Leslie Green - IR, Green Communications Consulting, LLC Gary Fischer - VP and CFO Morris Young - CEO.

Hamed Khorsand - BWS Financial Jon Fisher - Dougherty & Company Gus Richard - Northland Capital Markets Edwin Mok - Needham & Co. Sean Boyd - Next Mark Capital.

Good afternoon everyone and welcome to AXT's fourth quarter and fiscal year 2017 financial conference call. Leading the call today is Dr. Morris Young, Chief Executive Officer, and Gary Fischer, Chief Financial Officer. My name is Amanda and I'll be your coordinator today. At this time, all participants are in a listen-only mode.

Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to Leslie Green, Investor Relations of AXT..

Thank you, Amanda, 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 the relocation of our facility, 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 some 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 to differ materially.

These uncertainties and risks include, but are not limited to, overall conditions in the market in which the Company competes, the global financial conditions and uncertainties, 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 via link from our Web-site, 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 Web-site at axt.com through February 21, 2019. Also, before we begin, I want to note that shortly following the close of the market today, we issued a press release reporting our financial results for the fourth quarter and fiscal year 2017.

This information is available on the Investor Relations portion of our Web-site at axt.com. I would now like to turn the call over to Gary Fischer for a review of our fourth quarter and fiscal year results.

Gary?.

Thank you, Leslie, and good afternoon to everyone. Total revenue for the fourth quarter of 2017 was $26.3 million, which is within the range of our guidance. This compares with $28.2 million in the third quarter of 2017 and $20.3 million for the fourth quarter of 2016.

This is a 30% increase in quarterly revenue as compared with the fourth quarter of 2016. Of our total revenue, substrate sales were $20.5 million, compared with $22.4 million in the prior quarter. Revenue from our raw material joint ventures was $5.8 million in Q4. Q3 was also $5.8 million.

In the fourth quarter of 2017, revenue from North America was 9%, Asia Pacific was 67%, and Europe was 24%. Two customers generated more than 10% of revenue in Q4 and the top five customers generated approximately 36% of total revenue, reflecting again our diversification of both products and customers.

Gross margin in the fourth quarter was 37.2% compared with 39.5% in the prior quarter. Total operating expenses were $6.1 million in the fourth quarter of 2017 compared with $5.9 million in the third quarter. Total operating expenses in Q4 included one-time expenses of approximately $400,000, primarily related to severance payments.

Looking ahead, with the transition of our new factory now well underway, we are gaining a bit more clarity on our headcount requirements and other relocation-related expenses, including training and travel. As such, we are anticipating that our quarterly OpEx in 2018 will remain at approximately this Q4 level.

Total stock compensation expense for the fourth quarter of 2017 was $444,000. Operating profit for the fourth quarter was $3.7 million, compared with $5.2 million in the previous quarter. Interest and other income for the fourth quarter was a net charge of $330,000. This net number consists of four categories.

Number one is the interest earned of $127,000. Number two is equity accounting on our unconsolidated joint venture companies, which was a loss of $307,000. The third was foreign exchange loss of $188,000. And the fourth is other items that equalled a gain of $38,000. The tax provision for the fourth quarter was $131,000, compared with $181,000 in Q3.

For Q4 of 2017, we had a net profit of $3.1 million, or $0.08 per share. By comparison, we had a net profit of $4.4 million, or $0.11 per share, in the third quarter and $2.2 million in Q4 2016. This was a 42% increase over Q4 2016. The diluted share count in Q4 was 40.45 million shares.

Onto some balance sheet comments, cash and cash equivalents and investments closed at $77.0 million as of December 31. September 30 was $78.3 million. So, cash was down $1.3 million. Depreciation and amortization in the fourth quarter was $1.1 million and capital expenditures were $4.7 million.

Accounts receivable, net of reserves, were $22.3 million at December 31, compared with $20.9 million at September 30. Net inventory at December 31 was $45.8 million, compared with $40.8 million in inventory as of September 30. Ending inventory consisted of approximately 51% in raw materials, 44% in work-in-progress, and only 5% in finished goods.

Both WIP and raw materials increased, and this is intentional as we see raw material prices increasing and as we build inventory during the relocation. This concludes the discussion of our quarterly financial results. Let me now briefly highlight the fiscal year.

For the fiscal year 2017, which is our calendar year, revenue was $98.7 million, up from $81.3 million in fiscal year 2016. This was a 21% increase over 2016. Gross margin for fiscal year 2017 improved nicely to 34.9% of revenue, up from 32.4% of revenue for fiscal year 2016. Our profitability in fiscal year 2017 also increased meaningfully.

We achieved net income of $10.1 million, or $0.26 per share, compared with $5.6 million or $0.17 per share for fiscal year 2016. This is an 80% increase in net profit as compared to fiscal year 2016. Okay, this concludes the financial review. I will now turn it over to Dr. Morris Young for a review of our business..

Thank you, Gary, and good afternoon everybody. Our Q4 results capped off a strong year of execution for AXT. We delivered healthy growth in 2017, including record indium phosphide revenue and solid performance across our product portfolio.

In addition, we achieved improvement across our key financial metrics, driving an 80% increase in our net profitability over the prior year. We also made good progress on the relocation of our gallium arsenide manufacturing facility and we are on track with our stated goal to provide qualification wafers in Q1.

As we move into 2018, we are excited to see a resurgence of demand for compound semiconductor substrate in new applications across our product portfolio that has the potential to reshape the technology landscape over the coming decades.

As such, we will continually invest in the advancement of our products, our customer support capability, and believe that we are positioning the Company well for continued growth and new opportunities in 2018 and beyond.

For example, indium phosphide was a strong driver for our business in 2017, and is expected to be a significant contributor in 2018. This is largely due to the strength of our technology and market position, as well as growth in demand from both established and emerging applications.

One of the fast-growing applications currently for AXT is data center connectivity, driven by indium phosphide based silicon photonics. This technology solves the key data center networking challenges, including latency, bandwidth, power [dissipation] [ph], and signal integrity.

Leading industry analysts believe that silicon photonics is reaching a tipping point of widespread adoption. As evidence, optical transceivers and other components based on this technology are now in volume production by a growing ecosystem of providers.

Hyperscale data centers such as Facebook and Amazon Azure have also publicly announced its adoption. In addition, data center expansion in other parts of the world such as China, Japan and U.K. could provide additional demand in 2018 and beyond.

In particular, China now has more than 700 million Internet users and companies such as Tencent and Baidu continue to build hyperscale data centers to accommodate growing Internet traffic. During 2017, data center connectivity surpassed passive optical networks as the largest driver of our indium phosphide revenue.

Prior to this, the EPON and GPON markets were key contributors for indium phosphide demand in applications such as fiber-to-the-home and fiber-to-the-office. Throughout the past year, a slowdown in purchasing from carriers as well as the inventory buildup in the supply chain constrained market growth.

However, we have been encouraged by recent indications from our customers that suggest conditions are improving in key regions such as China. This strengthening of demand may drive improvement in the PON market in 2018 and give AXT another avenue for growth.

We will be watching this closely as AXT supplies into a number of regions and customers worldwide is well positioned to benefit as market improves.

And finally, a third area of focus for indium phosphide is telecommunications, where the current infrastructure upgrade cycles and preparation for 5G are providing opportunities in short haul, long haul, and networking deployments.

Though still a relatively small portion of our indium phosphide revenue, we believe that this application could be a contributor to our revenue growth for years to come. In total, we believe that we are in an early stage of a multiyear opportunity for our indium phosphide business.

This is a highly specialized material in which AXT has made considerable market progress, both in terms of outstanding technical properties of our material as well as our customer traction.

As a result, we are currently increasing our indium phosphide capacity in a meaningful way in order to meet the expected increase in demand for our product in 2018 and beyond.

Now turning to gallium arsenide, over the last 2.5 decades, the application that has driven our gallium arsenide business has certainly evolved, and yet the material is as relevant today to the unfolding technology landscape as it was when it was first commercialized, our VGF gallium arsenide substrate, in the late 1980s.

Applications such as 3-D sensing, augmented and virtual reality, 5G wireless, LIDAR for autonomous cars, retina recognition, [indiscernible] based Internet connectivity, and many others are emerging and will require the performance characteristics and adaptability that gallium arsenide uniquely offers.

Further, the stringent technical specification of these high end applications continues to severely limit the number of companies that could produce substrates in enough volume to meet global demand.

As a pioneer in VGF gallium arsenide substrates, AXT continues to bring innovation and deep expertise in material science to our markets, helping our customers to unlock the potential of new technology by overcoming technical barriers. Our work in gallium arsenide based [indiscernible] solar cells for the automotive market is a perfect example.

Working with our customers, AXT engineers developed substrate that feature unique [indiscernible] and specialized properties for this application. Audi and BMW are now using gallium arsenide based solar panels on certain new models to provide power to the vehicle's climate control system fan without draining the battery.

In addition, Audi and Alta Devices are also integrating solar cells into panoramic glass roofs of Audi models to generate solar energy that extend the range of Audi electric vehicles. We are also excited about the potential of 3-D sensing technology for our business.

While AXT is not currently participating in the initial deployment of 3-D sensing technology for Apple iPhone X, we believe 3-D sensing technology present a significant long-term opportunity for AXT.

In addition to Apple, we are hearing from a number of sources that 3-D sensing capability are on the product roadmaps of several other device manufacturers and we believe we will see more widespread adoption by 2019. The strict technical requirements of 3-D sensing provide a strong barrier to entry to new low-end players.

Today, only three competitors, including AXT, are able to provide low EPD substrates in significant volume for production ramp. We understand that our product meet the technical qualifications and perform well for this application.

With the relocation of our gallium arsenide manufacturing facility showing good progress, we are on track to have the first 3-D sensing substrates from our new site for customer qualification this quarter. Once submitted, the length of qualification process will depend on the sense of urgency within the supply chain.

We believe that we could see modest amount of incremental opportunity from this application in 2018, but with more meaningful contribution in 2019. It is however very important to note that the mobile device application is likely just the beginning of many applications that will be using 3-D sensing technology in the coming years.

Some analysts have stated that by the year 2020-2022, the volume of gallium arsenide used for 3-D sensing in autonomous vehicles will be equal to or greater than that used in mobile phones. We are hearing that development work is already underway with these applications.

We'll continue to monitor this and other new applications closely and believe we are well-positioned to participate in their adoption. In total, we are enjoying stable revenue from our traditional markets for gallium arsenide, including power amplifiers for mobile phones as well as LED lightings, signage and display.

In addition, we are encouraged to see our substrate selling into a wide variety of nascent applications that have the potential to become meaningful to our business over the coming years, underscoring the long-term nature of our product portfolio.

Now turning to germanium substrates, this segment of our business was again strong in Q4 as the satellite industry continued its potential positive trend. We typically see a fairly constant demand for germanium substrate used in satellite solar cells, but in 2017 our germanium substrate revenue grew approximately 30%.

Though we are not expecting this level of growth in 2018, but we do believe that positive market conditions are likely to provide continued opportunity for growth over the coming quarters.

Finally, with regard to our partially owned raw material companies in China, recently we have begun to see an increase in raw material pricing, particularly gallium, largely a result of overall improvement in commodity pricing.

The increase to-date remains modest, and on the whole has served to bring suppliers close to breakeven levels, following a very significant decline in pricing over the last two years.

We do believe that as the demand for compound semiconductor substrate continue to increase, our holdings will provide important leverage for our operations as well as opportunity for positive contribution to our overall financial model.

Now before I close, I'd love to give you an update on the relocation of our gallium arsenide manufacturing to our new facilities in the city of Dingxing, China. With the continued solid execution of our team, we are on schedule with our plans and pleased with our progress to date.

This new technically advanced facility gives us the opportunity to plan our business for our next stage of growth and to support long-term requirements of our customers. We are excited for this facility to become a showcase for our capabilities for customers and investors alike.

As we have discussed, we are executing a staged relocation of gallium arsenide throughout 2018, which means that we will produce substrates from both our current site in Beijing and the new Dingxing site for a period of time, and then gradually increase production volume at the new site.

In closing, this year we will celebrate 32 years in business, including 20 years as a public company. Over that time, AXT has grown and evolved significantly.

Our business focus and operational discipline developed over time has allowed us to hold our ground against much larger competitors, to weather significant technology transitions in our industry, and build a sustainable business model of growth and profitability.

With the enduring entrepreneurial spirit of AXT, that has driven us to embrace new applications for our technology and our product, to recognize future growth opportunities, and develop the core competencies to supporting and to identify the strategies [indiscernible] of vertically integrating our supply-chain.

I'm very grateful to the entire team at AXT for their talent, their dedication and their tireless effort on behalf of our Company, our customers and our shareholders. We are very proud of the unique Company we have built together and we are excited about our future.

We see great upside potential for all the applications across the product portfolio that we have already qualified into and supplied. In addition, new applications and opportunities from incremental applications such as 3-D sensing hold promises for 2018 and beyond.

This is exciting time for our business and we look forward to reporting to you on our progress. This concludes my prepared comments. I will now turn the call back to Gary for our first quarter guidance.

Gary?.

Thank you, Morris. As we discussed, we are excited to see the upside potential across our portfolio and we believe we are well-positioned in many applications that will drive our business growth in 2018 and beyond. Coming off of a solid Q4, we expect to see revenue in Q1 approaching $26.0 million to $27.0 million.

If we take the midpoint of our Q1 guidance, this would be a 29% increase over Q1 of 2017. Given the expected Q1 OpEx levels that I discussed earlier, we believe our profit per share in Q1 will be in the range of $0.07 to $0.09 based on 40.44 million diluted common shares outstanding.

This concludes our prepared comments, but Morris and I will be glad to answer your questions now.

Operator?.

[Operator Instructions] Our first question comes from the line of Hamed Khorsand of BWS. Your line is open..

So, just wanted to discuss, as far as this increase in OpEx, is this all related to the Beijing facility and is that what you are talking about as far as growth in this year's goal as you are ramping this facility up right now?.

This is Gary. So, in the Q4 2017, no, it's not all related to the relocation because there's about $400,000 of severance-related expenses.

However, as we look on the horizon going forward with setting aside the one-time things I just mentioned, we do think our OpEx will be around the $6 million, and that will then – mostly that increase is related to expansion of the building that's going on with new employees, with training and things like that..

Okay, because I just want to make – it's about $1.1 million more than what you guys were at the beginning of 2017..

I agree. I understand..

Okay..

I think what's happened over the last 12 months is, the market opportunities that Morris described had become more and more tangible, more and more understandable. And so, we think that it's important to invest throughout the income statement, but that's going to mean building up a little bit more on OpEx as well..

Okay. And then on the last call, I mean it sounded like you guys were still questioning the PON market as far as it contributing to any demand.

What are you seeing as far as the end markets there, especially with China and the Lunar New Year in Q1?.

We think PON market is having a good recovery, although we'd like to wait and see how long it will continue. But we think the recovery is pretty solid as of now..

Okay. And then my last question is, you've usually talked about Q1 being sequentially up from Q4 and this time your guidance suggests it's going to be flat.

What's driving that, what are you seeing that you are questioning that there would be a sequential increase in Q1?.

I guess we never thought of it, but we do have our own sort of unique way of coming up with this guidance. We take it from our sales representatives as well as looking at our booking as well as projecting what the future growth is going to be like, and it come out to be exactly like Q4 was.

But I think specifically maybe I think indium phosphide is sort of continuing the growth trend, germanium is a little bit better, and the gallium arsenide is a little bit weaker. I think that's probably overall it's flat..

Yes, this is Gary. If you look at the historical trends, you are correct, we usually come down in Q4 from Q3. So there is some seasonality there. Q1, sometimes it's close to Q4, sometimes it's a little bit above Q4, but it's still a solid quarter. We have positive trends, we think things are okay.

And we don't give guidance beyond Q1 but I think you can tell from the tone of the content, we are very optimistic about the future quarter. So, I think it's okay, I think it's a solid quarter and you have to make your own judgment about it. But we don't think there's anything wrong or anything sort of going on that we don't understand.

This is just how the numbers came out, and you know us, we just sort of say it like it is..

Okay, all right. Thank you..

Our next question comes from the line of Jon Fisher of Dougherty & Company. Your line is open..

Just going through the segments just the way you talked about germanium and InP and in gallium arsenide, gallium arsenide kind of came across as probably more neutral in your commentary than the other two, and I guess I would push a little bit more as a follow-up to the prior question, kind of LED and OSRAM had been a really strong source of demand through 2017.

Has there been any sort of meaningful slowdown in demand from OSRAM or in lighting or in LED or what are you seeing in gallium arsenide that kind of makes your tone when you talk about that substrate maybe a little more neutral than the more bullish tone you had for InP and germanium?.

First of all, we don't really comment on specific customers. It can get us into a lot of trouble. So we don't talk about OSRAM or anyone else. I think gallium arsenide, yes we had pretty good growth in Q3 and Q4, and I think it's holding its own right now.

But maybe one specific area we see a little bit weakness is we hear some customers because the 3-D sensing market is so strong, people are giving up on the [indiscernible] business in preference to do the [indiscernible] business, such that it impacted our demand for the [indiscernible] gallium arsenide substrate.

But we also have a variety of applications. So, it's an accumulation of all these customers giving us these results or predictions, but we don't see any particular area which is weakening significantly going into the future..

Okay. And when you compare sequential performance, Q4 2016 and Q4 2017, the deceleration from Q3 was greater this year than it was in 2016.

When you look at the three primary substrates, were any of the substrates sequentially on a quarterly basis or were all three of them down and was there any one in particular that was down most significantly?.

There is no super big trend in any direction. Since we were down in aggregate 1.8 million, everything was generally down except raw materials..

Indium phosphide was up..

But again, the numbers rolled out we think very strongly. Our outlook for gallium arsenide is very positive. And again, this is the way the numbers came and we just put them out there. But our expectations and enthusiasm are not diminished for any of these products. It's very solid..

Okay.

And then from a CapEx standpoint, kind of what would be the outlook for CapEx in 2018, a step-up from 2017 levels or kind of in line with 2017 levels, or would there be a step down from 2017 levels?.

I think by the end of 2018, it will probably be more than 2017. I don't know how much more yet though because both years have the building stuff going on and we're not done with that yet. But generally what we say for CapEx is for the equipment side of it, it runs $4 million to $6 million a year.

In the last couple of years that's probably been on the low side of the $4 million to 6 million range. Right now we are doing a little bit more in equipment. As Morris said, for indium phosphide we're buying more furnaces. So, both on the equipment side and then on the facilitization side, it will be up a little bit..

Don't forget, we also said, in order for us to build the new facility, we're going to purchase new equipment in the order of 25% to 30% more new equipment to be put into the new facility and get them running before we start to move the old equipment into the new arrangement.

So that's why you see a spike in the equipment purchases in the last quarter. I think it was 4.5 million instead of just 1 million. So, it could be more, but some of that is building and some of that is equipment. But in general it's meeting our expectations. We are on track with what we expect..

And then the last question, just from a geographic standpoint when you look at revenues, are you comfortable with the performance of all three of the main geographies in Q4 and kind of whatever you inferred outlook is for Q1, or is there any weakness in any one of the particular main geographies?.

The geographic trend for our product is pretty dominated by the Asia Pacific region, and that's not going to change. Does it mean that we don't think we can improve in any of these three regions? No, I think we can improve in all three of them, North America, Europe and Asia Pacific.

We're not disappointed in any of the regions and this is pretty much how it's been. We know we have made some changes in Europe. Our sales representatives for over 20 years retired and so we hired a direct employee who is off to a good start and we hope that he can do more business development in the European front..

Okay, thank you..

Our next question comes from the line of Dave Kang of B. Riley FBR. Your line is open..

This is actually [indiscernible] filling in for Dave. First question, I appreciate the visibility on the gallium arsenide potential qualification timing. Just kind of curious in terms of customer reception, it sounds like capacity for 3-d sensing is actually tight across the universe of gallium arsenide suppliers.

So, I'm just curious if the small revenue you expect in 2018 is perhaps conservative just given the fact that there is some new demand out there from other OEMs as well as the core adding new products? So, just kind of curious, when the customers get qualified and maybe if there is a potential ramp for something higher than just marginal revenue in 2018?.

It could happen. We were told that – we have multiple fronts, by the way, not only that particular company. Other customers are running qualification. But since they are not running production right now, it's difficult for us to put an exact number on it.

But overall we are excited about it, but when we build our business model or our budget, we don't put that much of a big expectation out of it because it's something which once we qualify, it can run big, it can run small, it could take a quarter or two to become comfortable. And as I also said, this is not only one customer.

We have multiple customers. But one of them probably is the biggest that everybody knows, but there are other smaller customers running qualification as well..

Got it. Thank you. And then just on the indium phosphide front, you guys mentioned that you are doing capacity expansion.

Just kind of curious what end markets would drive that capacity expansion? I would assume you have some sort of visibility to invest, curious if that's driven by an improvement in GPON or if that's all primarily datacom?.

I think it's all of the above..

All of the above, yes..

The data center business is showing very strong projection for growth. GPON is coming up as well. The whole silicon photonics advancement, which is widely understood now I think and expected to continue for multiple years, it's going to help us a lot and probably more steady than the EPON/GPON market. But both are strong, that's what we are seeing..

Okay. And then just last question on gross margin, you guys mentioned better pricing and you've built some inventory as a reflection of better pricing.

Just kind of question on 2018 gross margin levels, assuming pricing stays level or improves more per your outlook, how does that drive gross margin? And then, just given the growth in indium phosphide, how does that also fit in to your kind of outlook year-over-year for gross margin?.

The gross margin is the most volatile line on our income statement. We say that repeatedly to your community. So, if you look at the four quarters of 2017, first two quarters it was like 30.5% and that range, second two quarters it was over 35%, 39% and then 37%.

So, we continue to say that the safest way probably for anyone running a model would be maybe somewhere in the mid-30s. Our goals are greater than that, but I think it's probably appropriate to be realistic and conservative. So that's kind of what we would guide. Let me clarify one thing as it is.

As the raw material prices increase, which Morris mentioned, we have a hedging sort of business model strategy, because it will actually bring our substrate gross margin down a little bit because we may have to pay more for the cost of raw materials in the open market, but it will help our 10 joint venture companies, or many of them, because they will be able to charge a higher ASP.

So, we have three companies that we consolidate and then seven down below that we use the equity method of, and you may not have watched it closely but I know David has, David Kang has, and other analysts, but that line down below has been negative for all of 2016 and all of 2017 and we've been saying that we are hoping it will come back to be neutral and we still think that's a very realistic hope.

So, raw material prices are increasing and that's going to help those companies improve..

Got it, helpful, thanks guys..

Our next question comes from the line of [Rene Zenner of Octavian] [ph]. Your line is open..

Just to follow up on the raw material price situation, can you talk to the drivers, I mean the price for gallium obviously has been sliding for many years, and now towards beginning of December we saw quite a steep rise, but not only in gallium, also in indium phosphide volume, so you mostly acted in gallium, I'm looking back with your financials a couple of years ago, you had very significant contribution from both the direct consolidated investments as well as your [indiscernible] consolidated investments, once the gallium price goes above $150 and we are close to $200 now, so maybe you could talk us through the drivers between the price increases and what it could mean for the numbers in 2018 and what is embedded in your Q1 guidance in terms of relative price implications?.

This is Gary. So, what would it mean? What I've been telling you guys for about six months is that my goal and Morris' goal is to get the raw material companies back to at least break-even in aggregate, and for the seven companies that we use the equity method for, for Q4 there was still a charge of $307,000.

So, that's down nicely from the beginning of the year, which was $900,000 charge. So, we are going in the right direction. I think for people running models, it's probably reasonable to put it at for the year of [2018, zero] [ph].

Maybe there is upside but we tend to be more conservative, so we don't want people to get too far ahead in terms of modelling.

But the overall impact in aggregate in the history of the Company, the partially owned companies, there are 10 of them that we have partial ownership of, they have been accretive and it's been helpful not only financially but it's given us visibility into the supply chain, it's given us shorter lead time, better control, especially if there are shortages.

So, then for 2016 and 2017, it's been a little bit tough, but now we think that that toughness we hope is behind us and we will at least be into sort of a neutral zone. But we can't see farther ahead. You'd be just as good at guessing as we are.

Even though we have a lot of knowledge about China, you have the access to all these world charts and things like that..

All right.

And what do you think about the recent drivers for the price increase of overall raw materials as [indiscernible] run rate before?.

Say that again, please..

What do you think of the drivers for the pricing staying low for a very long time and now it's risen, gallium has risen 70% since midyear..

So he is asking, what were the drivers for the prices to be low for so long and what's causing them come back up now?.

Okay, so the reason for it to go down so much was too much capacity. As you know that during the last cycle back in 2010, the gallium price went wild, it went to almost $1,000 a kilogram, so everybody in China started to build capacity. So, way too much capacity that drives the price down.

Now why is it coming back up now? I think during the last two years, just about everybody even in China is losing money in producing gallium. So, some of them threw up their towel and quit the business.

And also I think the other driver potentially up a little bit in pricing as they say, solid [indiscernible] coming up in using those gallium arsenide as well as gallium is used for LED production as well as making the fluorescent light bulb for the powder.

So, gallium has many, many, multiple applications which in technology field has seen increase in demand. That drives the price up..

Okay, thanks very much..

Our next question is from the line of Gus Richard of Northland. Your line is open..

I just had two quick questions.

First on what is the impact of mix, gallium arsenide versus indium phosphide in terms of margin contribution? In other words, which product has higher margins?.

We don't give hard numbers. We'd like to help you by being able to do that, but we've found out that customers and competitors were listening to these calls. But what we have said publicly is that indium phosphide is higher than gallium arsenide. That's well known.

So, if we have a choice of selling $100 worth of gallium arsenide versus $100 of indium phosphide….

We sell both..

We'd sell both..

Right, understood. And then in the second half of the year you had a nice increase in gross margin.

Was that driven by mix or is that higher capacity utilization because you're preparing to move locations?.

Yes to both. Mix was better. So for example, Q3 and Q4 indium phosphide basically had an all-time high for those two quarters, the second half of the year. And the volume secondly for production was high, just because we were both producing to ship and we were also producing for a little bit of a bank account for categories to have extra inventory.

So, both of those contributed..

Okay.

And in the near-term, there will be a little bit of an outgoing tide in terms of margins just because your utilization rates would be falling a little bit as your new factory comes up?.

No. Go ahead, Morris..

No, I think in the moving of the factory, we're just in the beginning. It's going to last for a whole year. I don't want you to have the wrong impression that people have taken more material just help our business and in the future once we move then they are going to deplete their inventory. I don't think that's….

Yes, that's not happening..

Yes, that's not happening..

No, that's not what I'm trying to suggest. I was thinking that you'd have two facilities and they wouldn't be fully utilized as you were moving from one foot to the other..

Here's the interesting thing, and we have discussed this with people that drill down into the detail. So, when we buy new equipment, that's basically a push because of expectations on volume and near-term outlook, which as you can see from the tone of today's message, we are very optimistic and excited about that.

So, we are buying more equipment because we would no matter what location we were in, and then that equipment would be depreciated over five years. The facility depreciation rate is 27.5 years. So, having an extra facility, it doesn't move the needle as much as people might expect.

And once you understand what the depreciation lifecycle is, then people realize, okay, then it's not huge. So, no, we don't expect.

The reason we – I know you haven't been following the Company too much, but the reason we keep trying to set people's expectations for margin in the mid-30s is because our margin is volatile, it changes sometimes, but it's not because we have some secret awareness that there is going to be the tide going out. In fact, our guidance for Q1 is modest.

We don't give guidance beyond that with hard numbers, but you need to read between the lines and get the message because we feel very optimistic about future quarters, we don't see the tide going out..

Yes, I was just speaking in terms of margins. I appreciate your patience and the explanation.

Just one final one for me, can you talk a little bit about tax rate given the changes in the tax law for the upcoming year?.

Yes. Basically we don't think the tax law in the United States the change will have, currently we don't think there is any big significant difference. The reason is that we have from historical times when the Company had started we built up a big NOL carryforward.

So we don't have a huge tax liability in the United States and having the rate drop probably won't have a big impact on us. So, we generally pay a modest amount of taxes and most of them are in China..

Got it.

So, thinking about a similar rate as compared to 2017?.

Let's take a look at 2017, so give me a second. 2016 was $733,000, 2017 was $792,000. So, I would guess we'll be north of $792,000 because our volume is going to be up, we are paying, we have more employees, maybe more different kinds of taxes, but it's not going to spike up to $3 million or something like that..

Got it. Thank you so much for answering the questions and your patience..

Our next question comes from the line of Edwin Mok of Needham. Your line is open..

Sorry, I joined the call late, so I missed part of the comment. I apologize ahead of time. But I have three quick questions.

First, did you disclose how much indium phosphide grew this year or this last quarter or they it reach 30% of sales in 2017, any color you provided around that?.

We didn't disclose a hard percent. The last time we had given sort of percent guidance, we had said maybe several quarters back that indium phosphide was approximately 30% of revenue. That's still okay..

I think general, sure, we are very feeling strongly about indium phosphide, but we do have a record year for indium phosphide, but on the other hand gallium arsenide, also germanium, grew. Germanium grew almost 30%, as we said in our prepared comments.

But perhaps we are more excited about indium phosphide growth is it has more legs to come because you are building upon an existing business which has potential to grow further. As we said, the PONs market is recovering.

I think that's a very excited market because in the past year and a half it was mainly the data center growth opportunity which helped us in indium phosphide growth, but if PON was to come back, then that should layer on top of it.

So, I think it's perhaps not the percentage which gave us the excitement, but overall year-over-year I think we have over 25% – 22% to 23% growth in our revenue from 2016 to 2017, correct?.

21%, right, the whole total revenue..

Okay, that's actually helpful. Can I jump quickly on GaAs, Morris, you said, since there is a seemingly emerging application GaAs that is driving some growth here, but still [indiscernible] is still a big driver there.

Is there a way to you can kind of think about which one of those markets you see a particular strength in the near-term or that you are seeing you are particularly optimistic about in the near term, or does it mostly come from still call it the main RF/PA market that the traditional market where you've seen kind of just grow in volume?.

The traditional market actually would deliver good revenue growth. The 3-D sensing has greatest potential but because it comes from such a small volume to begin with, so we expect the contribution for this year may be smaller but we do see gallium arsenide, especially LED, that has a great potential to increase in volume, yes..

Yes, so that's in existing market, but it seems to be strengthening..

And it's requiring a high-end gallium arsenide, which is good for us..

Okay, great. And then the last question I have, just kind of want to understand where we stand on the JV problems.

I think last time we talked, you guys were pushing JV to take some stuff to improve the cost and [indiscernible] business becomes more profitable, any way to kind of think about that or is this still kind of [indiscernible] discount maybe closer to breakeven range?.

Generally they are improving and maybe we did comment a little bit ago but you might've missed it, but if you compare 2017 beginning to 2017 ending, it was $900,000 charge for the seven equity companies, dropping down to $307,000.

And because prices are rising right now, we do think that it's very reasonable for that group to at least get to breakeven, probably very soon. So, beyond that I wouldn't suggest modelling any uptick yet, I think it's too soon. But it's probably next time we give guidance, we can give a little more color and maybe let people move it up a little bit.

But until we have a little more time under our belt, I think breakeven is probably good..

Okay, great. Actually that's all I have. Thank you..

Our next question is from the line of Sean Boyd of Next Market Capital. Your line is open..

Just a quick one for me and that's related to comments about indium phosphide and the strength that you are seeing on the silicon photonics for data centers and then this kind of recovery in the PON market, I know these states kind of flipped flopped and you've got a greater contribution from silicon photonics here at this point into the indium phosphide, and I'm just wondering do you anticipate it to stay that way? And in very rough numbers I'm thinking about the business as sort of half from silicon photonics and maybe a quarter from PON.

Is there anything you can do to help me on that and really if we go and we think about 2018 now? That's the question. Thank you..

I'm not trying to avoid the question but the standard answer is, actually we don't really know exactly where our customers are using our substrate for. We just sell indium phosphide substrate, whether it's 2-inch, 3-inch, 4-inch, we divide it into different doping levels.

But when the customer takes it, when they grow the epilayer out, they can use it for PON, they can use it for detector, or they can use it for silicon photonics. The reason why we know silicon photonics is running very, very strong growth is because there are certain customers we know for sure that are using it for silicon photonics.

But others we don't, we just don't know. So, sometimes we add up and say, silicon photonics let's say is 25% and PONs market is 15%. Oops, you only come up with 40%. What's the rest of 60%? So, it's the others that are we don't know.

So, what I would say is, the ratio silicon photonics is bigger than PONs for sure, but what percentage it is we really don't know. We can't help you on that..

Got it, okay. Thanks guys..

Thank you. And at this time I'm showing no further questions. I'd like to turn the call back over to Dr. Morris Young for the closing remarks..

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 any of us. We would like to look forward to speaking with you in the near future..

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