This quarterly report on Form 10-Q, including the following sections, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, particularly statements relating to our expectations regarding results of operations, customer demand, improvements in our product quality, our ability to expand our markets and increase sales, customer qualifications of our products, gross margins, favorable pricing, reliable supply and enhanced sourcing lead-times of raw materials, and our reserve balances. These forward-looking statements are based upon management's current views with respect to future events and financial performance, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated in such forward-looking statements. Such risks and uncertainties include those set forth under the section entitled "Risk Factors" below, which identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certain risk factors identified in this Form 10-Q and other filings we have made with the Securities and Exchange Commission. Forward-looking statements may be identified by the use of terms such as "anticipates," "believes," "estimates," "expects," "intends," and similar expressions. Statements concerning our future or expected financial results and condition, business strategy and plans or objectives for future operations are forward-looking statements.

These forward-looking statements are not guarantees of future performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2008 and the condensed consolidated financial statements included elsewhere in this report.

Overview

We are a leading worldwide developer and producer of high-performance compound and single element semiconductor substrates comprising gallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge). We currently sell the following substrate products in the sizes and for the applications indicated:

                  Product
Substrates                     Diameter                       Applications
GaAs (semi-insulating)    2", 3", 4", 5", 6"    †  Power amplifiers and radio frequency
                                                integrated circuits for wireless
                                             †  handsets (cell phones)
                                             †  †  Direct broadcast television
                                             †  †  High-performance transistors
                                             †  †  Satellite communications

GaAs (semi-conducting)            2", 3", 4" †  †  High brightness light emitting diodes
                                             †  †  Lasers
                                             †  †  Optical couplers

InP                               2", 3", 4"    †  Broadband and fiber optic
                                             †  communications

Ge                                    2", 4" †  †  Satellite and terrestrial solar cells
                                             †  †  Optical applications

We manufacture all of our semiconductor substrates using our proprietary vertical gradient freeze (VGF) technology. Most of our revenue is from sales of GaAs substrates. We manufacture all of our products in the People's Republic of China (PRC or China), which generally has favorable costs for facilities and labor compared to comparable facilities in the United States or Europe. We also have three majority-owned and two minority-owned joint ventures in China which provide us favorable pricing, reliable supply and enhanced sourcing lead-times for key raw materials which are central to our final manufactured products. These joint ventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles and boron oxide. AXT's ownership interest in these entities ranges from 25% to 83%. We consolidate the three ventures in which we own a majority or controlling financial interest and employ equity accounting for the two joint ventures in which we have a 25% interest. We purchase portions of the materials produced by these ventures for our own use and the joint ventures sell the remainder of their production to third parties. We use our direct sales force in the United States and independent sales representatives in Europe and Asia to market our substrates. We believe that, as the demand for compound semiconductor substrates is expected to increase, we are positioned to leverage our PRC-based manufacturing capabilities and access to favorably priced raw materials to increase our market share. However, the economic downturn that began in 2008, coupled with inventory overhang in the industry put pressure on our financial performance in 2008 and has continued to have an impact on our results in 2009.

While the volatile business and financial markets are prompting us to continue to take a conservative approach to our business, we remain optimistic about our business. Positive industry trends, coupled with our competitive manufacturing and cost advantages give us confidence in our ability to continue to drive future business in 2009. Following very challenging industry conditions early in the year, we are pleased to report that the improvements we began to see at the end of the first quarter continued through the second quarter, resulting in stronger sales and improved gross margins. We believe that inventory levels in the supply chain have improved from the first quarter, with the exception of our gallium raw materials, which are not expected to begin to recover until later in 2009. Our qualification efforts in both gallium arsenide and germanium substrates have been very successful and we are pleased with our increasing diversification in these areas.

As of June 30, 2009, our principal sources of liquidity were $30.6 million in cash and cash equivalents and short-term investments, excluding restricted deposits. Cash and cash equivalents and short-term investments of $30.6 million increased by $1.1 million in the second quarter of 2009 compared to the first quarter of 2009.

On July 20, 2009, we announced the appointment of Dr. Morris S. Young as Chief Executive Officer, effective July 16, 2009. Dr. Young fills the vacancy created by the March 2009 departure of Dr. Philip C.S. Yin as the Company's chief executive officer. Dr. Young continues to serve as a member of the Board of Directors of the Company.

Critical Accounting Policies and Estimates

We have prepared our condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. As such, we have had to make estimates, assumptions and judgments that affect the amounts reported on our financial statements. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that are believed to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. The discussion and analysis of our results of operations and financial condition are based upon these condensed consolidated financial statements.

We have identified the policies below as critical to our business operations and understanding of our financial condition and results of operations.

A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations. They may require us to make assumptions about matters that are highly uncertain at the time of the estimate, and different estimates that we could have used, or changes in the estimate that are reasonably likely to occur, may have a material impact on our financial condition or results of operations. We believe that the following are our critical accounting policies:

Revenue Recognition

We manufacture and sell high-performance compound semiconductor substrates and sell certain raw materials including gallium, germanium dioxide, and pBN crucibles. After we ship our products, there are no remaining obligations or customer acceptance requirements that would preclude revenue recognition. Our products are typically sold pursuant to a purchase order placed by our customers, and our terms and conditions of sale do not require customer acceptance. We recognize revenue upon shipment and transfer of title of products to our customers, which is either upon shipment from our dock, receipt at the customer's dock, or removal from consignment inventory at the customer's location, provided that we have received a signed purchase order, the price is fixed or determinable, title and risk of ownership have transferred, collection of resulting receivables is probable, and product returns are reasonably estimable. We do not provide training, installation or commissioning services. Additionally, we may provide discounts or other incentives to customers in order to secure business.

We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized.

Allowance for Doubtful Accounts

We periodically review the likelihood of collection on our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We provide a 100% allowance for receivables from U.S. customers in excess of 90 days and for receivables from customers located outside the U.S. in excess of 120 days. We assess the probability of collection based on a number of factors, including the length of time a receivable balance has been outstanding, our past history with the customer and their creditworthiness.

As of June 30, 2009 and December 31, 2008, our accounts receivable, net, balance was $12.9 million and $11.5 million, respectively, which was net of an allowance for doubtful accounts of $358,000 and $663,000, respectively. If actual uncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could have a material impact on our financial results for the period.

Warranty Reserve

We maintain a warranty reserve based upon our claims experience during the prior twelve months. Warranty costs are accrued at the time revenue is recognized. As of June 30, 2009 and December 31, 2008, accrued product warranties totaled $1.5 million and $1.6 million, respectively. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financial condition and results of operations.

Inventory Valuation

Inventories are stated at the lower of cost or market. Cost is determined using the weighted average cost method. Our inventory consists of raw materials as well as finished goods and work-in-process that include material, labor and manufacturing overhead costs. Given the nature of our substrate products, and the materials used in the manufacturing process, the wafers and ingots comprising work-in-process may be held in inventory for up to two years and three years, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory, and we provide a valuation allowance for certain inventories based upon the age and quality of the product and the projections for sale of the completed products. As of each of June 30, 2009 and December 31, 2008, we had an inventory reserve of $12.5 million and $12.0 million, respectively for excess and obsolete inventory. The majority of this inventory has not been scrapped, and accordingly, may be sold in future periods. If actual demand for our products were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results of operations.

Impairment of Investments

We classify our investments in debt and equity securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." All available-for-sale securities with a quoted market value below cost (or adjusted cost) are reviewed in order to determine whether the decline is other-than-temporary. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value.

In addition to our five joint ventures, we have in the past invested in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee's management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in our carrying value.

Fair Value of Investments

In the current market environment, the assessment of the fair value of debt instruments can be difficult and subjective. The volume of trading activity of certain debt instruments has declined, and the rapid changes occurring in today's financial markets can lead to changes in the fair value of financial instruments in relatively short periods of time. SFAS No. 157 establishes three levels of inputs that may be used to measure fair value.

Level 1 instruments represent quoted prices in active markets. Therefore, determining fair value for Level 1 instruments does not require significant management judgment, and the estimation is not difficult. Level 2 instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments, including:

† Determining which instruments are most similar to the instrument being priced requires management to identify a sample of similar securities based on the coupon rates, maturity, issuer, credit rating, and instrument type, and subjectively select an individual security or multiple securities that are deemed most similar to the security being priced.

† Determining whether a market is considered active requires management judgment. Our assessment of an active market for our marketable debt instruments generally takes into consideration activity during each week of the one-month period prior to the valuation date of each individual instrument, including the number of days each individual instrument trades and the average weekly trading volume in relation to the total outstanding amount of the issued instrument.

† Determining which model-derived valuations to use in determining fair value requires management judgment. When observable market prices for identical securities or similar securities are not available, we price our marketable debt instruments using non-binding market consensus prices that are corroborated with observable market data or pricing models, such as discounted cash flow models, with all significant inputs derived from or corroborated with observable market data.

Level 3 instruments include unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities. The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. As of June 30, 2009, we did not have any assets or liabilities without observable market values that would require a high level of judgment to determine fair value (Level 3 assets).

Impairment of Long-Lived Assets

We evaluate the recoverability of property, equipment and intangible assets in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." When events and circumstances indicate that long-lived assets may be impaired, we compare the carrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to these assets. In the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the assets' fair value. Fair values are determined based on quoted market values, discounted cash flows or internal and external appraisals, as applicable. Assets held for sale are carried at the lower of carrying value or estimated net realizable value.

Employee Stock Options

We grant options to substantially all management employees and believe that this program helps us to attract, motivate and retain high quality employees, to the ultimate benefit of our stockholders. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123(R)"), using the modified prospective application transition method. Under this transition method, stock-based compensation cost was recognized in the condensed consolidated financial statements for all share-based payments after January 1, 2006. Compensation cost recognized includes the estimated expense for the portion of the vesting period after January 1, 2006 for share-based payments prior to, but not vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, "Accounting for Stock-Based Compensation." We recognize these compensation costs net of an estimated forfeiture rate over the requisite service period of the award, which is generally the vesting term of four years for stock options. Results for prior periods have not been restated, as provided for under the modified prospective application transition method.

Income Taxes

We account for income taxes in accordance with SFAS No. 109 ("SFAS 109"), "Accounting for Income Taxes,"which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized.

We provide for income taxes based upon the geographic composition of worldwide earnings and tax regulations governing each region, particularly China. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws, particularly in foreign countries such as China.

Effective January 1, 2007, we adopted FASB Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109." See Note 13-"Income Taxes" in the condensed financial statements for additional information.

Results of Operations



Revenue



                                 Three Months Ended
                                      June 30,                 Increase
                             2009              2008           (Decrease)    % Change
                                         ($ in thousands)
GaAs                      $    10,108   $           13,142   $     (3,034 )    (23.1 )%
InP                               684                  500            184       36.8 %
Ge                              1,217                1,384           (167 )    (12.1 )%
Raw materials and other         1,046                4,906         (3,860 )    (78.7 )%
Total revenue             $    13,055   $           19,932   $     (6,877 )    (34.5 )%

Revenue decreased $6.9 million, or 34.5%, to $13.1 million for the three months ended June 30, 2009 from $19.9 million for the three months ended June 30, 2008. Total GaAs substrate revenue decreased $3.0 million, or 23.1%, to $10.1 million for the three months ended June 30, 2009 from $13.1 million for the three months ended June 30, 2008. The decline in revenue was primarily due to the overall weaker demand environment and inventory overhang, affecting sales of all diameters.

Sales of 5 inch and 6 inch diameter GaAs substrates were $4.4 million for the three months ended June 30, 2009 compared to $6.1 million for the three months ended June 30, 2008. Despite our renewed supply agreement with IQE plc for 2009, the demand from their end customers also dropped due to the worldwide economic slowdown causing IQE as well as our other customers to temporarily utilize their excess inventory. However, under our agreement with IQE, they have agreed to purchase from us a minimum of approximately $14.3 million of GaAs substrates through March 2010 and accordingly we expect demand from IQE group will increase in the latter half of 2009.

Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates were $5.7 million for the three months ended June 30, 2009 compared with $7.1 million for the three months ended June 30, 2008. Similar to the larger diameter substrate customers, the decrease in revenue from smaller diameter substrates was due to the drop in demand from our LED semi-conducting customers while they continue to utilize their excess inventory.

InP substrate revenue increased $0.2 million, or 36.8%, to $684,000 for the three months ended June 30, 2009 from $500,000 for the three months ended June 30, 2008 as demand from customers in the optical networking industry has remained steady.

Ge substrate revenue decreased $0.2 million, or 12.1%, to $1.2 for the three months ended June 30, 2009 from $1.4 million for the three months ended June 30, 2008. While our Ge substrate revenue has dropped in the first quarter of 2009, our newly qualified European customer began to release full production orders during the second quarter of 2009 for concentrated photovoltaic solar applications.

Raw materials revenue decreased $3.9 million, or 78.7%, to $1.0 million for the three months ended June 30, 2009 from $4.9 million for the three months ended June 30, 2008. The decrease in raw materials revenue was primarily due to the worldwide drop in demand for 4N gallium. In particular, our China joint venture Jiya has experienced the impact of the slowdown causing their customers to postpone or cancel orders while utilizing excess inventory.

                                 Six Months Ended
                                     June 30,                Increase
                            2009             2008           (Decrease)    % Change
                                       ($ in thousands)
GaAs                      $  15,120   $           26,862   $    (11,742 )    (43.7 )%
InP                           1,174                  978            196       20.0 %
Ge                            1,839                2,769           (930 )    (33.6 )%
Raw materials and other       2,576                8,957         (6,381 )    (71.2 )%
Total revenue             $  20,709   $           39,566   $    (18,857 )    (47.7 )%

Revenue decreased $18.9 million, or 47.7%, to $20.7 million for the six months ended June 30, 2009 from $39.6 million for the six months ended June 30, 2008. Total GaAs substrate revenue decreased $11.7 million, or 43.7%, to $15.1 million for the six months ended June 30, 2009 from $26.9 million for the six months ended June 30, 2008. The decline in revenue was primarily due to the overall weaker demand environment and inventory overhang, affecting sales of all diameters.

Sales of 5 inch and 6 inch diameter GaAs substrates were $5.7 million for the six months ended June 30, 2009 compared to $12.9 million for the six months ended June 30, 2008. Despite our renewed supply agreement with IQE plc for 2009, the demand from their end customers also dropped due to the worldwide economic slowdown causing IQE as well as our other customers to temporarily utilize their excess inventory. However, under our agreement with IQE, they have agreed to purchase from us a minimum of approximately $14.3 million of GaAs substrates through March 2010 and accordingly we expect demand from IQE group will increase in the latter half of 2009.

Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates were $9.5 million for the six months ended June 30, 2009 compared with $13.9 million for the six months ended June 30, 2008. Similar to the larger diameter substrate customers, the decrease in revenue from smaller diameter substrates was due to the drop in demand from our LED semi-conducting customers while they continue to utilize their excess inventory.

InP substrate revenue increased $0.2 million, or 20.0%, to $1.2 million for the six months ended June 30, 2009 from $1.0 million for the six months ended June 30, 2008 as demand from customers in the optical networking industry has remained steady.

Ge substrate revenue decreased $0.9 million, or 33.6%, to $1.8 for the six months ended June 30, 2009 from $2.8 million for the six months ended June 30, 2008. While our Ge substrate revenue has dropped in the first quarter of 2009, . . .