Cash and cash equivalents decreased $9.6 million to $14.8 million as of June 30, 2004 compared with $24.3 million as of December 31, 2003. Short-term investments increased by $5.2 million to $19.9 million as of June 30, 2004 compared with $14.7 million as of December 31, 2003. We converted approximately $7.8 million of the total $9.6 million of Chinese Renminbi from the sale of our opto-electronic assets into United States dollars during the first quarter of 2004 and invested most of that into short-term investments. The remaining funds were converted in early April 2004.

Net cash ~~provided~~used by operating activities of ~~$6.0 million~~$185,000 for the ~~nine months~~six month period ended ~~September~~June 30, ~~2003~~2004 was comprised primarily of our net loss adjusted for non-cash items ~~of $15.7~~which netted to $2.8 million, consisting primarily of ~~a loss on disposal from our discontinued opto-electronics division~~depreciation of ~~$9.5 million and depreciation expense of $4.6~~$2.4 million, and by a ~~$14.9~~$2.6 million net change in assets and liabilities. The net change in assets and liabilities resulted primarily from ~~decreases~~a decrease in accounts receivable and inventory ~~and income tax receivable~~partially offset by an increase in prepaid expenses and a decrease in accrued liabilities.

~~Accounts~~

Net accounts receivable decreased ~~$1.8~~by $1.9 million, or ~~24.6%~~30.3%, to ~~$5.4~~$4.4 million ~~at September~~as of June 30, ~~2003~~2004 compared ~~to $7.2~~with $6.3 million atas of December 31, ~~2002.~~2003. The decrease ~~includes $700,000 net write-down~~reflects better collections from customers and an additional sales returns reserve of ~~opto-electronics accounts receivable through loss on disposal. Inventories~~$745,000 recorded in the first quarter of 2004.

Net inventories decreased ~~$11.5~~$2.3 million, or ~~30.6%~~9.4% to ~~$37.6~~$21.8 million ~~at September~~as of June 30, ~~2003~~2004 compared ~~to $37.6~~with $24.1 million atas of December 31, ~~2002.~~2003. The ~~decrease in inventory is~~Company adopted a ~~result~~strategy of our continued effort to minimize cash outflows utilizing more effective inventory management policies. The decrease also includes a $1.4 million net write-down of opto-electronics inventory through loss on disposal, and $600,000 of inventory sold

~~through the asset sale of our discontinued opto electronics division. We expect our~~using inventory to ~~continue~~conserve cash during the first half of 2004. During the second half of 2004, we do not expect to maintain the same rate of net inventory decrease ~~throughout the remainder~~as we experienced in first half of ~~2003.~~2004.

Net cash ~~provided~~used by investing activities of ~~$11.2~~$6.8 million for the ~~nine months~~quarter ended ~~September~~June 30, ~~2003~~2004 includes ~~net proceeds from the sale~~purchases of property and equipment of ~~$14.8~~$0.7 million primarily used to transfer production capacity to China for the substrate division, and ~~purchases of equipment of $1.9 million. It also includes $3.3 million in~~ purchases of high grade investment securities with maturities of less than two years totaling $20.7 million, partially offset by ~~$5.7 million in~~ sales of ~~these~~high grade investment securities ~~as well as an increase~~totaling $10.4 million and a change in the investments providing our restricted cash of ~~$4.0~~$4.2 million.

We do not have any plans to initiate any major new capital spending projects ~~during 2003.~~through 2004. We are currently completing certain projects at our China facilities and ~~are continuously constructing minor improvements to~~closing our ~~existing production~~remaining manufacturing facilities in ~~China and the United States.~~Fremont, California. We expect to invest ~~an additional $400,000~~approximately $2.0 million in capital projects ~~throughout the remainder of 2003.~~in 2004. We believe that our existing and planned facilities and equipment are sufficient to fulfill current and expected future orders.

In February 2003, our Board of Directors authorized the repurchase of up to 2 million shares of our common stock over a one-year period. To date we have not repurchased any shares. If repurchased, repurchased shares will be retired. We expect to sell shares of common stock of Finisar Corporation to fund our stock repurchase program.

Net cash used in financing activities of ~~$9.6~~$2.5 million ~~for the nine months ended September 30, 2003 includes~~consisted of scheduled payments of $2.7 million related to long-term borrowings, partially offset by proceeds of ~~$424,000 from the sale of common stock~~$0.2 million through our employee stock compensation ~~programs, offset by payments of $1.6 million on long-term debt and to settle all equipment loans and $8.4 million to settle all capital leases.~~programs.

Our main Fremont, California manufacturing facility is financed by long-term borrowings, which were refinanced by taxable variable rate revenue bonds in 1998. These bonds mature in 2023 and bear interest at a variable rate that was ~~1.35% at September~~1.4% as of June 30, ~~2003.~~2004. The bonds are traded in the public market. Repayment of principal and interest under the bonds is supported by a letter of credit from our bank and is paid on a quarterly basis. We have the option to redeem the bonds in whole or in part during their term. ~~At September~~As of June 30, ~~2003, $8.6~~2004, $8.5 million was outstanding under these bonds.

~~At September~~

As of June 30, ~~2002~~2004, the credit facility maintained by us with a bank included a letter of credit supporting repayment of our industrial bonds with an outstanding amount of $8.6 million. The Company has pledged and placed ~~cash and~~ certain investment securities with ~~the trust department~~an affiliate of the bank as additional collateral for this facility. We have also pledged ~~cash~~certain investments for a credit facility for our workers compensation ~~insurance as well as $1 million of the proceeds from the sale of the assets of our discontinued opto-electronics division held in escrow.~~insurance. As a result, ~~$10.4~~$8.6 million of our cash and ~~our long-term~~short-term investments are restricted.

~~At September~~

We currently hold a note payable secured by certain buildings and land in China totaling $1.5 million as of June 30, ~~2003, we had available cash, cash equivalents and liquid short and long-term investments of $35.2 million.~~ 2004. The balance on this note is due in December 2004.

We believe that ~~our existing~~we have adequate cash and ~~liquid~~ investments ~~cash generated from operations, coupled with additional efforts to reduce our expenditures in support of our substrate business, will be sufficient~~ to meet ~~our working capital expenditure requirements for~~the Company’s needs over the next 12 months. ~~However, our existing cash and liquid investments could decline during the remainder of 2003 due to a continued or further weakening of the economy or changes in our planned cash outlay.~~

If our sales ~~continue to~~ decrease, however, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity, require us to use more cash at a more rapid rate than expected, and require us to seek additional capital. There can be no assurance that such additional capital will be available or, if available it will be at terms acceptable to the Company. Cash from operations could be affected by various risks and uncertainties, including, but not limited to those set forth below under “Risks Related to Our Business.”

Outstanding contractual obligations as of June 30, 2004 are summarized as follows (in thousands):

	Debt		Operating Leases		Total
2004 (remaining six months)	$	1,818	$	717	$	2,535
2005	420		1,222		1,642
2006	420		901		1,321
2007	420		681		1,101
2008	385		681		1,066
Thereafter	6,345		2,855		9,200
	$	9,808	$	7,057	$	16,865

We lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through March 2013. Total rent expense under these operating leases was approximately $352,000 and $705,000 for the three month and six month periods ended June 30, 2004, respectively.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entities, which addresses consolidation by business enterprises of variable interest entities, or VIEs, either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46, or FIN 46(R), resulting in an effective date of no later than the first interim or annual period ending after March 15, 2004. The Company’s adoption of FIN 46(R) did not have an impact on our results of operations or financial position.

In April 2004, the Emerging Issues Task Force issued Statement No. 03-06, (EITF 03-06), Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings Per Share. EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 was effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-06 did not have a material effect on the Company’s results of operations or financial position.

Risks Related to Our Business

~~The disposal of our opto-electronics business may fail to result in the benefits we anticipate.~~

We may not obtain the benefits we expect as a result of discontinuation of our opto-electronics business, such as greater strategic focus on our core businesses. We may be required to return to the buyer some or all of the $1 million held in escrow should the buyer successfully claim that we breached one of the representations or warranties made to it. The buyer may not reimburse us for the limited set of continuing services and leases that we are providing. Our building in Monterey Park may not be sold for the $1 million at which we are carrying it on our balance sheet.

We may incur ~~additional costs associated with the discontinued operations which could materially reduce our short term earnings.~~

~~We may be required to raise additional capital in the future, which may not be available.~~

We anticipate that our existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. However, our liquidity is affected by many factors including, among others, the extent to which we pursues additional capital expenditures, the level of our production efforts, andclaims or other ~~factors~~liabilities or obligations related to ~~the uncertainties~~our failureto follow requirements for testing of ~~the industry~~products and ~~global economies. Accordingly,~~provision of testing dataand information relating to customer requirements. Additionally, customers maycancel or reduce future shipments in response to these failures.

We have recently determined that we had not followed requirements for testing of products and provision of testing data and information relating to customer requirements. See preceeding “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation - Overview” and “Item 4. Controls and Procedures” below for further information. Although we are notifying affected customers concerning our findings, there can be no assurance that ~~events~~we will not incur customer claims or other liabilities or obligations in connection with this matter, nor, if we receive any such claims, that we will not have to restate results from prior periods. In addition, revenue in future periods may be adversely impacted if customers cancel or reduce orders or decide not to continue ordering from us as a result of this disclosure. We have been notified of several cancellations of future orders by customers pending further information regarding enhancements to our product testing and quality control systems. We cannot be sure that we will not receive additional cancellations of orders by other customers, or fail to win expected future orders from customers, as a result of our disclosure of our investigation conclusions.

Because of power shortages in China, we may have to temporarily close our China operations, which would adversely impact our ability to manufacture our products, meet customer orders, and result in reduced revenues for the period.

The Chinese government has indicated that the country faces a power crunch this summer and that power demand in 24 provinces outstripped supply in peak periods during the first four months of 2004. Instability in electrical supply has caused sporadic outages among residential consumers. As a result, the Chinese government has called for tough measures to ease the energy shortage which is expected to last at least through 2005. Provinces have imposed power brownouts to reduce electricity demand and some companies in Beijing have been ordered to give their employees a week off to ease the pressure on power supply. It is anticipated that the plants, most of which are state-owned, will be closed and reopened on a staggered schedule to reduce power consumption during the capital’s hottest months, with the first closings occurring in early July. The policy is expected to continue until the end of August. We closed most of our operations for a week in late July 2004 in conformance with this policy. If we are required to make additional temporary closures of our Beijing operations, we will be unable to manufacture our products, and will be unable to meet customer orders except from inventory on hand. As a result, we could lose sales, adversely impacting our revenues, and our relationships with our customers could suffer, impacting our ability to generate future sales. In addition, if power is shut off at our Beijing operations at any time, either voluntarily or as a result of unplanned brownouts, during certain phases of our manufacturing process including our crystal growth phase, the work in process may be ruined and rendered unusable, causing us to incur expense that will not be covered by revenue, and negatively impacting our cost of goods sold and gross margins.

Intellectual property infringement claims may be costly to resolve and could divert management attention.

Other companies may hold or obtain patents on inventions or may otherwise claim proprietary rights to technology necessary to our business. The markets in which we compete are comprised of competitors who in some cases hold substantial patent portfolios covering aspects of products that could be similar to ours. We could become subject to claims that we are infringing patent, trademark, copyright or other proprietary rights of others, and have been sued by a substrate competitor concerning alleged patent infringement. On April 15, 2003, Sumitomo Electric Industries, Ltd., (SEI) filed a complaint in the ~~future~~Tokyo District Court, Civil Division against the Company and its Japanese distributor alleging patent infringement of two patents held by SEI in Japan. The suit seeks penalties from us in the amount of $1.67 million plus interest and court costs and the cessation of our sales of gallium arsenide substrates in Japan. We intend to defend ourself vigorously in these law suits. Both parties have completed submitting arguments and evidence in litigation in Japan and we currently retain all of our options which include appealing any court decision and launching an effort to have Sumitomo’s patent invalidated in Japan. However, there can be no assurance that the court will not ~~require~~rule against us ~~to seek additional capital,~~on the infringement claim, or ~~if so required,~~ that ~~such capital will be available~~we can settle this matter on terms acceptable to us, if at all.

~~Much~~

Litigation to determine the validity of alleged claims, such as that between us and Sumitomo, could be time-consuming and result in significant expense to us and divert the efforts of our ~~cash resources are denominated~~technical and management personnel, whether or not the litigation is ultimately determined in ~~Chinese reminbi~~our favor. If a law suit is decided against us, including the lawsuit with Sumitomo, we could be subject to significant liabilities, requiring us to seek costly licenses or preventing us from manufacturing and ~~held in accounts in China and, under some circumstances,~~selling our products. We may not be ~~easily exchanged for US dollars. The value~~able to obtain required licensing agreements on terms acceptable to us or at all. If we lose the litigation with Sumitomo, we may have to pay royalties to Sumitomo on products sold in Japan, or cease sales of our ~~Chinese cash holdings are also~~products to customers in Japan.

If we fail to comply with environmental and safety regulations, we may be subject to significant fines or cessation of our operations; in addition, we could be subject to suits for personal injuries caused by hazardous materials.

We are subject to federal, state and local environmental and safety laws and regulations in all of our operating locations. These laws, rules and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development, and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our operations. In March 2001, we settled a claim made by the California Occupational Saftey and Health Administration, or Cal-OSHA, in an investigation primarily regarding impermissible levels of potentially hazardous materials in certain areas of our manufacturing facility in Fremont, California for $200,415, and we have recently been the target of press allegations concerning our environmental compliance programs and exposure of our employees to hazardous materials, and there is a possibility that former employees may file litigation against us. Although we have put in place engineering, administrative and personnel protective equipment programs to address these issues, our ability to expand or continue to operate our present locations could be restricted or we could be required to acquire costly remediation equipment or incur other significant expenses. Existing or future changes in ~~the exchange rate between Chinese reminbi and US dollars. If our US dollar commitments exceeded the cash we have available~~laws or regulations in the United States and China may require us to incur significant expenditures or liabilities, or may restrict our operations. In addition, our employees could be exposed to chemicals or other hazardous materials at our facilities and we may be ~~unable~~subject to ~~access~~lawsuits seeking damages for wrongful death or personal injuries allegedly caused by exposure to chemicals or

hazardous materials at our facilities.

If litigation is brought against us, litigation is inherently uncertain and while we would expect to defend ourself vigorously, it is possible that our business, financial condition, results of operations or cash ~~held~~flows, could be affected in ~~China to satisfy these commitments.~~any particular period by such litigation if brought against us.

The semiconductor industry is cyclical and ~~is currently experiencing~~has experienced a ~~severe and prolonged~~ downturn which hasadversely impacted our operating results.

Our continuing business depends in significant part upon manufacturers of electronic and opto-electronic semiconductor devices, as well as the current and anticipated market demand for such devices and products using such devices. As a supplier to the semiconductor industry, we are subject to the business cycles that characterize the ~~industry-the~~industry. The timing, length and volatility of these cycles are difficult to predict. The semiconductor industry has historically been cyclical because of sudden changes in demand for semiconductors and capacity requirements, including capacity utilizing the latest technology. The rate of changes in demand, including end demand, is ~~accelerating,~~high, and the effect of these changes upon us ~~is occurring sooner,~~occurs quickly, exacerbating the volatility of these cycles. These changes have affected the timing and amounts of customers’ capital equipment purchases and investments in new technology. These industry cycles create pressure on our net sales, gross margin and net income.

The industry has ~~in the past, and will likely in the future, experience~~previously experienced periods of oversupply that result in significantly reduced demand for semiconductor devices and components, including our products, both as a result of general economic changes and overcapacity. When these periods occur, our operating results and financial condition are adversely affected, and create pressure on our revenue, gross margins and net income. Inventory buildups in telecommunications products and slower than expected sales of computer equipment resulted in overcapacity and led to reduced sales by our customers, and therefore reduced purchases of our products. During periods of weak demand such as those experienced over the past ~~year,~~years, customers typically reduce purchases, delay delivery of products and/or cancel orders of component parts such as our products. Increased price competition has resulted, causing pressure on our net sales, gross margin and net income. We ~~have over the past year~~ experienced cancellations, price reductions, delays and push outs of orders, which have resulted in reduced revenues. If the economic downturn ~~continues,~~were to continue, or occur again in the future, further order cancellations, reductions in order size or delays in orders will materially adversely affect our business and results of operations. ~~Although we have taken actions~~Actions to reduce our costs, ~~if our actions are~~such as those we have recently taken, may be insufficient to align our structure with prevailing business ~~conditions, we~~conditions. We may be required to undertake additional cost-cutting measures, and may be unable to invest in

marketing, research and development and engineering at the levels we believe are necessary to maintain our competitive position. Our failure to make these investments could seriously harm our business.

~~The financial condition~~

During periods of ~~our customers may affect their ability to pay amounts owed to us.~~

~~Many of our customers are facing business downturns that~~increasing demand for semiconductor devices, we must have ~~reduced their cash balances~~sufficient manufacturing capacity and their prospects. We frequently allow our customers to pay for products we ship to them within 30 to 90 days after delivery. Subsequent to our shipping a product some customers have been unable to make payments as due, reducing our cash balances and causing us to incur charges to allow for a possibility that some accounts might not be paid. At least three customers that owed us a significant amount have filed for bankruptcy protection and we are unlikely to receive a substantial portion or any of the amounts owed to us as part of a bankruptcy settlement. Other customers may also be forced to file for bankruptcy. If our customers do not pay their accounts when due, we will be required to incur charges that would reduce our earnings.

~~A reoccurrence of Severe Acute Respiratory Syndrome (SARS) may adversely impact our manufacturing operations and some of our key suppliers and customers~~

The majority of our substrate manufacturing activities are conducted in China. In addition, we source key raw materials, including gallium, from our joint ventures in China. The SARS outbreak was most notable in China. One employee at our LED production facility in China contracted SARS in late April prompting us to close the facility for ten days. There was no significant impact to our ability to fill customer orders. If there were to be another outbreak of SARS and if our employees contracted the disease, we may be required to temporarily close our manufacturing operations. Similarly, if one of our key suppliers is required to close for an extended period, we may not have enough raw material inventory to continue manufacturing operations. In addition, while we possess management skills among our China staff that enable us to maintain our manufacturing operations with minimal on-site supervision from our US-based staff, our business could also be harmed if travel to or from Asiameet customer demand, and the United States is restricted or inadvisable, as it was earlier in 2003. None of our substrate competitors is and few of our opto-electronics competitors are as dependent on manufacturing facilities in China as we are. If our manufacturing operations were closed for a significant period, we could lose revenue and market share during that period which would depress our financial performance and could be difficult to recapture. Finally, if one of our key customers is required to close for an extended period, we may notmust be able to ~~ship product~~attract, hire, train and retain qualified employees to ~~them,~~meet demand. It appears that the semiconductor industry is in the early stages of an upturn and increasing demand. However, we cannot predict the sustainability of a recovery, if any, and the industry’s rate of growth in this recovery, if it occurs. If we are unable to effectively manage our ~~revenue would decline~~resources and ~~our financial performance would suffer.~~

~~The impact of changes in global economic conditions~~production capacity during an industry upturn, there could be a material adverse effect on our ~~customers may cause us to fail to meet expectations, which would negatively impact the price~~business, financial condition and results of ~~our stock.~~operations.

Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. More specifically, the macro-economic environment that we faced in the second half of 2001 and continued to face in 2003 is more uncertain than in prior periods, has lasted longer than expected and has materially and adversely affected us and our operating results and may continue to do so. The revenue growth and profitability of our business depends on the overall demand for our substrates, and we are particularly dependant on the market conditions for the wireless, fiber optics and telecommunications industries. Because our sales are primarily to major corporate customers whose businesses fluctuate with general economic and business conditions, a softening of demand for products that use our substrates, caused by a weakening economy may result in further or prolonged decreased revenues. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing products due to the downturn in their business and in the general economy.

~~Unpredictable fluctuations in our operating results could disappoint analysts or our investors, which could cause our stock price to decline.~~

We have not over the past year been able to sustain growth, and may not be able to return to historic growth levels in the current economic environment. Our net loss in 2002 is the largest in our history and our losses have continued during 2003. We have and may continue to experience significant fluctuations in our revenue and earnings. Our quarterly and annual revenue and operating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including:

• ~~decline in general economic conditions or downturns in the industry in which we compete;~~
• ~~fluctuations in demand for our products;~~
• ~~expansion of our manufacturing capacity;~~
• ~~expansion of our operations in China;~~
• ~~limited availability and increased cost of raw materials;~~
• ~~the volume and timing of orders from our customers, and cancellations, push outs and delays of customer orders;~~
• ~~fluctuation of our manufacturing yields;~~
• ~~decreases in the prices of our competitors’ products;~~
• ~~costs incurred in connection with any future acquisitions of businesses or technologies;~~
• ~~increases in our expenses, including expenses for research and development; and~~
• ~~our ability to develop, manufacture and deliver high quality products in a timely and cost-effective manner.~~

Due to these factors, we believe that period-to-period comparisons of our operating results may not be a meaningful indicator of our future performance. Our operating results have over the past year at times been below the expectations of securities analysts or investors. If this occurs again in future periods, the price of our common stock would likely decline or fluctuate.

A substantial percentage of our operating expenses are fixed in the short term and we may be unable to adjust spending to compensate for an unexpected shortfall in revenues. As a result, any delay in generating revenue could cause our operating results to be below the expectations of market analysts or investors, which could also cause our stock price to fall.

The lead-time for customer orders is generally less than three months. As a result, our visibility regarding future financial performance is uncertain and we have and may continue to provide investors with financial guidance that we cannot meet. As a result, our operating results could be below the expectations of market analysts or investors, which could also cause our stock price to fall.

If the economy recovers and we are again in a period of high demand for ourproducts, we may be unable to expand our manufacturing capacity quickly enoughto meet increased demand, we may make decisions to expand capacity that are notprofitable, and we may be unable to lower our costs or increase revenue.

~~Although we are currently~~

It appears that the industry may be in ~~a period of overcapacity, reduced sales, and decreased margins, if the economy recovers,~~an upturn, which may cause demand ~~may~~to increase rapidly as it has in prior years after other cyclical downturns in the economy and the industries in which we operate. If this happens, in order to meet increased demand and maintain our market share, we may need to increase production, which could require us to build new facilities, expand and modify our existing facilities, purchase additional manufacturing equipment, and add qualified staff. If we are not at that time able to expand our manufacturing capacity, we will be unable to increase production, which may adversely impact our ability to meet increased production demand while reducing unit costs, margins and improving our operating results.

We are currently constructing ~~and/or~~and modifying facilities in California and China. Our construction activities subject us to a number of risks, including:

•
•unforeseen environmental or engineering problems;
• ~~unavailability or late delivery of production equipment;~~
• ~~delays in completing new facilities;~~
• ~~delays in bringing production equipment on-line;~~
• ~~work stoppages or delays;~~
• ~~inability to recruit and train qualified staff;~~
• ~~unanticipated cost increases and restrictions imposed by requirements of local, state or federal regulatory agencies in the United States and China.~~

• unavailability or late delivery of production equipment;

•    delays in completing new facilities;
•    delays in bringing production equipment on-line;
•    work stoppages or delays;
•    inability to recruit and train qualified staff; and
•    unanticipated cost increases and restrictions imposed by requirements of local, state or federal regulatory agencies in the   United States and China.
If any of these risks occurs, construction may be costlier than anticipated and completion could be delayed, which could hurt our ability to expand capacity and increase our sales. In addition, if we experience delays in expanding our manufacturing capacity, we ~~might~~may not be able to timely meet customer requirements, and we could lose future sales. We are also completing selective investments in equipment and facilities as part of our previously planned capacity expansion. To offset the additional fixed operating expenses, we must increase our revenue by increasing production and improving yields. If demand for our products does not grow, if prices decline significantly, or if our yields do not improve as anticipated, we may be unable to offset these costs against increased revenue, which would adversely impact our operating results.
Unpredictable fluctuations in our operating results could disappoint analystsor our investors, which could cause our stock price to decline.
We have not over the past year been able to sustain growth, and may not be able to return to historic growth levels in the current economic environment. Our net loss in 2002 was the largest in our history and our losses continued during 2003. We believe we will endure losses for at least part of 2004.
We have and may continue to experience significant fluctuations in our revenue and earnings. Our quarterly and annual revenue and operating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including:
•      decline in general economic conditions or downturns in the industry in which we compete;
•      fluctuations in demand for our products;
•      expansion of our manufacturing capacity;
•      expansion of our operations in China;
•      limited availability and increased cost of raw materials;
•      the volume and timing of orders from our customers, and cancellations, push outs and delays of customer orders;
•      fluctuation of our manufacturing yields;
•      decreases in the prices of our competitors’ products;
•      costs incurred in connection with any future acquisitions of businesses or technologies;
•      increases in our expenses, including expenses for research and development; and
•      our ability to develop, manufacture and deliver high quality products in a timely and cost-effective manner.
Due to these factors, we believe that period-to-period comparisons of our operating results may not be meaningful indicators of our future performance. Our operating results have over the past year at times been below the expectations of securities analysts or
25

investors. If this occurs again in future periods, the price of our common stock could decline or fluctuate.
A substantial percentage of our operating expenses are fixed in the short term and we may be unable to adjust spending to compensate for an unexpected shortfall in revenues. As a result, any delay in generating revenue could cause our operating results to be below the expectations of market analysts or investors, which could also cause our stock price to fall.
Our results of operations may suffer if we do not effectively manage ourinventory.

We must manage our inventory of component parts, work-in-process, and finished goods effectively to meet changing customer requirements, while keeping inventory costs down and improving gross margins. Some of our products and supplies have in the past and may in the future become obsolete while in inventory due to changing customer specifications, or become excess inventory due to decreased demand for our products and an inability to sell the inventory within a foreseeable period. Furthermore, if current costs of production increase or sales prices drop below the standard prices at which we value inventory, we may need to take a charge for a reduction in inventory values. We have in the past had to take inventory valuation and impairment charges. If we are not successfully able to manage our inventory, we may need to write off unsaleable, obsolete or excess inventory, which could adversely affect our results of operations. ~~On October 1, we implemented a new inventory control system that~~
Decreases in average selling prices of our products may reduce gross margins.
The market for compound semiconductor substrates is characterized by pressures on average selling prices resulting from factors such as increased competition or overcapacity. We may experience ~~unexpected difficulties~~price pressures on our products, and if average selling prices decline in the future, our revenues and gross margins could decline. We may be unable to reduce the cost of our products sufficiently to counter the effect of lower selling prices and allow us to keep pace with competitive pricing pressures and our margins could be adversely affected.
The disposal of our opto-electronics business may fail to result in thebenefits we anticipate.
We may not obtain the benefits we expect as a result of discontinuation of our opto-electronics business, such as greater strategic focus on our core businesses. We may be required to return to the buyer some or all of the $1 million of the sale proceeds which will be held in escrow should the buyer successfully claim that we breached one of the representations or warranties made to it. Our building in Monterey Park may not be sold for the $1 million at which we are carrying it on our balance sheet. We may incur additional costs associated with the discontinued operations which could materially reduce our short term earnings.
A reoccurrence of Severe Acute Respiratory Syndrome (SARS) or the outbreak of adifferent contagious disease may adversely impact our manufacturing operationsand some of our key suppliers and customers.
The majority of our substrate manufacturing activities are conducted in China. In addition, we source key raw materials, including gallium, from our joint ventures and other suppliers in China. The 2003 SARS outbreak was most notable in China and a small number of cases have been reported to date in 2004. One employee at our LED production facility in China contracted SARS in late April 2003 prompting us to close the facility for ten days. There was no significant impact to our ability to fill customer orders. If there were to be another outbreak of SARS or a different contagious disease and if our employees contracted the disease, we may be required to temporarily close our manufacturing operations. Similarly, if one of our key suppliers is required to close for an extended period, we may not have enough raw material inventory to continue manufacturing operations. In addition, while we possess management skills among our China staff that enable us to maintain our manufacturing operations with minimal on-site supervision from our US-based staff, our business could also be harmed if travel to or from Asia and the United States is restricted or inadvisable, as it was during parts of 2003. None of our substrate competitors is as dependent on manufacturing facilities in China as we ~~use it~~are. If our manufacturing operations were closed for a significant period, we could lose revenue and market share during that period which would depress our financial performance and could be difficult to ~~develop reporting information~~recapture. Finally, if one of our key customers is required to close for an extended period, we may not be able to ship product to them, our revenue would decline and our financial performance would suffer.
The impact of changes in global economic conditions on our customers may causeus to fail to meet expectations, which would negatively impact the price of ourstock.
Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. More specifically, the macro-economic environment that we faced in 2003 was more uncertain than in some prior periods, lasted longer than expected and has materially and adversely affected us and our operating results and may continue to do so. The revenue
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growth and profitability of our business depends on the overall demand for our substrates, and we are particularly dependant on the market conditions for the ~~fourth quarter~~wireless, solid-state illumination, fiber optics and telecommunications industries. Because our sales are primarily to major corporate customers whose businesses fluctuate with general economic and business conditions, a softening of ~~2003.~~demand for products that use our substrates, caused by a weakening economy may result in further or prolonged decreased revenues. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing products due to the downturn in their business and in the general economy.
If we do not successfully develop new products to respond to rapidly changingcustomer requirements, our ability to generate sales and obtain new customersmay suffer.

Our success depends on our ability to offer new products and product features that incorporate leading technology and respond to technological advances. In addition, our new products must meet customer needs and compete effectively on quality, price and performance. The life cycles of our products are difficult to predict because the markets for our products are characterized by rapid technological change, changing customer needs and evolving industry standards. If our competitors introduce products employing new technologies or performance characteristics, our existing products could become obsolete and unmarketable. During the past year, we have seen our competitors selling more substrates manufactured using a crystal growth technology similar to ours, which has eroded our technological differentiation. If we fail to offer new products, we may not generate sufficient revenue to offset our development costs and other expenses or meet our customers’ requirements. Other companies, including ~~IBM,~~Triquent, are actively developing substrate materials that could be used to manufacture devices that could provide the same high-performance, low-power capabilities as ~~GaAs-based~~GaAs- and InP-based devices at competitive prices. If these substrate materials or VGF derived products are
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successfully developed and semiconductor device manufacturers adopt them, demand for our GaAs substrates could decline and our revenue could suffer.

The development of new products can be a highly complex process, and we may experience delays in developing and introducing new products. Any significant delays could cause us to fail to timely introduce and gain market acceptance of new products. Further, the costs involved in researching, developing and engineering new products could be greater than anticipated.
Our operating results depend in large part on further customer acceptance ofour existing substrate products ~~and on our ability to develop new products based on our core VGF technology.~~manufactured in China.
Some of our competitors have developed a crystal growth technique similar to our VGF technology. Furthermore, some customers have reduced their orders from us until our surface quality is as good and consistent as that offered by competitors. As a result, some customers are now allocating their requirements for VGF grown substrates across more competitors and we believe that we have lost revenue and market share as a result of these customer decisions, which we may be unable to recover. If we are unable to retain our market share, our revenue and performance will decline.
To shift more of our substrate manufacturing operations to China successfully, we will need our customers to qualify products manufactured in China. If we are unable to achieve qualifications for these products, our China facility will be underutilized, our investments in China will not be recouped and we will be unable to lower our costs by moving to China. We may lose sales of our products to competitors who are not manufacturing in China, or whose operations in China have already been qualified by customers. All of these events could reduce our revenue but increase our cost structure. In addition, we announced a plan to stop producing products in China during the third quarter of 2004. If customers do not fully qualify our China production by the time we cease our California production, we may lose additional customers.
Furthermore, some customers have reduced their orders from us until our surface quality is as good and consistent as that offered by competitors. As a result, some customers are now allocating their requirements for VGF grown substrates across more competitors and we believe that we have lost revenue and market share as a result of these customer decisions, which we may be unable to recover. If we are unable to retain our market share, our revenue and performance will decline.
Intense competition in the markets for our products could prevent us fromincreasing revenue and sustaining profitability.

The markets for our products are intensely competitive. We face competition for our substrate products from other manufacturers of substrates, such as Freiberger, Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor device manufacturers that produce substrates for their own use, and from companies, such as ~~IBM,~~Triquent, that are actively developing alternative materials to GaAs and some semiconductor devices are being marketed using these materials. We believe that at least two of our competitors are shipping high volumes of GaAs substrates manufactured using a technique similar to our VGF technique. Other competitors may develop and begin using similar technology. If we are unable to compete effectively, our revenue may not increase and we may be unable to be profitable. We face many competitors that have a number of significant advantages over us, ~~particularly~~including:
•      greater experience in ~~our compound semiconductor device products, including:~~
• ~~greater experience in~~ the business;
• ~~more manufacturing experience;~~
• ~~extensive intellectual property;~~
• ~~broader name recognition; and~~
• ~~significantly greater financial, technical and marketing resources.~~

•      more manufacturing experience;
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•      extensive intellectual property;
•      broader name recognition; and
•      significantly greater financial, technical and marketing resources.
Our competitors could develop new or enhanced products that are more effective than ~~the~~our products ~~that we have developed or may develop.~~are.

The level and intensity of competition has increased over the past year and we expect competition to continue to increase in the future. Competitive pressures caused by the current economic conditions have resulted in reductions in the prices of our products, and continued or increased competition could reduce our market share,
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require us to further reduce the prices of our products, affect our ability to recover costs or result in reduced gross margins.
~~If we have low product yields, the shipment of our products may be delayed and our operating results may be adversely impacted.~~
     ~~Our products are manufactured using complex technologies, and the number of usable substrates we can produce can fluctuate as a result of many factors, including:~~
• ~~impurities in the materials used;~~
• ~~contamination of the manufacturing environment;~~
• ~~substrate breakage;~~
• ~~equipment failure, power outages or variations in the manufacturing process; and~~
• ~~performance of personnel involved in the manufacturing process.~~
     Because many of our manufacturing costs are fixed, our revenue could decline if our yields decrease but our costs would change little, if at all. We have experienced product shipment delays and difficulties in achieving acceptable yields on both new and older products, and delays and poor yields have adversely affected our operating results, as have quality control problems experienced on our substrate products. We may experience similar problems in the future and we cannot predict when they may occur or their severity. In addition, many of our manufacturing processes are new and are still being refined, which can result in lower yields, particularly as we focus on producing larger diameter substrates.
~~Demand for our products may decrease if our customers experience difficulty manufacturing, marketing or selling their products.~~
     Our products are used as components in our customers’ products. Accordingly, demand for our products is subject to factors affecting the ability of our customers to successfully introduce and market their products, including:
• ~~the competition our customers face in their particular industries;~~
• ~~the technical, manufacturing, sales and marketing and management capabilities of our customers;~~
• ~~the financial and other resources of our customers; and~~
• ~~the inability of our customers to sell their products if they infringe third party intellectual property rights.~~
~~If demand for the products offered by our customers decreases, our customers may reduce purchases of our products.~~
     As a result of current levels of demand and inventory, some of our customers have reduced sales of their products, causing them to reduce purchases of our products for both production and research and development purposes. As a result, our revenues have declined and may fail to recover until the overcapacity has been depleted and demand for our customers’ products once again increases and their expenditures for research and development increase.
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~~We purchase critical raw materials and parts for our equipment from single or limited sources, and could lose sales if these sources fail to fill our needs.~~
     We depend on a limited number of suppliers for certain raw materials, components and equipment used in manufacturing our products, including key materials such as gallium, arsenic and quartz. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts and none of our suppliers guarantees supply of raw materials or equipment to us. If we lose any of our key suppliers, our manufacturing efforts could be significantly hampered and we could be prevented from timely producing and delivering products to our customers. We have experienced delays obtaining critical raw materials and spare parts, including gallium, due to shortages of these materials. We may experience delays due to shortages of materials and may be unable to obtain an adequate supply of materials. These shortages and delays could result in higher materials costs and cause us to delay or reduce production of our products. If we have to delay or reduce production, we could fail to meet customer delivery schedules and our revenue and operating results could suffer.
~~If we fail to comply with environmental and safety regulations, we may be subject to significant fines or cessation of our operations.~~
     We are subject to federal, state and local environmental and safety laws and regulations in all of our operating locations. These laws, rules and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our operations. In March 2001, we settled a claim made by the California Occupational Safety and Health Administration, or Cal-OSHA, in an investigation primarily regarding impermissible levels of potentially hazardous materials in certain areas of our manufacturing facility in Fremont, California for $204,415. Although we have put in place engineering, administrative and personnel protective equipment programs to address these issues, our ability to expand or continue to operate our present locations could be restricted or we could be required to acquire costly remediation equipment or incur other significant expenses. In addition, existing or future changes in laws or regulations may require us to incur significant expenditures or liabilities, or may restrict our operations.
~~The loss of one or more of our key substrate customers would significantly hurt our operating results.~~
     A small number of substrate customers have historically accounted for a substantial portion of our total revenue. Five customers accounted for 29.7% of our total revenue for the three months ended September 30, 2003 and 35.7% for the three months ended September 30, 2002. One customer accounted for 12.4% of our revenue for the three months ended September 30, 2003. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate customers. Our customers are not obligated to purchase a specified quantity of our products or to provide us with binding forecasts of product purchases. In addition, our customers may reduce, delay or cancel orders at any time without any significant penalty, and during the past year, we have experienced slower bookings, significant push outs and cancellation of orders. In addition, due to the difficult economic environment, several of our previously large customers have stopped operations entirely. If we lose a major customer or if a customer cancels, reduces or delays orders, our revenue would decline. In addition, customers that have accounted for significant revenue in the past may not continue to generate revenue for us in any future period. Any delay in scheduled shipments of our products could cause net sales to fall below our expectations and the expectations of market analysts or investors, causing our stock price to decline.
Defects in our products could diminish demand for our products.

Our products are complex and may contain defects. We have experienced quality control problems with some of our products over the past two years, which caused customers to return products to us, to reduce orders for our products, or both. If we continue to experience quality control problems, or experience these or other problems in new products, customers may cancel or reduce orders or purchase products from our ~~competitors.~~competitors and sales of our products could decline. Defects in our products could cause us to incur higher manufacturing costs and suffer product returns and additional service expenses, all of which could adversely impact our operating results.
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     ~~We are also developing new substrate products and product enhancements.~~ If ~~our~~ new products developed by us contain defects when released, our customers may be dissatisfied and we may suffer negative publicity or customer claims against us, lose sales or experience delays in market acceptance of our new products.
~~Our substrate products~~If we have ~~a long qualification cycle that makes it difficult to plan our expenses and forecast our results.~~
     ~~Customers typically place orders with us for our substrate products three months to a year or more after our initial contact with them. The sale~~low product yields, the shipment of our products may be ~~subject to delays due to our customers’ lengthy internal budgeting, approval~~delayed and evaluation processes. During this time, we may incur substantial expenses and expend sales, marketing and management efforts while the customers evaluate our products. These expenditures may not result in sales of our products. If we do not achieve anticipated sales in a period as expected, we may experience an unplanned shortfall in our revenue. As a result, we may not be able to cover expenses, causing our operating results ~~to vary. In addition, if~~may be adversely impacted.
Our products are manufactured using complex technologies, and the number of usable substrates we can produce can fluctuate as a ~~customer decides not to incorporate our products into its initial design, we may not have another opportunity to sell products to this customer for~~result of many months or even years. In this difficult economic climate, the average sales cycle for our products has lengthened even further and is expected to continue to make it difficult to accurately forecast our future sales. We anticipate that sales of any future substrate products under development will also have lengthy sales cycles and will, therefore, be subject to risks substantially similar to those inherentfactors, including:
•      impurities in the ~~lengthy sales cycle~~materials used;
•      contamination of ~~our current substrate products.~~the manufacturing environment;
As•      substrate breakage;
•      equipment failure, power outages or variations in the manufacturing process; and
•      performance of personnel involved in the manufacturing process.
If our ~~business matures, we may need to upgrade~~yields decrease, our ~~systems.~~
     ~~In the past, periods of rapid growth and expansion has strained our management and other resources. The expansion~~revenue could decline because many of our manufacturing ~~capacity~~costs are fixed, or would increase. We have experienced product shipment delays and ~~the shift of manufacturing operations to China placed~~difficulties in achieving acceptable yields on both new and ~~continue to place a significant strain on our operations~~older products, and ~~management resources,~~delays and we are in the process of upgrading our inventory control systems and may implement additional systems relating to consolidation of our financial results. If we fail to manage these changes effectively, our operations may be disrupted.
     ~~To manage our business effectively, we may need to implement additional and improved management information systems, further develop~~poor yields have adversely affected our operating administrative, financial and accounting systems and controls, add experienced senior level managers, and maintain close coordination among our executive, engineering, accounting, marketing, sales and operations organizations.
     ~~If necessary, we will spend substantial sums to support our future growth and shift to China and to comply with the reporting and attestation requirements of the Sarbanes-Oxley Act of 2002.~~results. We may incur additional unexpected costs. Our systems, procedures or controls may not be adequate to support our operations, and we may be unable to expand quickly enough to exploit potential market opportunities.
     We anticipate that our existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. The Company’s liquidity is affected by many factors including, among others, the extent to which the Company pursues additional capital and business acquisition expenditures, the level of the Company’s production efforts, and other factors related to the uncertainties of the industry and global economies.
~~If we fail to manage periodic contractions, we may utilize our cash balances and our existing cash and cash equivalent balances could decline.~~
     If we fail to manage our contractions successfully we may continue to draw down our cash reserves, which would adversely affect our operating results and financial condition, reduce our value and may impinge our ability to raise debt and equity fundingexperience similar problems in the future ~~at a time~~and we cannot predict when wethey may be required to raise additional cash. As part of our effort to reduce costs, we may lose key staff, production resources, and technology that we will need to grow when end markets recover. These events could reduce our ability to grow profitably as markets recover.
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As a result of the difficult economic conditions, we have implemented restructuring and workforce reductions, which may adversely affect the morale and performance of our personnel and our ability to hire new personnel.
occur or their severity. In connection with our efforts to streamline operations, reduce costs and bring staffing and structure in line with current demand for our products, we implemented a corporate restructuring beginning in 2001 and reduced our workforce, shifted production activities to China, reduced capital expenditures, and discontinued our opto-electronics business. Our restructuring may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce and loss of employee morale and decreased performance. In addition, the recent trading levels of our stock have decreased the value of our stock options granted to employees under our stock option plan. As a result of these factors, our remaining personnel may seek employment with larger, more established companies or companies that they perceive as having less volatile stock prices. Continuity of personnel can be very important factors in the sales and production of our products and completion of our research and development efforts.
~~Any future acquisitions may disrupt our business, dilute stockholder value or distract management attention.~~
     As part of our strategy, we may consider acquisitions of, or significant investments in, businesses that offer products, services and technologies complementary to ours. Acquisitions entail numerous risks, including:
• ~~we may have difficulty assimilating the operations, products and personnel of the acquired businesses;~~
• ~~our ongoing business may be disrupted;~~
• ~~we may incur unanticipated costs;~~
• ~~our management may be unable to manage the financial and strategic position of acquired or developed products, services and technologies;~~
• ~~we may be unable to maintain uniform standards, controls and procedures and policies; and~~
• ~~our relationships with employees and customers may be impaired as a result of any integration.~~
     For example, we incurred substantial costs in connection with our acquisition of Lyte Optronics in May 1999, including the assumption of approximately $10.0 million of debt, which was subsequently repaid, resulting in a decline of cash available. We have also incurred consistent operating losses for the business since the acquisition, and have recently discontinued all operations acquired in our acquisition of Lyte Optronics.
     To the extent that we issue shares of our stock or other rights to purchase stock in connection with any future acquisitions, dilution to our existing stockholders will result and our earnings per share may suffer. Any future acquisitions may not generate additional revenue or provide any benefit to our business.
~~If any of our facilities is damaged by actions such as fire, explosion, or natural disaster, we may not be able to manufacture our products.~~
     ~~The ongoing operation~~particular, many of our manufacturing processes are new and ~~production facilities in California and China is critical to our ability to meet demand for our products. If we~~ are not able to use all or a significant portion of our facilities for prolonged periods for any reason, we will not be able to manufacture products for our customers. For example, a natural disaster, fire or explosion caused by our use of combustible chemicals and high temperatures during our manufacturing processes would render some or all of our facilities inoperable for an indefinite period of time. Actions outside of our control, such as earthquakes, could also damage our facilities, rendering them inoperable. Some of our manufacturing and research and development is currently performed at our Fremont, California facilities,still being refined, which ~~are located near an active seismic fault line. If we are unable to operate our facilities and manufacture our products, we will lose customers and revenue and our business will be harmed.~~
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~~If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to successfully manage our business or achieve our objectives.~~
     Our success depends upon the continued service of Morris S. Young, Ph.D., our president, chairman of the board and chief executive officer, as well as other key management and technical personnel. We do not have long-term employment contracts with, or key person life insurance on, any of our key personnel.
     We believe our future success will also depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing, finance and manufacturing personnel. The competition for these employees is intense and we cannot assure you that we will be successful in attracting and retaining new personnel. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel in the future or delays in hiring required personnel, particularly engineers, could make it difficult for us to manage our business and meet key objectives, including the timely introduction of new products.
~~If we are unable to protect our intellectual property, we may lose valuable assets or incur costly litigation.~~
     We rely on a combination of patents, copyrights, trademark and trade secret laws, non-disclosure agreements and other intellectual property protection methods to protect our proprietary technology. However, we believe that, due to the rapid pace of technological innovation in the markets for our products, our ability to establish and maintain a position of technology leadership also depends on the skills of our development personnel.
     Despite our efforts to protect our intellectual property, a third party could develop products or processes similar to ours. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around our patents. We believe that at least two of our competitors have begun to ship GaAs substrates produced using a process similar to our VGF technique. Our competitors may also develop and patent improvements to the VGF technology upon which we rely, and thus may limit any exclusivity we enjoy by virtue of our patents or trade secrets.
     It is possible that pending or future United States or foreign patent applications made by us will not be approved, that our issued patents will not protect our intellectual property, or that third parties will challenge the ownership rights or the validity of our patents. In addition, the laws of some foreign countries may not protect our proprietary rights to as great an extent as do the laws of the United States and it may be more difficult to monitor the use of our intellectual property. Our competitors may be able to legitimately ascertain non-patented proprietary technology embedded in our systems. If this occurs, we may not be able to prevent the development of technology substantially similar to ours.
     We may have to resort to costly litigation to enforce our intellectual property rights, to protect our trade secrets or know-how or to determine their scope, validity or enforceability. Enforcing or defending our proprietary technology is expensive, could cause us to divert resources and may not prove successful. Our protective measures may prove inadequate to protect our proprietary rights, and if we fail to enforce or protect our rights, we could lose valuable assets.
~~Intellectual property infringement claims may be costly to resolve and could divert management attention.~~
     Other companies may hold or obtain patents on inventions or may otherwise claim proprietary rights to technology necessary to our business. The markets in which we compete are comprised of competitors who in some cases hold substantial patent portfolios covering aspects of products that could be similar to ours. We could become subject to claims that we are infringing patent, trademark, copyright or other proprietary rights of others, and have recently been sued by two competitors concerning alleged patent infringement. Litigation to determine the validity of alleged claims could be time-consuming andcan result in significant expense to us and divert the efforts of our technical and management personnel, whether or not the litigation is ultimately determined in our favor. If a lawsuit is decided against us, we could be subject to significant liabilities, requiring us to seek costly licenses or preventing us from manufacturing and selling our products. We may not be able to obtain required licensing agreements on terms acceptable to us or at all.lower yields.
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We derive a significant portion of our revenue from international sales, andour ability to sustain and increase our international sales involvessignificant risks.

Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented ~~64%~~77.8% of our total revenue for the ~~three~~six months ended ~~September~~June 30, ~~2003~~2004 and ~~54%~~64.6% for the ~~three~~six months ended ~~September~~June 30, ~~2002.~~2003. We expect that sales to customers outside the U.S. will continue to represent a significant portion of our revenue, particularly sales to customers in Asia.

Currently, an increasing percentage of our sales are to customers headquartered in Asia. Certain manufacturing facilities and
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suppliers are also located outside the U.S. Managing our global operations presents challenges, including periodic regional economic downturns, trade balance issues, varying business conditions and demands, political instability, variations in enforcement of intellectual property and contract rights in different jurisdictions, differences in the ability to develop relationships with suppliers and other local businesses, changes in U.S. and international laws and regulations including U.S. export restrictions, fluctuations in interest and currency exchange rates, the ability to provide sufficient levels of technical support in different locations, cultural differences, shipping delays and terrorist acts or acts of war, among other risks. Many of these challenges are present in China, which represents a large potential market for semiconductor equipment and where AXT anticipates significant opportunity for growth. Global uncertainties with respect to: (i) economic growth rates in various countries; (ii) sustainability of demand for electronics products; (iii) capital spending by semiconductor manufacturers; (iv) price weakness for certain semiconductor devices; and (v) political instability in regions where we have operations may also affect our business, financial condition and results of operations.
Our dependence on international sales involves a number of risks, including:
•
•changes in tariffs, import or export restrictions and other trade barriers;
• ~~unexpected changes in regulatory requirements;~~
• ~~longer periods to collect accounts receivable;~~
• ~~changes in export license requirements;~~
• ~~political and economic instability;~~
• ~~unexpected changes in diplomatic and trade relationships; and~~
• ~~foreign exchange rate fluctuations.~~

•      unexpected changes in regulatory requirements;
•      longer periods to collect accounts receivable;
•      changes in export license requirements;
•      political and economic instability;
•      unexpected changes in diplomatic and trade relationships; and
•      foreign exchange rate fluctuations.
Our sales are denominated in U.S. dollars, except for sales to our Japanese and some Taiwanese customers, which are denominated in Japanese yen. Thus, increases in the value of the U.S. dollar could increase the price of our products in non-U.S. markets and make our products more expensive than competitors’ products in these markets. Also, denominating some sales in Japanese yen subjects us to fluctuations in the exchange rates between the U.S. dollar and the Japanese yen. The functional currencies of our Japanese and Chinese subsidiaries are the local currencies. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for these subsidiaries, as well as in translation of the assets and liabilities of these assets at each balance sheet date. If we do not effectively manage the risks associated with international sales, our revenue, cash flows and financial condition could be adversely affected.
IfDemand for our ~~expansion~~products may decrease if our customers experience difficultymanufacturing, marketing or selling their products.
Our products are used as components in ~~China~~our customers’ products. Accordingly, demand for our products is ~~more costly than we expect, our operating results will suffer.~~
     ~~As part~~subject to factors affecting the ability of our ~~planned reduction~~customers to successfully introduce and market their products, including:
•      the competition our customers face in their particular industries;
•      the technical, manufacturing, sales and marketing and management capabilities of our ~~cost structure, we~~customers;
•      the financial and other resources of our customers; and
•      the inability of our customers to sell their products if they infringe third party intellectual property rights.
If demand for the end user applications for which our products are ~~building new facilities and expanding existing facilities in China. If we~~used decreases, or our customers are unable to ~~build~~develop, market and ~~expand~~sell their products, demand for our ~~Chinese facilities~~products will decrease.
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The financial condition of our customers may affect their ability to payamounts owed to us.
Many of our customers are facing business downturns that have reduced their cash balances and their prospects. We frequently allow our customers to pay for products we ship to them within 30 to 120 days after delivery. Subsequent to our shipping a product, some customers have been unable to make payments as due, reducing our cash balances and causing us to incur charges to allow for a possibility that some accounts might not be paid. At least three customers that owed us a significant amount have filed for bankruptcy protection and we are unlikely to receive a substantial portion or any of the amounts owed to us as part of a bankruptcy settlement. Other customers may also be forced to file for bankruptcy. If our customers do not pay their accounts when due, we will be required to incur charges that would reduce our earnings.
We purchase critical raw materials and parts for our equipment from single orlimited sources, and could lose sales if these sources fail to fill our needs.
We depend on a limited number of suppliers for certain raw materials, components and equipment used in manufacturing our products, including key materials such as quartz tubing, polishing solutions, and paralytic boron nitride. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts and no supplier guarantees supply of raw materials or equipment to us. If we lose any of our key suppliers, our manufacturing efforts could be significantly hampered and we could be prevented from timely producing and delivering products to our customers. We have experienced delays obtaining critical raw materials and spare parts, including gallium, due to shortages of these materials. We may experience delays due to shortages of materials and may be unable to obtain an adequate supply of materials. These shortages and delays could result in higher materials costs and cause us to delay or reduce production of our products. If we have to delay or reduce production, we could fail to meet customer delivery schedules and our revenue and operating results could suffer.
The loss of one or more of our key substrate customers would significantly hurtour operating results.
A small number of substrate customers have historically accounted for a substantial portion of our total revenue. Five customers accounted for 35.6% and 34.6% of our total revenue for the three month and six month periods ended June 30, 2004, respectively. One customer accounted for 5.8% and 9.5% of our revenue for the three month and six month periods ended June 30, 2004. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate customers. Our customers are not obligated to purchase a specified quantity of our products or to provide us with binding forecasts of product purchases. In addition, our customers may reduce, delay or cancel orders at any time without any significant penalty, and during the past year, we have experienced slower bookings, significant push outs and cancellation of orders from some customers. In addition, due to the difficult economic environment, several of our previously large customers have stopped operations entirely. If we lose a major customer or if a customer cancels, reduces or delays orders, our revenue would decline. In addition, customers that have accounted for significant revenue in the past may not continue to generate revenue for us in any future period. Any delay in scheduled shipments of our products could cause net sales to fall below our expectations and the expectations of market analysts or investors, causing our stock price to decline.
Our substrate products have a long qualification cycle that makes it difficultto plan our expenses and forecast our results.
Customers typically place orders with us for our substrate products three months to a year or more after our initial contact with them. The sale of our products may be subject to delays due to our customers’ lengthy internal budgeting, approval and evaluation processes. During this time, we may incur substantial expenses and expend sales, marketing and management efforts while the customers evaluate our products. These expenditures may not result in sales of our products. If we do not achieve anticipated sales in a ~~timely manner,~~period as expected, we may experience an unplanned shortfall in our revenue. As a result, we may not be able to ~~reduce the costs of our products as planned. If our expansion in China proves more costly than we anticipate or we incur greater ongoing costs than we expect,~~cover expenses, causing our operating results ~~would~~to vary. In addition, if a customer decides not to incorporate our products into its initial design, we may not have another opportunity to sell products to this customer for many months or even years. In the current competitive and economic climate, the average sales cycle for our products has lengthened even further and is expected to continue to make it difficult to accurately forecast our future sales. We anticipate that sales of any future substrate products will also have lengthy sales cycles and will, therefore, be ~~adversely affected.~~ subject to risks substantially similar to those inherent in the lengthy sales cycle of our current substrate products.
If we are unable to protect our intellectual property, we may lose valuableassets or incur costly litigation.
We rely on a combination of patents, copyrights, trademark and trade secret laws, non-disclosure agreements and other intellectual property protection methods to protect our proprietary technology. However, we believe that, due to the rapid pace of technological innovation in the markets for our products, our ability to establish and maintain a position of technology leadership also depends on
30

the skills of our development personnel.
Despite our efforts to protect our intellectual property, a third party could develop products or processes similar to ours. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around our patents. We believe that at least two of our competitors have begun to ship GaAs substrates produced using a process similar to our VGF technique. Our competitors may also develop and patent improvements to the VGF technology upon which we rely, and thus may limit any exclusivity we enjoy by virtue of our patents or trade secrets.
It is possible that pending or future United States or foreign patent applications made by us will not be approved, that our issued patents will not protect our intellectual property, or that third parties will challenge the ownership rights or the validity of our patents. In addition, the laws of some foreign countries may not protect our proprietary rights to as great an extent as do ~~not realize~~
31
~~expected cost savings once our expansion is complete in China, our margins~~the laws of the United States and it may be ~~negatively impacted~~more difficult to monitor the use of our intellectual property. Our competitors may be able to legitimately ascertain non-patented proprietary technology embedded in our systems. If this occurs, we may not be able to prevent the development of technology substantially similar to ours.
We may have to resort to costly litigation to enforce our intellectual property rights, to protect our trade secrets or know-how or to determine their scope, validity or enforceability. Enforcing or defending our proprietary technology is expensive, could cause us to divert resources and may not prove successful. Our protective measures may prove inadequate to protect our proprietary rights, and if we fail to enforce or protect our rights, we could lose valuable assets.
We need to continue to improve or implement our systems, procedures andcontrols and may not receive favorable attestation of our internal controlsystems by our independent auditors.
The new requirements adopted by the Securities and Exchange Commission in response to the passage of the Sarbanes-Oxley Act of 2002 will require annual review and evaluation of our internal control systems, and attestation of these systems by our independent accountants. We are currently reviewing our internal control procedures and considering further documentation of such procedures that may be necessary. Although the guidelines for the evaluation and attestation of internal control systems have been finalized, the evaluation and attestation processes are new and untested. Therefore, we can give no assurances that our systems will satisfy the new requirements of the Securities and Exchange Commission or that we will receive a favorable review and attestation by our independent auditors.
In the past, periods of rapid growth and expansion has strained our management and other resources. The expansion of our manufacturing capacity and the shift of manufacturing operations to China placed and continue to place a significant strain on our operations and management resources. We recently upgraded our inventory control systems and may implement additional systems relating to consolidation of our financial results. If we fail to manage these changes effectively, our operations may be disrupted.
To manage our business effectively, we may need to implement additional and improved management information systems, further develop our operating, administrative, financial and accounting systems and controls, add experienced senior level managers, and maintain close coordination among our executive, engineering, accounting, marketing, sales and operations organizations.
If we fail to manage periodic contractions, we may utilize our cash balancesand our existing cash and cash equivalent balances could decline.
We anticipate that our existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. However, our liquidity is affected by many factors including, among others, the extent to which we pursue additional capital expenditures, the level of our production, and other factors related to the uncertainties of the industry and global economies. If we fail to manage our contractions successfully we may draw down our cash reserves, which would adversely affect our operating results and financial condition, reduce our value and may impinge our ability to raise debt and equity funding in the future, at a time when we may be required to raise additional cash. Accordingly, there can be no assurance that events in the future will not require us to seek additional capital, or, if so required, that such capital will be available on terms acceptable to us, if at all. As part of our effort to reduce costs, we may lose key staff, production resources, and technology that we will need to grow when end markets recover. These events could reduce our ability to grow profitably as markets recover.
We anticipate that our existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. Our liquidity is affected by many factors including, among others, the extent to which we pursue additional capital expenditures, the level of our production efforts, and other factors related to the
31

uncertainties of the industry and global economies. Accordingly, there can be no assurance that events in the future will not require us to seek additional capital sooner, or, if so required, that such capital will be available on terms acceptable to us if at all.
We have made and may continue to make strategic investments in raw materialssuppliers, which may not be successful and may result in the loss of all orpart of our investment.
Through fiscal 2003, we have recorded minority investments in raw material suppliers in China, that provide us with opportunities to gain supply of key raw materials that are important to our substrate business, and other products at lower cost than other suppliers. These affiliates each have a market beyond that provided by us. As of June 30, 2004, we had no obligations to make further investments in any of these companies, although we may choose to do so under certain conditions. We do not have influence over all of these companies, each of which is located in China, and in some we have made only a strategic, minority investment. We may not be successful in achieving the financial, technological or commercial advantage upon which any given investment is premised, and we could end up losing all or part of our investment.
Any future acquisitions may disrupt our business, dilute stockholder value ordistract management attention.
As part of our strategy, we may consider acquisitions of, or significant investments in, businesses that offer products, services and technologies complementary to ours. Acquisitions entail numerous risks, including:
•      we may have difficulty assimilating the operations, products and personnel of the acquired businesses;
•      our ongoing business may be disrupted;
•      we may incur unanticipated costs;
•      our management may be unable to manage the financial and strategic position of acquired or developed products, services and technologies;
•      we may be unable to maintain uniform standards, controls, procedures, and policies; and
•      our relationships with employees and customers may be impaired as a result of any integration.
For example, we incurred substantial costs in connection with our acquisition of Lyte Optronics in May 1999, including the assumption of approximately $10.0 million of debt, which was subsequently repaid, resulting in a decline of cash available. We also incurred consistent operating losses for the business following the acquisition, and have discontinued all operations and sold the related assets acquired in our acquisition of Lyte Optronics during 2003.
To the extent that we issue shares of our stock or other rights to purchase stock in connection with any future acquisitions, dilution to our existing stockholders will result and our earnings per share may suffer. Any future acquisitions may not generate additional revenue or provide any benefit to our business.
If any of our facilities is damaged by actions such as fire, explosion, ornatural disaster, we may not be able to manufacture our products.
The ongoing operation of our manufacturing and production facilities in California and China is critical to our ability to meet demand for our products. If we are not able to use all or a significant portion of our facilities for prolonged periods for any reason, we will not be able to manufacture products for our customers. For example, a natural disaster, fire or explosion caused by our use of combustible chemicals and high temperatures during our manufacturing processes would render some or all of our facilities inoperable for an indefinite period of time. Actions outside of our control, such as earthquakes, could also damage our facilities, rendering them inoperable. Some of our manufacturing and research and development is currently performed at our Fremont, California facilities, which are located near an active seismic fault line. If we are unable to operate our facilities and manufacture our products, we will lose customers and revenue and our business will be harmed.
32

Changes in China’s political, social and economic environment may affect ourfinancial performance.

Our financial performance may be affected by changes in China’s political, social and economic environment. The role of the Chinese central and local governments in the Chinese economy is significant. Chinese policies toward economic liberalization, and laws and policies affecting technology companies, foreign investment, currency exchange rates and other matters could change, resulting in greater restrictions on our ability to do business and operate our manufacturing facilities in China. Any imposition of surcharges or any increase in Chinese tax rates could hurt our operating results. The Chinese government could revoke, terminate or suspend our license for national security and similar reasons without compensation to us. If the government of China were to take any of these actions, we would be prevented from conducting all or part of our business. Any failure on our part to comply with governmental regulations could result in the loss of our ability to manufacture our products in China.

China has from time to time experienced instances of civil unrest and hostilities. Confrontations have occurred between the military and civilians. Events of this nature could influence the Chinese economy, result in nationalization of foreign-owned operations such as ours, and could negatively affect our ability to operate our facilities in China.
The effect of terrorist threats and actions on the general economy coulddecrease our revenues.
~~the~~
The United States continues to be on alert for terrorist activity. The potential near- and long-term impact terrorist activities may have in regards to our suppliers, customers and markets for our products and the U.S. economy are uncertain. There may be embargos of ports or products, or destruction of shipments or our facilities, or attacks that affect our personnel. There may be other potential adverse effects on our operating results due to a significant event that we cannot foresee. Since we perform substantially all of our manufacturing operations in China, and a significant portion of our customers are located outside of the Untied States, terrorist activity or threats against US-owned enterprise are a particular concern to us.
Our stock price has been and may continue to be volatile.

Our stock price has fluctuated significantly since we began trading on the ~~Nasdaq~~NASDAQ National Market. For the ~~three~~twelve months ended ~~September~~June 30, ~~2003,~~2004, the high and low closing sales prices of our common stock were ~~$3.12~~$4.58 and $1.20, respectively. A number of factors could cause the price of our common stock to continue to fluctuate substantially, including:
•
•actual or anticipated fluctuations in our quarterly or annual operating results;
• ~~changes in expectations about our future financial performance or changes in financial estimates of securities analysts;~~
• ~~announcements of technological innovations by us or our competitors;~~
• ~~new product introduction by us or our competitors;~~
• ~~large customer orders or order cancellations; and~~
• ~~the operating and stock price performance of comparable companies.~~

•      changes in expectations about our future financial performance or changes in financial estimates of securities analysts;
•      announcements of technological innovations by us or our competitors;
•      new product introduction by us or our competitors;
•      large customer orders or order cancellations; and
•      the operating and stock price performance of comparable companies.
In addition, the stock market in general has experienced extreme volatility that often has been unrelated to the operating performance of particular companies. These broad market and industry fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating performance.
32
~~Provisions in our charter, bylaws or Delaware law may delay or prevent a change in control of our company.~~
     Provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a merger, acquisition or change of control of us, or changes in our management. These provisions include:
• ~~the division of our board of directors into three separate classes, each with three year terms;~~
• ~~the right of our board to elect a director to fill a space created by a board vacancy or the expansion of the board;~~
• ~~the ability of our board to alter our bylaws;~~
• ~~the ability of our board to authorize the issuance of up to 2,000,000 shares of blank check preferred stock; and~~
• ~~the requirement that only our board or the holders of at least 10% of our outstanding shares may call a special meeting of our stockholders.~~
     Furthermore, because we are incorporated in Delaware, we are subject to the provisions of Section 203 of the Delaware General Corporation Law. These provisions prohibit large stockholders, in particular those owning 15% or more of the outstanding voting stock, from consummating a merger or combination with a corporation unless:
• ~~66 2/3% of the shares of voting stock not owned by these large stockholders approve the merger or combination, or~~
• ~~the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of our outstanding voting stock.~~
We have adopted certain anti-takeover measures that may make it more difficultfor a third party to acquire us.

Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock, while potentially providing desirable flexibility in connection with possible acquisitions and for other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock.
~~Further, on~~
On April 24, 2001, our board of directors adopted a preferred stock purchase rights plan intended to guard against certain takeover
33

tactics. The adoption of this plan was not in response to any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation may have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.
In addition, provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a merger, acquisition or change of control of us, or changes in our management, including:
•      the division of our board of directors into three separate classes, each with three year terms;
•      the right of our board to elect a director to fill a space created by a board vacancy or the expansion of the board;
•      the ability of our board to alter our bylaws;
•      the ability of our board to authorize the issuance of up to 2,000,000 shares of blank check preferred stock; and
•      the requirement that only our board or the holders of at least 10% of our outstanding shares may call a special meeting of our stockholders.
Furthermore, because we are incorporated in Delaware, we are subject to the provisions of Section 203 of the Delaware General Corporation Law. These provisions prohibit large stockholders, in particular those owning 15% or more of the outstanding voting stock, from consummating a merger or combination with a corporation unless:
•      66 2/3% of the shares of voting stock not owned by these large stockholders approve the merger or combination, or
•      the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of our outstanding voting stock.
Legislative actions, higher insurance costs and potential new accountingpronouncements are likely to cause our general and administrative expenses toincrease and impact our future financial position and results of operations.

In order to comply with the newly adopted Sarbanes-Oxley Act of 2002, as well as proposed changes to listing standards by ~~Nasdaq,~~NASDAQ, and proposed accounting changes by the Securities and Exchange Commission, we may be required to increase our internal controls, hire additional personnel and additional outside legal, accounting and
33
advisory services, all of which will cause our general and administrative costs to increase. Insurers ~~are likely to~~may increase premiums as a result of the high claims rates they incurred over the past year, and so our premiums for our various insurance policies, including our directors’ and officers’ insurance policies, ~~are likely to increase.~~increased during 2003. Proposed changes in the accounting rules, including legislative and other proposals to account for employee stock options as a compensation expense among others, could materially increase the expense that we report under generally accepted accounting principles and adversely affect our operating results.
~~Item 3~~.~~Qualitative and Quantitative Disclosures About Market Risk~~
ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Risk

We use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. We have purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of ~~September~~June 30, ~~2003,~~2004, we had no outstanding commitments with respect to foreign exchange contracts.
34

Interest Rate Risk
Cash and cash equivalents earning interest and certain variable rate debt instruments are subject to interest rate fluctuations. The following table sets forth the probable impact of a 10% change in interest rates (in thousands):

Current Proforma Proforma
Balance Current Interest 10% Interest 10% Interest
September 30, Interest Income/ Rate Decline Rate Increase
Instrument 2003 Rate (Expense) Income/(Expense) Income/(Expense)

Cash and cash equivalents $ 21,486 1.80 % $ 387 $ 348 $ 425
Bonds 8,550 1.35 % (115 ) (104 ) (127 )

$ 271 $ 244 $ 298

Instrument

Balance
June 30,
2004

Current
Interest
Rate

Current
Interest
Income/
(Expense)

Proforma
10% Interest
Rate Decline
Income/(Expense)

Proforma
10% Interest
Rate Increase
Income/(Expense)

Cash and cash equivalents

$
14,783

1.00
%
$
148

$
133

$
163

Bonds

8,300

1.42
%
(118
)
(106
)
(130
)

$
30

$
27

$
33

Equity Risk
We also maintain minority investments in private and publicly traded companies. These investments are reviewed for other than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value include whether the related company would have insufficient cash flow to operate for the next twelve months, significant changes in the operating performance and changes in market conditions. ~~On June 30,~~In 2003, we recorded ~~$1.3~~$2.0 million ~~charge~~in charges to other expense to write down our investment in two private US companies. As of ~~September~~June 30, ~~2003,~~2004, the minority investments we continue to hold ~~totaled $5.3~~amounted to $2.0 million. In 2000, we recorded a $27.3 million non-cash gain as a result of acquiring Finisar Corporation common stock in connection with Finisar Corporation’s acquisition of Demeter Technologies, a company in which we held warrants to purchase preferred stock. In 2001 and 2002, we determined that this investment had suffered a decline in market value that was other than temporary and accordingly recorded a $15.6 million and $10.8 million non-cash loss respectively, as a result of writing down our investment in Finisar Corporation common stock to market value. These gains and losses were included in other expense.
~~Item~~ITEM 4. CONTROLS AND PROCEDURES.~~Controls and Procedures~~
(a) Under the supervision and with the participation of our management, ~~including~~ our ~~principal executive officer~~Interim Chief Executive Officer and ~~principal financial officer, we conducted an evaluation~~Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule ~~13a-14(c)~~13a-15(e) promulgated under the Securities Exchange Act of 1934, as ~~amended (the “Exchange Act”), as of the end of the period covered by this report.~~amended. Based ~~on their~~upon that evaluation, our ~~principal executive officer~~
34
Interim Chief Executive Officer and ~~principal financial officer~~our Chief Financial Officer concluded that the our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report, except as described below relating to certain product testing procedures, as of the end of the period covered by this quarterly report.
~~(b) As required by Rule 13a-15(d),~~
In March 2004, as part of the Company’s implementation of our ~~management, including our principal executive officer~~Code of Business Conduct and ~~principal finance officer, also~~Ethics, we learned of certain failures to comply with requirements for product testing and the provision of testing data and information relating to requirements of certain customers. The Audit Committee of the Company’s Board of Directors conducted an ~~evaluation~~investigation into our product testing practices and procedures, with the assistance of outside counsel.
The investigation confirmed that certain requirements for product testing and the provision of testing data and information relating to certain customer requirements were not being complied with. We implemented measures to ensure greater operational controls and compliance with customer requirements. As a result of the investigation, the Audit Committee concluded that certain executive management changes should be implemented. Donald L. Tatzin, formerly Chief Financial Officer, has been appointed Interim Chief Executive Officer, Wilson W. Cheung, our Vice President, Corporate Controller, has been promoted to Chief Financial Officer. Morris Young, Ph.D., formerly our Chairman, President and Chief Executive Officer, will be responsible for improving and expanding the Company’s China operation. He will also remain a director. The Board of Directors has also determined to separate the role of Chairman and Chief Executive Officer, and accordingly, Jesse Chen, a current AXT board member, has become Chairman of the Board. In addition, the Audit Committee concluded that additional review of the organization and performance of operations, quality control and product testing would be conducted, resulting in possible additional changes in management and non-management functions. The Audit Committee also instructed management to implement additional training programs for employees involved in production, testing and quality assurance. The Audit Committee believes that these measures will address the issues raised above and provide the necessary operational oversight and assurance that the Company is complying with the requirements for product testing and the provision of testing data and other customer information.
(b) No significant changes in internal ~~control~~controls over financial reporting ~~to determine whether any changes occurred~~were made during the quarter ~~covered by this report that have materially affected, or are reasonably likely to materially affect,~~ended June 30, 2004, although as described above, we implemented executive management changes, including a change in our ~~internal control over financial reporting. Based on that evaluation, there has been no such change~~Chief Executive Officer and Chief Financial Officer roles, during the quarter, ~~covered by this report. It should be noted that any system~~and are implementing operational changes and measures to improve our operational controls over product testing, provision of ~~controls, however well designed~~testing and ~~operated, can provide only reasonable~~other customer data and ~~not absolute assurance that the objectives of the system will be met.~~
quality assurance.
35

PART IIOTHER INFORMATION
Item 1. Legal Proceedings

From time to time ~~we are~~the Company is involved in judicial or administrative proceedings concerning matters arising in the ordinary course of ~~our~~ business. ~~We do~~The Company does not expect that any of these matters, individually or in the aggregate, will have a material adverse effect on ~~our~~its business, financial condition, cash flows or results of operation.

On April 15, 2003, Sumitomo Electric Industries, Ltd., (SEI) filed a complaint in the Tokyo District Court, Civil Division against usthe Company and ~~our~~its Japanese distributor alleging patent infringement of two patents held by SEI in Japan. The suit seeks penalties from AXT in the amount of $1.67 million plus interest and court costs and the cessation of AXT’s sales of gallium arsenide substrates in Japan. AXT intends to defend itself vigorously in these lawsuits and continues to sell its products in Japan. Both parties have completed submitting arguments and evidence in litigation in Japan. We retain all of our options which include appealing any court decision and launching an effort to have Sumitomo’s patent invalidated in Japan.

On June 11, 2003, Cree, Inc. filed a complaint in the United States Court for Northern District of California against usthe Company alleging patent infringement. The complaint ~~seeks~~sought damages and injunction against infringement. On July 23, 2003, wethe Company filed a counter complaint in the United States Court for Northern District of California, denying any patent infringement and alleging that Cree’s actions were intentionally designed to interfere with ~~our~~the Company’s prospective business relationships. ~~A court hearing is scheduled for late February~~The Company reached an agreement with Cree resolving the disputes between us and signed a settlement agreement on March 5, 2004. The resolution of the disputes did not have a material adverse impact on the Company’s consolidated financial position or results of operations. All parties signed a final release regarding all disputes between them on April 15, 2004.
Item 2. Changes in Securities and Use of Proceeds
     ~~None~~
None
Item 3. Defaults upon Senior Securities
     ~~None~~
None
Item 4. Submission of Matters to a Vote of Security Holders
     ~~None~~
AXT held its annual meeting of stockholders at its headquarters in Fremont, California on May 18, 2004. Of the 23,042,982 shares outstanding as of the record date, 20,907,474 shares were represented by proxy at the meeting. Proxies were solicited by the Company pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended. At the meeting, AXT’s stockholders voted on the following matters:
(1)   Proposal to elect one class III director to hold office for a three-year term, and until his successor is elected and qualified.

For

Against

Leonard J. LeBlanc

20,732,335

175,139

(2)   Proposal to ratify the selection of PricewaterhouseCoopers LLP as our independent auditors for the year ending December 31, 2004.

For

Against

Abstain

PricewaterhouseCoopers LLP

20,825,550

77,174

4,750

Item 5. Other Information
     ~~None~~
35None
36

Item 6. Exhibits and Reports on Form 8-K
a. Exhibits
a.
Exhibit
Number
~~Exhibits~~
Description

3.1 (1) Restated Certificate of Incorporation

3.2 (2) Certificate of Designation, Preferences and Rights of Series A Preferred Stock, as filed with the Secretary of State of the state of Delaware on May 27, 1999 (which is incorporated herein by reference to Exhibit 2.1 to the registrant’s Form 8-K dated May 28, 1999)

3.3 (3) Second Amended and Restated Bylaws

4.1 (4) Registration Rights Agreement dated as of May 27, 1999, by and among American Xtal Technology, Inc., Lyte Optronics, Inc. and Keith Halsey and Robert Shih

4.2 (3) Rights Agreement dated as of April 24, 2001, by and between AXT, Inc. and Computershare Trust Company

10.14 (5) Second Modification to Credit Agreement between U.S. Bank National Association and AXT, Inc. dated September 30, 2002

10.15 (6) Reimbursement Agreement between Wells Fargo Bank National Association and AXT, Inc. dated April 7, 2003

10.16 Asset purchase agreements dated September 4, 2003 by and between Dalian Luming Science and Technology Group Co., Ltd and AXT, Inc., and by and between Lumei Optoelectronics Corp., AXT, Inc., Lyte Optoelectronics, Inc., Beijing Tongmei Xtal Technology and Xiamen Advanced Semiconductor Co., Ltd.

31.1 Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1 Certification by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2 Certification by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
~~(1)~~
3.1(1)
~~Incorporated~~
Restated Certificate of Incorporation
3.2(2)
Certificate of Designation, Preferences and Rights of Series A Preferred Stock (which is incorporated herein by reference
3.3(3)
Second Amended and Restated Bylaws
3.4
Certificate of Amendment to the ~~Exhibit~~Restated Certificate of Incorporation
31.1
Certification by Interim Chief Executive Officer Pursuant to Section 302 of the ~~same number filed with our Annual Report on Form 10-K for the year ended December 31, 1998.~~Sarbanes-Oxley Act of 2002.
~~(2)~~
31.2
~~Incorporated~~
Certification by ~~reference~~Chief Financial Officer Pursuant to Section 302 of the ~~Exhibit number 3.1 filed with our Form 8-K on June 14, 1999.~~Sarbanes-Oxley Act of 2002.
~~(3)~~
32.1
~~Incorporated~~
Certification by ~~reference~~Interim Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the ~~Exhibit number 3.4 filed with our Form 8-K on May 30, 2001.~~Sarbanes-Oxley Act of 2002.
~~(4)~~
32.2
~~Incorporated~~
Certification by ~~reference~~Chief Financial Officer Pursuant to ~~the Exhibit~~18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the ~~same number filed with our Annual Report on Form 10-K for the year ended December 31, 1999.~~
~~(5)~~ ~~Incorporated by reference to the Exhibit~~Sarbanes-Oxley Act of ~~the same number filed with our Quarterly Report on Form 10-Q for the three and nine months ended September 30,~~ 2002.
~~(6)~~ ~~Incorporated by reference to the Exhibit of the same number filed with our Quarterly Report on Form 10-Q for the three and six months ended June 30, 2003.~~
b. ~~Reports on Form 8-K~~
~~None.~~
(1) Incorporated by reference to the exhibit of the same number filed with the SEC with our Annual Report on Form 10-K for the year ended December 31, 1998.
36
~~SIGNATURES~~
(2) Incorporated by reference to Exhibit 2.1 to registrant’s Form 8-K filed with the SEC on June 14, 1999.
(3) Incorporated by reference to Exhibit 3.4 to registrant’s Form 8-K filed with the SEC on May 30, 2001.
b. Reports on Form 8-K
We filed or furnished the following reports on Form 8-K during the quarter ended June 30, 2004:
On May 24, 2004 we furnished a report on Form 8-K announcing our earnings for the quarter ended March 31, 2004.
On May 24, 2004, we filed a report on Form 8-K announcing our executive management changes.
On June 24, 2004, we filed a report on Form 8-K announcing our change in certifying accountants and a workforce reduction at our Fremont manufacturing facility.
37

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
AXT, INC.
~~AXT, INC.~~
Dated: August 5, 2004
By:
~~Dated: November 13, 2003~~ ~~By:~~ ~~/s/ Morris S. Young~~
~~Morris S. Young~~
~~Chief Executive Officer~~
~~Dated: November 13, 2003~~ ~~By:~~
/s/ Donald L. Tatzin
Donald L. Tatzin
Interim Chief Executive Officer
(Principal Executive Officer)
/s/ Wilson W. Cheung
Wilson W. Cheung
Chief Financial Officer
(Principal Financial and Accounting Officer)
38

EXHIBIT INDEX
Exhibit
Number
Description
~~Dated: November 13, 2003~~
3.1(1)
~~By:~~ ~~/s/ John Drury~~
~~John Drury~~
~~Corporate Controller~~
37
~~INDEX TO EXHIBITS~~
~~Number~~ ~~Description~~
~~3.1(1)~~ Restated Certificate of Incorporation
3.2(2)
Certificate of Designation, Preferences and Rights of Series A Preferred Stock ~~as filed with the Secretary of State of the state of Delaware on May 27, 1999~~ (which is incorporated herein by reference ~~to Exhibit 2.1 to the registrant’s Form 8-K dated May 28, 1999)~~
3.3(3)
Second Amended and Restated Bylaws
~~4.1(4)~~
3.4
~~Registration Rights Agreement dated as~~
Certificate of ~~May 27, 1999, by and among American Xtal Technology, Inc., Lyte Optronics, Inc. and Keith Halsey and Robert Shih~~Amendment to the Restated Certificate of Incorporation
~~4.2(3)~~
31.1
~~Rights Agreement dated as of April 24, 2001, by and between AXT, Inc. and Computershare Trust Company~~
~~10.14(5)~~ ~~Second Modification to Credit Agreement between U.S. Bank National Association and AXT, Inc. dated September 30, 2002~~
~~10.15(6)~~ ~~Reimbursement Agreement between Wells Fargo Bank National Association and AXT, Inc. dated April 7, 2003~~
~~10.16~~ Asset purchase agreements dated September 4, 2003 by and between Dalian Luming Science and Technology Group Co., Ltd and AXT, Inc., and by and between Lumei Optoelectronics Corp., AXT, Inc., Lyte Optoelectronics, Inc., Beijing Tongmei Xtal Technology and Xiamen Advanced Semiconductor Co., Ltd.
~~31.1~~
Certification by Interim Chief Executive Officer ~~pursuant~~Pursuant to Section 302 of the Sarbanes-Oxley Act of ~~2002~~2002.
31.2
Certification by Chief Financial Officer ~~pursuant~~Pursuant to Section 302 of the Sarbanes-Oxley Act of ~~2002~~2002.
32.1
Certification by Interim Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of ~~2002~~2002.
32.2
Certification by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of ~~2002~~2002.
(1) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Annual Report on Form 10-K for the year ended December 31, 1998.
~~(1)~~ ~~Incorporated by reference to the Exhibit of the same number filed with our Annual Report on Form 10-K for the year ended December 31, 1998.~~
~~(2)~~ ~~Incorporated by reference to the Exhibit number 3.1 filed with our Form 8-K on June 14, 1999.~~
~~(3)~~ ~~Incorporated by reference to the Exhibit number 3.4 filed with our Form 8-K on May 30, 2001.~~
~~(4)~~ ~~Incorporated by reference to the Exhibit of the same number filed with our Annual Report on Form 10-K for the year ended December 31, 1999.~~
~~(5)~~ ~~Incorporated by reference to the Exhibit of the same number filed with our Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2002.~~
~~(6)~~ ~~Incorporated by reference to the Exhibit of the same number filed with our Quarterly Report on Form 10-Q for the three and six months ended June 30, 2003.~~
38(2) Incorporated by reference to Exhibit 2.1 to registrant’s Form 8-K filed with the SEC on June 14, 1999.
(3) Incorporated by reference to Exhibit 3.4 to registrant’s Form 8-K filed with the SEC on May 30, 2001.
39

ý
~~(Mark One)~~
x		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the quarterly period ended ~~September~~June 30, ~~2003~~2004

or

o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the transition period ~~from______to_________~~from to

DELAWARE		94-3031310
~~DELAWARE~~		~~94-3031310~~
(State or other jurisdiction of		~~(I.R.S. Employer~~
Incorporation or organization)		(I.R.S. Employer Identification No.)

Class			Outstanding at July 23, 2004
~~Class~~	~~Outstanding at September 30, 2003~~

Common Stock, $.001 par value		~~22,931,338~~	23,046,320


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003		~~CONDENSED CONSOLIDATED BALANCE SHEETS~~
Condensed Consolidated Statements of Operations for the three and six month periods ended June 30, 2004 and 2003		~~CONDENSED CONSOLIDATED STATEMENTS OF INCOME~~
Condensed Consolidated Statements of Cash Flows for the six month periods ended June 30, 2004 and 2003		~~CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS~~
Notes To Condensed Consolidated Financial Statements		~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. ~~Qualitative~~Quantitative and ~~Quantitative~~Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART IIII. OTHER INFORMATION
	Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
~~SIGNATURES~~Signatures
~~INDEX TO EXHIBITS~~
~~EXHIBIT 10.16~~
~~EXHIBIT 31.1~~
~~EXHIBIT 31.2~~
~~EXHIBIT 32.1~~
~~EXHIBIT 32.2~~


			~~Page~~
~~PART I. FINANCIAL INFORMATION~~
	~~Item 1.~~	~~Financial Statements~~
		~~Condensed Consolidated Balance Sheets at September 30, 2003 and December 31, 2002~~		3
		~~Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2003 and 2002~~		4
		~~Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002~~		5
		~~Notes To Condensed Consolidated Financial Statements~~		~~6-14~~
	~~Item 2.~~	~~Management’s Discussion and Analysis of Financial Condition and Results of Operations~~		~~14-34~~
	~~Item 3.~~	~~Quantitative and Qualitative Disclosures About Market Risk~~		34
	~~Item 4.~~	~~Controls and Procedures~~		~~34-35~~
~~PART II. OTHER INFORMATION~~
	~~Item 1.~~	~~Legal Proceedings~~		35
	~~Item 6.~~	~~Exhibits and Reports on Form 8-K~~		36
		~~Signatures~~		37
		~~Exhibits~~


				September 30			December 31,
				2003			2002

				(Unaudited)
Assets:
	Current assets
		Cash and cash equivalents		$	21,486		$	13,797
		Short-term investments			14,010			8,205
		Accounts receivable			4,953			7,195
		Inventories			26,095			37,598
		Prepaid expenses and other current assets			1,804			4,002
		Income tax receivable			72			8,783
		Assets held for sale			1,000			5,957

			Total current assets		69,420			85,537
	Property, plant and equipment				22,730			39,982
	Other assets				4,773			5,341
	Restricted deposits				9,402			11,150
	Long-term investments				2,406			3,657

			Total assets	$	108,731		$	145,667

Liabilities and Stockholders’ Equity:
	Current liabilities
		Accounts payable		$	1,899		$	4,228
		Accrued liabilities			9,483			11,407
		Current portion of long-term debt			1,765			965
		Current portion of capital lease obligation			—			3,562

			Total current liabilities		13,147			20,162
		Long-term debt, net of current portion			10,874			13,289
		Long-term capital lease, net of current portion			—			4,847
		Other long-term liabilities			1,583			1,712

			Total liabilities		25,604			40,010

	Stockholders’ equity:
		Preferred stock, $.001 par value per share; 2,000 shares authorized; 883 shares issued and outstanding			3,532			3,532
		Common stock, $.001 par value per share; 70,000 shares authorized; 22,931 and 22,495 shares issued and outstanding			154,937			154,485
		Accumulated deficit			(76,813	)		(52,197	)
		Other comprehensive income (loss)			1,471			(163	)

			Total stockholders’ equity		83,127			105,657

		Total liabilities and stockholders’ equity		$	108,731		$	145,667

	June 30, 2004			December 31, 2003
Assets:
Current assets
Cash and cash equivalents	$	14,783		$	24,339
Short-term investments	19,858			14,669
Accounts receivable, net of allowance of $4,946 and $4,304 as of June 30, 2004 and December 31, 2003, respectively	4,390			6,297
Inventories	21,822			24,083
Prepaid expenses and other current assets	2,572			1,301
Assets held for sale	1,000			1,000
Total current assets	64,425			71,689
Property, plant and equipment	20,968			21,795
Other assets	3,290			4,237
Restricted deposits	8,615			9,302
Total Assets	$	97,298		$	107,023

Liabilities:
Current liabilities
Current portion of long-term debt	$	1,923		$	3,694
Accounts payable	2,791			2,638
Accrued liabilities	7,802			8,296
Accrued restructuring	1,040			—
Total current liabilities	13,556			14,628
Long-term debt, net of current portion	7,885			8,842
Other long-term liabilities	1,282			1,255
Total liabilities	22,723			24,725
Stockholders’ Equity:
Preferred stock, $0.001 par value per share; 2,000 shares authorized; 833 shares issued and outstanding	3,532			3,532
Common stock, $0.001 par value per share; 70,000 shares authorized; 23,047 and 22,957 shares issued and outstanding, respectively	155,371			155,178
Accumulated deficit	(85,335		)	(78,928		)
Accumulated other comprehensive income	1,007			2,516
Total stockholders’ equity	74,575			82,298
Total Liabilities and Stockholders’ Equity	$	97,298		$	107,023


			Three Months Ended						Nine Months Ended
			September 30,						September 30,
			2003			2002			2003			2002

Revenue			$	8,529		$	11,726		$	25,583		$	36,362
Cost of revenue				8,029			12,885			24,135			35,505

Gross profit				500			(1,159	)		1,448			857
Operating expenses:
	Selling, general and administrative			2,654			3,495			7,973			11,108
	Research and development			301			486			1,048			1,742
	Property, plant and equipment impairment loss			—			542			—			14,632

		Total operating expenses		2,955			4,523			9,021			27,482

Loss from operations				(2,455	)		(5,682	)		(7,573	)		(26,625	)
Interest expense				145			105			368			362
Other (income)/expense, net				(3	)		(308	)		1,035			8,183

Loss before income tax benefit				(2,597	)		(5,479	)		(8,976	)		(35,170	)
Income tax provision				—			10,673			—			4,433

Loss from continuing operations				(2,597	)		(16,152	)		(8,976	)		(39,603	)
Discontinued operations:
	Loss from operations			(1,591	)		(19,533	)		(6,165	)		(32,149	)
	Gain /(loss) on disposal			1,625			—			(9,475	)		—
	Income tax (benefit)			—			(7,012	)		—			(8,103	)

Gain /(loss) from discontinued operations				34			(12,521	)		(15,640	)		(24,046	)

Net loss			$	(2,563	)	$	(28,673	)	$	(24,616	)	$	(63,649	)

Basic and diluted loss per share:
	Loss from continuing operations			(0.11	)		(0.72	)		(0.39	)		(1.76	)
	Loss from discontinued operations			0.00			(0.56	)		(0.69	)		(1.07	)
	Net loss			(0.11	)		(1.28	)		(1.08	)		(2.84	)
Shares used in per share calculations:
	Basic			22,857			22,478			22,727			22,443
	Diluted			22,857			22,478			22,727			22,443

	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003

Revenue	$	9,524		$	8,519		$	19,300		$	17,054
Cost of revenue	8,695			7,844			17,938			16,106
Gross profit	829			675			1,362			948
Operating expenses:
Selling, general and administrative	3,203			2,819			5,973			5,319
Research and development	350			368			691			747
Restructuring charge	1,077			—			1,077			—
Total operating expenses	4,630			3,187			7,741			6,066
Loss from operations	(3,801		)	(2,512		)	(6,379		)	(5,118		)
Interest expense	58			108			167			223
Other expense (income), net	113			1,269			(54		)	1,038
Loss before provision for income taxes	(3,972		)	(3,889		)	(6,492		)	(6,379		)
Provision for incomes taxes	97			—			137			—
Loss from continuing operations	(4,069		)	(3,889		)	(6,629		)	(6,379		)
Discontinued operations:
Gain (loss) from discontinued operations	222			(2,747		)	222			(4,574		)
Loss from disposal	—			(11,100		)	—			(11,100		)
Net loss	$	(3,847	)	$	(17,736	)	$	(6,407	)	$	(22,053	)

Basic and diluted loss per share:
Loss from continuing operations	$	(0.18	)	$	(0.17	)	$	(0.29	)	$	(0.28	)
Gain (loss) from discontinued operations	0.01			(0.61		)	0.01			(0.69		)
Net loss	$	(0.17	)	$	(0.78	)	$	(0.28	)	$	(0.97	)

Basic and diluted shares used in per share calculations	23,045			22,702			23,020			22,665

	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003

Revenue	$	—		$	2,897		$	—		$	7,019
Cost of revenue	—			4,443			—			9,119

Gross loss	—			(1,546		)	—			(2,100		)
Operating expenses:
Selling, general and administrative	(222		)	750			(222		)	1,536
Research and development	—			342			—			707
Impairment costs	—			—			—			—
Total operating expenses	(222		)	1,092			(222		)	2,243
Gain (loss) from operations	222			(2,638		)	222			(4,343		)
Interest expense	—			109			—			231
Gain (loss) before benefit for income taxes and loss on disposal	222			(2,747		)	222			(4,574		)
Income tax (benefit)	—			—			—			—
Loss on disposal	—			(11,100		)	—			(11,100		)
Net gain (loss)	$	222		$	(13,847	)	$	222		$	(15,674	)

	June 30, 2004		December 31, 2003
Current assets:
Cash	$	560	$	539
Accounts receivable, net	19		250
Assets held for sale	1,000		1,000
Total current assets	1,579		1,789
Other assets	200		200
Total assets	$	1,779	$	1,989
Current liabilities:
Accounts payable	$	—	$	43
Accrued liabilities	462		1,232
Total liabilities	462		1,275
Net assets	1,317		714
Total liabilities and net assets	$	1,779	$	1,989

Available for sale	Cost		Unrealized Gain /(loss)			Aggregate Fair value
Money market	$	8,898	$	—		$	8,898
Corporate bonds	17,103		(67		)	17,036
Government agency bonds	5,275		(1		)	5,274
Corporate equity securities	1,464		1,210			2,674
	$	32,740	$	1,142		$	33,882
Recorded as :
Cash equivalents	$	5,409
Short-term investments	19,858
Restricted deposits	8,615
	$	33,882


			Aggregate		Unrealized
Available for sale	Cost		Fair value		Gain/(loss)

Money market	$	8,628	$	8,628		—
Corporate bonds		13,748		13,831		83
Government agency bonds		4,503		4,507		4
Corporate equity securities		1,115		2,688		1,573

	$	27,994	$	29,654	$	1,660

Recorded as:
Cash equivalents	$	8,628
Short-term investments		14,010
Restricted deposits		4,610
Long-term investments		2,406

	$	29,654

	June 30, 2004		December 31, 2003
Inventories:
Raw materials	$	5,951	$	7,086
Work in process	14,724		16,027
Finished goods	1,147		970
	$	21,822	$	24,083

For the three month period ended June 30, 2004	Restructuring Accrual as of March 31, 2004		Additions/ Reversals		Payments			Restructuring Accrual as of June 30, 2004
Future lease payments related to abandoned facilities	$	—	$	690	$	—		$	690
Workforce reduction	—		387		(37		)	350
Total	$	—	$	1,077	$	(37	)	$	1,040


	Nine Months Ended
	September 30,

	2003			2002

Risk free interest rate		2.7	%		3.0	%
Expected life (in years)		5.0			5.0
Dividend yield		0.0	%		0.0	%
Volatility		117.0	%		101.0	%


		Three Months Ended				Nine Months Ended
		September 30,				September 30,

		2003		2002		2003		2002

Net revenues:
	United States	$	3,030	$	6,232	$	8,947	$	21,050
	Canada		40		71		147		982
	Europe		1,621		1,549		4,661		3,990
	Japan		1,080		1,299		2,866		2,270
	Taiwan		1,405		1,436		4,549		3,267
	Asia Pacific and other		1,353		1,139		4,413		4,803

	Consolidated	$	8,529	$	11,726	$	25,583	$	36,362

	Three Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2004		2003
Net revenues:
United States	$	2,142	$	2,013	$	4,199	$	5,917
Europe	2,287		1,731		3,702		3,040
Canada	35		84		89		107
Japan	1,023		1,298		2,259		1,786
Taiwan	2,539		1,655		5,683		3,144
Asia Pacific and other	1,498		1,738		3,368		3,060
Consolidated	$	9,524	$	8,519	$	19,300	$	17,054


	Investment		Investment
	Balance		Balance
	September 30,		December 31,		Accounting	Ownership
Affiliate	2003		2002		Method	Percentage

Xilingol Tongli Ge Co. Ltd.	$	794	$	773	Equity		25	%
Emeishan Jia Mei High Pure Metals Co., Ltd.		605		614	Equity		25	%
Beijing Ji Ya Semiconductor Material Co., Ltd.		959		1,071	Consolidated		51	%
Nanjing Jin Mei Gallium Co., Ltd.		510		616	Consolidated		88	%
Beijing BoYu Manufacturing Co., Ltd.		409		409	Consolidated		70	%

For the six month period ended June 30, 2004	Restructuring Accrual as of December 31, 2003		Additions/ Reversals		Payments			Restructuring Accrual as of June 30, 2004
Future lease payments related to abandoned facilities	$	—	$	690	$	—		$	690
Workforce reduction	—		387		(37		)	350
Total	$	—	$	1,077	$	(37	)	$	1,040

Affiliate	Investment Balance June 30, 2004		Investment Balance December 31, 2003		Accounting Method	Ownership Percentage
Xilingol Tongli Ge Co. Ltd.	$	820	$	822	Equity	25	%
Emeis han Jia Mei High Pure Metals Co., Ltd.	599		603		Equity	25	%
Beijing Ji Ya Semiconductor Material Co., Ltd.	1,071		1,071		Consolidated	51	%
Nanjing Jin Mei Gallium Co., Ltd.	616		616		Consolidated	88	%
Beijing BoYu Manufacturing Co., Ltd.	409		409		Consolidated	70	%

	Three Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2004		2003

Beginning accrued warranty and related costs	$	135	$	—	$	—	$	—
Charged to cost of revenue	—		—		135		—
Actual warranty expenditures	—		—		—		—
Ending accrued warranty and related costs	$	135	$	—	$	135	$	—

•		~~decline in general economic conditions or downturns in the industry in which we compete;~~

•		~~fluctuations in demand for our products;~~

•		~~expansion of our manufacturing capacity;~~

•		~~expansion of our operations in China;~~

•		~~limited availability and increased cost of raw materials;~~

•		~~the volume and timing of orders from our customers, and cancellations, push outs and delays of customer orders;~~

•		~~fluctuation of our manufacturing yields;~~

•		~~decreases in the prices of our competitors’ products;~~

•		~~costs incurred in connection with any future acquisitions of businesses or technologies;~~

•		~~increases in our expenses, including expenses for research and development; and~~

•		~~our ability to develop, manufacture and deliver high quality products in a timely and cost-effective manner.~~

•		•unforeseen environmental or engineering problems;

•		~~unavailability or late delivery of production equipment;~~

•		~~delays in completing new facilities;~~

•		~~delays in bringing production equipment on-line;~~

•		~~work stoppages or delays;~~

•		~~inability to recruit and train qualified staff;~~

•		~~unanticipated cost increases and restrictions imposed by requirements of local, state or federal regulatory agencies in the United States and China.~~

•		~~greater experience in~~ the business;

•		~~more manufacturing experience;~~

•		~~extensive intellectual property;~~

•		~~broader name recognition; and~~

•		~~significantly greater financial, technical and marketing resources.~~

•		~~impurities in the materials used;~~

•		~~contamination of the manufacturing environment;~~

•		~~substrate breakage;~~

•		~~equipment failure, power outages or variations in the manufacturing process; and~~

•		~~performance of personnel involved in the manufacturing process.~~

•		~~the competition our customers face in their particular industries;~~

•		~~the technical, manufacturing, sales and marketing and management capabilities of our customers;~~

•		~~the financial and other resources of our customers; and~~

•		~~the inability of our customers to sell their products if they infringe third party intellectual property rights.~~

•		~~we may have difficulty assimilating the operations, products and personnel of the acquired businesses;~~

•		~~our ongoing business may be disrupted;~~

•		~~we may incur unanticipated costs;~~

•		~~our management may be unable to manage the financial and strategic position of acquired or developed products, services and technologies;~~

•		~~we may be unable to maintain uniform standards, controls and procedures and policies; and~~

•		~~our relationships with employees and customers may be impaired as a result of any integration.~~

•		•changes in tariffs, import or export restrictions and other trade barriers;

•		~~unexpected changes in regulatory requirements;~~

•		~~longer periods to collect accounts receivable;~~

•		~~changes in export license requirements;~~

•		~~political and economic instability;~~

•		~~unexpected changes in diplomatic and trade relationships; and~~

•		~~foreign exchange rate fluctuations.~~

•		•actual or anticipated fluctuations in our quarterly or annual operating results;

•		~~changes in expectations about our future financial performance or changes in financial estimates of securities analysts;~~

•		~~announcements of technological innovations by us or our competitors;~~

•		~~new product introduction by us or our competitors;~~

•		~~large customer orders or order cancellations; and~~

•		~~the operating and stock price performance of comparable companies.~~

•		~~the division of our board of directors into three separate classes, each with three year terms;~~

•		~~the right of our board to elect a director to fill a space created by a board vacancy or the expansion of the board;~~

•		~~the ability of our board to alter our bylaws;~~

•		~~the ability of our board to authorize the issuance of up to 2,000,000 shares of blank check preferred stock; and~~

•		~~the requirement that only our board or the holders of at least 10% of our outstanding shares may call a special meeting of our stockholders.~~

•		~~66 2/3% of the shares of voting stock not owned by these large stockholders approve the merger or combination, or~~

•		~~the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of our outstanding voting stock.~~


						Current			Proforma			Proforma
	Balance		Current			Interest			10% Interest			10% Interest
	September 30,		Interest			Income/			Rate Decline			Rate Increase
Instrument	2003		Rate			(Expense)			Income/(Expense)			Income/(Expense)

Cash and cash equivalents	$	21,486		1.80	%	$	387		$	348		$	425
Bonds		8,550		1.35	%		(115	)		(104	)		(127	)

						$	271		$	244		$	298

Instrument	Balance June 30, 2004		Current Interest Rate		Current Interest Income/ (Expense)			Proforma 10% Interest Rate Decline Income/(Expense)			Proforma 10% Interest Rate Increase Income/(Expense)
Cash and cash equivalents	$	14,783	1.00	%	$	148		$	133		$	163
Bonds	8,300		1.42	%	(118		)	(106		)	(130		)
					$	30		$	27		$	33

		For		Against		Abstain
PricewaterhouseCoopers LLP		20,825,550		77,174		4,750


3.1	(1)	Restated Certificate of Incorporation

3.2	(2)	Certificate of Designation, Preferences and Rights of Series A Preferred Stock, as filed with the Secretary of State of the state of Delaware on May 27, 1999 (which is incorporated herein by reference to Exhibit 2.1 to the registrant’s Form 8-K dated May 28, 1999)

3.3	(3)	Second Amended and Restated Bylaws

4.1	(4)	Registration Rights Agreement dated as of May 27, 1999, by and among American Xtal Technology, Inc., Lyte Optronics, Inc. and Keith Halsey and Robert Shih

4.2	(3)	Rights Agreement dated as of April 24, 2001, by and between AXT, Inc. and Computershare Trust Company

10.14	(5)	Second Modification to Credit Agreement between U.S. Bank National Association and AXT, Inc. dated September 30, 2002

10.15	(6)	Reimbursement Agreement between Wells Fargo Bank National Association and AXT, Inc. dated April 7, 2003

10.16		Asset purchase agreements dated September 4, 2003 by and between Dalian Luming Science and Technology Group Co., Ltd and AXT, Inc., and by and between Lumei Optoelectronics Corp., AXT, Inc., Lyte Optoelectronics, Inc., Beijing Tongmei Xtal Technology and Xiamen Advanced Semiconductor Co., Ltd.

31.1		Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

~~(1)~~ 3.1(1)		~~Incorporated~~ Restated Certificate of Incorporation

3.2(2)		Certificate of Designation, Preferences and Rights of Series A Preferred Stock (which is incorporated herein by reference

3.3(3)		Second Amended and Restated Bylaws

3.4		Certificate of Amendment to the ~~Exhibit~~Restated Certificate of Incorporation

31.1		Certification by Interim Chief Executive Officer Pursuant to Section 302 of the ~~same number filed with our Annual Report on Form 10-K for the year ended December 31, 1998.~~Sarbanes-Oxley Act of 2002.

~~(2)~~ 31.2		~~Incorporated~~ Certification by ~~reference~~Chief Financial Officer Pursuant to Section 302 of the ~~Exhibit number 3.1 filed with our Form 8-K on June 14, 1999.~~Sarbanes-Oxley Act of 2002.

~~(3)~~ 32.1		~~Incorporated~~ Certification by ~~reference~~Interim Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the ~~Exhibit number 3.4 filed with our Form 8-K on May 30, 2001.~~Sarbanes-Oxley Act of 2002.

~~(4)~~ 32.2		~~Incorporated~~ Certification by ~~reference~~Chief Financial Officer Pursuant to ~~the Exhibit~~18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the ~~same number filed with our Annual Report on Form 10-K for the year ended December 31, 1999.~~

~~(5)~~		~~Incorporated by reference to the Exhibit~~Sarbanes-Oxley Act of ~~the same number filed with our Quarterly Report on Form 10-Q for the three and nine months ended September 30,~~ 2002.

~~(6)~~		~~Incorporated by reference to the Exhibit of the same number filed with our Quarterly Report on Form 10-Q for the three and six months ended June 30, 2003.~~

b.		~~Reports on Form 8-K~~

		~~None.~~

				AXT, INC.
			~~AXT, INC.~~
Dated: August 5, 2004	By:

~~Dated: November 13, 2003~~		~~By:~~	~~/s/ Morris S. Young~~

			~~Morris S. Young~~
			~~Chief Executive Officer~~

~~Dated: November 13, 2003~~		~~By:~~	/s/ Donald L. Tatzin
			Donald L. Tatzin
		Interim Chief Executive Officer
		(Principal Executive Officer)

		/s/ Wilson W. Cheung
		Wilson W. Cheung
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

Exhibit Number		Description
~~Dated: November 13, 2003~~ 3.1(1)		~~By:~~	~~/s/ John Drury~~ ~~John Drury~~ ~~Corporate Controller~~