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Edited Transcript of AXTI earnings conference call or presentation 26-Apr-17 8:30pm GMT

Thomson Reuters StreetEvents

Q1 2017 AXT Inc Earnings Call

Fremont Apr 29, 2017 (Thomson StreetEvents) -- Edited Transcript of AXT Inc earnings conference call or presentation Wednesday, April 26, 2017 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Gary L. Fischer

AXT, Inc. - CFO and Corporate Secretary

* Morris S. Young

AXT, Inc. - Co-Founder, CEO and Director

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Conference Call Participants

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* Hamed Khorsand

BWS Financial Inc. - Principal and Research Analyst

* Joseph A. Maxa

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst

* Richard Cutts Shannon

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Thomas Andrew Sepenzis

Northland Capital Markets, Research Division - MD and Senior Research Analyst

* Yeuk-Fai Mok

Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to AXT First Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn the conference over to Gary Fischer, Chief Financial Officer. Sir, you may begin.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [2]

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Thank you, Tekia, and good afternoon, everyone. Before we begin, I would like to remind you that during the course of this conference call, including comments made in response to your questions, we will provide projections or make other forward-looking statements regarding, among other things, the future financial performance of the company and our ability to control costs and improve efficiencies, increase orders in succeeding quarters, improve our competitive position as the market improves, our ability to meet market demands for our products, as well as other market conditions and trends, including expected growth in the markets we serve.

We wish to caution you that such statements deal with future events, are based upon management's current expectations and are subject to risks and uncertainties that could cause actual events or results to differ materially. These uncertainties and risks include, but are not limited to, overall conditions in the markets in which the company competes, global financial conditions and uncertainties, market acceptance and demand for the company's products and the impact of delays by our customers on the timing of sales of products. In addition to the factors that may be discussed in this call, we refer you to the company's periodic reports filed with the Securities and Exchange Commission and available online by link from our website for additional information on risk factors that could cause actual results to differ materially from our current expectations. This conference call will be available on our website at axt.com through April 26, 2018. Also, before we begin, I want to note that shortly following the close of market today, we issued a press release reporting financial results for the first quarter of 2017. This information is available on the Investor Relations portion of our website, which is at axt.com.

Now turning to a review of our first quarter results. As many of you know, on the evening of March 15, we experienced an electrical short-circuit fire at our Beijing manufacturing facility. No injuries occurred, and there was no structural damage to the building involved. The fire primarily affected the electrical power supply supporting 2-inch, 3-inch and 4-inch gallium arsenide and germanium crystal growth. In addition, the critical wastewater pipe that services our wafer processing operation was accidentally damaged by the fire department during efforts to locate and suppress the fire. And we shut down that part of facility at their request. As a result, our initial expectation was that revenue for Q1 could be impacted by temporary halt to production for those specific products. As such, we revised our guidance for the quarter to a range of $18.0 million to $18.5 million, down from the previous guidance of $19.5 million to $20.5 million.

On March 20, we're pleased to report that we've resumed production at our facility. Our quick recovery was made possible by several factors: First, we were able to repair the wastewater pipe much faster than we anticipated, which allowed us to resume wafer processing and order shipments after 4 days. This was critical to our Q1 backlog; second, our customer design -- our custom-designed furnaces enabled us to rotate key furnace hardware between crystal growth diameters, allowing us to use some 6-inch furnace capacity for 2-inch, 3-inch and 4-inch diameter gallium arsenide and germanium crystal growth production; and finally, we have sufficient redundancy in our furnaces, and we're able to relocate some furnaces within the plant to an area designated for crystal growth expansion and begin bringing them back online in their new location. We expect to be back at full production this quarter. Through the adaptability of our equipment and facility and a reserve of staged inventory of smaller diameter crystalline ingots that we quickly moved to wafer processing, we were able to mitigate the effects of the fire on our production.

Throughout the process, our primary focus was on supporting the needs of our customers without interruption. We're proud to report that we succeeded in fulfilling all customer orders. As a result, our revenue came in above our revised guidance of $18.0 million to $18.5 million and in fact, even slightly higher than our original Q1 guidance of $19.5 million to $20.5 million. So now coming to Q1, we had expected our gross margin to be lower than the 37% reported in Q4. However, the sequential decline was somewhat steeper than originally expected, as we made the decision to temporarily set aside certain production efficiencies in order to ensure that we meet the customer demands during this period of recovery after the fire.

With that in mind, total revenue for the first quarter of 2017 was $20.6 million. This compares with $20.3 million in the fourth quarter of 2016. Of our total revenues, substrates sales increased to $16.6 million compared with $16.0 million in the prior quarter. Revenue from our raw material joint ventures was $4.0 million in Q1 compared with $4.3 million in Q4. In the first quarter of 2017, revenue from North America was 10%, Asia Pacific 63% and Europe was 27% of total revenue. One customer generated more than 10% of revenue in Q1, and the top 5 customers generated approximately 35% of total revenue, reflecting again our diversification of both products and customers.

Gross margin in the first quarter was 30.5% compared with 37.1% in the prior quarter. To put this in context, as we discussed, last quarter Q4 2016 margin performance was particularly strong as a result of the favorable product mix, yield improvements and other efficiencies. Going into Q1, we were not expecting to achieve similar levels, but our Q1 margin performance came in a bit lower than our initial expectation, largely as a result of prioritizing customer requirements over production efficiency, as we work to recover from the fire.

We would expect to see margins go up in the current quarter, with longer-term goals to have margins at or above 35%. Total operating expenses for the first quarter were $4.9 million compared with $5.2 million in Q4 of 2016.

Total stock compensation expense was $312,000 for the first quarter, of which $8,000 was included in cost of revenues, $256,000 in SG&A and $48,000 in R&D.

Operating profit for the first quarter of 2017 was $1.4 million compared with $2.3 million in the previous quarter. Interest and other income for the first quarter was a net charge of $787k. This net number consists of 4 categories: First, net interest earned of $98k; second, small foreign exchange gain of $15k; third, equity accounting on our unconsolidated joint ventures, a loss of $933k; and four, other items equaling a gain of $33k. The unconsolidated joint venture number includes an impairment charge of $313k for one of the gallium companies that has been struggling.

For Q1 of 2017, we have a net profit of $665,000 or $0.02 per share. By comparison, we had a net profit of $2.2 million or $0.06 per share in the fourth quarter of 2016.

The diluted share count in Q4 was 33.734 million. The diluted share count in Q1 moved up on a prorated basis to 35.624 million.

On March 7, we closed a public offering of 5.3 million shares of common stock, including an overallotment option of 692,307 shares at a price of $6.50 per share. After deducting underwriting fees and offering expenses, net proceeds from the offering was $32.3 million.

We expect to use the proceeds for general purposes, which will, of course, include the relocation of our gallium arsenide product line as well as capital for the expansion of our operations to meet the requirements of exciting business opportunities across our portfolio and other things.

As a result, cash and cash equivalents and investments closed at a total of $86.8 million as of March 31, 2017, up from $53.7 million as of December 31, 2016.

Depreciation and amortization in the first quarter was $1.1 million and CapEx was $700k.

Accounts receivables net of reserves were $17.6 million as of March 31, 2017, compared with $14.5 million at December 31, 2016. Net inventory at March 31 was $39.2 million compared with $40.2 million in inventory as of December 31.

Ending inventory consisted of approximately 42% in raw materials, 52% in work in progress and 6% in finished goods. The spread between the 3 buckets remains very, very constant from quarter-to-quarter.

Okay, this concludes our financial review. I will now turn the call over to Dr. Morris Young for a review of our business. Morris?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [3]

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Thank you, Gary, and good afternoon, everybody. This has been a very busy quarter for us. We're seeing an encouraging progress in adoption of several emerging technologies, and we're continuing to invest in our product development, production capacity and customer engagement and support capability in order to position ourselves for coming business opportunities.

We're also very actively preparing for the relocation of our gallium arsenide substrate business, which will occur in stages and is expected to take place in approximately 2 -- next 2 years. In addition, we recently completed a successful secondary offering, helping to ensure that AXT is well capitalized for both business expansions and coming relocation. And finally, as Gary mentioned, we experienced and then quickly and effectively dealt with a short-circuit fire at our Beijing facility. Throughout a busy and productive quarter, I'm most proud of the way our team has pulled together with a sheer sense of purpose to support all our key stakeholders, including our customers, investors and fellow employees. 2017 will likely to be a very important year for AXT.

And I believe, we're taking the correct steps to ready our business for our next phase of growth. Now beginning with indium phosphide business. Q1 was other strong quarter of sales, though down a bit from Q4 in spite of some recent mix signals in the news, we have been encouraged by indication that our customers that suggest improved conditions in key regions.

EPON and GPON market, particularly in China have historically being the key driver for indium phosphide demand in application such as fiber-to-the-home and office. We believe that in the last 4 quarters, there was a slowdown in purchasing from carriers as well as inventory buildup in supply chain that constrained market growth. And we are taking appropriate measure view of the market widespread recovery.

However, our Q2 inventory booking indicates that our indium phosphide revenue could be a record for us. The strength is coming from our many spot orders from smaller accounts, the new large orders from customers serving the China home market and continuous strength in silicon photonics. As we discussed last quarter, we particularly pleased that the application in data centers connectivity continue to mature. We continue to see growth in sales relating to indium phosphide based silicon photonics, which integrates live signals and electronics using semiconductor technology.

Silicon photonics is expected to lower power consumption and improve data center performance. And these are key considerations given the ongoing strong growth in cloud computing, IoT, mobility and video streaming.

Commercialization of the technology began to have a traction in 2016 and has continued to advance to a more widespread market adoption in 2017.

Now turning to gallium arsenide. Sales were substantially higher in Q1. We saw particularly strength in wireless applications where demand has stabilized in the wake of SOI technology incursion in the market. Certain applications remain best suited for gallium arsenide, and we are likely to just remain so for the foreseeable future.

Semiconducting gallium arsenide demand was also a bit stronger than expected, which we knew primary -- that was -- revenue primarily coming from our traditional markets. Looking ahead, a 3D sensing market can provide a new growth opportunity for high-end substrate manufacturers should technology enjoy more widespread adoption into a variety of products.

In mobile phones, the technology is likely to be used for augmented reality applications by enhancing camera capability to enable object recognition, (inaudible) data and greater precision and object replacement. Gaming and facial recognition for security are examples of 2 early applications. The technology also has applications outside of the mobile, in smart TVs, automobiles, industrial, and medical devices and gaming consoles, among others.

The strict requirement of 3D sensing are likely to provide a strong barrier to entry to new players in the market. Today, only 3 competitors, including AXT, are able to provide low EPD substrates in sufficient volume for production ramp. And we expect that market growth will provide exciting opportunities for all in the coming years.

Now turning to germanium substrates. Sales were about flat in the quarter, but still reflecting a decent improvement in the worldwide satellite market, particularly in China. Remote sensing, communications and positioning and navigation remained in predominant applications, but certain regions like China are now deploying satellite for new applications, such as greenhouse emission monitoring and the oil exploration, which involve landing satellite data with other data streams.

Germanium substrate cells continue to provide steady profitable revenue and strengthening market conditions could provide additional opportunity over the coming years. Our raw material revenue was down about $258,000 in Q1 compared with the prior quarter.

As the market continue to struggle with overcapacity, still many of the markets, includes our joint venture supply, are experiencing growth. And over time, this may serve to rebalance the economics of supply and demand.

In closing, we believe that 2017 will be a important year for AXT. We're optimistic about a number of exciting growth opportunities across healthy markets for indium phosphide, gallium arsenide and germanium substrates. We continue to demonstrate tremendous expertise in producing consistently high-quality products for some of the today's most technically difficult applications.

We're well capitalized to support our planned capacity increase and business expansion. And we're firmly committed to continue improvement in our financial model. Finally, I want to recognize our team for its solid execution on behalf of our customers in overcoming a difficult challenge in this last quarter.

Gary and I will continue to spend a considerable amount of time in Beijing ensuring firsthand the success and efficiency of our operations, and we prepare for our expected growth.

And this conclude my prepared comments. I will now turn the call back to Gary for our second quarter guidance. Gary?

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [4]

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Thank you, Morris. Okay. Q2 is shaping up nicely. We expect revenue growth in Q2 of about 9% quarter-to-quarter. As such, we believe that total revenues will be in the range of $22.0 million to $23.0 million.

In terms of our bottom line outlook for Q2, we're expecting to be in a range of $0.04 to $0.06 profit per share based on 37.624 million diluted common shares outstanding. Factored into this range is our belief that the 7 partially own companies that are accounted for using the equity method will represent a charge in Q2 of approximately $280,000. This is a strong improvement from the $933,000 charge in Q1 and even the $558,000 charge in Q4 of 2016.

Okay. This concludes our prepared comments. Morris and I will be glad to answer your questions now. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Edwin Mok with Needham & Company.

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [2]

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So first, I want to focus on indium phosphide. Morris, you mentioned that you expect -- based on your backlog and order trend, you expect a record quarter in the June quarter, but we obviously have heard more data point about the Chinese market being struggling more, is it just growth from silicon photonics that is offsetting that? Or you mentioned something about smaller customer buying as well, can you give may be a little more color on that?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [3]

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Sure. I think it's our understanding of the market is not total, because a lot of customers just buy substrate from us. They don't really tell us what exactly they're using it for. But for the China PONs market, we are seeing a renewed growth -- quite a bit of recovery from second half of 2016 level. So actually the order pattern is pretty strong in April and May, but we're still anxiously waiting for the June order. So we do want to see same pattern, but we do recognize from the order, they are for the China PONs market. And of course, silicon photonics, we believe it's in growth mode. And they have grown quite substantially from similar periods like compared to last year. But the other thing that maybe I could comment is that, the second half of 2016, the PONs market really took a beating because of older inventory or this glut in inventory. But our revenue, nevertheless, didn't really take too much of a slowdown. Although we grew less robustly compared to prior year, but nevertheless that was a growth year. And I definitely accounted -- say that -- that may be accounted for by the growth of the silicon photonics market, which we don't believe is slowing down. We think it still has more legs to go.

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [4]

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All right. Great. I know, as you said, customer doesn't necessary tell you what they use substrate for, maybe hard for you to describe that, but is there a way to just carve -- maybe just describe how your market exposure has been? I think, historically, if I go back like 2 years ago, when we can -- can say vast majority has been the China PON market. Do you think that has changed now? Do you think silicon photonics account for 1/3 of the business, anyway you can describe like that?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [5]

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Yes, Gary?

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [6]

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Yes. We're happy to serve -- give a guestimate because we do discuss it internally. We do think silicon photonics has grown, and it could be as much as 25% of our indium phosphide now. We still think the EPON, GPON is the biggest part and then we have the category that I will call everything else, which is may be another 25% to 30%.

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [7]

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As you know, Gary, good comparison is, I think, that 20%, 25% guesstimate on the silicon photonics compared to, let's say, 2 years ago, it was almost negligible.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [8]

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Zero, yes, yes, yes, compared to 2 years ago, silicon photonics is -- it's going in the direction that the investment community and analytical community has thought that would and it's the one that Morris thinks it will be going in that direction too. So it's fulfilling our expectation. And we think it's going to be strong. So we are aware that there is a lot of noise out there, especially this morning and today about what's going on in the optics in China markets and stuff, but I guess, we're seeing a little bit more positively on a micro level for AXT as opposed to the macro level that you guys are all seeing in the marketplace.

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [9]

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Yes, one explanation maybe I can offer is that the PONs market hitting on us compared to last year was really very dramatic, okay. And that was a result of maybe inventory correction or -- so all the demand almost just died. And now, although china market is just maybe not as robust, but nevertheless, whatever you do, you need a PON. So -- as other explanation why we're seeing the market is still fairly healthy for us.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [10]

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Yes. Go ahead, Edwin.

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [11]

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Great. That was very, very helpful color. So I always have to ask this questions and I'm sure the other guys want to ask the similar question. But on the 3D sensing, do you guys have any incremental color in terms of what's going the near-term demand? I think you guys have previously talked about that you gone through a qualification process with one of your major key customer, any update on that front? Have you gotten any color in terms of when either decision will be made or that if the market does in fact decide to have 3D sensing on mobile that you -- do you expect to see any orders coming, just any kind of color you provide on that?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [12]

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Sure, Edwin. Unfortunately, up to this point, we don't have a order. We're going to -- we delivered almost over 1,000 wafers for qualification and with some key customers. We're still anxiously waiting. There was really no bad news to say our product is not good. But of course, we're still anxious. We're waiting for the order. But I think we are still doing all the preparation work. We are actively developing our product development to be able to yield very high yields for this very demanding low EPD requirement for these applications. We're actively engaging with potential customers. And also, we are preparing ourselves for active sales and engagement from hiring more people to strengthen our preparation for this market to take off. And also given that application is so widespread all the way from artificial intelligence to automobile to cellphone market and everything else, I think, perhaps, everybody is really very focused on this one single customer. But we believe that, sure, this could be a big driver for the great demand for this material. But I believe that if this VCSEL business -- it's going to solve a lot of problems for renewed applications, not only cellphones, but also driverless cars and artificial intelligence, we think our preparation is not going to go in vain.

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [13]

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Okay, great. That's helpful color. Last question, I'll ask one more question, I'll pass on to other guys. Just on the new production site, can you provide a little more color where you are at right now? Have you identified a site, at least near-term timing, you've any rough idea when you're going to start -- actually start building up the site and then how...?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [14]

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The fire affected us. The pure interruption was only for 4 days, but we are still busy doing some amendment still because there are some furnaces which were affected and was building more capacity for that. But, nevertheless, because of the inventory, we build up our ingots that is not going to -- we don't think it's going to affect revenue possibility in Q2. And we are also very actively doing the site selection and so that we will make a final decision on the new location pretty soon. We believe it's going to be within weeks instead of months now. And once we made that decision on the new location, we will provide a game chart. We will provide a strategy both to our investors as well as to our customers who are anxiously waiting to see that. We do believe that we have better ideas how to, well, both remove some of the concern of our consumers and also provide opportunities, especially someone who is going to look for a great growth potential both indium phosphide and the low EPD VCSEL supply chain that we could provide a good solution to this market.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [15]

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Yes, Morris and I are going to Beijing next week and a week after. So we'll be there for 2 weeks. One of the top 2 or 3 things that we're going to work on is concluding the site selection. And just to add a little bit of color as a reminder that we're looking at what we think is going to be about a 2-year program. It's a staged relocation. We'll never be down production. We'll increase production in Beijing at the new site and then slowly phase it out from Beijing for gallium arsenide. So we have the plan and we have a couple sites that were very close.

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Operator [16]

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Our next question comes from Richard Shannon with Craig-Hallum.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [17]

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Maybe I'll have first couple of questions on indium phosphide. Just an effort to try do some modeling here on this -- parts of the substrate business. Wondering if you can give us a sense of what kind of growth year on year growth you're expecting for indium phosphide in the second quarter? You talked about it being a record quarter. What kind of growth rate does that look like, and what was the previous record quarter, when did that occur?

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [18]

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I think the last record quarter was probably the second...

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [19]

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It was in 2016.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [20]

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Yes, for sure. I don't remember which one. We're not really giving a prediction for growth in 2017. We're not sure for one thing at this stage of the year, but given the strengthening PON market that Morris just spoke about for the equipment market and the commercialization of silicon photonics for the data center connectivity, we believe its growth rate could exceed that from 2016 into 2017.

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [21]

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So let me give you a little more optimistic view. I think if this -- I think 2016 second half, our indium phosphide revenue was really being negatively affected by the PONs market because of the adjustment of inventory, et cetera. And then, indium -- silicon photonics is really the savior as we still offer -- we still have grown in the mid-teens with that indium phosphide for 2016. But now, for 2017, I think we are starting to see the renew demand for PONs market. I mean, again, I want to reiterate we are seeing the demand from China. But of course, that's conflicting with what previous saying the China market is still slow and always going to slow down. But I think the offered explanation could very well be that the kind of a slow market in the second half of 2016 was an overcorrection. So we're not coming back, okay. But you add on top of it silicon photonics really are not slowing down at all. So if it provides another growth year for 2017 compared with the '16, then definitely, 2017 would have been a better growth year than 2016, okay. So it's better than mid-teens level.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [22]

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Okay. All right. Fair enough. Another question on the indium phosphide topic around silicon photonics. I think if I caught your commentary right, you think that's roughly a quarter of your indium phosphide business, is that what I heard?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [23]

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Yes. That's correct.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [24]

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Okay. How many customers are in there? How many...

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [25]

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That we're not so sure about. When we made our estimate based on the one that we do know about.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [26]

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Yes, that's correct. And...

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [27]

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Okay. I think we can all guess on the who the one is, I just wondering if there are any more that you're aware of, but I think that -- I think your message is clear there, so that's helpful.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [28]

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So we don't (inaudible) acknowledge of the others.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [29]

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Right. Okay. Question on the JVs. I think you're talking about charges for this quarter being a lot lower than previously. Can you help us understand why is this, higher revenues or better margins or what's the driver for the lower charge for JVs?

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [30]

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Yes. Well, first of all, I will underline what I said in my prepared remarks that the large number in Q1 had a $313,000 impairment charge, which means we have a company that's struggling and we took the conservative position and wrote our asset investment down to 0. So -- but even so without that, we would have been roughly around $600,000, close to what it was in Q4. What's happening is this: number one, the germanium material pricing has gone up, and so that's going to help our germanium company, which was one of the companies that was dragging us down quite a bit in 2016. They were kind of leader in the pack of bad numbers. So that's helping us. And we do have kind of a hedging strategy for our listening audience, as you know. So we're glad that our germanium company that we have partial ownership. We own 25% of that mining company for germanium in China. We're glad they're doing better, but that also will eventually seep back in to higher germanium raw material costs for our germanium substrate. So it's a little bit of yin and yang here on those kind of situations. So germanium is the one thing. And then our refined gallium companies have seen a slight improvement in their P&L. And the rest is sort of noise level stuff, but I will say it's those 2 things, the germanium company and then the refined gallium companies are improving. I think we probably said to a number of you that our goal for 2017, as we like to see that line down there below, the operating numbers being neutralized. We're not so sure it will become a huge positive by year-end, but we'd like to see it get to a like a breakeven kind of point. And I think Q2, which we have a glimpse at now, is giving us a positive sense that this is achievable, but we have long ways to go.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [31]

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Okay, great. My last question for you, probably for you Gary, as you talked about the gross margin goal of hitting 35%, wondering if you can give us any sense of what kind of a profile of business you expect to have mix wise versus -- substrates versus raw materials? And also what kind of revenue scale needed to hit that?

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [32]

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Right. Well, just a couple of data points. If you look at the 2016 numbers, that's where we broke it out in the 10-K and raw materials were 19% of revenue. Coincidentally, that's almost exactly what the percentage was for Q1 that we just finished up. So I think rule of thumb, in the coming quarters, raw metals is going to be high-teens, 19%, 20%, something like that. Substrates will be the rest. But probably over time and I'm not saying it would be obvious quarter-to-quarter, that the raw materials will probably fall a bit lower, because we think the substrate businesses will grow faster. And that growth is going to be primarily driven by indium phosphide. So to get to 35%, we would like to see -- we think the easiest way to accomplish that is to grow our indium phosphide business. Indium phosphide is a very difficult product to make, and we happen to be very good at it. And we have decent yields. And so it's profitable product line for us. So as a business person, if I have to have a $1 million of sort of free revenue, I will always say I wanted to be in the indium phosphide at AXT because that's the best product. So if we can grow indium phosphide, then that's the way -- that's the path to get to what we're talking about so.

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Operator [33]

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Our next question is from Tom Sepenzis with Northland Securities.

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Thomas Andrew Sepenzis, Northland Capital Markets, Research Division - MD and Senior Research Analyst [34]

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Congratulations on the rapid recovery. I was wondering if (inaudible) silicon germanium, you did mention a couple of the markets that you may have said are either recovering or expecting growth out of that business. Or is that just something that you believe will (inaudible) forward?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [35]

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Yes, silicon photonics should continue to be growth market. I mean, while we were talking about a recovering market, it's the PONs market.

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Thomas Andrew Sepenzis, Northland Capital Markets, Research Division - MD and Senior Research Analyst [36]

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No, no, sorry, silicon germanium.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [37]

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Germanium. Not silicon germanium, germanium. Okay.

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [38]

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Germanium market, I think, it's sort of last quarter was down slightly, but I think because of the satellite applications, they're growing strong. We expect that to grow Q2 again. So germanium is a very strong market.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [39]

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Yes, a lot of the germanium goes in satellites and the satellite business is diverse and it was part of our script in Morris prepared comments. So we're seeing a lot of good stuff. It still -- Tom, it's still our third in terms of the product revenue. It doesn't generate as much, it's behind indium phosphide and gallium arsenide, but it's growing recently. And it's a stable product and it's contributing so.

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [40]

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Yes, the good thing about germanium is, you know, everything goes into satellite needs lengthy time for qualification and good quality. So that business is a very defendable business. Not everybody can do (inaudible) like what we do.

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Thomas Andrew Sepenzis, Northland Capital Markets, Research Division - MD and Senior Research Analyst [41]

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Great. And then, Gary, you mentioned the charge for the JVs is going to be about $280,000 in the June quarter, is that a good number to use moving forward? How should we be thinking about that on a longer-term basis?

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [42]

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I don't know.

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [43]

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I think we should in 1 quarter, I guess...

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [44]

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Yes. We'll try to get give some sense. We normally don't give guidance at that detail level, but because the numbers are jumping around so much, it's kind of silly not to discuss it a little bit and just be straight out about it. So let's -- we have to where we're going to learn a little bit more on trip. We always get a little more knowledge when our feet are on the ground, particularly Dr. Morris Young's feet on the ground in China. So Morris is on the board of all 10 of these companies. And so we try and meet with them and it's pretty useful. So -- sorry, Tommy, I don't have a good answer for Q3, 4 or next year. But what we hope and what we think is credible and reasonable is that it will continue to trend. The negative will continue to melt down to a smaller and smaller amount.

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Operator [45]

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Our next question is from Joe Maxa with Dougherty & Company.

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Joseph A. Maxa, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [46]

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Regarding indium phosphide and what you're hearing from your customers, I'm wondering what you're thinking about the second half of the year? You talked about silicon photonics continue to be a growth engine and the PON market is stabilizing. So are we assuming you should see incremental growth each quarter as year progresses and into next year?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [47]

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As we stated in our prepared commentary, I mean, from our sales department, we do see pretty strong order pattern that we know specifically designated for China PONs market, okay. And but that's compared to what we're experienced last year. Silicon photonics, we do see that demand is strong. We do believe that probably more predictable and it's going to continue. But whether it's going to have a second kick or not in the first quarter or not, we don't know. And the other phenomenon we also saw was there's a lot of the small pockets or orders from, let's say, the third tier customers. They usually buy hundreds of wafers at a time and they're fairly active. So that -- so the least need to be 2 things. I mean, a lot of people are thinking this market is robust. Usually, a 100 wafer order will lead to 200, 300 and eventually to thousands of wafers orders, okay. So we're encouraged by that, accumulation of little orders, and so we do have a good reputation out there. And then, people when they want indium phosphide, they come to us. So I think, hopefully, all those little orders will start to grow, I mean, to bigger markets.

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Joseph A. Maxa, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [48]

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Okay. That's helpful. And talking about the noise out there today, can you give us any indication of what your exposure is to Huawei over in China?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [49]

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No, no, Joe. We usually -- we really don't want to comment on customers -- specific customer especially. And I can only say these. I think when the substrate demand come to us, I mean, this is a long way, because you never know what customer want to build inventory. As I said, I suspect some of the renewed ordering pattern for our PONs market that we believe goes through the PONs really come from the fact that last year, they were done so much. So they have to come back somehow. So we're anxious to see whether it's going to continue for the next months to the next month. So after a one more quarter, maybe we can all conclude whether the PONs market really is coming back strong or they just recovering. I mean, so far, we've seen almost like 70% what they used do. But last year, we went down to almost like 20%, 25%.

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Joseph A. Maxa, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [50]

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On the indium phosphide side, are you seeing -- I mean, I'm assuming you have plenty of capacity to meet your demand, but are you coming up to a point where you need to start adding capacity?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [51]

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This is, again, I'll say this -- good point about AXT, we have always been telling our customers, because we know VGF from inside out. We design our own furnaces. We probably expand this as we see market. And unfortunately, last year, we prepare a lot of potential growth was, we didn't grow as much, but growth is really a easy thing for us to take care.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [52]

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Yes, there is -- as I said in others discussions, they're certainly 2 tracks on adding capacity. One is the footprint, the facility and that track is a longer track. And then the second is manufacturing equipment, chief of which is the furnaces, but also maybe more wafer size, some grinders to grind the wafers and things like that. But the cycle for those kinds of things is about 90 days. So the detail we can give use is that we have the footprint for indium phosphide that we can add more equipment. And so if -- when we cross that line, we'll just pull the trigger. And 90 days later, we'll have more and more capacity. So we think we're in control of our future. Let's put it that way.

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Joseph A. Maxa, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [53]

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And then lastly from me. To get the JV impact to neutral by year-end, what does that entail? I mean, I'm assuming there's not another impairment charge coming to get it there, but is it you need pricing that keep going higher, what are you thinking that needs to happen?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [54]

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Yes. Well, the raw gallium price recovered quite a bit in the fourth quarter. Unfortunately, during Q1, it took out a dip. Although it didn't reach all-time low, but I think that's probably normal because as soon as the price recovers. All the people -- everybody wants to restart their production. And then, so you see price pressure on the capacity -- on the material again. But I think, eventually, the stronger will survive. And I think the other good thing about it is our JVs are -- we weigh them either #1 or 2. So I think they will be survivors. And second, I do believe that application for gallium will continue to grow. You just look at your 3D sensing thing. If it really become widespread adoption of 3D sensing to everything, including automobiles, and so the best way to describe it is, if you want to give intelligence, a vision to a machine, you got to have lasers. And the best way to provide a laser is the VCSEL. And then you need gallium arsenide. So now what really improve, not only our ability to serve the market, also you can create more demand for gallium. And not to mention, they are solar cells applications and magnet using gallium. None of these end markets actually decline. So I believe -- I firmly believe it's matter of time when the gallium market will recover. But as far as how far will it recover, I believe 2016. You're looking at gallium price selling as low as $100, $110 a kilogram. I don't think we'll ever go back there again. So I think I'm optimistic that we should see, although it may not be a straight line, but gradually it should improve somehow.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [55]

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Yes, so, I mean, Morris comments in term of the gallium, we embrace that's probably not going to move the needle in '17, because the 3D things really an '18 growth phenomenon. But the other part of the answer I would give is more help on the germanium side. The germanium company was one of the top leaders in the downward numbers. And so -- and we only have 1 germanium company, which is fine. For example, we have several gallium companies. We have 2 arsenide companies. We have a resin company that is used for gallium extraction from aluminum. But the germanium company, we didn't -- we didn't have as much influence as some of our other companies. It's a state-owned business. So even though, I think Morris and I are both I think on the board of that one, but it's -- let's just say, it's easier to influence some of the other companies where this one is like you talk to like one of our other companies, we had a reduction in force, right, last year. But because this is a state-owned company and they want to keep employees employed. It's not even in discussion. We can't even bring up the topic of having reduction in force. So what we need is for the germanium price to go up a little bit more and maybe for them to get a little more efficient in their yields. That's in addition to what Morris said about the gallium, I think that's the other thing that I'm watching. So it's trending okay. So I'm like okay and I'm cautious, but I feel like the needle is beginning to swing back in the right direction.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [56]

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Thanks, Joe. Next question?

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Operator [57]

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Our next question comes from Hamed Khorsand with BWS Financial.

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Hamed Khorsand, BWS Financial Inc. - Principal and Research Analyst [58]

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Couple of questions. One is how much visibility do you have from your customers in the orders that you're seeing right now?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [59]

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So what do you mean how much visibility? You mean how much is in the backlog?

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Hamed Khorsand, BWS Financial Inc. - Principal and Research Analyst [60]

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Lead times that you have and how much -- how confident you are of the guidance you're giving. I mean, usually, I'm expecting you guys will have some sort of lead times. I'm trying to understand how much visibility you have in the quarter, we're only about 1 month into it?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [61]

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Yes. Usually, we see we don't have that much of a good visibility. But looking at a strong quarter, such as Q2, some of the lines are very busy. So I think the confidence level is pretty high.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [62]

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Yes, and there's a visibility that you get from a hard PO and there's -- but there's another kind of visibility, which is that we've been continually getting orders. And we get feedback and guidance verbally. And because it's hard to change suppliers once we're in, our share of that business is probably won't go down. And hopefully, we can take it up or we might be the sole supplier. So to be blunt, we don't have the backlog fully booked for Q2, but our confidence level is probably as high as it's been in 5 or 6 quarters, 7 quarters. I mean, it's strong, yes, so.

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Hamed Khorsand, BWS Financial Inc. - Principal and Research Analyst [63]

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Okay. My other question was, as far as the efficiency goes in production, are you back to normal for Q2 or not yet?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [64]

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Well, we're still slightly affected. I think some of the places that we used to have are more compact. Now we have to, perhaps, travel a little bit longer distance in order to make the production line connected. But I do hope that as time goes, we should be able to mitigate that. And what influence our gross margin, I guess, everybody worry about gross margin and profitability, I think the product mix definitely will play a big role.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [65]

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It's a bigger role than the fire...

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [66]

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Yes, inefficiencies.

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [67]

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The inefficiencies from the fire so. So in a sense, we'll never be back to normal, because we actually pulled stuff out of the building that had the fire and we moved it to the building next door. So there's a new norm that we're putting together. But what I would say is that, what we're doing is mostly going to be invisible to the shareholder community and the investment community. So we're working on it. We can't tell you everything is fine. There's no more work to do. We still think about it. It's going to be one of the hot topics when we get over there next week kind of where do we stand, what are the next steps. But we're very encouraged with how our team has responded. And fortunately and by sheer coincidence, Morris and I were both there as scheduled before this fire happened, but it enabled Morris especially to step in and show very strong leadership and our team stepped up. So the short answer is, it's not ever going to be normal in the old way. And we're still working on stuff, but certainly you won't be able to tell, it's going to be invisible to you.

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [68]

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Yes.

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Operator [69]

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We have a follow-up from Richard Shannon from Craig-Hallum.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [70]

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Just 1 question from me. Morris, you've been talking with your direct customers on the topic of 3D sensing for a while. I'm sure you're trying to develop this answer and it changes over time. But I'm curious what kind of size of a market for gallium arsenide substrates you see for 3D sensing relative to what you either as a quantifiable number or relative to your current gallium arsenide markets you're serving?

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [71]

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That's really very hard question to answer, Richard. I'll tell you because the reason is that depending upon what size that, I believe, is going to come. I mean, I have seen some predictions last year, that number was pretty high and assuming the ASP, then we're talking about quite a substantial uptick for the total addressable market for gallium arsenide substrates. But recently, you see numbers are or I will characterize to -- well, first of all, we don't have an order, we're frustrated, but also even if the order were to come, I think the prediction is that it's going to be much smaller. So really, I think, also we hear from the rumor mills whether you're using it for the full 3D sensing or you're only using for facial recognition. So basically, there are 2 ways to use this VCSEL. One is a 2 big 100 VCSEL arrays and then a third one for facial recognition. And I think the big lasers, which will use a lot of substrates, we don't know where they are at this point. So you can do the calculation. The old calculation was something like 10,000 6-inch wafers per month. And you take the nominal cost or selling price of this. And there's a substantial uptick adjustable substrate markets. I mean, that's only a part of the cellphone that they plan to sell to, but we don't hear that number anymore. So...

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Gary L. Fischer, AXT, Inc. - CFO and Corporate Secretary [72]

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Yes, maybe a little bit slower, but -- so if you go out to 2019, we pass, in our mind, 2 critical hurdles, which, of course, we don't control. The first is the initial company is going to use this VCSEL, is the application broadly accepted. And then the second is do people like Samsung bring up their own version of the VCSEL program to just to stay competitive in the cellphone market. If those things happen, then we're talking a significant increase in the TAM for gallium arsenide. And we believe that all 3 players will have a tiger by the tail. So it's definitely going to be something has to be managed and it's going to take a lot of management talent and a lot of production capacity. But percentages and when they reach to that point, we don't know yet. I think you guys will figure it out as sooner as we do probably.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [73]

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I'll guess we'll see, but always great to ask you guys, you obviously have a great view point and in the food chain as well. But I appreciate the thoughts, guys.

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Operator [74]

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I'm showing no further questions at this time. I would like to turn the conference back over to Dr. Morris Young, Chief Executive Officer, for any closing remarks.

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Morris S. Young, AXT, Inc. - Co-Founder, CEO and Director [75]

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Thank you. Thank you for participating in our conference call. During the second quarter, I will be presenting at a 14th Annual Craig-Hallum Institutional Investor Conference in Minneapolis. And I hope to see many of you there. As always, please feel free to contact me or Gary Fischer directly. If you would like to meet with us, we do look forward to speaking with you in the near future.

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Operator [76]

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