AXT, Inc. (AXTI) Q4 2016 Earnings Report, Transcript and Summary

Good day ladies and gentlemen and welcome to AXT Fourth Quarter 2016 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would like to introduce your hosts for today’s conference Gary Fischer. Sir, you may begin.

Thank you Terence and good afternoon everyone. Before we begin, I would again like to remind you that during the course of this conference call, including comments made in response to your questions, we will provide projections or make other forward-looking statements regarding, among other things, the future financial performance of the Company and our ability to control costs and improve efficiency, increase orders in succeeding quarters, improve our competitive position as the market improves, our ability to meet market demands for our products as well as other market conditions and trends including expected growth in the markets we serve. We wish to caution you that such statements deal with future events, are based upon management's current expectations and are subject to risks and uncertainties that could cause actual events or results to differ materially. These uncertainties and risks include, but are not limited to, overall conditions in the markets in which the Company competes, global financial conditions and uncertainties, market acceptance and demand for the Company's products and the impact of delays by our customers on the timing of sales of products. In addition to the factors that may be discussed in this call, we refer you to the Company's periodic reports filed with the Securities and Exchange Commission and available online by link from our website for additional information on risk factors that could cause actual results to differ materially from our current expectations. This conference call will be available on our website at axt.com through February 22, 2018. Also, before we begin, I want to note that shortly following the close of market today, we issued a press release reporting financial results for the fourth quarter of 2016 and the year ending 2016. This information is available on the Investor Relations portion of our website at axt.com. Thank you, and now turning to a review of our fourth quarter results total revenue in fourth quarter of 2016 was $20.3 million compared with $21.9 million in the third quarter of 2016. This is above the high-end of our expectations, which were $18.5 million to $19.5 million. In an effort to understand the underlying trends of our business, many of you have asked us to provide bit more granularity in the way we report revenue. So therefore beginning this quarter, we will also breakout revenue results for substrates and for raw materials. In the Q4 2016, revenue from substrate sales was $16.0 million compared with $17.0 million in the prior quarter. Revenue from our raw material joint ventures was $4.3 million in Q4 compared to $4.9 million in Q3. In the fourth quarter of 2016 revenue from North America was 6%, Asia Pacific was 71% and Europe was 23% of total revenue. In the fourth quarter we had no customer that generated more than 10% of revenue and the top five customers generated approximately 35% of total revenue reflecting, again, our diversification of both products and customers. Also for the entire year of 2016, we had no customer that generated 10% or more of revenue. Gross margin in the fourth quarter was 37.1%. This is an improvement from the prior quarter and is an result of the favorable mix and good progress in manufacturing efficiencies and yield improvements. Total OpEx in the fourth quarter was $5.2 million. This is up a little from the prior quarter but in general we have continued to keep OpEx relatively flat quarter to quarter. Total stock compensation expense was $298,000 for the fourth quarter of 2016, which $5,000 included in cost of revenues, $246,000 in SG&A and $47,000 in R&D. Operating profit for the fourth quarter of 2016 was $2.3 million compared with $2.7 million in the previous quarter. Interest and other income in the fourth quarter was a net charge of $274,000. This net number consists of four categories: one, interest earned of $106,000; two, foreign exchange loss of $95,000; three, equity accounting on our unconsolidated joint ventures, of a loss of $558,000; and four, other items equaling a gain of $274,000. For Q4 of 2016, we had a net profit of $2.2 million, which is $0.06 per share. This is north of our guidance, which was a range of profit of $0.02 to $0.04 per share. By comparison, we had a net profit of $2.2 million or $0.07 per share in the third quarter of 2016. Cash and cash equivalents and investments increased nicely in the quarter by $6.4 million moving us from a total of $47.3 million as of September 30, 2016 to $53.7 million as of December 31, 2016. Depreciation and amortization in the fourth quarter was $1.3 million and CapEx was about $900,000. Accounts receivables, net of reserves, were $14.5 million at December 31, 2016 compared with $18.4 million at September 30, 2016. Net inventory at December 31 was $40.2 million compared with $38.7 million in inventory at September 30. Ending inventory consisted of approximately 44% in raw materials, 50% in work in process and 6% in finished goods. The spread between the three buckets remains consistent. That covers the quarterly comparison. And allow me to briefly highlight the entire fiscal year, which is our calendar year. For the fiscal year, 2016 revenue was $81.3 million up from $77.5 million in fiscal year 2015. In 2016 revenue from substrate sales was $65.6 million compared with $58.2 million in 2015. Revenue from our raw material joint ventures was $15.7 million in 2016 compared with $19.3 million in 2015. Gross margin for the fiscal year 2016 improved meaningfully to 32.4% of revenue, up from 21.7% of revenue for fiscal year 2015. Our profitability in fiscal year 2016 also increased meaningfully. We achieved net income of $5.6 million or $0.17 per share compared with a net loss of $2.2 million or $0.07 per share for fiscal year 2015. That is a swing of $7.9 million year-to-year. Moving from a loss to a profit, which I guess to use non-financial terms is pretty cool. This concludes our financial review, I’ll now turn the call over to Dr. Morris Young for a review of our business.

Thank you Gary. And good afternoon everybody. Our positive Q4 results capped off a year of growth and diversification of AXT. Revenue came in ahead of our expectation, driven by a growing number of exciting technology applications. In addition, we continue to demonstrate improvements in our business model. Our gross margin performance is the highest we have seen in many years. These are partially the result of continual leverage for a number of cost improvement programs implemented over the last 18-months as well as good progress on our yields. We also benefited from an optimal product mix in the quarter. Our profitability also exceeded our expectation in the quarter and with continued – we generated healthy positive cash flow. As we enter into 2017, we’re encouraged by the evidence that the market is evolving in our favor in several strategy carriers that can provide further growth and expansion opportunities. The first is in indium phosphide. The indium phosphide bounced back nicely in Q4, overall we continue to benefit from the demand for PON equipment, which is expected to rise to more than $43 billion by year 2025 according to a December report by Grandeur Research. Growth in this market is being driven globally by the increasing adoption among telecom carriers for fiber to the home and fiber to the office applications. As we have noted in Q3. and even into October we saw some weakness in the demand for indium phosphide in certain geographies such as Taiwan and China, which is likely the results of too much inventory. Improvement in the second half of Q4 is encouraging. But there bit more time perhaps is needed to sort out the inventories. Looking-forward, we believe that the industry transition from the 2.5G to 10G PONs will provide further growth opportunities in the second half of 2017. Now turning to data center connectivity. We continue to see growing emphasis in indium phosphide based silicon photonics technology. This is likely a function of both the massive growth in data driven by cloud computing, Internet of Things, mobility and video streaming as well as the constraint and Moore's law which is driving the industry to seek alternative ways to achieve performance improvements. In 2016, was an important year in the commercialization of silicon photonics and the turning point for market adoption as many companies made investment in the technology. We want to give you a little color on this to frame out our positive perspective. In addition to early players in the market such an Intel, IBM, Cisco and HP, the ecosystem of companies focused on the development of silicon photonics continues to grow. Sienna, Juniper Networks, both made acquisition in 2016 to bring silicon photonics expertise in house, indicating the continued proliferation of this technology and its growing adoption. Acacia Communications a maker of coherent transceivers based on a silicon photonics IC, with long distant transmission had a successful IPO in May. And we are seeing a number of start-ups moving closer to launching products. From a product perspective, Intel, Mellanox, [indiscernible] launched silicon photonics devices during the last year. And Intel announced that Microsoft Azure will be an early adopter for its hyper scale computing environment. And in Q4 Broadcom announced the Tomahawk II Switch Series, whose roadmap is expected to include a device with 25.6 terabytes per second capacity by the year 2020. This is likely to require optical interfaces to move data on and off the chip and across the board. And could represent an other inflection point for silicon photonics technology. In total, all of these data points indicate that the indium phosphide technology is moving beyond the research phase to market adoption. Our own revenue from this application continues to grow and early indication from our customers suggests that they are planning for increased demand for 2017. One of the positives in our business model is a long trajectory in the market applications. The data center upgrades, expansion is generally expected to be a multi-year cycle. As such, we are ready to meet the volume and the specification requirements for this exciting market opportunity. AXTI has been a leader in the development of high-performance indium phosphide substrates for more than 20 years. And we believe that our deep expertise in these demanding material is allowing us to make an early market lead. As indium phosphide remains as an emerging material, we expect to see some lumpiness in our sales of the indium phosphide product in any give quarter but feel confident that indium phosphide will be a primary source of growth and opportunity in our business for the foreseeable future. Now let's turning to gallium arsenide. Gallium arsenide continues to provide a healthy base of profitable revenue. As expected, sales of semi-insulating gallium arsenides showed some weakness in Q4 due to short-term events or adjustment at our customers but we expect to see some improvement in Q1. Sales of semi-conducting gallium arsenide were generally flat from the prior quarter, largely supported by demand from our traditional markets. In addition, we're watching with interest the continued market development of VCSEL’s for 3D sensing applications such as gaming, mobile phones, smart TV’s, high speed communications and high power material processors. Recent news indicate that key mobile devise manufacturers are likely to incorporate this technology in upcoming high-end smart phone platforms, which would lead today numbers between 500 to 600 million units per year. This could make the technology a mid-term and long-term game changer driving a sizable increase in demand for high performance semiconducting gallium arsenide substrates for the VCSEL applications. We believe that we will see meaningful revenue traction in 3D sensing applications beginning in late 2017 and are preparing our business today for increased demand, including R&D investments, capacity planning and sales readiness. 3D sensing requires devices with highly precise functionality and consistent reliability. The competitive landscape of substrate suppliers that can meet this specification at – is limited. Therefore we expect to be a player in this market and view this opportunity as a other exciting growth driver for our industry and for our business. Turning to our raw material business, it is still pretty tough out there. Although the pricing environment is improving modestly as we have seen in the past. A strong pricing environment can have a meaningful positive impact on our business. While our joint venture in total remains a headwind on our bottom line we believe that each one of our joint ventures has encouraging business opportunities in this coming year. In closing, this is exiting time for AXT. Our strategy to invest in emerging markets and to diversify our revenue across a variety of applications and to differentiate ourselves through deep expertise in some of the most challenging materials is succeeding. In essence,0 I believe we are leading in the areas where the market is headed. In addition our commitment to improving our manufacturing yields, operational efficiencies and strong financial discipline is allowing us to achieve some of the highest margins in the years and to deliver profitability and positive cash flow. We are executing well across our organization, and we are positioned for continued growth in 2017. I want to thank our customers our shareholders for their ongoing support of the AXT and our employees worldwide for their ongoing dedication to our mission. This concludes my prepared comments. I will turn the call back to Gary.

Thank you Morris. We believe that the revenue contribution in Q1 is likely to be similar to that in Q4. As such we believe that the total revenues will be in the range of $19.5 million to $20.5 million. In terms of our bottom-line outlook for Q1, we're expecting to be in the range of $0.02 to $0.04 profit per share based on 33.7 million diluted common shares outstanding. Okay, this concludes our prepared comments and Morris and I will be glad to answer your questions. Terence please take it over.

Thank you. [Operator Instructions] And our first question comes from Richard Shannon from Craig-Hallum. Your line is open.

Well, hi Morris and Gary thank you for taking my questions and congratulations to good ending to 2016. Let’s see a couple of questions from me. First maybe on the guidance for me, Gary. You gave us a revenue range similar to what you just gave us, the EPS number that was a little bit lower. Should we infer that the gross margins might be a little lower and/or a little bit higher OpEx or how can you help us resolve those differences?

Yeah, you know I think, we are very delighted with the gross margin in Q4. It was one of those kind of nice quarters where the sun and moon and the earth lined up. So I don't think the gross margins will be 37% in Q1. And I still think it's best for, people running models to be in the low 30’s until we have a few more quarters where we can sort of see how things even out.

I think you mentioned to that topic of gross margins, curios if you can help us understand the mix versus the efficiency benefits there, seems like raw materials were lower and I think pricing is still rather low there, and can you just talk about the mix versus yield and efficiency improvements to help that.

Let me take a first crack at it. I think it is very difficult to really differentiate the two unless we really run very deep models. I mean, they are of course number of things that we are doing, improving yield is a yet another one and improving efficiency I mean will reduce headcounts in our operation and we are running more wafers through the line and obviously some of the product mix do help us but for us to separate what’s – what bucket it is a little bit more difficult. But I think in all categories it’s helping us. I mean lastly I think the lower cost of raw material input – also is helping our gross margin as well. So other than our raw material business is trending very tough – but the substrate business is actually getting very good.

Okay, fair enough, one or two last questions from me on your comments Morris on 3D sensing you talked about pickup later in 2016, it seems like we are being heard from other companies who have a relationship in this space talking about a pick-up or potentially maybe before that. Especially since they’re a little bit later in the manufacturing cycle here so. Gary if you could lay out your comments there and why you would necessarily see something earlier than later in 2017 and any suggestion of the potential size here relative to your current business criteria as well thanks.

Yeah Richard we are excited about this opportunity, and so far we are already sending quite a bit of sample and sample quantities to our customers for evaluation as well as qualification. But we just – we have see some predictions and projections but we haven’t really starting to run those number into our production yet. So we’d much rather be conservative in terms of projection and be ready for the R&D as well as capacity planning and R&D and sales readiness for the market. But to run the model this early especially it’s a rapid ramping I believe it would – if the market would adopt this technology potentially the volume can run a –fast but right now we just not.

Yeah let me, add something to just underline what Morris said. Is that we are actually making great progress on lower density yields, we’ve got some really smart scientists working on it and some manufacturing managers and leaders and its been very encouraging. So we are not, we are not sitting around, sort of waiting for the bells to ring, we are being very pro-active and we are making great progress. So we are ready and when the market rings our bell we will be able to deliver. And on that end we are still waiting for that to get to that point until we cross the line, we think it is better to be cautious.

Understood, appreciate that detail. Last quick question from me guys. I will jump back in the queue. I guess do you have any update on the time frame for the eventual move of you factory in Beijing.

Yes we have been in this selection of site process and we think the move for our factory, we projected it is probably going to be end of 2018 or early 2019 event and let me just add one more thing. We also planned, we are watching this 3D sensing market development very carefully and it is exciting too and if the market were to really evolve into a major event for the 3D sensing going forward then the move could be a blessing for AXT because we are planning to build a factory to accommodate this growth.

We are acquiring enough land that we can expand our footprint over the years going forward if needed. And we will build enough initially in the footprint so that the building is fitted out and we can add equipment and capacity quickly. And that is one of the strengths, we have proven that in the indium phosphide growth. We think it is a differentiator for us that we have sort of a entrepreneurial ability to move fast to add equipment which can grow the capacity.

For instance the land that we are looking at it is approximately 80% larger than the land that we presently own. And the factory because we are going to design very single step rather than we have accumulated all the – whole factory Tomahawk facility which we will add over the last sever or ten years which by definition is less efficient. So we expect it to build out a very efficient factory with small capacity. Of course we will be prudent not to over build and then – but we want to be ready of this market opportunity if we were to really develop it to reality.

The key is to get the permits and the infrastructure done in advance and then which is not very expensive and then we can move equipment in line as the market demands.

Okay, that makes sense, I appreciate all that detail guys, that all the questions from me. Appreciate you, talk to you later.

Take care.

And our next question comes from the line of Edwin Mok from Needham & Company. Your line is open.

Hi everyone, this is actually [indiscernible] congrats on the great quarter and thanks for taking our question. May be just a dive a little bit deeper into 3D sensing market, have you guys initially begun to size the opportunity, if it becomes adopted what kind of opportunity can we expect and do you think a double digit growth rate can be achievable or is it too early stage to predict.

Well I think the interesting think is that right now it is zero. So any growth is going to be double digit, or infinity but I think the market is very exciting, I have seen some reports in saying it is supposed to be at least two chips per phone in some model and potentially three chips on this VCSEL one two large VCSELs and one small ones but some phone we may only require two but we believe the early stage will only adapt into the high-end phones. So I’ve seen some reports in saying in the phone the VCSEL opportunities between $2 to $4. But you got to discount it back into the substrates and because there is this other layer which is epi. So I think the – I think the growth potential or the market opportunity definitely is very substantial and great opportunity for all the gallium arsenide players especially for those who can meet those low EPT requirements. So but how big it is, I mean it really depends upon how fast you think the adoption is going to be and but smartphone is not the only application, there are mobile devices which require also autonomous cars that also requires it. So the way I envisioned VCSEL business is a it provides the machine vision to understand its environment, to enter into computer data processing capability to understand what everything are, so you can measure depth, height, as well as volume. So I think it is a great opportunity to enable machine to have eyes so it can develop intelligence. So I think really how big the market is, it’s I think one is a study a little bit more. The volume is definitely its a great, great opportunity.

I can give you perspectives number one is I embedded testing because my boss asked me to, so I showed the Lenovo phone has tangle in it to a couple of – and they like to do the gaming stuff and I think gaming will be a strong appeal for this application. The other perspective is this that the potential here, I mean, there is no sense trying to limit the words, but the potential here is significant. And since we are a small cap company, if the market accepts this application, it’s going to move our needle for sure. So we just don’t know how much – we don’t know how soon, and you know I think you guys will be probably more accurately are figuring it out than we can because you’re talking to more data points.

Got it, thanks for that color guys. And so in terms of VCSEL can you talk a little bit about your competitive position with regards to VCSEL and you could kind of share like what type of share you have your relative to your competitors?

Well, basically, there are three legitimate players in this market other than us that's a German substrate maker and that's a Japanese substrate maker. And I think the other big requirement for this application is it requires because it's a VCSEL is stands for lasers and lasers hate effects because a dislocation or defect underneath the laser will kill the device. And since you're running a ray of lasers up to 100 at least laser per chip, so too much defect in the substrate will kill the device such that the defect density requirement is a key barrier for entry. So I think the race to achieve this consistent low defect density at affordable cost and a big volume, I believe now is the race, but it seems this market potentially is going to be so big. I believe is going to benefit all the industry players, the three of us, and who is going to win, I mean we hope we are. One of the things we have been you know promoting AXT is that we know VGF since we are the first entry into the market with the VGF product with no VGF crystal grows for 30 years. And VGF is known to be able to reduce defect density in substrates. So we think we have a lag up, but of course we do have a lot of respect – our competitors and the race has not even begins yet. So we’re all lining up at the starting gate. We hope we can win, but if not you know at least it will benefit the whole industry for sure.

Got it, thanks for that color Morris. Maybe just one last question for me how much of indium phosphide grow in 2016 year-over-year and based on the trends that you have outlined in your prepared remarks on silicon photonics and fiber to home in office. Can we expect – this type of growth can be sustainable in 2017 and beyond?

Yes, so, let me give you some color. I think we have said before in 2014 and 2015, we were growing more than 50% year-over-year for two years. And with the beginning of 2016, we started out pretty good and then some time in June or even earlier all of a sudden all the PONs market seems to start. And we heard from our customers and our customers’ customer, they have seems to be an overview inventory because in the two previous years people is just expecting too much everybody double order or triple order. And we believe they are in the process of weeding out the inventory and in fact I heard one of the market intelligence said even one of the distributor in China bankrupted, they are expensing out or using up the inventory. But I think the important thing to remember is PON is a very necessary device to enable the fiber optics to be connected. Everywhere you will need to communicate with indium phosphide light, PON is needed, okay. So I don’t think that market is going away, it’s just having an inventory adjustment. With that said, you did [indiscernible] in 2016. And we are in the low double-digit growth for 2016 with the impact of the slowdown of the PONs market, but we do believe that some time in 2017 that should recover. With that said, I think also the silicon photonics saw a very vibrant 2016. There are a number of our end customers announcing they have new product introduction and they are telling everybody in the street and market, they are preparing for market growth for 2017. So we think that the silicon photonics business will continue to grow for 2017 and sometime later this year perhaps whereas the PONs market the inventory adjustment [indiscernible] add-on to the growth opportunity to improve 2017. So to answer your question in our model, we do believe 2017 we’ll see – will give us a better growth percentage wise than 2016 on indium phosphide.

Okay, thank guys. Congrats again on the great quarter.

Thanks.

Thank you.

And our next question comes from Tom Sepenzis for Northland. Your line is open.

Hey, congratulations on the quarter. I just want to follow up on the – if you were to win some of the VCSEL business in the second half of the year, where would you be building that product, would that be in the current fab?

Yes.

And what is the timing that you will complete the new fab?

We think as soon as we can probably finish the construction of the new factory is probably the first quarter of 2018. But that’s the facility…

Okay and how long you love to stay in the current facility?

We think we have a good setup with the local government. We like to run the two parallel lines both with the old location as well as the new location for a period to allow our customer to qualify the new facility before we move on to shutdown in both facility, move on to the new facility. And don’t forget that’s only require for gallium arsenide, indium phosphide actually there is no pressure to move although in our own mine once when we you move to the new facility, we think we as well move indium phosphide as well.

Eventually in the future, yeah.

Yeah.

So we think the term that the facility is the first step of course, the overall move of equipment will be done in stages, so we will never going to turn off everything off and then move it and then it back on. We will move it like 25% at a time, so we will never be down in terms of production. And we can do things like build inventory for key customers and things like that, so that there is a safety net for them. We don’t have an exact timeline yet, but our discussions with the government agencies, we have talked about 2018, first half of 2019 and that’s kind of what we’re circling.

Okay. So I guess what I’m trying to get out of it in terms of the volume, the potential volume with the VCSEL win in the second half of this year. Do you have the current capacity in the existing fab?

Yes.

And then is that making conversations at all difficult with any potential customers?

Yes, we believe that we have look at our yield and look at our number of furniture, we should be able to read that demand. But of course I mean right now the numbers that we have seen talked to our customers are only preliminary and we haven’t really – got any firm order, I mean, once we have got it then we’re going to make a hard calculation. And you know the other thing is that I do believe that once they qualified us they require us to deliver upon this facility with the existing equipment for at least the first set of the product launch which potentially would last for two years.

So, Tom, there is a silver lining sometimes in the ebb and flow of businesses as you may recall, AXT add a quite bit of capacity in the ramp of gallium arsenide in the 2009, 2010, 2011 stage and then when the Silicon On Insulator cannibalized some of these sockets, we took that some of that capacity down and guess what, we still have to furnish the stuff though. So we’re – we think we’re in good shape that’s not an issue at all. So…

Great, thank you. And then I think we didn’t talk about today because it’s still a couple of years down as the indium phosphide and 5G cellular, power amplifier potential market there. I was just hoping you might rank the opportunities as you see them like the top three in terms of potential revenue growth over the next three years in terms of silicon photonics, 5G or VCSEL as what order do you think that come in terms of potential growth?

Yeah that a very good question. I think you know in my mind I think this silicon photonics or indium phosphide that’s a verge study and has a great potential and should be a steady business although it’s very hard to gauge because silicon photonics was just introduced late last year and because it’s coming from a very small volume based to begin with when they were no – I mean although we’re seeing some number that’s projected to grow 50% year-over-year for the next four, five years. I mean that comes from a very large big company protection. So if that were to grow out of 55% year-over-year, potentially it can exceed the PON business opportunities.

Exactly…

So I think that’s a very solid business, and it’s very difficult in penetrating our business. VCSEL, I believe with this low EPD requirement, it’s a great opportunity especially it’s a commercial product, so the volume rank could be just tremendous. I really think so and it really – it’s our responsibility to capture how much of this opportunity that is presented to us and we’re very anxious, but of course at this point, we don’t want to build a expectation too much because – in the next year you say well maybe they going to launch with a limiter version may only of the – through that feature. We think that eventually we will be here, but it’s just about the timing and volume. As far 5G is concerned using indium phosphide, I think that’s going to be a three or four years of wave business. We are still developing our 6-inch indium phosphide capability and you know if that business were to come that’s going to overwhelm everything else, but it seems this is going to be four, five years from now, we’re going to need to discount it very heavily, the expectation at least.

Yeah, Tom, kind of a conscious summary we think that the indium phosphide has a high barrier to entry, we see the optical network PON business going on and on even though it’s taking a – took a breather at the end of the year and we think silicon photonics could exceed that that product line in terms of the application. I mean so indium phosphide is like gold for us. It’s in the bank. We know how to do it. We’re already doing it. So we can also do low EPD, but at least for this year, we’re really expecting indium phosphide to continue to be the driver. In 2018, we think it could very well be a 3 horse race, silicon photonics, the PON business and the VCSEL business. And we in each one we probably don’t care which horse wins because we have all three horses.

Yeah too…

Congratulations again. My last question – the VCSEL business being gas based, would you expect gross margins to come back down if that was to equal indium terms of revenue, or does that have a higher gross margin than the traditional…

We normally talk about individual product gross margin, but let me characterize this product. This EPD requirement so called defect density, it’s very stringent that the EPD let me give you an example I mean it’s very technical, but EPD requirement for very good laser quality material is less than 500. This product – figure out of specification is less than 100, okay. Not only that on top of it, it’s the size of this crystal is actually 6-inches. The larger the crystal is the more difficult is to make this low defect density. The reason I mean elaborating on this is more difficult, so then the yield is so lower for just about everybody. So the raise among us is who can achieve higher yield in shorter time to get a higher gross margin? I don’t want to discuss the gross margin openly, because I think, some of our long customer maybe listening and we have a very good gross margin and lower the price. But I think, this is a challenge for the industry, who ever can achieve this lower – meet this specification, which could yield is going to benefit. And we believe we’re well positioned for this race. Is that a good answer?

It’s a great answer. Thank you very much for the clarity, I appreciate it.

And our next question comes from Dave Kang from B. Riley. Your line is open.

Yes, thank you. Good afternoon. First, couple of questions regarding your indium phosphide business, so is this still about 30% of revenues total sales.

Yes, it is about there.

Okay. And then within indium phosphide you talked about silicon photonics and Chinese or PON business. Sounds like PON is still bigger than silicon photonics. So is it fair to kind of – Chinese partners maybe half of indium phosphide then maybe silicon photonics is maybe 20% or 30% is something like that, roughly.

Yes, Dave, it’s very difficult for us to really identify what is what. We know some of the customers that we work with. And they are using for silicon photonics and we can identify. But some of the substrate results to they don’t tell us what they use it for. Especially for those who we sell it to [indiscernible] from their proprietary reasons, they don’t like us to know. And the reason why we know some of the designated for PONs business is because again we work with someone special specific customers they feel wow this is for Chinese market and this meaningful part. We know that. But there’s a lot of big brackets of it, we say we don’t know. Okay, that could be for – either for detectors, avalanche photodetectors or PIN diode or it could be for lasers. And whether you’re going to use the laser in what fashion, what is long distance, metro or four PON business, it’s very difficult for us to tell. Okay.

Got it.

Okay, to answer your question in general, we believe PON business was very – it’s bigger, because it’s used everywhere and silicon photonics is gaining traction.

Got it. And is it fair to assume that – I assume indium phosphide is the biggest component bigger than gallium arsenide or semi-insulating and semiconducting. Is that correct? But then overall gallium arsenide is bigger than indium phosphide.

That’s correct, yes.

Got it.

Semi-insulating and semiconducting if you combine the two is still bigger than indium phosphide.

Got it. And then Gary you talked about investing in R&D and CapEx, can you provide any kind of quantitative flavor. How much we’re talking about in terms of R&D and CapEx for 3D sensing.

I don’t have a broken down in CapEx. We usually spend, we say $4 million to $6 million a year, but it’s really been on the low side of that in 2016, it was below $4 million in CapEx. But I would expect in the next couple of years we will be above $4 million, but probably will not above $6 million. There’s nothing specific to say that, okay, we’re buying CapEx equipment for low EPV. When we buy furnaces for gallium arsenide, it’s a furnace for gallium arsenide. So we might tweak it a little bit, but it’s not like it’s uniquely just you can only do low EPD in this furnace.

We are running a lot of experimental R&D activity in the crystal growth area to improve our yields and to achieve those very stringent requirements. I think we are.

Yes. So…

But, it’s not showing up, I think amazingly in our R&D budget, so but I think we have achieved quite a bit in R&D.

We’ve assigned more people to it. But we didn’t necessarily go hire 10 people. We just took some really smart experts within the Company and turned him loose. So that’s why the – it’s hard to say, we added ten people and the each cost a $100,000 and that’s a million dollars. It’s not like that.

Got it. And couple of more, regarding maybe you talked about this already, but I think I missed it. But regarding your first quarter revenue, although, can you just go over the assumptions of various components. Whether something is – whether indium phosphide will be flat, gallium arsenide will – how should we expect gallium arsenide, whether they’re going to be up or down? Any color regarding your components.

Yes, from my perspective, so I don’t provide numbers but I seeing the budget for the projection. We have sort of a set way of coming out with this projections. Okay, first of all, our visibility is really traditionally very short. Hopefully we can improve, with demand that the product, but lot of our customer just pooled the material potentially in the last minute. But I think in Q1 projection I think semi-insulating gallium arsenide is going to rebound from the fourth quarter. Because fourth quarter really some of the customers are saying maybe the inventory – still that inventory is over with – they’re going to resume ordering. So semi-insulating is going to be up a little bit. Indium phosphide actually is going to be down a bit a tech from the fourth quarter. I think semiconducting, I think it’s sort of flat and germanium is having a good quarter, because the satellite activity is fairly strong.

That might be up a little bit.

Yes, that might be up a little bit.

And lastly, raw materials.

Raw material, we think it’s going to be sort of flat and down slightly.

Okay, got it. That’s helpful. And last question is that – this is just a theoretical question, but let’s say a new phone with a 3D sensing will launch in September, and when do you see the orders for that – theoretically speaking.

Well theoretically speaking, I mean, of speaking of launch in September I think we should start to see some revenue in June, because they need some time to build it.

Right, so about one quarter head start.

Yes, I think so.

That’s fairly realistic, yes.

Yes, okay. That was it for me, thank you.

Thank you, Dave.

And our next question comes from Joe Maxa from Dougherty & Company. Your line is open.

Yes, thank you. Just wanted to follow-up on kind of the mix. I’m just thinking more about on raw material side, as far as looking year-over-year it’s been weak as you’ve stated. And do you expect that to continue to be weak. I’m just thinking about is it more of a volume or a pricing issue that’s been weak year-over-year and how does that look going forward.

Yes, Joe, I think raw material, we really see a beating in 2016. I think the first half of 2016 the price of gallium, probably came down a good 30%. Although it’s started to recover in the fourth quarter, but we don’t know how firm it’s going to be going forward. So I think the raw gallium price – the 49 gallium price has really hit the bottom in sometime in October or September. And now it’s probably 10% to 15% higher than the bottom level, but the question is how far would it run or will it go back again. I don’t think it’s going to go back but we just still have no idea. Although some of the other business for our joint ventures, I mean we can get a little bit more color. We have a joint venture, which placing to the OLED market and that is going to see a very exciting growth, although they are with joint ventures. So their annual revenue is seeing the neighborhood of very small. So although they see very good growth, but in our total mix is not going to make move the needle so to speak. And we have yet another joint venture which place into the good florist. And higher for LED lighting that is also seeing very strong growth, but again it’s a very small business opportunity. So the main focus probably is on gallium, I think how far it would go from here on is anybody’s guess.

But the decline in revenue is primarily due to pricing. We did furlough one of the gallium factories for about six months in 2016. So that also took the revenue down a little bit.

So is that back up and running.

Partially.

Yeah.

Okay. And back on the operating expenses I thought I heard you mention you were going to be perhaps ramping R&D and sales to prepare for the gallium arsenide or the 3D sensing opportunities. Should we – what should we be thinking about as far as your overall OpEx, especially as we get into – I suppose Q2 and the back half of the year.

Well, if you look back over six or eight quarters. It’s pretty flat – it’s plus or minus couple of hundred thousand dollars. What I suggest people should think of is that if there’s no big hockey stick, but there are some key hires we’d like to make this year. And so I think you can it’ll inch up maybe $100,000 each quarter at most. But I don’t – it’s not going to get to $6 million in it. I can’t see it getting – it’s not going to be huge jump. So and again, we’re and – when we say we’re investing in sales readiness, it doesn’t necessarily mean we’re hiring more sales people. It just means that we are lining up our debts we’re making plans, we’re making sure we’re in front of the potential customers and things like that.

Yes I also I’d like to add a little bit color on this, so called R&D low defect density. I mean we are making good progress, but I think because we are running our factory and some of our production can be diverted in to that R&D run. So the material we produce actually are sellable material. So they’re not necessarily getting into the R&D expense, bucket. So that’s a great advantage for running a factory that, we’re running sustainable business, we have other six inch substrate requirements. So we’re just running that with the aim of developing lower EPT material and existing customer doesn’t mind either and of course by the way, if we achieve very low EPT, they belong to a different price category and we see before the future.

And Morris you mentioned, expecting increased revenue in the silicon photonics market from – in 2017. Any sense on the timing of that, should we be thinking it’s more of a back half or do you expect to see that continue in the second quarter and then continue ramp through the year.

I think it’s going to be a continue ramp, although if we compare year-over-year, this year’s customer requirement is far greater than what we got last year the first quarter. But however this quarter of this year, we’re still being sort of putting a penalty box on the PONs business. So it’s a compensation of the silicon photonics, it’s still holding us up. But don’t forget PONs business back in early 2016 was a greater major business. I think, there’s other phenomena we also said, the industry said that the industry is in transition from the 2.5G PON to 10G PON. So I heard people are saying that they’re reluctant to build 2.5G, because the speed is lower. So they were transitioning to the high speed 10G PON, and when that business start to ramp that should also help us. Because as I understand it the 10G PON requires larger real estate to make the device work better and so larger real estate means more substrate that means more revenue for us.

Okay, that’s all I had. Thank you.

Thank you.

And at this time I’m showing no further questions.

Okay, well thank you for participating on our conference call. As always, please feel free to contact me or Gary Fischer directly if you would like to meet with us. And we’re looking forward to speaking with you in the near future.

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