UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC. 20549

FORM 10-Q

(Mark One)

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

for the quarterly period ended June 30, ~~2004~~2005

or

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

for the transition period from to

Commission File Number 000-24085

AXT, INC.

(Exact name of registrant as specified in its charter)

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

4281 Technology Drive, Fremont, California 94538

(Address of principal executive offices) (Zip code)

(510) 683-5900

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ý NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO ý

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class		Outstanding at July ~~23, 2004~~29, 2005
Common Stock, ~~$.001~~$0.001 par value		~~23,046,320~~23,007,043

AXT, INC.

FORM 10-Q

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of June 30, ~~2004~~2005 and December 31, ~~2003~~2004
Condensed Consolidated Statements of Operations for the three and six month periods ended June 30, ~~2004~~2005 and ~~2003~~2004
Condensed Consolidated Statements of Cash Flows for the six month periods ended June 30, ~~2004~~2005 and ~~2003~~2004
Notes To Condensed Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. ~~Changes in~~Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults ~~upon~~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

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

AXT, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share data)

	June 30, 2004			December 31, 2003			June 30, 2005			December 31, 2004
Assets:
Current assets
Cash and cash equivalents	$	14,783		$	24,339		$	15,112		$	12,117
Short-term investments	19,858			14,669			9,881			20,062
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
Accounts receivable, net of allowance of $526 and $1,087 as of June 30, 2005 and December 31, 2004, respectively							4,955			4,034
Inventories, net							15,336			16,462
Prepaid expenses and other current assets	2,572			1,301			2,438			2,523
Assets held for sale	1,000			1,000			—			1,250
Total current assets	64,425			71,689			47,722			56,448
Property, plant and equipment	20,968			21,795
Property, plant and equipment, net							17,556			19,045
Restricted deposits							8,215			8,215
Other assets	3,290			4,237			3,789			3,832
Restricted deposits	8,615			9,302
Total Assets	$	97,298		$	107,023
Total assets							$	77,282		$	87,540

Liabilities:
Liabilities and stockholders’ equity:
Current liabilities
Current portion of long-term debt	$	1,923		$	3,694
Accounts payable	2,791			2,638			$	1,816		$	1,895
Accrued liabilities	7,802			8,296			3,994			4,765
Accrued restructuring	1,040			—			504			552
Current portion of long-term debt							450			450
Income taxes payable							3,015			2,925
Total current liabilities	13,556			14,628			9,779			10,587
Long-term debt, net of current portion	7,885			8,842			7,300			7,600
Other long-term liabilities	1,282			1,255			1,362			1,336
Total liabilities	22,723			24,725			18,441			19,523
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
Commitments and contingencies (Note 11)
Stockholders’ equity:
Preferred stock, $0.001 par value per share; 2,000 shares authorized; 883 shares issued and outstanding							3,532			3,532
Common stock, $0.001 par value per share; 70,000 shares authorized; 23,017 and 23,119 shares issued and outstanding, at June 30, 2005 and December 31, 2004, respectively							23			23
Additional paid-in-capital							155,296			155,431
Accumulated deficit	(85,335		)	(78,928		)	(99,963		)	(92,561		)
Accumulated other comprehensive income	1,007			2,516			(47		)	1,592
Total stockholders’ equity	74,575			82,298			58,841			68,017
Total Liabilities and Stockholders’ Equity	$	97,298		$	107,023
Total liabilities and stockholders’ equity							$	77,282		$	87,540

See accompanying notes to condensed consolidated financial statements.

AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share data)

	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003			2005			2004			2005			2004

Revenue	$	9,524		$	8,519		$	19,300		$	17,054		$	6,032		$	9,524		$	12,666		$	19,300
Cost of revenue	8,695			7,844			17,938			16,106			5,905			8,695			12,260			17,938
Gross profit	829			675			1,362			948			127			829			406			1,362
Operating expenses:
Selling, general and administrative	3,203			2,819			5,973			5,319			2,716			3,203			6,968			5,973
Research and development	350			368			691			747			423			350			785			691
Restructuring charge	1,077			—			1,077			—
Restructuring charges													237			1,077			362			1,077
Total operating expenses	4,630			3,187			7,741			6,066			3,376			4,630			8,115			7,741
Loss from operations	(3,801		)	(2,512		)	(6,379		)	(5,118		)	(3,249		)	(3,801		)	(7,709		)	(6,379		)
Interest expense	58			108			167			223
Other expense (income), net	113			1,269			(54		)	1,038
Interest income, net													131			54			250			78
Other expense, net													(196		)	(225		)	(301		)	(191		)
Loss before provision for income taxes	(3,972		)	(3,889		)	(6,492		)	(6,379		)	(3,314		)	(3,972		)	(7,760		)	(6,492		)
Provision for incomes taxes	97			—			137			—			18			97			53			137
Loss from continuing operations	(4,069		)	(3,889		)	(6,629		)	(6,379		)	(3,332		)	(4,069		)	(7,813		)	(6,629		)
Discontinued operations:
Gain (loss) from discontinued operations	222			(2,747		)	222			(4,574		)
Loss from disposal	—			(11,100		)	—			(11,100		)
Gain from discontinued operations, net of tax													53			222			411			222
Net loss	$	(3,847	)	$	(17,736	)	$	(6,407	)	$	(22,053	)	$	(3,279	)	$	(3,847	)	$	(7,402	)	$	(6,407	)

Basic and diluted loss per share:
Loss from continuing operations	$	(0.18	)	$	(0.17	)	$	(0.29	)	$	(0.28	)	$	(0.14	)	$	(0.18	)	$	(0.34	)	$	(0.29	)
Gain (loss) from discontinued operations	0.01			(0.61		)	0.01			(0.69		)
Gain from discontinued operations													—			0.01			0.02			0.01
Net loss	$	(0.17	)	$	(0.78	)	$	(0.28	)	$	(0.97	)	$	(0.14	)	$	(0.17	)	$	(0.32	)	$	(0.28	)

Basic and diluted shares used in per share calculations	23,045			22,702			23,020			22,665
Shares used in computing basic and diluted net loss per share													23,079			23,045			23,113			23,020

See accompanying notes to condensed consolidated financial statements.

AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

	Six Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2005			2004

CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(6,407	)	$	(22,053	)	$	(7,402	)	$	(6,407	)
Adjustments to reconcile net loss to net cash used in operations:
Depreciation	2,437			3,456			2,068			2,437
Amortization of marketable securities premium/discount	123			225			152			123
Non-cash restructuring charge	1,077			—			362			1,077
Loss on disposal	—			11,100
Impairment write-down on investments	—			1,257
Gain on disposal of property, plant and equipment	—			(11		)
Loss on disposal of property, plant and equipment							217			—
Stock based compensation	—			28			(2		)	—
Gain on disposal of discontinued operations							(53		)	(222		)
Changes in assets and liabilities:
Accounts receivable, net	1,907			11			(921		)	1,907
Inventories	2,261			5,755
Inventories, net							1,126			2,261
Prepaid expenses	(1,271		)	1,487			85			(1,271		)
Other assets	39			(70		)	43			38
Accounts payable	153			(830		)	(79		)	153
Accrued liabilities	(531		)	(1272		)	(1,181		)	(309		)
Income taxes	—			636			90			—
Other long-term liabilities	27			(107		)	26			27
Net cash used in operating activities	(185		)	(388		)	(5,469		)	(186		)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment	(702		)	(1,704		)	(827		)	(702		)
Proceeds from sale of property, plant and equipment	—			5,172
Proceeds from sales of property, plant and equipment							31			—
Purchases of marketable securities	(20,650		)	(1,808		)	(5,380		)	(20,650		)
Proceeds from sale of marketable securities	10,422			4,700			13,988			10,422
Decrease (increase) in restricted cash	4,151			(3,623		)
Net cash (used in) provided by investing activities	(6,779		)	2,737
Proceeds from sale of assets held for sale, net							1,303			—
Decrease in restricted cash							—			4,150
Net cash provided by (used in) investing activities							9,115			(6,780		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from (payments of):
Issuance of common stock	193			185			60			193
Capital leases payments	—			(2,204		)
Repurchase of common stock							(193		)	—
Long-term debt payments	(2,728		)	(485		)	(300		)	(2,728		)
Net cash used in financing activities	(2,535		)	(2,504		)	(433		)	(2,535		)
Effect of exchange rate changes	(57		)	(45		)	(218		)	(55		)
Net decrease in cash and cash equivalents	(9,556		)	(200		)
Net increase (decrease) in cash and cash equivalents							2,995			(9,556		)
Cash and cash equivalents at the beginning of the period	24,339			13,797			12,117			24,339
Cash and cash equivalents at the end of the period	$	14,783		$	13,597		$	15,112		$	14,783

See accompanying notes to condensed consolidated financial statements.

AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

~~(Unaudited)~~

Note 1. Basis of Presentation

The accompanying ~~interim~~ condensed consolidated financial statements of AXT, Inc. (“AXT” ~~or the~~, “Company”), we,” “us,” and “our” refer to AXT, Inc. and all of its consolidated subsidiaries) are unaudited, and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary to present fairly the financial position, results of operations and cash flows of AXT and its subsidiaries for all periods presented.

Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ materially from those estimates.

The results of operations are not necessarily indicative of the results to be expected in the future or for the full fiscal year. It is recommended that these condensed consolidated financial statements be read in conjunction with ~~the Company’s~~our consolidated financial statements and the notes thereto included in ~~its 2003~~our 2004 Annual Report on Form 10-K and ~~its~~our Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on March ~~29, 2004~~18, 2005 and May ~~24, 2004,~~6, 2005, respectively.

Revenues from continuing operations ~~increased in fiscal 2003~~decreased for the three month period ended June 30, 2005 compared to the same period of fiscal ~~2002.~~2004. In response to continued net losses, ~~the Company has~~we have taken measures including the ~~continued~~ shifting of production to China to reduce costs and ~~increase~~control cash flows. As of June 30, ~~2004, the Company~~2005, we had available cash, cash equivalents and ~~liquid~~ short-term investments of ~~$34.6~~$25.0 million, excluding restricted deposits. ~~The Company believes~~We believe that ~~its~~our existing cash and ~~liquid~~cash equivalents and short-term investments, ~~cash generated from operations, coupled~~together with additional efforts to reduce expenditures in support of the continuing substrate business will be sufficient to meet working capital ~~expenditure~~ requirements for the next 12twelve months. However, existing cash and ~~liquid~~cash equivalents and short-term investments could decline during the remainder of ~~2004~~2005 due to a weakening of the economy, a loss in revenue, an unanticipated increase in expenses, or changes in our planned cash outlay.

If ~~the Company’s sales decrease, the ability~~our performance fails to ~~generate cash from operations~~improve, we will ~~be adversely affected which could adversely affect its future liquidity, requiring it~~continue to use cash and may at ~~a more rapid rate than expected and~~some time be forced to seek additional capital. There can be no assurance that ~~such~~ additional capital will be available or, if available to us, that it will be at terms acceptable to ~~the Company.~~

~~Certain reclassifications have been made to the prior years consolidated financial statements to conform to current period presentation.~~us.

Note 2.2. Discontinued Operations and related Assets Held for Sale

OnIn June ~~24,~~ 2003, ~~the Company~~we announced the discontinuation of ~~its~~our opto-electronics division, which ~~was~~we had established as part of ~~the~~our May 1999 acquisition of Lyte Optronics, Inc. in May 1999. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in the consolidated statements of operations.Inc.. The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs) for the illumination markets, including full-color displays, wireless handset backlighting and traffic signals, and also manufactured vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in our condensed consolidated statements of operations for all periods presented.

OnIn September ~~27,~~ 2003, ~~the Company~~we completed athe sale of substantially all of the assets of ~~its~~our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. ~~Proceeds~~A portion of the purchase price equal to $1.0 million ~~will be~~was held in escrow to satisfy any claims that the purchasers might make for ~~up to~~breaches of representations or warranties by us. Of this total escrow, $750,000 could be released after the one year anniversary of the sale of the opto-electronics business and the remainder could be released after the second anniversary of the sale. Given the difficult negotiations we encountered with the acquiring company when negotiating the sale of the opto-electronics business, as well as the historical operating problems of the business, we determined there was significant uncertainty regarding the recoverability of the escrowed amounts. Accordingly, we did not recognize the cash held in escrow in recording the sale of the opto-electronics division, and have only recorded amounts as and when they are received. To date, we have resolved all claims made against the first $750,000 held in escrow, and have

received approximately $719,000 from the escrow. Accordingly, we recorded a gain on discontinued operations for the six month period ended June 30, 2005 of $300,000. We also recorded a gain on discontinued operations of $58,000 in property tax refunds for the same period. The remaining $250,000 held in escrow will not be ~~recorded~~released until ~~all claims,~~September 2005, if ~~any, are settled. We expect this escrow to be released, if~~the buyer makes no claims ~~are made~~ against it ~~on or about September 28, 2004. Of this $1.0 million escrow, up to $250,000 will be held in escrow for a second year and will not be recorded until all claims, if any, are settled. The Company retains~~by such date.

In June 2005, we completed the sale of a building located in Monterey Park, ~~CA, that it intends to sell in 2004.~~California. This asset ~~has~~had been classified as “assets held for ~~sale~~sale” in the amount of $1.25 million on the condensed consolidated balance sheets as of ~~June 30, 2004 and~~ December 31, ~~2003.~~

~~The Company recorded a loss~~2004. We received net proceeds on ~~disposal~~the sale of ~~$9.5~~the property of approximately $1.3 million ~~during the nine months ended September 30, 2003. The Company~~and accordingly recorded a gain on ~~discontinued operations~~sale of ~~$0.2 million during~~$53,000 for the ~~three and six month periods~~quarter ended June 30, ~~2004.~~2005.

~~The Company’s~~Our condensed consolidated financial statements have been presented to reflect the opto-electronics business as a discontinued operation for all periods presented. Operating results of the discontinued operation are as follows (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended June 30,					Six Months Ended June 30,
	2004			2003			2004			2003			2005		2004			2005		2004

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			—		(222		)	—		(222		)
Research and development	—			342			—			707			—		—			—		—
Impairment costs	—			—			—			—			—		—			—		—
Total operating expenses	(222		)	1,092			(222		)	2,243			—		(222		)	—		(222		)
Gain (loss) from operations	222			(2,638		)	222			(4,343		)	—		222			—		222
Interest expense	—			109			—			231			—		—			—		—
Gain (loss) before benefit for income taxes and loss on disposal	222			(2,747		)	222			(4,574		)	—		222			—		222
Income tax (benefit)	—			—			—			—			—		—			—		—
Loss on disposal	—			(11,100		)	—			(11,100		)
Net gain (loss)	$	222		$	(13,847	)	$	222		$	(15,674	)
Gain on disposal													53		—			411		—
Net income (loss)													$	53	$	222		$	411	$	222

The carrying value of the assets and liabilities of the discontinued opto-electronics business included in the condensed consolidated balance sheets are as follows (in thousands):

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

~~Assets held for sale consist of a building and are carried at management’s estimated fair value less costs to sell.~~

	June 30, 2005		December 31, 2004
Current assets:
Cash	$	522	$	537
Accounts receivable, net	19		19
Assets held for sale	—		1,250
Total current assets	541		1,806
Other assets	—		200
Total assets	$	541	$	2,006
Current liabilities:
Accrued liabilities	$	318	$	359
Total liabilities	318		359
Net assets	223		1,647
Total liabilities and net assets	$	541	$	2,006

Note 3. Accounting for ~~Stock Options~~Stock-Based Compensation

~~The Company records~~We account for stock-based employee compensation ~~expense for employee stock options based upon their~~arrangements using the intrinsic value ~~on the date of grant pursuant to~~method as prescribed in Accounting Principles Board Opinion No. 25, ~~(APB 25), “Accounting~~“Accounting for Stock Issued to ~~Employees”~~Employees,” and ~~has adopted~~related interpretations thereof. Accordingly, compensation cost for stock options is measured as the ~~disclosure-only alternative~~excess, if any, of the market price of AXT’s stock at the date of grant over the stock option exercise price. The following table illustrates the effect on our net loss and net loss per share if we had applied the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, ~~(SFAS 123) “Accounting~~“Accounting for Stock-Based Compensation”. Because the Company establishes the exercise price based on the fair market value of the Company’s stock at the date of grant, the options have no intrinsic value upon grant, and therefore no expense is recorded. Each quarter, the Company reports the potential dilutive impact of stock options in its diluted earnings per share using the treasury-stock method. Out-of-the-money stock options (i.e., options where the average sales price of our common stockCompensation,” as ~~reported on the Nasdaq National Market during the period is below the exercise price of the option) are not included in diluted earnings per share.~~

~~As required under~~amended by SFAS ~~123 and Statement of Financial Accounting Standards~~ No. 148, ~~(SFAS 148), “Accounting~~“Accounting for Stock-Based Compensation Transition and Disclosure,” ~~the~~ to options granted under our stock option plans. For purposes of this pro forma ~~effects~~disclosure, the value of ~~stock-based compensation on net income~~ ~~(loss)~~the options is estimated using the Black-Scholes option pricing model and ~~net income (loss) per common share had~~amortized to expense over the ~~Company applied~~options’ vesting periods. Because the ~~fair~~estimated value ~~recognition principles~~is determined as of ~~SFAS 123 to employee stock options have been estimated at~~ the date of grant, ~~using~~ the ~~Black-Scholes option-pricing model.~~actual value ultimately

~~The Black-Scholes option-pricing model was developed~~7

realized by the employee may be significantly different.

Had compensation cost for ~~use in estimating~~our options been determined based on the fair value ~~of traded options that have no restrictions and are fully transferable and negotiable~~at the grant dates, as prescribed in a free trading market. Black-Scholes does not consider the employment, transfer or vesting restrictions that are inherent in the Company’s employee options. Use of an option valuation model, as required by SFAS 123 ~~includes highly subjective assumptions based on long-term predictions, including the expected stock price volatility~~ and ~~average life of each option grant. Because the Company’s employee options~~SFAS 148, our pro forma net loss and net loss per share would have characteristics significantly different from those of freely traded options, and because changes in the assumptions underlying the option-pricing model can materially affect the Company’s estimate of the fair value of those options, in the Company’s opinion, the existing valuation models, including Black-Scholes, are not reliable single measures and may misstate the fair value of the Company’s employee options.been as summarized below (in thousands except per share data):

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Net loss :
As reported	$	(3,279	)	$	(3,847	)	$	(7,402	)	$	(6,407	)
Less: Stock-based employee compensation expense (income) included in net loss as reported	2			—			(3		)	—
Less: Stock-based compensation expense using the fair value based method, net of related tax	(232		)	(253		)	(467		)	(846		)
Pro forma net loss	$	(3,509	)	$	(4,100	)	$	(7,872	)	$	(7,251	)
Basic and diluted net loss per share:
As reported	$	(0.14	)	$	(0.17	)	$	(0.32	)	$	(0.28	)
Pro forma	$	(0.15	)	$	(0.18	)	$	(0.34	)	$	(0.31	)
Shares used in computing basic and diluted net loss per share	23,079			23,045			23,113			23,020

~~The Company~~

We calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model as prescribed by SFAS 123 using the following assumptions:

	Six Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2005		2004
Weighted average risk free interest rate	1.6	%	2.7	%	3.72	%	1.68	%
Expected life (in years)	5.0		5.0		5.0		5.0
Dividend yield	—		—		—		—
Volatility	85.3	%	114.0	%	93.2	%	85.3	%

The weighted average grant date fair value ~~as of the date of grant~~ of options granted during the six ~~months~~month period ended June 30, 2005 and 2004 were $0.86 and ~~2003 were~~ $1.97 ~~and $1.05,~~per share, respectively.

An analysis of historical information is used to determine the above assumptions, to the extent that historical information is relevant, based on the terms of the grants being issued in any given period. Assumptions related to the Employee Stock Purchase Plan are not presented as the related compensation expense amounts are insignificant.

Had compensation cost for the Company’s options been determined based on the fair value at the grant dates, as prescribed in SFAS 123 and SFAS 148, the Company’s pro forma net loss and net loss per share would have been summarized as follows (in thousands~~, except per share data):~~

Three Months Ended
June 30,

Six Months Ended
June 30,

2004

2003

2004

2003

Net loss :

As reported

$
(3,847
)
$
(17,736
)
$
(6,407
)
$
(22,053
)
Stock-based compensation determined under fair value method

(253
)
(1,743
)
(846
)
(3,566
)
Pro forma net loss

$
(4,100
)
$
(19,479
)
$
(7,253
)
$
(25,619
)
Net loss per share:

As reported:

Basic and diluted

$
(0.17
)
$
(0.78
)
$
(0.28
)
$
(0.97
)
Pro forma net loss :

Basic and diluted

$
(0.18
)
$
(0.86
)
$
(0.32
)
$
(1.13
)
Shares used in per share calculation:

Basic and diluted

23,045

22,702

23,020

22,665

~~Because additional option grants are expected to be made each quarter, the above pro forma disclosures are not representative of pro forma effects on reported net income (loss) for future quarters.~~

Note 4. Cash, Cash Equivalents and Short-Term Investments4~~. Investments~~

~~The Company classifies its investment securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards No. 115~~ ~~(SFAS 115) “Accounting for Certain Investments in Debt~~Our cash, cash equivalents and ~~Equity Securities.” All~~short term investments are carried at fair market value, which is determined based on quoted market prices, with net unrealized gains and losses included in comprehensive income, net of tax. A decline in the market value of the security below cost that is deemed other than temporary is charged to earnings, resulting in the establishment of a new cost basis for the security. The components of investments as of June 30, 2004 are summarizedclassified as follows (in thousands):

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

	June 30, 2005									December 31, 2004
	Amortized Cost		Gross Unrealized Gain		Gross Unrealized (Loss)			Fair Value		Amortized Cost		Gross Unrealized Gain		Gross Unrealized (Loss)			Fair Value
Classified as:
Cash	$	6,690	$	—	$	—		$	6,690	$	8,638	$	—	$	—		$	8,638
Cash equivalents:
Money market fund	645		—		—			645		1,681		—		—			1,681
US Treasury and agency securities	—		—		—			—		—		—		—			—
Commercial paper	4,777		—		—			4,777		398		—		—			398
Repurchase agreements	3,000		—		—			3,000		1,400		—		—			1,400
Total cash equivalents	8,422		—		—			8,422		3,479		—		—			3,479
Total cash and cash equivalents	15,112		—		—			15,112		12,117		—		—			12,117

Short-term investments:
US Treasury and agency securities	4,481		—		(12		)	4,469		10,468		—		(16		)	10,452
Asset-backed securities	3,796		—		(13		)	3,783		4,410		—		(25		)	4,385
Commercial paper	493		—		—			493		1,708		—		(1		)	1,707
Corporate bonds	7,791		—		(23		)	7,768		8,737		—		(30		)	8,707
Corporate equity securities	1,467		116		—			1,583		1,465		1,561		—			3,026
Total short-term investments	18,028		116		(48		)	18,096		26,788		1,561		(72		)	28,277
Total cash, cash equivalents and short-term investments	$	33,140	$	116	$	(48	)	$	33,208	$	38,905	$	1,561	$	(72	)	$	40,394
Contractual maturities on short-term investments:
Due within 1 year	$	14,034						$	14,118	$	21,879						$	23,394
Due after 1 through 5 years	3,994							3,978		4,909							4,883
	$	18,028						$	18,096	$	26,788						$	28,277

~~Note~~ 5~~. Assets Held for Sale~~

~~Assets held for sale at~~The short-term investments amounts include $8.2 million recorded as restricted deposits on the condensed consolidated balance sheets as of June 30, 2004 consist of a building located in Monterey Park, California, which is part of the Company’s discontinued opto-electronics division (see Note 2). This building is carried at management’s estimated fair value less costs to sell, totaling $1.0 million as of both June 30, 20042005 and December 31, ~~2003.~~2004, respectively.

We manage our short-term investments as a single portfolio of highly marketable securities that is intended to be available to meet our current cash requirements. As of June 30, 2005 and December 31, 2004, we had no gross realized gains or losses on sales of our available-for-sale securities.

The gross unrealized losses related to our portfolio of available-for-sale securities were primarily due to a decrease in the fair value of debt and equity securities as a result of an increase in interest rates during 2004 and the first half of 2005. We have determined that the gross unrealized losses on our available-for-sale securities as of June 30, 2005 are temporary in nature. We reviewed our investment portfolio to identify and evaluate investments that have indications of possible impairment. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value. The following table provides a breakdown of our available-for-sale securities with unrealized losses as of June 30, 2005 (in thousands):

	In Loss Position < 12 months					In Loss Position > 12 months					Total In Loss Position
	Fair Value		Gross Unrealized (Loss)			Fair Value		Gross Unrealized (Loss)			Fair Value		Gross Unrealized (Loss)
Short-term investments:
US Treasury and agency securities	$	3,469	$	(12	)	$	—	$	—		$	3,469	$	(12	)
Asset-backed securities	1,231		(4		)	2,552		(9		)	3,783		(13		)
Corporate bonds	6,342		(18		)	1,426		(5		)	7,768		(23		)
Total in loss position	$	11,042	$	(34	)	$	3,978	$	(14	)	$	15,020	$	(48	)

Note 5. Inventories, Net6~~. Inventories~~

The components of ~~inventory~~inventories are summarized below (in thousands):

	June 30, 2005		December 31, 2004
Inventories, net:
Raw materials	$	4,896	$	4,416
Work in process	9,763		10,474
Finished goods	677		1,572
	$	15,336	$	16,462

Note 6. Restructuring Charges

Our restructuring accrual is as follows (in thousands):

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, 2005	Restructuring Accrual as of March 31, 2005		Additions/ Reversals			Payments			Restructuring Accrual as of June 30, 2005
Future lease payments related to abandoned facilities	$	462	$	169		$	(144	)	$	487
Workforce reduction	86		(30		)	(56		)	—
Japan office closure	—		98			(81		)	17
Total	$	548	$	237		$	(281	)	$	504

For the six month period ended
June 30, 2005

Restructuring
Accrual as of
December 31,
2004

Additions/
Reversals

Payments

Restructuring
Accrual as of
June 30, 2005

Future lease payments related to abandoned facilities

$
552

$
208

$
(273
)
$
487

Workforce reduction

—

56

(56
)
—

Japan office closure

—

98

(81
)
17

Total

$
552

$
362

$
(410
)
$
504

~~Note~~ 7On March 14, 2005, we announced that we would be reducing the workforce at our Beijing, China manufacturing facility by approximately 100 positions or approximately 15%. This measure was taken as part of our ongoing effort to reduce our cost structure and bring capacity in line with current market demand. In March 2005, we recorded a restructuring charge of $86,000 relating to the reduction in work force, which we completed in June 2005. On an annual basis, we anticipate payroll and related expense savings of approximately $0.3 million relating to this reduction in force. ~~Restructuring Charge~~

~~The Company’s restructuring accrual is summarized as follows (in thousands):~~

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

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

~~During~~For the three and six month ~~period~~periods ended June 30, ~~2004, the Company~~2005 we recorded a restructuring ~~charge~~charges of ~~$1.1 million~~$169,000 and $208,000, respectively, related ~~to the reduction in force effected in June 2004, and~~ to lease costs associated with facilities located in California that are no longer required to support production.

The remaining restructuring accrual for future lease payments related to abandoned U.S. facilities of ~~$0.7 million and workforce reduction of $0.4 million~~$487,000, is expected to be paid out through ~~calendar 2004,~~2006, and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.

On April 28, 2005, we closed our Japan office as part of our ongoing effort to reduce our cost structure. In the three month period ended June 30, 2005 we recorded a restructuring charge of $98,000 relating to the closure of our Japan office of which $17,000 is in the restructuring accrual balance at June 30, 2005. On an annual basis, we anticipate payroll and related expense savings of approximately $0.3 million relating to the closure of our Japan office. The remaining restructuring accrual for our Japan office closure of $17,000 is expected to be paid out through 2005, and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.

Note 8.7. Net Loss Per Share

Basic net loss per common share is calculated by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net loss per common and common equivalent shares include the dilutive effect of common stock equivalents outstanding during the period calculated using the treasury stock method. Common stock equivalents consist of the shares ~~issuable~~issueable upon the exercise of stock options.

A reconciliation of the numerators and denominators of the basic and diluted net loss per share calculations is ~~summarized~~ as follows (in thousands, except per share data):

	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003			2005			2004			2005			2004
Numerator:
Net loss	$	(3,847	)	$	(17,736	)	$	(6,407	)	$	(22,053	)	$	(3,279	)	$	(3,847	)	$	(7,402	)	$	(6,407	)
Less : Preferred stock dividends	(44		)	(44		)	(88		)	(88		)
Less: Preferred stock dividends													(44		)	(44		)	(88		)	(88		)
Net loss available to common stockholders	$	(3,891	)	$	(17,780	)	$	(6,496	)	$	(22,141	)	$	(3,323	)	$	(3,891	)	$	(7,490	)	$	(6,495	)
Denominator:
Denominator for basic net loss per share - weighted average common shares	23,045			22,702			23,020			22,665			23,079			23,045			23,113			23,020
Effect of dilutive securities:
Common stock options	—			—			—			—			—			—			—			—
Denominator for dilutive net loss per share	23,045			22,702			23,020			22,665
Denominator for dilutive net loss per common share													23,079			23,045			23,113			23,020
Basic and diluted net loss per share	$	(0.17	)	$	(0.78	)	$	(0.28	)	$	(0.97	)	$	(0.14	)	$	(0.17	)	$	(0.32	)	$	(0.28	)
Options excluded from diluted net loss per share as the impact is antidilutive	1,916			3,124			1,916			3,231
Options excluded from diluted net loss per share as the impact is anti-dilutive													2,492			1,916			2,492			1,916

Note 9.8. Comprehensive Loss

The components of comprehensive loss are ~~summarized~~ as follows (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003			2005			2004			2005			2004

Net loss	$	(3,847	)	$	(17,736	)	$	(6,407	)	$	(22,053	)	$	(3,279	)	$	(3,847	)	$	(7,402	)	$	(6,407	)
Foreign currency translation gain (loss)	1			1			(57		)	(45		)
Unrealized gain (loss) on available for sale investments	(296		)	921			(1,452		)	677
Foreign currency translation (loss) gain													(74		)	1			(218		)	(57		)
Unrealized loss on available for sale investments													(200		)	(296		)	(1,421		)	(1,452		)
Comprehensive loss	$	(4,142	)	$	(16,814	)	$	(7,916	)	$	(21,421	)	$	(3,553	)	$	(4,142	)	$	(9,041	)	$	(7,916	)

Note 10.9. Segment Information and Foreign Operations

~~The Company has~~Segment Information

We operate in one ~~operating~~ segment ~~comprising~~for the design, development, manufacture and distribution of high-performance compound semiconductor ~~substrates.~~ substrates and sale of materials. In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” our chief operating decision-maker has been identified as the Chief Executive Officer, who reviews operating results to make decisions about allocating resources and assessing performance for the Company. All material operating units qualify for aggregation under SFAS No. 131 due to their identical customer base and similarities in economic characteristics, nature of products and services, and procurement, manufacturing and distribution processes. Since we operate in one segment, all financial segment and product line information required by SFAS No. 131 can be found in the

condensed consolidated financial statements.

Geographical Information

The ~~Company’s operating segment reports~~following table represents revenue amounts (in thousands) reported for products shipped to customers in the corresponding geographic region:

	Three Months Ended June 30,				Six Months Ended June 30,
	2005		2004		2005		2004
Net revenues:
North America*	$	1,310	$	2,180	$	2,282	$	4,288
Europe	1,802		2,287		3,584		3,702
Japan	559		1,023		799		2,259
Taiwan	402		2,539		2,058		5,683
Asia Pacific and other	1,959		1,495		3,943		3,368
Consolidated	$	6,032	$	9,524	$	12,666	$	19,300

*Primarily the United States

Long-lived assets consist primarily of property, plant and equipment, and are attributed to the ~~Interim Chief Executive Officer.~~

~~The Company sells its substrates products~~geographic location in ~~the United States and in other parts of the world, and maintains operations in the United States, Japan and China. Revenues~~which they are located. Long-lived assets by geographic ~~location based on the country where the customer is located~~ ~~are summarized~~region were as follows (in thousands):

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

	As of
	June 30, 2005		December 31, 2004
Long-lived assets:
North America	$	6,738	$	7,163
Asia Pacific	10,818		11,882
	$	17,556	$	19,045

Significant Customers

11One customer represented 14.6% and 9.6% of revenues for the three month periods ended June 30, 2005 and 2004, respectively. One customer represented 12.2% and 9.5% of revenues for the six month periods ended June 30, 2005 and 2004, respectively. Our top five customers represented 38.7% and 35.6% of revenue for the three month periods ended June 30, 2005, and 2004, respectively. Our top five customers represented 39.8% and 34.6% of revenue for the six month periods ended June 30, 2005, and 2004, respectively.

Note 11.10. Corporate Affiliates

~~The Company’s~~We have made strategic investments in ~~its~~private companies located in China in order to gain access to raw materials at a competitive cost that are critical to our substrate business. Our investments in these private corporate affiliates are summarized ~~as follows~~below (in thousands):

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
%

	Investment Balance As of
Affiliate	June 30, 2005		December 31, 2004		Accounting Method	Ownership Percentage
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
Xilingol Tongli Ge Co. Ltd	843		863		Equity	25
Emeishan Jia Mei High Pure Metals Co., Ltd	581		593		Equity	25

The investment balances for ~~those~~the two affiliates accounted for under the equity method are included ~~within “Other assets”~~in other assets in the condensed consolidated balance sheets. We own 25% of the ownership interests in each of these affiliates. These two affiliates are not considered variable interest entities because:

•both affiliates have sustainable businesses of their own;

•our voting power is proportionate to our ownership interests;

•we only recognize our respective share of the losses and/or residual returns generated by the affiliates if they occur, or both and

•we do not have controlling financial interests in either affiliate, do not maintain operational or management control, nor control of the board of directors, and are not required to provide additional investment or financial support to either affiliate.

Undistributed retained earnings relating to our corporate affiliates were $1.8 million and $1.4 million as of June 30, 2005 and 2004, respectively. Net income recorded from our corporate affiliates were $243,000 and $382,000 for the three month periods ended June 30, 2005 and 2004, respectively. Net income recorded from our corporate affiliates were $332,000 and $612,000 for the six month periods ended June 30, 2005 and 2004, respectively.

The minority interest for those affiliates that are consolidated is included within “Other long-term liabilities” in the condensed consolidated balance sheets and within “Other ~~income, net”~~expense (income)” on the condensed consolidated statements of operations.

Undistributed retained earnings relating to the Company’s corporate affiliates was $1,380,000 as of June 30, 2004 and $794,000 as of June 30, 2003. Net income recorded from the Company’s corporate affiliates were $382,000 and $612,000 for the three month and six month periods ended June 30, 2004, respectively. Net loss recorded from the Company’s corporate affiliates were $41,000 and $67,000 for the three and six month periods ended June 30, 2003, respectively.

The Company invested in these companies because each provides materials that are important to the Company’s substrate business, each can provide products at lower cost than other suppliers, and each has a market beyond that provided by the Company. As of June 30, 2004, the Company had no obligations to make furtherWe have considered investments in ~~any~~other joint ventures, including a new joint venture investment in China for a germanium business opportunity. If agreement is reached with the other parties concerning the formation of ~~these companies, although it~~this joint venture, we may, ~~choose~~upon the fulfillment of certain conditions, invest up to ~~do so under certain conditions.~~$1.0 million in the new joint venture in 2005.

Note 12.11. Commitments and Contingencies

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

On ~~April~~October 15, ~~2003, Sumitomo Electric Industries, Ltd., (SEI)~~2004, a purported securities class action lawsuit was filed a complaint in the Tokyo District Court, Civil Division against us and our 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. The Company retains all of its 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 the Northern District of ~~California against~~California. City of Harper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The Court consolidated the ~~Company alleging patent infringement.~~case with a subsequent related case and appointed a lead plaintiff. On April 5, 2005, the lead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc. et al., No. C 04 4362 MJJ. The lawsuit complaint names AXT, Inc. and our chief technology officer, as defendants, and is brought on behalf of a class of all purchasers of our securities from February 6, 2001 through April 27, 2004. The complaint ~~sought~~alleges that we announced financial results during this period that were false and misleading. No specific amount of damages is claimed. We believe that there are meritorious defenses against this litigation and ~~injunction against infringement. On July 23, 2003,~~intend to vigorously defend it. However, due to the ~~Company filed a counter complaint in~~inherent uncertainties of litigation, we cannot accurately predict 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 the Company’s prospective business relationships. The Company reached an agreement with Cree resolving the disputes between us and signed a settlement agreement on March 5, 2004. The resolutionultimate outcome of the ~~disputes did not~~litigation. Any unfavorable outcome of the litigation could have ~~a material~~an adverse impact on ~~the Company’s consolidated~~our business, financial ~~position or~~condition and results of operations. ~~All parties signed a final release regarding all disputes between them on April 15, 2004.~~

12On June 1, 2005, a lawsuit was filed in the Superior Court of California, County of Alameda, Zhao et. Al. vs. American Xtal Technology, et. Al., No. R 605215713. The lawsuit complaint names AXT and its chief technology officer and former interim chief executive officer, and is brought on behalf of two former employees and their minor child. The complaint alleges personal injury, general negligence, intentional tort, wage loss and other damages, including punitive damages, as a result of exposure of defendants, including the minor child in utero, to high levels of gallium arsenide in gallium arsenide wafers, and methanol. The complaint seeks damages of $10 million each for pain, suffering and inconvenience, and for emotion distress, special damages to be determined, and punitive damages in the amount of $10 million. We believe that there are meritorious defenses against this litigation and intend to vigorously defend it. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operations.

~~The Company has~~Contract Commitment

We have entered into contracts to supply several large customers with GaAs wafers. The contracts ~~guarantee the~~guaranteed delivery of a certain number of wafers between January 1, 2001 and December 31, 2004 with a current contract value of ~~$1.0 million.~~$130,000. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, ~~the Company~~we could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. ~~The Company has~~We have not received any claims for non-performance penalties due to non-delivery. Partial prepayments received for these supply contracts totaling ~~$793,000~~$125,000 and ~~$994,000~~$130,000 are included in accrued liabilities in the accompanying condensed consolidated balance sheets as of June 30, ~~2004~~2005 and December 31, ~~2003.~~2004, respectively. As of June 30, ~~2004, the Company has~~2005, we have met all of ~~its~~our current delivery obligations under these contracts and ~~expects~~expect to continue to meet delivery requirements during the remainder of the contract terms.

~~The Company indemnifies certain customers~~13

Indemnification Agreements

We enter into standard indemnification arrangements in the ordinary course of business. Pursuant to these arrangements, we indemnify, hold harmless, and agree to reimburse the indemnified parties for ~~attorney fees and damages and costs awarded against these parties in certain circumstances if its products are found to infringe certain patents and they are sued~~losses suffered or incurred by the indemnified party, generally their business partners or customers, in connection with any U.S. patent, ~~holder and awarded damages. There are limits on and exceptions~~or any copyright or other intellectual property infringement claim by any third party with respect to ~~its~~our products. The term of these indemnification agreements is generally perpetual anytime after the execution of the agreement. The maximum potential ~~liability for indemnification relating to intellectual patent infringement claims. The Company cannot estimate the~~ amount of ~~potential~~ future payments ~~if any, that it might~~we could be required to make under these agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal.

We have entered into indemnification agreements with our directors and officers that may require us to indemnify our directors and officers against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from willful misconduct of a culpable nature; to advance their expenses incurred as a result of ~~these agreements. To date, the Company has not paid~~ any ~~claim or been required~~proceeding against them as to ~~defend any action related~~which they could be indemnified; and to ~~its indemnification obligations,~~obtain directors’ and ~~accordingly, the Company has not accrued any amounts for such indemnification obligations. However,~~officers’ insurance if available on reasonable terms, which we ~~may record charges~~currently have in ~~the future as a result of these indemnification obligations.~~place.

Product Warranty

We warrant our products for a specific period of time, generally twelve months, against material defects. We provide for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The ~~Company’s financial statements include accruals for potential~~accrued warranty costs represent the best estimate at the time of sale of the total costs that we expect to incur to repair or replace product ~~liability~~parts that fail while still under warranty. The amount of accrued estimated warranty costs are primarily based on historical experience as to product failures as well as current information on repair costs. On a quarterly basis, we review the accrued balances and ~~warranty claims~~update these based on the Company’s claims experience. Such costs are accrued at the time revenue is recognized. As of June 30, 2004 and December 31, 2003, accrued product warranties totaled $135,000 and $0 respectively, and are included in “accrued liabilities” in the accompanying condensed consolidated balance sheets. If there is a material increase in customer claims compared with our historical ~~experience, or if costs of servicing claims are greater than expected, we may record a charge against~~warranty cost ~~of sales.~~

trends. The following table ~~reconciles changes~~reflects the change in ~~the Company’s accrued product warranties which is included in accrued liabilities for~~our warranty accrual during the three month and six month periods ended June 30, ~~2004~~2005 and ~~2003, respectively~~2004 (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,				Three Months Ended June 30,					Six Months Ended June 30,
	2004		2003		2004		2003		2005			2004		2005			2004

Beginning accrued warranty and related costs	$	135	$	—	$	—	$	—	$	135		$	135	$	135		$	—
Charged to cost of revenue	—		—		135		—		(53		)	—		(53		)	135
Actual warranty expenditures	—		—		—		—		—			—		—			—
Ending accrued warranty and related costs	$	135	$	—	$	135	$	—	$	82		$	135	$	82		$	135

Sales Returns

In ~~April~~March 2004, ~~the Company determined~~we increased our reserve for repair and replacement costs by $745,000, after determining that ~~it ha~~dwe had not followed certain requirements for testing of products and provision of testing data and information relating to customer requirements for certain shipments made over the past several years. Since April 2004, the Company has continued to notify the affected customers concerning its findings. The Company has established a reserve based on its best estimate of future returns related to this matter. Although actual returns may differ, the Company does not believe future claims in the aggregate will be material. One of the customers has cancelled outstanding orders for scheduled future deliveries totaling approximately $352,000. This customer represented approximately 2.8% of the Company’s total consolidated revenue for the three month period ended June 30, 2004 and 3.7% of the Company’s total consolidated revenue for the six month period ended June 30, 2004. The Company has recorded a reserve for sale returns of $745,000 and believes this is adequate to cover any product returns related to this matter, however, the Company is unable to assess the impact that this matter might have, if any, on our future revenues or gross margins. Approximately ~~$125,000~~$487,000 of the $745,000 sales returns reserve has been utilized ~~in July 2004. Refer~~as of June 30, 2005. We will continue to ~~“Item 4 Controls and Procedures”~~monitor the returns for ~~further information.~~this specific reserve.

Note ~~13.~~12. Foreign Exchange Contracts and Transaction Gains/Losses

~~The Company uses~~We use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. ~~The Company has~~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 June 30, ~~2004, the Company~~2005, we had no outstanding commitments with respect to foreign exchange contracts.

~~The Company~~We incurred a foreign currency transaction exchange ~~losses~~loss of ~~$(75,000) and $(11,000)~~$29,000 for the three ~~and six~~ month ~~periods~~period ended June 30, ~~2004, respectively,~~2005, and a foreign currency exchange loss of $75,000 for the three month period ended June 30, 2004. We incurred a foreign currency transaction exchange ~~gains~~loss of $1~~3,000 and $65,000~~$49,000 for the ~~three and~~ six month ~~periods~~period ended June 30, ~~2003, respectively.~~2005, and a foreign currency exchange loss of $11,000 for the six month period ended June 30, 2004.

Note ~~14.~~13. Recent Accounting Pronouncements

In ~~January 2003,~~December 2004, the Financial Accounting Standards Board ~~(FASB)~~ issued ~~Interpretation~~Statement of Financial Accounting Standards No. ~~46 (FIN 46)~~123 (revised 2004) (“SFAS 123R”), ~~Consolidation of Variable Interest Entities~~“Share-Based Payment,”, which ~~addresses consolidation by business enterprises of variable interest entities, or VIEs, either that do not have sufficient equity investment~~requires companies to measure and recognize compensation expense for all stock-based payments at risk to permit the entity to finance its activities without additional subordinated financial support, or 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 03-06fair value. SFAS 123R was originally effective for ~~fiscal~~all interim periods beginning after ~~March 31, 2004. The~~June 15, 2005. Early adoption is encouraged and retroactive application of ~~EITF 03-06 did not have a material effect on~~ the ~~Company’s results~~provisions of ~~operations or financial position.~~SFAS 123R to

the beginning of the fiscal year that includes the effective date is permitted, but not required.

In March 2005, the U.S. Securities and Exchange Commission, (“ SEC”), released Staff Accounting Bulletin 107 (“SAB107”), “Share-Based Payments” . The interpretations in SAB 107 express views of the SEC staff, regarding the interaction between SFAS 123R and certain SEC rules and regulations, and provide the staff’s views regarding the valuation of share-based payment arrangements for public companies. In particular, SAB 107 provides guidance related to share-based payment transactions with nonemployees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of SFAS 123R in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS 123R, the modification of employee share options prior to adoption of SFAS 123R and disclosures in Management’s Discussion and Analysis subsequent to adoption of SFAS 123R.

In April 2005, the SEC approved a new rule that delays the effective date of SFAS 123R to the first annual or interim reporting period for fiscal years beginning on or after June 15, 2005. SFAS123R will be effective for us beginning with the first quarter of fiscal 2006. We are currently evaluating the impact of SFAS 123R on our financial position and results of operations. See Note 3. Accounting for Stock-Based Compensation for information related to the pro forma effects on our reported net loss and net loss per share when applying the fair value recognition provisions of the previous SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “…under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges....” This Statement requires that those items be recognized as current period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of this Statement is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based upon management’s current views with respect to future events and financial performance, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. Such risks and uncertainties include those set forth under “Risks Related to our Business” below. Forward-looking statements may be identified by the use of terms such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” and similar expressions. Statements concerning our future or expected financial ~~position,~~results and condition, business strategy and plans or objectives for future operations are forward-looking statements.

These forward-looking statements are not guarantees of future performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in ~~the Company’s~~our Annual Report on Form 10-K for the year ended December 31, ~~2003~~2004 and the condensed consolidated financial statements included elsewhere in this report.

Overview

We were founded in 1986 to commercialize and enhance our proprietary vertical gradient freeze (VGF) technique for producing high-performance compound semiconductor substrates. As a result of the discontinuance of our opto-electronics division, and the sale of substantially all of the assets of this business in 2003, we now have one operating segment: our substrate division. We made our first substrate sales in 1990 and our substrate division currently sells gallium arsenide (GaAs) and indium phosphide (InP) substrates to manufacturers of semiconductor devices for use in applications such as fiber optic and wireless telecommunications, light emitting diodes (LEDs) and lasers. We also sell raw materials including gallium and germanium through our participation in majority- and minority-owned joint ventures. We have the capability to manufacture germanium substrates for use in satellite solar cells but withdrew from this business during 2000 so that we could more profitably use our then constrained capacity. We are now trying to ~~requalify~~re-qualify our germanium substrates with the few existing satellite solar cell system manufacturers.

~~Our total revenue from continuing operations was $9.5 million for the second quarter of 2004, $8.5 million for the second quarter of 2003 and $9.8 million for the first quarter of 2004.~~ Discontinued Opto-Electronics Business

In the second quarter of 2004 we incurred a loss from continuing operations of $4.1 million compared with a loss of $3.9 million for the second quarter of 2003 and a loss of $2.6 million for the first quarter of 2004.

On June ~~24,~~ 2003, we announced the discontinuation of our opto-electronics division, which we had established as part of our acquisition of Lyte Optronics, Inc. in May 1999. The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs) for the illumination markets, and also manufactured vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in our condensed consolidated statements of operations for all periods ~~presented (see~~presented. See Note ~~3 of the notes~~2 to our condensed consolidated financial statements for details regarding the accounting for discontinued operations). The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs) for the illumination markets, including full-color displays, wireless handset backlighting and traffic signals, and also manufactured vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks.operations.

OnIn September ~~27,~~ 2003, we completed athe sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group, Co., Ltd. for the ~~China~~Chinese Renminbi (RMB) equivalent of $9.6 million. ~~During~~A portion of the ~~first quarter of 2004, $7.8~~purchase price equal to $1.0 million was ~~converted~~held in escrow to ~~US dollars. The remaining funds were converted to US dollars in early April 2004. $1.0 million~~satisfy any claims that the purchaser might make for breaches of representations or warranties by us. Of this total escrow $750,000 could be released after the one year anniversary of the ~~sales proceeds is maintained in an escrow account for up to one year~~sale of the opto-electronics business and the remainder could be released after the second anniversary of the sale. Given the difficult negotiations we encountered with the acquiring company when negotiating the sale ~~date~~of the opto-electronics business, as well as the historical operating problems of the business, we determined there was significant uncertainty regarding the recoverability of the escrowed amounts. Accordingly, we did not recognize the cash held in escrow in recording the sale of the opto-electronics division, and ~~will not be~~have only recorded ~~until~~amounts as and when they are received. As of June 30, 2005, we have resolved all claims made against the ~~escrow, if any, are settled. We expect this escrow to be released, if no claims are made against it, on or about September 28, 2004. Of this $1.0 million escrow, up to $250,000 will be~~first $750,000 held in escrow ~~for a second year~~by the acquiring company, and have received all but $31,000 of the first $750,000 held in escrow. As of June 30, 2005, we have $250,000 in escrow which will not be ~~recorded~~eligible for release until ~~all claims made against~~September 2005.

In June 2005, we completed the ~~escrow, if any, are settled. We retain~~sale of a building located in Monterey Park, ~~CA, that we~~ ~~intend to sell in 2004.~~California. This asset ishad been classified as “assets held for ~~sale~~sale” in the amount of $1.25 million on ~~our~~the condensed consolidated balance sheets as of December 31, ~~2003~~2004. We received net proceeds on the sale of the property of approximately $1.3 million and accordingly recorded a gain on sale of $53,000 in the quarter ended June 30, ~~2004.~~2005.

1516

Our continuing business, primarily sales of our substrate products, is dependant on the semiconductor industry, which is highly cyclical and has historically experienced downturns both as a result of economic changes and of overcapacity. We experienced a growth period that lasted from our initiation of sales in 1990 through the first half of 2001. In the second half of 2001, we experienced a $44.9 million, or 58.5% decrease in revenue compared with the first half as a result of the rapid decline in the mobile and fiber optic telecommunications markets. Together with other industry participants, we experienced lower revenues, slower bookings, push outs and cancellation of orders. As such, we recorded losses in the third and fourth quarters of 2001.Restructuring Charges

During the first half of 2002 our revenues grew due to improvements in the wireless market. In the second half of 2002 our revenue fell, however, because the substrate industry was still facing excess capacity that caused prices to decline, and because we experienced a loss of market share after two competitors developed technologies similar to ours. In addition, certain customers selected competitors’ products in order to diversify their supply sources and due to the belief that the competitors’ substrates offered better surface qualities. Full year 2002 revenue declined $63.9 million, or 58.8% compared with 2001. We recorded losses in each quarter of 2002 and incurred impairment charges against fixed assets and inventory due to the decline in demand and prices. In reaction to the economic downturn, we initiated an aggressive effort to reduce substrate manufacturing costs. This included moving much of our substrate manufacturing operations to China, reducing capacity in our Fremont, CA facility and developing and investing in key low-cost raw material sources.

In 2003, we believe that the wireless communications and HBLED markets grew, but our revenue did not increase until the fourth quarter of 2003 due to continued reductions in prices and the time required to improve our substrate surface quality and regain some lost customers. Revenue for 2003 fell by $10.2 million, or 22.6% compared with 2002. We recorded net losses in each quarter of 2003. During 2003 we continued to shift more of our manufacturing operations to China and reduced our costs incurred in the United States.

During the first half of 2004, our revenue increased compared with the fourth quarter of 2003, primarily as a result of increased demand for HBLEDs. We recorded net losses in the first two quarters of 2004. During the second quarter of 2004, we announced plans to cease all production activities in the United States and to manufacture our products only in China.

We cannot predict the level of future industry demand or of our ability to regain lost market share, but they have impacted our ability to sell our products and operate profitably. If demand for our products remains depressed for an extended period, our business will be harmed as a result. Our business performance will be most influenced by market demand for compound semi-conductor substrates, our ability to offer products that equal or exceed the quality provided by competitors, product pricing, our ability to shift more of our manufacturing production to China, and our ability to create and defend our intellectual property while not infringing on the intellectual property of others.

~~In April 2004, we determined that we ha~~d not followed requirements for testing of products and provision of testing data and information relating to customer requirements for certain shipments made over the past several years. We have notified the affected customers concerning our findings. We have established a reserve based on our best estimate of future returns related to this matter. Although actual returns may differ, we do not believe future claims in the aggregate will be material. One of our customers has cancelled outstanding orders for scheduled future deliveries totaling approximately $352,000. This customer represented approximately 2.8% of our total consolidated revenue for the three month period ended June 30, 2004 and 3.7% of our total consolidated revenue for the six month period ended June 30, 2004. We have recorded a reserve for sales returns of $745,000 and believe this is adequate to cover any product returns related to this matter, however, we are unable to assess the impact that this matter might have, if any, on our future revenues or gross margins. Approximately $125,000 of the $745,000 sales returns reserve has been utilized in July 2004. See “Item 4. Controls and Procedures” for further information.

In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down ~~the~~our remaining manufacturing facilities in the ~~US. This charge is~~United States. In the third and fourth quarter of 2004, we incurred additional restructuring charges of $231,000 for a total of $1.3 million in 2004. These charges comprised of costs related to the reduction in work force effected in June 2004, and lease costs associated with the facilities located in California that are no longer required to support production. ~~See Note 8~~In aggregate, we eliminated 50 positions, 47 of which were production workers. On an annual basis, we anticipate payroll and related expense savings of $1.5 million. On March 14, 2005, we announced a reduction of our workforce at our Beijing, China manufacturing facility of approximately 100 positions or approximately 15%. This measure was taken as part of our ongoing effort to reduce our cost structure and bring capacity in line with current market demand. We recorded a restructuring charge of $56,000 in the ~~notes~~ six month period ended June 30, 2005 relating to ~~our~~the reduction in force, which we completed in March 2005. On an annual basis, we anticipate payroll and related expense savings of approximately $0.3 million relating to this reduction in force.

For the three and six month periods ended June 30, 2005, we recorded restructuring charges of $169,000 and $208,000, respectively, related to lease costs associated with facilities located in California that are no longer required to support production. The remaining restructuring accrual for future lease payments related to abandoned U.S. facilities of $487,000, is expected to be paid out through 2006, and is included on the accompanying condensed consolidated ~~financial statements~~balance sheet as accrued restructuring.

In April, 2005, we closed our Japan office as part of our ongoing effort to reduce our cost structure. In the three month period ended June, 2005 we recorded a restructuring charge of $98,000 relating to the closure of our Japan office of which $17,000 is in the restructuring accrual balance at June 30, 2005. On an annual basis, we anticipate payroll and related expense savings of approximately $0.3 million relating to the closure of our Japan office. The remaining restructuring accrual for ~~further details.~~our Japan office closure of $17,000 is expected to be paid out through 2005 and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.

For the ~~second quarter~~remainder of ~~2004,~~2005, we will continue to reduce costs by qualifying new lower cost suppliers, moving more of our ~~revenue from continuing operations increased~~administrative functions to ~~$9.5 million from $8.5 million~~China where our costs are lower, and streamlining our organization structure and costs in the ~~second quarter of 2003, primarily due~~United States and China to ~~greater sales of GaAs substrates, which benefited from increasing demand from~~bring them in line with our key end-use markets, red and amber HBLEDs and wireless handsets. Our gross margin also increased from the second quarter of 2003 to 8.7 percent due to higher yields and a greater share of our production being completed in China.current business.

Critical Accounting Policies and Estimates

We have prepared our condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. As such, we have had to make estimates, assumptions and judgments that affect the amounts reported on our financial statements. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that are believed to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. The discussion and analysis of our results of operations and financial condition are based upon these condensed consolidated financial statements. We have identified the policies below as critical to our business operations and understanding of our financial condition and results of operations. A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations. They may require us to make assumptions about matters that are highly uncertain at the time of the estimate, and different estimates that we could have used, or changes in the estimate that are reasonably likely to occur, may have a material impact on our financial condition or results of operations.

We believe that the following are our critical accounting policies:

Revenue Recognition

We manufacture and sell high-performance compound semiconductor substrates and sell certain raw materials including gallium, germanium dioxide, and pBN crucibles. After we ship our products, there are no remaining obligations or customer acceptance requirements that would preclude recognition of the revenue earned on the sale. Our products are typically sold pursuant to a purchase order placed by our customers, and our terms and conditions of sale do not require customer acceptance. We recognize revenue upon shipment and transfer of title of products to our customers, which is either upon

shipment from our dock, receipt at the customer’s dock, or removal from consignment inventory at the customer’s location, provided that we have received a signed purchase order, the price is fixed or determinable, title ~~has~~and risk of ownership have transferred, collection of resulting receivables is probable, and product returns are reasonably ~~estimable, there~~estimable. We do not provide training, installation or commissioning services. Additionally, we do not provide discounts or other incentives to customers except for one customer with whom we agreed in the fourth quarter of 2004 to provide a certain amount of cumulative discounts on future product purchases from us. We will recognize these discounts in future periods as a reduction in revenue as products are no customer acceptance requirements and there are no remaining obligations. We establish a reserve when there is uncertainty regarding customer acceptance. We assess the probability of collection based on a number of factors including past history with the customer and credit worthiness. sold to this customer.

We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized. ~~During~~In the first quarter of 2004, we ~~increased our~~recorded a reserve for sales returns byof $745,000 related to our failure to follow certain testing requirements and provision of testing data and information to certain customers. This reserve was based on discussions with some of the affected customers and review of specific ~~shipments made during~~shipments. Approximately $487,000 of the ~~quarter. Except~~$745,000 sales returns reserve had been utilized as of June 30, 2005. We will continue to monitor the returns for ~~sales in Japan and some sales in Taiwan, which in both cases are denominated in Japanese yen, we denominate and collect our international sales in U.S. dollars.~~this specific reserve.

Allowance for Doubtful Accounts

We periodically review the likelihood of ~~collecting~~collection on our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We provide a 100% allowance for U.S. receivables in excess of 90 days and for foreign receivables in excess of 120 days. We assess the probability of collection based on a number of factors, including the length of time a receivable balance has been outstanding, our past history with the customer and their credit worthiness.

As of June 30, 2005 and December 31, 2004, our accounts receivable balance was ~~$4.4~~$5.0 million and $4.0 million, respectively, which iswas net of an allowance for doubtful accounts of ~~$4.9 million.~~$0.5 million and $1.1 million, respectively. If actual uncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could have a material impact on our financial results for the period.

Warranty Reserve

We maintain a warranty reserve based upon our claims experience during the prior twelve months. ~~Such~~Warranty costs are accrued at the time revenue is recognized. As of June 30, ~~2004,~~2005, accrued product warranties totaled ~~$135,000.~~$82,000. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financial condition and results of operations.

Inventory Valuation

Inventories are stated at the lower of cost or market. Cost is determined using the ~~standard~~weighted average cost method. ~~Finished~~Our inventory consists of raw materials as well as finished goods and work-in-process ~~inventories~~that include material, labor and manufacturing overhead costs. Given the nature of our substrate products, and the materials used in the manufacturing process, the wafers and ingots comprising work-in-process may be held in inventory for up to two years and three years, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory and we provide a valuation allowance for certain inventories based upon the age and quality of the ~~product. Competitive delivery times~~product and the projections for sale of the completed products. As of June 30, 2005, we had an inventory reserve of $17.5 million for excess and obsolete inventory. The majority of this inventory has not been scrapped. If actual demand for our products were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results of operations.

Impairment of Investments

We classify our investments in debt and equity securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” All available-for-sale securities with a quoted market value below cost (or adjusted cost) are ~~frequently~~reviewed in order to determine whether the decline is other-than-temporary. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value.

We invest in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee’s management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time ~~required~~sufficient to allow for ~~us to manufacture a product, requiring us to build some work-in-process inventories~~any anticipated recovery in ~~anticipation of orders. If orders are not obtained for the products built, the products will ultimately be deemed obsolete and we will establish a reserve for their~~our carrying value. We also review our inventory to ensure costs can be realized upon ultimate sale to our customers. If we determine that the value of any items in ending inventory exceeds the sales value less any related selling costs, a reserve is established for the difference.

Impairment of Long-Lived Assets

We evaluate the recoverability of property, equipment, and intangible assets in accordance with ~~Statement of Financial Accounting Standards No. 144, or~~ SFAS No. 144, ~~“Accounting~~“Accounting for the Impairment or Disposal of Long-Lived Assets.” When events and circumstances indicate that long-lived assets may be impaired, we compare the carrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to such ~~assets and in~~assets. In the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the asset’s fair value.

~~Investments~~Employee Stock Options

We ~~determine~~grant options to substantially all management employees and believe that this broad-based program helps us to attract, motivate, and retain high quality employees, to the ~~appropriate classification~~ultimate benefit of ~~investments at~~our stockholders. We currently account for share-based payments to employees using the ~~time~~intrinsic value method under APB Opinion No. 25 and, as such, generally recognize no compensation cost for employee stock options. Statement of ~~purchase. Available-for-sale investments are carried at their fair value~~Financial Accounting Standards No. 123 (revised), “Share-Based Payment” (SFAS 123R) will be effective for us beginning with the first quarter of fiscal 2006. The adoption of SFAS No. 123R is expected to result in a material increase in expense during fiscal 2006 based on ~~quoted market prices~~unvested options outstanding as of June 30, 2005 and current compensation plans. While the ~~balance sheet date. The amortized cost~~effect of securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in “other (income) and expense, net.” Realized gains or losses are determinedadoption depends on the specific identification method and are reflected in “other (income) and expense, net.” Net unrealized gains or losses are recorded directly in stockholders’ equity. Those unrealized losses that are deemed to be other than temporary are reflected in “interest and other income, net.” We also maintain minority investments in private companies which are accounted for under the cost basis. 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 changeslevel of share-based payments granted in the future and unvested grants on the date we adopt SFAS 123(R), the effect of this accounting standard on our prior operating ~~performance~~results would approximate the effect of SFAS 123 as described in the disclosure of pro forma net loss and ~~changes in market conditions.~~net loss per share. See Note 3 to our condensed consolidated financial statements.

Income Taxes

We account for ~~deferred~~ income taxes in accordance with SFAS No. 109 (SFAS 109), “Accounting for Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the ~~liability method, under which the expected future tax consequences~~effect of ~~timing~~temporary differences between the book and tax ~~basis~~bases of recorded assets and ~~liabilities are recognized as~~liabilities. SFAS 109 also requires that deferred tax assets ~~and liabilities. Valuation allowances are established when necessary to reduce net deferred tax assets when management estimates, based on available objective evidence, that~~be reduced by a valuation allowance if it is more likely than not that a portion of the ~~future income tax benefit represented by the net~~ deferred tax asset will not be realized.

We provide for income taxes based upon the geographic composition of worldwide earnings and tax regulations governing each region, particularly China. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws, particularly in foreign countries such as China.

Results of Operations

~~The following table sets forth certain information relating to the operations of the Company expressed as a percentage of total revenues for the periods indicated:~~

Three Months Ended
June 30,

Six Months Ended
June 30,

2004

2003

2004

2003

Revenues

100.0
%
100.0
%
100.0
%
100.0
%
Cost of revenues

91.3

92.1

92.9

94.4

Gross profit

8.7
%
7.9
%
7.1
%
5.6
%
Operating expenses:

Selling, general and administrative

33.6

33.1

30.9

31.2

Research and development

3.7

4.3

3.6

4.4

Restructuring charge

11.3

—

5.6

—

Total operating expenses

48.6

37.4

40.1

35.6

Loss from operations

(39.9
)
(29.5
)
(33.0
)
(30.0
)
Interest expense

(0.6
)
1.3

(0.9
)
1.3

Other (expense) income, net

(1.2
)
14.9

0.3

6.1

Loss before provision for income taxes

(41.7
)
(45.7
)
(33.6
)
(37.4
)
Provision for incomes taxes

(1.0
)
—

(0 .7
)
—

Loss from continuing operations

(42.7
)
(45.7
)
(34.3
)
(37.4
)
Discontinued operations:

Gain (loss) from discontinued operations, net of tax

2.3

(162.5
)
1.1

(91.9
)
Gain (loss) from disposal

—

—

—

—

Net loss

(40.4
)%
(208.2
)%
(33.2
)%
(129.3
)%

~~Three months ended June 30, 2004 compared with three months ended June 30,~~~~2003~~Revenue

	Three Months Ended June 30,				Increase
	2005		2004		(Decrease)			% Change
	($ in thousands)
GaAs	$	4,487	$	7,498	$	(3,011	)	(40.2	)%
InP	280		533		(253		)	(47.5	)
Raw Materials	1,256		1,473		(217		)	(14.7	)
Other	9		20		(11		)	(55.0	)
Total revenue	$	6,032	$	9,524	$	(3,492	)	(36.7	)%

~~Revenue from continuing operations.~~

Revenue from continuing operations ~~increased $1.0~~decreased $3.5 million, or ~~11.8%~~36.7%, to $6.0 million for the three month period ended June 30, 2005 compared with $9.5 million for the three ~~months~~month period ended June 30, ~~2004 compared with $8.5~~2004.

Total GaAs substrate revenue decreased $3.0 million, or 40.2%, to $4.5 million for the three ~~months~~month period ended June 30, ~~2003.~~

~~Total GaAs substrate revenue increased $0.5 million, or 6.5%, to~~2005 compared with $7.5 million for the three ~~months~~month period ended June 30, ~~2004 compared with $7.0~~2004. Sales of 2 inch and 3 inch diameter GaAs substrates were $2.5 million for the three ~~months~~month period ended June 30, ~~2003.~~2005 compared with $4.3 million for the three month period ended June 30, 2004. The decrease in GaAs substrate revenue is due to existing quality issues, the continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers and a decline in orders from customers who are qualifying our China-grown products. InP substrate revenue decreased $253,000, or 47.5%, to $280,000 for the three month period ended June 30, 2005 compared with $533,000 for the three month period ended June 30, 2004. The decrease in InP substrate revenue was due to a decline in orders from customers who are qualifying our China-grown products.

	Six Months Ended June 30,				Increase
	2005		2004		(Decrease)			% Change
	($ in thousands)
GaAs	$	9,680	$	15,536	$	(5,856	)	(37.7	)%
InP	417		1,049		(632		)	(60.2	)
Raw Materials	2,552		2,675		(123		)	(4.6	)
Other	17		40		(23		)	(57.5	)
Total revenue	$	12,666	$	19,300	$	(6,634	)	(34.4	)%

Revenue from continuing operations decreased $6.6 million, or 34.4%, to $12.7 million for the six month period ended June 30, 2005 compared with $19.3 million for the six month period ended June 30, 2004.

Total GaAs substrate revenue decreased $5.9 million, or 37.7%, to $9.7 million for the six month period ended June 30, 2005 compared with $15.5 million for the six month period ended June 30, 2004. Sales of 5”2 inch and 6”3 inch diameter GaAs substrates were ~~$1.3~~$6.3 million for the ~~three months~~six month period ended June 30, ~~2004~~2005 compared with ~~$0.8~~$9.3 million for the ~~three months~~six month period ended June 30, ~~2003. InP substrate revenue increased $30,000, or 6.0%, to $533,000 for the three months ended June 30, 2004 compared with $503,000 for the three months ended June 30, 2003.~~2004. The ~~increase~~decrease in GaAs substrate revenue ~~during the past year~~ is due to ~~market growth~~existing quality issues, the continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers and a decline in orders from customers who are qualifying our China-grown products. InP substrate revenue decreased $632,000, or 60.2%, to $417,000 for the ~~HBLED and wireless handset markets and~~six month period ended June 30, 2005 compared with $1.0 million for the six month period ended June 30, 2004. The decrease in InP substrate revenue was due to a decline in orders from customers who are qualifying our ~~ability to gain share among some Asian customers.~~China-grown products.

~~International~~Revenue by Geographic Region

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
North America *	$	1,310		$	2,180		$	(870	)	(39.9	)%
% of total revenue	22		%	23		%
Europe	1,802			2,287			(485		)	(21.2	)
% of total revenue	30		%	24		%
Japan	559			1,023			(464		)	(45.4	)
% of total revenue	9		%	11		%
Taiwan	402			2,539			(2,137		)	(84.2	)
% of total revenue	7		%	27		%
Asia Pacific (excluding Japan and Taiwan)	1,959			1,495			464			31.0
% of total revenue	32		%	16		%
Total revenue	$	6,032		$	9,524		$	(3,492	)	(36.7	)%

*Primarily the United States

Asia Pacific revenue increased to ~~77.1%~~32% of total revenue from continuing operations for the three ~~months~~month period ended June 30, ~~2004~~2005 compared with ~~76.4%~~16% of total revenue from continuing operations for the three ~~months~~month period ended June 30, ~~2003.~~2004. The increase was primarily due to ~~a greater share~~increased sales of GaAs substrates to customers in China and Singapore which are being

used in opto-electronics applications. The overall decrease in other geographic areas for our GaAs substrates is due to existing quality issues, continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers, and delays in orders from customers who are qualifying our China-grown products.

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
North America *	$	2,282		$	4,288		$	(2,006	)	(46.8	)%
% of total revenue	18		%	22		%
Europe	3,584			3,702			(118		)	(3.2	)
% of total revenue	28		%	19		%
Japan	799			2,259			(1,460		)	(64.6	)
% of total revenue	7		%	12		%
Taiwan	2,058			5,683			(3,625		)	(63.8	)
% of total revenue	16		%	30		%
Asia Pacific (excluding Japan and Taiwan)	3,943			3,368			575			17.1
% of total revenue	31		%	17		%
Total revenue	$	12,666		$	19,300		$	(6,634	)	(34.4	)%

*Primarily the United States

International revenue increased to 82% of total revenue from continuing operations for the six month period ended June 30, 2005 compared with 78% of total revenue from continuing operations for the six month period ended June 30, 2004. Asia Pacific revenue increased to 31% of total revenue from continuing operations for the six month period ended June 30, 2005 compared with 17% of total revenue from continuing operations for the six month period ended June 30, 2004. The increase was primarily due to increased sales of GaAs substrates to customers in China and Singapore which are being used in opto-electronics ~~applications~~applications. The overall decrease in other geographic areas for our GaAs substrates is due to existing quality issues, continuing pricing pressures causing prices to decline, overall lower demand from our wireless application customers, and ~~the majority of~~delays in orders from customers who are qualifying our ~~customers for these applications being in Asia.~~China-grown products.

Gross Margin

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
Gross profit	$	127		$	829		$	(702	)	(84.7	)%
Gross Margin %	2.1		%	8.7		%

Gross margin. Gross margin ~~increased~~decreased to 2.1% of total revenue for the three month period ended June 30, 2005 compared with 8.7% of total revenue for the three ~~months~~month period ended June 30, ~~2004 compared with 7.9%~~2004. Gross margin in the three month period ended June 30, 2005 was negatively impacted by a $765,000 charge to cost of revenues as a result of an inventory valuation adjustment. There was no such adjustment in the three month period ended June 30, 2004. The impact of the charge in the three month period ended June 30, 2005 was to reduce gross margin from 14.8% to 2.1%. Our average selling prices have dropped, our revenue is down, and given our current excess capacity, our gross margins are not expected to improve significantly for the remainder of 2005.

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
Gross profit	$	406		$	1,362		$	(956	)	(70.2	)%
Gross Margin %	3.2		%	7.1		%

Gross margin. Gross margin decreased to 3.2% of total revenue for the ~~three months~~six month period ended June 30, ~~2003. The increase~~2005 compared with 7.1% of total revenue for the six month period ended June 30, 2004. Gross margin for the six month period ended June 30, 2005 was ~~primarily due~~negatively impacted by a $765,000 charge to ~~a larger sales volume that enabled us to cover more fixed costs as well as reduced costs that we incurred~~cost of revenues as a result of ~~moving most~~an inventory valuation adjustment. There was no such adjustment for the six month period ended June 30, 2004. The impact of the charge in the six month period ended June 30, 2005 was to reduce gross margin from 9.2% to 3.2%. Our average selling prices have dropped, our ~~production~~revenue is down, and given our current excess capacity, our gross margins are not expected to ~~China, where we incur lower production costs than in our California operations.~~improve significantlyfor the remainder of 2005.

Selling, ~~general~~General and ~~administrative expenses.~~ Administrative Expenses

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
Selling, general and administrative expenses	$	2,716		$	3,203		$	(487	)	(15.2	)%
% of total revenue	45.0		%	33.6		%

Selling, general and administrative expenses ~~increased~~decreased $487,000 to $2.7 million for the three month period ended June 30, 2005 compared with $3.2 million for the three ~~months~~month period ended June 30, 2004. The reasons for this decrease was that the three month period ended June 30, 2004 ~~compared with $2.8 million for the three months ended June 30, 2003. The increase is due to an additional accrual~~included $350,000 of ~~$350,000 for~~ legal fees related to anthe investigation by our Audit Committee into product testing and compliance practices and $300,000 of audit and Sarbanes-Oxley related expenses. For the three month period ended June 30, 2005 we had $548,000 of expenses relating to the decommissioning of our Fremont, California facilities, which was partially offset by a reduction in ~~second quarter~~the allowance for doubtful accounts of ~~2004. As a percentage of revenue, selling,~~$270,000.

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)		% Change
	($ in thousands)
Selling, general and administrative expenses	$	6,968		$	5,973		$	995	16.7	%
% of total revenue	55.0		%	30.9		%

Selling, general and administrative expenses ~~were 33.6%~~increased $995,000 to $7.0 million for the ~~three months~~six month period ended June 30, ~~2004~~2005 compared with ~~33.1%~~$6.0 million for the ~~three months~~six month period ended June 30, ~~2003.~~2004. The increase was primarily due to $1.8 million of expenses for the six month period ended June 30, 2005 relating to the decommissioning of our Fremont, California facilities, offset by $350,000 of legal fees related to the investigation by our Audit Committee into product testing and compliance practices and $300,000 of audit and Sarbanes-Oxley related expenses for the six month period ended June 30, 2004.

Research and ~~development expenses.~~ Development

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)		% Change
	($ in thousands)
Research and development	$	423		$	350		$	73	20.9	%
% of total revenue	7.0		%	3.7		%

Research and development expenses ~~decreased $18,000,~~increased $73,000, or ~~4.9%~~20.9%, to $423,000 for the three month period ended June 30, 2005 compared with $350,000 for the three ~~months~~month period ended June 30, ~~2004 compared with $368,000 for~~2004. During the three ~~months~~month period ended June 30, ~~2003. As a percentage of total revenue,~~2005 we incurred $64,000 in severance pay to employees that had been performing research and development activities.

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)		% Change
	($ in thousands)
Research and development	$	785		$	691		$	94	13.6	%
% of total revenue	6.2		%	3.6		%

Research and development expenses ~~were 3.7%~~increased $94,000, or 13.6%, to $785,000 for the ~~three months~~six month period ended June 30, ~~2004~~2005, compared with ~~4.3%~~$691,000 for the ~~three months~~six month period ended June 30, ~~2003. Although~~2004. During the six month period ended June 30, 2005, we ~~reduced~~incurred $64,000 in severance pay to employees that had been performing research and development ~~expenses as part of our effort to adjust costs in line with our current business, we~~activities. We believe that continued investment in product development is critical to attaining our strategic objectives of maintaining and increasing our technology leadership, and have appointed Dr. Morris Young as our Chief Technology Officer. As a result, we expect research and development expenses to remain at ~~current~~the levels of recent quarters or to increase in future periods. Research and development efforts during the first ~~quarter~~six months of ~~2004~~2005 were focused primarily on improving the yield and surface quality of our GaAs ~~substrates.~~substrates, and we expect these activities to continue.

Restructuring Charges

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
Restructuring charges	$	237		$	1,077		$	(840	)	78.0	%
% of total revenue	3.9		%	11.3		%

During the three month period ended June 30, 2005, we recorded restructuring charges of $237,000 of which $169,000 related to lease costs associated with facilities located in California that are no longer required to support production, and $98,000 related to the closure of our Japan office. Offsetting these charges, we had a credit adjustment of $30,000 related to the reduction in our China work force effected in March 2005.

In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down our remaining manufacturing facilities in the United States.

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
Restructuring charges	$	362		$	1,077		$	(715	)	66.4	%
% of total revenue	2.9		%	5.6		%

During the six month period ended June 30, 2005, we recorded restructuring charges of $362,000, of which $208,000 related to lease costs associated with facilities located in California that are no longer required to support production, $98,000 related to the closure of our Japan office, and $56,000 related to the reduction in our China work force effected in March 2005.

Interest ~~expense.~~ Income, net

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)		% Change
	($ in thousands)
Interest income, net	$	131		$	54		$	77	142.6	%
% of total revenue	2.2		%	0.6		%

Interest ~~expense decreased $50,000, or 46.3%,~~income, net increased $77,000 to ~~$58,000~~$131,000 for the three ~~months~~month period ended June 30, 2005 compared with $54,000 for the three month period ended June 30, 2004 ~~compared with $108,000 for the three months ended June 30, 2003. Interest expense decreased due to~~as a result of lower debt levels as we ~~continue~~continued to pay down our ~~debt.~~debt.

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)		% Change
	($ in thousands)
Interest income, net	$	250		$	78		$	172	220.5	%
% of total revenue	2.0		%	0.4		%

Interest income, net increased $172,000 to $250,000 for the six month period ended June 30, 2005 compared with $78,000 for the six month period ended June 30, 2004 as a result of our lower debt levels as we continued to pay down our debt.

Other ~~income~~Income and ~~expense, net.~~ Expense, net

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
Other income (expense), net	$	(196	)	$	(225	)	$	(29	)	(12.9	)%
% of total revenue	(3.2		)%	(2.4		)%

Other expense ~~decreased $1.2 million to $113,000~~was $196,000 for the three ~~months~~month period ended June 30, ~~2004~~2005 compared with other expense of ~~$1.3 million~~$225,000 for the three ~~months~~month period ended June 30, ~~2003.~~2004. The decrease in other expense was mainly due to ~~an impairment charge in 2003~~foreign exchange losses related to the Japanese yen and a ~~non-consolidated subsidiary~~decrease in the minority interest’s share in our joint ventures.

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)		% Change
	($ in thousands)
Other income (expense), net	$	(301	)	$	(191	)	$	110	57.6	%
% of total revenue	(2.4		)%	(1.0		)%

Other expense was $301,000 for ~~$1.3 million.~~the six month period ended June 30, 2005 compared with other expense of $191,000 for the six month period ended June 30, 2004. The increase in other expense was mainly due to foreign exchange losses related to the Japanese yen, an increase in the minority interest’s share in our joint ventures, and a loss on disposal of equipment.

Provision for Income Taxes

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
Provision for income taxes	$	18		$	97		$	(79	)	(81.4	)%
% of total revenue	0.3		%	1.0		%

We provided for income ~~taxes.~~ ~~Due to our continuing operating losses in the United States and uncertainty regarding future profitability, we recorded a full valuation allowance for our US losses against our net deferred tax assets~~taxes of ~~$34.6 million in 2003. We incurred a tax liability of $97,000~~$18,000 for our overseas businesses for the three ~~months~~month period ended June 30, 2005 compared to $97,000 for the three month period ended June 30, 2004.

~~Six months ended June 30, 2004 compared with six months ended June 30,~~~~2003~~24

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	($ in thousands)
Provision for income taxes	$	53		$	137		$	(84	)	(61.3	)%
% of total revenue	0.4		%	0.7		%

~~Revenue from continuing operations.~~ ~~Revenue from continuing operations increased $2.2 million, or 13.2%, to $19.3 million for the six months ended June 30, 2004 compared with $17.1 million for the six months ended June 30, 2003.~~

Total GaAs substrate revenue increased $1.5 million, or 11.0%, to $15.5 million for the six months ended June 30, 2004 compared with $14.0 million for the six months ended June 30, 2003. Sales of 5” and 6” diameter GaAs substrates were $2.8 million for the six

~~months ended June 30, 2004 compared with $~~2.1 million for the six months ended June 30, 2003. InP substrate revenue decreased $18,000, or 1.7%, to $1.1 million for the six months ended June 30, 2004 compared with $1.1 million for the six months ended June 30, 2003. The increase in GaAs substrate revenue during the past year is due to market expansion in the HBLED and wireless handset markets and to our ability to gain share among Asian customers.

International revenue increased to 77.8% of total revenue from continuing operations for the six months ended June 30, 2004 compared with 64.6% of total revenue from continuing operations for the six months ended June 30, 2003. The increase was primarily due to a greater share of our GaAs substrates being used in opto-electronics applications and the majority of our customers for these applications being in Asia.

~~Gross margin.~~ Gross margin increased to 7.1% of total revenue for the six months ended June 30, 2004 compared with 5.6% of total revenue for the six months ended June 30, 2003. The increase was primarily due to a larger sales volume that enabled us to cover more fixed costs as well as reduced costs that we incurred as a result of moving most of our production to China, where we incur lower production costs than in our California operations.

~~Selling, general and administrative expenses.~~ Selling, general and administrative expenses increased to $6.0 million for the six months ended June 30, 2004 compared with $5.3 million for the six months ended June 30, 2003. The increase is due to an additional accrual of $350,000 for legal fees related to the investigation by our Audit Committee into product testing and compliance practices in second quarter of 2004, and $300,000 for auditing and Sarbanes-Oxley related expenses for 2004. As a percentage of revenue, selling, general and administrative expenses were 30.9% for the six months ended June 30, 2004 compared with 31.2% for the six months ended June 30, 2003.

~~Research and development expenses.~~ Research and development expenses decreased $56,000, or 7.5%, to $691,000 for the six months ended June 30, 2004 compared with $747,000 for the six months ended June 30, 2003. As a percentage of total revenue, research and development expenses were 3.6% for the six months ended June 30, 2004 compared with 4.4% for the six months ended June 30, 2003. Although we reduced research and development expenses as part of our effort to adjust costs in line with our current business, we believe that continued investment in product development is critical to attaining our strategic objectives of maintaining and increasing our technology leadership, and as a result, we expect research and development expenses to remain at current levels or increase in future periods. Research and development efforts during the first quarter of 2004 were focused primarily on improving the yield and surface quality of our GaAs substrates.

~~Interest expense.~~ Interest expense decreased $56,000, or 25.1%, to $167,000 for the six months ended June 30, 2004 compared with $223,000 for the six months ended June 30, 2003. Interest expense includes a prepayment penalty incurred by voluntarily repaying off a loan before it was due with an outstanding principal balance of $781,000, which we acquired in 1996. Interest expense decreased due to lower debt levels as we continue to pay down our debt.

~~Other income and expense, net.~~ Other income increased $1.1 million to $54,000 for the six months ended June 30, 2004 compared with other expense of $1.0 million for the six months ended June 30, 2003. The increase was mainly due to an impairment charge in 2003 related to a non-consolidated subsidiary for $1.3 million.

~~Provision~~We provided for income ~~taxes.~~ ~~Due to our continuing operating losses in the United States and uncertainty regarding future profitability, we recorded a full valuation allowance for our US losses against our net deferred tax assets~~taxes of ~~$34.6 million in 2003. We incurred a tax liability of $137,000~~$53,000 for our overseas businesses for the six ~~months~~month period ended June 30, 2005 compared to $137,000 for the six month period ended June 30, 2004.

Gain from Discontinued Operations

	Three Months Ended June 30,						Increase
	2005			2004			(Decrease)			% Change
	$ in thousands)
Gain from discontinued operations	$	53		$	222		$	(169	)	(76.1	)%
% of total revenue	0.9		%	2.3		%

During the three month period ended June 30, 2005, we received net proceeds of approximately $1.3 million from the sale of a building located in Monterey Park, California and recorded a gain of $53,000. For the three month period ended June 30, 2004, we recorded a gain of $222,000 as a result of our reversal of accrued liabilities of general and administrative expenses no longer required in connection with legal fees and cleanup costs.

	Six Months Ended June 30,						Increase
	2005			2004			(Decrease)		% Change
	$ in thousands)
Gain from discontinued operations	$	411		$	222		$	189	85.1	%
% of total revenue	3.2		%	1.2		%

For the six month period ended June 30, 2005, the gain from discontinued operations is made up of a gain of $300,000 which was the remaining portion of the first $750,000 held in escrow due to us from the sale of our opto-electronics business, $58,000 in property tax refunds, and a gain of $53,000 from the sale of a building located in Monterey Park, California. For the six month period ended June 30, 2004, we recorded a gain of $222,000 as a result of our reversal of accrued liabilities of general and administrative expenses no longer required in connection with legal fees and cleanup costs.

Liquidity and Capital Resources

We consider cash and cash equivalents and short-term investments as liquid and available for use. Short-term investments are comprised of government bonds and high-grade commercial debt instruments. Also included in short-term investments is our investment in common stock ~~investment in~~of Finisar Corporation. As of June 30, ~~2004,~~2005, our principal sources of liquidity were ~~$34.6~~$25.0 million in cash and cash equivalents and short-term investments, excluding restricted deposits.

Cash and cash equivalents and short-term investments ~~excluding $2.3~~decreased $7.2 million ~~and $3.7~~to $25.0 million ~~for~~as of June 30, 2005 compared with $32.2 million as of December 31, 2004. Of this decrease, $1.5 million was the decrease in our investment in Finisar common stock from $2.7 million as of ~~June 30, 2004 and~~ December 31, ~~2003, respectively, decreased $3.0 million~~2004 to ~~$32.3~~$1.2 million as of June 30, ~~2004 compared~~2005, and $1.9 million was our payment to Sumitomo Electric Industries, Ltd. consisting of $1.4 million in connection with ~~$35.3~~our settlement agreement and $0.5 million ~~as of December 31, 2003.~~

~~Cash and cash equivalents decreased $9.6 million~~relating 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.~~cross-license fee.

Net cash used by operating activities of ~~$185,000~~$5.5 million for the six month period ended June 30, ~~2004~~2005 was comprised primarily of our net loss of $7.4 million, adjusted for non-cash items ~~which netted to $2.8 million,~~ consisting primarily of depreciation of ~~$2.4~~$2.1 million, and partially offset by a ~~$2.6 million~~ net ~~change~~increase of $811,000 in assets and liabilities. The net ~~change~~increase in assets and liabilities resulted primarily from ~~a decrease~~an increase in accounts receivable, ~~and inventory~~ ~~partially offset by an increase in prepaid expenses~~net and a decrease in accrued ~~liabilities.~~liabilities partially offset by a decrease in inventory, net.

Net accounts receivable ~~decreased~~increased by ~~$1.9~~$1.0 million, or ~~30.3%~~22.8%, to ~~$4.4~~$5.0 million as of June 30, ~~2004~~2005 compared with ~~$6.3~~$4.0 million as of December 31, ~~2003.~~2004. The ~~decrease reflects better collections from customers and an additional sales returns reserve~~increase was primarily a result of ~~$745,000 recorded~~the decrease in the ~~first quarter of 2004.~~allowance for doubtful accounts as we recovered some accounts that were fully reserved and some accounts improved in aging that led to a decrease in the allowance.

Net inventories decreased ~~$2.~~3$1.2 million, or ~~9.4%~~6.8% to ~~$21.8~~$15.3 million as of June 30, ~~2004~~2005 compared with ~~$24.1~~$16.5 million as of December 31, ~~2003. The Company adopted~~2004, primarily due to a ~~strategy of using~~$765,000 inventory ~~to 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 as we experienced in first half of 2004.~~valuation adjustment.

Net cash ~~used~~provided by investing activities of ~~$6.8~~$9.1 million for the ~~quarter~~six month period ended June 30, ~~2004 includes purchases~~2005 included the sales of ~~property and equipment of $0.7 million primarily used to transfer production capacity to China for the substrate division, and purchases of high grade~~ investment securities ~~with maturities~~totaling $14.0 million, and proceeds from assets held for sale of ~~less than two years totaling $20.7~~$1.3 million partially offset by ~~sales~~purchases of ~~high grade~~ investment securities ~~totaling $10.4~~of $5.4 million and ~~a change in the investments providing our restricted cash~~purchases of ~~$4.2~~property, plant and equipment, net of $0.8 million.

We do not have any plans to initiate any major new capital spending projects through ~~2004.~~2005. We are currently completing certain projects at our China facilities and closing our remaining manufacturing facilities in Fremont, California. We expect to invest approximately ~~$2.0~~$0.4 million in capital projects ~~in 2004.~~for the remainder of 2005. We believe that our existing and planned facilities and equipment are sufficient to fulfill current and expected future orders.

Net cash used in financing activities of ~~$2.5 million~~$433,000 for the six month period ended June 30, 2005 consisted of ~~scheduled~~ payments of ~~$2.7 million~~$300,000 related to long-term borrowings and $193,000 to repurchase our common stock, partially offset by proceeds of ~~$0.2 million~~$60,000 through our employee stock ~~compensation~~purchase and stock option 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 ~~1.4%~~3.42% as of June 30, ~~2004.~~2005. 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. As of June 30, ~~2004, $8.5~~2005, $7.8 million was outstanding under these bonds.

As of June 30, ~~2004~~2005, 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~~$8.2 million. ~~The Company has~~We have pledged and placed certain investment securities with an affiliate of the bank as additional collateral for this facility. ~~We have also pledged certain investments for a credit facility for our workers compensation insurance. As a result, $8.6 million of our cash and short-term investments are restricted.~~

~~We currently hold a note payable secured by certain buildings and land in China totaling $1.5 million as of June 30, 2004. The balance on this note is due in December 2004.~~

We believe that we have adequate cash and investments to meet ~~the Company’s~~our needs over the next 12 months. If our ~~sales decrease, however, our ability~~performance fails to ~~generate cash from operations~~improve, we will ~~be adversely affected which could adversely affect our future liquidity, require us~~continue to use ~~more~~ cash and may at ~~a more rapid rate than expected, and require us~~some time be forced 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.~~us. 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~~2005 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

	Payments due by period
Contractual Obligations	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Long-term debt	$	7,750	$	450	$	1,420	$	900	$	4,980
Operating leases	6,114		1,200		2,060		1,508		1,346
Purchase obligation	1,017		1,017		—		—		—
Total	$	14,881	$	2,667	$	3,480	$	2,408	$	6,326

We lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through March 2013. Total rent ~~expense~~payments under these operating leases waswere approximately ~~$352,000~~$722,000 and $705,000 for the ~~three month and~~ six month periods ended June 30, 2005 and 2004, respectively.

Recent Accounting Pronouncements

In ~~January 2003,~~December 2004, the Financial Accounting Standards Board ~~(FASB)~~ issued ~~Interpretation~~Statement of Financial Accounting Standards No. ~~46,~~123 (revised 2004) (“SFAS 123R”), “Share-Based Payment,” which requires companies to measure and recognize compensation expense for all stock-based payments at fair value. SFAS 123R was originally effective for all interim periods beginning after June 15, 2005. Early adoption is encouraged and retroactive application of the provisions of SFAS 123R to the beginning of the fiscal year that includes the effective date is permitted, but not required.

In March 2005 the U.S. Securities and Exchange Commission, or ~~FIN 46,~~SEC, released Staff Accounting Bulletin 107, ~~Consolidation~~“Share-Based Payments,” or SAB 107. The interpretations in SAB 107 express views of ~~Variable Interest Entities~~the SEC staff, or staff, regarding the

interaction between SFAS 123R and certain SEC rules and regulations, and provide the staff’s views regarding the valuation of share-based payment arrangements for public companies. In particular, SAB 107 provides guidance related to share-based payment transactions with nonemployees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of SFAS 123R in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS 123R, the modification of employee share options prior to adoption of SFAS 123R and disclosures in Management’s Discussion and Analysis subsequent to adoption of SFAS 123R.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, ~~which addresses consolidation by business enterprises~~ an amendment of ~~variable interest entities,~~ARB No. 43, Chapter 4. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “…under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges....” This Statement requires that those items be recognized as current period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of this Statement is not expected to have a material effect on our consolidated financial position, results of operations or ~~VIEs, either: (1)~~cash flows.

In December 2004, the FASB issued SFAS No. 153 (SFAS 153), “Exchanges of Nonmonetary Assets—An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.” SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces it with an exception for exchanges that do not have ~~sufficient equity investment at risk to permit~~commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to ~~finance its activities without additional subordinated financial support, or (2) in which~~change significantly as a result of the ~~equity investors lack an essential characteristic of a controlling financial interest. In December 2003,~~exchange. SFAS 153 is effective for the ~~FASB completed deliberations of proposed modifications to FIN 46, or FIN 46(R), resulting in an effective date of no later than~~fiscal periods beginning after June 15, 2005. We do not expect the ~~first interim or annual period ending after March 15, 2004. The Company’s~~ adoption of ~~FIN 46(R) did not~~SFAS 153 to have ana material impact on our consolidated financial position, results of operations or ~~financial position.~~cash flows.

In April ~~2004,~~2005, the ~~Emerging Issues Task Force issued Statement No. 03-06, (EITF 03-06),~~SEC approved a new rule that delays the effective date of SFAS 123R to the first annual or interim reporting period for fiscal years on or after June 15, 2005. SFAS123R will be effective for us beginning with the first quarter of fiscal 2006. We are currently evaluating the impact of SFAS 123R on our financial position and results of operations. See Note 3. ~~Participating Securities~~Accounting for Stock-Based Compensation for information related to the pro forma effects on our reported net loss 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~~net loss per share ~~by companies that have issued securities other than common stock that contractually entitle~~when applying the ~~holder to participate in dividends and earnings~~fair value recognition provisions 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 howprevious SFAS No. 123, “Accounting for Stock-Based Compensation,” 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.stock-based employee compensation.

Risks Related to Our Business

We may incur claims or other liabilities or obligations related to our failureto follow requirements for testing of products and provision of testing dataand information relating to customer requirements. Additionally, customers maycancel or reduce future shipments in response to these ~~failures.~~failures, or require re-qualifications.

~~We have recently~~During the first quarter of 2004, we determined that we hadhad 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 notifyingWe notified affected customers concerning our findings, however, there can be no assurance that 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~~order from us as a result of this disclosure. We ~~have been notified of~~experienced several cancellations of future orders by customers pending further information regarding enhancements to our product testing and quality control systems. In addition, some customers are requiring additional qualification of our China operations before placing future orders with us. 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.~~conclusions, or that our customers will qualify our China operations and place future orders with us.

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.~~revenues.

The Chinese government ~~has indicated that the country faces~~faced a power crunch ~~this~~over the summer of 2004 and reported 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 and commercial consumers. As a result, the Chinese government ~~has called for~~implemented tough measures in 2004 to ease the energy shortage which is expected to last at least through 2005. Provinces ~~have~~ imposed power brownouts during 2004 to reduce electricity demand and some companies in Beijing ~~have been~~were ordered to give their employees a week off to ease the pressure on power supply. ~~It is anticipated that the~~The plants, most of which are state-owned, ~~will be~~were 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~~during 2004. As a result we closed most of our operations for a week in late July 2004 in conformance with this policy. Some shortages have already been reported in 2005 and the power shortages may be more severe than during 2004. If we are required to make additional temporary closures of our Beijing and joint venture operations during 2005, we ~~will~~may be unable to manufacture our products, and ~~will~~would then 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. We are attempting to partially mitigate the potential effects of power outages by building inventory in anticipation of power outages during the summer. This inventory build is prepared to accommodate forecast demand rather specific customer orders. If the inventory we build is not ordered by customers, we may have to scrap these products and incur a cost which will reduce our gross margins.

~~Intellectual property infringement claims may be costly to resolve and could divert management attention.~~Our operating results depend in large part on further customer acceptance of our existing substrate products manufactured in China.

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 thatAs 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 complaintnow manufacturing only in China, if the 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 cessationshift of our ~~sales of gallium arsenide substrates~~substrate manufacturing operations to China is to be successful, we will need our customers to qualify products manufactured in ~~Japan. We intend~~China. If we are unable to ~~defend ourself vigorously~~achieve qualifications for these products, our China facility will be underutilized, our investments in ~~these law suits. Both parties have completed submitting arguments and evidence in litigation in Japan~~China will not be recouped and we ~~currently retain all of~~will be unable to lower our ~~options which include appealing any court decision and launching an effort~~costs by moving to have Sumitomo’s patent invalidated in Japan. However, there can be no assurance that the court will not rule against us on the infringement claim, or that we can settle this matter on terms acceptable to us, if at all.

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 technical and management personnel, whether or not the litigation is ultimately determined in 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 selling our products.China. We may ~~not be 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 products to competitors who are not manufacturing in China, or whose operations in China have already been qualified by customers. If customers do not fully qualify our China production, we may lose additional customers and fail to achieve revenue growth.

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 compound semiconductor 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.

Defects in ~~Japan.~~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 which caused customers to return products to us, 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 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.

If 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.

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.~~locations, including laws and regulations of China. 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~~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 $200,415, and during 2004 we ~~have recently been~~were the target of press allegations and correspondence purportedly on behalf of current and/or former employees concerning our environmental compliance programs and exposure of our employees to hazardous ~~materials,~~materials. In June 2005, a complaint was

filed against us and ~~there~~a current and former officer, alleging personal injury, general negligence, intentional tort, wage loss and other damages, including punitive damages, as a result of exposure of defendants, who are former employees of AXT, including a minor child in utero, to high levels of gallium arsenide in gallium arsenide wafers, and methanol. There is a possibility that other current and/or former employees may ~~file~~bring additional 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 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 subject to lawsuits seeking damages for wrongful death or personal injuries allegedly caused by exposure to chemicals or

hazardous materials at our facilities.

Litigation is inherently uncertain and while we would expect to defend ourselves vigorously, it is possible that our business, financial condition, results of operations or cash flows could be affected in any particular period by such litigation now pending, and any additional litigation if brought against us.

Problems Incurred by Our Joint Ventures or Venture Partners Could Result in a Material Adverse Impact on Our Financial Condition or Results of Operations

We have invested in five joint venture operations in China that produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. We purchase the materials produced by these ventures for our use and sell other portions of their production to third parties. Our ownership interest in these entities ranges from 25 percent to 88 percent. We consolidate the three ventures in which we own a majority interest and employ equity accounting for the two joint ventures in which we have a 25 percent interest. Several of these ventures occupy facilities within larger facilities owned and/or operated by one of the other venture partners. Several of these venture partners are engaged in other manufacturing activities at or near the same facility. In some facilities, we share access to certain functions, including water, treatment of hazardous waste or air quality treatment. If any of our joint venture partners in any of these five ventures experience problems with their operations, disruptions of our joint venture operations could result, having a material adverse effect on the financial condition and results of operation of our joint ventures, and correspondingly on our financial condition or results of operations.

In addition, if any of our joint ventures or venture partners with whom our joint ventures share facilities are deemed to have violated applicable laws, rules or regulations governing the use, storage, discharge or disposal of hazardous chemicals during manufacturing, research and development, or sales demonstrations, the operations of our joint ventures could be adversely affected and we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our joint venture operations as a result of the actions of the joint ventures or other venture partners. Employees working at the operations of our joint ventures or the operations of any of the other venture partners could bring litigation against us as a result of actions taken at the joint venture or venture partner facilities, even though we are not directly controlling the operations, including actions for exposure to chemicals or other hazardous materials at the facilities of our joint ventures or the facilities of any venture partner that are shared by our joint ventures. If litigation is brought against us, litigation is inherently uncertain and while we would expect to defend ~~ourself~~ourselves vigorously, it is possible that our business, financial condition, results of operations or cash flows could be affected in any particular period by such litigation if brought against ~~us.~~us, particularly if, as a non-Chinese company, litigation with us is deemed advantageous. Even if we are not deemed responsible for the actions of the joint ventures or venture partners, litigation could be costly, time consuming to defend and divert management attention; in addition, pursuit of us could occur if we are deemed to be the most financially viable of the partners.

Going forward, we believe that investing in additional joint ventures will be important to remaining competitive in our marketplace and ensuring a supply of critical raw materials. However, we may not be able to identify complementary joint venture opportunities or, even once opportunities are identified, we may not be able to reach agreement on the terms of the venture with the other venture partners. Additional joint ventures could cause us to incur contingent liabilities or other expenses, any of which could adversely affect our financial condition and operating results.

Since all of our joint venture activity is expected to occur in China, these activities could subject us to a number of risks associated with conducting operations internationally, including:

•Difficulties in managing geographically disparate operations;

•Difficulties in enforcing agreements through non-U.S. legal systems;

•Unexpected changes in regulatory requirements that may limit our ability to export the venture products or sell into particular jurisdictions or impose multiple conflicting tax laws and regulations;

•Political and economic instability, civil unrest or war;

•Terrorist activities that impact international commerce;

•Difficulties in protecting our intellectual property rights, particularly in countries where the laws and practices do not protect proprietary rights to as great an extent as do the laws and practices of the United States;

•Changing laws and policies affecting economic liberalization, foreign investment, currency convertibility or exchange rates, taxation or employment; and

•Nationalization of foreign owned assets, including intellectual property.

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

On June 11, 2003, Cree, Inc. filed a complaint in the United States Court for Northern District of California against us alleging patent infringement. The complaint sought damages and injunction against infringement. On July 23, 2003, we 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 prospective business relationships. We 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 our condensed consolidated financial position or results of operations.

On October 8, 2004, we announced that we had reached a tentative settlement of the litigation in Japan and interference actions in the United States with Sumitomo Electric Industries, Ltd. (“SEI”), which includes a global intellectual property cross-licensing agreement. AXT and SEI finalized this agreement on December 2, 2004. Accordingly, we recorded a charge of approximately $1.4 million for the quarter ended September 30, 2004 in connection with this settlement, and are expected to make royalty payments on future sales of certain products. The litigation was withdrawn in January 2005 and we abandoned the interference proceeding.

The semiconductor industry is cyclical and has experienced a 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 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, the manufacturing capacity of these semiconductors and ~~capacity requirements, including capacity utilizing~~changes in the ~~latest technology.~~technology employed in the semiconductors. The rate of changes in demand, including end demand, is high, and the effect of these changes upon us 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,~~revenue, gross margin and net ~~income.~~income (loss).

The industry has ~~previously~~in the past experienced periods of oversupply that result in significantly reduced demand and prices 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 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 experienced

cancellations, price reductions, delays and push outs of orders, which have resulted in reduced revenues. If the economic downturn ~~were to continue, or occur~~occurred again, ~~in the future,~~ further order cancellations, reductions in order size or delays in orders ~~will~~could occur and would materially adversely affect our business and results of operations. Actions to reduce our costs, such as those we have recently taken, may be insufficient to align our structure with prevailing business 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.

During periods of increasing demand for semiconductor devices, we must have sufficient manufacturing capacity and inventory to meet customer demand, and must be able to attract, hire, train and retain qualified employees to 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 resources and production capacity during an industry upturn, there could be a material adverse effect on our business, financial condition and results of operations.

~~If the economy recovers and we are again in a period of high demand for our~~~~products, we may be unable to expand our manufacturing capacity quickly enough~~~~to meet increased demand, we may make decisions to expand capacity that are not~~~~profitable, and we may be unable to lower our costs or increase revenue.~~

It appears that the industry may be in an upturn, which may cause demand 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 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; 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 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 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 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

~~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, including during 2004, had to take inventory valuation and impairment charges. If we are not ~~successfully~~ able to manage successfully our inventory in the future, we may again need to write off ~~unsaleable,~~un-saleable, obsolete or excess inventory, which could adversely affect our results of operations.

During the first half of 2005, we increased work-in-process inventory in order to avoid the effects of probable power shortages in China. We prepared this inventory in accordance with our forecast of demand rather than against specific customer orders. If we did not forecast correctly, customers may not order the inventory we manufactured, and we will incur a cost with no offsetting revenue. Ultimately, we would have to incur a charge for the value of unused inventory.

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~~have experienced and expect to continue to experience 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 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 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 a~~~~different contagious disease 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 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 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 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

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, 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 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 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.

If our yields decrease, our revenue could decline if we are unable to produce needed product on time while our manufacturing costs remain fixed, or could increase. 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. We may experience similar problems in the future and we cannot predict when they may occur or their severity. In particular, many of our manufacturing processes are new and are still being refined, which can result in lower yields.

If we do not successfully develop new products to respond to rapidly changingcustomer requirements, our ability to generate ~~sales and~~revenue, obtain new customers, and retain existing customers may 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,~~two years, 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 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- and InP-based devices at competitive prices. If these substrate materials or ~~VGF derived~~VGF-derived products are 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 of~~~~our existing substrate products manufactured in China.~~

~~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~~fail to offer new products or product enhancements or fail to achieve ~~qualifications for these~~higher quality 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~~not generate sufficient revenue to offset our ~~surface quality is as good~~development costs 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 retainother expenses or meet our ~~market share, our revenue and performance will decline.~~customers’ requirements.

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 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, including:

• greater experience in the business;

• more manufacturing experience;

• ~~extensive intellectual property;~~

• ~~broader name recognition; and~~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 our products 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, require us to further reduce the prices of our products, affect our ability to recover costs or result in reduced gross margins.

~~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, 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 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.

~~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.~~

If our yields decrease, our revenue could decline because many of our manufacturing costs are fixed, or would increase. 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. We may experience similar problems in the future and we cannot predict when they may occur or their severity. In particular, many of our manufacturing processes are new and are still being refined, which can result in lower yields.

~~We derive a significant portion of our revenue from international sales, and~~~~our ability to sustain and increase our international sales involves~~~~significant risks.~~

Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 77.8% of our total revenue for the six months ended June 30, 2004 and 64.6% for the six months ended June 30, 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~~

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.~~

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.

Demand for our products may decrease if our customers experience difficultymanufacturing, 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 end user applications for which our products are used decreases, or our customers are unable to develop, market and sell their products, demand for our products will decrease.

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~~During 2004, a ~~significant amount have~~customer of one agent filed for bankruptcy ~~protection~~protection. We incurred a charge equal to the amount owed us and ~~we are unlikely to receive~~believe that there is a substantial ~~portion or~~likelihood that we will be able to recoup little, if any, of the ~~amounts owed to us as part of a bankruptcy settlement.~~this amount. 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. WeAlthough several of these raw materials are purchased from suppliers in whom we hold an ownership interest, 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 in the past experienced delays obtaining critical raw materials and spare parts, including gallium, due to shortages of these materials. WeAlthough we hope to alleviate some of these delays and shortages as a result of our interests in our joint ventures, 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.

We have made and may continue to make strategic investments in raw materials suppliers, which may not be successful and may result in the loss of all or part of our investment.

We have made investments through our five joint ventures 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. These affiliates each have a market beyond that provided by us. 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.

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~~Our top five customers ~~accounted for 35.6%~~represented 39.8% and 34.6% of ~~our total~~ revenue for the ~~three month and~~ six month periods ended June 30, 2005, and 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~~revenue 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 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 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 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

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.

For example, we have recently been involved in litigation with Sumitomo Electric Industries, Ltd. (“SEI”) in Japan as well as interference actions in the United States. We and SEI approved a settlement of this litigation during the fourth quarter of 2004 and the litigation was withdrawn and we abandoned the interference proceeding. We incurred an initial charge of approximately $1.4 million and will have to pay ongoing royalties to SEI on certain of our products.

We derive a significant portion of our revenue from international sales, and our ability to sustain and increase our international sales involves significant risks.

Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 82% and 78% of our total revenue for the six month periods ended June 30, 2005 and 2004, respectively. 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 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 we anticipate 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.

We need to continue to improve or implement our systems, procedures andcontrols and may not receive a favorable attestation ofreport on our internal controlsystems by our independent ~~auditors.~~registered public accounting firm.

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 an attestation of these systems by our independent ~~accountants.~~registered public accounting firm beginning with our fiscal year ending December 31, 2006. We are currently reviewing our internal control procedures and considering further documentation of such procedures that may be necessary. ~~Although~~We are currently evaluating the ~~guidelines for the evaluation and attestation~~extent to which any of ~~internal control systems have been finalized, the evaluation and attestation processes are new and untested. Therefore, we~~our joint ventures may also be required to comply, if at all. We can give no assurances that our systems will satisfy the new requirements of the Securities and Exchange Commission, or if required, that any of the systems of our joint ventures will meet such requirements, or that we will receive a favorable review and attestation by our independent ~~auditors.~~registered public accounting firm.

In ~~the past, periods of rapid growth and expansion has strained our management and other resources. The expansion of our manufacturing capacity and~~addition, the shift of our manufacturing operations to China has placed and ~~continue~~continues to place a significant strain on our operations and management resources. We ~~recently~~have upgraded our inventory control systems and may implement additional systems relating to consolidation of our financial results, but continue to rely on certain manual processes in our operations and in connection with 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.

Legislative actions, higher insurance costs and potential new accounting pronouncements are likely to cause our general and administrative expenses to increase and impact our future financial position and results of operations.

In order to comply with rules and regulations adopted pursuant to the Sarbanes-Oxley Act of 2002 by the SEC, as well as changes to listing standards adopted by NASDAQ, and accounting changes adopted affecting accounting for stock-based compensation we may be required to increase our internal controls, hire additional personnel and additional outside legal, accounting and advisory services, all of which will cause our general and administrative costs to increase. Insurers may increase premiums as a result of the high claims rates they incurred over the past year. Changes in the accounting rules, including legislative and other rules 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.

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.

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 materials~~~~suppliers, which may not be successful and may result in the loss of all or~~~~part 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 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, 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, or~~~~natural 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.

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.

We may face additional risks as a result of the revaluation of the Chinese currency.

In July 2005, the People’s Republic of China agreed to a shift in Chinese currency policy and established a 2% revaluation of the renminbi, and the renminbi will now be referenced to a basket of currencies, with a daily trading band of +/-0.3%. Depending on market conditions and the state of the Chinese economy, it is possible that China will make more adjustments in the future. Over the next five to ten years, China may move to a managed float system, with opportunistic interventions. This reserve diversification may negatively impact the United States dollar and U.S. interest rates, which could in turn negatively impact the Company’s operating results and financial condition. A significant percentage of our sales are made to customers located outside of the United States, particularly Asia. 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. The functional currencies of our Chinese subsidiaries, including our joint ventures, are the local currency; since most of our operations are conducted in China, many of our costs are incurred in Chinese currency, which subjects us to fluctuations in the exchange rates between the U.S. dollar and the Chinese renminbi. 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. These risks may be increased by the fluctuation and revaluation of the Chinese renminbi. If we do not effectively manage the risks associated with this currency risk, our revenue, cash flows and financial condition could be adversely affected.

A reoccurrence of Severe Acute Respiratory Syndrome (SARS) or the outbreak of a different contagious disease 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 and other suppliers in China. The 2003 SARS outbreak was most notable in China and a small number of cases were reported 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 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 not be able to ship product to them, our revenue would decline and our financial performance would suffer.

The effect of terrorist threats and actions on the general economy coulddecrease our revenues.

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.

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 of our manufacturing and production facilities in 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. If we are unable to operate our facilities and manufacture our products, we will lose customers and revenue and our business will be harmed.

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

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

•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; and

•increases in our expenses, including expenses for research and development.

Our stock price has been and may continue to be volatile.

Our stock price has fluctuated significantly since we began trading on the NASDAQ National Market. For the twelve months ended ~~June 30,~~December 31, 2004, the high and low closing sales prices of our common stock were ~~$4.58~~$4.68 and ~~$1.20,~~$1.05, respectively, and for the six months ended June 30, 2005, the high and low closing sales prices of our common stock were $1.52 and $1.10, 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.

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.

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.

~~On April 24, 2001, our board of directors~~We have adopted a preferred stock purchase rights plan intended to guard against certain takeover

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%~~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 accounting~~~~pronouncements are likely to cause our general and administrative expenses to~~~~increase and impact our future financial position and results of operations.~~39

In order to comply with the newly adopted Sarbanes-Oxley Act of 2002, as well as proposed changes to listing standards by 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 advisory services, all of which will cause our general and administrative costs to increase. Insurers may increase premiums as a result of the high claims rates they incurred over the past year, and our premiums for our various insurance policies, including our directors’ and officers’ insurance policies, 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~~QUANTITATIVE AND ~~QUANTITATIVE~~QUALITATIVE 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 June 30, ~~2004,~~2005, we had no outstanding commitments with respect to foreign exchange contracts.

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):

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)			Balance as of June 30, 2005			Current Interest Rate		Projected Annual 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		$	15,112		0.50	%	$	76		$	68		$	84
Bonds	8,300		1.42	%	(118		)	(106		)	(130		)
Investment in debt and equity instruments														18,096			1.40		253			228			279
Long-term debt														(7,750		)	3.17		(246		)	(221		)	(271		)
					$	30		$	27		$	33							$	83		$	75		$	92

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. ~~In 2003,~~For the six month period ended June 30, 2005, we recorded ~~$2.0~~a $1.4 million ~~in charges to other expense~~charge to write down our investment in ~~two private US companies.~~one public U.S. company. As of June 30, ~~2004,~~2005, the minority investments we continue to hold amounted to ~~$2.0~~$3.0 million.

ITEM 4. CONTROLS AND PROCEDURES

(a) Under the supervision and with the participation of our management, our ~~Interim~~ Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our ~~Interim~~ Chief Executive Officer and 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.

In March 2004, as part of the Company’s implementation of our Code of Business Conduct and 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 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 controls over financial reporting were made during~~During the quarter ended June 30, ~~2004, although as described above,~~2005, we ~~implemented executive~~appointed an internal auditor directly responsible to the Audit Committee of the Board of Directors of the company, responsible for internal audit activities, including performing an independent appraisal of the various operations and systems of control within AXT and its subsidiaries and joint ventures and to assist management ~~changes, including a change in our Chief Executive Officer~~by providing independent analyses, appraisal, advice and ~~Chief Financial Officer roles, during the quarter,~~recommendations concerning accounting, asset management, information management and ~~are implementing operational changes~~control systems and ~~measures to improve our operational controls over product testing, provision of testing and~~such other ~~customer data and quality assurance.~~similar activities.

3540

PART II OTHER INFORMATION

Item 1. Legal Proceedings

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

On ~~April~~October 15, ~~2003, Sumitomo Electric Industries, Ltd., (SEI)~~2004, a purported securities class action lawsuit was filed a complaint in the 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 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 the Northern District of ~~California against the Company alleging patent infringement.~~California. City of Harper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The lawsuit names AXT, Inc. and our chief executive officer, China operations, as defendants, and is brought on behalf of a class of all purchasers of our securities from February 6, 2001 through April 27, 2004. The complaint ~~sought~~alleges that we announced financial results during this period that were false and misleading. No specific amount of damages is claimed. On February 4, 2005, the Court consolidated the case with a related case making similar allegations, and ~~injunction~~appointed a lead plaintiff, who will file a consolidated complaint. We believe that there are meritorious defenses against ~~infringement. On July 23, 2003,~~this litigation and intends to vigorously defend it. However, due to the ~~Company filed a counter complaint in~~inherent uncertainties of litigation, we cannot accurately predict 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 the Company’s prospective business relationships. The Company reached an agreement with Cree resolving the disputes between us and signed a settlement agreement on March 5, 2004. The resolutionultimate outcome of the ~~disputes did not~~litigation. Any unfavorable outcome of the litigation could have ~~a material~~an adverse impact on ~~the Company’s consolidated~~our business, financial ~~position or~~condition and results of operations. ~~All parties signed~~

On June 1, 2005, a ~~final release regarding all disputes between them~~lawsuit was filed in the Superior Court of California, County of Alameda, Zhao et. Al. vs. American Xtal Technology, et. Al., No. R 605215713. The lawsuit complaint names AXT and its chief technology officer and former interim chief executive officer, and is brought on ~~April 15, 2004.~~behalf of two former employees and their minor child. The complaint alleges personal injury, general negligence, intentional tort, wage loss and other damages, including punitive damages, as a result of exposure of defendants, including the minor child in utero, to high levels of gallium arsenide in gallium arsenide wafers, and methanol. The complaint seeks damages of $10 million each for pain, suffering and inconvenience, and for emotion distress, special damages to be determined, and punitive damages in the amount of $10 million. We believe that there are meritorious defenses against this litigation and intend to vigorously defend it. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operations.

Item 2. ~~Changes in~~Unregistered Sales of Equity Securities and Use of Proceeds

~~None~~During the three month period ended June 30, 2005, we repurchased the following shares of our common stock:

Period	Total Number of Shares Purchased	Average Price Paid Per Share		Total Number of Shares Purchased as Part of a Publicly Announced Plan or Program (1)	Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plan or Program
April 1, 2005 through April 30, 2005	57,200	1.21		57,200	1,902,067
May 1, 2005 through May 31, 2005	41,200	1.22		41,200	1,851,922
June 1, 2005 through June 30, 2005	36,500	1.23		36,500	1,807,145
Total	134,900	$	1.22	134,900	$	1,807,145

(1) Pursuant to a Plan publicly announced on August 25, 2004 in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934 to provide for the repurchase of up to $2 million of the Company’s common stock. Repurchases will be made from time to time in the open market during the twelve-month period ending July 31, 2005, at prevailing market prices. Repurchases will be made under the program using the Company’s own cash resources. The Board of Directors approved the extension of this Plan through July 31, 2006.

Item 3. Defaults upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

AXT held its annual meeting of stockholders at its headquarters in Fremont, California on ~~May 18, 2004.~~June 28, 2005. Of the ~~23,042,982~~23,199,454 shares outstanding as of the record date, ~~20,907,474~~21,695,589 shares were represented in person or 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~~two class ~~III director~~I directors to hold office for a three-year term and one class II director to hold office until ~~his successor is~~the annual meeting to be held in 2006, and until their respective successors are elected and qualified.

For

Against

Leonard J. LeBlanc

20,732,335

175,139

Class I directors	For	Against
Morris S. Young	21,342,742	352,847
David C. Chang	21,585,965	109,624

Class II director		For		Against
Phillip C.S. Yin		21,585,702		109,887

In addition, Leonard LeBlanc and Jesse Chen continued to serve the term of office as a continuing director after the meeting.

(2) Proposal to ratify the ~~selection~~appointment of ~~PricewaterhouseCoopers~~Burr, Pilger & Mayer LLP as our independent ~~auditors~~registered public accounting firm for the fiscal year ending December 31, ~~2004.~~2005.

For

Against

Abstain

PricewaterhouseCoopers LLP

20,825,550

77,174

4,750

		For		Against		Abstain
Burr, Pilger & Mayer LLP		21,558,386		16,576		120,627

Item 5. Other Information

None

3642

Item 6. Exhibits ~~and Reports on Form 8-K~~

a. Exhibits

Exhibit Number		Description
3.1(1)		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~~3.4(4)		Certificate of Amendment to the Restated Certificate of Incorporation

4.2(5)		Rights Agreement dated April 24, 2001 by and between AXT, Inc. and ComputerShare Trust Company, Inc.

10.17(6)		Offer letter to Mr. Philip C.S. Yin

10.17(7)		Offer letter to Mr. Minsheng Lin.*

10.18(8)		Employment agreement between the Company and Mr. Wilson W. Cheung.*

10.19(9)		Agreement respecting severance payment between the Company and Dr. Morris S. Young.*

31.1		Certification by ~~Interim~~ 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 ~~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.

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.

(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.

(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~~(4) Incorporated by reference to Exhibit 3.4 to registrant’s Form 10-Q filed with SEC 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,~~August 5, 2004.

~~On May 24, 2004, we~~(5) Incorporated by reference to the exhibit as of the same number as filed ~~a report on~~with the SEC in our Form 8-K ~~announcing our executive management changes.~~on May 30, 2001.

~~On June 24, 2004, we filed a report on~~(6) Incorporated by reference to Exhibit 99.1 to registrant’s Form 8-K ~~announcing our change in certifying accountants and a workforce reduction at our Fremont manufacturing facility.~~filed with the SEC on March 17, 2005.

37(7) Incorporated by reference to Exhibit 99.1 to registrant’s Form 8-K filed with the SEC on June 30, 2005.

(8) Incorporated by reference to Exhibit 99.2 to registrant’s Form 8-K filed with the SEC on June 30, 2005.

(9) Incorporated by reference to Exhibit 99.1 to registrant’s Form 8-K filed with the SEC on March 30, 2005.

*Management contract or compensatory plan.

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.

Dated: August ~~5, 2004~~9, 2005	By:	/s/ ~~Donald L. Tatzin~~Philip C. S. Yin
		~~Donald L. Tatzin~~Philip C. S. Yin
		~~Interim~~ Chief Executive Officer
		(Principal Executive Officer)

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

3844

EXHIBIT INDEX

Exhibit Number		Description
3.1(1)		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~~3.4(4)		Certificate of Amendment to the Restated Certificate of Incorporation

4.2(5)		Rights Agreement dated April 24, 2001 by and between AXT, Inc. and ComputerShare Trust Company, Inc.

10.17(6)		Offer letter to Mr. Philip C.S. Yin

10.18(7)		Offer letter to Mr. Minsheng Lin.*

10.19(8)		Employment agreement between the Company and Mr. Wilson W. Cheung.*

10.20(9)		Agreement respecting severance payment between the Company and Dr. Morris S. Young.*

31.1		Certification by ~~Interim~~ 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 ~~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.

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.

(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.

(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(4) Incorporated by reference to Exhibit 3.4 to registrant’s Form 10-Q filed with SEC on August 5, 2004.

(5) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 8-K on May 30, 2001.

(6) Incorporated by reference to Exhibit 99.1 to registrant’s Form 8-K filed with the SEC on March 17, 2005

(7) Incorporated by reference to Exhibit 99.1 to registrant’s Form 8-K filed with the SEC on June 30, 2005.

(8) Incorporated by reference to Exhibit 99.2 to registrant’s Form 8-K filed with the SEC on June 30, 2005.

(9) Incorporated by reference to Exhibit 99.1 to registrant’s Form 8-K filed with the SEC on March 30, 2005.

*Management contract or compensatory plan.

	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

	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 six month period ended June 30, 2005	Restructuring Accrual as of December 31, 2004		Additions/ Reversals		Payments			Restructuring Accrual as of June 30, 2005
Future lease payments related to abandoned facilities	$	552	$	208	$	(273	)	$	487
Workforce reduction	—		56		(56		)	—
Japan office closure	—		98		(81		)	17
Total	$	552	$	362	$	(410	)	$	504

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	%

	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