Axt Inc Q3 FY2022 Earnings Call

Good afternoon, everyone, and welcome to AXT's Third Quarter 2022 Financial Conference Call. Leading the call today is Dr. Morris Young, Chief Executive Officer; and Gary Fischer, Chief Financial Officer. My name is Andrea and I'll be your coordinator today. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Leslie Green, Investor Relations for AXT. Please go ahead.

Thank you, Andrea, 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 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, 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 outbreaks of other contagious diseases, 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 and 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 27, 2023. Also, before we begin, I want to note that shortly following the close of the market today, we issued a press release reporting financial results for the third quarter of 2022. 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, and good afternoon to everyone. Revenue for the third quarter of 2022 was $35.2 million, which is down from $39.5 million in the second quarter of 2022, but up from $34.6 million in the third quarter of 2021. To break down our Q3 '22 revenue for you by product category; indium phosphide came in at $17.7 million, gallium arsenide was $8.1 million, down from Q2 by about $4 million, which reflects the overall slowdown in the marketplace. Germanium substrates were $1.1 million. Our germanium substrate revenue was down by about $2.7 million from Q2, partly due to the general slowdown we observed and partly due to the payment issue we described last quarter. We expect to resolve that situation in the near future. As of today, we're not shipping to the customers in question. Finally, revenue from the two consolidated raw material joint venture companies in Q3 was $8.3 million. In the third quarter of 2022, revenue from Asia-Pacific was 67%, Europe 14%, and North America 19%. Top five customers generated approximately 41% of total revenue, and one customer was over the 10% level. Non-GAAP gross margin in the third quarter was 42.2% compared with 39.4% in Q2 of 2022 and 33.8% in Q3 of 2021. For those who prefer to track results on a GAAP basis, gross margin in the third quarter was 42.0%, compared with 39.1% in Q2, and 33.3% in Q3 of last year. As you can see, we continue to execute well on gross margin, despite lower volumes in Q3. Our favorable product mix, improved yields, and new indium phosphide recycling program all contributed to strong results. Total non-GAAP operating expense in Q3 was $9.2 million. This compares with $9.1 million in Q2 and with $7.7 million in Q3 of 2021. On a GAAP basis, total operating expense in Q3 of 2022 was $10.2 million, compared with $10.1 million last quarter. For comparison, total GAAP operating expense was $9.1 million in Q3 of 2021. Non-GAAP operating profit for the third quarter of 2022 was $5.6 million compared with non-GAAP operating profit in Q2 of 2022 of $6.4 million and $4.0 million in Q3 of 2021. For reference, GAAP operating profit for the third quarter of 2022 was $4.6 million compared with an operating profit of $5.3 million in Q2 of 2022, and an operating profit of $2.4 million in Q3 of 2021. Non-operating other income and expense for the third quarter of 2022 was a net gain of $2.7 million. This includes a gain of $2.0 million from the unconsolidated raw material companies. The full breakdown is in our press release. For Q3 of 2022, we had a non-GAAP net income of $6.8 million or $0.16 per share, compared with $6.7 million or $0.16 per share in the second quarter of 2022. Non-GAAP net income in Q3 of 2021 was $5.4 million or $0.13 per share. On a GAAP basis, net income in Q3 was $5.8 million or $0.13 per share. By comparison, net income was $5.5 million or $0.13 per share in the second quarter of 2022, and $3.8 million or $0.09 per share in Q3 of 2021. The weighted average diluted shares outstanding in Q3 was $43.0 million. Cash, cash equivalents and investments were $48.2 million as of September 30. By comparison, at June 30, it was $57.2 million. Depreciation and amortization in the third quarter was $2.1 million and capital investments were $4.7 million, mostly related to facilities. Stock comp was $1.0 million. Net inventory at September 30 was at $88.5 million, with 50% of the inventory being raw materials, 46% WiP, and finished goods making up 4%. This concludes the discussion of our quarterly financial results. Turning to our plan to list our subsidiary Tongmei in China on the STAR market in Shanghai, let me just give you a brief update. As previously reported, our IPO application was approved by the Shanghai Stock Exchange in July, and was then submitted to the China Securities Regulatory Commission, which we often refer to as the CSRC, in August for the next step in the review process. We have had feedback from the CSRC in the form of questions, and our advisors believe the questions were normal and customary. We hope to get CSRC approval soon, and Tongmei hopes to accomplish the offering as early as Q4 2022. This has been a long process, but we remain very enthusiastic and optimistic. We have posted a brief summary of the plan and the process on our website. Before I turn the call over to Morris, I want to take a moment to address the topic of export control restrictions with China, since some of you have asked. We have extensively studied the new restrictions and guidance, including consultation with our legal experts. As such, we and our attorneys have concluded that the new restrictions are not applicable to our products, equipment or manufacturing process. We do not expect to experience disruption as a result. Okay. With that, let me turn the call over to Dr. Morris Young for a review of our business and markets. Morris has been in China and is there right now. So he got up very early in the morning and it still is early in the morning there. Morris, go ahead.

Thank you, Gary. And well, good afternoon, everybody. Though a softening of the microenvironment reset our growth trajectory, the trends that have driven our revenue customer application expansion remain very much intact. Despite this setback, our Q3 results demonstrate several key things. First, indium phosphide is expanding and becoming an increasingly strategic material across the landscape. Second, AXT has continued to make meaningful sustainable progress in driving our gross margin performance. And third, we are successfully supporting the business, technical, and quality requirements of some of the most discerning Tier 1 companies in the world. These three factors underscore our firm confidence that our business has reached a turning point. The tide of innovation that is driving the expansion of applications for all materials we create is lifting our baseline opportunity. Even in the softer demand environment, more importantly, AXT is thoroughly positioned as a leader. Our product quality and technical capability have created a standard of excellence that is increasingly difficult for competitors to match, as evidenced by our market share gain in indium phosphide. Our Q3 indium phosphide revenue grew 12% over Q2 to set a new high for quarterly revenue. This is also a 48% increase over Q3 of 2021. Driving our growth was the ramp of two consumer applications that contributed meaningfully to our results and in line with our expectation coming into the quarter. As we mentioned previously, the first is the proximity sensor for audio devices and the second is the endo-gas sensor for high-end headsets. We're shipping into both applications in production quality. The strong performance in consumer was offset by a weakness in power and telecommunications applications, particularly in China. The data center market was also moderately weaker than we expected going into the quarter. The majority of the revenue shortfall in Q3 came from gallium arsenide. Industrial lasers and LEDs for automotive and wireless handset applications were all down in a meaningful way. Much of this is related to China where customer conservatism towards future demand, coupled with COVID and weather-related shutdowns within the supply chain resulted in a steep drop in orders. We're confident this is not a loss in market share, as we are not seeing customers canceling orders; more commonly, they are delaying or placing orders in place. In other cases, this is to get a better picture into future demand. In other cases, it may be the result of a shortage within the supply chain. We see this issue persisting through Q4, but because of the rapid decline in the second half of 2022, improvement in the demand environment or the supply environment could result in a relatively quick recovery in FY '23. This is also important to note that we continue to see a meaningful amount of development work happening for new applications in both indium phosphide and gallium arsenide. Customers are highly focused on new innovation; we believe that this will contribute to some exciting new use cases for our substrate in the coming fiscal year, including consumer and healthcare monitoring. A bit further out, microLED applications are growing increasingly more promising. We would not be surprised to see noticeable revenue in FY '24. In terms of our own innovation, I'm pleased with the progress we are making in both 8-inch gallium arsenide and 6-inch indium phosphide material. Our R&D investments are allowing us to ensure that we are ready to meet the market when applications for this larger diameter move closer to production. Finally, revenue from our two consolidated joint ventures was about $8.3 million in Q3. We expect the softer demand environment to bring sales down in Q4, mostly from GMA. That is as a result of raw material prices coming down and ongoing customer conservatism. We expect that those who make PBM crucibles are likely to remain steady. In closing, despite the setback of a weaker environment, we have made enormous progress in our business, and we are well positioned to weather the near-term softness. Today, we are the world leader in indium phosphide and we are the company that Tier 1 customers come to when they are bringing new innovations to market. We continue to raise the bar, our technical capability and our quality creating clear differentiation with our competitors. Further, we have worked hard to improve our efficiency, and as a result, we are delivering solid profitability. Over the coming quarters, the environment will do what it will. Though we will diligently manage our business through it, our eyes are on the horizon because the massive trends that will continue to transform the landscape of technology are not going away. AXT will be the leading supplier of many of these materials. I will now turn the call back to Gary for our fourth quarter guidance.

Thank you, Morris. That said, we expect Q4 revenue to be between $26 million and $29 million, which reflects our view that the inventory corrections will continue during the quarter. As such, we expect our non-GAAP net profit will be in the range of $0.03 to $0.05, and GAAP net profit will be in the range of $0.01 to $0.03. Share count will be approximately 43.0 million shares. Okay, this concludes our prepared comments. Morris and I will be glad to answer your questions now. Andrea, please go to Q&A.

Thank you. Our first question comes from Charles Shi with Needham and Company. Please go ahead.

Hi, good morning, Morris, good afternoon Gary, Leslie. Maybe first question, I want to ask you how to reconcile what we heard from your number one customer at the epi house in Taiwan. That particular company recently said they are quite bullish about the 5G and fiber rollout in China next year. And they think 2023 will be a growth year for them. What is your thought on business going into '23? I know fourth quarter '22 seems like the correction will continue, but into '23, are you seeing a similar trend as your number one customer, especially on the telecom and the data com side? Thank you.

Let me take this first, Gary. Yes, Charles. I think indeed we think indium phosphide will continue to grow. Although I think Q4 is taking a slight dip, I think the trend of indium phosphide growth is going to continue. I think not only telecom and datacom will be growing into 2023, but also the consumer product, I think is going to not only continue to grow. Hopefully, we're going to pick up one or two more new consumer product applications, which as you know, could be quite accelerating growth because it's a new product.

Yes, I'll add to that. That particular company is a long-term customer of ours, and we feel very strong with them, and we expect to continue to serve their needs.

Got it. Can you provide the total revenue opportunity you're seeing from the current consumer application and the second one? What feedback are you receiving from the end customer? What is the overall revenue opportunity during this smartphone cycle? Have there been any recent updates to the forecast they shared with you in the last few weeks or months? While you mentioned that the trend of indium phosphide growth will continue, I'm curious about the significant downward adjustment in your Q4 growth guidance and whether this might affect the ramp-up speed for the second consumer application in Q4.

Yes, I don't think there's a slowdown in the demand for the second consumer product in Q4. I believe the slight downturn in indium phosphide demand is mainly from our other China customers, which unfortunately we don't know exactly what they are doing. It could be data count, it could be the pounds market, etcetera. But definitely this particular customer is not slowing down. In fact, if I may add, I think they are only using on the high-end of the whole market in their first launch this year and hopefully, later on they are going to use it in the whole spectrum of product offerings. So we do expect perhaps the demand for this product on the second product to go up next year.

Yes. So maybe just to clarify, this is going to be my last question. To clarify, you are optimistic about two more consumer applications. Thus, the proliferation of the indium phosphide-based dispenser into the - well, that's their low-end product, but in the market, probably considered mid to high-end. Is that accounted as a third application or are you talking something completely different when you talk about the two more consumer applications there?

No, that's not considered a new win. We think that's probably going to increase the demand. But we haven't talked to the customer yet in terms of how much they want us to prepare because this is still early for next year demand. But I'm talking about possibly we can pick up one or two more new consumer product applications. As you know that we have at least two products sort of in the queue but we are not sure, especially with the world economy shaping up like this, when they are going to introduce this new product. Thanks, Charles.

Thanks, Charles. Next question.

Thank you. Our next question comes from Richard Shannon with Craig-Hallum Capital Group. Please go ahead.

Well, thanks, Morris and Gary for taking my questions. Let me ask just very specifically on the fourth quarter guidance here. You obviously talked about EBITDA down a bit. The overall number here at the midpoint is down a little bit more than 20%. Can you delineate the other categories how they're doing relative to the midpoint? I'm assuming gallium arsenide and maybe raw materials are down more than average, but maybe Gary, if you could delineate that a little more closely, that'd be great, please.

Yes. Well, we're trying to be conservative first of all. Secondly, we're uncertain about when the market is going to bounce back. But I don't think anyone on this call or in the tech business thinks it's going to bounce back in Q4. Therefore, we've forecasted all of the products to be down. A significant drop in raw materials. So, raw materials have been running about $8 million and that alone will be down to at least 25%. I think it's just reflective of the overall slowdown in the markets. So, as I said to our team, it's a good thing we're grown up because it is what it is. We can't change the whole marketplace, and it shifted on us. I wouldn't say overnight, but it was a very dramatic and rapid shift during the summer. We don't know when it will bounce back. Hopefully, it will be in Q1, but we'll have to get closer to Q1 before we'll know for sure.

Gary, I want to add to the point is that, I don't think we're losing market. That's very important to underline. Our underlying strength for the future remains solid. This new factory adding capacity, low EBD and response signals, as you can see that over the past five for the second new consumer product, we ramped our production very successfully. We didn't lose a stride. I think they are really making good marks to our most demanding customer. We think we are stronger and better than any time we are in the industry, but semiconductors unfortunately are difficult. When people are worried about supply, they buy a lot, and when they say scares or recession is coming through, then everybody wants to use their inventory. I mean the same thing for us. You see, we built some inventory, and it's going to take us a quarter or two to bring it back down. Then we're not going to buy from our customers. So the nature of the business, I would say.

That's very fair. Thanks for that commentary. My second question is on gross margins. I want to talk more about both the third quarter and then kind of the view into the fourth year. So you've talked in the past about volume being a fairly important indicator of gross margins and you obviously had a shortfall in your best gross margins ever. Clearly, the indium phosphide mix is helping a lot. Maybe you could delineate any other drivers here in the third quarter that helped you? And are there any things that can help you further such as recycling or yield improvements? Do those have more likes to grow out? And then as we look forward here, particularly with the much lower volumes, how do we think about gross margins? Can we look back at quarters of similar revenue and see it in that range? Or how do you help. Gary, can you help us think about - where to think about gross margin truly out in the fourth quarter?

Certainly. In our business model, there are multiple factors that influence gross margins rather than just one. Product mix is an important element, which is the first thing that comes to mind when considering the improvement in gross margin. Another contributing factor is our new indium phosphide recycling program, which we began testing in the fourth quarter of last year and moved to early production levels in the first quarter of this year. By the second quarter, we reached general production levels, and in the third quarter, it provided even more financial benefit than in the second quarter. This not only supports gross margin but also aligns with our sustainability efforts in recycling. Additionally, we have seen improvements in our yields, and overall, our manufacturing efficiencies are enhancing. The team has been solid, and I believe we are going through a stabilization period at our new sites, contributing to these efficiencies and yields. In the third quarter, we experienced a lot of positive trends across the board, which isn’t always the case. This allowed us to achieve a GAAP gross margin of 42%. Looking ahead, I see more potential for improvement in product mix, yields, and manufacturing efficiencies. We also have additional recycling strategies in development that we’re not ready to disclose. However, while we don’t expect to maintain a gross margin in the 40% range for the fourth quarter due to lower volumes, I believe a range of 37% to 38% is achievable. I haven't analyzed next year's gross margin prospects just yet, but I am confident we have several promising initiatives underway that will benefit us moving forward. What’s your next question?

For me, I reported a 10% customer. Is this a new customer or one you've had as a 10% in the past?

It's one that we've had before. We expect that there could be 10% going forward. They'll continue to be strong; they are servicing the consumer applications that we've touched on.

Okay, I figured that was the case. Okay, that's all for me. I'll jump on the line, thanks.

All right, thanks, Richard.

Next question?

Thank you. Please standby for our next question. Our next question comes from Hamed Khorsand from BWS Financial. Please go ahead.

Hi, my first question was how are you adjusting the business given the decline in revenue, but your inventory has been increasing quite a bit now. How are you going to adjust for that and to generate some free cash flow?

Well, first of all, let me assure you that we're very aware of what's happened to the inventory. It evolved because we were running really hard to keep up with demand, and we were deliberately building inventory, then things shifted pretty dramatically. So, we're very aware of it. Let me point out again that in our inventory right now, 50% of it is raw materials and 46% is WiP; only 4% is finished goods. I'm not worried about having to write down the inventory or anything like that. The way we're going to have to bring it down, which we will, is several things. Number one, I've already been communicating with my teammates in China and informing sort of a SWAT team to monitor inventory closely. Of course, we'll stop purchasing as much, because we have too much now. I think we can bring it down over the next couple of quarters, but it will help with cash, yes. Unfortunately, I think we're mirroring what we've seen in our customers. They're trying to manage their inventories also, so they stop buying as much. We are actually in the same position. We've been talking about this, and I've been in these situations before, and you know, there's a saying I use, 'If you want to change something, measure it.' So I'm looking at different ways to measure different things in the inventory and communicate that to the team and get everybody's attention. I feel it's an achievable goal to bring it back down.

Okay. I think what I'm trying to get to is also how are you adjusting to this environment? Because in Q2, you were doing something in the realm of 40% or 50% more in sales revenue per month than what you're guiding to now. That's quite a bit of an adjustment you would have to make. Are you putting people on leave, or how are you just doing the manufacturing there?

We're not putting people on leave. We're not hiring anybody either. But, you know, I think it would be detrimental to our mid-term in the future if we start jettisoning employees. We expect the market is going to come back. And when it does, we're going to be ready. In the meantime, we'll try and trim expenses; we'll try and improve efficiencies. We have a lot of dry powder of things that we can do to manage the business. We've considered whether we should do layoffs, but at this point, no, we're not going to.

Yes, one of the things we obviously are doing is, as you know that during the very busy time, we were asking people to take a lot of overtime and forfeit their vacations, etc. So now we're in a slower time. On the slower segments such as gallium arsenide and germanium, we either shift part of them to work in indium phosphide, because that's still quite busy. We're still building future capacity for the expected demand increase next year, but also we do encourage people to take their vacations as much as possible in preparation for the next run-up to the high demand later.

And my last question is, how would you describe the clarity that you have in the business right now?

You mean about the marketplace and the picture?

Yes, I think we are as clear as we can. Although the market is down, as we said, I don't think we're losing market share. Customers are out there. In certain segments, the demand is still strong; but we're covering a lot of business. For instance, nobody is happy to see that our guided revenue going forward is going down so much. On the other hand, part of it could very well be the gallium price erosion. I mean gallium price came down almost 20% and it's still going down maybe 10%. One of our joint ventures, JinMei, who sells gallium, did buy and sell gallium. If the gallium price is low, then their revenue comes down. It has nothing to do with other revenue coming down so much because in JinMei's business, we are refining it to high purity. It doesn't really hurt our business. When prices go down, people don't want to buy because they don't want to step into something that’s going down further. So why do I buy it a month later? This may be working to bring down inflation, so to speak. As far as the rest of the factory, we are holding our heads up quite a bit. We’re busy, very busy preparing for the IPO process. We still have a lot of R&D work. They're working very hard on doing 8-inch gallium arsenide and 6-inch indium phosphide development. The team spirit is high as I can say.

I agree.

Thank you. Please standby for our next question.

Okay, guys. Thanks for getting me back in the queue here. I guess two questions. First of all, Morris, you talked about microLED and you could imagine a scenario where it picks up in calendar '24. Can you give us more detail on what you're hearing and what you're engaged with the customers? My understanding is if that picks up nicely or you greenlight something there, you'll probably have to have some more capacity. How far in advance do you need to know about this before you get your capacity in place for such a build in that year?

Yes. I think we're increasingly more optimistic because it's shaping up nicely. I think the customers are making their commitment. As you know, one of them is building a very large factory down in Malaysia. Yes, indeed, we are seeing the demand curve really start to pick up in 2024, and we're making all the preparation for it. The demand in volume is fragile. I think it's going to start by several hundred wafers per month next year. We are already delivering some samples to our customers already. They are evaluating the performance of it. We expect between the two of us; our customer has asked to tweak the specifications that they want. It would take us some time to build a new factory for the capacity to deliver that increasing demand. We are working on it and expect to be able to deliver 5,000 wafers per month by the middle of next year. We expect it to further increase to close to 10,000 or 12,000 wafers a month in early 2024.

Okay, perfect. And just a quick follow-up on that topic, Morris. When do you expect your 8-inch wafers to intersect with that opportunity?

What do you mean? I mean, we're building a capacity for 8-inch.

The numbers are 8-inch wafers.

Got it.

Okay, perfect. Thank you. My second and last question here is on indium phosphide. I think you've talked about capacity here, and while the revenue seems to be going down a little bit in the fourth quarter, you've got some positive comments about new applications or additional volume in current applications in the consumer space. Where do you sit in terms of utilization of your capacity, and do you need to build more in the near term or next year?

Yes. Still fairly tight, and maybe Q4 is going to give us a little bit of a breather. We are still building capacity in anticipation for the volume ramp-up next year. We could be overbuilding. A lot of this buildup in capacity is in our own initiatives because we have to anticipate what our customers really want. Most of them give us at least three months' advance notice. But some customers, for instance, one is doing parallel development and they expect results back in, the last time we talked to them, about mid-next year. Whether they're going to come successful asking for more product on that? Obviously, we're going to be very close with them. As time goes closer, but for us to increase indium phosphide capacity is not as easy as gallium arsenide. It's more complicated, and it takes a lot of time. We need about six months to get all the things together. So we are doing a little bit more in advance of the products coming in. Last year, as you know, these two products, our consumer products, I believe we did a very nice job ramping our capacity to meet all the demand from our most demanding customers. So I pat myself on the back and say, good job, Morris. Hopefully, it's the same thing for the next consumer product ramp. But right now, I cannot promise you. They are not coming in with the orders yet.

Next question?

I'm not showing any more questions right now. I would like to turn the call back to Dr. Morris Young for closing remarks.

Okay. Thank you everybody for participating in our conference call. Let me see what other conferences we'll be attending. This quarter, we'll be presenting at Craig-Hallum's Alpha Cellular Conference in New York on November 17, and we will be participating at the Needham Conference in New York City on January 11. We look forward to seeing many of you there. As always, please feel free to contact me, Gary Fischer, or Leslie Green directly if you would like to set up a call. We look forward to speaking with you in the near future.

Thanks, everyone.

Thank you for your participation in today's conference. This concludes the program. You may now disconnect.