AXT's (AXTI) CEO Morris Young on Q2 2016 Results - Earnings Call Transcript

| About: AXT Inc (AXTI)

AXT Inc (NASDAQ:AXTI)

Q2 2016 Results Earnings Conference Call

July 27, 2016, 4:30 pm ET

Executives

Leslie Green - Investor Relations, Principal of Green Communications Consulting, LLC

Gary Fischer - Chief Financial Officer, Vice President, Corporate Secretary

Morris Young - Chief Executive Officer, Director

Analysts

Edwin Mok - Needham & Co.

Rich Shannon - Craig-Hallum

Zach Houston - Footprints Asset Management

Arthur Su - Needham & Co.

Operator

Good afternoon everyone and welcome to AXT's second quarter 2016 financial conference call. Leading the call today is Dr. Morris Young, Chief Executive Officer and Gary Fischer, Chief Financial Officer. My name is Rebecca and I will be your coordinator today. Please be advised, today's call is being recorded. [Operator Instructions].

I would now like to turn the call over to Leslie Green, Investor Relations for AXT. Please go ahead, Ma'am.

Leslie Green

Thank you Rebecca 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 and improve efficiency, increase orders in succeeding quarters, improve our competitive position as the market improves, as well as other market conditions and trends.

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 market in which the company competes, global financial conditions and uncertainties, market acceptance and demand for the company's products and the impact of delays by our customers on the timing of sales of products.

In addition to the factors that may be discussed on 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 events or results to differ materially from our current expectations. This conference call will be available on our website at axt.com through July 27, 2017.

Also, before we begin, I want to note that shortly following the close of market today, we issued a press release reporting financial results for the second quarter of 2016. 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 the second quarter results. Gary?

Gary Fischer

Thank you Leslie. Revenue for the second quarter of 2016 was $20.5 million, compared with $18.7 million in the first quarter of 2016. This is at the high-end of our expectations of $19.5 million to $20.5 million. In the second quarter of 2016, revenue from North America was 13%, Asia Pacific was 65% and Europe was 22% of total revenue. In the second quarter we had two customers that generated more than 10% of revenue and the top five customers generated approximately 42% of total revenue reflecting, again, our diversification of both products and customers.

Gross margin in the second quarter was 29.4%. This improvement from the prior quarter is the result of increasing product volume, a favorable mix and good progress in manufacturing efficiencies and yield improvements. Total operating expenses in the second quarter was $5.1 million. This is up slightly from the prior quarter as it includes a $226,000 charge related to a reduction in force at one of our consolidated subsidiaries in China. Total stock compensation in the quarter was $255,000, of which $5,000 was included in cost of revenues, $213,000 in SG&A and $37,000 in R&D. Operating profit for the second quarter of 2016 was $910,000 compared with $498,000 in the previous quarter.

Interest and other income for the second quarter was a gain of $28,000. This number consists of four categories. Net interest of $100,000, number two, foreign exchange gain of $169,00, number three, equity accounting on our unconsolidated joint ventures, a loss of $400,000 and number four are other items between a gain of $159,000.

For Q2 of 2016, we had a net profit of $1,151,000, which is $0.03 per share. This was approximately $0.01 over our guidance range, which was breakeven to a profit of $0.02 per share. By comparison, we had a net profit of $42,000 or $0.00 per share in the first quarter of 2016.

Along with profits, cash increased nicely in the quarter by $1.6 million. Cash and cash equivalents increased to approximately $45 million at June 30, 2016. This compares with $43.3 million at March 31, 2016.

Depreciation and amortization in the quarter were $1.2 million and capital expenditures were $1.0 million. Accounts receivable, net of reserves, were $18.0 million at June 30, 2016, compared with $19.7 million at March 31, 2016.

Net inventory is basically flat quarter-to-quarter. June ending inventory was $38.6 million and March ending inventory was $38.8 million. And the inventory consisted of approximately 52% in raw materials, 41% in work in progress and 7% in finished goods. This was close to the spread in Q1.

That covers the numbers for now, but we do have some changes which are favorable regarding our relocation. We have recently learned that a master development plan of the area where our manufacturing facility is located has not yet been formally approved by the China Central Government and the timeline for relocating our gallium arsenide wafer production operations has not yet been determined by the China Central Government. We believe the Central Government will undertake a comprehensive review of the master development plan, which will add time to the process.

We have also learned that there a number of factors that the Beijing City Government could consider that could extend the timeline for our relocation. We believe that we satisfy these factors and accordingly we may have some flexibility when we work with the government towards a resolution.

In addition, the Beijing City Government's Economic Development Bureau requested that we consider maintaining our indium phosphide production operations at our current site, along with our China headquarters and our R&D center. We will keep you informed as things progress

I would like now like to turn the call over to Dr. Morris Young.

Morris Young

Thank you Gary. Once again, we continued to show meaningful progress in our business. We achieved revenue at the high-end of our guidance range and exceeded our profitability expectations by a $0.01 a share. In addition, we further expanded the gross margin through yield improvements, manufacturing efficiencies, a higher production volume and we generated positive cash flow.

Q2 was another strong quarter for indium phosphide sales. While fiber optics communications continue to be the leading application for indium phosphide today, we are seeing increasing demand from data center connectivity applications, technically called silicon photonics. This demand reflects a broad base of development activities currently undertaken by vendors throughout the ecosystem.

In fact, at OFC this spring in Anaheim, a number of silicon photonics-based products and technologies will showcase including high-performance transceivers, optical modulators and detectors. Today, data center networks are transitioning from 40G to 200G. Moving forward, silicon photonics based solutions are expected to be a significant enabling factor for cloud and hyper scale computing environments to begin planning their migration to 200G-plus.

Based on market models, by Dell'Oro, C-RAN and [indiscernible], that 100G to 400G data center interconnect market is growing from $1.2 billion in 2016 to $5.1 billion in 2020. This is a 51% compound annual growth rate. This should result in a long product lifecycle for indium phosphide substrate. Our indium phosphide revenue have grown at an average rate of more than 50% annually for the last two years. As a result of increasing demand, AXT is strongly positioned with differentiated technology and manufacturing advantages, as well as significant barriers to market entry. We believe that our substrate in volume production offers the lowest etch pit density or EPD on the market. This is a critical specification that high performance optical devices and the area includes our VGF technology is particularly well-suited.

Our continued customer success is also the result of the deep expertise of our team and our strong commitment to collaborating with our customers. We have close relationships and we are actively involved in helping them solving their specific technical or processing issues in order to reap the full benefits of this challenging but exciting material. A majority of our sales and marketing professionals have PhD in either physics or material side and this is beneficial in building customer loyalty and respect. With our China-based facility and proprietary crystal growth equipment, we continue to expand capacity cost effectively as demand requires.

Now turning to gallium arsenide. We saw some sequential growth in revenue in Q2 from semi-insulating substrate, which have reached a relatively stable quarterly level of contribution. We are also seeing demand from customers for investigation of the activities into new applications for semi-insulating gallium arsenide that may provide additional upside.

Semiconducting gallium arsenide also increased modestly in the quarter. The majority of our revenue continues to be driven by demand for higher and LED applications such as backlighting, signage and automotive. However, we are closely monitoring semiconducting gallium arsenide applications requiring very low defect density material known as low EPD. These applications requiring low EPD is for vertical-cavity emitting lasers or VCSEL for short.

This emerging technology is gaining momentum in applications such as 3D sensing. The mobile phone and tablet market likely to be among the earliest adopters. But the technology is also very well suited for other areas such as Smart TV, high-speed communications and high power material process. The very low EPD requirement for VCSEL devices provides a great opportunity for AXT as our VGF technology and proprietary processes allow us to offer industry-leading specifications.

Similarly to indium phosphide, these requirements create a meaningful significant barrier to entry. Our belief is that we could see meaningful contribution from VCSEL applications sometime next year. It will benefit the topline but also contribute towards the higher gross margins.

Turning to raw materials. We saw no substantial changes to the pricing or demand environment for our key material in Q2. However, several China-based gallium suppliers, including two of our own joint venture companies, are in the process of scaling back production to align with market demand. In addition, others may be shutting down altogether. We believe that further market stabilization and eventual rebound in raw material pricing may come as a result of this decrease in volume production and excess inventory is being consumed.

Finally, I would like to say a few words about our gross margin performance. As Gary had mentioned earlier, we continue to benefit from a positive product mix benefiting from our increased sales of indium phosphide substrate and other material for high-end applications. We are excited about these business opportunities across our portfolio and believe that our solid competitive position will allow us to drive through our growth in strategic areas.

In addition, approximately two years ago we began implementing a variety of programs to reduce manufacturing costs. More recently, we have focused on increasing yield for both ingots and wafering process. Single crystal growth and the resultant wafer creation are highly technical and we have strengthened our proprietary process technology during this quarter. I am pleased to report that over time all these programs have begun to contribute meaningfully to our gross margin performance and I believe that there is plenty of room for further improvement. We expect to see sustainable benefit and continue to study additional areas in which we feel we may drive further improvements.

As a result, our gross margin is demonstrating a positive trend. For example, we improved by nearly 900 basis points in Q2 from the prior year. There are money factors that contribute to our gross margin. As such, we do expect to see fluctuations quarter-to-quarter, but believe that it can continue to improve over time.

In closing, this is exciting timing at AXT. We are highly focused on maximizing opportunities in strategy emerging areas where AXT is solidly positioned with tangible advantages in technology, in manufacturing capability and in in-house expertise. In addition, we are delivering a business model that prioritize cost efficiency, spending discipline and diligent cash management and our shareholder return. Across our organization, the AXT team is executing well and Gary and I are looking forward to reporting to you on our continued progress.

This concludes my prepared comments. I will now turn the call back to Gary for our third quarter guidance. Gary?

Gary Fischer

Thank you Morris. As we look ahead to Q3, we expect to see continued growth in our business in keeping with the near-term trends that Morris discussed. As such, we believe that revenues will be in the range of $20.5 million to $21.5 million. We are expecting the bottom line to be in the range of a $0.03 to $0.05 profit per share based on 32.5 million diluted common shares outstanding.

This concludes our prepared comments, Morris and I will be glad to answer your questions now. Operator?

Question-and-Answer Session

Operator

[Operator Instructions]. Your first question will come from Edwin Mok with Needham & Co.

Edwin Mok

Hi. Thanks for taking my question and congrats for a great quarter. First question, I guess, just on the guidance that you just gave. Can you help me out with a moving clock do you expect gross margin to vary? You did a great job this quarter of 29%. Do you expect that to further expand as you increase your topline in the coming quarter? And how should we think about OpEx?

Morris Young

Edwin, we didn't quite hear part of your question. Could you repeat the middle section?

Edwin Mok

Yes. No problem. Just a question in terms of your guidance. Do we expect gross margin to further expand this quarter? And the how do we think about OpEx for the quarter?

Morris Young

We don't know for sure what's going to happen to gross margin, because it's too early but we would expect it to be in the high 20s.

Edwin Mok

And the operating expense?

Morris Young

Operating expense, it's been trending remarkably flat for a number of quarters and we don't have anything that we know about in terms of new hires or new programs that's going to spike it up. So I think it will stay relatively flat.

Edwin Mok

Okay. Great. That's helpful. Second question I had is on indium phosphide. Just obviously you have done it very well [indiscernible] same growth, year-over-year growth. How much was indium phosphide as a percentage of revenue this quarter? If you can give some rough ideas on that? And then in terms of demand for that, we have heard some really robust projection out there that demand can potentially double in the next few quarters, et cetera, et cetera. How are you guys in terms of your capacity? Do you have excess capacity that you call ramp up? Can you move some of your other production capacity into indium phosphide? Can you give us some color on that?

Morris Young

I guess maybe I would like to take the second part of the question. I would like to see our capacity ramp up. That is a very sweet part of it and surely AXT can provide, because you can see that we have demonstrated, you can grow over 50% yearly over the last two years. So we are very well prepared. Don't forget also with all these very high growth rate, we didn't hit a stride in terms of product quality or missing some delivery, et cetera. So I think we are very well prepared for that.

Also we have words with our either existing customer as well as targeted new customers to increase our market share. So I think we are confident that we are going to see continued growth in that market. However, I think you said something product demand could be doubling. I would like to see here for who, then maybe we can ring them up. But I think you are absolutely right in certain specific areas such as what we reported in our script, that over 50% yearly growth rate for the next five years on the data center growth is definitely very, very amazingly robust.

So I wouldn't doubt about it. But then of course, indium phosphide is composed of sort of the more diverse applications now. Fibre to the Home may now have 50% growth year-over-year. And don't forget, we are also taking market share. So I think if the market was growing, let's say 10%, 16%, I think we are modeling somewhere around 25%, we should be able to grow faster than the market growth rate because we are taking market share.

Does that answer your question?

Edwin Mok

That's actually very, very helpful in terms of color there. In terms of percentage of revenue, can you give us some color on that?

Gary Fischer

Yes. This is Gary. I can answer that. So last quarter indium phosphide was a little bit north of 30% of our revenue and this quarter it was a little bit south of 30% of our revenue, but under a higher total revenue as a denominator. And then one other thing I think we should explain, you said something that can we reallocate or transfer equipment from one product line to another and there may be something that are common that can be used in each line but normally the way our business model works is, we don't grow for example, indium phosphide inside of the gallium arsenide furnace, as there's lots of reasons including contamination, including temperature control. Indium phosphide is growing under high pressure.

But we budget and plan for capacity expansion within the normal CapEx. Our CapEx is always running in last few quarters $1 million to $1.5 million a quarter and that includes new furnaces, it include more wafer saws, includes all the things that we need to grow the indium phosphide capacity. And we are ahead of the curve on that. We are not waiting until the orders come in because we have enough market knowledge where we can see where it's going to grow.

So okay, next question please.

Operator

And moving on, we will hear from Rich Shannon with Craig-Hallum.

Rich Shannon

Well, hi Morris and Gary, Thanks for taking my questions and my congratulations on a very nice second quarter. Maybe I will follow-up on the last question on topic of indium phosphide here. Gary, just to make sure I heard you right, I think you mentioned in your first quarter indium phosphide was a little bit more than 30%. This press pass quarter, a little bit less. That would suggest indium phosphide is on the order of flattish. Is that a correct interpretation? If so, what's the reason why it wasn't growing quarter-on-quarter as the optical market appears to be pretty robust out there?

Gary Fischer

Probably timing. We are not loosing sleep over it. It still, because it has a small TAM, there is some lumpiness, but it doesn't undercut anything that we think in terms of the business model going forward.

Rich Shannon

Okay. Fair enough. And then maybe I will take that same topic into the third quarter which is, how should we think about growth in indium phosphide in the third quarter relative to the overall midpoint growth rate implied in your guidance?

Morris Young

I think it should grow. So far the budget calls for, it will another record quarter.

Rich Shannon

Okay. Is indium phosphide the piece of your revenue growth for the third quarter? Or is there something that's doing better?

Gary Fischer

That's indium phosphide.

Rich Shannon

Indium phosphide. Okay. I apologize I am asking are mostly repeat what you said in your prepared remarks, Morris, I got uninterrupted. But can you repeat what you said regarding gallium pricing and I think you mentioned something about capacity coming offline? I apologize, but I just want to make sure I caught those comments again, please.

Morris Young

Right. The gallium price was sort of flat quarter-to-quarter. And what we also said that our two joint ventures in China have closed or stopped production sometime early June. And we know others in China they have closed down completely. And also, you can see that one of our additional expenses in our SG&A was a reduction of course that we had a substantial layoff in one of our joint venture producing gallium. So we think, the market is probably should take notice and start stabilizing the demand and supply side economics. Hopefully that will firm up the price.

Rich Shannon

Okay. Would you expect any near-term improvement? Is that something you expect over multi-year --

Morris Young

We are not building that into forecast. I think we would just say, it should be flat. But I think over time I am relatively excited about it. And as you know, I don't know if you detect a tone that we are increasingly optimistic about the gallium arsenide business overall. This opportunity in the VCSEL business, I think if it comes to fruition, it's a strong demand coming sometime in 2017. And also these other applications that I was talking about, the semi-insulating substrate also is creating a brand new demand. So you can see the market is such that the wireless side is sort of stabilized. So I can generalize as our pHEMT business is downward, okay. And HBT, it is taking hold of itself and yet there are other developments, which will create demand which not only speaks volume for us in terms of our substrate revenue as well profit contribution but also creates more new demand for gallium.

Rich Shannon

Morris, you did the job of leading to me to my next question. Part of that those last several comments you made here, specifically regarding the VCSEL markets. You mentioned some uptake sometime next year. What's giving you the confidence that that's coming? We have been hearing about applications like 3D sensing for frankly some time now. What gives you the confidence that it's coming in a fairly short period of time?

Morris Young

I think it comes, one of them is market research. In fact, one specific application is there is this company called Labana?

Rich Shannon

Lenovo? The Chinese OEM?

Morris Young

Yes. They are coming up with this new phone called the first Project Tango phone. And they have, it's very difficult for me to explain with a phone, but then you can go and Google it and we can imagine it.

Rich Shannon

Yes. I am familiar with Project Tango, Morris. And I have heard of that phone. So no need to explain it.

Morris Young

So I think that is an exciting opportunity and I think well, obviously it depends upon how they do that and how does the market receive that and we are also hearing lot of rumors in the market place, including potential request for quotation requiring very large volume applications for this. And also the other thing I am concluding is that, smartphone is selling very tiredly. There is no new features which will attract new customers in buying the next generation cell phone. And with the new brand new applications such Project Tango, I believe it is a very exciting opportunity for potentially all the cell phone makers to adopt this technology.

Rich Shannon

Okay.

Morris Young

Not to mention, I also saw the very high power VCSEL that you can produce actually can do material processing. So all these are very exciting with our new applications for gallium arsenide.

Rich Shannon

Okay.

Morris Young

Now the key is lasers. If it needs lasers, it needs very high quality, it needs low EPD that is right in our forte.

Rich Shannon

Okay. I appreciate all the details, Morris. Thank you very much. I have asked a lot of questions. I will jump out of line here. But thank you, very much.

Morris Young

Thank you Richard.

Gary Fischer

Next question please.

Operator

Moving on, we will hear from Zach Houston with Footprints Asset Management.

Zach Houston

Good afternoon Morris and Gary. Thanks for taking my call. Congratulations on another solid quarter.

Morris Young

Thank you.

Zach Houston

Can you just talk a little bit more about maybe some of the competitive advantages you are seeing in the indium phosphide space that's really allowing you take the market share?

Morris Young

Yes. I think, we do these by VGF, vertical gradient freeze. And as you know that AXT has been the pioneer and power house in VGF technology. We apply a little gallium arsenide and really lead us to the market leading position in gallium arsenide at one time in 2001 and we have continued that technology into indium phosphide. That enables us to leverage our know-how in VGF technology into indium phosphide, but also VGF is inherently capable of producing very low EPD materials. And that is almost perfectly to the demand of a lot of these optical devices, which requires very low EPD because EPD actually is called etch pit density. It's a defect density. It was purely devised in a high-performance optical device. That's our advantage.

Gary Fischer

We also have developed a lot of in-house process technology that we consider proprietary. The growth of indium phosphide crystal is very difficult. And so that's why there are only three companies in the world that produces in volume. But within that group of three, each company tries to increase their position, their yield, their specifications and we have probably excelled in that as a leader. And that's helped us.

Zach Houston

Perfect. Thank you guys, again.

Gary Fischer

Next question please.

Operator

We will go to Arthur Su with Needham & Co.

Arthur Su

Hi guys. I just had a quick follow-up question for Edwin. I know earlier you had mentioned that you were plans to add capacity due to the ramp up of indium phosphide. So are there any, can you help us kind of think about the potential revenue opportunity for capacity that you could, say, have in place in a year or next year or maybe even right now?

Morris Young

I do not know how to answer that question. I think capacity is a moving target. We review our capacity expansion plans almost every six months, because the dynamics of the market. We are having adding also our development into 6-inch indium phosphide, for instance. So I don't think we should think about capacity as the limitation to our indium phosphide market. I think you should think about what's the addressable market, how much can either gain market share or grow the market share.

Arthur Su

I guess I maybe will try to phrase it in a better way. Given the capacity expectation at the plants that you have for your capacity expansion, at full capacity, at full utilization, is there anyway we can plan what type of potential revenue AXT can generate? Or is that still the wrong way to look at it?

Gary Fischer

I think you guys probably can make some pretty educated estimates. As a policy, we don't want to wander into getting long-term revenue guidance. It's not that practical. And so event though it's linked to a question about capacity, we probably want you to make your own estimate. However, let me make that comment I think as it is pretty easy to understand is that we can add capacity incrementally.

It's important for anyone that's been thinking about capacity increases, you don't picture that as a digital phenomena like today we are X and after we spend $1 billion we will be at X plus $1 billion in CapEx. Our CapEx for indium phosphide can be added in increment of thousands of dollars, not even millions of dollars and definitely not billion of dollars. So we have a proprietary design, custom design pressure chamber that we work on. And we have other things that we build and we can order them and have them delivered over time, but it's not years, it's months or quarters. So capacity is really well managed by the company and I think it is under control.

Arthur Su

Great. Thanks for clarifying. Thank you.

Operator

And moving on, we will take a follow-up from Richard Shannon with Craig-Hallum.

Rich Shannon

Hi guys. Thanks for letting me ask a couple more quick questions. This won't take long. Let's see, first of all, you mentioned 10% customers, you have two of them. Is one of them the one you reported last quarter and historically has been a 10% customer?

Morris Young

Yes.

Rich Shannon

Can you characterize the second one at all? Specifically, what products and what revenue segment or segments are they generating revenue from?

Gary Fischer

It's a customer that buys indium phosphide.

Rich Shannon

Okay. Excellent. I appreciate that. My second question is on indium phosphide. Morris, given the nice growth rate and probably, in my view, a long-term sustained growth rate in the optical space, are you seeing any pressures on pricing curves that look more difficult in the future than they have been in the past two years?

Morris Young

I hope there is no customer on the call. Well, I really think right now we are not talking about that at all. The customers are very specific about what they want and obviously any customer who comes with very large volume wants to talk to us about price. But we are not seeing a big decrease. And what we are also sharing with them is that, look, if you were to increase our capacity by 50%, we are going to gain some benefit of that capacity utilization or the overhead. So we are going to give them some discount. So we can maintain our margin, let's say, okay. So I don't think we should ever begin to think about in that direction yet.

Rich Shannon

Okay. Fair enough. That's all my questions. Thank you.

Gary Fischer

Next question please.

Operator

At this time, there are no other questions. So I would like to turn things over to Dr. Young for any additional or concluding remarks.

Morris Young

Thank you for participating on our conference call. As always, please feel free to contact me or Gary Fischer directly if you would like to meet with us. We look forward to speaking with you in the near future.

Operator

And that does conclude today's presentation. We do thank everyone for your participation.

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