from a number of key players in the data center networking space. In addition, Intel also announced that Microsoft is deploying this technology in its Azure Cloud platform for connectivity between switches in order to drive scale.

Azure is the second largest cloud provider in the world. These two data point affirm the growing momentum of the technology and the likelihood of its eventual widespread adoption.

In addition to optical electronic applications such as these, indium phosphide may also become the material choice for electronic applications such as 5G wireless technology. We believe that the deployment of 5G in the years to come could provide yet another sizable opportunity for our indium phosphide business.

We are excited by our success to-date in only market lead indium phosphide. As an emerging material, we expect to see some lumpiness in our scale of sales in any given quarter, but we are confident that indium phosphide will be a primary source of growth and opportunity in our business for the foreseeable further.

The application that drives this demand are significant and will be rolled out incrementally over the long period of time. This closely mirrors the decade long product lifecycle that we have seen with gallium arsenide. The application of course evolve and change, but the fundamental material technology has a long trajectory.

Now, let’s turn to gallium arsenide. We had a solid quarter in Q3, demand was stronger than expected, however, our revenue forecast for Q4 is lower for gallium arsenide substrates. In general, sales of semi-insulating gallium arsenide has reached a relative stable level that provides a healthy base of profitable revenue for our business.

In addition, we are working with the customers on certain investigation of new applications for the material that could provide future upside potential. In the semiconducting gallium arsenide market, we continue to participate selectively in high-end LED applications such as backlighting, signage and automotive.

That plays value, our performance, reliability and efficient cost structure. While the LED market remains highly competitive and fragmented, we are seeing relative stable demand that we expect to continue into 2017.

Over the long-term , we are closely watching the continued market development of VCSEL for 3D sensing applications, such as gaming, mobile phones, Smart TVs, high-speed communications and high-power material processing.

3D sensing requires devices with relative high precision functionality and consistent reliability which add our gallium arsenide substrate, it translate into the need for very low defect densities that is very low EPD.

Our VGF technology and proprietary processes allow us to offer industry-leading specifications that creates a significant competitive advantage from high VCSEL applications. While we think it’s still best to take a conservative view of the rating and timing of market adoption of 3D sensing technology.

We believe that this application could provide attractive opportunity for our business if it is adopted into high end smartphones, which could total 500 million to 600 million units per year. In closing, our revenue continues to diversify with good opportunity to drive long-term growth and financial improvements.

We are focusing our resources on strategic product applications in indium phosphide, gallium arsenide, and germanium substrates that are showing promising market trends. Our raw material business remain under pricing pressure. But we are seeing price start to stabilize and in some cases improve.

This could lead to a more favorable pricing environment in quarters to come. In addition, we are delivering a business model that prioritize cost efficiency, spending discipline, diligent cash management and shareholder return. We feel positive about the coming year and look forward to reporting to you on our continued our progress.

This conclude my prepared comments. I would now turn the call back to Gary for our fourth quarter guidance.

Gary?.

Thank you, Morris. As Morris discussed, several factors are expected to come into play in Q4, including the market weakness and the rebalancing of gallium arsenide substrate revenue following an unusually strong quarter for that material in Q3. As such, we believe that total revenue will in the range of 18.5 to 19.5 million.

In spite of these near-term factors that are expected in down quarter in Q4. We do not see any fundamental changes in our key markets.

We are excited by the indium phosphide as a growth driver for our business in fiscal year 2017 and beyond and expect that gallium arsenide will continue to provide a stable revenue base with upside potential from VCSELs and other investigational applications.

In terms of our bottom line, the outlook for Q4 were expecting to be the range $2 to $4 profit per share based on 33.1 million diluted outstanding. Okay. This concludes our prepared comments. Morris and I would be glad to answer your questions now. Operator please take over..

Thank you. [Operator Instructions] Our first question comes from Tom Sepenzis from Northland Capital. Your line is open..

H, guys. Congratulations on the great quarter.

I was hoping you could touch on raw materials and what you are seeing there in terms of pricing if that’s changed at all?.

Tom as we said, gallium price during the quarter seems to have stabilized and have a little bit uptick, so is germanium pricing. However, we don’t want to pick the bottom so to speak, but we are cautiously optimistic it may improve in the coming quarters..

What are you expecting just in terms of your kind of both business revenue wise in December relative to [indiscernible]?.

As you know that if – for gallium, if the price of gallium improve materially, that should help our bottom line quite significantly because we have a large investment in gallium material supply.

As you know that this quarter, we had a negative of – what, Gary, $581,000?.

From the seven consolidated joint ventures, correct..

And they are mostly coming from the sales of gallium and germanium. So if those price start to improve then it should help us instead of negative it should help us on our bottom line..

Okay. What I’m trying to get at is, in your prepared comments you said that despite the slowdown in China, overall indium should be up in December quarter-over-quarter. Gallium looks like it stabilize, therefore, it should be around flat. Germanium is pretty small percentage of the overall business at this point.

So I’m just trying to figure out why you are expecting a drop of $2 million to $3 million top line?.

Okay. I misunderstood. I thought you were talking about the raw material business..

Yeah, I was trying to see if that was going to be down significantly that would account for that, but that doesn’t sound like you expect that to be down significantly.

So I’m just trying to figure out why the drop in revenue from $22 million down to $18.5 million to $19.5 million?.

The main decrease in revenue forecast come from two categories. Okay? One is raw material. We expect it to drop $1.5 million in raw material..

Okay..

In gallium arsenide, we expect it to decrease by about a little bit over $1 million. However, I think, while germanium, we also expect it to drop slightly, but I think it’s around $150,000, it’s not significant, but I think indium phosphide, we do expect revenue to have an uptick in Q4 relative to Q3.

Right, Garry?.

Yeah..

That translates into overall decrease..

That helps tremendously. I have one more and I will get back in queue.

Have you – has anyone started any trials using [indiscernible] for 5G mobile network that you know?.

Yeah, I think in 5G what format will be used, obviously, the verdict is still out. I mean there are people saying using [indiscernible] with very advanced structure, you can achieve very high frequency operation.

So one of the candidate, it’s going to be [indiscernible], but I think the challenge there is yield, also the alignment of these devices are very narrow. So they have a difficultly doing the manufacturing processing. On the other hand, indium phosphide, it’s also very early in the development.

There are – we know of, there are people very much interested to try our 6-inch indium phosphide, which we have not finished development yet and also there are people using our 3-inch, 4-inch indium phosphide substrate to develop indium phosphide HPT devices for the 5G applications.

So I think the race is on, but I think fortunately we have both end covered, but that would probably hope that indium phosphide will do better because it’s a new material and so the demand for that material could increasing significantly if that material was adopted.

So if you want to me, say, speculation mode, I think probably both material will be used and maybe the high-end will be using indium phosphide and the low end maybe gallium arsenide. But as you use increasing frequency in mobile communications, indium phosphide is just purely better mobility, better ability to handle higher frequency operations..

So, obviously, you are shipping at least some small volume in indium phosphide for amplifiers?.

Yes, but very small compared to auto electronic. As we said, auto electronic by far are the leading revenue driver for us now..

Yeah, I know. It’s just nice to see that there are [indiscernible] income.

And then I’m sorry, did you give a gross margin guidance for the December quarter [ph]?.

Gary, did we?.

No, no. No, we didn’t..

So it would most likely be backed up on sort of 28 to 29 levels that we saw earlier in the year on the run rate?.

I think it can begin with three, but it’s not going to as high as it was this quarter for sure..

Great. Thanks very much..

You are welcome..

Thank you. And our next question comes from Richard Shannon from Craig-Hallum. Your line is open..

Hi, Morris and Gary, thanks for taking my questions.

Let see, maybe I will follow up on a couple of topics already started here, maybe looking into the fourth quarter revenue guidance, maybe I missed what you are implying regarding some of the piece here, but Morris I think you said raw material you are expecting to come down I think you said $1.5 million or so sequentially.

Given the fact that I think you are implying the pricing is firming up here would suggest some volumes are falling off there.

Can you give us a understanding what’s driving that? Is this a temporary situation or could it remain at these more depressed levels?.

Yeah, I think raw material does depend upon, I mean from my speculation understanding, in the third quarter, we had a sizable delivery to the Japan market in the tune of 10 tons of gallium. So my estimate is that the market is realizing the pricing has hit a bottom, so people want to accelerate the delivery.

Okay? So you don’t expect other [indiscernible] buy again in Q4, but of course I’m not speculating to say that gallium price is going to skyrocket, but I think the delivery of very large volumes sort of you can speculate that people are saying hit the bottom, let me buy up and get my inventory filled up. So that’s the relativity.

But I don’t think as you see our raw material business in the last three, four quarter, I mean, has up and downs, but I think it ranges from all the way from $5 million a quarter to $3 million, $3.2 million a quarter, I mean, last quarter was strong, but I think Q4 because of the high volume delivery in Q3 is expected to go down – in Q4, but I don’t think it’s going to continue.

No..

Okay, that’s helpful.

And then on the topic, Gary and Morris, I may have missed why you are expecting lower revenues in the fourth quarter, is that semi-insulating applications, is this – you expect this to be more of a temporary or more of a sustaining trend here?.

The expectation actually is from both but surprisingly semiconducting is about down very slightly, $100,00, $150,000, but more significantly it’s from semi-insulating. We are seeing two major customers are telling us that they have an inventory adjustment in Q4, so they want us to hold our shipment.

Then we are checking with them and they are saying, it should come back in Q1..

Okay..

It’s a dropdown this quarter. We don’t think it’s a fundamental change in the volume and market..

Okay. That’s what I thought, but just wanted to confirm that one. Let see a couple of more question from me.

You mentioned a single 10% customer, is this the one that you’ve had many time over the past several years or is this the more new – more recent one that’s more optically – more indium phosphide oriented?.

It’s the older – the other one..

The other one? Okay..

It’s the other one..

I guess maybe last question for me, you brought up the topic of 3D sensing and gesture recognition.

I wanted to get a sense of when the earliest you might see the opportunity arise in terms of when do you AXTI to pick up production here? It’s my understanding that capacity is somewhat limited for such volumes that might be required for even a medium sized smartphone application, so if were to deliver to a smartphone OEM in the second half of the year, when would that require your pick up in production?.

It’s a very good question, Richard, but I think – I think this thing is sort of a mix of flux. I think, you know, at least, the customer is giving you the signal that the pickup should come either earlier than middle next year.

But on the other hand, we see things are still a little bit in flux, because we haven’t seen the order yet, we are definitely in qualification mode, so that – so how to protect what’s going to come, it’s very difficult for me, okay. Because we are really at the bottom of the food chain.

So as far as answering your question about capacity is concerned, yes, we have been in communication with our customers, as you – you know, look, if they say, people are coming, we got to prepare. It is somewhat challenging. But also there is other factor in play is this EPD spec is very tight today. So we do have a challenge in our yield.

So we do expect that we work ahead and improve the yield significantly. If we can then capacity become second hand issue. But if you we cannot, then we need to increase capacity to fulfill even the projected volume that is coming..

Okay. Fair enough..

Did I answer your question?.

Yes, you did, Morris. Thank you. I think that’s enough for me, I will jump out of line, but thank you guys..

And our next question comes from Arthur Su from Needham. Your line is open..

Hi, guys. Congrats on a great quarter and thanks for taking my questions. So first question is on GM, gross margin, you highlighted a few characters, more volume, better product mix and then some progress in generating manufacturing efficiencies.

I was wondering if you could give a little bit more color on how these three factor rank, which one contributed more and how sustainable you think this level is going forward?.

Gary?.

Okay, yeah. I’m not sure weight them extemporaneously as to which one was the biggest driver. Obviously, we are helped with higher volume because it spreads the fixed cost over more units. It was not ASPs I can tell you that. The ASPs did not go up. It wasn’t like some big blip that allow us to get higher margin because of ASPs.

It’s definitely about increased yields. We’ve made some tremendous progress in the crystal growth part of our production. Crystal growth has a bit of black magic in it for me as a business guy.

So there is a lot of very small, but very sensitive steps in crystal growth process and we’ve made – we’ve done a lot of experimentation and we’ve made just frankly a lot of good results, which result in higher yields, which then of course brings your cost down.

But reciprocally on the wafer side, after we’ve grown the crystal have the ingot and then convert it to wafers, there is also a lot of steps in the wafer manufacturing side that has to do with how you saw the ingot up, how you polish it, how you clean it that have a lot of proprietary process technology, which we’ve also been focusing on and that has also increase yields.

So I think cost reduction on the floor, we’ve had a lot of long running programs now for the last 18 months to 24 months to be more efficient in how we use floor stock, so that’ helped. But I would say most of the gain has to do with yield and maybe secondly it’s a tie between overall cost efficiencies and increased volume..

Yeah, so can I chime in for one other point. If you see, I think, our product actually [indiscernible] that is, look, when you say we don’t – we didn’t see a big price increase, never. I told you will we ever see a price increase..

We wish..

If we wish. So our customer needs lower price, however, when you address a certain market, let’s say last year you were delivering UPT as 1,000 EBB [ph] for certain market, the unit price per square inch is such and all of a sudden there is a new demand which would apply CB Deal 500 or either 100, the price will go up.

But you don’t put that into price increase but rather you’re switching the market to a different specification in that higher price. So I think we are doing that gradually but I think that more than offset than the usual price decrease that you see every year..

Yes, I think it’s probably noteworthy for the business analysis standpoint. Since we did disclose the indium phosphide was a little bit soft and yet our revenue was high for the overall revenue for the quarter, so that has to mean that the other products are doing okay in terms of manufacturing yields and gross margins.

So in fact that’s an appropriate and accurate conclusion..

The other question is, can we sustain?.

Okay, can we sustain it? We think we can. Of course we want to keep the volume up but we actually – I don’t want you guys to get carried away and be too optimistic but I think something in the low – beginning in the low 30s is safe for modeling but our goals are to continue to improve the gross margin and we think it’s a realistic goal.

It’s been very interesting just to focus on manufacturing and running the business, and it’s something that as a management team we are confident about and we feel like we’re making good progress..

Great. Thanks for all of that great color. Moving on to indium phosphide, I know it’s – there was a slight decline this quarter and you expect uptick modest increase in 4Q.

Can you remind us what the exposure you have to do the China market and what will be responsible for the uptick in 4Q?.

Yes, I think the significant, our exposure to the China market in the GPON and EPON market is very significant. We were talking to a analyst the other day and saying, GPON and EPON actually is relatively low in the pricing food chain, our technology food chain as compared to 100G or 400G transceivers.

But nevertheless where you translate into [indiscernible] everybody needs a indium phosphide to begin with. So for us, those GPON and EPON are quite significant. And so the turn off in the last quarter continue into Q4 is actually quite significant for us, but I think our analysis is that we believe we are accolade is that market driven go away.

It’s inventory adjustment and we are not seeing, we’re losing market share at all but we are into risk if you were to comeback when they have a big jump in demand if they got – this figure was turned off for a while..

Yes and we can say this to that. Yes, we have exposure in China and we’ve explained and commented on that but as we said our indium phosphide revenue in Q4 is going to increase but it’s not because of China, it’s because of everything else. And so our exposure remains in China but we do think we have a diverse market approach.

We do also see the datacenter photonics business increasing and collectively those things are offsetting the weakness in China..

Thank you. So on excluding China, would you say the investment in the business is pretty stable or would you characterize it is having a little bit lumpiness across the quarters..

No, actually it’s increasing. We do expect for instance the data center business to increase significantly in the coming quarters..

Great. Okay, I think that’s all from me. Thanks for taking my questions..

Thanks, Arthur..

And our next question comes from Zach Houston from Footprint Asset Management, your line is open..

Good afternoon, Gary and Morris. Congratulations on another good quarter. I guess just start off with I know Morris you talked a little bit about it on the prepared remarks but could you just talk a little bit more about maybe the life cycle that you’re seeing for the indium phosphide.

I know you guys had a good run with the gallium and then just following that what specific drivers are you seeing or that you could dive a little bit more into detail in regard to the lumpiness that you may see in the short term on the indium phosphide side..

Sure. So our prepared comment, I’m a old veteran in using this, I was talking to Gary and actually remember in the year 1995 or even before that we see the gallium arsenide cycle just booms.

The demand for 980 pump lasers for the fiber optic communication, in fact my lasers but just the price is lower and back then there was start of demand for gallium arsenide substrates.

And then we were followed on by other laser applications and other optical electronic applications and finally towards the end of the twentieth century while 1998, 1999 the stock of the electronic application for gallium arsenide picks into the application of the wireless smart phones and it enjoyed the 6 inch gallium arsenide for many, many years.

So our comment was that, we think the indium phosphide should take it parallel past to that, okay.

So I will say this is too early in the innings for indium phosphide to offer electronic application deal because if you read into some of these recent reports, would you call it optical super cycle, the data centeres, the metro upgrade, it’s hard for me to repeat those research findings.

How many cities in China, I think 360 cities, every city has so many connections and translate to something like 400 or 4 million of these transceivers with it.

And that the total capacity for the other optical transceiver capability is only 250,000 but of course those are markets we get excited but the demand to our customers – when the future demand to our subsidiary level.

The guy who makes 400 G, 100 G substrates using substrate it’s probably equivalent to the GPON and EPON, but nevertheless our advantage was due to everything down to earth and the more advanced device we want to make, you want low EPT stuff which we excel.

And by the way any partner, no junk subsidiary needed, all off to an electronic application needs some degree of low EPD. So I don’t know if I’ve explained this. So I think for us we are throwing not in the center of all this optical cycle.

Nevertheless wherever the cycle continues it will always filter down to us and yet another driver we were talking to analysts was this upgrade to 5G. We have opportunity to play into the mobile device as HPT for the high speed amplifier or switches.

But nevertheless even in the infrastructure on the pole, the meaning sale when you collect all this information from all the internet of ringing, mobile phones and all these connection needs to be translated to either the central tower or back to the data center.

So if you think about all this traffic, all of this fiber optic for communication, whether you need fiber optic communication light is needed, a laser night needs indium phosphide substrate. So I think it’s very exciting to phenomenon to see, I think it’s going to be – if you don’t see anything else on the horizon at all to replace light.

So I think we’re going to see quite a few years of growth..

Okay. Okay, that’s helpful. Thank you. And then just shifting gears on the side, you touched based a little bit on the qualification going on now. I just wondering if you received any feedback on that front and as well as could you just talk a little bit about how you may see the market share break up with the VCSEL application..

No, we haven’t got the feedback yet. We deliver the material. We’re anxiously waiting for the results. And as far the market share is concerned, they are mainly suppliers. Other than AXT, there is a German supplier, there is a Japanese supplier. I think if you take from this year March, I think we have certain advantages.

We develop our own VGF earnings as we’re being VGF for the last 30 years. So we know how to make low substrates but of course we respect our competitors, they also had very good scientists. My take is that this market was to develop quickly if demand is strong, it will really play into our strength.

That is we can react to very fast developmental market and very stringent requirement or specification, EPT is what we’re good at that’s what I think. But when with this market launch, when will this market develops, it’s really hard for me to say..

Okay. Thank you. That concludes my questions and congratulations again on a good quarter..

Thanks..

Thanks..

[Operator Instructions] And we have a follow-up question from Arthur Su. Your line is open..

Hey guys, I just had a quick question on the relocation of the gallium arsenide wafer production operation in China.

Do you have any update on the progress of that?.

Yes, we can give you some cost update because we don’t have any – we haven’t even picked the land side yet. So in the first step has been to work with the agencies and the government, and that has gone very well in the last probably four or five months.

Frankly, we were a little bit nervous at first but it’s become much more good spirited and good faith. And so that’s going well and we have been serving various sites in China. We’d like to put our gallium arsenide line into.

We’ve narrowed it down to about two, and Morris and I both go to China next month and we hope that we can get very close to a decision. So that’s just the first step which is pick a physical location and then we’ll have to proceed to construct a building and fit it up and things like that. So we are talking a long cycle, it’s going to take a while.

We are talking years not weeks or months by any means, but it’s going good and it’s kind of a headache but it’s actually not as bad as we thought maybe six or nine months ago..

Yes, absolutely. We certainly one of the priority in our selection of new site, we like to be close to what we are because that helps the physical move as well as retaining some of the key employees which I think is key to save production. So we’re relatively optimistic about the development..

We continue to expect that we will remain in the current location for research and development for China headquarters for indium phosphide. So the focus is on gallium arsenide and we are proceeding..

Thanks for that color. Appreciate it..

And at this time, I’m showing no further questions..

Okay. Thank you and thank you for participating in our conference. AXT Management will be presenting at Needham Technology Conference in January of 2017. As always, feel free to contact me or Gary Fischer directly if you would like to meet with us. We look forward to speaking with you in the near future. .

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may now disconnect. Everyone have a great day..