AXT, Inc. (AXTI) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. And welcome to the Q2 2017 AXT Inc Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session and instructions will follow at that time [Operator Instructions]. As a reminder, this conference is being recorded. I would like to introduce your host for today’s conference, Gary Fischer, Chief Financial Officer. You may begin.

Thank you, and good afternoon to, everyone. Before we begin, as usual, I would like to remind you that during the course of this conference call, including comments made in response to your questions, we will provide projections or make other forward-looking statements regarding, among other things, the future financial performance of the Company and our ability to control costs and improve efficiencies, increase orders in succeeding quarters, improve our competitive position in the market, 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 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, 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 Web site 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 Web site at axt.com through July 26, 2018. Also, before we begin, I want to note that shortly following the close of market today, we issued a press release reporting financial results for the second quarter of 2017. This information is available on the Investor Relations portion of our Web site at axt.com. Now, turning to a review of our second quarter results. With that in mind, total revenue for the second quarter of 2017 was $23.6 million compared with $20.6 million in the first quarter of 2017. Of our total revenues, substrate sales increased to $19.1 million compared with $16.6 million in the prior quarter. Revenue from our raw material joint ventures was $4.4 million in Q2 compared with $4 million in Q1. In the second quarter of 2017, revenue from North America was 7%, Asia-Pacific 68%, and Europe was 25%. Two customers generated more than 10% of revenue in Q2, and the top five customers generated approximately 37% of total revenue, reflecting again our diversification at both products and customers. Gross margin in the second quarter was 30.8% compared with 30.5% in the prior quarter. It's important to note that gross margin from the substrate business was higher than the corporate level, offset by gross margin from the raw material business, which included a lower cost or market write-down of raw gallium from one of our consolidated joint venture companies. This reduced our total gross margin by almost 1 percentage point. As we look forward to Q3, our expected increase in volume will benefit the gross margin, specifically as unit volume grows. The manufacturing overhead costs are spread over more units. And as we all know that helps the gross margin. I'll provide more color on this in our Q3 guidance in a bit. Total operating expenses in the second quarter were $5 million compared with $4.9 million in Q1. Actually, the spread was only $44,000; Q1 operating expense was $4.917 million and rounds down; Q2 was $4.961 million rounds up. We continue to run relatively flat quarter-to-quarter for OpEx. Total stock compensation was $310,000 in the second quarter. Operating profit for the second quarter of 2017 was $2.3 million compared with $1.4 million in the previous quarter. Interest and other income for the second quarter was a net charge of $176,000. This net number consists of four categories; number one, net interest earned of $114,000; number two, foreign exchange loss of $90,000; number three, equity accounting on our unconsolidated joint venture companies, a loss of $188,000; and number four, other items equaling a loss of $12,000. In addition, the tax provision for the second quarter was $321,000 compared with $159,000 in Q1. For Q2 of 2017, we have a net profit of $1.9 million or $0.05 per share. By comparison, we had a net profit of $665,000 or $0.02 per share in the first quarter. The diluted share count in Q2 is $39.7 million shares. Cash and cash equivalents and investments closed at $87.5 million as of June 30th, up $767,000 from $86.8 million as of March 31st. Depreciation and amortization in the second quarter was $1.1 million and CapEx was $1.9 million. Accounts receivable, net of reserves, were $18.3 million at June 30th compared with $17.6 million at March 31st. Net inventory at June 30th was $40.6 million compared with $39.2 million of inventory as if March 31st. Ending inventory consisted of approximately 49% in raw materials, 46% in WP and 5% in finished goods. Okay, this concludes the financial review. I'll turn the call now over to Dr. Morris Young for review of our business. Morris?

Thank you, Gary, and good afternoon everybody. 2017 is shaping up to be a solid year of growth for AXT. While much attention lately has been placed on certain applications for compound semiconductor substrates, we are seeing an expanding universe of emerging applications and technologies across our portfolio that are driving growth in every one of our substrate product categories. As a result, we achieved record revenue in indium phosphide substrates in Q2, and posted solid growth in semi-insulating gallium arsenide, semi-conducting gallium arsenide, and germanium substrates. Our customer and revenue base continue to diversify, giving us a broad-based opportunity for continued growth. This is particularly evident in indium phosphide with key applications are being in augmented. And we are also receiving many spot orders from smaller accounts serving a wide variety of emerging applications. These smaller orders do help the revenue but more importantly, they indicate an increasing interest in indium phosphide. We believe there are many new development programs underway, either at the research level or at the development stage level; although, each maybe a small volume today some will likely grow into true production level volumes in the future. One of the positive elements in our business model is that the product cycle lifetime is very long, long subject. One market segment that has received a lot of attention is the passive optical network applications in the fiber-to-the-home and office. In Q2, the EPON market continued to be a strong revenue generator. As many of you know, the EPON market hit a low in 2016 as a result of inventory rebalancing. In the last few quarters, we’ve seen our revenue from this market bounce back, though not at the level we experienced in 2016. China is certainly a key region and its recovery will provide further opportunity for revenue growth for AXT. But the AXT supplies into a number of regions and customers worldwide, and we see healthy opportunity in the global power market for many years to come. In the meantime, demand for indium phosphide from silicon photonics applications continue to grow, providing AXT with other major driver for our revenue. Silicon photonics is a breakthrough technology in datacenter connectivity that enables high speed data transfer for low-power consumption over optical fiber. It is quickly the research and development base to commercial development with leading global companies, such as Intel, HP, Cisco, IBM, Broadcom, Infinera, Mellanox and many others driving its adoption. In less than 18 months, we have seen this application go from contributing virtually no revenue to now contributing more than 25% of our indium phosphide revenue. Further, with a number of silicon photonics products coming to the market this year, the growth rate is likely to accelerate. In addition to datacenter connectivity, silicon photonics is being leveraged in a wide variety of applications in telecommunications, Internet of Things, metrology, consumer electronics and display, healthcare, sensing, autonomous cars, security and others. As I said, we believe some of these applications will generate good volume for us in the future. And finally, a third area of focus for indium phosphide is telecommunications. With the current infrastructure upgrade cycle and preparation for 5G are providing opportunities in short haul, long haul and metro deployment. We believe that this application will be a market driver and contributor to our revenue growth for many years to come. In total, we believe that we are in the early stage of indium phosphide growth, and that 2017 and '18 will prove to be pivotal years. Overall, the optical applications are expanding and the small number of companies supplying indium phosphide wafers should benefit from this expansion. We're excited that investment we have made into product development, manufacturing efficiencies and customer support, are positioning us to optimize what is shaping up to be a very exciting market in the coming years. Now turning to gallium arsenide, sales was up in Q2 and are expected to be up by healthy percentage again in Q3. As many of you know, this area of our business has continued to provide a solid, profitable and stable revenue base for quite some time now. Over the wireless side, traditional applications, including power amplifiers for RF devices that did not move to SOI. We also believe that our substrates are going into cellphone Wi-Fi receivers and transmitters. Now on the LED side of our gallium arsenide substrate business. Traditional applications include backlighting, signage and display and among others. All of these applications are expected to continue to contribute to our gallium arsenide substrate revenue for the foreseeable future. In addition, one of the unique things about gallium arsenide is that is governs a spectrum on light that isn't seen by the human eyes, making it ideally suited for application that call for infrared right. We're excited to see a host of new such applications coming to the market that are providing other ways of growth for these substrates. For example, we’re currently experiencing growing customer demand for a variety of other high-end applications for infrared lighting, in which low EPD requirements, limited number of competitors that can meet the stringent specifications. These applications include virtual augmented reality, retinal recognition and automotive sensing, among others. In addition, amongst the most well publicized market development these days right now is 3-D sensing. We view this as a major opportunity for high-end substrate manufacturers in our industry, because the strict technical requirement of 3-D sensing provides a strong area to entry to new or low end players. Today, only three competitors, including AXT, are able to provide low EPD substrates in sufficient volume for production ramp. And we expect that market growth in the coming year will provide exciting opportunity for all. In total, gallium arsenide is experiencing resurgence in demand, driven by combination of the two applications and newly emerging technologies. Among other substrate material, gallium arsenide has the advantage of being a highly reliable, proven industrialized material with a healthy supply chain. As pioneers of low, now industry standard VGF technology and as a leader in low EPD substrate, we are in a good position to benefit from this trend. Now turning to germanium substrates, sales increased in the quarter, reflecting a decent improvement in the worldwide satellite market, particularly in China. The predominant applications remain in communications, positioning and navigation, and remote sensing. We believe that strengthening market conditions are likely to provide opportunity for AXT’s revenue growth over the coming year. Finally, with regard to our raw material business, the market continues to struggle with overcapacity, particularly in raw gallium. As Gary mentioned, during Q2, one of our gallium joint venture took an inventory write-down, which was reflected in our financials. Many of the markets, including our joint venture supplies, are improving. Our joint venture companies are an important part of our supply chain strategy and we do expect future improvement. Overtime, we are hopeful that this may serve as a rebalancing economics of supply and demand. Before I close, I wanted to take a moment to give you an update on a couple of operational components of our business. First, I am pleased to report that we had identified a new site for our gallium arsenide manufacturing facility. And we do expect to finalize the agreement in the very near future. We’ll give you full details when we are able. But what I can tell you now is that it is reasonably close to our current location, and it has 140,000 square-feet of manufacturing space already built plus an additional building that can be used as dormitory and offices. Existing buildings will ease the logistic requirements for our technicians. As discussed, we’re planning a phased transition to avoid any line task situations and provide product continuity. I also want to note that we have recently hired two direct sales professionals; one will be based in Europe and the other in the United States. We’re now actively working to further build our direct strategic partnership with key customer accounts in these regions. These individuals combine good technical skills with a strong customer presence. We believe additional direct coverage will allow us to deepen our relationships with certain current customers, and to participate in ever broadening universe of new customers and applications for our products. Now, in closing, this is exciting time for our business. For the last couple of years, we have anticipated the potential growth of silicon photonics and we're now excited to see it now making a material and growing contribution to our indium phosphide revenue. Coupled with the sizable opportunity in fiber to the home and office in a number of smaller emerging applications, we remain confident that indium phosphide will continue to be a major driver for our business for many years to come. In addition, with the number of new applications for gallium arsenide all directed within our core competency, we are seeing renewed growth in area of our business that some thought within the twilights. As I have said many times, gallium arsenide is not going away. This ongoing diversification of our revenue base expands our business potential, reduces our dependency on any one product or application. Operationally, our recent investment in R&D and customer support are allowing us to provide consistently high quality products from some of the today's most technically difficult applications and give us, our customers, the technical support they need to make product initiatives a success. We're actively planning for growth and business expansion and we're making good progress with the relocation of our gallium arsenide facility. As always, we remain firmly committed to continue in our business and financial model. This concludes my prepared comments. I will now turn the call back to Gary for our third quarter guidance. Gary.

Thank you, Morris. Once again, as Morris said, Q3 shaping up nicely reflecting an increase in each of our substrate categories. Because of this, we believe that total revenues in Q3 will be in the range of $26.5 million to $27.5 million. As I mentioned earlier, we're seeing a meaningful positive impact by increased volume because our manufacturing overhead costs are spreading over more units, and this helps gross margin. We estimate that in Q3 this is expected to provide 1% to 2% increase from our Q2 gross margin level. In addition, we work diligently with one of our three consolidated joint venture companies to increase the utilization of a very important raw material that they supply for our manufacturing process. As a result, our cost savings from this effort in Q3 is expected to provide an additional 1% to 2% benefit to our gross margin over Q2. And this illustrates the tangible benefit derived from our supply chain strategy. As a result, in Q3, we're expecting to be in the range of $0.08 to $0.10 per share based on a share count of $39.8 million diluted common shares outstanding. So this concludes our prepared comments. Morris and I will be glad to answer your questions now. Operator?

Thank you [Operator Instructions]. And our first question comes from the line of Joe Maxa from Dougherty & Company. Your line is now open.

Thank you, and congratulations on a nice quarter, and heck of guidance. Can you give us a little color what maybe the breakout of the upside in the guidance? I mean, you talked about all three segments growing. But it is indium phosphide more so than gallium arsenide, or would you break that out pretty equally?

Well, they’re all -- gallium arsenide is going up, LED gallium arsenide and semi-insulating gallium arsenide, indium phosphide is going up and germanium is going up. And it’s a significant movement. They’re all pretty much double-digit in growth, yes. And indium phosphide is growing probably the most. If you keep gallium arsenide in two different buckets between LED and wireless, indium phosphide will be the biggest dollar growth, yes.

It’s reflective of the color Morris tried to give. And as we would like to say, there is a story behind every number. So Morris gave you some of the story of what’s going on in the marketplace. And the beauty of numbers as they roll out and illustrate what was just said.

And the indium phosphide, it sounds like the key driver of that is the silicon photonics?

Yes, that’s correct.

I wanted to ask a little bit more on the 3D sensing side, what’s your scene out there? And when -- it sounds like you don’t have in order yet, which is understandable. But I am wondering what’s your thought process is as far as preparing for that?

You’re right. We don’t have an order in hand. We want one. We’re working very diligently. We’re very hard to work with our customers to remove any barriers in front of placing an order. We have worked with our customers, and the feedback so far is, our material works very fine in the line. We have one of the lowest EPD requirements, sufficiently fulfilling the requirement. But somehow, we just don’t have the order yet. And I believe this is in early stage in its development. So we believe to battle -- the longer term, there’s a lot of opportunity for us, but we’re not also limiting ourselves. Although, everybody knows that’s one customer, which is dominant but there are many other smaller customers that are actively looking at material. And we are really putting our money where our mouth is. We’re doing good development in terms of technically reducing the EPD everybody likes and we are hiring a sales and marketing person to look at what the customer requirement really is, and we’re working in the long-term. We believe that we will benefit from it. But we just don’t know when yet.

You’re accelerating the plans to open your new facility in part to take advantage of the 3-D sensing opportunity?

Yes, absolutely.

And that has existing footage already constructed. It was a motivator in the selection of this site.

And when would you expect to be running that, maybe not for 3-D sensing. But just be up and running in that facility assuming you close it relatively quickly?

We do expect it to start operation in stages. I think the first stage is probably doing some of the crystal growth, which we do expect it to be completed in three to four months because of the interesting building we already have. And then wafer processing probably keeps a little bit longer, because it evolves with building out the clean room. And so we do expect samples from this clean room environment with the processing part by the end of first quarter of 2018. But our -- one of the beauty of our business is such that we believe some of our customers who accept a true stage mix. In other words, we will qualify the crystal growth side first and still doing the polishing on our Beijing facility. And later on when the wafer processing is completed there we will then qualify the wafer processing as well. This has the advantage as you know that our business is very, very, I should say, robust but it's very good. So I think that would be for customers a more safety net to get more capacity as their demand increases.

Just one last one from me, the Q3 guidance you gave. Is that a number, I mean, I know you’re not giving forward guidance. But is that a reasonable number to think about, going forward, at those levels? Or do you expect to see growth from there?

Well, we don't think it's a blip. And we would expect it to be sustainable, and be added to, so absolutely.

Okay, thank you very much.

At all these, we're not counting the 3-D sensing yet.

That's great.

Thank you. And our next question comes from the line of Edwin Mok from Needham and Company. Your line is now open.

So first question is just circle back on indium phosphide, I guess two things. I’d probably ask, first, is Morris you mentioned there are some small orders coming that help the quarter. Is that a trend that you just continue to see going to this quarter or give you confidence about this double digit growth this quarter? And are those small orders coming all over the world, or especially concentrated around China for supply and market? Or could you give some color on that?

First, actually it's actually come from all over the world. We’ve seen some new activities in Europe. I mean there are companies setting up actually a new facility setting up from Europe. We definitely see it very active in China. The United States is probably mostly existing customers, but we are getting into them. We’re telling them we are really good, reliable high volume and good quality material provider. And we're gaining market there but I think the smaller application, I mean so most of these smaller accounts are probably not addressing EPON market. I think the EPON market is probably a lot more -- a little bit mature. I think some of these -- we actually don't know what they're doing actually. But we are seeing they are taking hundreds of wafers instead of thousands and now that's consistent as some of the larger customers take monthly orders. But we definitely see, we visited that and they are very, very enthusiastic about the development of our indium phosphide businesses.

I remember a few quarters you guys talked about this indium phosphide being 30% of your sales or somewhere of that magnitude. Is that fair to think of the business at the site now?

Can you repeat that question?

I remember you guys talk about indium phosphides being around 30% of your sales, something of that magnitude. Is it fair to assume around that range?

Yes, it is still close to that range. The one thing that’s made a little bit of difference is the other two product site tests growing also. So I mean when we were saying around 30%, we were seeing good growth in indium phosphide, but relatively flat in other product lines. Now, the market has been -- the demand for all the products has been very good. So it’s a horse for us.

For the first quarter, you guys talked about GPON market improved although modest to 2016 rate. For the third quarter, are you still counting on EPON market to remain at that similar level?

Yes, but we stated in our prepared comments, GPONs market level is not as high as some of the 2015 numbers. It has appreciable drop from 2015 levels. But as you recall, if we say 2015 was a 100 by the second half of 2016, it went down to 20. Now, it’s bouncing back to something like 65, okay. We’re counting the GPONs market to be around 60 to 70. It has not returned to 100 yet, because I guess the 2015 level has quite a bit of this building inventory and there is a shortage in material. But I do believe the GPONs market will recover and also I believe that potentially the new GPON, which is the 10G-EPON, will then accelerate the adoption of the market or the demand for this EPON market again.

Yes, definitely nice bonding of demand, end market demand which is great, beyond just GPON market. Can I just ask a question around seasonality, I think if I go back and look at historically, 4Q your substrate business also raw material typically is down sequentially, and you guys seen a double-digit range. This year seems that the market is very, very strong right now. Do you expect -- do you think that you may outperform that seasonal pullback in fourth quarter, or at least that’s a smaller pullback in the fourth quarter?

Well, we don’t have numbers yet from our field guys on Q4. However, we have color and a total sense Q4 is looking good. We think it’s quite possible it won’t be down, or if it’s down, it will be just down a tab but it could also be up a tab. So we don’t know. But what you are speaking to Edwin is the fact that yes if you look back historically, Q4 has generally been down from Q3 and for seasonality reasons. But those reasons still exist. However, the strength and dynamism in the marketplace right now is going to offset that.

And also in Q4, we have two events you have to consider. One is the year-end most customary. If they're not that busy, they want to reduce their inventory. And the second thing is perhaps particular to AXT is we have our manufacturing in China where October 1st is the holidays and they usually take 10 days off. So with this full in line, it's difficult for first quarter to grow, but you're right. The demand for what we see now is very strong.

So it's not out of the question, it's just not clear yet.

Gary, I have a question around the raw material. You mentioned that there is a write-down that you have in the gross margins by 1 point. And I think the raw material business based on prior report suggests this still not profitable. If that were to think about, how or if this cost saving that you talked about is going to start bringing that back that to be a profitable business? Or is there more work then to be done for that business for the business?

Well, the seven companies that we use the equity method of accounting for, they finally dropped below a significant hit. We were hopeful that their charge to our income statement in Q2 would be less than negative $200,000. And we were actually on that, came in at minus 188, so that's a huge step forward from the previous three or four quarters, especially Q1, which was over $900,000 because we had a write down in that quarter. So those seven companies we're hoping that they can get to breakeven in aggregate by the end of this year, or maybe just at the charge or the loss that we see continues to go downhill. Then there is the three consolidated subsidiaries, two of those companies are actually pretty strong and they are beneficial for us. And then the one that's the raw gallium company is still struggling. So what's happening is the two healthy ones are already pretty much offsetting the raw gallium company. So the 10 joint ventures in aggregate for them starting in 2016 and up until now have been problematic. But if you go back, historically, they've been accretive and beneficial. And I'm very pleased with the identification, which we credit more score in this case. But could really work with this particular subsidiary to increase their output, so that we can buy this important raw material at their manufacturing cost because of the way the accounting report, and that’s beneficial for us.

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

So first off I wanted to start off with was last quarter you were talking about broader customer base with the indium phosphide. This quarter you're talking about the same, but the unit volumes are increasing. Now did you see a return of orders from your large customers, or are you seeing that going into Q3? Or are you depending on the smaller customers to make up the difference?

Actually, I think it's from both. The larger customers they are increasing the demand, the volume, but not adding one, I mean some of them and the other. But we do notice that other very distinct phenomenon is that there is a lot of smaller orders, and they do contribute to the revenue. But those are less predictive, because they will give us a clear path of how many they want to order next quarter or next month. So in our projection, we’re probably mainly looking for the existing long-term customers, they’re giving us the color or guidance on how much the demand will go for the next quarter and after that.

And then on the pricing, given that you’re seeing so much demand, why is it that you still don’t have pricing power?

Because we’re in the semiconductor business…

Well, I guess specifically you are saying why do we raise prices, I guess, to a certain degree, we can but customer obviously is very reluctant and we haven’t got to that stage yet. So the first order of benefit to us is that we can benefit from this spread out of our fixed cost. So we’ll gain from that, we are already thankful and good. And then our capacity start to get constrained and we’re getting way over our expected runway, because don’t forget we have to deliver this set of revenue for our Wall Street friends. So we’re very cognizant of the fact how we need to get orders. But once we’ve got that and as you over that, then we could be selective, some of the lower, margin wise, we will start to drop and we’ll not pursue those lower end markets. That in a way is increasing price. And lastly, I would also comment look, we have been seeing there’s other way to increase prices with some of these customers, they start to migrate, for instance, in indium phosphide they migrate from 2 inch to 3 inch. They put a little bit more stringent specification onto it, and every time they do all these then the price is different. So we can gain margin in that way. I mean, the other matter is 3-D sensing, look this is a brand new market. And although we are not happy to report, we don’t have the order but this market once we get in should give us healthy margin, because they are very difficult to meet those specifications. So that is in other way to improve the price and gross margins.

I think we can improve margins by features and benefits, diameter sizes and specifications. But we’re both over-age 50 in my entire career I’ve never been to be able to just raise the prices. So I wouldn’t bake any of that into anybody’s forecast, if I think it doesn’t happen.

Back in 2000, increase by 6 inch price of 450 to 480.

There you go.

And then two quarters later it’s us…

Last question is did you have any crystal growth capacity in the quarter, and do you plan on doing it in Q3?

Yes. And one of the strength of AXT is that we have already saying to our investors as well as our customers, is that where know VGF from inside out. So we are very dynamic in terms of adding capacity for crystal growth, because we do assembly of the crystal growth equipment ourselves.

Thank you. And our next question comes from the line of Tom Sepenzis from Northland Capital Markets. Your line is now open.

Thanks and congratulations on a great quarter and guidance. Just wondering, if there is any risk at all in the current inventory, I know you just did the write down in the June quarter. But what risks are we looking at in the current inventory that might get written down in the next six to 12 months, or is there any?

Of course, it's very difficult to predict the future. You know how the view is. If we have certain inventory, especially the gallium manufacturer, let's say, 10 tons of this inventory and it carries at this current price and I believe, right now, it's RMB820 or maybe RMB830. And it writes to that level and it next quarter dropped down to 7, I know you have to write it down. But so far, we believe that it's at a very, very low value already. So I believe anything it could go up. But again, we don’t want to predict the future.

So we wouldn't expect any LCM or lower cost of market that would touch the substrate inventory. This is specifically a problem because of the raw materials' businesses and it's uniquely focused, almost singularly focused around raw gallium. Even our purified gallium company, we don’t have write down problems, it's the raw gallium in China that has been problematic. So it's not broad in scope, it's narrow and we can identify it. But we can't predict. But it's not likely to go down further, but we can't predict.

And then in terms of operating expenses, obviously, you're not expecting a huge shift here in Q3. But just directionally, looking out a few quarters with the higher revenue, do you planned to start spending more on R&D to get back to levels that you had maybe in 2016, or earlier for anything? Or should we expect that they'll stay pretty low here?

I think they’ll tick-up some but probably not because of reinvesting in R&D, which I'll comment on in a second. We've added two new sales guys and we're still adding a couple of more professional people. So there is some labor there. As a side note, one the reasons the RD number is lower is because we had some things that were charged to R&D, because they were truly R&D but then they went into production. So now the effort that goes towards those that product line, which happens to be in one of the subsidiaries, is going through cost of goods sold. So it's really a change in the business model that it was a development program, so it should be charged by GAAP rules to R&D but it went into product. Now, if you’re fine tuning it, it's difficult to capture just the development cost so it's all in cost of goods sold.

When did that shift occur, was that in the March quarter?

Yes, it was.

Thank you. And our next question comes from the line of Richard Shannon from Craig-Hallum. Your line is now open.

I guess I just got a few left here. First one is on gross margins. Gary, you mentioned something about the benefit in the third quarter coming from a new raw material or something like that of 100 to 200 basis points. Just wondering if you can detail that more about where that’s coming from and as well as that as a sustaining at one-time benefit?

It’s an important ingredient into one of the substrates for single crystal growth. And more so the idea was to push this Company to produce more, because we do buy also from an independent third party but because of the opportunity to buy more from one of our subsidiary companies. We would then have that cost of goods sold via their manufacturing cost, because of how the elimination rules work for GAAP accounting. So it’s a strategy that we can build on. It’s too soon to say that we can repeat it over and over and over, because we need to see what their capacity levels are. And Morris and I are both going to China in August, so it’s a topic that we’ll be discussing with this company, yes.

Question on CapEx, as you make this facility move it sounds like you’ll finalize this plan shortly. Are there any duplicative expenses here you’re running both facilities at the same time that are meaningful? And if so, how long would they last?

Yes, I think we probably would operate in our two facilities for maybe year, year and half, would you say? But however I don’t think the expenses we will incur more is the extra equipment we’re going to buy in anticipation for the larger volume as well as for the ease of moving to new facility. We already told our purchasing people to buy 20% more material that you should see the situation coming online once we got those installed, they will start to produce material. But if our business were to pickup then we should be able to absorb that as our demand goes higher if 3-D sensing some of the silicon indium phosphide business will do increasing volume. As far as manpower is concerned, I think for the transitional period of time, we probably should have a little bit more expenses, the added expenses or manpower such as cafeteria, workers from both sides and garner the site from the line.

So it’s a very important and intelligent question, and we have looked at it in various ways. And you have to break it into categories. So obviously, the single biggest dollar expenditure is for the land and the buildings and then that gets depreciated, but the good news is that that’s depreciated over 27.5 years. So because of the useful life spend what we’re allowed to use even though it’s the largest single dollar category, it doesn’t really have super big impact overtime. And then as we vacate in Beijing, we will furlough some of that space and then eventually we hope to monetize it. So once we do the furlough step, you won’t be depreciating anymore because it’s not in use. So that’s the facility. Then you have equipment, we are adding equipment and that’s going to increase depreciation expense. But that’s going to happen mostly because the volume is going up. It’s not happening because of two sites and so in that case then we wouldn’t do it unless we thought that the business needed to have it done for the quarter and pay for it. And certainly then you have what I would call manpower and administrative cost. And that's clearly going to be an increase. But the labor rate in the new location, first of all, it's in China of course but it's even less than Beijing, because Beijing will be the highest labor rate and we're in a different city now for the new location, which we haven't announced what it is yet. So that labor rate is in China and it's not in Beijing. So it's not really going to be too noticeable to an outside observer in financials. We have a little more hotel that spans driving back and forth. So there you can't say it's not going to be more expensive, but I think you can say in the scope of the financial statement, it will be barely noticeable, if at all.

Another question I guess more for Morris. You're pretty clear that you don't currently have an order for 3-D sensing and you’re working hard towards it. You want to take a guess as to when you might see one to have an order by the end of this year, or is that still hard to tell? Or can you give us the sense of what that visibility and pipeline looks like to get that first order?

We are actively working with our customer and customer is customer, and customer is hopefully customer’s customers’ customer. And when we move in some of this requirement they want it from us. And so far as we know the feedback we have very good material property, they love our EPD. We have some other issues with the customers that actually including moving at the site. But I don't know whether that's a absolute no, because we understand our material, merits of our material property may get us in. But we just don't know yet. We do have some secondary customers that we are working with; although, they are taking very small volume right now in the hundreds of wafer for sampling. But we are still hoping that they can be developed into substantial customers. So to answer your question, we are keeping touch with the customer. We are working diligently and hopefully, we can remove any entry barriers to getting to the first round, but we don't know when that's going to be.

My last question probably for you Morris, germanium is doing pretty well here and you talked about a favorable satellite cycle. I guess my question is what’s your experience as to how long your satellite cycles can last? And do you see the cycle being any different than what you’ve seen in the past?

But of course this cycle could be different. I mean, there is a lot of interest in building large cycle with the GPS. And now China wants to build their own [indiscernible] and that's a big driver we know, and that’s like the U.S. GPS. And I know our substrate is also seeing Russian satellite, as well as the European satellite systems. And looking forward, I do believe that other potential that is one left, and that program actually is huge. It could be 10 times this, but we're not counting on that. So I think we are both feeling sound for the germanium business, because we see the germanium pool from the satellite business is very strong, but what do we know, maybe a quarter, two quarters, or maybe three. But beyond that, it’s very difficult to predict.

And I’m showing no further questions, at this time. I will turn call back over to Dr. Morris Young, Chief Executive Officer for closing remarks.

Thank you for participating in our conference call. During the third quarter, we will be participating in second annual DWS Financial Summer Roadshow Extravaganza in New York and the 2017 Dougherty & Company Institutional Investor Conference in Minneapolis. We hope to see many of you there. As always, please feel free to contact me or Gary Fischer directly if you would like to meet with us. We look 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 and you may now disconnect. Everyone, have a great day.