AXT, Inc. (AXTI) Q3 2018 Earnings Report, Transcript and Summary

Good afternoon everyone and welcome to AXT's Third Quarter 2018 Financial Conference Call. Leading the call today is Dr. Morris Young, Chief Executive Officer and Gary Fischer, Chief Financial Officer. My name is Loren and I will be your coordinator today. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the call over to Leslie Green, Investor Relations for AXT. Ms. Green, you may begin.

Thank you, Loren 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 and our ability to control costs, improve efficiency, increase orders in succeeding quarters, improve our competitive position in the market, our schedule and timeliness regarding the relocation plan, our thoughts on air pollution in Beijing, our ability to meet demands for our products, as well as other market conditions and trends including those expected growth in the markets that we serve, global economic and political conditions including trade tariffs and restrictions, 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 results or event to differ materially. These uncertainties and risk include but are not limited to overall conditions in the market in which the company compete, global financial conditions and uncertainties, potential tariffs and trade restrictions increased environmental regulations in China market acceptance and demand for the company's product and the impact and delay - 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 July 25, 2019. Also before we begin, I want to note that shortly following the close of market today we issued a press release reporting financial results for the third quarter. This information is available on the Investor Relations portion of our website at axt.com. I would now like to turn the call over to Gary Fischer for a review of our third results. Gary?

Thank you, Leslie and good afternoon. Total revenue for the third quarter of 2018 was $28.6 million, this compares with $27.1 million in the second quarter of 2018 and $28.2 million for the third quarter of 2017. This represents year to date growth of approximately 9% over the same period in 2017. Of our total revenue substrate sales were $22.8 million compared with $21.6 million in the prior quarter. Revenue from our raw material joint ventures was $5.8 million in Q3 compared with $5.5 million in Q2. In the third quarter of 2018, revenue from North America was 11%, Asia Pacific was 72% and Europe was 17%. In the third quarter one customer reached 10% of revenue and the top five cost customer generated approximately 39% of total revenue. Gross margin in the third quarter was 37.1% compared with 40.6% in the prior quarter. Our substrate products held their own in terms of gross margin, but are three consolidated raw material companies each had a quarter to quarter decline, that plus the fact that Q2 had about a 1% incremental upside from the sale of material previously written off account for the change from Q2 to Q3. Total operating expenses in Q3 were $6.3 million compared with $6.5 million in Q2. Operating expenses continue to be in line with our run rate expectations for the year. Total stock compensation expense for the third quarter was 461,000. Operating profit for the third quarter of 2018 was $4.3 million compared with $4.5 million in the previous quarter and $5.2 million for Q3 of 2017. Interest and other income for the third quarter was a net gain of 200k. This consists of three categories, one, net interest which we earned 100k and two equity accounting in our unconsolidated joint venture companies which broke even and three foreign exchange gain of 100k. The tax provision in the third quarter was 410,000 compared to 367,000 in Q2. I do want to take a moment to talk about the U.S. tariffs with China. In the tariff list that was released by the United States government on September 24th 2018 it included wafer substrates that we manufacture and import to the United States. Therefore our Q4 2018 forecast will include approximately $150,000 for tariffs of 10% charge on the importing wafers into the United States from China. It has been said that President Trump might raise the rate to 25% in 2019. These amounts are now what we would consider to be dramatic hits, nevertheless they are real and will have an impact going forward unless the two countries can sort out and resolve the trade war issues. For Q3 2018 we had a net profit of $3.9 million or $0.10 per share. By comparison, we had a net profit of $3.9 million or $0.10 per share per share in the second quarter of 2018 and $4.4 million or $0.11 per share in Q3 2017. The diluted share count in Q3 was 40,331,000 shares. Cash and cash equivalent investments it closed at $42 million as of September 30th. By comparison at June 30th it was $54 million. The primary reason for the decline was the new facility and equipment. Depreciation and amortization in the third quarter was $1.2 million and capital expenditures were $12.7 million. Accounts receivables net of reserves were $23.3 million as of September 30th compared with $22.4 million as of June 30th. Net inventory at September 30th was $58.7 million compared with $57.0 million in inventory at June 30. Ending inventory consisted of approximately 51% in raw materials, 44% in work in process and only 5% in finished goods. Okay. This concludes the financial comments. I’ll turn the call now over to Dr. Morris Young for review of our business. Morris?

Thank you, Gary. And good afternoon, everybody. We continue to execute solidly in Q3. Our revenue and profitability came in at a high end of our expectations, highlighting demand for our product, across a diverse set of applications and our ongoing effort to drive efficiencies in our business. Many of the key applications into which we sell appear to be in the early stages of a large and promising lifecycle. We are also encouraged to see new emerging applications that are likely to contribute to our growthfull [ph] for years to come. As such, the relocation of our gallium arsenide germanium manufacturing lines is providing us the opportunity to plan for growth in our industry and to prepare our business to meet increasing customer demand. Now turning to our markets. We achieved another record quarter in the phosphate revenue in Q3 with relative strength in all of its primary applications. In particular, demand for silicon photonics based applications such as data center connectivity grew from the prior quarter. These are coming as a result of a substantial increase in the volume of global network and data center traffic that is driving the need for a more cost effective energy efficient and high bandwidth solutions. We believe that the continued adoption of silicon photonics technology and hypocenter, hyperscale and enterprise data centers, as well as the transition over time to 100G and 400G technologies will feel the need for indium phosphide for years to come. In addition to data center connectivity, the current infrastructure upgrade cycle and preparation for 5G in telecommunication applications are providing opportunities in short haul, long haul and metro deployments. As other data point for the expected growth in this application, Intel announced in Q3 that it has begun assembling a new portfolio of 100 gigabit per second silicon photonics transceivers that are optimized to meet the bandwidth requirement and the [indiscernible] environment conditions of 5G communication infrastructure. The industry moved to 5G, along with a ramp in existing network traffic for services such as video streaming is likely to strain the existing communication infrastructure. As a result they it will be – it will need to support an expanded spectrum range over time, driving demand for more efficient solutions. Beyond silicon photonics, power applications contributed meaningfully to our record Q3 indium phosphide revenue. As expected, power sales were down from Q2 following a very strong first half and this is likely to continue through Q4. This market trend tends to be somewhat lumpy quarter over quarter. The power applications should provide significant opportunities for our indium phosphide product over many years. Driving the demand is the ongoing need for faster broadband networks and increasing fibre to the home requirements. In the report published in August, Ilonio [ph] indicated that it believed the global powers market to be on track to grow at a five year compounded annual growth rate of nearly 40% by 2017 to 2022, driven by the adoption of next-generation power technology such as 10-gigabit per second EPA [ph] and AXT is now well positioned in this market and supplies virtually all the major customers. Q3 was also a growth quarter overall for our gallium arsenide business, driven by increased revenue from semi-insulating substrates. While those applications remain unremarkable, we saw contribution from the emerging use of [indiscernible] solar cells. The reduced rate and ongoing progress in energy efficiency making the solar cells effective for extending the lifetime of drones and other types of unmanned aerial vehicles. This technology is similar to what we have seen used in certain automobiles to expand battery life. Our experience with the emerging solar cell application is that its demand is lumpy, but the expansion of its use in multiple industries suggests that its adoption were likely to grow over time. Growth in the semi conducting gallium arsenide substrate are offset somewhat in Q3 by weaker demand conditions in LEDs. Based on the discussion with customers in this space, we expect a softness in our traditional lighting, signage and display applications to persist in Q4. It's worth noting that we are beginning to see more meaningful contribution from Android-based 3D sensing. To date, this year our revenue have reached nearly $1 from 3D sensing programs in Asia. Though the commercialization of the technology in the Android ecosystem is still is - in its early stages. We expect that revenue will ramp slowly over the course of 2019 and into 2020, as new devices come to market. In addition with the technology performance of our wafer and the solid progress we are making in relocating our gallium arsenide production line, we're positioning ourselves to expand beyond Android in the coming years. Given the many applications of 3D sensing technology, we believe that it will represent a great opportunity for all high end substrate manufacturers for years to come. Broadly speaking, gallium arsenide is continuing to experience a period of renewed innovation with a number of new applications being developed to take advantage of this unique properties. Applications such as Otamendi [ph] and Virtual reality, 5G wireless, LIDAR for other autonomous cars, retinal recognition and many others are emerging and will require the performance characteristics adaptability [indiscernible] that offers. Most recently we have seen rising demand for gallium arsenide in high power fiber lasers that supplement traditional cutting, welding and drilling tools for industries, micro fabrication, aerospace and defense applications. The stringent technical specifications for these high end applications continue to serve to severely limit the number of companies that can provide substrates in [indiscernible] to meet global demand. And importantly, as demand for these application increases AXT will be uniquely positioned through our current capacity expansion to accommodate the growing requirement of our customers. As a update, on our relocation, I'm proud of the work our team is doing to execute this significant undertaking efficiently, while ensuring that the need of our current customers remain the forefront of our focus. Every quarter we put behind us - that diminishes our execution risk and moves us closer to those supporting the next leg of industry growth with new modern facilities and plenty of room for expansion. As we have said, our ongoing strategy is to complete the move and measure in incremental way in order to provide a seamless transition for our customers, while ramping up to meet the increasing demand. For the end of this year, we expect to have relocated approximately sixpences 60% of our wafer production and expect to be close to completion by the middle of 2019. We are now well underway with customer qualifications including all of our major customers. Further, our internal qualification results to date demonstrate consistent specification across our sites, which gives us the confidence that those remaining customers who require qualification will find quality levels that are on par with substrates from our - made from our current facility Turning to germanium substrates. As expected this area of our business was a bit down [ph] in Q3 coming off suffers strong quarters. Overall the satellite industry is expected to continue its positive strength providing us with upside opportunities in the quarters to come. And finally, raw revenue increased modestly in Q3 with raw prices holding relatively stable. The continued relative health of our partially raw material companies allow us to be breakeven with the seven that we account for using the equity method. Additional three that would consolidate contribute to our profitability in Q3. It is important to note that the benefit to rising raw material prices for our joint ventures is offset somewhat on the subsidy side of our business by higher cost of our cost of sold. But on balance these unique vertical integration provided tremendous value in managing the market dynamics for the materials that are critical to our manufacturing and offers certain volume and cost advantage that would aid in our competitiveness. Now in closing, 2018 has been a critical year of execution for AXT. The our success to date in driving growth and profitability in our business, while undertaking the construction of two new facilities and the relocation of our gallium arsenide and germanium production lines demonstrates the talent and dedication of the AXT team. And though our work is still underway, we look forward to the coming quarters for measured optimism and a firm belief that we are positioning ourselves to benefit from the numerous opportunities that are taking shape in front of us. This concludes my prepared comments. I will now turn the call back to Gary for our guidance. Gary? Gary Fischer Thank you, Morris. We expect to see revenue in Q4 of between $26.5 million to $27.5 million. We remain confident in a gross margin going forward of around 37.5%. However in this Q4 we believe we will be lower than that as a result of a drag from the three raw material companies that we consolidate, as well as some year end inventory adjustments. As a result, we believe our profit per share in Q4 will be in the range of $0.05 to $0.07 based on 40.431 million diluted common shares outstanding. Okay. This concludes our prepared comments. Morris and I will be glad to answer your questions now. Loren, the operator.

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

Hi, Morris and Gary. Thanks for taking my questions. Question on the fourth quarter sales guidance here, a little bit down sequentially, I wonder if maybe at a high level Gary can you help us understand the moving parts here by the three major substrates, as well as raw materials?

Yes. The substrate guys, I mean, the raw material guys will probably be flat, plus or minus a little bit, no big change there in the revenue side. On the wafer substrate side, Morris can chime in here to help out, generally as you as you know Richard Q4 is typically a bit down from Q3 and we were hoping that this year might be different, but it's not going to be. So there's a general softness in the on the LED side. We're seeing some softness and generally we're just - we think that the revenue for no specific reasons, but it's going to be less in Q4, less in Q3.

Yes, just of our category exceeding substrates are down slightly. Indium phosphide, we were hoping for it to continue to grow, but that we had a very good quarter Q3. And so we a bit cautious it continue growth and in semi-insulating I think things are a bit soft as well. And Gary just said about semiconducting. So just about every category and the other thing the JV business, I think it could be sort of flat. Otherwise everybody is down slightly.

Okay. Would you attribute this to - similar reasons, we've seen a lot of other companies reporting so far this season by general macro weakness or Gary I think you said you're not seeing any specific customers. I just want to make clear that you're not - there's no specific customers and or geographies that you are seeing some of those weakness from?

Right. I think that's accurate. It's just a general softness and you could say at least part of it is macroeconomic, but part of it is cyclical and seasonal for AXT because we generally don't have a strong Q4 revenue number.

Yes, I think the other thing is this, we do have our own way of coming up to the [indiscernible] and they do change this. We collected data from our sales people and as they start to see some industry softness it tend to be slightly lower in their forecast. That's everything if it is down 5% then that's what contributes to their softness in the overall.

Okay. Let me ask question on gross margins. Gary I heard your comments about the confidence in 37.5 overall here, but this quarter get dragged down here. I didn't have enough time to try to run this through my model quickly, so I wondered if you can give us a sense of how much lower you're expecting that. And then also how much of it are you expecting from the tariff you mentioned earlier in your comments.

Okay. So…

Gary, are you still there?

Are we cut off?

Guys can you hear me. This is Richard.

Yes, we can hear you.

Okay. went blank for about 25 seconds. I didn't hear a thing after my question.

Can you hear me now Richard.

I can hear you now, Gary.

Okay. So let me let me repeat, something - there's nothing - we didn't touch anything in this room, so must be the gremlins for Halloween out there playing shoes [ph] on people so. So for gross margin we're seeing - for this quarter…

Guys, I don’t know if you can hear me, the gremlins are active to say the least. You just came back in again.

How about now?

I can hear you now, but as soon as you started answering my question it went out for 10 seconds.

Okay, go ahead

Must be my voice is haunting the ghosts. Okay. So about Q4 gross margin and about Q4 tariffs, gross margin will be around 35% on my model, plus or minus something. And then on the tariffs, I'm using a $150,000 each quarter if it's 10%. We don't know what the - what the president will do in 2019. But it's reported that he has said he's considering to raise it to 25%. So neither of those number…

Pardon me. This is the operator, that we are experiencing some technical difficulties. Please stand by your conference we'll begin momentarily. Once again we are experiencing technical difficulties. Pardon me speakers, are you able to hear and speak now.

I can hear you fine. Can you hear me?

Yes, I can hear you as well.

And Gary I can you too.

All right. I think I covered gross margin, but let me just repeat on the tariffs, at 10% we estimate it'll cost us $150,000 a quarter that would be the cost of goods sold. And it's been, it's been said that the president will possibly increase the tariffs to 25%. So that's a wildcard. And of course, not out of - its out of our control. Neither number 10% is a killer issue, but they are real numbers and it's detrimental to us, so we can complain or bang our head against the wall or whatever, but that's the way it is. So..

I think I'll jump on the line and maybe jump in later, but thanks a lot for the time guys.

[Operator Instructions] And our next question comes from Hamed Khorsand [BWS Financial] Your line is now open.

What happened in Q3 with indium phosphide that all of sudden you saw positive traction, but now you're seeing - you're saying that that's not happening again in Q4 or are you trying to be conservative. What was that one time event that caused indium phosphide increase in Q3?

There wasn't any one time event. It was just strong demand and the demand is kind of levelled off for Q4. So instead of growing it's relatively flat but it wasn't - it wasn't - it wasn't a one off or anything - generally the silicon photonics part was strong, the pond was still okay, but wasn't as strong as Q2 and we think the pond will remain soft in Q4. And then we don't have a prediction yet about what happens to pond in Q1.

And do you have any insight as to - if this is more inventory related to your customers or you don't have that kind of visibility?

Well, Hamed, I think the way we run our projections is such that, again these are early stage of the quarter. We obviously take our customers advice on how strong they think the growth is. But on the other hand when we gave guidance we have to take what's in the backlog and what our customers telling us that they expect to order from us. And those are the number column Yes and it's scary said he's now going to be drastically down but we don't think it's going to grow significantly next quarter but it's still holding. It's all good and are not I. I want to say that word tributing [ph] There have been times when we've had some inventory corrections for Indian phosphate in the food chain. I'm not so sure that our guys have told us that specifically this time they're just forecasting relatively flat in the queue for any of us by the day. But it's probably based on the customers in market demand as opposed to the customer having too much inventory because that having been said. But the other thing is that our customer our in the bombsite probably has two levels of entry. One is our Antigua or customer and the customer also has a potential inventory if they to grow. So if they were to be on the inventory then they probably pool very strongly and if they think that they have enough the majority they need the flat or if they want to consume some inventory then they may be. But I think overall order trend is we are confident we will continue to grow quarter to quarter. That's what we see.

Okay. And then from inside standpoint on the solar cell commentary were that your product was ending up on the way for cider ending up in Solsbury [ph] and ending up and being used for car batteries?

We think it's mostly for the for the solar cells.

Thank you. And our next question comes from Gus Rashard with Northland. Your line is now open.

Yes. Thanks for taking my question. In terms of affect do you feel like that is peaking in terms of the cost of moving facilities and going to start to level out and come down?

That's a very good question guestimate and we've been looking at it. We have some people in our corporate control are actually over in the Beijing this week and one of my request was for her to drill down on that. Looking forward you know we're we're pretty much at what our expectations were for the run rate right now and we have a track record historically of having lobbying in multiple quarters where it stays pretty stable. I don't I don't really think it's going to go back down don't I think. I think it's going to stay up. So I don't. I would caution you to not take it down below 6 million and we haven't put the numbers together yet for next year but I would just I think it's going to be somewhere in the mid 60s when we finished putting it together.

Got it very helpful. And then force I think you mentioned you done about a million dollars worth of substrates for Vic Falls at this point. Is that preproduction volume is can we give a little more color on that.

Yes from what we know it's mostly preproduction Wallum I mean customers are buying hundreds some hundreds and some 50 for samples for the volume of work and nobody has given the business any consistent volume production volume yet and just will. But we have we do have multiple customers taking Wallon samples from us. In aggregate it's you know it's to a million dollars. We don't we don't view it as production yet but I think we view it as planting seeds. And as the Android community begins to ramp in production which we all know that's not quite yet but it's some horizon then we would expect some of those seats are going to grow and become volume production. But we're not taking it into our numbers at this point.

Got it. And then on the LDP weakness that you know broad base one customer any color there.

Really broad base. Our customers are telling us you know the old future looks bright but then they do see softness going forward and in the last quarter as well.

Got it. Okay I'll jump in line thanks.

Thank you. And I am showing no further questions at this time. I would now like to turn the call back over to Dr. Morris Morash for any closing remarks.

Thank you for that. Does a baby all conference call during Q4 would be participating in the crowd Kelland officer like coughers alone will the team in New York City we look forward to seeing you there. As always please feel free to contact me. Karen Leslie going directly if you would like to meet with us. We'll look forward to speaking with you in the near future. Happy Halloween.

Ladies and gentlemen thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone has a wonderful day.