AXT, Inc (AXTI) - A Compelling 5G Value Arbitrage Opportunity

Summary

• AXT, Inc (AXTI) is a US-headquartered supplier of semi-conductor substrates, primarily Indium Phosphide (InP), Gallium Arsenide (GaA) as well as Gallium, with factories and operations based in China.
• In November 2020, AXTI announced that it initiated a process to list its subsidiary, Tongmei, on the China STAR market, expected to list in Q2 2022 (typically 18 month process).
• ACMR is the only other US company to pursue STAR listing (expected to list 1H 2021). ACMR share price increased ~700% from when it announced to its high since then.
• As required ahead of a STAR listing, AXTI sold equity (~7% of the company) to Chinese private equity investors at a value of ~$15 per share, presumably a discount to the expected IPO price.
• AXTI trades at ~$11 per share at the time of this article, a 27% discount to the Chinese private equity investment round, and presumably an even greater discount to expected Tongmei IPO value.

Indium Phosphide Scarcity Value

"You cannot transmit data through light without Indium Phosphide." For anyone that appreciates the importance of Indium Phosphide for applications such as 5G infrastructure and Silicon Photonics (data center) based on this seminal quote from AXTI's CFO, they may be interested to learn that AXTI is just one of three producers of InP in the world, and many customers claim it has the highest quality product. This scarcity value is a key component of AXTI's attractiveness as a small cap company on its way to a potential $1B+ market cap ($465M currently) should its STAR market listing be successful. AXTI's most recent earnings transcript speaks of the momentum in InP demand, which is not surprising given we are just at the beginning of the 5G investment supercycle. 

Management's bullishness regarding InP witnessed a sharp uptick on the recent Q4 2020 earnings call: We expect to hit – exceed that elusive $30 million revenue quarter-per-quarter mark. We expect to ramp up production with multiple Tier 1 companies. And finally, we're excited to successfully move AXT towards a 2022 listing on the stock market in China. We believe this year will be transformative for AXT and in turn for our employees, our customers, and our shareholders while we said it before, I am truly excited to report to you on our progress. So let's now get started with indium phosphide. Q4 of 2020 was a strong – second strongest revenue quarter for our indium phosphide portfolio in the history of AXT. Our results were exceeded only by Q2 2019 when we received a very large order from a single customer who we believe was building an inventory for expected future demand. In Q4 2020, however, our revenue achievement was spread across many customers and many applications. We believe the current revenue diversity demonstrates the broad and sustainable nature of our growth opportunities in indium phosphide." AXTI does not typically discuss full year guidance, so this conviction is notable. After listening to years of quarterly earnings calls, my view is that the tone is markedly different now.

Gallium Arsenide’s Many High-Growth Applications

In addition to InP, AXTI also produces Gallium Arsenide (GAA). AXTI is just one of two companies in the world that produces both InP and GaA. Key applications for GaA include LED lighting, Micro LEDs, 3-D sensing and industrial lasers. Automotive is a key end-market for GaA, which bodes well for AXTI given the strong demand environment in this market.The recent earnings call also alludes to several other tailwinds for GaAs - "...IoT applications seem to be providing a lift in ongoing demand for semi-insulating gallium arsenide substrate. New applications both emerging today and on the horizon include world-facing cameras, augmented and virtual reality, automotive sensors and biosensors and more."

Apple Rumors

An exciting kicker to the AXTI story are the rumors that it will be a supplier to Apple watches. This was discussed in a November 2020 Northland equity research report, where the analyst state that the new Apple watch includes an oxygen sensor, and estimates AXTI's opportunity per watch can be 20-50cents, as it likely includes BOTH InP and GaAs lasers and detectors.

State of the Art Facilities Matter

In terms of asset quality, AXTI recently completed a multi-year, extensive migration to a new facility in China (still owns the old facility located in Beijing estimated to be worth at least ~$30M). This migration created disruption in performance as customers must qualify the new facility. With this issue in the rearview mirror, what was once a distraction is now a strength in that it left AXTI with a new state-of-the-art facility in China.

“STAR-bitrage” – Trapped Value Poised to be Unlocked

The most compelling part of the AXTI story is now the arbitrage presented by the prospect of the STAR market listing. After the announcement in November 2020, the stock jumped to about $9-10 per share. In January 2021, AXTI completed a sale of just over 7% of the company at an implied value of ~$15 per share to various Chinese private equity firms (required as part of the STAR market listing). The stock reached around $12 per share around this time. The $15 per share mark was known at the time of November 2020 announcement, implying the stock traded at a 40% discount to the mark upon announcement. Even so, it took two more months and closing of the private equity investment for the stock to approach $12. This pattern highlights both the risk and opportunity of AXTI. The risk is clearly the time until the STAR listing, which can mean STAR market valuations compress or something goes wrong with Chinese regulators along the process. The opportunity is that this process is not very well known among US investors, and the large discount of AXTI's share price to the $15 mark set by the Chinese investors is reminiscent of ACMR, which took significant time from when it first announced its intentions to list on STAR to realize its 700% increase to its high. AXTI seems to be following a similar pattern. Furthermore, the more appropriate reference price is not the $15 mark, but rather some premium to that price as private equity surely would expect the IPO price to be higher than where they invested. One more important factor that can drive the discount is the so-called value trap - in order for AXTI (a US holding company) to realize the value from a STAR market listing, that value will need to be transferred from China to the US. Given AXTI's over 70% of the Tongmei subsidiary to be listed, it can simply dividend over profits to the US Subsidiary. There may be a limit on how much of the proceeds from the IPO (minimum must IPO 10% of the company) AXTI can send over to the US, as a certain portion of this may be earmarked for investment in China. Regardless, with a $465M market cap today, the potential to reach $1B upon listing on the STAR market in Q2 2022, scarcity value, and strong growth drivers from a host of end-markets, AXTI seems to be a microcap poised to lose that designation in 2022.

Finally, AXTI blew away estimates in Q4 2020, driving the stock up to $15.  The stock got caught up in the tech swoon since then, sending it plummeting as low as the $10 range. Following earnings, BWS Financial raised its price target to $20, The lower AXTI goes, the larger the arbitrage opportunity. I am long AXTI, and it currently represents the largest investment in my portfolio.