AXT, Inc. (AXTI) Q4 2018 Earnings Report, Transcript and Summary

Good afternoon everyone and welcome to AXT's Fourth Quarter and Fiscal Year 2018 Financial Conference Call. Leading the call today is Dr. Morris Young, Chief Executive Officer and Gary Fischer, Chief Financial Officer. My name is Kathryn 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.

Thank you, Kathryn 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 competes, 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 delays by our customers on the timing of sales and 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 20, 2020. Also before we begin, I want to note that shortly following the close of market today we issued a press release reporting financial results for the fourth quarter and fiscal year of 2018. 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 fourth quarter and fiscal year results. Gary?

Thank you, Leslie and good afternoon. Total revenue for the fourth quarter of 2018 was 22.2 million, this compares with 28.6 million in the third quarter of 2018 and 26.3 million for the fourth quarter of 2017. Of our total revenue substrate sales were 17.2 million, compared with 22.8 million in the prior quarter. Revenue from our raw material joint ventures was 5.0 million in Q4, compared with 5.8 million in Q3. In the fourth quarter of 2018, revenue from North America was 10%. Asia Pacific was 69% and Europe was 21%. In the fourth quarter, one customer reached 10% of revenue, and the top five customers generated approximately 35% of total revenue. Gross margin in the fourth quarter was 26.3%, compared with 37.1% in the prior quarter. This decline was the result of three factors. First, the drop in revenue meant that our overhead costs were spread out over fewer units produced and sold. So each unit carried a greater share of the overhead. With higher revenue, we can spread the overhead costs more favorably and that delivers a higher gross margin as we saw in the earlier three quarters of 2018. Lower revenue is a key factor and understanding the lower gross margin. The second factor is that the manufacturing overhead numbers have increased as we have hired and trained new employees and accrued other costs resulting from the relocation of gallium arsenide and germanium. And the third factor is the cost of raw materials, especially in germanium, we saw a sharp increase, but in general, material costs moved up in Pete in late Q3 and Q4. We are seeing things move back down now, but they were a contributor to reduce gross margin in Q4. As we look forward, we certainly believe we can go back in the previous ranges. The timing will depend on the recovery in the markets we serve as an increase in revenue will be a primary driver for the improvement. In addition, we're also implementing programs to improve yields and stabilize and optimize the efficiencies of multiple manufacturing sites. These are expected to contribute to an improvement over the next couple of quarters. Moving on, total operating expenses in Q4 were 6.5 million, compared with 6.3 million in Q3. Total stock compensation expense in the fourth quarter was 534,000. Operating loss for the fourth quarter of 2018 was 638,000, compared to the operating profit of 4.3 million in the previous quarter, and 3.7 million for Q4 2017. Interest and other income for the fourth quarter was a net loss of 414k. This number consists of three main categories. Number one, net interest earned of 256k, number two foreign exchange gain or 390k and number three equity accounting on our unconsolidated joint venture companies, which was a loss of 1.1 million. This loss was primarily the result of a $1.1 million charge incurred by one of our partially owned supply chain companies, which was required to temporarily shut down during the fourth quarter to install manufacturing improvements mandated by a regional environmental agency. It has since resumed production and operations. Income tax for the fourth quarter was a benefit of $173,000, compared with a provision of 410,000 in Q3. As expecting our Q4 results included approximately 150k and tariffs as a result of the 10% tariff charge on importing wafers into the United States from China. For q4 2018, we have a net loss of 1.1 million or loss of $0.03 per share, by comparison with a net profit of 3.9 million or $0.10 per share in the third quarter of 2018 and a profit of 3.1 million or $0.08 per share in Q4 2017. The share count in Q4 was 39.2 million shares. Cash, cash equivalents and investments closed at 39 million as of December 31, by comparison at September 30, it was 42 million. The primary reasons for the decline was the new facility and equipment. Depreciation and amortization in the fourth quarter was 1.4 million and capital expenditures were 11 million. Accounts receivables net of reserves were 19.5 million at December 31, compared with 23.3 million at September 30, 2018. Net inventory at December 31, was 58.6 million, compared with 58.7 million in inventory at September 30. Ending inventory consisted of approximately 46% in raw materials, 48% in work in progress and only 6% in finished goods. Let me give you a little bit more color about inventory and specifically about our focus to now start trending it down. We did let inventory grow on the front end of the relocation program and then we slowed that down last spring and inventory has been relatively flat since June 30, 2018. We began efforts to reduce inventory in Q3 of last year and believe that we will begin to see more meaningful results over the coming quarters. With the programs we have in place, we would expect to be able to drive it below 50 million and perhaps a bit more over the coming year. We have made the reduction in inventory a focus for our team in China. And in my last few trips, I've conducted an all hands meeting with the team to keep us all focused. Morris also attends as we want the team to understand that this is important. I'm going back to China in March and will continue to focus on this topic. Before we move on to the fiscal year results, I want to say one more thing about the use of cash in 2019. Our primary expenditure will be focused on the completion of the facility for which we expect to spend approximately 21 million over the course of 2019. Some of this cost will be offset in our cash balance by our reduction in inventory, as I've discussed, as well as our expectation of returning to positive operating cash flow in the second half of 2019. Also, as a reminder, the current facility in Beijing has considerable value that we will be able to monetize in the future. Okay, this concludes the discussion of our quarterly financial results. Let me now briefly highlight the fiscal year. For fiscal year 2018 revenue was 102.4 million up from 98.7 million in fiscal year 2017. Gross Margin for 2018 was 36.2% of revenue, compared with 34.9% for 2017. Net income for the fiscal year of 2018 was 9.7 million or $0.24 per share, compared with 10.1 million or $0.26 per share for fiscal year 2017. Okay, this concludes our financial review. I'll turn the call over to Dr. Morris Young for a review of our business. Morris?

Thank you, Gary and good afternoon everybody. Coming off of a strong Q3, we entered Q4 with understanding that our customers across our portfolio were cautious regarding our Q4 requirements. As we discussed in October, the reasons behind these were both market related and customer specific. In fact our revised guidance in January underscored that Q4 turned out to be a significantly more disappointing than we had originally estimated. This shortfall was a combination of trade tension, weakness in the LED market, particularly in China and for applications such as automotive, slowdown in growth in datacenter market, as well as inventory rebalancing at several of our large customers and the natural lumpiness of revenue from emerging applications for our gallium arsenide product. In total, it felt like a perfect storm. As we move into Q1, two things appear to be true. First, the markets and geographies that were weak in Q4 will remain so throughout Q1. And second, the inventory correction at certain customers will also continue through Q1. Having said that in our current discussion with customers sentiment is improving for 2019 demand in all of our key applications that drive our business. For indium phosphide, demand for datacenter connectivity, power and telecommunications is expected to strengthen during the year. Though Q1 is remaining sluggish, customers are expressing optimism about the continued adoption of silicon photonics technology in cloud and large enterprise datacenters as well as transition over time to 100G to 400G technologies. In addition, preparation for 5G communication infrastructure in the second half or 2019 and throughout 2020, I expect to provide opportunity in short or long haul metro and even front haul deployment. The power market is relatively stable in Q1 at this current reduced rate, but early discussion with customers suggest that we could see improvements in the market in quarter or two out, though visibility remains limited. We're also seeing some interesting in indium phosphide research and development activities and new customers that could add incrementally to our growth opportunity in 2019. Similarly while they LED market has been - has seeing a setback in recent quarters, customer sentiment indicate that demand for high end application in second half is likely to show some recovery. Further, AXT is well positioned across a variety of new applications for gallium arsenide when they start to ramp. 3D sensing for Android could provide us our first entry point this year as we shoot nearly a million dollars to pre-production programs in 2018. Thinking gallium arsenide for software application such a strong airplanes and automotive solar panels were lumpy in 2018. However, these programs are quite active and a few supply substrates for them with unique properties that further expand our competitive differentiations. We expect that they will again contribute positively to our 2019 revenue. For our germanium substrates, which they grew in 2018 over 2017 appear poised for a positive year in 2019 as a result of continued demand in centralized solar cells. As such the money drivers for our business remains intact. The trend that we have always believed would propel AXT in the years to come, continue to take shape in a very tangible way. Despite the quarter-to-quarter fluctuations these are major transformation trends that are not going away. Data center expansion, 5G, laser based sensing, LED proliferation, fiber optic communications and others. AXTs products are fundamental to all of it. Once more, we're actively preparing our business with these opportunities. The relocation of our manufacturing facility is progressing on schedule and we expect to have at least 90% of our gallium arsenide germanium production capability established by the end of Q2. This position us well for new and recovering gallium arsenide business opportunities. In addition, we are now well underway with current customer qualifications, including all of our major customers. Given all these dynamics, our priorities for the coming years are as follows. First, we'll drive improvements in our gross margin. Increasing revenue will help margin recovery, but we also believe that we can improve our manufacturing efficiency and the yields to achieve better results. We're implementing programs in Q1 to help address this issue. Second, we continue to be disciplined in our use of cash. These include efforts now underway to reduce inventory as Gary mentioned, as well as taking opportunity to delay or eliminate unnecessary expenditures and ally our capacity expansion with market conditions. Third, we'll continue to improve the important work of assisting and supporting our customers through the qualification of our new facilities. We believe the new location offer great benefits to them and we're committed to helping them making a seamless transition. And finally, we'll continue to focus on innovation. Across our portfolio, customers are actively developing new applications for our products and seeking our assistance and expertise in helping to make their vision a reality. Often this involves our mature scientist helping them overcome technical challenges within their particular process. In other cases, they require more stringent wafer specifications or specialized OP [ph] and our team applies decades of expertise to make this possible. In 2018, we made a significant improvement in the performance of our germanium substrate that is meaningful to our customers. As such, we enter 2019 with enhanced competitive position in the solar cell satellite market. And finally, we continue to set the space in our industry for low EPD characteristics in both gallium arsenide and indium phosphide material. Our innovation in this area is unmatched by our competitors and we believe they will become a key differentiator for AXT across a variety of applications in 2019. In closing, 2018 was a mixed year; global economic conditions were made more difficult by the uncertainties of trade tensions and spending in certain end markets. They took a pause impacting our expected growth and profitability for the year. Despite these challenges, indium phosphide revenues set out a record in 2018 as silicon photonics passed the tipping point of broader market adoption. We also saw growth in host of new gallium arsenide applications that further suggest this material is entering its next period of expansion. In addition, AXT made a significant progress in 2018 in relocation of our gallium arsenide and germanium product lines. Meeting every major milestone we established needed the relocation, noise, timing was of our choosing, but we believe strongly that will prove out to be beneficial to our business. The new facility gives us long-term capacity and a new level of sophistication in our manufacturing to accommodate the major trend they are likely to drive demand for our product in the years ahead. Further, every bit of progress made diminishes the risk of our business and position us for the future we envision. As we look to the years ahead, we're encouraged that the tones of our customer discussion include expectation for market recoveries this year. We believe our competitive position remains strong and this will enable us to return to growth when the market recovers. In the meantime, we intend to continue our relocation, strength in our business and drive greater efficiency of our model. This concludes my prepared comments. I will now turn the call back to Gary for our first quarter guidance. Gary?

Thank you, Morris. As we discussed, we do not expect business conditions to improve meaningfully in the first quarter. As such, we expect to see revenue in Q1 of between 20.0 million to 21.0 million. We believe our loss per share in Q1 will be in the range of $0.04to $0.06 based on 39.2 million basic shares outstanding. Okay, this concludes our prepared comments and Morris and I would be glad to answer your questions now. Kathryn? Operator?

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

Morris and Gary, thank you for taking my questions. Maybe a couple questions on the guidance here. I just want understand if there's any difference in growth rates of your major product categories, indium phosphide, gallium arsenide and germanium raw materials relative to each other that gets you to your guidance for the first quarter.

I think there's no major differentiation, although I think we are relatively optimistic about the future of indium phosphide. I think we would probably start to see some indication that it's going to come strong and continue be strong in Q2 as well. The initial market right now we don't have much visibility at all, germanium, although, it could be sort of flattish in Q1, but we did see a major inquiry of germanium that gave us the optimism that potentially it can come out on Q2 and beyond.

Yeah, this is Gary. I think that's accurate. I don't think there's any special meaning that one product application or one substrate material is changed from Q4 to Q1. As Morris says, we do see some light at the end of some of these tunnels we think for Q2, but it's really pretty much what Q4 was, is more in the same in Q1.

Okay, second question also from a financial point of view and I didn't have a chance to run the numbers given guidance. I came just for the Q&A, but what's implied for gross margins here typically revenues have a factor in gross margin. Since it's down I would imagine you wouldn't expect it up much here if at all, but just wondering Gary if you can give us any more color on how you expect gross margins in the first quarter?

Yeah, well as - Yes, I'm happy to comment. As I said, the robust gross margins that we enjoyed in the first three quarters of 2018 - first two quarters of 2018, a key contributor to that was solid revenue. So it goes - it's pretty much obvious if we have revenue this low for Q1, there's not going to be much change in gross margin, so yeah.

Okay and maybe if you can comment a little bit further and I realize if I ask you to have visibility that you clearly don't have a lot of right now. But how should we think about the gross margin progression throughout the year? I mean, if we hit revenue numbers similar to what you may have hit in 2018, should we expect similar gross margins? Or are there other impacts negative or positive we should think about?

No, I think internally we think if we can reach those numbers that we should be back in that range. So yeah, of course, given you know our product proportionality on to the some of our product and more profitable and the product mix right yeah and so if they recovered strongly then definitely will give us benefit. And germanium pricing, I mean definitely hit a high of late Q3 of last year and now they start to decline. And so we shall see whether it declines any further because customer price is very difficult to move - we can hold on to the pricing that we offer them, but you cannot usually cannot raise your price with customers.

Yeah, to put it another way, since we can't raise prices, but we also don't see a lot of price degradation. So if the order rate returns and the revenue returns we should have high goals and we should shoot to be back in those ranges.

Okay, fair enough. One last question for me, I'll jump on the line. In indium phosphide if you get some relatively more positive comments about datacenter demand there, doesn't sound you're expecting much pick up this quarter, but wondering if you can talk about what you would expect there? Could we possibly see a record or near record quarter overall for indium phosphide this year? And do you have any view or line of sight into adding more sizable customers other than your kind of your lead one in the silicon photonic space?

Yeah Richard, although we're still in early stages, but the last time we were doing discussion with a major customer we're trying to - and it looks like it could provide us some upside for Q2 and if we win that contract that would be a great opportunity for us. Although, I think there is inventory correction at this point from some of our major datacenter customers, I do expect that correction to be over by Q2 or Q3. So that should provide some recovery as well as the 5G front haul, I mean, again, according to our customer and customer's customer, they all commented that they do expect that product to start to ramp by Q4 of this year and that should layer on to the growth. And we also said, we saw some research activities of using indium phosphide for glucose monitoring which could provide some potential for - but not –perhaps not production volume by next year even maybe 2020, but nevertheless it could be a major opportunity. And we also are working with yet another Japanese customer and that should develop into a major growth opportunity for 2020. So yeah, multiple layers of customers and opportunity as we look ahead on indium phosphide, it becomes clear that I think they should provide us with opportunities to grow. So we are actively preparing given such a downtime where we're cautiously preparing for capacity expansion on indium phosphide.

Yeah and just let me add sort of the summary cap which is that nothing's changed in a negative way about indium phosphide, so as the economy returns to sort of a normal run rate we saw record setting quarters several times in 2018 and it's almost common sense that will see that again in 2019 if indeed things come back like we are advised that they will.

Okay, that's fair enough. That's all the questions for me. I'll jump the line. Thank you, guys.

Thanks Rich, good luck to you, yeah.

Thank you. Our next question comes with Quinn Bolton with Needham & Company. Your line is open.

Hi, Morris and Gary. Obviously, sort of a tough near term outlook, but it seems like you're starting to as you say see some light at the end of the tunnel. Kind of wondering as you have these customer discussions, are folks starting to place orders on the books for deliveries in the second quarter that give you some confidence that Q1 maybe the trough or this visibility in purchase order coverage not yet really give you good insight into Q2?

We normally say we do have a long-term visibility. I mean, most of our customers especially now give us very short orders and when they want it they want it next two weeks. But we did, as I commented earlier with I was on the phone with a major, major customer and they are –we're talking about potentially big orders, but still we're in discussion stage. But I think I'm getting excited because there's not a whole lot of suppliers in the world and we have the best product we believe, so we should be able to get it, but nevertheless, again it's Q2. So we got to get through Q1 first which is 40 days away.

Yeah Quinn, a lot of our main customers do give us rolling forecasts and we do now built the forecast. Couple of years back we tried not to do that. But just like it happened in the Q4 numbers. They gave us a forecast, but they didn't come through with it. So we're seeing some positive notes. But we don't normally have much visibility anyway. And it's probably premature to say Q1is absolutely, definitely the trough, although I think probably we think it is. But that's more intuition than the fact that we can go look at the backlog and say, look at the backlog is this.

Yeah, and the other thing I want to comment is that you know our business, I mean, we don't have - although, we do have a large inventory, but we don't have a whole lot of finished goods inventory, so if somebody were to place a major order with us, it's at least six weeks away. So we have to enter the book now to sort of give them the delivery before the end of Q1.

Yeah, it'll be almost too late to move the needle for Q1, but it can for Q2. So yeah, it's a very fair question and I guess our answer is that we're getting indications that Q1 is the trough, but if you compared - if you went and studied our backlog it wouldn't necessarily lead skeptic to the same conclusion.

On the indium phosphide side, it sounds certainly like you're seeing headwinds that I think many in the datacenter marketer seen with inventory digestion. Just a question about the mix between datacom and telecom applications right now, is your business mostly skewed to datacom and sort of the 5G telco brings the mix perhaps more to balance between datacom and telecom or just some comments around telco versus datacom in the new indium phosphide business.

Yeah, I'm not so sure we can tell the difference because we don't serve that into the market, we only deal - we mostly deal with Epi growers, Epi c customers and Epi customers they serve a variety of customers and when they - but I think most of them are datacenter and that probably datacom business. Telecom business, I mean, but then they also by substrates and they can make blazer for telecom applications, but it's hard for us to tell the major difference.

Yeah, no, 5G they'll do for the front line - sorry, front haul?

Yeah, 5G they'll do the front haul, but that's also from what we read. Our customer's customers are telling that the laser can be used for front haul 5G telecom applications.

And then Gary, just obviously a big step down in the gross margin in Q4 and Q1 and you kind of went through the three factors that led to that. Am I right to sort of think that the under absorption of fixed cost is probably the biggest of those three factors and that as we come into the first half of the year the germanium prices have already started to correct. I think you said your fixed costs due to the gas and germanium move probably start to come down after the middle part of the year. So are those that - those two factors sort of smaller factors and the biggest factors just really overall level of revenue is we're thinking about modeling that gross margin recovery.

Yeah, I think that's fair assessment. We do see a definite favorable trend and downward pricing of raw materials. So we're not really focusing on that as something to try and go change your move whereas we of course are focusing on revenue and cost, yeah.

Okay.

And for our raw material if price change, it takes a quarter or two because of our inventory. Yeah, it has to go through our inventory before it realized the benefits.

Okay and then lastly, Morris, I think you had mentioned a million dollar for pre-production order on the pixel, just as you look into the second half of the year and the recovery, what sort of assumptions are you planning for on that pixel opportunity? Are you kind of leaving it out of your kind of mainline forecast and leaving it is upside if it hits or are you starting to build in some expectations for that Android opportunity?

Yeah, we have three or four active customers who tell us that they are qualifying to somewhere around four to six develop programs of Android phones and those customers I think we hear that they're delivering to Android phones, but then none of them have told us specifically they are ready for production order at this point. So we're anxiously waiting. But nobody has told us that you're qualified, now, you can start to have the order. So I think our expectation is that we have worked on it and we work with our customers to satisfy most of their requirements such as EPD, such as name and certainly the pixel market seems to be a very tight specification market and we passed most of the requirements so far, so we do expect it to start to ramp, but none of them - we haven't got a major order - they told us, we're qualified, we're ready to go.

Okay Morris, Garry, thank you very much. I'll jump back in the queue.

Thanks, Quinn. Good luck to you.

Thank you. Our next question comes from Katherine Travnik with Dougherty [ph]. Your line is open.

Thanks for taking my question. One was just on –thinking about the modeling. So it looks like even though we might have the trough, we might have not had the trough. I understand we're not all clairvoyance on this, but I would expect that the OpEx, we should keep the OpEx going for similar to what was in Q4 that you're not going to any staff reductions that you do see opportunity, you are preparing for opportunity and not to really slice and dice any of the OpEx?

Right and I would add that we also don't expect it to go up, so I think flat is a - in that range is a safe way to model.

Okay, perfect. And then the other question is you did talk about 5G. Do you have any 5G customers in hand right now or orders?

Well, we should - I went to the OFC Conference in San Francisco and we definitely have discussion with our customers and one of the gallium arsenide customers are telling us that for 5G it looks like this opportunity for the pm [pm], gallium arsenide pm market to come back and they actually told us fairly robust predictions on how much will come back, but they haven't placed order. So I'm guardedly optimistic and the second area of the 5G is really our customer's customers are gearing up for the front haul for the 5G datacenter connections. The short answer is yes, we do have customers using our product for 5G, but its development stage. So that's what it is right now, it's not a high volume production yet so.

Okay, thank you.

Welcome. Good luck.

Thank you. Our next question comes from Hamed Khorsand with BWS Financial. Your line is open.

Hi and so first question I have, how much of this inventory in raw or work in progress is that the new facility versus the adjacent facility?

I think it's difficult to differentiate, but of course the major reason for the inventory build was because of the relocation issue. I mean, some of our customers have very sticky about while you make the transition that I want you to deliver from the old facility you want to make sure that you deliver from a new facility before I qualify you new facility. So that we build a fairly sizable inventory even given that we lost some business opportunity because they say well, you cannot supply me, guarantee that you can supply from the old facility, so we do have that issue. I think now is gradually coming off. I mean, customers qualify the new facility that means we can deliver on both facility we do have to maintain both facility inventory and so that should relieve that. But to differentiate how much we have in the new facility, it's all difficult.

So when should we expect the qualifications to happen? I mean, you guys were first thinking like it would happen around when you were at 60% and you've now been talking about 90% moving , so how far away are you?

Okay, so they are two layers, I mean, one is that we have built our facility and we said our facility should be ready by the end of June, in other words our facility is fully capable and we have delivered of course samples to our customers for qualification long before that and that's almost - some of them are a year ago. And we started to deliver sample to them, they started looking at it, they start to apply the rigorous method of qualification and the good news is that at least quite a few major customers have passed. They say, you're qualified, but nevertheless some of them are still telling us well, I want you to ramp in a controlled way. One specific customer is telling us you can deliver 20% of the product on the new facility, they want to watch the quality of it and the performance of it before they start to increase it to 50% ,75% and hopefully 100%. So our expectation is that we're fully ready to take order from our new facility by June 30 and hopefully given a six month transition every customer will start to - 70%, 80% of them will start to take all products from both the new as well as old facility.

Okay and with this kind of inventory on hand, does that play a role as far as how much you can control your gross margins right now or is it going to be - your gross margin is going to be hit right now because of the higher input costs on so forth? You're really running at lower –inefficient?

No, the inventory doesn't impact the gross margin, so yeah, it doesn't impact it.

Yeah, the inventory was just a bit harder.

Yeah, put it a different way to use debits and credits, but the inventory stays on the balance sheet and the gross margin is on the income statement. But it doesn't transfer to income statement at some punitive rate because it's so high. It transfers at the normal standard cost, so yeah. Any more questions Hamed?

Thank you, guys.

Okay. Good luck to you.

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

Thanks for taking my question. Actually, let me try it this way. As you transfer more production to the new facility, can you walk us through, until you're steady state, what that impact is going to be on the gross margin line? You've got to fill two facilities at this point and absorb them as you move more material to the new facility what happens the gross margin line and over what time?

Yeah, the facilities will be - will go into depreciation on a stage basis depending on the utilization rate. So that depreciation useful life will be 27.5 years, so the equipment that we depreciate is five years, but the facility stuff is 27.

However there's not a whole lot of new equipment added right to our new facility. So we don't expect to see a great increase in depreciation rate. However, I think it will be a bit higher depreciation rate as we move into the new facility as well the penalty we'll need to pay. However, I mean that there's other things that we need to manage is when do we decommission the old facility or Beijing influence? We don't use them that we stop depreciation of the old facility. So those are the two things that we have to manage as well. So there's not going to be -

Yeah, when do you expect to decommission the facility in Beijing?

Well, it won't be a digital phenomena, it'll be an analog phenomena. So we will probably decommission at least part of a building this calendar year. It's already under analysis and discussion. We haven't looked past that yet, but probably late this year or next year there could be more on one side of the street that we can decommission. The side of the street that we use for indium phosphide, which is also used for wafer processing and for sort of China headquarters stuff that will not get decommissioned anytime soon unless somebody comes in say with some very generous purchase offer. And we decided it's time to pull that trigger sooner than we thought so.

So one of the things I think it is - the depreciation base for our Beijing facility is somewhere around $22 million, $23 million right. The equipment part of it is actually very low mostly these facilities and land and those - the value of which is definitely three or four times of that. So once we move our production out of it, it really doesn't make any sense to continue to depreciate those parts, okay. So yeah, I think the depreciation with the new factory definitely will be higher. But I think, Gary, you made analysis it's not going to be phenomenally higher. I forgot how much it was, but I think something like a million dollars per quarter for depreciation for the new facilities.

Maybe a little bit. That's not low. That's for sure. I mean, I don't think to be much more than that. So Gus, in terms of the timing, I don't have an exact timeline yet. But I can I can say that the facility depreciation will go up throughout 2019, even when we start to decommission. Maybe there might be one quarter when they're equal I mean, there is breakeven or something one offsets the other. And then it'll play out in 2020. So we still need to get the timeline and understand a little bit more of the details that conform to GAAP and stuff like that. In the meantime we remain confident that if the market comes back and our products get used in the applications that we think they're going to be used in, then we can grow the revenue base to do the absorption. So yes, it's a business factor and it's a good question. It's probably not - we think it's a management problem, yeah.

Okay, got it and then just in '18 you ramped up SG&A for training and whatnot and the facilities move and my expectation was it was going to peak in Q2 and it looks like it's popped up again in December and just wondering what's forcing it back up and your expectation for it to remain at that level going forward.

Well, it's more than one thing. A fair amount of it is facility related and the relocation. Some of it involves like building consultants and facility consultants as we do the construction. So we don't capitalize that were expensive. I don't, I don't think you should tend it down until I can get my arms around it more. I think it'd be, I think that'd be too positive or to too aggressive of a step. So for now, I think you should trend it to be flat plus or minus 100k and it's something that we want to drill down on more and we haven't done that yet.

So let me go from 25,000. We have not hired, I mean, you and I are - we carry our SG&A, we haven't hired new people. My salary and definitely didn't have that kind of an increase, so the step up is related to our new factory, okay. So if you drill down, it could be a new facility contract and we need to review on the new environment, design work, et cetera. But then now instead of one facility, now we have three facilities, but they are China related, job, people et cetera. SG&A people, but they cannot be that high, okay. So I think once we make the move, definitely we are a little bit higher, but it's not going to be enormously high. I think it will come down to some reasonable level I think, though if we didn't transform into an expensive AXT.

Okay, got it. That's it for me. Thanks so much.

Okay. Good luck.

Thank you. And there are no further questions in the queue. I'd like to turn the call back to Dr. Morris Young for any closing remarks.

Thank you for participating in our conference call. As always, please feel free to contact me Gary Fisher, also Leslie Green 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 participating in today's conference. This concludes today's program. You may all disconnect. Everyone have a great day.