AXT, Inc. (AXTI) Q2 2019 Earnings Report, Transcript and Summary

Good afternoon, everyone and welcome to AXT’s Second Quarter 2019 Financial Conference Call. Leading the call today is Dr. Morris Young, Chief Executive Officer and Gary Fischer, Chief Financial Officer. My name is Howard and I will be your coordinator today. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to Leslie Green, Investor Relations for AXT. Please go ahead.

Thank you, Howard and good afternoon everyone. Before we begin, I would like to remind you that during the course of this conference call, including comments made in response to your questions we will provide projections or make other forward-looking statements regarding, among other things, the future financial performance of the company, market conditions and trends including expected growth in the markets we serve, emerging applications, using chips or devices fabricated on our substrates, our product mix, our ability to increase orders and succeeding quarters to control costs and expenses, to improve manufacturing yields and efficiency, to utilize our manufacturing capacity, the schedule and timeliness regarding our relocation, the growing environmental health and safety and chemical industry regulations in China as well as global economic and political conditions, including trade tariffs and restrictions. We wish to caution you that such statements deal with future events are based on management’s current expectations and are subject to risks and uncertainties that could cause actual events or results to differ materially. These uncertainties and risks include but are not limited to overall conditions in the markets 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, the financial performance of our partially owned supply chain company and the impact of delays by our customers on the timing and sales of their products. In addition to the factors that maybe discussed in this call, we refer you to the company’s periodic reports filed with the Securities and Exchange Commission. These are available online by link from our website and contain additional information on risk factors that could cause actual results to differ materially from our current expectations. This conference call will be available on our website at axt.com through July 24, 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 second 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 second quarter results. Gary?

Thank you, Leslie and good afternoon everyone. Total revenue for the second quarter of 2019 increased by 23% to $24.8 million. By comparison, revenue in the first quarter of 2019 was $20.2 million and revenue in the second quarter of ‘18 was $27.1 million. Of our total revenue, substrate sales increased to $20.6 million from $16.8 million in the prior quarter. Revenue from our raw material joint ventures was $4.2 million in Q2 compared with $3.4 million in Q1. In the second quarter of 2019, revenue from North America was 6%, Asia-Pacific 75% and Europe 19%. In the second quarter, two customers reached 10% of revenue and the top 5 customers generated approximately 48% of total revenue. Gross margin in the second quarter was 34.3%, up from 33.1% in the prior quarter. This improvement was primarily the result of product mix. Total operating expenses in Q2 were $6.2 million compared with $6.1 million in Q1. Total stock compensation expense for the second quarter was $568,000. Operating income for the second quarter of 2019 was $2.3 million compared with $626,000 in the previous quarter and $4.5 million for Q2 of 2018. Interest and other income was a net loss of $300,000 for the second quarter compared with a loss of $1.4 million in the first quarter of 2019 and a gain of $400,000 for the second quarter of 2018. Interest and other income net for the second quarter of 2019 included interest income of $18,000, a foreign exchange loss and other expenses totaled $90,000 and a net gain of $8,000 from the partially owned companies in AXT’s supply chain accounted for under the equity method. Income tax for the second quarter of 2019 was a charge of $597,000 compared with the charge of $156,000 in Q1. Our Q2 results included approximately $107,000 in tariffs as a result of the tariff charge on importing wafers into the United States from China. That rate by the way increased to 25% from 10% on May 10. For Q2 2019, we had a net income of $1.5 million or a profit of $0.04 per share. By comparison, we had a net loss of $1.1 million or a loss of $0.03 per share in the first quarter of 2019 and a net income of $3.9 million or profit of $0.10 per diluted share in Q2 2018. The share count for Q2 was 40,123,000 shares. Cash and cash equivalents and investments increased to $37.5 million as of June 30. By comparison at March 31, it was $34.1 million. Depreciation and amortization in the second quarter was $1.4 million and CapEx was $5.5 million. Accounts receivables net of reserves were $18.2 million at June 30 compared with $19.5 million at March 31. Net inventory at June 30 decreased to $50.3 million compared with $53.0 million in inventory at March 31. Ending inventory consisted of approximately 48% in raw materials, 47% in working progress and only 5% in finished goods. As we noted previously, the reduction in inventory is the focus for us in 2019. Before I conclude on the numbers, I want to provide with an update on our use of cash in 2019 for the facility relocation. Previously, we estimated that we will use about $21 million of cash for the relocation in 2019. That is still our estimate. For the first half of 2019, we will now spend about $9 million and we think the second half will be about $12 million. We are operating cash flow positive for the first half of 2019 for approximately $5 million, which helps offset the outflow. We do have a $10 million line of credit with Wells Fargo Bank, which we have not utilized and we are setting up a bank loan in Chinese renminbi in China as another source of cash. Further, we think the second half of 2019 will also be positive operating cash flow. We are continuing to monitor cash and remain confident that we have sufficient resources. As a remainder, the current facility in Beijing has considerable value that we will be able to monetize in the future. Okay. This wraps it up for the financial review. I will now turn the call over to Dr. Morris Young for a review of the business. Morris?

Thank you, Gary and good afternoon everybody. Amidst a backdrop of turbulent geopolitical and global economic conditions, AXT posted a solid quarter. Revenue came in just ahead of our expectations and our indium phosphide sales achieved an all-time high having surpassed gallium arsenide as the single largest revenue contributor again this quarter. In addition, with continued focus on manufacturing efficiency, inventory reduction and cash management, we improved our gross margins and achieved positive cash flow. We are continuing to execute on the relocation of our facility and believe that we are laying a solid foundation for the significant technology trends that are likely to drive growth in our business over time. To begin, indium phosphide continues to emerge as a highly strategic material at the core of several major technology trends, still early in their development. For example, during the second quarter, we completed the shipment of the large order relating to 5G infrastructure. We believe this order is evidence that a major infrastructure upgrade cycle for 5G is on horizon. In fact, a recent report published by the CTIA, a wireless communication trade association, they suggest that by 2020 approximately 80 operators in more than 40 countries worldwide will have made 5G services available to their subscribers. While the timing and market opportunity are difficult to predict, we believe that indium phosphide will play important role at critical junctures of the 5G architecture where the higher frequencies are required and latency would not be acceptable. AXT is well positioned to supply into all the major supply chain for these applications. And we believe that the quality of our materials offers a compelling value proposition for our customers. In Q2, we also saw an increase in indium phosphide demand for the PONs market. Fiber connections for PON were among the first application to drive demand for our substrates and the opportunity worldwide remains significant. We believe it may strengthen further with the 5G rollout in 2020 and beyond. In the near-term it is typical for this market to be lumpy quarter-over-quarter. So, we are not expecting incremental growth from policy in Q3. We are however pleased to see initial indication of the improvement in the data center connectivity market as we enter Q3. As many of you know, this market has been soft for several quarters as a result of a difficult demand environment coupled with excess inventory. Indium phosphide plays a critical role in emerging silicon photonics technology. This technology is experiencing broader adoption, particularly in hyperscale and large enterprise data centers with high bandwidth, low latency and long reach are all key requirements. Silicon photonics scale also drive significant improvement in power efficiency, which is a major factor in large scale data centers. With expected growth in new data intensive services, data centers would need to be able to move large amount of data through the network resulting in greater performance requirements from interconnects throughout the entire architecture. As a result, our customers are expressing optimism about the transition over time to 100G and 400 gigabit Ethernet technologies. For example, Intel announced in April that it expects to reach volume production on its 400G silicon photonics transceiver in Q4 of this year. As the industry moves to higher speed, the architectural benefits of silicon photonics becomes increasingly compiling and the opportunity for indium phosphide is likely to be significant. In short, the application of PON data center connectivity and telecommunication contribute the vast majority of our revenue for indium phosphide and their potential is expanding. 4 years ago, PON was the only meaningful driver for our indium phosphide revenue. 3 years ago, we reported to you that the data center will begin adding to the demand for indium phosphide. Earlier this year, we saw telecom beginning to contribute with an exciting feature. Correspondingly, over the past 4 years, our revenue from this material has grown from $1 million or $2 million a quarter to more than 10 million. As we look out further, we believe indium phosphide could fuel other major applications based on the development work being done right now. These include health monitoring, advanced 5G wireless devices and lidar for the automotive industry. Now, turning to the gallium arsenide, our revenue for both wireless and LED applications have seen setbacks in recent quarters. While weakness is persisting in wireless applications, we are now pleased to see the beginning of a potential improvement in LED market for higher end applications as we enter into Q3. Discussions with certain customers are taking a more positive turn than in the previous quarters and we are seeing incremental stronger demand. That said, we remain cautiously optimistic until we see more widespread improvement across our customer base. Overall, 2018 has seen a softer year for gallium arsenide market. We have used this opportunity to execute a methodical and careful relocation of our gallium arsenide manufacturing. I am grateful to the entire AXT team and I am proud of our success to-date with the sizable undertaking. We are increasingly now focused on assisting our customers through the process of a qualification shipment and shipment grant from the new facility. Those efforts will likely continue through the balance of the year and into Q1. Finally, before I hand over the call back to Gary for Q3 guidance, I want to note that with the changes we made last quarter to our portfolio raw material companies, we are able to show improvement in the overall contribution to our results in Q2. In particular, those we account for with the equity method had a cumulative gain in this quarter. This comes at a time when the pricing environment for raw material is stabilizing and we are doing a better job and leveraging the benefit of our portfolio in improving our substrate cost structure. Now, in closing, Q2 was a quarter of positive progress on many fronts. In a difficult demand environment, we achieved solid financial results, including profitability expansion, cash generation, major emerging technology trends continued to gain momentum in strategic areas of our business, such as indium phosphide, laying a foundation for our growth over the next several years. In the meantime, we are executing our move focusing on manufacturing excellence and continued to invest in our technology. We believe the market is showing early signs of the improvement and we are ready for the opportunity. This concludes my prepared comments. I will now turn the call back to Gary for our third quarter guidance. Gary?

Thank you, Morris. As we discussed, we had a strong increase in our revenue in Q2 in part driven by a sizable order for indium phosphide and that will not repeat in Q3. However, as Morris noted, we are pleased to see indications of an improving demand environment for indium phosphide in the data center and for gallium arsenide in LEDs. As such, we expect to see revenue in Q3 between $24.5 million to $26.0 million. We believe our earnings per share in Q3 will be in the range of $0.01 to $0.03 based on 40.123 million diluted shares outstanding. This concludes our prepared comments. Morris and I will be glad to answer your questions now. Howard?

[Operator Instructions] Our first question or comment comes from the line of Richard Shannon. Your line is open.

Gary, thank you for taking my questions. Gary, maybe I will ask a question on the guidance from you here, one, I typically ask here given we have only had a few seconds to absorb it here, one, to get your take on how we should think about gross margins as we go from the second quarter to the third, obviously had a good number in the second quarter, seems like with little bit I guess similar level of those revenues which should be in the similar range of gross margins, but just want to make sure that we are reading the tea leaves the right way here?

Well, actually, I think the gross margin will not be as good in Q3 and it’s primarily because of product mix is not quite as, Richard, for indium phosphide. So, I probably knock it down a bit in new model.

Okay. Let me ask you about those revenue segment movements here. It seems like you are suggesting indium phosphide will be down sequentially. Is that a fair assessment?

Yes.

Okay. Then how should we think about gallium arsenide, it seems like it would have to be up somewhat, from your comment, it sounds like wireless is still maybe a little bit tepid, but LED sounds reasonably good. So would gallium arsenide be up then sequentially?

Yes. You are absolutely right. LED is showing signs of recovery. And although one customer are telling us they are seeing better second half definitely than first half, but the upcoming is not uniform at this time. So we have good – so revenue from LED definitely will be up for Q3 and second half will definitely be better than Q1 as first half.

First half okay. And then would you expect indium phosphide to still be higher than gallium arsenide in the third quarter?

Hang on, let me just check some notes here, might be a tie or indium phosphide might be a bit lower.

Okay. It gives us good perspective there. Maybe a question or two on the new facility here. Just want to get your anymore thoughts on the state of the progress here, I think last quarter you talked about perhaps as much as 15% to 20% of the revenues move from the old facility to the new one. Want to get an update there and whether you still expect to be largely transferred over by the end of this year?

Yes, that is a good question. I think the facility is ready. We have done all the qualification work that none of them are turning back. It’s all good result so far we have seen. I think however with the demand ongoing offset being soft, I think there is not much of a urgency from our customers, once for transfer, especially that we are showing our customers that our Beijing facility can still support them. So, our estimate between upper teens of 20% that is coming from the new locations, but we are working with our customers to encourage them to take more and more from the new facility as we progress into second half as well as Q1 of next year.

Okay, fair enough. I will ask one more question and jump out of line and that’s related to 3D sensing. We have seen a couple of companies in the 3D sensing, Fuji comments here in the last several days and it seems like we are seeing a pickup in the Android space. So maybe I want to ask you kind of a twofold question, which is any comments you can give relative to opportunities to qualify quality and B qualified vendor into Apple’s 3D sensing food chain and then what you are seeing in terms of the Android space or qualifications orders etcetera?

I think if you ask me whether we have any potential order for volume production for second half of the year, the answer is no. We are still working with our customers to make sure that they will take our product and we do note that from several sources that 3D sensing is still very much in the forefront of the growth perspective for money – for the industry. That’s a good news for us. However, I think the expected volume production, we don’t see it for the second half of this year and as we move – complete the moves to our new factory within our perspective will become better and better.

Okay, fair enough. That’s all the questions for me guys. Thank you.

Thanks Richard.

Thank you. Our next question or comment comes from the line of Quinn Bolton from Needham. Your line is open.

Morris and Gary, congratulations on the nice second quarter results. Wanted to follow-up on your initial comments on the 5G demand, specifically hoping you could give us a little bit more color on what that application is, I assume it’s something in the optical front-haul or backhaul, but just wondering if you could provide a little bit more color on that opportunity? Thanks.

Sure. Usually when our customer orders substrate from us, we don’t know what the applications are. So the way that would classify each one of this application is that some of things are certain size and from the demand of specification that we sort of know what is – whether it’s for pause or data center. As far as 5G infrastructure is concerned, this particular customer is a telecom manufacturer and they are launching a 5G infrastructure build. So, we think for 5G infrastructure rollout. But how big the market is and how big the opportunity is really very good for us to tell, but as we see that especially this is a first order they sort of larger order they gave us. So we needed a little bit time to see how big it is and what other manufacturer of 5G infrastructure will give those orders to give us an indication that what a perspective market and the opportunity was. We think as we also said 5G will not only give us the infrastructure build out in the front-haul and backhaul as a potential business opportunity for us for indium phosphide, but also for datacenter they need to get higher speed, connection that will also increase the opportunity as well as PONs market. Every time that you make an optical connection, you need PONs. So, I think overall the 5G should be very good news. So as we said PON is the first layer and data center is the second layer and then finally 5G infrastructure build out. I think it’s all going to layer out to the opportunity for our indium phosphide material.

Got it. And then your comments on the data center you said you are starting to see demand beginning to improve, just wondering was that across multiple of the optical module or data center laser companies or was it driven by sort of just a small handful of customers just kind of trying to get a sense of how broad based that the beginning to that demand uptick are?

Well, we have customers – most of these customers we have are happy-goers and obviously they don’t tell us what their customers are, but when we listen to their conference call they are also saying they have a diversified customer base, but they do seem to indicate they have a very large customer in particular which they are supplying to, but they are also diversifying to other customers.

Got it. And then just the last question on the gas side of the business, obviously you said that you still have yet to see the smartphone demand picking up by I guess I would think seasonally as you go into the second half with new models in a typical year be a seasonal uptick in that business. Do you think this year it’s just where we continue to go through inventory digestion in the smartphone market or do you have some sense why that demand may still be weak going into the second half?

Yes. I would characterize our business. I mean the last quarter of 2019 was a very particularly bad year and everybody was trying to cut the inventory and everybody was uncertain about the business perspective of the future. So we saw our revenue come down very dramatically. As the quarter improved, first quarter we saw a sizable order for indium phosphide that’s on the second half of first quarter. And second quarter, we definitely are seeing things up better and overall second half seems to be better than first half, but as far as what wireless in particular is concerned, definitely second half will be better than first half, but whether that is recovering to the 2017 and ‘18 level I would still say it’s on recovering mode, but it will not reach the 2017 or ‘18 level.

Got it. Okay, thank you very much.

Thanks, Quinn.

Thank you. Our next question or comment comes from the line of Gus Richard from Northland. Your line is open.

Thanks for taking the question. Just quickly you didn’t mention the germanium business in your prepared remarks. Any comments around that product line?

Germanium is as usual. I mean they don’t – we don’t see a big uptick, but the satellite are zeroing on reasonably strong demand. We expect the business to actually improve as we enter into the second half of the year.

Okay. And then you mentioned LED was better and I think you said it was you are seeing some demand from the high-end and I am assuming that’s not just low end blue LEDs, is there any additional color around what parts of the LED market are improving?

Yes. We are having one particular customer who are giving us strong signal their business is recovering and we saw in their website they are indicating their LEDs are for high end for automobile as well as driver alertness monitoring as infrared so they are fairly sizeable customer but however we have a diversified customer in the LEDs some of the medium size or smaller size we are also in high end I am not showing same recovery. That’s why we are hedging a little bit we think the large customer if they are indicator than I think we are seeing that beginning of the recovering of LEDs for sure?

Okay so the application is around the automotive market primarily.

Yes and high end signage too but Automotive is a key driver.

And the other big application is actually printer heads.

Okay alright. Perfect. Thank you so much.

Thank you. [Operator Instructions] Our next question or comment comes from the line of Hamed Khorsand from BWS Financial. Your line is open.

So first off just want to ask you what’s the difficulty you are seeing or the feedback that you are getting from customers as far as this move to the new facility is concerned it seems like it’s a on going issue now you are talking about Q1 of next year?

Yes let me take this Morris here. I think you know it does depends upon the customers I mean some the most difficult customers are people who deal with telecommunications they have a very rigid and [indiscernible] cycles and some of the customers have told us once you sense qualification is samples they need 12 months okay so that given that was started a qualification process sometime first half of last year then they are just about ready to finish their qualification once they finish the qualification they will start [indiscernible] into the water and order a [indiscernible] maybe shifting [indiscernible] evaluate how good the performance is and compared with our old factory so if [indiscernible] also they need to be comfortable that will delivering better [indiscernible] facility and the second perhaps you say hindrance that seems to be is that the market is not very robust so people are taking it high [indiscernible] customer doesn’t like to move and sometimes you need to encourage them to give them emergency and unfortunately we can that’s our own fault we also showed our customer that we can still supply them from our old factory and normally this [indiscernible] we don’t want to see [indiscernible] so those are probably the factor and as I think industry want to recover a little bit and also these are the factor we hear our customers said [indiscernible] Morris tell me when once you have 50% or 60% customer [indiscernible] we will start buying more from this new factory [indiscernible] for their 50 60% so I mean we do have good customers that will looking with and we hold their hands that [indiscernible] and the business opportunity improves a little bit and I think it will go.

Yes this is Gary. Let me summarize that and add one more thing that yes there is not a huge sense of urgency on the customers part because this is a little bit slow and secondly there is a little bit gains may shift going on between the customer that where they don’t want to be on the first 20% [indiscernible] through the tunnel so to speak but no one has had any complaints about what they have seen in terms of the wafers okay so there is not an issue here about there is a problem with the wafers it is really customer motivation [indiscernible] we have our internal call data it is exactly what we always expected which is that you can’t tell the difference between the sides and that’s what the customer here is finding also so we just need to keep them motivated and we are working on that with our sales guys and what confident will happen that is taking just longer than we wanted it to.

How much of your revenue is coming from the new facility?

It fluctuates. Probably I would say in the low 20s maybe.

Okay. And then can you just talk about this tone that you had earlier in your comments why there is so much focus on the cash balance this quarter. It seems like that’s becoming a big priority even though you have $36 million of cash in the balance sheet?

Well for one thing cash went up so I want to make sure people notice that.

Yes, I noticed down that, but you are also making those comments though.

We had comments last quarter too. So people are asking me please comment on cash. So I am happy to comment on that. That’s why I am doing it so.

Okay, great. Thank you.

You are welcome.

Thank you. Our next question or comment comes from the line of Mason Hemze from Dougherty & Company. Your line is now open.

Related to the new facility, I am curious that what capacity are you operating there and then where are you in transitioning your customers to getting new orders out of the new facility?

Well, by definition the new facility will be able to completely take over all the production in our Tongmei facility. So, if we say it’s shipping about 20%, so utilization is only 20%.

Okay. And then as far as getting those customers certified to deliver out of that new facility, where are you at in that transition?

Well, as I said, we are delivering qualification samples. I mean, so far we have not heard any bad news, but it depends upon what cycle they qualify and we ourselves keep on telling asking them, I mean can you take more sample wafer delivery from the new facility. So that’s an interactive process. We are pushing it.

Okay. And then in terms of the gallium arsenide, what’s your viewpoint, I am looking forward on some of those end-market applications and if it’s favorable could we expect any increases in OpEx going forward?

Well, our view about gallium arsenide going forward is that they are definitely expanding market especially if you look at the 3D sensing opportunity. And we expect that to be a driver, but also industrial lasers are expanding and other application that we sell into. Expansion of gallium arsenide revenue should not cost us a lot in terms of OpEx, so there is not a one-to-one correlation. Our business model for sales relies on direct sales primarily and we compensate our sales professionals not based on some mathematical formula if they get a big order. So if revenue goes up, it doesn’t necessarily mean that the selling costs go up.

Yes. So, there is other line of question maybe I should comment is that you see we are building the new factory based upon, I think we estimate around 30% increase from our Beijing facility. So to take our highest gallium arsenide revenue per year and x30% with price erosion over the next year or two, so you should have plenty of capacity to expand to, so if you got to ask that business will do expanding market size where we incurred more cost, the answer is no

Okay, thank you.

You are welcome.

Thank you. I am showing no additional questions in the queue at this time. I would like to turn the conference back over to Dr. Morris Young for any closing remarks.

Thank you. Thank you for participating in our conference call. During Q3, we will be participating in 11th Annual BWS Financial Growth and Values Summer Investor Series in New York on August 13 as well as the Jefferies 2019 Semiconductor Hardware and Communication Infrastructure Summit in Chicago on August 27 and the 2019 Dougherty & Company Institutional Investor Conference in Minneapolis on September 5. We look forward to seeing many of you there. As always, please feel free to contact me, Gary Fischer and 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 the program. You may now disconnect. Everyone, have a wonderful day.