Axt Inc Q3 FY2020 Earnings Call

Good afternoon, everyone, and welcome to AXT's Third Quarter 2020 Financial Conference Call. Leading the call today is Dr. Morris Young, Chief Executive Officer; and Mr. Gary Fischer, Chief Financial Officer. My name is Joanna, and I will be your coordinator today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. And as a reminder, this conference call may be recorded. I would now like to turn the call over to Ms. Leslie Green, Investor Relations for AXT. Ma'am, the floor is yours.

Thank you, Joanna, 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, market conditions and trends including expected growth in the markets we serve, emerging applications using chips or devices fabricated on our substrates, our product mix, our ability to increase orders in succeeding quarters to control costs and expenses, to improve manufacturing yields and efficiencies, to utilize our manufacturing capacity, the schedule and timeliness regarding our relocation, the growing environmental health and safety and chemical industry regulations in China, as well as global economic and political conditions, including trade tariffs and restrictions. We wish to caution you that such statements deal with future events and are based on 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, COVID-19 or other outbreaks of a contagious disease; potential tariffs and trade restrictions; increased environmental regulations in China; market acceptance and demand for the company’s products; the financial performance of our partially owned supply chain companies and the impact of delays by our customers on the timing of sales of their 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. These are available online by link from our website and contain 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 October 28, 2021. 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 third quarter of 2020. This information is available on the Investor Relations portion of our website at axt.com. I would now like to turn the call over to Gary Fischer for a review of our third quarter results. Gary?

Thank you, Leslie. As many of you are aware, Morris and I spend a considerable amount of time in China on behalf of AXT. But this year, because of the pandemic, we have been Zooming instead of flying. However, we are both currently in our Beijing offices, and it is about 4:30 in the morning. So we went through the mandatory 14-day quarantine when we arrived, which was a unique experience. And the whole process of getting the visas and the required COVID tests and all the rest was stressful. But we want our shareholders to know that we are glad to do it because we're excited about what's happening and about the opportunities that we see for AXT. So it's been a good trip and we're not leaving yet. We're still here. So now let's turn to the results of Q3. Total revenue for the third quarter of 2020 was $25.5 million, an increase of more than 15% from $22.1 million in the second quarter of 2020 and more than a 28% increase from $19.8 million in the third quarter of 2019. Of our total revenue, substrate sales were $20.3 million in Q3 compared with $16.9 million in the second quarter and $16.0 million in Q3 of 2019. So that's a good step up. Revenue from our raw material joint ventures was $5.2 million in Q3, down slightly from $5.3 million in Q2 and up from $3.9 million in Q3 of 2019. In the third quarter of 2020 revenue from the Asia Pacific was 70%, Europe was 17%, and North America was 13%. An interesting aspect of the Q3 revenue is that, even though revenue grew 15% quarter-to-quarter, we had no customer that reached 10% of revenue in Q3, which speaks to the diversification of our revenue base. The top five customers generated approximately 29% of total revenue. Gross margin in the third quarter was 34.6%, up from 30.6% in the prior quarter. The improvement in gross margin was due to a combination of higher revenue, product mix, some improvements in manufacturing, as well as strong performance from one of the two consolidated raw material companies. By comparison, gross margin was 29.0% in Q3 of 2019. Total operating expenses in Q3 were $6.6 million, up from $6.3 million in the prior quarter. Over 100% of the increase over Q2 is connected to some of the development work that we are conducting. SG&A actually decreased in Q3 by $124,000 and R&D increased by $480,000. Total stock compensation for the third quarter was $648,000. Operating profit for the third quarter of 2020 was $2.2 million compared with an operating profit of $478,000 in the previous quarter. Operating loss in Q3 of 2019 was $478,000. Other income net for the third quarter of 2020 is a charge of $59,000. This includes a net profit of $45,000 from the partially owned companies in the AXT supply chain accounted for under the equity method. This is noteworthy because it means that collectively these joint ventures turned profitable in Q3. We had a foreign exchange loss of $135,000 and a net gain of $31,000 in net interest income and expenses. Income tax for the third quarter of 2020 was a charge of $637,000 compared with a charge of $920,000 in Q2. Our Q3 results included approximately $320,000 in tariffs as a result of the 25% tariff charge on importing wafers into the United States from China. For Q3 2020, we had a net profit of $991,000 or a net profit of $0.02 per diluted share. By comparison, we had a net profit of $361,000 or a profit of $0.01 per diluted share in the second quarter of 2020 and a net loss of $900,000 or a loss of $0.02 per share in Q3 2019. The share count in Q3 was 40.979 million shares. Let's look at the balance sheet briefly. Cash, cash equivalents and investments were $29.8 million as of September 30th. By comparison, at June 30 it was $32.5 million. This is a decrease of $2.7 million, but actually operating cash increased by about $200,000. Let me explain why. You may recall that last summer, we took out a $5.8 million bank loan in China. That loan has now been renewed, but the bank requires that we pay back the loan and then they reissue it again. That's customer in China. So we paid the full amount back in Q3, but the bank issued half back in Q3 and the other half in October, which is our Q4. Our cash decrease would have been offset by the amount of $2.9 million that slipped into October and we would have been cash positive for the quarter. As a result, we continue to feel good about our cash management and our cash balance. Depreciation and amortization in the third quarter was $995,000 and CapEx was about $5.7 million. Net inventory at September 30 decreased by $1.2 million in the quarter and ended at $48.4 million. The decrease was a result of increased sales. Ending inventory consisted of approximately 48% of raw materials, 48% in work-in-progress, and 4% in finished goods. These portions stay fairly constant in our business model. Okay. I know I spoke fast, but this concludes our financial review. And now I'll turn the call over to Dr. Morris Young for a review of our business. Morris?

Thank you, Gary. We're pleased to report solid third quarter results with revenue and earnings above our guidance range. Our indium phosphide sales increased over the prior quarter, exceeding our expectations, and again surpassed our total gallium arsenide revenue. This was driven by meaningful growth in strategic applications such as 5G telecommunications, where we believe that indium phosphide is being used in the 10G laser interconnects and will also be used in the emerging 25G laser interconnects for 5G base stations. In related applications, we also saw strong growth in passive optical networks or PON. That delivered broadband network access to the end user. The power market is currently robust and seems to be reflecting the momentum of 5G adoption in many parts of the world, particularly China. With the build-out of new 5G services capabilities, the ongoing increases in bandwidth requirements and the acceleration of cloud adoption, demand for indium phosphide in hyperscale data centers continues. Remote work has also accelerated the migration of workloads from on-premise data centers to cloud. Some cloud providers have cited as much as a 30% increase in data usage. Our revenue from data center connectivity has been steady at a healthy level throughout 2020. We believe we're benefiting from both the overall growth in adoption of silicon photonics in the data center, as well as our transition from having a direct- indirect sales relationship with a Tier 1 player to a direct sales relationship. As a result of our ongoing qualification effort, we are excited to report that we began ramping up our direct sales in Q3. We believe that this is a validation of our ability to serve strategic high-volume applications and to meet the needs of some of the most prestigious exacting companies in the world. While market news is indicating that Q3 may be a softer quarter for the data center connectivity applications, we expect our sales in this space to be relatively steady through Q4. Looking ahead, as hyperscale data centers transition to faster, more reliable and scalable infrastructure, high-capacity connectivity will continue to be essential to keep pace with the ever-expanding number of users, devices, and applications. Some believe that the transition from 100G to 400G will happen faster than the move to 100G. We believe this is great news for the entire supply chain for data center equipment providers including AXT. As we have discussed, the low defect density and other key specifications of our indium phosphide substrates made them particularly well suited for a number of applications. To support what we believe will be a growing demand in 2021, we're investing in our own technology advancements. As Gary mentioned, we have substantial R&D efforts underway to bring this to the market of our six-inch indium phosphide substrates. AXT has long set the pace in our industry for the advancement towards larger diameter substrates and we are excited about our progress. Equally important, we are encouraged by the strong level of customer interest in larger diameter substrates as we believe this advancement will enable the market to ramp higher-volume applications. We're also investing in our manufacturing processes with increased automation and many other capabilities that will further improve our quality and consistency. All of these investments will benefit our ability to serve customers in our core applications of 5G, PON, and data centers. We are also positioning ourselves positively in new application categories, such as health care monitoring, consumer products, and LiDAR. Turning to gallium arsenide, we had another solid quarter with sales growing from Q2, driven by improving LED revenue from automotive and other applications. This growth spans multiple customers some of whom are building volume with us once again, now that our move is largely completed. We also saw continued demand from wireless applications driven by a variety of IoT applications, including Wi-Fi devices. As we mentioned last quarter, it is difficult to predict the enduring strength of the increased demand, but we do believe that gallium arsenide is going through a resurgence of development activities. Collectively, gallium arsenide applications appear to be poised for substantial growth in the next couple of years. New applications may include world-facing cameras, augmented and virtual reality, automotive sensors, biosensors, and more. On the horizon, micro LED may follow as the next major volume driver for gallium arsenide chips. Micro LED, which should not be confused with mini LED, use one red, one green, and one blue LEDs for each pixel. The modular nature of the micro LED is expected to allow them to scale from wearable devices and handheld devices to very large screens like high-end television of the future. They will consume less power, provide sharper contrast, and produce brilliant lighting and colors. This is an exciting space that will add significant new value to the LED market in 2024 and beyond. Tier 1 players are already driving this development and we believe that our wafers are being used for early-stage activities. Similar to indium phosphide, customers in several gallium arsenide applications are also expressing real interest in larger diameter substrates. As such, we also have a significant R&D effort underway to bring 8-inch gallium arsenide to the market. Once again, our VGF technology is highly suitable for the requirement of producing larger diameter substrates and we look forward to reporting our progress to you. With the amount of growth opportunities across our portfolio, our capability to expand our manufacturing capacity has never been more valuable or timely. I'm very proud of the continued ramp of our Kazou and Dingxing facilities which have now become significant competitive differentiators. In Q3, we had another important milestone in the transitioning of our manufacturing to these locations. One of our largest gallium arsenide customers who has been ramping its volume from Dingxing since early this year is now taking 100% of its volume from our new facility. Customers such as this one and others that continue to ramp are reporting an improvement in quality and consistency as the benefit of our new state-of-the-art lines. With this significant milestone, we're confident that we will have approximately 75% or more of our gallium arsenide revenue coming out of the new facility by the end of Q4. In addition, another Tier 1 customer conducted a week-long visit to our AXT and visited our Beijing site, Kazou site, and Dingxing site, our two new manufacturing sites. They have employees in China, so international travel and quarantines were not an issue. And finally, turning to raw materials, we have two companies that we're consolidating our revenue. Sales from these companies were approximately consistent with the prior quarter. In particular, our joint venture Bo Yu, which manufactures high-temperature PBM crucibles and other products, continue to see healthy growth. Jin Mei, our gallium arsenide joint venture is also positioning improving sales results as gallium arsenide continued to increase in its volume. In addition, as Gary mentioned, we're pleased that joint ventures for which we account using the equity method also collectively contributed positively to our net results in Q3. In closing, we are excited to see so many of our applications and customers' opportunities for which we have been preparing for over the last two years that are now taking shape. The materials we produce are proving to be an essential part of many of the technologies that will define advancement in telecommunications, networking, healthcare, consumer products, and other verticals for many years to come. In addition, we're making a concerted investment of time and resources to elevate our business and manufacturing processes to meet the rigorous standards of several ongoing qualifications that are expected to provide incremental opportunities in 2021. With the gallium arsenide manufacturing relocation now largely being behind us and the success of our effort clearly evident in customer acceptance, our new facilities are now poised to be a cornerstone of our growth and market differentiation. We believe we've positioned ourselves for an exciting new year ahead. This concludes my prepared comments. I will now turn the call back to Gary for our fourth quarter guidance. Gary?

Thank you, Morris. As Morris discussed, the demand environment remains healthy, with a number of growth drivers leading the way. While Q4 is typically a seasonally down quarter for us, we believe that we can achieve results in line with or even a bit better than Q3. As such, we expect to see revenue in Q4 of between $25.0 million to $26.0 million. We believe that our net profit will be in the range of $0.01 to $0.03. Share count will be approximately 41 million shares. Okay. This concludes our prepared comments. Morris and I will be glad to answer your questions. Joanna, do you want to handle the Q&A please?

Sure. Thank you so much. We have a question coming from the line of Richard Shannon from Craig-Hallum. Your line is open.

Hi, guys. Thanks for taking my questions and Gary and Morris, thanks for getting up so early in China. Maybe, I'll probably ask a question, I can probably guess most of the answer. But on the fourth quarter guidance here we're expecting revenues maybe flat to perhaps slightly up here. Can you kind of give us a sense by your substrate types and raw materials, how we're expecting things to move sequentially? I'm guessing indium phosphide will be up, but wondering if you could help us with the other dynamics.

Yes. I think, indium phosphide will be up. I think, wireless is probably going to be down slightly and semiconducting LEDs will be up. And raw material is going to be flat and germanium is going to be down slightly. So indium phosphide is going to be up.

Okay. That's helpful. And maybe a couple of quick questions on the guidance here as we get down to the bottom line, you’re talking about $0.01 to $0.03 here. Any help you can give us on gross margins here? I would assume that we could probably see gross margin flat up from the third quarter. And then, you talked about OpEx being a bit up here, I think, $6.6 million up a bit from last quarter and the trend here recently. Are you expecting continued investment in R&D for these new manufacturing processes to sustain for a while?

Yes. So a couple of comments. First of all, on gross margin, we made a good step up. We've been saying most of this year that we think we can get back to the mid-30s. I think it's probably wise to just sort of keep it flat from Q3 to Q4. Don't get carried away. But we're pleased with the mix and the yields and things like that. So it's definitely coming into line with what we expected. OpEx will be a bit higher for a couple more quarters. So $6.6 million, $6.7 million somewhere in that range I think. And then we'll try and unwind it a bit going forward, but not right now. So this is all because of R&D. So it's a good thing that's happening.

Yes, I have a few more questions, but I will let others chime in after this. Morris, as we look toward the fourth quarter, you mentioned that datacom remains stable, and there's a shift from an indirect to a direct relationship with your customer. Can you elaborate on the actual demand from this customer compared to any inventory fluctuations that might obscure the true demand environment for you at the moment?

Yes. From our perspective, I think we're seeing the demand sort of being steady. But as we sort of redirect their supply line from indirect to direct, if we put the summation together, they are sort of steady. But as we see the order book Q4 is still steady. But as far as the inventory is concerned, we don't have that much of a visibility, because that company is a very large company, so they could build inventory or they could be depleting their inventory. So we don't really know that.

Okay. That's fair. I have a couple more questions. We haven't asked about this in a while, but I'm curious about your thoughts on 3D sensing. It seems like you're making good progress with moving customers into the new facility, with some being completely transitioned. What are your expectations for 3D sensing as we approach next year, particularly regarding the Android and potentially the Apple ecosystem?

Yes, I think we're excited about the new facility. I think all the reports we have more than one customer telling us that their device yield rate is actually higher from the new facility than the old one. We are still collecting data and see, which specifics have made improvements, and we're going to further do more improvement. And also, our manufacturing yield actually is better for our new facility than the old one. And so with this new set of information, we definitely will use that as a very strong data point to knock on the doors of the VCSEL 3D sensing opportunities going into the next year, definitely.

Last question, I'll step back from the line here. You mentioned improvements in your statistical process control for manufacturing last quarter and again this quarter. Additionally, you hinted at potential new customers for next year. Can you share what specific materials you're referring to and any insights about the applications that may arise from these customers interested in the new manufacturing quality process?

Yes. Actually, this process is going on with both gallium arsenide and indium phosphide, interestingly. One large indium phosphide customer that we're dealing with we have a set-up direct lines from our technical support to their purchasing guys, who really tell us exactly what they need us to do so that we can either direct our research and development to that, or buy extra metrology equipment to see what exactly they can see out of their yield. So that will help us a lot. And we expect several machines that we're purchasing will be online shortly and that also increased our research and development budget. So I think we're all excited about it, and we're paying ahead in the front end. But I think the new customers that we're developing are all Tier 1 customers. And they when they know that we're doing exactly what we're developing with the existing customer they are excited. And we will be sort of solving the problem ahead of the schedule for their product ramp. So the answer is it's both gallium arsenide as well as indium phosphide.

Appreciate the perspective. I'll jump out of the line. Thank you guys.

Thank you, Richard.

Thank you. Your next question comes from the line of Gus Richard from Northland. Your line is open.

Yes. Thanks for taking the question. Just in terms of gross margin in the fourth quarter it sounds like you're going to have a more favorable mix of indium phosphide plus flat to up volume. Can you just give a little bit of color on puts and takes on gross margin in the fourth quarter? I would expect based on your commentary it should be flat to up.

Yes, I believe you understand us well, so you are right on track. I just want to keep expectations modest because that's how we operate.

I’m excited about the results we’re seeing from our new factory, which is improving our yield. We're also making progress in crystal growth, but that process takes longer since it involves longer growth times. Tweaks in crystal growth adjustments take more time compared to wafer processing, where each cycle is shorter. I believe we can achieve further improvements in crystal growth over time, and product mix significantly impacts our outcomes. Additionally, as we stabilize our labor force after shifting to fewer manufacturing sites, I expect we’ll see some efficiencies gained there as well. Would you agree?

Yes, I agree. Yes. That's good color.

So moving into 2021 I think your margins a couple of years ago peaked in the high 30s, close to 40. Is a thought of mid- to high 30s reasonable guess for next year?

I haven't done a detailed analysis for next year yet because we have been quite busy. There will be some factors to consider. I'm happy to provide more insights when I have a clearer picture. However, I would advise everyone on your side of the business to avoid being overly aggressive. Let's wait and see how things unfold.

Okay. And then just final one on indium phosphide. It sounds like it's going to be up sequentially in the fourth quarter. Is that driven more by PON or more by silicon photonics?

It's definitely more than from PON. We were seeing very strong demand out of the PON.

Okay. Got it. I’ll jump back in line. Thanks.

Thanks, Gus.

Thank you. Your next question comes from the line of Hamed Khorsand from BWS Financial. Your line is open.

Hi. I just wanted to understand. You were talking more about the larger diameter substrates. Is that going to lead to a higher CapEx spend next year? And how far along are you on those projects?

That's a good question. I think our capital expenditures are more focused on facilities like DI water and cleanroom construction. Most of that spending is behind us, and we have built more than enough capacity. Regarding equipment, I believe the additional spending won't be as significant. Additionally, we will only purchase equipment when we have business opportunities, which will occur after we complete the development.

Yes. So to be specific, again we haven't done hard numbers yet, but we believe CapEx will trend down next year and it will switch. It's going to be less facilities-related and more equipment and tuning up related. So we are excited about some of the things that are on the list. There's some metrology stuff, some surface measurement things that we're investing in at the request of some of the larger customers. Our whole team is excited to take these steps but it's not going to make CapEx be higher than 2020.

And we're also doing a lot of automation. I think that will help us. I mean maybe spending a little bit more money on the front end buying automated equipment. But on the delivery side, we have better quality and more consistent quality that will help us on the back end.

Okay. And then on the going direct to customer is that going to be a normal event for you? Are you going to go after other larger customers directly instead of going through middle people?

No, that is not our initiative, it's customer specific. They wanted it. It's that we're driving it.

Yes. The key thing to understand is what enables the specific customer we're thinking of to do this is that they have their own API capability. So if a customer doesn't want to do API then they're not going to probably buy direct from us. They're going to buy from the API houses.

Okay. That’s it for me. Thank you.

Good to hear from you Hamed. Just good luck on your stuff, though.

We have another question from Ailon Bushan from Nanocap Growth Fund. Your line is open.

Hi guys. Excellent quarter. Good to see you're making progress growing revenues again. I have a question regarding: have you made any progress or continued exploring a possible listing on the Star Exchange in China?

We have looked into the potential listing on the Star Exchange in China and are aware that it has been brought up by several individuals in your community. I've dedicated a significant amount of time to researching this topic, which I find quite intriguing. While I can't provide many details at this moment, I'm happy to share more information as we learn further. I understand that you've mentioned this, and others in the fund management sector have also expressed interest in the Star market.

Okay. Regarding a large company like Apple, who I assume likely sources some of their high-purity indium phosphide or gallium arsenide from Sumitomo, is there another possible supplier besides you that could meet the specifications they would need? Are you the only potential alternative supplier available to them in the future?

I think we are number one in market share for indium phosphide. We believe we have an advantage over our competitor in terms of quality and, most importantly, capacity—the ability to meet demand if they increase production. We take pride in our indium phosphide capabilities. Now that we have developed 6-inch capability, we believe we are ahead of the competition. Regarding customers' choice to use multiple suppliers, we do our best to attract them to choose us, while always being mindful of our competitors.

Okay. I appreciate that. And lastly on the Investor Relations front, I think three months have passed and we haven't seen a single press release or anything really the company communicating with the market other than through analysts on what's really going on during these time periods. Is there anything new that you plan to do to increase awareness of the company and the uniqueness of your business?

Yes, there is. Several members of the investor relations community have suggested that we should take a more proactive approach. We have a couple of initiatives that we have been working on, but to be honest, our focus shifted when we arrived in China. The chance to visit China came about due to a new set of visas we received. Typically, we have visas for China, but they were all suspended, which required us to go through a significant process to obtain new ones. This included COVID testing and a quarantine period, and we have extended our stay here. Both Morris and I will be here for a couple of months. There has been a lot happening, but we believe there is much to share and promote, and we have a strategy in place for that, so you will see some of it coming soon.

Yes. Our traditional style is how many times you can announce a 6-inch indium phosphide, right? And yet, if we announce a larger diameter, that probably will last for a long time. But we do hear you. I think we do need to promote ourselves a little bit better and we are working on it.

Okay. Thank you. I appreciate it.

But we hear you and we accept the challenge and we're going to do more.

We have a follow-up question from Richard Shannon from Craig-Hallum. Your line is open.

Hey, guys. Just one quick question on a follow-up on CapEx. Gary, can you give us a sense of what you're thinking about for CapEx for the fourth quarter? And then you said you don't expect it to be higher in 2021. Can you give us a sense of what you're thinking here? And then kind of longer term, if you look before 2017 you're kind of averaging low to mid single-digit millions per year in CapEx. When do we get down to that level again?

Yes, I think Q4 won't exceed Q3. It will likely decrease a bit and continue to trend down. As for getting back to single-digits, I haven't analyzed it thoroughly, but probably not next year. Next year will likely still be in the low double-digits. However, the following year could potentially reach single-digits. We also need to consider the market trends that Morris mentioned earlier. If those trends prove beneficial for us, we would require more resources and consider the level of customers we are targeting. For instance, we are acquiring a machine that a customer specifically requested. So, while I think we might drop below double-digits by 2022, I haven't conducted a comprehensive analysis yet.

Yes. Let me try to chime in here. I think you're right. I mean in normal terms we have couple years our CapEx I think is in the $5 million to $6 million a quarter range? a year. And then we stepped up of course with the new factory. But I would say, if our CapEx keeps on going that must mean that our customer is coming. And with the new facility already built ahead of that time, so the more CapEx means more machines that actually will increase our capacity. I think it's good news rather than bad news.

Yes. I want to emphasize again what Ailon mentioned about clearly communicating our vision. Our significant investment in state-of-the-art facilities provides us with a competitive edge. The ability to quickly increase our capacity will be very attractive to large customers who anticipate a rise in their own demand. If these factors align, our capital expenditures will likely exceed our historical averages, but it will be for positive reasons, and we will all celebrate that growth.

Okay. Appreciate the perspective guys. That's all for me. Thank you.

All right. Good luck to you. Joanna?

Yes, sir. I am showing no further questions at this time. I would like to turn the conference back to Dr. Morris Young, CEO.

Thank you for participating in our conference call this quarter. We will be taking part in the 11th Annual Craig-Hallum Alpha Select Conference on November 17. As always, please feel free to contact me, Gary Fischer, or Leslie Green directly if you would like to set up a call with us and we look forward to speaking with you in the near future.

Thank you speakers. Ladies and gentlemen, this concludes today's conference call. Thank you all for joining. You may now disconnect.