Earnings Call Transcript - AXTI Q4 2020

Operator, Operator

Good afternoon, everyone, and welcome to AXT's Fourth Quarter and Fiscal 2020 Financial Conference Call. Leading the call today is Dr. Morris Young, Chief Executive Officer, and Gary Fischer, Chief Financial Officer. My name is Buena, and I will be your coordinator today. I would now like to turn the call over to Leslie Green, Investor Relations for AXT. Thank you. Please go ahead, ma'am.

Leslie Green, Investor Relations

Thank you, Buena, 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, 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 market in which the company competes, global financial conditions and uncertainties, COVID-19 and other outbreaks of 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 February 18, 2022. 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 fourth quarter and fiscal year 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, with a review of our fourth quarter and fiscal year results.

Gary Fischer, CFO

Thank you, Leslie, and good afternoon, everyone. Total revenue for the fourth quarter of 2020 was $27 million, up 6% from $25.5 million in the third quarter of 2020, and up more than 46% from $18.4 million in the fourth quarter of 2019. Of our total revenue, substrate sales were $21.5 million in Q4, compared with $20.3 million in the third quarter, and $14.5 million in Q4 of 2019. Revenue from our raw material joint ventures was $5.5 million in Q4, up from $5.2 million in Q3, and up from $3.9 million in Q4. In the fourth quarter of 2020, revenue from Asia Pacific was 71%, Europe was 16%, and Taiwan was 13%, and North America was 13%. In the fourth quarter, 2 customers reached 10% of revenue, and the top 5 customers generated approximately 37% of total revenue. Gross margin in the fourth quarter was 33.9%, down slightly from 34.6% in the prior quarter. Given that, in Q4 of 2019, the gross margin was 21%, the year-on-year comparison is very encouraging. This spread is a quick illustration of the leverage we get from higher revenue, and I think it is noteworthy in terms of evaluating our business model. Both Q3 of 2020 and the recent Q4 are much stronger. I think we can still achieve higher than the recent 2 quarters in terms of gross margin, and Morris and I will be watching for some specific items. One, of course, is product mix, another is overall revenue volume. A third is that we think there are still some gains to be made in yields in manufacturing efficiencies, as the manufacturing teams settle into the new locations. Total operating expenses in Q4 were $7.2 million, up from $6.6 million in the prior quarter, and $6.7 million in Q4 of 2019. R&D is up $125,000 over Q3, as we are making good progress on some R&D programs. SG&A is up $460,000, and that increase is driven by several factors. The largest contributor is year-end bonuses totaling about $350,000. About half of this was in the 2 consolidated raw material companies. We had a good year with a strong finish, and in Q4, it was nice to be able to reward our team. Second, we had a charge for bad debt of $50,000, something that does not happen too often in our business model. We also had charges related to the private equity round and preparing for the IPO in China, and travel was up as a number of us, including Morris and me, went to China. Total stock compensation expense for the fourth quarter was $692,000. Operating profit for the fourth quarter was $1.9 million, compared with an operating profit of $2.2 million in the previous quarter, and an operating loss of $2.8 million in Q4 of 2019. Other income net for the fourth quarter 2020 was a gain of almost $600,000. This includes grants of almost $540,000. Especially noteworthy is a net profit of $354,000 from the partially owned companies in the AXT supply chain, accounted for under the equity method, so that's good news. It's nice to see that group be positive again. The market for raw materials has tightened up, and this is a good sign. We think this will hold in 2021. These gains were offset by a foreign exchange loss of $300,000 and a net charge of $40,000 for interest income and expense. Income tax for the fourth quarter of 2020 was a charge of $108,000 compared with a charge of $673,000 in Q3. Our Q4 results included approximately $400,000 in tariffs as a result of the 25% tariff charged on importing wafers into the United States from China. For Q4 2020, we have a net profit of $2.1 million, or profit of $0.05 per diluted share. By comparison, we had a net profit of $1 million, or profit $0.02 per diluted share in the third quarter of 2020, and a net loss of $2 million, or a loss of $0.05 per share in Q4 of 2019. The share count for Q4 was 42.042 million shares. Cash, cash equivalents, and investments were $78.6 million as of December 31. By comparison, at September 30, it was $29.8 million. This increase is a result of the $48.8 million increase directly related to the IPO of partnering with private equity firms in China. Without that, cash would have been flat. I'll give a brief update on the Star Market IPO project in a moment. Depreciation and amortization in the fourth quarter was $1.37 million, and investments were $5.3 million. Net inventory at December 31 increased by $3.2 million in the quarter and ended at $51.5 million. Ending inventory consisted of approximately 48% in raw materials, 47% for work in progress, and only 5% in finished goods. The largest increase was in raw materials, and this was deliberate on our part. This concludes the discussion of our quarterly financials. Let me just briefly highlight the fiscal year. For the fiscal year 2020, revenue was $95.4 million, up almost 15% from $83.3 million in fiscal year 2019. This represented growth in every revenue category across our portfolio and underscores the momentum we are seeing in major technology trends that drive demand for our compound semiconductor substrates. Gross margin for fiscal year 2020 was 31.7% of revenues, up from 29.8% of revenue for fiscal year 2019. Net income for the fiscal year 2020 was $3.2 million or $0.07 per diluted share, compared with a net loss of $2.6 million, or $0.07 per share, for fiscal year 2019. I'd now like to give you a brief update and comments about our plan to list our company in China on the STAR Market in Shanghai, and these comments also include some forward-looking statements. On November 16, we announced a strategic plan to access China's capital markets and progress to an initial public offering by our company, the formal name of Beijing Tongmei Xtal Technology Company, our wafer manufacturing company there in China, although the short name is Tongmei. The first major step in this process is engaging reputable private equity firms in China to invest funds in Tongmei. This went smoothly, was met with enthusiasm, and closed faster than we expected. In January, the final installment of $1.5 million in private equity funding came in. In total, we have banked approximately $49 million, and in aggregate, sold approximately 7.28% of Tongmei. Simultaneously, we have been working on some reorganization plans, which will make Tongmei have broader product lines, more consolidated revenue, more customers and, in general, strengthen this company and support the high valuations awarded by that investment community. One example is that we are moving our 2 raw material companies, BoYu and Jin Mei, into the Tongmei family. We did receive some very positive feedback from a number of shareholders when we announced this. Several of you described this as unlocking a hidden asset, and that resonates with Morris, Leslie, and me. Morris founded it in 1998, and the management team has nurtured and steered that company now for over 22 years. Morris and I both spent over 2 months there in the fall of 2020, including the mandatory 2-week quarantine. Especially with the relocation having gone so well, we agree that we are now unlocking a hidden asset in China. One of you also responded with an email that just said, "Wow," and that resonates for us, too. We hope to file the application with the China Securities Regulatory Commission by the end of June. There's a lot to accomplish to achieve that goal, and it will be a busy 4 months for us. This concludes the financial review. I'll now turn the call over to Dr. Morris Young for a review of our business.

Dr. Morris Young, CEO

Thank you, Gary, and good afternoon, everyone. 2020 was a year of solid achievement for AXT, highlighted by growth in Q4, which is usually a slower quarter. We successfully relocated our gallium arsenide manufacturing, upgraded our business and manufacturing processes to meet Tier 1 standards, and increased capacity due to rising demand. With the momentum of 5G and related technologies, along with new applications in healthcare and consumer devices, we believe AXT is well-positioned to lead our industry and enable key trends for the coming decades. We are prepared for this. While we rarely make fiscal year projections, I will share a few today. First, in 2021, we anticipate launching 8-inch gallium arsenide and 6-inch indium phosphide in the market. We expect to exceed the $30 million revenue mark quarterly. We plan to scale up production with several Tier 1 companies and look forward to AXT's potential listing on the STAR Market in China in 2022. This year is expected to be transformative for AXT, our employees, customers, and shareholders. I am genuinely excited to share our progress with you. Now, let's discuss indium phosphide. Q4 of 2020 was our second strongest revenue quarter for our indium phosphide portfolio, surpassed only by Q2 2019, when we received a significant order from a single customer expecting future demand. In Q4 2020, our revenue came from a diverse range of customers and applications, showcasing the sustainable growth opportunities in our indium phosphide segment. We first mentioned 5G revenue in our earnings report in April 2019. Now, a year later, 5G and related power applications are significantly driving our indium phosphide revenue, particularly strong in China and Taiwan, with no signs of slowing in 2021 as 5G continues to roll out globally. We believe the industry's capacity remains very tight; our Beijing facility continues to operate at high levels to meet customer demand. AXT is uniquely positioned to scale quickly and cost-effectively, and we expect to gain market share due to our short lead times compared to primary competitors. In data center connectivity, the growing number of users, devices, and applications is pushing the transition to faster, more scalable technologies. High-capacity connectivity will remain crucial, with many now believing that the shift from 100G to 400G will occur faster than the initial move to 100G. We are witnessing this trend in silicon photonics through strong and steady demand for data center-related revenue. We are also pleased with the productive customer relationships we are building in this area, utilizing the Tier 1 processes we have developed to enhance customer experiences across our portfolio. In 2021, we expect to see the emergence of new applications for indium phosphide in healthcare monitoring and consumer devices, many innovatively driven by Tier 1 players that highlight the unique properties of indium phosphide. These applications could open new growth avenues, for which we are well positioned and engaged. Now regarding gallium arsenide, LED revenue has continued to improve, driven by high-end applications like automotive. While wireless gallium arsenide revenue saw a seasonal decline in Q4, IoT applications appear to be boosting ongoing demand for semi-insulating gallium arsenide substrates. Emerging applications include world-facing cameras, augmented and virtual reality, automotive sensors, biosensors, and more. As mentioned earlier, micro-LED may emerge as the next major volume driver for gallium arsenide chips, expected to consume less power, provide sharper contrast, and produce brilliant colors. Their applications are poised to expand from portable devices to large screens, such as high-end televisions. Although market expectations vary and can change, reports suggest that the micro-LED market for small consumer devices could reach an annual demand of 2 million 6-inch gallium arsenide substrates, which would surpass the current semiconductor gallium arsenide substrate market. Regardless of the specifics, this is an exciting area that could add significant value to the LED market in 2024 and beyond. Tier 1 players are already advancing development, and we believe our wafers are being utilized for initial activities. In recent quarters, we have focused less on germanium substrate due to developments in other parts of our portfolio. Still, it's important to note that this segment grew over 20% in 2020 after a significant decline in 2019, mainly driven by the recovering satellite solar cell market, which we expect to further improve in 2021. Now, on to raw materials, the business is experiencing significant momentum. In 2020, both BoYu and Jin Mei relocated their factories to our campus in Kazuo, allowing them to expand capacity in response to strong market demand. BoYu, which manufactures high-temperature pBN crucibles and pBN-based tools for OLED, is seeing healthy growth. Jin Mei, another joint venture for AXT, supplies high-purity materials and is also posting solid results as gallium prices increase. Their relocation and expansion have enabled both joint ventures to explore new business opportunities that fuel continued growth. Their proximity to our manufacturing lines allows AXT to enhance recycling efforts to produce high-value products while improving manufacturing economics. Additionally, joint ventures that we account for using the equity method contributed positively to our profitability in Q4, benefiting from rising commodity prices driven by strong demand. In summary, we are entering a new phase of growth and development. Major technology trends we've discussed in previous quarters are gaining momentum, and we can see new ones on the horizon. Our facilities in Tongmei, Beijing, Dingxing, and Kazuo are prepared to meet the moment and support the innovations of some of the most discerning customers globally. 2021 is shaping up as a transformative year for our industry and AXT specifically. Part of our journey will involve preparing for our STAR Market listing, which we believe will enhance our financial position and unlock further value for our stakeholders. We are grateful to have you with us on this journey and appreciate your ongoing support and enthusiasm. This concludes my prepared comments. I will now hand the call back to Gary for our first quarter guidance.

Gary Fischer, CFO

Thank you, Morris. As Morris discussed, the demand environment remains healthy, with a number of growth drivers leading the way. We expect to see revenue in Q1 of between $28.5 to $29.5 million. We believe that our net profit will be in the range of $0.05 to $0.07, with a share count of approximately 42.1 million shares. This concludes our prepared comments. Morris and I will be glad to answer your questions now.

Operator, Operator

Your first question is from Richard Shannon of Craig-Hallum.

Richard Shannon, Analyst

Congratulations on some really nice numbers here. A number of questions here. Let me start just very quickly with the guidance here, Gary, Morris, $29 million at the midpoint here versus the $27 million number. Typically, you're seasonally down a little bit in the first quarter. Kind of help us, A, describe the individual segments here, and then kind of describe qualitatively what's driving all of this. What's helping you to a much better than seasonal first quarter of the year?

Dr. Morris Young, CEO

Gary, do you want to take a first crack?

Gary Fischer, CFO

Yes. First of all, without getting into specific numbers, the seasonality is currently unusual because we usually experience a downturn in Q4, but this most recent Q4 saw an increase, which is the first time that's happened in several years. Typically, Q1 wouldn't be lower than Q4; it might be stable or slightly up. That said, we are anticipating growth and witnessing a lot of momentum. The raw material companies are performing well, and while Morris can elaborate on this, we are experiencing rising raw material prices, which will impact our financials, both for the equity companies we account for using the equity method and for BoYu and Jin Mei. Additionally, we continue to observe strong market demand, perhaps not as robust for gallium arsenide wireless, but all other substrate categories are performing well. Morris, would you like to add anything?

Dr. Morris Young, CEO

Certainly. Indium phosphide is performing exceptionally well. Our lead time has increased compared to our competitors, and we are still maintaining the shortest lead time. We are expanding our capacity, and the demand remains very strong. Regarding germanium, the business is stable. As Gary mentioned, the wireless sector may be the weakest point, but it is expected to hold steady. I also want to point out that in Q1, we have a month with only 28 days in February, and due to the Chinese New Year, our factory will be closed for about a week, resulting in fewer working days. Despite this, demand is very robust, and we are confident in our ability to increase guidance for revenue.

Richard Shannon, Analyst

Okay. That's helpful, those comments. I want to follow up on kind of gross margins here. Always like to try to figure out what you're thinking here. You're talking about indium phosphide being strong, and also raw materials I think is helpful. Directionally, Gary, you could help us think about, relative to the fourth quarter, where you're looking for gross margins?

Gary Fischer, CFO

We understand the factors that influence it, and we aim to communicate them regularly to your community. The mix remains favorable, which is a positive aspect. As total revenue increases, it helps cover fixed costs across more units, and we generally observe a rise in volume. It's important to note that as some larger accounts start contributing, the volume may increase, but the gross margin might stabilize since high-volume sales to Tier 1 customers could diminish some pricing advantages. However, gross profit dollars can still increase, and we aim to restore gross margin to 35%. We are confident that this will happen, though we cannot specify when; hopefully, it will be soon. Our ultimate goal is to exceed that margin, and we believe there is potential for us to achieve that. We feel comfortable about this situation. Morris, do you have anything to add?

Dr. Morris Young, CEO

Yes. I think what I will comment, usually, gross margin is CFO's territory, but I would say this. I mean, we just finished the move for our gallium arsenide factory, which is not a small matter. I think we have done an excellent job not losing any customers, and we are ramping up fairly nicely. And then we said once they settle the factory, we still got more efficiency gain or yield improvement to do. As I said, indium phosphide business is very strong and depends about how much more we can do on indium phosphide. I think that should help us on gross margin. I think the other thing is, obviously, the overall revenue. We said before that we are looking for that elusive $30 million mark. And we believe that the overall cost of running the factory and everything else is going to be a lot more efficient as we pick up revenue.

Richard Shannon, Analyst

I would like to quickly revisit the topic of gross margins as you look ahead. Gary, in your earlier comments, you mentioned the potential for yield improvements, which Morris also referenced. This is an important transition, and I would like to know how much more improvement you anticipate. I'm interested in this both from a quantitative perspective and in a straightforward way, considering the same product mix and the expected increase in volume. Is it feasible to achieve 40% gross margins as you improve yields back to their previous levels?

Dr. Morris Young, CEO

I definitely think we can achieve that. We need to consider the product mix, particularly in high-end gallium arsenide and indium phosphide. If we fully utilize the factory, we can gain market share and improve gross margins. There's been some healthy debate about this with Gary, as he is responsible for calculating those margins, while I can only promise improved gross margins. However, I firmly believe we can reach our goals.

Richard Shannon, Analyst

Fair enough.

Gary Fischer, CFO

Morris is my boss, so I'm not going to disagree with him.

Richard Shannon, Analyst

I think that's a good policy, Gary. For the last question, I will step out of line. Indium phosphide is showing some strong growth. I have a multipart question for you, Morris. You mentioned in your prepared remarks that there is strength in 5G and PON. It seems there's been a bit of a pause in the industry due to trade tensions with Huawei, which I believe is the main factor. I would like to know how much this is coming back compared to other factors, such as datacom or the new applications you mentioned.

Dr. Morris Young, CEO

Well, so far, I mean, I read the news about the trade tension and etc. But I think our 5G application does not limit itself to Huawei or any particular region. Indium phosphide is used for the front haul link on the base stations. And China itself is building 600,000 last year, and they're going to just increase rather than decrease. So, like it or not, they need indium phosphide to do that linkage. And with the pandemic worldwide, maybe the 5G build-out is sort of slowed down in 2020. And I think as the economy recovers, definitely, somebody is going to catch up or to try to catch up. And that definitely will use indium phosphide, PON. And I think it's just a measure of how much more it's going to increase, rather than it's going to have a slowdown. And that's from reading. And as far as the other applications I was talking about, yes, we're working with our customers. Yes, we are gaining a lot of trust, and we're seeing their ramp, but where are they going to launch the product, we don't know. Honestly, I think we hope soon then later.

Richard Shannon, Analyst

Okay. Fair enough. I will jump out of line.

Operator, Operator

Your next question is from Hamed Khorsand of BWS Financial.

Hamed Khorsand, Analyst

So, first off, I just want to see, what's driving your clarity more as just to your comments about $30 million a quarter this year? I mean, is it your customers committing to more orders? What are you seeing beyond this quarter qualitatively from your customers that's giving you that confidence?

Dr. Morris Young, CEO

Yes, let me respond this way. Typically, we don't have clear visibility. A customer can cancel an order at any time, as we often mention. However, our indium phosphide order book is currently very strong, and I don't observe any signs of slowdown. Looking at the applications for indium phosphide, the last time we saw such strength was in 2015, primarily driven by PON, which eventually slowed down as silicon photonics began to rise. Currently, indium phosphide applications include 5G, which I believe is just getting started, and has potential for significant growth. Additionally, silicon photonics is not showing any signs of slowing down. We have engaged with a first-year customer who is purchasing directly rather than through an epi supply, giving us opportunities for increasing orders with them. We also see potential in consumer product applications, which we believe haven't yet begun to take off. In terms of semiconductor gallium arsenide, the automotive industry remains robust. One of our large customers has adjusted their revenue guidance from a 4% to 6% increase to an 8% to 12% increase, which is positive news. Other automotive LED customers are conveying similar signals. We have yet to tap into the VCSEL high-power laser market, which also seems promising. Wireless demand is a bit uncertain; while 2020 was a growth year, we lack precise indicators for future growth. Nevertheless, the overall demand appears favorable. Lastly, we had a 20% growth in germanium last year, and the order patterns seem solid, excluding projects like OneWeb and 5G communications. Thus, I believe germanium is set for a good year as well. Across all four categories, we're performing well. Additionally, raw materials for our two joint ventures are not only transitioning to their new factories but are also expanding capacity. The market for these materials is strong, with increasing prices and solid demand.

Hamed Khorsand, Analyst

Okay. And then my other question was that, are you adding customers, or is the revenue lift coming from existing customers?

Dr. Morris Young, CEO

I believe it's a combination of both. Some of the customers I've spoken with are new and are placing large orders, which we hope will grow. Additionally, some existing customers who previously purchased smaller amounts will become significant clients due to our new qualifications. Furthermore, we have been focusing on enhancing our factory capabilities to cater to Tier 1 customers, including SBC control, which requires stricter metrology and control processes. This will lead to higher engineering costs and efforts to meet customer needs, but ultimately, it will enhance trust in our quality and encourage more business opportunities.

Gary Fischer, CFO

Yes. I'd like to add to that, Hamed, and just to say that we do have good communication between AXT and our customers, and that's one of our strengths, and we promote that and our sales and marketing group is very devoted to listening to the customer. And sometimes, what we hear, we don't like. And we've been through those cycles before, and you've been with us when we've gone through some of them. But right now, it's like turning up the volume on your stereo system. There's just a lot of positive feedback about their expectations. So communications is up and what's good. A second thing, which Morris touched on, is the relocation is over. So there are customers who are holding back, just as some investors held back, frankly, because they were concerned about the relocation risk. Now that's been converted into an opportunity. We're going to grow the company and take market share. So I think that's brought some customers back, and then - or to increase their volume. And then there are new customers that we've been shipping, shall we say, pilot production levels to, and that's going to eventually turn on. So it's basically customer feedback. I mean, that's what's happening.

Hamed Khorsand, Analyst

Okay. And then my last question was going to be, as far as the tight capacity is concerned, do you know how much capacity you're short as far as the market is concerned? And what's to drive your competition doesn't build up capacity and just there's ample supply out there?

Dr. Morris Young, CEO

I think that depends on the product. We always respect our competition, but indium phosphide is a very challenging material. Its specific applications are primarily for high-end telecommunication lasers and consumer products, which have strict requirements. We not only have the capacity but also maintain a very high quality standard, putting us ahead of our competitors. We are working to build that capacity, and our customers provide us with their needs and projections. However, we take those projections with caution, as sometimes they place double or triple orders. Nonetheless, we can't overlook them since we don't want to disappoint our customers. We are following their guidance closely and hope to meet their expectations. It's important to note that indium phosphide isn’t easily obtained; it requires qualification time and adherence to stringent specifications. Our customers often need to visit our factory to inspect the material and even specify the metrology tools we use for wafer inspection before shipment. We have been collaborating with them on this application for almost two years, providing constant feedback. We don’t take this business for granted, as customers can always decide to share their business with competitors, but they do provide guidance on their requirements.

Gary Fischer, CFO

Yes, Hamed, let me add a little bit more, that if you look at the characteristics of our competitors and of AXT, even though AXT has been around a long time, there's still quite an entrepreneurial spirit in the company management, which both Morris and I try and project, as well as our other key vice presidents. If you compare that to one of our other competitors, they're much more conservative. They're more consensus-based in their decision-making, and they don't move as fast. So I'm not saying that no customer can add capacity and grow, but the likelihood is much lower than it is with AXT. In the case of another customer, a competitor, they're privately financed. They don't have access to capital in the markets like we do, and they're not part of a big company. So I think we have some reasons to believe that there's barriers to entry in terms of rapidly adding capacity. The only company who can prove that they can do it well is AXT, because we just did it.

Operator, Operator

There's no questions at this time, and I would like to turn it back to Dr. Morris Young, CEO of AXT, for any further comments.

Dr. Morris Young, CEO

Okay, thank you. Thank you for participating in our conference call. 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. We do look forward to speaking with you in the near future.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call, and thank you for participating. You may now disconnect.