10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC. 20549

FORM 10-Q

(Mark One)

x	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2002
or
o	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ____________ to ____________

Commission File Number 0-24085

AXT, INC.
(Exact name of registrant as specified in its charter)

DELAWARE
(State or other jurisdiction of
Incorporation or organization) 94-3031310
(I.R.S. Employer
Identification No.)

4281 Technology Drive, Fremont, California 94538
(Address of principal executive offices) (Zip code)
(510) 683-5900
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES x     NO o

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at September 30, 2002
Common Stock, $.001 par value	22,495,094

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TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED INCOME STATEMENTS (Unaudited)
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Qualitative and Quantitative Disclosures About Market Risk
	Item 4. Evaluation of Disclosure Controls and Procedures
PART II OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
Index to Exhibits
EXHIBIT 10.14
EXHIBIT 99.1
EXHIBIT 99.2

AXT, INC.

TABLE OF CONTENTS

			Page
PART I.	FINANCIAL INFORMATION
	Item 1.	Financial Statements
		Condensed Consolidated Balance Sheets at September 30, 2002 and December 31, 2001	3
		Condensed Consolidated Income Statements for the three and nine months ended September 30, 2002 and 2001	4
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2002 and 2001	5
		Notes To Condensed Consolidated Financial Statements	6-13
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14-33
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	34
	Item 4.	Evaluation of Disclosure Controls and Procedures	35
PART II.	OTHER INFORMATION
	Item 1.	Legal Proceedings	35
	Item 6.	Exhibits and Reports on Form 8-K	35-36
		Signatures	37
		Certifications	37-39

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

AXT, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)

				September 30,			December 31,
				2002			2001
				(Unaudited)
Assets:
	Current assets
		Cash and cash equivalents		$	12,647		$	37,538
		Short-term investments			4,591			25,673
		Accounts receivable			11,868			15,684
		Inventories			50,570			55,587
		Prepaid expenses and other current assets			6,023			3,577
		Income tax receivable			7,721			—
		Deferred income taxes			—			10,557
			Total current assets		93,420			148,616
	Property, plant and equipment				47,189			82,573
	Restricted deposits				10,315			—
	Long-term investments				6,906			6,552
	Other assets				5,104			4,511
	Goodwill				—			1,107
			Total assets	$	162,934		$	243,359
Liabilities and Stockholders’ Equity:
	Current liabilities
		Accounts payable		$	4,902		$	2,943
		Accrued liabilities			10,025			13,362
		Income tax payable			3,000			308
		Current portion of long-term debt			957			2,336
		Current portion of capital lease obligation			3,971			4,372
			Total current liabilities		22,855			23,321
		Long-term debt, net of current portion			10,236			14,342
		Long-term capital lease, net of current portion			5,783			10,002
		Other long-term liabilities			1,567			1,273
		Deferred income taxes			—			8,099
			Total liabilities		40,441			57,037
	Stockholders’ equity:
		Preferred stock, $.001 par value; 2,000 shares authorized; 883 shares issued and outstanding			3,532			3,532
		Common stock, $.001 par value per share; 70,000 shares authorized; 22,495 and 22,383 shares issued and outstanding			154,485			153,635
		Retained earnings			(34,665	)		28,984
		Other comprehensive income			(859	)		171
			Total stockholders’ equity		122,493			186,322
		Total liabilities and stockholders’ equity		$	162,934		$	243,359

See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.
CONDENSED CONSOLIDATED INCOME STATEMENTS (Unaudited)
(In thousands, except per share data)

			Three Months Ended						Nine Months Ended
			September 30,						September 30,
			2002			2001			2002			2001
Revenue			$	14,948		$	22,783		$	50,919		$	104,159
Cost of revenue				18,491			17,423			51,241			66,300
Gross profit (loss)				(3,543	)		5,360			(322	)		37,859
Operating expenses:
	Selling, general and administrative			4,993			5,826			14,853			17,105
	Research and development			1,308			1,701			3,756			6,834
	Property, plant and equipment and goodwill impairment loss			15,107			—			39,086			—
		Total operating expenses		21,408			7,527			57,695			23,939
Income (loss) from operations				(24,951	)		(2,167	)		(58,017	)		13,920
Interest expense				364			493			1,114			1,637
Other (income)/expense				(303	)		(488	)		8,188			(1,542	)
Income (loss) before provision for income taxes				(25,012	)		(2,172	)		(67,319	)		13,825
Provision expense (benefit) for income taxes				3,661			(782	)		(3,670	)		4,977
Net income (loss)			$	(28,673	)	$	(1,390	)	$	(63,649	)	$	8,848
Basic income (loss) per share				(1.28	)		(0.06	)		(2.84	)		0.40
Diluted income (loss) per share				(1.28	)		(0.06	)		(2.84	)		0.39
Shares used in per share calculations:
	Basic			22,478			22,333			22,443			22,246
	Diluted			22,478			22,333			22,443			22,931

See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In thousands)

					Nine Months Ended
					September 30,
					2002			2001
CASH FLOWS FROM OPERATING ACTIVITIES:
	Net income (loss):				$	(63,649	)	$	8,848
	Adjustments to reconcile net income (loss) to cash provided by (used in) operations:
		Depreciation				7,498			6,187
		Deferred income taxes				3,259			—
		Amortization				299			266
		Stock compensation				—			83
		Impairment write-down on marketable equity securities				9,160			—
		Non-cash (gain)\loss on marketable equity securities				(251	)		—
		Loss on disposal of property, plant and equipment				323			—
		Impairment loss on property, plant and equipment and goodwill				39,086			—
		Changes in assets and liabilities:
			Accounts receivable			3,816			4,624
			Inventories			5,017			(6,692	)
			Prepaid expenses			(2,341	)		(228	)
			Other assets			(125	)		(120	)
			Accounts payable			1,959			(1,532	)
			Accrued liabilities			(3,336	)		3,256
			Income taxes			(5,031	)		—
			Other long-term liabilities			294			64
				Net cash (used in) provided by operating activities		(4,022	)		14,756
CASH FLOWS FROM INVESTING ACTIVITIES:
	Purchases of property, plant and equipment					(10,412	)		(24,321	)
	Purchases of marketable securities					(16,366	)		(22,748	)
	Proceeds from sale of marketable securities					15,570			1,034
				Net cash used in investing activities		(11,208	)		(46,035	)
CASH FLOWS FROM FINANCING ACTIVITIES:
	Proceeds from (payments of):
		Issuance of common stock				850			4,612
		Capital leases borrowings				—			3,143
		Capital leases payments				(4,620	)		(3,231	)
		Short-term debt payments				—			(966	)
		Long-term debt borrowings				637			—
		Long-term debt payments				(6,699	)		(2,171	)
				Net cash (used in) provided by financing activities		(9,832	)		1,387
Effect of exchange rate changes						171			130
Net decrease in cash and cash equivalents						(24,891	)		(29,762	)
Cash and cash equivalents at the beginning of the period						37,538			68,585
Cash and cash equivalents at the end of the period					$	12,647		$	38,823
Non cash activity:
	Purchase of property, plant and equipment through financing				$	577		$	2,170

See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation

     The accompanying condensed consolidated balance sheets as of September 30, 2002 and December 31, 2001, the condensed consolidated income statements for the three and nine months ended September 30, 2002 and 2001, and the condensed consolidated statements of cash flows for the nine months ended September 30, 2002 and 2001 have been prepared by AXT, Inc. (“AXT” or the “Company”) and are unaudited. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosure normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary to present fairly the financial position, results of operations and cash flows of AXT and its subsidiaries for all periods presented.

     Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these condensed consolidated financial statements in conformity with generally accepted accounting principles. Actual results could differ materially from those estimates.

     The results of operations are not necessarily indicative of the results to be expected in the future or for the full fiscal year. It is recommended that these condensed consolidated financial statements be read in conjunction with the Company’s consolidated financial statements and the notes thereto included in its 2001 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 26, 2002.

     Certain reclassifications have been made to the prior years consolidated financial statements to conform to current period presentation.

Note 2. Gain on Demeter Warrants

     In August 2000, the Company entered into a business transfer and acquisition agreement with Demeter Technologies, Inc., a Delaware corporation founded by Theodore S. Young, the former president of the Company’s fiber optic division and a former member of the Company’s board of directors, and Robert Shih, the former chief technology officer of the Company’s opto-electronics division. Under this agreement, the Company agreed to transfer certain non-core rights to Demeter relating to research and development activities in the field of fiber optics. The Company entered into non-competition agreements with Messrs. Shih and Young that prohibit them from certain activities, including the manufacture of certain VCSEL devices. The Company leased to Demeter a portion of its owned facility in El Monte, California, subleased a portion of its rented facility in El Monte, California, leased certain equipment, including an MOCVD machine, and sold certain inventory relating to fiber optics to Demeter. In exchange, Demeter granted to the Company a warrant to purchase up to 4.5 million shares of its Series A convertible preferred stock at a price of $0.5714 per share. Demeter was purchased by Finisar Corporation and as a result, AXT converted its Demeter warrant for approximately 1.1 million shares of Finisar Corporation common stock on November 21, 2000. On November 21, 2000, a gain of $27.3 million was recorded in other income as a result of the transaction. On December 10, 2001, the Company received approximately 86,000 additional shares of common stock of Finisar Corporation that had been held in escrow in accordance with the terms of the acquisition agreement between Demeter and Finisar. A gain of $1.1 million was recorded in other income as a result of receiving these additional shares. On December 31, 2001, the Company wrote its investment in Finisar Corporation down to current market value, in accordance with SFAS 115, resulting in a realized loss of $16.7 million recorded in other income and expense. On February 4, 2002, the Company received approximately 24,000 additional shares of common stock of Finisar Corporation that had been held in escrow in accordance with the terms of the acquisition agreement between Demeter and Finisar. A gain of $251,000 was recorded in other income as a result of receiving these additional shares. The investment in Finisar Corporation common stock is accounted for as available for sale and

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classified as a short-term investment. On June 30, 2002, the Company wrote its investment in Finisar Corporation down to current market value, in accordance with SFAS 115, resulting in a realized loss of $9.2 million recorded in other income and expense.

Note 3. Long-Lived Asset Impairment

     In the second quarter of 2002, the Company completed an impairment review of certain manufacturing assets used in the substrate and opto-electronics divisions. The review was undertaken due to the recent history of operating losses, declines in the demand for our products due to macro economic conditions and excess capacity resulting in part from the relocation of certain manufacturing operations in the Company’s substrate division to China.

     Upon completion of the review, the Company determined that the carrying value of the manufacturing assets was not expected to be recoverable and accordingly recorded an impairment charge in order to write-down the related assets to their estimated fair value. The Company determined the amount of the impairment charge by estimating the net present value of expected future cash flows to be generated by the assets. Based on this analysis, the Company recorded non-cash impairment charges of $14.1 million in the substrate segment and $9.9 million in the opto-electronics segment for the laser diode operating unit.

     In the third quarter of 2002, the Company completed an impairment review of certain manufacturing assets in the opto-electronics division. The review was undertaken due to the unexpected operating losses incurred in the third quarter, declines in product demand due to the Company’s inability to manufacture high volumes of its LED products to the Company’s customers’ requirements, and the need for the Company to reduce its current level of production to conserve cash.

     Upon completion of the review, the Company determined that the carrying value of the manufacturing assets was not expected to be recoverable and accordingly recorded an impairment charge in order to write-down the related assets to their estimated fair value. The Company determined the amount of the impairment charge by estimating the net present value of expected future cash flows to be generated by the assets. Based on this analysis, the Company recorded a non-cash impairment charge of $14.0 million.

Note 4. Goodwill Impairment

     The Company adopted the provisions of SFAS 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002. Under the transition provisions of SFAS No. 142, there was no goodwill impairment at January 1, 2002 based upon the Company’s analysis at that time. However, during the quarter ended September 30, 2002, circumstances developed that indicated that the goodwill was likely impaired and the Company performed an impairment analysis as of September 30, 2002. This analysis resulted in a $1.1 million impairment of goodwill. The circumstances that led to the impairment included a net loss for the quarter and a significant drop in the Company’s market capitalization.

Note 5. Investments

     The Company classifies all of its investment securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and does not hold any debt securities with the positive intent and ability to hold to maturity, or trading securities bought and held principally for the purpose of selling in the near term. All investments considered to be strategic in nature are carried at fair value, which is determined based on quoted market prices, with net unrealized gains and losses included in comprehensive income, net of tax. The components of investments at September 30, 2002 are summarized below (in thousands):

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			Aggregate		Unrealized
Available for sale	Cost		Fair value		Gain/(loss)
Money market	$	6,434	$	6,434	$	—
Corporate bonds		17,321		17,476		155
Government agency bonds		3,502		3,526		24
Corporate equity securities		2,782		810		(1,972	)
	$	30,039	$	28,246	$	(1,793	)
Recorded as:
Cash equivalents	$	6,434
Short-term investments		4,591
Long-term investments		6,906
Restricted deposits		10,315
	$	28,246

Note 6. Inventories

     Inventories are stated at the lower of cost or net realizable value. Cost is determined using the weighted average cost method. Finished goods and work-in-process inventories include material, labor and manufacturing overhead costs. 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. The components of inventory are summarized below (in thousands):

			September 30,			December 31,
			2002			2001
Inventories, net:
	Raw materials		$	19,833		$	21,308
	Work in process			28,927			30,265
	Finished goods			16,617			17,368
		Valuation allowances		(14,807	)		(13,354	)
			$	50,570		$	55,587

Note 7. Net Income (loss) Per Share

     Basic earnings per common share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per common share include dilutive potential common shares calculated using the treasury stock method. Dilutive potential common shares consist of the shares issuable upon the exercise of stock options.

     A reconciliation of the numerators and denominators of the basic and diluted earnings per share calculations is summarized below (in thousands except per share data):

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			Three Months Ended						Nine Months Ended
			September 30,						September 30,
			2002			2001			2002			2001
Numerator:
	Net income (loss)		$	(28,673	)	$	(1,390	)	$	(63,649	)	$	8,848
	Less: Preferred stock dividends			(44	)		(44	)		(133	)		(133	)
	Net income (loss) available to common stockholders		$	(28,717	)	$	(1,434	)	$	(63,782	)	$	8,715
Denominator:
	Denominator for basic earnings per share — weighted average common shares			22,478			22,333			22,443			22,246
	Effect of dilutive securities:
		Common stock options		—			—			—			685
	Denominator for dilutive earnings per share			22,478			22,333			22,443			22,931
Basic earnings per share			$	(1.28	)	$	(0.06	)	$	(2.84	)	$	0.39
Diluted earnings per share			$	(1.28	)	$	(0.06	)	$	(2.84	)	$	0.38
Options excluded from diluted net income per share as the impact is antidilutive				2,757			2,670			2,845			1,136

Note 8. Comprehensive Income

     The components of comprehensive income are summarized below (in thousands):

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2002			2001			2002			2001
Net Income (loss)	$	(28,673	)	$	(1,390	)	$	(63,649	)	$	8,848
Foreign currency translation gain (loss)		(33	)		263			171			131
Unrealized gain (loss) on available for sale investments		(1,123	)		(9,918	)		(1,201	)		(16,525	)
Comprehensive (loss) income	$	(29,829	)	$	(11,045	)	$	(64,679	)	$	(7,546	)

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Note 9. Segment Information

     The Company has two reportable segments as of September 30, 2002: substrates and opto-electronics. The segments in which the Company operates are subject to rapid technological change and significant competition. Also, the number of suppliers of certain materials used by the Company and the number of customers are limited.

     Selected industry segment information is summarized below (in thousands):

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2002			2001			2002			2001
Substrates Division
	Net revenues from external customers	$	11,726		$	20,455		$	36,362		$	97,326
	Gross profit (loss)		(1,159	)		6,470			857			41,207
	Impairment loss		542			—			14,632			—
	Operating income (loss)		(5,682	)		1,093			(26,625	)		24,111
	Identifiable assets		138,776			204,276			138,776			204,276
Opto-electronics Division
	Net revenues from external customers	$	3,222		$	2,328		$	14,557		$	6,833
	Gross (loss)		(2,384	)		(1,110	)		(1,179	)		(3,348	)
	Impairment loss		14,565			—			24,454			—
	Operating (loss)		(19,269	)		(3,260	)		(31,392	)		(10,191	)
	Identifiable assets		24,158			41,005			24,158			41,005
Total
	Net revenues from external customers	$	14,948		$	22,783		$	50,919		$	104,159
	Gross profit (loss)		(3,543	)		5,360			(322	)		37,859
	Impairment loss		15,107			—			39,086			—
	Operating income (loss)		(24,951	)		(2,167	)		(58,017	)		13,920
	Identifiable assets		162,934			245,281			162,934			245,281

     The Company sells its products in the United States and in other parts of the world, and maintains operations in the United States, Japan and China. Revenues by geographic location, based on the country in which the customer is located, were as follows (in thousands):

		Three Months Ended				Nine Months Ended
		September 30,				September 30,
		2002		2001		2002		2001
Net revenues:
	United States	$	6,659	$	12,278	$	22,077	$	51,936
	Europe		1,597		4,037		4,148		20,151
	Canada		172		1,673		1,134		6,212
	Japan		1,318		—		2,289		—
	Malaysia		483		—		6,760		—
	Taiwan		3,068		2,601		8,005		12,326
	Asia Pacific and other		1,651		2,194		6,506		13,534
	Consolidated	$	14,948	$	22,783	$	50,919	$	104,159

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Note 10. Corporate Affiliates

     The Company’s corporate affiliates are summarized below (in thousands):

	Investment		Investment
	Balance		Balance
	September 30,		December 31,		Accounting	Ownership
Affiliate	2002		2001		Method	Percentage
Xilingol Tongli Ge Co. Ltd.	$	807	$	810	Equity		25	%
Emeishan Jia Mei High Pure Metals Co., Ltd.		613		629	Equity		25	%
Beijing Ji Ya Semiconductor Material Co., Ltd.		1,071		1,071	Consolidated		51	%
Nanjing Jin Mei Gallium Co., Ltd.		616		616	Consolidated		88	%

     Undistributed retained earnings relating to the Company’s corporate affiliates was $986,000 at September 30, 2002. Net income recorded from the Company’s corporate affiliates was $25,000 and $256,000 for the three and nine months ended September 30, 2002 respectively.

Note 11. Restructuring Costs

     On December 14, 2000, the Company’s Board of Directors approved management’s plan to exit its unprofitable 650 nm laser diode product line within its opto-electronics division. As a result, during the fourth quarter of 2000, the Company recorded a pre-tax restructuring charge of $8.2 million. The restructuring charge included $2.1 million for incremental costs and contractual obligations for such items as leasehold termination payments and other facility exit costs incurred as a direct result of this plan.

     The components of the restructuring charge are summarized below (in thousands):

			Utilized
							Balance
	Reserve		Cash		Non-cash		September 30, 2002
Inventory write-off	$	1,844	$	—	$	1,844	$	—
Property, plant and equipment write-off		3,436		—		3,436		—
Goodwill write-off		848		—		848		—
Other restructuring costs		2,124		899		121		1,104
	$	8,252	$	899	$	6,249	$	1,104

     The fair value of assets determined to be impaired in accordance with the guidance for assets to be disposed set forth in SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of,” was determined in accordance with management estimates, and exit costs incurred as a direct result of the restructuring plan were determined in accordance with EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” The restructuring actions, as outlined by the plan, are substantially complete. The remaining costs are approximately $1.1 million and relate to clean up of a leased facility. The clean up is expected to be completed in 2002.

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Note 12. Commitments

     From time to time the Company is involved in litigation in the normal course of business. Management believes that the outcome of matters to date will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.

     On May 1, 2001, the Santa Clara Center for Occupational Safety and Health filed a complaint for injunctive relief and civil penalties against the Company in the Superior Court of California, County of Alameda, Hayward Division, Case No. H218237-5. The complaint alleged violations of California Business and Professions Code section 17200 et seq., and violations under Proposition 65 and California Health and Safety Code section 25249 et seq. as a result of AXT’s use of arsenic and inorganic arsenic compounds in its workplace. On June 24, 2002, the Company participated in a private mediation, and as a result, reached a settlement of all claims, pursuant to which the Company agreed to pay the Santa Clara Center for Occupational Safety and Health an amount equal to $175,000. The parties have executed a settlement agreement, and the court approved the settlement on September 20, 2002, and dismissal of the case is pending.

     The Company has entered into contracts to supply several large customers with GaAs wafers. The contracts guarantee the delivery of a certain number of wafers between January 1, 2001 and December 31, 2002 with a current contract value of $8.2 million. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, the Company could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. Partial prepayments received for these supply contracts totaling $2.9 million are included in accrued liabilities at September 30, 2002. As of September 30, 2002 the Company has met all of its delivery obligations under these contracts and expects to do so for the remainder of the contract terms.

Note 13. Foreign Exchange Contracts and Transaction Losses

     The Company uses short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. The Company has purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of September 30, 2002, the Company’s outstanding commitments with respect to the foreign exchange contracts, which were commitments to sell Japanese yen, had a total contract value of approximately $3.7 million.

     The Company incurred a foreign transaction exchange loss of $46,121 and a gain of $107,443 for the three and nine months ended September 30, 2002 respectively and gains of $84,500 and $394,300 for the three and nine months ended September 30, 2001 respectively.

Note 14. Credit Facility

     At June 30, 2002, the credit facility maintained by the Company with a bank included a $5 million line of credit with no balance outstanding, term loans in the amount of $4.8 million and a letter of credit supporting repayment of the Company’s industrial revenue bonds with an outstanding amount of $9.4 million. The credit facility is collateralized by all corporate personal and real property owned by the Company. As of June 30, 2002, the Company was in default of the credit facility by failure to maintain certain financial covenants required under the terms of the facility. As a result, on September 30, 2002 we modified the credit agreement with our bank, which waived the covenant default, terminated the credit line, amended the financial covenants and added additional collateral to secure repayment of the bonds. At September 30, 2002 the credit facility included a letter of credit supporting our bonds with an outstanding amount of $9.2 million and foreign exchange and overdraft obligations in the amount of $1.1 million. The Company has pledged and placed certain investment securities with the trust department of the bank as additional collateral for this facility. As a result, $10.3 million of our long-term investments are restricted. At September 30, 2002 we are in compliance with the financial covenants as amended.

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Note 15. Income taxes

     The Company recorded an income tax provision expense of $3.7 million and a benefit of $3.7 million for the three and nine months ended September 30, 2002 respectively. Included in the provisions is a charge of $14.9 million and $24.5 million for the three and nine months ended September 30, 2002 respectively, to record a valuation allowance against cumulative tax benefits due to uncertainties regarding the ability to realize the deferred tax assets arising from the asset impairment charges recorded during the second and third quarters.

Note 16. Recent Accounting Pronouncements

     In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 and No. 142, or SFAS 141, “Business Combinations”, and SFAS 142, “Goodwill and Other Intangible Assets.” Under SFAS 141, all business combinations must be accounted for using the purchase method of accounting; use of the pooling-of-interests (pooling) method is prohibited. The provisions of the statement will apply to all business combinations initiated after June 30, 2001. SFAS 142 will apply to all acquired intangible assets whether acquired singly, as a part of a group, or in a business combination. The statement will supersede APB Opinion No. 17, “Intangible Assets”, and will carry forward provisions in APB Opinion No. 17 relating to internally developed intangible assets. Adoption of SFAS 142 will result in ceasing amortization of goodwill. All of the statement should be applied in fiscal years beginning after December 31, 2001 to all goodwill and other intangible assets recognized in an entity’s statement of financial position at that date, regardless of when those assets were initially recognized. During the quarter, as a result of our periodic review of the recoverability of goodwill in accordance with SFAS 142, we recorded an impairment charge of $1.1 million.

     In October 2001, the FASB issued Statement of Accounting Standards No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 supercedes SFAS 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.” SFAS 144 applies to all long-lived assets (including discontinued operations) and consequently amends Accounting Principles Board Opinion No. 30 (APB 30), “Reporting Results of Operations- Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” SFAS 144 develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS 144 requires the long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally, SFAS 144 expands the scope of discontinued operations to include all components of the entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS 144 is effective for the Company for all financial statements issued in fiscal 2002. During the nine months ended September 30 2002, the Company recorded non-cash impairment charges of $38.0 million to write down to estimated fair value, idle manufacturing assets to be held and used.

     In July 2002, the FASB issued Statement of Accounting Standards No. 146, “Accounting for Costs Associated with Exit and Disposal Activities.” This statement revises the accounting for exit and disposal activities under EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity,” by spreading out the reporting of expenses related to restructuring activities. Commitment to a plan to exit an activity or dispose of long-lived assets will no longer be sufficient to record a one-time charge for most anticipated costs. Instead, companies will record exit disposal costs when they are “incurred” and can be measured at fair value, and they will subsequently adjust the recorded liability for changes in estimated cash flows. The provisions of SFAS No. 146 are effective prospectively for exit or disposal activities initiated after December 31, 2002. Companies may not restate previously issued financial statements for the effect of the provisions of SFAS No. 146 and liabilities that a company previously recorded under EITF Issue 94-3 are grandfathered. We do not believe that the adoption of SFAS No. 146 will have a material impact on our consolidated financial statements.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. 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. Such risks and uncertainties include those set forth under “Risks Related to our Business” below. Forward-looking statements may be identified by the use of terms such as “anticipates,’’ “believes,’’ “estimates,” “expects,’’ “intends,’’ and similar expressions. Statements concerning our financial position, 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 the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 and the condensed consolidated financial statements included elsewhere in this report.

Overview

     We were founded in 1986 to commercialize and enhance our proprietary vertical gradient freeze (VGF) technique for producing high-performance compound semiconductor substrates. We currently operate two divisions: our substrate division and our opto-electronics division. We made our first substrate sales in 1990 and our substrate division currently sells gallium arsenide (GaAs) and indium phosphide (InP) substrates to manufacturers of semiconductor devices for use in applications such as fiber optic and wireless telecommunications, light emitting diodes (LEDs) and lasers. We also sell germanium substrates for use in satellite solar cells. We acquired Lyte Optronics, Inc., on May 28, 1999, and currently operate part of Lyte’s historical business as our opto-electronics division. The opto-electronics division manufactures high-brightness LED’s (HBLEDs) for the illumination markets, including full-color displays, automobile lighting and traffic signals, and also manufactures vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks. We previously operated the consumer products division, discontinued in December 2000, which had focused on the design and manufacture of laser-pointing and alignment products for the consumer, commercial and industrial markets.

Critical Accounting Policies and Estimates

     We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States. As such, we have made estimates and judgments that affect the preparation of these statements based upon historical experience and on other assumptions that are believed to be reasonable under the circumstances. The discussion and analysis of our results of operations and financial condition are based upon these statements. Actual results may differ from these estimates under different assumptions or conditions. We have identified the policies below as critical to our business operations and understanding of our financial condition and results of operations.

     We recognize revenue upon shipment of products to our customers, provided that we have received a signed purchase order, the price is fixed, title has transferred, collection of resulting receivables is probable, product returns are reasonably estimable, there are no customer acceptance requirements and there are no remaining significant obligations. We assess the probability of collection based on a number of factors including past history with the customer and credit worthiness. We provide for future returns at the time revenue is recognized, based on historical experience, current economic trends and changes in customer demand. Except for sales in Japan and some sales in Taiwan, which in both cases are denominated in Japanese yen, we denominate and collect our international sales in U.S. dollars.

     We periodically review the collectability of our accounts receivable balances and provide an allowance for doubtful accounts receivable based upon the age of these accounts. We provide a 100% allowance for U.S. receivables in excess of 90 days and for foreign receivables in excess of 120 days. At September 30, 2002 our accounts receivable balance was $11.9 million net of an allowance for doubtful accounts of $8.2 million.

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     Inventories are stated at the lower of cost or net realizable value. Cost is determined using the weighted average cost method. Finished goods and work-in-process inventories include material, labor and manufacturing overhead costs. 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. We also review our inventory to ensure costs can be realized upon ultimate sale to our customers. If we determine that the value of any items in ending inventory plus any related selling costs exceeds the sales value, a reserve is established for the difference.

     Our industry requires substantial investments in property and equipment in order to meet demand and changes in technology. In addition, we occasionally make investments in companies, which are developing promising relevant technologies. We review the carrying value of our long-lived assets and investments in order to identify any impairment. Long-lived assets are written down when the carrying value of these assets exceeds their related undiscounted future cash flows. Key assumptions in estimating future cash flows include estimates of sales volumes, changes in selling prices and cost of materials. It is possible that actual results will differ from these estimates and such differences may be material and require future adjustments to the carrying value of our long-lived assets. In the second and third quarters of 2002, we completed an impairment review of certain manufacturing assets used in the substrate and opto-electronics divisions. The review was undertaken due to the recent history of operating losses, declines in the demand for our products due to macro economic conditions, the Company’s inability to manufacture high volumes of its LED products to the Company’s customers’ requirements, and excess capacity resulting in part from the addition of certain manufacturing operations in our substrate division in China. Upon completion of the review, we determined that the carrying value of the manufacturing assets was not expected to be recoverable and accordingly recorded an impairment charge in order to write-down the related assets to their estimated fair value. We determined the amount of the impairment charge by estimating the net present value of expected future cash flows to be generated by the assets. Based on this analysis for the nine months ended September 30, 2002, we recorded non-cash impairment charges of $14.1 million in the substrate segment and $23.9 million in the opto-electronics segment.

     In connection with the preparation of our consolidated financial statements, we must estimate our income taxes by the jurisdiction in which we operate. This process requires us to estimate our actual current tax exposure and asses temporary differences resulting from differing treatment of items, such as deferred revenue and/or expense, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations.

     Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance of $24.5 million as of September 30, 2002, due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of certain net operating losses carried forward and tax credits, before they expire. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance which could materially impact our financial position and results of operations.

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Results of Operations

     The following table sets forth certain information relating to our financial results expressed as a percentage of total revenues for the periods indicated:

			Three Months Ended						Nine Months Ended
			September 30,						September 30,
			2002			2001			2002			2001
Revenues				100.0	%		100.0	%		100.0	%		100.0	%
Cost of revenues				123.7			76.5			100.6			63.7
Gross profit (loss)				(23.7	)		23.5			(0.6	)		36.3
Operating expenses:
	Selling, general and administrative			33.4			25.6			29.2			16.4
	Research and development			8.8			7.5			7.4			6.6
	Property, plant and equipment and goodwill impairment loss			101.1						76.8
		Total operating expenses		143.3			33.1			113.4			23.0
Income (loss) from operations				(167.0	)		(9.6	)		(114.0	)		13.4
Interest expense				2.4			2.2			2.2			1.6
Other (income)/expense				(2.0	)		(2.1	)		16.1			(1.5	)
Income (loss) before provision for income taxes				(167.4	)		(9.7	)		(132.3	)		13.3
Provision expense (benefit) for income taxes				24.5			(3.4	)		(7.2	)		4.8
Net Income (loss)				(191.9	)%		(6.3	)%		(125.1	)%		8.5	%

Three Months Ended September 30, 2002 Compared to Three Months Ended September 30, 2001

     Revenue. Revenue decreased $7.8 million, or 34.4%, to $14.9 million for the three months ended September 30, 2002 compared to $22.8 million for the three months ended September 30, 2001. Revenue from our substrate division, which represented 78.5% of total revenue for the three months ended September 30, 2002, decreased $8.7 million, or 42.7%, to $11.7 million compared to $20.5 million for the three months ended September 30, 2001. Total GaAs substrate revenue decreased $2.1 million, or 18.8%, to $9.0 million for the three months ended September 30, 2002 compared to $11.1 million for the three months ended September 30, 2001. Sales of 5 inch and 6 inch GaAs substrates increased $1.4 million, or 82.6%, to $3.0 million for the three months ended September 30, 2002 compared to $1.6 million for the three months ended September 30, 2001. InP substrate revenue decreased $6.8 million, or 86.2%, to $1.1 million for the three months ended September 30, 2002 compared to $7.9 million for the three months ended September 30, 2001. The decrease in GaAs and InP substrate revenue is due to decreased volume and sales prices as a result of the slowdown in our markets including telecommunications, high speed electronic devices, and short wavelength lasers.

     Revenue from our opto-electronics division, which represented 21.5% of total revenue for the three months ended September 30, 2002 increased $894,000, or 38.4% to $3.2 million compared to $2.3 million for the three months ended September 30, 2001. The increase was a result of higher sales volume of HBLED products. HBLED revenue increased $987,000, or 64.0%, to $2.5 million for the three months ended September 30, 2002 compared to $1.5 million for the three months ended September 30, 2001. HBLED revenue decreased $3.1 million sequentially from the prior quarter. The decrease was primarily due to a decrease in sales volume to our largest customer, Agilent, and to a $921,000 sales return allowance. The decrease in sales volume to Agilent was due to our inability to manufacture a high volume of product to the customers’ specification. We are currently working to improve our manufacturing processes and are hopeful that we will resume shipping product to Agilent late in the fourth quarter. The sales return allowance was due to products returned during the third quarter and to anticipation of future return of products shipped during the third quarter. VCSEL and laser diode revenue decreased $93,000, or 11.8%, to $692,000 for the three months ended September 30, 2002 compared to $785,000 for the three months ended September 30, 2001.

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     International revenue increased to 55.5% of total revenue for the three months ended September 30, 2002 compared to 46.1% of total revenue for the three months ended September 30, 2001. The increase was primarily due to increased sales of HBLED products to customers in Asia.

     Gross margin. Gross margin decreased to negative 23.7% of total revenue for the three months ended September 30, 2002 compared to 23.5% of total revenue for the three months ended September 30, 2001. Gross margin at the substrate division decreased to negative 9.9% of substrate revenue for the three months ended September 30, 2002 compared to 31.6% of substrate revenue for the three months ended September 30, 2001. The decrease was primarily due to lower volume and sales prices of substrates spread over a relatively fixed manufacturing overhead base and charges related to aging inventory. As a result, we have initiated manufacturing cost reductions in order to align our costs with lower expected sales volumes and prices. We are currently shifting much of our substrate manufacturing to China, where costs are lower, and reducing capacity at our Fremont, California facility. Gross margin at the opto-electronics division decreased to negative 74.0% of opto-electronics revenue for the three months ended September 30, 2002 compared to negative 47.7% of opto-electronics revenue for the three months ended September 30, 2001. The decrease in opto-electronics margin was primarily due to the decrease in sequential HBLED revenue from the prior quarter. In the previous several quarters, we had increased our manufacturing overhead costs in order to increase our production capacity to sustain higher revenue levels, which we achieved through the second quarter of 2002. In early October, we took action to reduce the HBLED manufacturing overhead costs to align them with expected future revenue levels. These efforts to reduce costs will continue.

     Selling, general and administrative expenses. Selling, general and administrative expenses decreased $833,000, or 14.3%, to $5.0 million for the three months ended September 30, 2002 compared to $5.8 million for the three months ended September 30, 2001. As a percentage of total revenue, selling, general and administrative expenses were 33.4% for the three months ended September 30, 2002 compared to 25.6% for the three months ended September 30, 2001. The increase in selling, general and administrative expenses as a percentage of total revenue was primarily due to decreased revenue from lower sales volume and prices. We are currently taking action to reduce our selling, general and administration costs and align them with expected future revenue levels. As a result, except for possible increases in bad debt expense, we expect these costs to decrease in both absolute value and as a percentage of revenue in future quarters.

     Research and development expenses. Research and development expenses decreased $393,000, or 23.1%, to $1.3 million for the three months ended September 30, 2002 compared to $1.7 million for the three months ended September 30, 2001. As a percentage of total revenue, research and development expenses were 8.8% for the three months ended September 30, 2002 compared to 7.5% for the three months ended September 30, 2001. The decrease in research and development expenses was primarily the result of our decision to reduce expenses and align them with expected future revenues.

     Long-Lived Asset Impairment. In the third quarter of 2002, we completed an impairment review of certain manufacturing assets in the opto-electronics division. The review was undertaken due to the unexpected operating losses incurred in the third quarter, declines in product demand due to our inability to manufacture high volumes of our LED products to our customers’ requirements and the need for the Company to reduce its current level of production to conserve cash. Upon completion of the review, we determined that the carrying value of the manufacturing assets was not expected to be recoverable and accordingly recorded an impairment charge in order to write-down the related assets to their estimated fair value. We determined the amount of the impairment charge by estimating the net present value of expected future cash flows to be generated by the assets. Based on this analysis, we recorded a non-cash impairment charge of $14.0 million.

     Goodwill Impairment. We adopted the provisions of SFAS 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002. Under the transition provisions of SFAS No. 142, there was no goodwill impairment at January 1, 2002 based upon our analysis at that time. However, during the quarter ended September 30, 2002, circumstances developed that indicated that the goodwill was likely impaired and we performed an impairment analysis as of September 30, 2002. This analysis resulted in a $1.1 million impairment of goodwill. The circumstances that led to the impairment included a net loss for the quarter and a significant drop in our market capitalization.

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     Interest expense. Interest expense decreased $129,000, or 26.2%, to $364,000 for the three months ended September 30, 2002 compared to $493,000 for the three months ended September 30, 2001 due to the repayment of debt and a reduction of rates on our variable interest rate debts over the period.

     Other income and expense. Other income decreased $185,000 to $303,000 for the three months ended September 30, 2002 compared to income of $488,000 for the three months ended September 30, 2001.

     Provision for income taxes. Our effective tax rate decreased to 14.6% for the three months ended September 30, 2002 compared to 36.0% for the three months ended September 30, 2001. The current quarter tax rate is primarily the result of recording a valuation allowance against the tax benefits related to the asset impairment charges that were taken in the second and third quarters. The valuation allowance was applied to the benefit due to uncertainty regarding its recoverability.

Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30, 2001

     Revenue. Revenue decreased $53.3 million, or 51.1%, to $50.9 million for the nine months ended September 30, 2002 compared to $104.2 million for the nine months ended September 30, 2001. Revenue from our substrate division, which represented 71.4% of total revenue for the nine months ended September 30, 2002, decreased $60.9 million, or 62.6%, to $36.4 million compared to $97.3 million for the nine months ended September 30, 2001. Total GaAs substrate revenue decreased $42.2 million, or 61.5%, to $26.4 million for the nine months ended September 30, 2002 compared to $68.6 million for the nine months ended September 30, 2001. Sales of 5 inch and 6 inch GaAs substrates decreased $12.9 million, or 62.8%, to $7.7 million for the nine months ended September 30, 2002 compared to $20.6 million for the nine months ended September 30, 2001. InP substrate revenue decreased $16.6 million, or 79.9%, to $4.2 million for the nine months ended September 30, 2002 compared to $20.8 million for the nine months ended September 30, 2001. The decrease in GaAs and InP substrate revenue is due to decreased volume and sales prices as a result of the slowdown in our markets including telecommunications, high speed electronic devices, and short wavelength lasers.

     Revenue from our opto-electronics division, which represented 28.6% of total revenue for the nine months ended September 30, 2002, increased $7.8 million, or 113.0% to $14.6 million compared to $6.8 million for the nine months ended September 30, 2001. The increase was a result of higher sales volume of HBLED products. HBLED revenue increased $8.5 million, or 205.7%, to $12.6 million for the nine months ended September 30, 2002 compared to $4.1 million for the nine months ended September 30, 2001. The higher HBLED sales volume was primarily concentrated with one customer, Agilent, during this period. In the current quarter, HBLED revenue decreased $3.1 million sequentially from the prior quarter. The decrease was primarily due to a decrease in sales volume to Agilent, and to a $931,000 sales return allowance. The decrease in sales volume to Agilent was due to our inability to manufacture a high volume of product to the customer specification. We are currently working to improve our manufacturing processes and are hopeful that we will resume shipping product to Agilent late in the fourth quarter. The sales return allowance was due primarily to products returned during the third quarter and to anticipation of future return of products shipped during the third quarter. As a result of our current manufacturing difficulties, the year to date revenue growth in HBLED revenue is not indicative of future HBLED revenue growth. VCSEL and laser diode revenue decreased $731,000, or 26.9%, to $2.0 million for the nine months ended September 30, 2002 compared to $2.7 million for the nine months ended September 30, 2001.

     International revenue increased to 56.6% of total revenue for the nine months ended September 30, 2002 compared to 50.1% of total revenue for the nine months ended September 30, 2001. The increase was primarily due to increased sales of HBLED products to customers in Asia.

     Gross margin. Gross margin decreased to negative 0.6% of total revenue for the nine months ended September 30, 2002 compared to 36.3% of total revenue for the nine months ended September 30, 2001. Gross margin at the substrate division decreased to 2.4% of substrate revenue for the nine months ended September 30, 2002 compared to 42.3% of substrate revenue for the nine months ended September 30, 2001. The decrease was primarily due to lower volume and sales prices of substrates spread over a relatively fixed manufacturing overhead base and charges related to aging inventory. As a result, we have initiated manufacturing cost reductions in order to align our costs with lower expected sales volumes and prices. We are currently shifting much of our substrate

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manufacturing to China, where costs are lower, and reducing capacity at our Fremont, California facility. Gross margin at the opto-electronics division increased to negative 8.1% of opto-electronics revenue for the nine months ended September 30, 2002 compared to negative 49.0% of opto-electronics revenue for the nine months ended September 30, 2001. The increase was primarily due to increased unit sales of our HBLED products.

     Selling, general and administrative expenses. Selling, general and administrative expenses decreased $2.2 million, or 13.2%, to $14.9 million for the nine months ended September 30, 2002 compared to $17.1 million for the nine months ended September 30, 2001. As a percentage of total revenue, selling, general and administrative expenses were 29.2% for the nine months ended September 30, 2002 compared to 16.4% for the nine months ended September 30, 2001. The increase in selling, general and administrative expenses as a percentage of total revenue was primarily due to decreased revenue from lower sales volume and prices. We are currently taking action to reduce our selling, general and administrative costs and align them with expected future revenues. As a result, except for possible increases in bad debt expense, we expect these costs to decrease in both absolute value and as a percentage of revenue in future quarters.

     Research and development expenses. Research and development expenses decreased $3.0 million, or 45.0%, to $3.8 million for the nine months ended September 30, 2002 compared to $6.8 million for the nine months ended September 30, 2001. As a percentage of total revenue, research and development expenses were 7.4% for the nine months ended September 30, 2002 compared to 6.6% for the nine months ended September 30, 2001. The decrease in research and development expenses was primarily the result of our decision to reduce expenses and align them with expected future revenues.

     Long-Lived Asset Impairment. In the second quarter of 2002, we completed an impairment review of certain manufacturing assets used in the substrate and opto-electronics divisions. The review was undertaken due to the recent history of operating losses, declines in the demand for our products due to macro economic conditions and excess capacity resulting in part from the relocation of certain manufacturing operations in our substrate division to China. Upon completion of the review, we determined that the carrying value of the manufacturing assets was not expected to be recoverable and accordingly recorded an impairment charge in order to write-down the related assets to their estimated fair value. We determined the amount of the impairment charge by estimating the net present value of expected future cash flows to be generated by the assets. Based on this analysis, we recorded non-cash impairment charges of $14.1 million in the substrate segment and $9.9 million in the opto-electronics segment for the laser diode operating unit. In the third quarter of 2002, we completed an impairment review of certain manufacturing assets in the opto-electronics division. The review was undertaken due to the unexpected operating losses incurred in the third quarter, declines in product demand due to our inability to manufacture high volumes of our LED products to our customers’ requirements, and the need to reduce our current level of production to conserve cash. Upon completion of the review, we determined that the carrying value of the machinery and equipment was not expected to be recoverable and accordingly recorded an impairment charge in order to write-down the related assets to their estimated fair value. We determined the amount of the impairment charge by estimating the net present value of expected future cash flows to be generated by the assets. Based on this analysis, we recorded a non-cash impairment charge of $14.0 million.

     Goodwill Impairment. We adopted the provisions of SFAS 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002. Under the transition provisions of SFAS No. 142, there was no goodwill impairment at January 1, 2002 based upon our analysis at that time. However, during the quarter ended September 30, 2002, circumstances developed that indicated that the goodwill was likely impaired and we performed an impairment analysis as of September 30, 2002. This analysis resulted in a $1.1 million impairment of goodwill. The circumstances that led to the impairment included a net loss for the quarter and a significant drop in our market capitalization.

     Interest expense. Interest expense decreased $523,000, or 31.9%, to $1.1 million for the nine months ended September 30, 2002 compared to $1.6 million for the nine months ended September 30, 2001 due to the repayment of debt and a reduction of rates on our variable interest rate debt over the period.

     Other income and expense. Other expense increased $9.7 million to $8.2 million for the nine months ended September 30, 2002 compared to income of $1.5 million for the nine months ended September 30, 2001. The

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increase for the nine months ended September 30, 2002 is primarily due to a non-cash charge of $9.2 million taken to write-down to current market value our investment in Finisar Corporation common stock.

     Provision for income taxes. Our effective tax rate decreased to 5.5% for the nine months ended September 30, 2002 compared to 36.0% for the nine months ended September 30, 2001. The current year tax rate is primarily the result of recording a valuation allowance against the tax benefits related to the asset impairment charges that were taken in the second and third quarters. The valuation allowance was applied to the benefit due to uncertainty regarding its recoverability.

Liquidity and Capital Resources

     We consider cash and cash equivalents, short-term investments and long-term investments as liquid and available for use. Short and long-term investments are comprised of government bonds and high grade commercial debt instruments. Also included in short-term investments is our common stock investment in Finisar Corporation.

     Cash and cash equivalents, short-term investments and long-term investments, excluding $810,000 and $11.6 million for our investment in Finisar common stock at September 30, 2002 and December 31, 2001 respectively, decreased $34.7 million to $23.3 million at September 30, 2002 compared to $58.1 million at December 31, 2001. The decrease in available cash included restricting $10.3 million as additional collateral with our bank as a result of the modification to our credit facility, purchases of capital equipment of $10.4 million, debt repayments of $11.3 million and $4.0 million used in operating activities.

     Net cash used in operating activities was $4.0 million for the nine months ended September 30, 2002 which comprised primarily of our net loss adjusted for non-cash items of $59.4 million, and by a $253,000 net change in assets and liabilities. The net change in assets and liabilities resulted primarily from a decrease in accounts receivable and inventory, and an increase in accounts payable, offset by decreases in accrued liabilities, income taxes and prepaid expenses.

     Accounts receivable decreased $3.8 million, or 24.3%, to $11.9 million at September 30, 2002 compared to $15.7 million at December 31, 2001. The change reflects lower sales volume, collections of $53.2 million and an increase in our allowance for doubtful accounts of $1.5 million. Days sales outstanding were 73 at September 30, 2002 based on sales during the previous nine months. Inventories decreased $5.0 million, or 9.0% to $50.6 million at September 30, 2002 compared to $55.6 million at December 31, 2001. Inventory turns for the nine month period were 1.0 at September 30, 2002. Our inventory balance remains high in relation to current sales due to the inventory buildup we incurred during the period of rapid growth that we experienced through the second quarter of 2001. We are continuously monitoring our inventory levels, have reduced inventory purchases and have put in place measures to significantly reduce the balance. We expect that these measures will significantly improve cash flows from operations in future periods. We expect to reduce the current inventory balance significantly by the end of 2003.

     Net cash used in investing activities of $11.2 million for the nine months ended September 30, 2002 includes purchases of property and equipment of $10.4 million primarily used to increase wafer processing capacity in China for the substrate division, and to increase HBLED epitaxy growth and wafer processing capacity at the opto-electronics division. It also includes $16.4 million in purchases of high-grade investment securities with maturities of less than two years offset by $15.6 million in sales of these securities.

     We do not have any plans to initiate any major new capital spending projects through 2003. We are currently completing certain projects in process and are continuously constructing minor improvements to our existing production facilities in China and California. We expect to invest approximately $2.0 million to complete projects in progress in the fourth quarter and expect to invest $4 million in 2003. We believe that our existing facilities and equipment are sufficient to fulfill current and expected future orders.

     Net cash used in financing activities of $9.8 million for the nine months ended September 30, 2002 includes proceeds of $850,000 from the sale of common stock through our employee stock compensation programs and proceeds of $637,000 from a new equipment loan, offset by payments of $6.7 million for payments on long-term debt and $4.6 million for capital lease payments.

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     We generally finance equipment purchases through secured equipment loans and capital leases over four or five-year terms at interest rates ranging from 4.6% to 8.8% per annum. Our main Fremont, California manufacturing facility is financed by long-term borrowings, which were refinanced by taxable variable rate revenue bonds in 1998. These bonds mature in 2023 and bear interest at 2.0% below the prime rate. The bonds are traded in the public market. Repayment of principal and interest under the bonds is supported by a letter of credit from our bank and is paid on a quarterly basis. We have the option to redeem the bonds in whole or in part during their term. At September 30, 2002, $9.2 million was outstanding under these bonds.

     At June 30, 2002, the credit facility that we had with our bank included a $5 million line of credit with no balance outstanding, term loans in the amount of $4.8 million and a letter of credit supporting repayment of our bonds with an outstanding amount of $9.4 million. The credit facility is collateralized by all corporate personal and real property. As of June 30, 2002, we were in default of the credit facility by failure to maintain certain financial covenants required by the facility. As a result, on September 30, 2002 we modified the credit agreement with our bank which waived the covenant default, terminated the credit line and term loans, amended the financial covenants and added additional collateral to secure the remaining amounts due. At September 30, 2002 the credit facility included a letter of credit supporting our bonds with an outstanding amount of $9.2 million and foreign exchange and overdraft obligations in the amount of $1.1 million. We have pledged and placed certain investment securities with the trust department of our bank as additional collateral for this facility. As a result, $10.3 million of our long-term investments are restricted. At September 30, 2002 we were in compliance with the financial covenants as amended.

     As a result of the significant revenue declines that we have experienced over the past several quarters, we have taken cost reduction measures and continue to pursue additional measures to reduce our cost of doing business and increase our cash flows. At September 30, 2002, we had available cash of $23.3 million. We believe that this balance, coupled with additional efforts to reduce our expenditures in support of our substrates and opto-electronic businesses, will be sufficient to fund working capital and capital expenditure requirements for the next 12 months.

     If our sales continue to decrease, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity, require us to use more cash at a more rapid rate than expected, and require us to seek additional capital, if available on acceptable terms.

Risks Related to Our Business

The semiconductor industry is cyclical and is currently experiencing a severe and prolonged downturn which has adversely impacted our operating results.

     Our business depends in significant part upon manufacturers of electronic and opto-electronic semiconductor devices, as well as the current and anticipated market demand for such devices and products using such devices. The semiconductor industry is highly cyclical. The industry has in the past, and will likely in the future, experience periods of oversupply that result in significantly reduced demand for semiconductor devices and components, including our products, both as a result of general economic changes and overcapacity. When these periods occur, our operating results and financial condition are adversely affected. Inventory buildups in telecommunications products and slower than expected sales of computer equipment have resulted in overcapacity and led to reduced sales by our customers. During periods of declining demand such as those experienced over the past year, customers typically reduce purchases, delay delivery of products and/or cancel orders of component parts such as our products. Increased price competition may result, causing pressure on our net sales, gross margin and net income. We have over the past year experienced cancellations, delays and push outs of orders, which have resulted in reduced revenues. If the economic downturn continues, further order cancellations, reductions in order size or delays in orders will materially adversely affect our business and results of operations. Although we have taken actions to reduce our costs, if our actions are insufficient to align our structure with prevailing business conditions, we may be required to undertake additional cost-cutting measures, and may be unable to invest in marketing, research and development and engineering at the levels we believe are necessary to maintain our competitive position. Our failure to make these investments could seriously harm our business. In addition, we may be required to seek additional sources of cash, which may not be available on acceptable terms or at all.

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The impact of changes in global economic conditions on our customers may cause us to fail to meet expectations, which would negatively impact the price of our stock.

     Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. More specifically, the macro-economic environment that we have faced in the second half of 2001 and are continuing to face in 2002 is more uncertain than in prior periods, has lasted longer than expected and has materially and adversely affected us and our operating results and may continue to do so. The revenue growth and profitability of our business depends on the overall demand for our substrates, LED’s and laser diodes, and we are particularly dependant on the market conditions for the wireless, fiber optics and telecommunications industries. Because our sales are primarily to major corporate customers whose businesses fluctuate with general economic and business conditions, a softening of demand for products that use our substrates, LEDs and laser diodes caused by a weakening economy may result in further or prolonged decreased revenues. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing products due to the downturn in their business and in the general economy.

Unpredictable fluctuations in our operating results could disappoint analysts or our investors, which could cause our stock price to decline.

     We have not over the past year been able to sustain our historical growth rate, and may not be able to return to historic growth levels in the current economic environment. We have and may continue to experience significant fluctuations in our revenue and earnings. Our quarterly and annual revenue and operating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including:

• decline in general economic conditions or downturns in the industry in which we compete;

• fluctuations in demand for our products;

• expansion of our manufacturing capacity;

• expansion of our operations in China;

• limited availability and increased cost of raw materials;

• the volume and timing of orders from our customers, and cancellations, push outs and delays of customer orders;

• fluctuation of our manufacturing yields;

• decreases in the prices of our competitors’ products;

• costs incurred in connection with any future acquisitions of businesses or technologies;

• increases in our expenses, including expenses for research and development; and

• our ability to develop, manufacture and deliver high quality products in a timely and cost-effective manner.

     Due to these factors, we believe that period-to-period comparisons of our operating results may not be a meaningful indicator of our future performance. Our operating results have over the past year at times been below the expectations of securities analysts or investors. If this occurs again in future periods, the price of our common stock would likely decline or fluctuate.

     A substantial percentage of our operating expenses are fixed in the short term and we may be unable to adjust spending to compensate for an unexpected shortfall in revenues. As a result, any delay in generating revenue could cause our operating results to be below the expectations of market analysts or investors, which could also cause our stock price to fall.

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     The lead-time for customer orders is generally shorter than it was a year ago. As a result, our visibility regarding future financial performance is uncertain and we may provide investors with financial guidance that we cannot meet. As a result, our operating results could be below the expectations of market analysts or investors, which could also cause our stock price to fall.

If the economy recovers and we are again in a period of high demand for our products, if we fail to expand our manufacturing capacity, we may not be able to meet increased demand, lower our costs or increase revenue.

     Although we are currently in a period of overcapacity, if the economy recovers, demand may increase rapidly as it has in prior years. In order to meet increased demand and maintain our market share, we may need to increase production, which could require us to build new facilities, expand and modify our existing facilities, purchase additional manufacturing equipment, and add qualified staff. If we do not expand our manufacturing capacity, we will be unable to increase production, which may adversely impact our ability to reduce unit costs, margins and improve our operating results.

     We are currently constructing and modifying facilities in California and China. Our construction activities subject us to a number of risks, including:

• unforeseen environmental or engineering problems;

• unavailability or late delivery of production equipment;

• delays in completing new facilities;

• delays in bringing production equipment on-line;

• work stoppages or delays;

• inability to recruit and train qualified staff;

• unanticipated cost increases and restrictions imposed by requirements of local, state or federal regulatory agencies.

     If any of these risks occurs, construction may be costlier than anticipated and completion could be delayed, which could hurt our ability to expand capacity and increase our sales. In addition, if we experience delays in expanding our manufacturing capacity, we might not be able to timely meet customer requirements, and we could lose future sales. We are also making investments in equipment and facilities as part of our previously planned capacity expansion. To offset the additional fixed operating expenses, we must increase our revenue by increasing production and improving yields. If demand for our products does not grow or if our yields do not improve as anticipated, we may be unable to offset these costs against increased revenue, which would adversely impact our operating results.

Our results of operations may suffer if we do not effectively manage our inventory.

     To achieve commercial success with our products, we will need to manage our inventory of component parts and finished goods effectively to meet changing customer requirements. Some of our products and supplies have in the past and may in the future become obsolete while in inventory due to changing customer specifications, excess inventory or decreased demand for our products. We have in the past had to take inventory valuation and impairment charges. If we are not successfully able to manage our inventory, we may need to write off unsaleable, obsolete or excess inventory, which could adversely affect our results of operations.

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Our HBLED and VCSEL products are in their early stages, and we may not be able to achieve anticipated sales of these products.

     We have experienced declining revenue for both our HBLED and laser diode products as a result of a loss of revenue from our leading LED customer and a decline in the market for our laser diode products. We may be unable to successfully market and increase sales of these products. To market and increase sales of our HBLED and VCSEL products, we will have to continue to develop additional distribution channels and achieve certain product and reliability specifications. We may be unable to obtain significant increases in revenue and may seek potential investors for our opto-electronics business. We must also continue our research and development efforts to apply our proprietary VGF technique to new substrate products and successfully introduce and market new opto-electronic semiconductor devices, including enhancements to our HBLED and VCSEL products.

If we do not successfully develop new products to respond to rapidly changing customer requirements, our ability to generate sales and obtain new customers may suffer.

     Our success depends on our ability to offer new products that incorporate leading technology and respond to technological advances. In addition, our new products must meet customer needs and compete effectively on quality, price and performance. The life cycles of our products are difficult to predict because the markets for our products are characterized by rapid technological change, changing customer needs and evolving industry standards. If our competitors introduce products employing new technologies, our existing products could become obsolete and unmarketable. If we fail to offer new products, we may not generate sufficient revenue to offset our development costs and other expenses or meet our customers’ requirements. Other companies, including IBM and Motorola, are actively developing substrate materials that could be used to manufacture devices that could provide the same high-performance, low-power capabilities as GaAs-based devices at competitive prices. If these substrate materials are successfully developed and semiconductor device manufacturers adopt them, demand for our GaAs substrates could decline and our revenue could suffer. Similarly, other companies, including Kopin, are developing alternative production technologies for HBLEDs. If they are successful, demand for our HBLEDs could drop and our revenue could decline.

     The development of new products can be a highly complex process, and we may experience delays in developing and introducing new products. Any significant delays could cause us to fail to timely introduce and gain market acceptance of new products. Further, the costs involved in researching, developing and engineering new products could be greater than anticipated.

Our operating results depend in large part on further customer acceptance of our existing substrate products and on our ability to develop new products based on our core VGF technology.

     A large share of GaAs substrates are manufactured from crystals grown using the traditional Liquid Encapsulated Czochralski, or LEC, or Horizontal-Bridgeman, or HB, techniques. In order to expand sales of our products, we must continue to promote our VGF technique as a preferred process for producing substrates, and we must offer products with superior prices and performance on a timely basis and in sufficient volumes. If we fail to gain increased market acceptance of our VGF technique, we may not achieve anticipated revenue growth.

     To shift more of our substrate manufacturing operations to China successfully, we will need our customers to qualify products manufactured in China. If we are unable to achieve qualifications for these products, our China facility will be underutilized, our investments in China will not be recouped and we will be unable to lower our costs by moving to China. All of these events could reduce our revenue but increase our cost structure.

Intense competition in the markets for our products could prevent us from increasing revenue and sustaining profitability.

     The markets for our products are intensely competitive. We face competition for our substrate products from other manufacturers of substrates, such as Freiberger, Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor device manufacturers that produce substrates for their own use, and from companies, such as IBM and Motorola, that are actively developing alternative materials to GaAs and some semiconductor devices are

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being marketed using these materials. We believe that at least two of our competitors are shipping GaAs substrates manufactured using a technique similar to our VGF technique. Other competitors may develop and begin using similar technology. If we are unable to compete effectively, our revenue may not increase and we may be unable to be profitable. We face many competitors that have a number of significant advantages over us, particularly in our compound semiconductor device products, including:

• greater experience in the business;

• more manufacturing experience;

• extensive intellectual property;

• broader name recognition; and

• significantly greater financial, technical and marketing resources.

     Our competitors could develop new or enhanced products that are more effective than the products that we have developed or may develop. For example, some competitors in the HBLED market offer devices that are brighter than our HBLEDs and have other desirable features. Some of our competitors may also develop technologies that enable the production of commercial products with characteristics similar to or better than ours, but at a lower cost.

     The level and intensity of competition has increased over the past year and we expect competition to continue to increase in the future. Competitive pressures caused by the current economic conditions have resulted in reductions in the prices of some of our products, and continued or increased competition could reduce our market share, require us to further reduce the prices of our products, affect our ability to recover costs or result in reduced gross margins.

If we have low product yields, the shipment of our products may be delayed and our operating results may be adversely impacted.

     Our products are manufactured using complex technologies, and the number of usable substrates and devices we can produce can fluctuate as a result of many factors, including:

• impurities in the materials used;

• contamination of the manufacturing environment;

• substrate breakage;

• equipment failure, power outages or variations in the manufacturing process; and

• performance of personnel involved in the manufacturing process.

     Because many of our manufacturing costs are fixed, our revenue could decline if our yields decrease but our costs would change little, if at all. We have experienced product shipment delays and difficulties in achieving acceptable yields on both new and older products, and delays and poor yields have adversely affected our operating results. We may experience similar problems in the future and we cannot predict when they may occur or their severity. In addition, many of our manufacturing processes are new and are still being refined, which can result in lower yields, particularly as we focus on producing higher diameter substrates and new opto-electronic semiconductor devices. For example, we recently made substantial investments in equipment and facilities to manufacture blue, green and cyan HBLEDs and VCSELs. If we are unable to produce adequate quantities of our high-brightness LEDs and VCSELs, we may not be able to meet customer demand and our revenue may decrease while our costs remain largely unchanged.

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Demand for our products may decrease if our customers experience difficulty manufacturing, marketing or selling their products.

     Our products are used as components in our customers’ products. Accordingly, demand for our products is subject to factors affecting the ability of our customers to successfully introduce and market their products, including:

• the competition our customers face in their particular industries;

• the technical, manufacturing, sales and marketing and management capabilities of our customers;

• the financial and other resources of our customers; and

• the inability of our customers to sell their products if they infringe third party intellectual property rights.

If demand for the products offered by our customers decreases, our customers may reduce purchases of our products.

     As inventory of telecommunication products and computer equipment has increased in the past year, resulting in overcapacity in the market, our customers have reduced sales of their products, causing them to reduce purchases of our products. As a result, our revenues have declined and may fail to recover until the overcapacity has been depleted and demand for our customers’ products once again increases.

We purchase critical raw materials and parts for our equipment from single or limited sources, and could lose sales if these sources fail to fill our needs.

     We depend on a limited number of suppliers for certain raw materials, components and equipment used in manufacturing our products, including key materials such as gallium, arsenic, quartz, and graphite susceptors. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts and none of our suppliers guarantees supply of raw materials or equipment to us. If we lose any of our key suppliers, our manufacturing efforts could be significantly hampered and we could be prevented from timely producing and delivering products to our customers. We have experienced delays obtaining critical raw materials, including gallium, due to shortages of these materials. We may experience delays due to shortages of materials and may be unable to obtain an adequate supply of materials. These shortages and delays could result in higher materials costs and cause us to delay or reduce production of our products. If we have to delay or reduce production, we could fail to meet customer delivery schedules, and our revenue and operating results could suffer.

     We have periodically encountered a decline in quality of graphite susceptors, which has led to lower yields of our HBLED products. If these quality problems continue, our ability to manufacture our HBLED products would be reduced, we could fail to meet customer delivery schedules, and our revenue and operating results could suffer.

If we fail to comply with environmental and safety regulations, we may be subject to significant fines or cessation of our operations.

     We are subject to federal, state and local environmental and safety laws and regulations. These laws, rules and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our operations. In March 2001, we settled a claim made by the California Occupational Safety and Health Administration, or Cal-OSHA, in an investigation primarily regarding impermissible levels of potentially hazardous materials in certain areas of our manufacturing facility in Fremont, California for $204,415. Although we have put in place engineering, administrative and personnel protective equipment programs to address these issues, our ability to expand or continue to operate our present locations could be restricted or we could be required to acquire costly remediation equipment or incur other significant expenses. In addition, existing or future changes in laws or regulations may require us to incur significant expenditures or liabilities, or may restrict our operations.

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The loss of one or more of our key substrate customers would significantly hurt our operating results.

     A small number of substrate and HBLED customers have historically accounted for a substantial portion of our total revenue. Five customers accounted for 35.7% of our total revenue for the three months ended September 30, 2002 and 30.3% for the three months ended September 30, 2001. No one customer accounted for greater than 10% of total revenue for the three months ended September 30, 2002, or the three months ended September 30, 2001. Our substrate revenue accounted for 78.5% of our total revenue for the three months ended September 30, 2002 and 89.8% for the three months ended September 30, 2001. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate and HBLED customers. Our customers are not obligated to purchase a specified quantity of our products or to provide us with binding forecasts of product purchases. In addition, our customers may reduce, delay or cancel orders at any time without any significant penalty, and during the past year, we have experienced slower bookings, significant push outs and cancellation of orders. If we lose a major customer or if a customer cancels, reduces or delays orders, our revenue would decline. In addition, customers that have accounted for significant revenue in the past may not continue to generate revenue for us in any future period. Any delay in scheduled shipments of our products could cause net sales to fall below our expectations and the expectations of market analysts or investors, causing our stock price to decline.

Defects in our products could diminish demand for our products.

     Our products are complex and may contain defects. In the past we have experienced quality control problems with some of our products, which caused customers to return products to us or reduce orders for our products, such as our recent reduction in orders for our LED products by Agilent. If we continue to experience quality control problems, or experience these problems in new products, customers may cancel or reduce orders or purchase products from our competitors. Defects in our products could cause us to incur higher manufacturing costs and suffer product returns and additional service expenses, all of which could adversely impact our operating results.

     We are also developing new products and product enhancements, including substrates and compound semiconductor device products. If our new products contain defects when released, our customers may be dissatisfied and we may suffer negative publicity or customer claims against us, lose sales or experience delays in market acceptance of our new products.

Our substrate and opto-electronic semiconductor device products have a long sales cycle that makes it difficult to plan our expenses and forecast our results.

     Customers typically place orders with us for our substrate and opto-electronic semiconductor device products three months to a year or more after our initial contact with them. The sale of our products may be subject to delays due to our customers’ lengthy internal budgeting, approval and evaluation processes. During this time, we may incur substantial expenses and expend sales, marketing and management efforts while the customers evaluate our products. These expenditures may not result in sales of our products. If we do not achieve anticipated sales in a period as expected, we may experience an unplanned shortfall in our revenue. As a result, we may not be able to cover expenses, causing our operating results to vary. In addition, if a customer decides not to incorporate our products into its initial design, we may not have another opportunity to sell products to this customer for many months or even years. In this difficult economic climate, the average sales cycle for our products has lengthened even further and is expected to continue to make it difficult to accurately forecast our future sales. We anticipate that sales of any future substrate and opto-electronic semiconductor device products under development will also have lengthy sales cycles and will, therefore, be subject to risks substantially similar to those inherent in the lengthy sales cycle of our current substrate and opto-electronic semiconductor device products.

As our business matures, we may need to upgrade our systems.

     In the past, periods of rapid growth and expansion has strained our management and other resources. The expansion of our manufacturing capacity and the shift of manufacturing operations to China has placed and continues to place a significant strain on our operations and management resources. If we fail to manage these changes effectively, our operations may be disrupted. To manage our business effectively, we may need to implement

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additional and improved management information systems, further develop our operating, administrative, financial and accounting systems and controls, add experienced senior level managers, and maintain close coordination among our executive, engineering, accounting, marketing, sales and operations organizations.

     If necessary, we will spend substantial sums to support our future growth and shift to China and may incur additional unexpected costs. Our systems, procedures or controls may not be adequate to support our operations, and we may be unable to expand quickly enough to exploit potential market opportunities. Our future operating results will also depend on expanding sales and marketing, research and development and administrative support. If we cannot attract qualified people or manage growth effectively, our business and operating results could be adversely affected.

If we fail to manage periodic contractions, we may utilize our cash balances.

     We have experienced a period of rapid contraction in our business that caused us to reduce our costs in order to conserve our cash resources. However, in the three months ended September 30, 2002, we utilized $5.0 million in our operating activities and for the nine months ended September 30, 2002, we utilized $4.0 million in our operating activities. If we fail to manage our contractions successfully we may continue to draw down our cash reserves, which would adversely affect our operating results and financial condition, reduce our value and may impinge our ability to raise debt and equity funding in the future, at a time when we may be required to raise additional cash. As part of our effort to reduce costs, we may lose key staff, production resources, and technology that we will need to grow when end markets recover. These events could reduce our ability to grow profitably as markets recover.

As a result of the difficult economic conditions, we have implemented restructuring and workforce reductions, which may adversely affect the moral and performance of our personnel and our ability to hire new personnel.

     In connection with our efforts to streamline operations, reduce costs and bring staffing and structure in line with current demand for our products, we implemented a corporate restructuring beginning last year and reduced our workforce, shifted production activities to China and reduced capital expenditures. Our restructuring may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce and loss of employee moral and decreased performance. In addition, the recent trading levels of our stock have decreased the value of our stock options granted to employees under our stock option plan. As a result of these factors, our remaining personnel may seek employment with larger, more established companies or companies that they perceive as having less volatile stock prices. Continuity of personnel can be very important factors in the sales and production of our products and completion of our research and development efforts.

Any future acquisitions may disrupt our business, dilute stockholder value or distract management attention.

     As part of our strategy, we may consider acquisitions of, or significant investments in, businesses that offer products, services and technologies complementary to ours, such as our acquisition of Lyte Optronics in May 1999. Acquisitions entail numerous risks, including:

• we may have difficulty assimilating the operations, products and personnel of the acquired businesses;

• our ongoing business may be disrupted;

• we may incur unanticipated costs;

• our management may be unable to manage the financial and strategic position of acquired or developed products, services and technologies;

• we may be unable to maintain uniform standards, controls and procedures and policies; and

• our relationships with employees and customers may be impaired as a result of any integration.

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     For example, we incurred substantial costs in connection with our acquisition of Lyte Optronics, including the assumption of approximately $10.0 million of debt, much of which has been repaid or renegotiated, resulting in a decline of cash available. We incurred one-time charges and merger-related expenses of $2.8 million and an extraordinary item of $508,000 relating to the early extinguishment of debt in the quarter ended September 30, 1999 as a result of the acquisition.

     To the extent that we issue shares of our stock or other rights to purchase stock in connection with any future acquisitions, dilution to our existing stockholders will result and our earnings per share may suffer. Any future acquisitions may not generate additional revenue or provide any benefit to our business.

If any of our facilities is damaged by actions such as fire, explosion, or natural disaster, we may not be able to manufacture our products.

     The ongoing operation of our manufacturing and production facilities in California and China is critical to our ability to meet demand for our products. If we are not able to use all or a significant portion of our facilities for prolonged periods for any reason, we will not be able to manufacture products for our customers. For example, a natural disaster, fire or explosion caused by our use of combustible chemicals and high temperatures during our manufacturing processes would render some or all of our facilities inoperable for an indefinite period of time. Actions outside of our control, such as earthquakes, could also damage our facilities, rendering them inoperable. Some of our crystal growth is currently performed at our Fremont, California facilities, which are located near an active seismic fault line. If we are unable to operate our facilities and manufacture our products, we will lose customers and revenue and our business will be harmed.

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to successfully manage our business or achieve our objectives.

     Our success depends upon the continued service of Morris S. Young, Ph.D., our president, chairman of the board and chief executive officer, as well as other key management and technical personnel. We do not have long-term employment contracts with, or key person life insurance on, any of our key personnel.

     We believe our future success will also depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing, finance and manufacturing personnel. The competition for these employees is intense, especially in Silicon Valley, and we cannot assure you that we will be successful in attracting and retaining new personnel. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel in the future or delays in hiring required personnel, particularly engineers, could make it difficult for us to manage our business and meet key objectives, including the timely introduction of new products.

If we are unable to protect our intellectual property, we may lose valuable assets or incur costly litigation.

     We rely on a combination of patents, copyrights, trademark and trade secret laws, non-disclosure agreements and other intellectual property protection methods to protect our proprietary technology. However, we believe that, due to the rapid pace of technological innovation in the markets for our products, our ability to establish and maintain a position of technology leadership also depends on the skills of our development personnel.

     Despite our efforts to protect our intellectual property, a third party could develop products or processes similar to ours. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around our patents. We believe that at least two of our competitors have begun to ship GaAs substrates produced using a process similar to our VGF technique. Our competitors may also develop and patent improvements to the VGF, LED and VCSEL technologies upon which we rely, and thus may limit any exclusivity we enjoy by virtue of our patents.

     It is possible that pending or future United States or foreign patent applications made by us will not be approved, that our issued patents will not protect our intellectual property, or that third parties will challenge the ownership rights or the validity of our patents. In addition, the laws of some foreign countries may not protect our proprietary rights to as great an extent as do the laws of the United States and it may be more difficult to monitor the

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use of our intellectual property. Our competitors may be able to legitimately ascertain non-patented proprietary technology embedded in our systems. If this occurs, we may not be able to prevent the development of technology substantially similar to ours.

     We may have to resort to costly litigation to enforce our intellectual property rights, to protect our trade secrets or know-how or to determine their scope, validity or enforceability. Enforcing or defending our proprietary technology is expensive, could cause us to divert resources and may not prove successful. Our protective measures may prove inadequate to protect our proprietary rights, and if we fail to enforce or protect our rights, we could lose valuable assets.

We might face intellectual property infringement claims that may be costly to resolve and could divert management attention.

     Other companies may hold or obtain patents on inventions or may otherwise claim proprietary rights to technology necessary to our business. The markets in which we compete are comprised of competitors who in some cases hold substantial patent portfolios covering aspects of products that could be similar to ours. We could become subject to claims that we are infringing patent, trademark, copyright or other proprietary rights of others, and are currently in discussions with one company concerning alleged patent infringement. Litigation to determine the validity of alleged claims could be time-consuming and result in significant expense to us and divert the efforts of our technical and management personnel, whether or not the litigation is ultimately determined in our favor. If a lawsuit is decided against us, we could be subject to significant liabilities, requiring us to seek costly licenses or preventing us from manufacturing and selling our products. We may not be able to obtain required licensing agreements on terms acceptable to us or at all.

We derive a significant portion of our revenue from international sales, and our ability to sustain and increase our international sales involves significant risks.

     Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 55.5% of our total revenue for the three months ended September 30, 2002 and 46.1% for the three months ended September 30, 2001. We expect that sales to customers outside the U.S. will continue to represent a significant portion of our revenue.

     Our dependence on international sales involves a number of risks, including:

• changes in tariffs, import or export restrictions and other trade barriers;

• unexpected changes in regulatory requirements;

• longer periods to collect accounts receivable;

• changes in export license requirements;

• political and economic instability;

• unexpected changes in diplomatic and trade relationships; and

• foreign exchange rate fluctuations.

     Our sales are denominated in U.S. dollars, except for sales to our Japanese and some Taiwanese customers, which are denominated in Japanese yen. Thus, increases in the value of the U.S. dollar could increase the price of our products in non-U.S. markets and make our products more expensive than competitors’ products in these markets. Also, denominating some sales in Japanese yen subjects us to fluctuations in the exchange rates between the U.S. dollar and the Japanese yen. The functional currencies of our Japanese and Chinese subsidiaries are the local currencies. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for these subsidiaries, as well as in translation of the assets and liabilities of these assets at each balance sheet date. If

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we do not effectively manage the risks associated with international sales, our revenue, cash flows and financial condition could be adversely affected.

If our expansion in China is more costly than we expect, our operating results will suffer.

     As part of our planned expansion of our manufacturing capacity, we are building new facilities and expanding existing facilities in China. If we are unable to build and expand our Chinese facilities in a timely manner, we may not be able to increase production of our products and increase revenue as planned. If our expansion in China proves more costly than we anticipate or we incur greater ongoing costs than we expect, our operating results would be adversely affected. If we do not realize expected cost savings once our expansion is complete in China, our margins may be negatively impacted and our operating results may suffer.

Changes in China’s political, social and economic environment may affect our financial performance.

     Our financial performance may be affected by changes in China’s political, social and economic environment. The role of the Chinese central and local governments in the Chinese economy is significant. Chinese policies toward economic liberalization, and laws and policies affecting technology companies, foreign investment, currency exchange rates and other matters could change, resulting in greater restrictions on our ability to do business and operate our manufacturing facilities in China. Any imposition of surcharges or any increase in Chinese tax rates could hurt our operating results. The Chinese government could revoke, terminate or suspend our license for national security and similar reasons without compensation to us. If the government of China were to take any of these actions, we would be prevented from conducting all or part of our business. Any failure on our part to comply with governmental regulations could result in the loss of our ability to manufacture our products in China.

     China has from time to time experienced instances of civil unrest and hostilities. Confrontations have occurred between the military and civilians. Events of this nature could influence the Chinese economy, result in nationalization of foreign-owned operations such as ours, and could negatively affect our ability to operate our facilities in China.

The effect of terrorist threats on the general economy could decrease our revenues.

     On September 11, 2001, the United States was subject to terrorist attacks at the World Trade Center buildings in New York and the Pentagon in Washington D.C., and continues to be on alert for further terrorist activity. In addition, the United States continues to consider hostile activity with Iraq. The potential near- and long-term impact of these attacks and other terrorist activities, as well as the threat of war may have in regards to our suppliers, customers and markets for our products and the U.S. economy, are uncertain. There may be other potential adverse effects on our operating results due to this significant event that we cannot foresee.

Our stock price has been and may continue to be volatile.

     Our stock price has fluctuated significantly since we began trading on the Nasdaq National Market. For the nine months ended September 30, 2002, the high and low closing sales prices of our common stock were $16.89 and $2.08 respectively. A number of factors could cause the price of our common stock to continue to fluctuate substantially, including:

• actual or anticipated fluctuations in our quarterly or annual operating results;

• changes in expectations about our future financial performance or changes in financial estimates of securities analysts;

• announcements of technological innovations by us or our competitors;

• new product introduction by us or our competitors;

• large customer orders or order cancellations; and

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• the operating and stock price performance of comparable companies.

     In addition, the stock market in general has experienced extreme volatility that often has been unrelated to the operating performance of particular companies. These broad market and industry fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating performance.

If we fail to comply with Nasdaq rules, our common stock may be delisted from the Nasdaq National Market, which could eliminate the trading market for our common stock.

     If we fail to meet the criteria for continued listing on The Nasdaq National Market, our common stock may be delisted from The Nasdaq National Market. If the stock is delisted, it would significantly decrease the liquidity of an investment in AXT common stock. In addition, the stock may be deemed to be penny stock. If our common stock is considered penny stock, it would be subject to rules that impose additional sales practices on broker-dealers who sell our securities. For example, broker-dealers would have to make a special suitability determination for the purchaser and have received the purchaser’s written consent to the transaction prior to sale. Also, a disclosure schedule must be prepared prior to any transaction involving a penny stock and disclosure is required about sales commissions payable to both the broker-dealer and the registered representative and current quotations for the securities. Monthly statements are also required to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stock. Because of these additional obligations, some brokers may be unwilling to effect transactions in penny stocks. This could have an adverse effect on the liquidity of our common stock and the ability of investors to sell the common stock.

We may need additional capital to fund expansion of our manufacturing capacity and our future operations, which may not be available.

     We may need additional capital to fund expansion of our manufacturing and production capacity and our future operations or acquisitions. If we raise additional capital through the sale of equity or debt securities, the issuance of such securities could result in dilution to existing stockholders. These securities could have rights, preferences and privileges that are senior to those of holders of our common stock. For example, in December 1998 we issued debt securities for the purchase and improvement of our facilities in Fremont, California.

     If we require additional capital in the future, it might not be available on acceptable terms, or at all. If we are unable to obtain additional capital when needed, we may be required to reduce the scope of our product line, the planned expansion of our manufacturing capacity or of our product development and marketing efforts, which could adversely affect our business and operating results.

Provisions in our charter, bylaws or Delaware law may delay or prevent a change in control of our company.

     Provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a merger, acquisition or change of control of us, or changes in our management. These provisions include:

• the division of our board of directors into three separate classes, each with three year terms;

• the right of our board to elect a director to fill a space created by a board vacancy or the expansion of the board;

• the ability of our board to alter our bylaws;

• the ability of our board to authorize the issuance of up to 2,000,000 shares of blank check preferred stock; and

• the requirement that only our board or the holders of at least 10% of our outstanding shares may call a special meeting of our stockholders.

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     Furthermore, because we are incorporated in Delaware, we are subject to the provisions of Section 203 of the Delaware General Corporation Law. These provisions prohibit large stockholders, in particular those owning 15% or more of the outstanding voting stock, from consummating a merger or combination with a corporation unless:

• 66 2/3% of the shares of voting stock not owned by these large stockholders approve the merger or combination, or

• the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of our outstanding voting stock.

We have adopted certain anti-takeover measures that may make it more difficult for a third party to acquire us.

     Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock, while potentially providing desirable flexibility in connection with possible acquisitions and for other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock. Further, on April 24, 2001, our board of directors adopted a preferred stock purchase rights plan intended to guard against certain takeover tactics. The adoption of this plan was not in response to any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation may have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.

The financial condition of our customers may affect their ability to pay amounts owed to us.

     Many of our customers are facing business downturns that have reduced their cash balances and their prospects. We frequently allow our customers to pay for products we ship to them within 30 to 90 days after delivery. Subsequent to our shipping a product some customers have been unable to make payments as due, reducing our cash balances and causing us to incur charges to allow for a possibility that some accounts might not be paid. At least two customers that owed us a significant amount have filed for bankruptcy protection and we are unlikely to receive a substantial portion of the amount owed to us as part of a bankruptcy settlement. Other customers may also be forced to file for bankruptcy. If our customers do not pay their accounts when due, we will be required to incur charges that would reduce our earnings.

Legislative actions, higher insurance cost and potential new accounting pronouncements are likely to cause our general and administrative expenses to increase and impact our future financial position and results of operations.

     In order to comply with the newly adopted Sarbanes-Oxley Act of 2002, as well as proposed changes to listing standards by Nasdaq, and proposed accounting changes by the Securities and Exchange Commission, we may be required to increase our internal controls, hire additional personnel and additional outside legal, accounting and advisory services, all of which will cause our general and administrative costs to increase. Insurers are likely to increase premiums as a result of the high claims rates incurred over the past year, and so our premiums for our various insurance policies, including our directors’ and officers’ insurance policies, are likely to increase. Proposed changes in the accounting rules, including legislative and other proposals to account for employee stock options as a compensation expense among others, could materially increase the expense that we report under generally accepted accounting principles and adversely affect our operating results.

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Item 3. Qualitative and Quantitative Disclosures About Market Risk

Foreign Currency Risk

     We use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. We have purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. Because the effect of movements in currency exchange rates on forward exchange and currency options contracts generally offset the related effect of the underlying items being hedged, these financial instruments are not expected to subject AXT to risks that would otherwise result from changes in currency exchange rates. As of September 30, 2002, our outstanding commitments with respect to the foreign exchange contracts, which were commitments to sell Japanese yen, had a total contract value of approximately $3.7 million.

     We incurred a foreign transaction exchange loss of $46,121 and a gain of $107,443 for the three and nine months ended September 30, 2002 respectively and gains of $84,500 and $394,300 for the three and nine months ended September 30, 2001 respectively.

Interest Rate Risk

     Cash and cash equivalents earning interest and certain variable rate debt instruments are subject to interest rate fluctuations. The following table sets forth the probable impact of a 10% change in interest rates (in thousands):

						Current			Proforma			Proforma
	Balance		Current			Interest			10% Interest			10% Interest
	September 30,		Interest			Income/			Rate Decline			Rate Increase
Instrument	2002		Rate			(Expense)			Income/(Expense)			Income/(Expense)
Cash and cash equivalents	$	12,647		2.01	%	$	254		$	229		$	280
Bonds		9,215		1.97	%		(182	)		(163	)		(200	)
						$	72		$	66		$	80

Equity Risk

     We also maintain minority investments in private and publicly traded companies. These investments are reviewed for other than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value include whether the related company would have insufficient cash flow to operate for the next twelve months, significant changes in the operating performance and changes in market conditions. Investments in publicly traded companies are carried at fair market value based on quoted market prices of the investments as of September 30, 2002. These investments are subject to market risk of equity price changes. As of September 30, 2002, the minority investments we continue to hold totaled $4.6 million at estimated fair value of which investments in publicly traded companies was $810,000 and investments in private companies was $3.8 million.

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Item 4. Evaluation of Disclosure Controls and Procedures

(a)  Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), within 90 days of the filing date of this report. Based on their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective.

(b)  There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced in paragraph (a) above.

PART II OTHER INFORMATION

Item 1. Legal Proceedings

     From time to time we may be involved in litigation in the normal course of business. Management believes that the outcome of matters to date will not have a material adverse effect on our financial position or results of operations or cash flows.

     On May 1, 2001, the Santa Clara Center for Occupational Safety and Health filed a complaint for injunctive relief and civil penalties against the Company in the Superior Court of California, County of Alameda, Hayward Division, Case No. H218237-5. The complaint alleges violations of California Business and Professions Code section 17200 et seq., and violations under Proposition 65 and California Health and Safety Code section 25249 et seq. as a result of AXT’s use of arsenic and inorganic arsenic compounds in its workplace. On June 24, 2002, the Company participated in a private mediation, and as a result, reached a settlement of all claims, pursuant to which the Company agreed to pay the Santa Clara Center for Occupational Safety and Health an amount equal to $175,000. The parties have executed a settlement agreement, and the court approved the settlement on September 20, 2002 and dismissal of the case is pending.

Item 2. Changes in Securities and Use of Proceeds

          None

Item 3. Defaults Upon Senior Securities

          None

Item 4. Submission of Matters to a Vote of Security Holders

          None

Item 5. Other Information

          None

Item 6. Exhibits and Reports on Form 8-K

a. Exhibits

3.1(1)	Restated Certificate of Incorporation
3.2(2)	Certificate of Designation, Preferences and Rights of Series A Preferred Stock, as filed with the Secretary of State of the state of Delaware on May 27, 1999 (which is

35

	incorporated herein by reference to Exhibit 2.1 to the registrant’s Form 8-K dated May 28, 1999)
3.3(3)	Second Amended and Restated Bylaws
4.1(4)	Registration Rights Agreement dated as of May 27, 1999, by and among American Xtal Technology, Inc., Lyte Optronics, Inc. and Keith Halsey and Robert Shih
4.2(3)	Rights Agreement dated as of April 24, 2001, by and between AXT, Inc. and Computershare Trust Company
10.14	Second Modification to Credit Agreement between U.S. Bank National Association and us dated September 30, 2002
99.1	Certification by Chief Executive Officer
99.2	Certification by Chief Financial Officer

(1)	As filed with the SEC in our Annual Report on Form 10-K for the year ended December 31, 1998.
(2)	As filed with the SEC in our Form 8-K on June 14, 1999.
(3)	As filed with the SEC in our Form 8-K on May 30, 2001.
(4)	As filed with the SEC in our Annual Report on Form 10-K for the year ended December 31, 1999.

b. Reports on Form 8-K

          None

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

AXT, INC.

Dated: November 12, 2002	By:	/s/ Morris S. Young
		Morris S. Young Chief Executive Officer

Dated: November 12, 2002	By:	/s/ Donald L. Tatzin
		Donald L. Tatzin Chief Financial Officer

Dated: November 12, 2002	By:	/s/ John E. Drury
		John E. Drury Corporate Controller

     I, Morris S. Young, certify that:

     1. I have reviewed this quarterly report on Form 10-Q of AXT, Inc.;

     2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

     3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

     4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

     a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

     b. evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

     c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

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     5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

     a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

     b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

     6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Dated: November 12, 2002	By:	/s/ Morris S. Young
		Morris S. Young Chief Executive Officer

     I, Donald L. Tatzin, certify that:

     1. I have reviewed this quarterly report on Form 10-Q of AXT, Inc.;

     2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

     3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

     4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

     a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

     b. evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

     c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

     5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors:

     a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

     b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

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     6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Dated: November 12, 2002	By:	/s/ Donald L. Tatzin
		Donald L. Tatzin Chief Financial Officer

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Index to Exhibits

Exhibits
Number	Description
3.1(1)	Restated Certificate of Incorporation
3.2(2)	Certificate of Designation, Preferences and Rights of Series A Preferred Stock, as filed with the Secretary of State of the state of Delaware on May 27, 1999 (which is incorporated herein by reference to Exhibit 2.1 to the registrant’s Form 8-K dated May 28, 1999)
3.3(3)	Second Amended and Restated Bylaws
4.1(4)	Registration Rights Agreement dated as of May 27, 1999, by and among American Xtal Technology, Inc., Lyte Optronics, Inc. and Keith Halsey and Robert Shih
4.2(3)	Rights Agreement dated as of April 24, 2001, by and between AXT, Inc. and Computershare Trust Company
10.14	Second Modification to Credit Agreement between U.S. Bank National Association and us dated September 30, 2002
99.1	Certification by Chief Executive Officer
99.2	Certification by Chief Financial Officer

(1)	As filed with the SEC in our Annual Report on Form 10-K for the year ended December 31, 1998.
(2)	As filed with the SEC in our Form 8-K on June 14, 1999.
(3)	As filed with the SEC in our Form 8-K on May 30, 2001.
(4)	As filed with the SEC in our Annual Report on Form 10-K for the year ended December 31, 1999.

EX-10.14 3 f85875exv10w14.txt EXHIBIT 10.14 EXHIBIT 10.14 SECOND MODIFICATION TO CREDIT AGREEMENT This Second Modification to Credit Agreement (the "Second Modification") is entered into as of September 30, 2002, by and among AXT, INC., a Delaware corporation ("Borrower"), and U.S. BANK NATIONAL ASSOCIATION ("U.S. Bank"), as a Lender (defined in the Credit Agreement defined below) and as agent (in such capacity, "Agent"). U.S. Bank is currently the sole Lender. Except as otherwise specifically provided herein, all capitalized terms used and not defined herein shall have the meaning set forth in the Credit Agreement (defined below). RECITALS A. Pursuant to the terms of that certain Credit Agreement (as amended from time to time, including hereby and by the First Modification described below, the "Credit Agreement") dated as of August 28, 2000, by and among Borrower, Lenders and Agent, Lenders and Agent agreed to provide Borrower the following: (i) a Line of Credit not to exceed at any time the aggregate principal amount of Twenty Million Dollars ($20,000,000.00); (ii) Term Loan A in the principal amount of One Million One Hundred Ninety Thousand Dollars ($1,190,000.00); (iii) Term Loan B in the principal amount of One Million Six Hundred Ten Thousand Dollars ($1,610,000.00); (iv) Term Loan C in the principal amount of Three Million Two Hundred Thousand Dollars ($3,200,000.00); and (v) a Letter of Credit Facility. B. Borrower and Agent entered into that certain Modification of Credit Agreement (the "First Modification") dated December 31, 2001, in order to, among other things, decrease the amount of the Line of Credit to $5,000,000.00, change the interest rates applicable to the Credits and to extend the Line Maturity Date. C. As of June 30, 2002, Borrower defaulted under Section 6.9(d) of the Credit Agreement by reason of Borrower's failure to maintain the Tangible Net Worth required thereunder. As a result, Borrower and Agent wish to modify the Credit Agreement to, among other things, amend the financial covenants and add Additional Collateral (as defined below) to secure the Credits. AGREEMENT 1. Recitals. The recitals set forth above are true, accurate and correct. 2. Reaffirmation of Credit Agreement. The Borrower reaffirms all of its obligations under the Credit Agreement and the Borrower acknowledges that as -1- of the date hereof, it has no claims, offsets or defenses with respect to the payment of sums due under the Notes or any other Loan Document. 3. Waiver of Covenant Default. Upon the effectiveness of this Second Modification and satisfaction of the conditions precedent set forth herein, Agent hereby waives any default by Borrower under Section 6.9(d) of the Credit Agreement by reason of Borrower's failure to maintain the Tangible Net Worth required thereunder prior to the date hereto. 4. Termination of Line of Credit and Term Loans. Pursuant to Section 2.8(a) of the Credit Agreement, Borrower has elected to terminate the Line of Credit and to repay in full the Term Loans. Effective herewith, Lender shall no longer have any obligations to fund under the Line of Credit or the Term Loans and within five (5) days after the date of this Second Modification, Agent shall cause the Deeds of Trust encumbering the El Monte Property and the Monterey Park Property to be reconveyed. Upon effectiveness of this Second Modification, all representations, warranties and covenants shall apply only to the Collateral remaining in effect after such reconveyances occur. 5. Modifications to Credit Agreement. The Credit Agreement is hereby amended as follows: a. Permitted Indebtedness. The following subsection (j) is added to the definition of "Permitted Indebtedness" in Section 1.1 of the Credit Agreement: "(j) Indebtedness incurred by Borrower or any Subsidiary which is secured by (i) Borrower's foreign receivables, provided Agent and the receivables lender thereunder shall have entered into an intercreditor agreement in form and substance satisfactory to Agent and/or (ii) fixed assets of Borrower or its Subsidiaries located in China." b. Permitted Liens. The following subsection (k) is added to the definition of "Permitted Indebtedness" in Section 1.1 of the Credit Agreement: "(k) liens securing Indebtedness incurred by Borrower or any Subsidiary which is secured by (i) Borrower's foreign receivables, provided Agent and the receivables lender thereunder shall have entered into an intercreditor agreement in form and substance satisfactory to Agent and/or (ii) fixed assets of Borrower or its Subsidiaries located in China." c. Tangible Net Worth. The definition of "Tangible Net Worth" in Section 1.1 of the Credit Agreement is amended in its entirety to read as follows: "'Tangible Net Worth' means, as of any date of determination, the consolidated stockholder's equity as of that date determined in accordance with GAAP, less (i) the [book] value of all assets that are considered intangible assets under GAAP, including customer lists, -2- goodwill, covenants not to compete, copyrights, trade names, trademarks and patents, less (ii) the book value of the common stock Borrower owns in Finisar Corporation." d. Line of Credit/Term Loans. Sections 2.1, 2.2, 2.4, 2.5(a)-(d), 2.6, 2.8, 2.9, 2.10, 2.11(a)-(c), 2.13 and Section 6.16 are deleted in their entirety. e. Letter of Credit Facility Fee. Section 2.5(e) of the Credit Agreement is amended in its entirety to read as follows: "Letter of Credit Facility Fee. Borrower shall pay to Agent a Letter of Credit Facility fee (for itself) in an amount equal to one and one-half of one percent (1.50%) per annum of the Stated Amount of the Letter of Credit, payable quarterly in advance on the first day of each quarterly period beginning December 1, 2002, until the earlier of the termination or expiration of the Letter of Credit Facility, which fee shall be non-refundable even if the Letter of Credit is terminated or canceled before its stated expiration date." f. Required Compensating Balances with Agent. Section 3.4 of the Loan Agreement (added pursuant to the First Modification) is deleted in its entirety. g. Financial Statements. Section 6.3 of the Credit Agreement is amended in its entirety to read as follows: "FINANCIAL STATEMENTS. Provide to Agent all of the following, in form and detail satisfactory to Agent: a. not later than one hundred and twenty (120) days after and as of the end of each fiscal year, an audited financial statement of Borrower and each entity whose financial results are consolidated with those of Borrower for reporting purposes, prepared by a nationally recognized certified public accountant, to include a balance sheet, income statement, statement of cash flows, reconciliation of net worth and notes to financial statements, together with Borrower's 10-K report; b. not later than thirty (30) days prior to the end of each fiscal year, an annual budget for Borrower, prepared by Borrower, which shall include three-year -3- projections of Borrower's operations and planned capital expenditures and financial projections for Borrower and each entity whose financial results are consolidated with those of Borrower for reporting purposes for the next fiscal year; c. not later than forty-five (45) days after and as of the end of each fiscal quarter, (i) a financial statement of Borrower and each entity whose financial results are consolidated with those of Borrower for reporting purposes, prepared by Borrower, to include a balance sheet and income statement; and (ii) Borrower's filed 10-Q Statement; d. not later than thirty (30) days after and as of the end of each fiscal quarter, a certificate of the chief financial officer or other executive officer of Borrower that Borrower is in compliance with the financial covenant set forth in Section 6.9; e. contemporaneously with each quarterly financial statement of Borrower required under (c), above, a certificate of the chief financial officer or other executive officer of Borrower that said financial statements are accurate, calculating the financial covenant set forth in Section 6.9 below and stating that Borrower is in compliance with the financial covenant set forth in Section 6.9 below which Borrower is then required to comply with, and that there exists no Event of Default nor any condition, act or event which, with the giving of notice or the passage of time or both, would constitute an Event of Default; f. within thirty (30) days after the end of each month, a report prepared by Borrower indicating the current market value of all investments and brokerage accounts pledged to Agent as collateral under any Security Agreement, respective advance rates as approved by Agent, and the resulting collateral value as per Agent's requirements and policies, and verifying that such collateral value equals at least 100% of the amount of all obligations owed to Lender under the Credit Agreement and otherwise and including copies of the applicable brokerage statements for such accounts; -4- g. any and all copies of any filing and report made by Borrower with the Securities Exchange Commission; and h. from time to time such other information as Agent may reasonably request." h. Financial Condition. Section 6.9 of the Credit Agreement is amended in its entirety to read as follows: "FINANCIAL CONDITION. Maintain Borrower's financial condition as follows, based on the consolidated financial statements of Borrower and each entity whose financial results are consolidated with those of Borrower for reporting purposes, using generally accepted accounting principles consistently applied and used consistently with prior practices: a. Maintain, as of the end of each fiscal quarter commencing with the quarter ended September 30, 2002, a Tangible Net Worth not less than One Hundred and Ten Million Dollars ($110,000,000.00)." 6. Additional Collateral. In consideration of Agent's waiver of Borrower's default of the covenant provided for in Section 6.9(d) of the Credit Agreement and in consideration of the modifications contained herein, pursuant to that certain Security Agreement (the "Additional Collateral Security Agreement") dated as of the date hereof and entered into by and between Borrower and Agent, Borrower shall assign to Agent a security interest in an investment account in the name of Borrower held within the trust department of U.S. Bank (collectively, the "Additional Collateral") which Additional Collateral shall at all times have a balance based on the then-current marketable value of the securities held therein in excess of Lender's Exposure (as defined below) when valued according to the advance rates set forth in Exhibit A attached hereto. As used herein, "Exposure" shall mean from time to time, the sum of all of Borrower's outstanding obligations under the Loan Documents, including the amount of any undrawn letters of credit issued by Agent for the benefit of Borrower, and all non-credit commitments issued by Agent in favor of Borrower as detailed in Exhibit B attached hereto, plus the aggregate related trailing six month fee expense related thereto. If the balance of the Additional Collateral shall at any time be less than Lender's Exposure, Borrower shall deliver additional investments or cash into the Additional Collateral account within two (2) business days after Agent's notice to Borrower of such deficiency. Borrower shall deliver to Agent account statements and reports for -5- the Additional Collateral as is required under Section 6.3 of the Credit Agreement and such other information related thereto as Agent may require. The Additional Collateral shall at all times remain subject to a valid control agreement in favor of Agent in form and substance satisfactory to Agent. Borrower shall not be permitted to make withdrawals with respect to the Additional Collateral except with Agent's prior consent. 7. Conditions Precedent. Before this Second Modification becomes effective and any party becomes obligated under it, all of the following conditions shall have been satisfied at the Borrower's sole cost and expense in a manner acceptable to the Agent in the exercise of Agent's sole judgment: a. The Agent shall have received fully executed and, where appropriate, acknowledged originals of the following: i. this Second Modification; ii. a Reaffirmation of Guaranty and Security Agreement executed by each Guarantor (the "Guarantor's Consent"); iii. a Closing Certificate executed by Borrower; iv. an incumbency certificate for Borrower; v. the Additional Collateral Security Agreement granting Borrower a security interest in the Additional Collateral; vi. a control agreement executed by Borrower, Agent and the holder of the Additional Collateral, in form and substance satisfactory to Agent; vii. verification that the Additional Collateral has been established with the trust department of U.S. Bank having a balance (based on the current marketable value of the securities held therein margined according to the advance rates set forth in Exhibit A) in excess of Lender's current Exposure of $10,678,885.00; and viii. any other agreements or resolutions (including evidence of the Borrower's and each Guarantor's authority to enter into this Second Modification and the Guarantor Consent, respectively) that the Agent may reasonably require or request in connection with this Second Modification or the Credit Agreement. b. Agent shall have filed a UCC-1 with the Secretary of State of Delaware with respect to the Additional Collateral and Security Agreement. -6- c. The Term Loans have been repaid in full. 8. The Borrower's Representations and Warranties. The Borrower represents and warrants to Lenders as follows: a. Credit Agreement. All representations and warranties made and given by the Borrower in the Credit Agreement are true, accurate and correct. b. No Default. Except for the default being waived hereunder, no Event of Default has occurred and is continuing, and no event has occurred and is continuing which, with notice or the passage of time or both, would be an Event of Default. c. Borrowing Entity. Borrower is a corporation which is duly organized, validly existing and in good standing in the State of Delaware and is duly qualified in each jurisdiction in which it is required to be qualified, except where the failure to be so qualified would not have a Material Adverse Effect. Except as otherwise disclosed or delivered to Agent, there have been no changes in the formation documents of Borrower or any Guarantor since the inception of the Credit Agreement. 9. Incorporation. This Second Modification shall form a part of the Credit Agreement, and all references to the Credit Agreement shall mean the Credit Agreement as hereby modified. 10. No Prejudice; Reservation of Rights. Except as specifically amended by this Second Modification, this Second Modification shall not effect or limit any rights or remedies of the Agent or Lenders under the Credit Agreement. The Agent and Lenders reserve, without limitation, all rights which they have against any indemnitor, guarantor, or endorser of the Credit Agreement. 11. No Impairment. Except as specifically hereby amended, the Credit Agreement shall remain unaffected by this Second Modification and the Credit Agreement shall remain in full force and effect. 12. Purpose and Effect of Approvals. In no event shall any approval of any matter in connection with the Credit Agreement of the Agent or Lenders be a representation of any kind with regard to the matter being approved or a waiver of any rights under the Credit Agreement. 13. Reimbursement of Expenses. The Borrower agrees to reimburse the Agent for all costs and expenses incurred by the Agent in connection with this Second Modification, including reasonable legal fees and expenses of the Agent's counsel. -7- 14. Integration. The Credit Agreement, including the First Modification and the Second Modification: (a) integrate all the terms and conditions mentioned in or incidental to the Credit Agreement; (b) supersede all oral negotiations and prior and other writings with respect to their subject matter; and (c) are intended by the parties as the final expression of the agreement with respect to the terms and conditions set forth in those documents and as the complete and exclusive statement of the terms agreed to by the parties. If there is any conflict between the terms, conditions and provisions of this Second Modification and those of any other agreement or instrument, the terms, conditions and provisions of this Second Modification shall prevail. 15. Miscellaneous. This Second Modification may be executed in counterparts, and all counterparts shall constitute but one and the same document. If any court of competent jurisdiction determines any provision of this Second Modification, the First Modification or the Credit Agreement to be invalid, illegal or unenforceable, that portion shall be deemed severed from the rest, which shall remain in full force and effect as though the invalid, illegal or unenforceable portion had never been a part of the Credit Agreement. This Second Modification shall be governed by the laws of the State of California, without regard to the choice of law rules of that State. As used here, the word "include(s)" means "includes(s), without limitation," and the word "including" means "including, but not limited to." -8- IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first set forth above. "Borrower" AXT, INC., a Delaware corporation By /s/ Donald L. Tatzin Donald L. Tatzin Chief Financial Officer "Agent" and "Lender" U.S. BANK NATIONAL ASSOCIATION By /s/ Karl W. Wilson Karl W. Wilson Vice President -9- EXHIBIT A ADVANCE RATES AGAINST U.S. BANK DEPOSITS AND FIXED INCOME SECURITIES

Investment Type Advance Rate - --------------- ------------ U.S. Bank Deposit Account 100% U.S. Governments or Agencies Securities with less than 5 years to maturity 90% Commercial Paper A2/P2 or better 80% Bonds BAA or better by Moodys 80%

-10- EX-99.1 4 f85875exv99w1.txt EXHIBIT 99.1 EXHIBIT 99.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of AXT, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), Morris S. Young, as Chief Executive Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. November 12, 2002 /s/ Morris S. Young ----------------------- Morris S. Young Chief Executive Officer EX-99.2 5 f85875exv99w2.txt EXHIBIT 99.2 EXHIBIT 99.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of AXT, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), Donald L. Tatzin, as Chief Financial Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. November 12, 2002 /s/ Donald L. Tatzin ----------------------- Donald L. Tatzin Chief Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----

EX-10.14

                                                                   EXHIBIT 10.14

                     SECOND MODIFICATION TO CREDIT AGREEMENT

      This Second Modification to Credit Agreement (the "Second Modification")
is entered into as of September 30, 2002, by and among AXT, INC., a Delaware
corporation ("Borrower"), and U.S. BANK NATIONAL ASSOCIATION ("U.S. Bank"), as a
Lender (defined in the Credit Agreement defined below) and as agent (in such
capacity, "Agent"). U.S. Bank is currently the sole Lender. Except as otherwise
specifically provided herein, all capitalized terms used and not defined herein
shall have the meaning set forth in the Credit Agreement (defined below).

                                    RECITALS

      A. Pursuant to the terms of that certain Credit Agreement (as amended from
time to time, including hereby and by the First Modification described below,
the "Credit Agreement") dated as of August 28, 2000, by and among Borrower,
Lenders and Agent, Lenders and Agent agreed to provide Borrower the following:
(i) a Line of Credit not to exceed at any time the aggregate principal amount of
Twenty Million Dollars ($20,000,000.00); (ii) Term Loan A in the principal
amount of One Million One Hundred Ninety Thousand Dollars ($1,190,000.00); (iii)
Term Loan B in the principal amount of One Million Six Hundred Ten Thousand
Dollars ($1,610,000.00); (iv) Term Loan C in the principal amount of Three
Million Two Hundred Thousand Dollars ($3,200,000.00); and (v) a Letter of Credit
Facility.

      B. Borrower and Agent entered into that certain Modification of Credit
Agreement (the "First Modification") dated December 31, 2001, in order to, among
other things, decrease the amount of the Line of Credit to $5,000,000.00, change
the interest rates applicable to the Credits and to extend the Line Maturity
Date.

      C. As of June 30, 2002, Borrower defaulted under Section 6.9(d) of the
Credit Agreement by reason of Borrower's failure to maintain the Tangible Net
Worth required thereunder. As a result, Borrower and Agent wish to modify the
Credit Agreement to, among other things, amend the financial covenants and add
Additional Collateral (as defined below) to secure the Credits.

                                    AGREEMENT

1.    Recitals. The recitals set forth above are true, accurate and correct.

2.    Reaffirmation of Credit Agreement. The Borrower reaffirms all of its
      obligations under the Credit Agreement and the Borrower acknowledges that
      as


                                      -1-


      of the date hereof, it has no claims, offsets or defenses with respect to
      the payment of sums due under the Notes or any other Loan Document.

3.    Waiver of Covenant Default. Upon the effectiveness of this Second
      Modification and satisfaction of the conditions precedent set forth
      herein, Agent hereby waives any default by Borrower under Section 6.9(d)
      of the Credit Agreement by reason of Borrower's failure to maintain the
      Tangible Net Worth required thereunder prior to the date hereto.

4.    Termination of Line of Credit and Term Loans. Pursuant to Section 2.8(a)
      of the Credit Agreement, Borrower has elected to terminate the Line of
      Credit and to repay in full the Term Loans. Effective herewith, Lender
      shall no longer have any obligations to fund under the Line of Credit or
      the Term Loans and within five (5) days after the date of this Second
      Modification, Agent shall cause the Deeds of Trust encumbering the El
      Monte Property and the Monterey Park Property to be reconveyed. Upon
      effectiveness of this Second Modification, all representations, warranties
      and covenants shall apply only to the Collateral remaining in effect after
      such reconveyances occur.

5.    Modifications to Credit Agreement. The Credit Agreement is hereby amended
      as follows:

      a.    Permitted Indebtedness. The following subsection (j) is added to the
            definition of "Permitted Indebtedness" in Section 1.1 of the Credit
            Agreement: "(j) Indebtedness incurred by Borrower or any Subsidiary
            which is secured by (i) Borrower's foreign receivables, provided
            Agent and the receivables lender thereunder shall have entered into
            an intercreditor agreement in form and substance satisfactory to
            Agent and/or (ii) fixed assets of Borrower or its Subsidiaries
            located in China."

      b.    Permitted Liens. The following subsection (k) is added to the
            definition of "Permitted Indebtedness" in Section 1.1 of the Credit
            Agreement: "(k) liens securing Indebtedness incurred by Borrower or
            any Subsidiary which is secured by (i) Borrower's foreign
            receivables, provided Agent and the receivables lender thereunder
            shall have entered into an intercreditor agreement in form and
            substance satisfactory to Agent and/or (ii) fixed assets of Borrower
            or its Subsidiaries located in China."

      c.    Tangible Net Worth. The definition of "Tangible Net Worth" in
            Section 1.1 of the Credit Agreement is amended in its entirety to
            read as follows:

            "'Tangible Net Worth' means, as of any date of determination, the
            consolidated stockholder's equity as of that date determined in
            accordance with GAAP, less (i) the [book] value of all assets that
            are considered intangible assets under GAAP, including customer
            lists,


                                      -2-


            goodwill, covenants not to compete, copyrights, trade names,
            trademarks and patents, less (ii) the book value of the common stock
            Borrower owns in Finisar Corporation."

      d.    Line of Credit/Term Loans. Sections 2.1, 2.2, 2.4, 2.5(a)-(d), 2.6,
            2.8, 2.9, 2.10, 2.11(a)-(c), 2.13 and Section 6.16 are deleted in
            their entirety.

      e.    Letter of Credit Facility Fee. Section 2.5(e) of the Credit
            Agreement is amended in its entirety to read as follows:

            "Letter of Credit Facility Fee. Borrower shall pay to Agent a Letter
            of Credit Facility fee (for itself) in an amount equal to one and
            one-half of one percent (1.50%) per annum of the Stated Amount of
            the Letter of Credit, payable quarterly in advance on the first day
            of each quarterly period beginning December 1, 2002, until the
            earlier of the termination or expiration of the Letter of Credit
            Facility, which fee shall be non-refundable even if the Letter of
            Credit is terminated or canceled before its stated expiration date."

      f.    Required Compensating Balances with Agent. Section 3.4 of the Loan
            Agreement (added pursuant to the First Modification) is deleted in
            its entirety.

      g.    Financial Statements. Section 6.3 of the Credit Agreement is amended
            in its entirety to read as follows:

                  "FINANCIAL STATEMENTS. Provide to Agent all of the following,
            in form and detail satisfactory to Agent:

                  a. not later than one hundred and twenty (120) days after and
            as of the end of each fiscal year, an audited financial statement of
            Borrower and each entity whose financial results are consolidated
            with those of Borrower for reporting purposes, prepared by a
            nationally recognized certified public accountant, to include a
            balance sheet, income statement, statement of cash flows,
            reconciliation of net worth and notes to financial statements,
            together with Borrower's 10-K report;

                  b. not later than thirty (30) days prior to the end of each
            fiscal year, an annual budget for Borrower, prepared by Borrower,
            which shall include three-year


                                      -3-


            projections of Borrower's operations and planned capital
            expenditures and financial projections for Borrower and each entity
            whose financial results are consolidated with those of Borrower for
            reporting purposes for the next fiscal year;

                  c. not later than forty-five (45) days after and as of the end
            of each fiscal quarter, (i) a financial statement of Borrower and
            each entity whose financial results are consolidated with those of
            Borrower for reporting purposes, prepared by Borrower, to include a
            balance sheet and income statement; and (ii) Borrower's filed 10-Q
            Statement;

                  d. not later than thirty (30) days after and as of the end of
            each fiscal quarter, a certificate of the chief financial officer or
            other executive officer of Borrower that Borrower is in compliance
            with the financial covenant set forth in Section 6.9;

                  e. contemporaneously with each quarterly financial statement
            of Borrower required under (c), above, a certificate of the chief
            financial officer or other executive officer of Borrower that said
            financial statements are accurate, calculating the financial
            covenant set forth in Section 6.9 below and stating that Borrower is
            in compliance with the financial covenant set forth in Section 6.9
            below which Borrower is then required to comply with, and that there
            exists no Event of Default nor any condition, act or event which,
            with the giving of notice or the passage of time or both, would
            constitute an Event of Default;

                  f. within thirty (30) days after the end of each month, a
            report prepared by Borrower indicating the current market value of
            all investments and brokerage accounts pledged to Agent as
            collateral under any Security Agreement, respective advance rates as
            approved by Agent, and the resulting collateral value as per Agent's
            requirements and policies, and verifying that such collateral value
            equals at least 100% of the amount of all obligations owed to Lender
            under the Credit Agreement and otherwise and including copies of the
            applicable brokerage statements for such accounts;


                                      -4-


                  g. any and all copies of any filing and report made by
            Borrower with the Securities Exchange Commission; and

                  h. from time to time such other information as Agent may
            reasonably request."

      h.    Financial Condition. Section 6.9 of the Credit Agreement is amended
            in its entirety to read as follows:

                  "FINANCIAL CONDITION. Maintain Borrower's financial condition
            as follows, based on the consolidated financial statements of
            Borrower and each entity whose financial results are consolidated
            with those of Borrower for reporting purposes, using generally
            accepted accounting principles consistently applied and used
            consistently with prior practices:

                  a. Maintain, as of the end of each fiscal quarter commencing
            with the quarter ended September 30, 2002, a Tangible Net Worth not
            less than One Hundred and Ten Million Dollars ($110,000,000.00)."

6.    Additional Collateral. In consideration of Agent's waiver of Borrower's
      default of the covenant provided for in Section 6.9(d) of the Credit
      Agreement and in consideration of the modifications contained herein,
      pursuant to that certain Security Agreement (the "Additional Collateral
      Security Agreement") dated as of the date hereof and entered into by and
      between Borrower and Agent, Borrower shall assign to Agent a security
      interest in an investment account in the name of Borrower held within the
      trust department of U.S. Bank (collectively, the "Additional Collateral")
      which Additional Collateral shall at all times have a balance based on the
      then-current marketable value of the securities held therein in excess of
      Lender's Exposure (as defined below) when valued according to the advance
      rates set forth in Exhibit A attached hereto. As used herein, "Exposure"
      shall mean from time to time, the sum of all of Borrower's outstanding
      obligations under the Loan Documents, including the amount of any undrawn
      letters of credit issued by Agent for the benefit of Borrower, and all
      non-credit commitments issued by Agent in favor of Borrower as detailed in
      Exhibit B attached hereto, plus the aggregate related trailing six month
      fee expense related thereto. If the balance of the Additional Collateral
      shall at any time be less than Lender's Exposure, Borrower shall deliver
      additional investments or cash into the Additional Collateral account
      within two (2) business days after Agent's notice to Borrower of such
      deficiency. Borrower shall deliver to Agent account statements and reports
      for


                                      -5-


      the Additional Collateral as is required under Section 6.3 of the Credit
      Agreement and such other information related thereto as Agent may require.
      The Additional Collateral shall at all times remain subject to a valid
      control agreement in favor of Agent in form and substance satisfactory to
      Agent. Borrower shall not be permitted to make withdrawals with respect to
      the Additional Collateral except with Agent's prior consent.

7.    Conditions Precedent. Before this Second Modification becomes effective
      and any party becomes obligated under it, all of the following conditions
      shall have been satisfied at the Borrower's sole cost and expense in a
      manner acceptable to the Agent in the exercise of Agent's sole judgment:

      a.    The Agent shall have received fully executed and, where appropriate,
            acknowledged originals of the following:

            i.    this Second Modification;

            ii.   a Reaffirmation of Guaranty and Security Agreement executed by
                  each Guarantor (the "Guarantor's Consent");

            iii.  a Closing Certificate executed by Borrower;

            iv.   an incumbency certificate for Borrower;

            v.    the Additional Collateral Security Agreement granting Borrower
                  a security interest in the Additional Collateral;

            vi.   a control agreement executed by Borrower, Agent and the holder
                  of the Additional Collateral, in form and substance
                  satisfactory to Agent;

            vii.  verification that the Additional Collateral has been
                  established with the trust department of U.S. Bank having a
                  balance (based on the current marketable value of the
                  securities held therein margined according to the advance
                  rates set forth in Exhibit A) in excess of Lender's current
                  Exposure of $10,678,885.00; and

            viii. any other agreements or resolutions (including evidence of the
                  Borrower's and each Guarantor's authority to enter into this
                  Second Modification and the Guarantor Consent, respectively)
                  that the Agent may reasonably require or request in connection
                  with this Second Modification or the Credit Agreement.

      b.    Agent shall have filed a UCC-1 with the Secretary of State of
            Delaware with respect to the Additional Collateral and Security
            Agreement.


                                      -6-


      c.    The Term Loans have been repaid in full.

8.    The Borrower's Representations and Warranties. The Borrower represents and
      warrants to Lenders as follows:

      a.    Credit Agreement. All representations and warranties made and given
            by the Borrower in the Credit Agreement are true, accurate and
            correct.

      b.    No Default. Except for the default being waived hereunder, no Event
            of Default has occurred and is continuing, and no event has occurred
            and is continuing which, with notice or the passage of time or both,
            would be an Event of Default.

      c.    Borrowing Entity. Borrower is a corporation which is duly organized,
            validly existing and in good standing in the State of Delaware and
            is duly qualified in each jurisdiction in which it is required to be
            qualified, except where the failure to be so qualified would not
            have a Material Adverse Effect. Except as otherwise disclosed or
            delivered to Agent, there have been no changes in the formation
            documents of Borrower or any Guarantor since the inception of the
            Credit Agreement.

9.    Incorporation. This Second Modification shall form a part of the Credit
      Agreement, and all references to the Credit Agreement shall mean the
      Credit Agreement as hereby modified.

10.   No Prejudice; Reservation of Rights. Except as specifically amended by
      this Second Modification, this Second Modification shall not effect or
      limit any rights or remedies of the Agent or Lenders under the Credit
      Agreement. The Agent and Lenders reserve, without limitation, all rights
      which they have against any indemnitor, guarantor, or endorser of the
      Credit Agreement.

11.   No Impairment. Except as specifically hereby amended, the Credit Agreement
      shall remain unaffected by this Second Modification and the Credit
      Agreement shall remain in full force and effect.

12.   Purpose and Effect of Approvals. In no event shall any approval of any
      matter in connection with the Credit Agreement of the Agent or Lenders be
      a representation of any kind with regard to the matter being approved or a
      waiver of any rights under the Credit Agreement.

13.   Reimbursement of Expenses. The Borrower agrees to reimburse the Agent for
      all costs and expenses incurred by the Agent in connection with this
      Second Modification, including reasonable legal fees and expenses of the
      Agent's counsel.


                                      -7-


14.   Integration. The Credit Agreement, including the First Modification and
      the Second Modification: (a) integrate all the terms and conditions
      mentioned in or incidental to the Credit Agreement; (b) supersede all oral
      negotiations and prior and other writings with respect to their subject
      matter; and (c) are intended by the parties as the final expression of the
      agreement with respect to the terms and conditions set forth in those
      documents and as the complete and exclusive statement of the terms agreed
      to by the parties. If there is any conflict between the terms, conditions
      and provisions of this Second Modification and those of any other
      agreement or instrument, the terms, conditions and provisions of this
      Second Modification shall prevail.

15.   Miscellaneous. This Second Modification may be executed in counterparts,
      and all counterparts shall constitute but one and the same document. If
      any court of competent jurisdiction determines any provision of this
      Second Modification, the First Modification or the Credit Agreement to be
      invalid, illegal or unenforceable, that portion shall be deemed severed
      from the rest, which shall remain in full force and effect as though the
      invalid, illegal or unenforceable portion had never been a part of the
      Credit Agreement. This Second Modification shall be governed by the laws
      of the State of California, without regard to the choice of law rules of
      that State. As used here, the word "include(s)" means "includes(s),
      without limitation," and the word "including" means "including, but not
      limited to."


                                      -8-


            IN WITNESS WHEREOF, the parties have executed this Agreement as of
the date first set forth above.

                                        "Borrower"

                                        AXT, INC., a Delaware corporation


                                        By    /s/ Donald L. Tatzin

                                                  Donald L. Tatzin
                                                  Chief Financial Officer

                                        "Agent" and "Lender"

                                        U.S. BANK NATIONAL ASSOCIATION


                                        By    /s/  Karl W. Wilson

                                              Karl W. Wilson
                                              Vice President


                                      -9-


                                    EXHIBIT A

                  ADVANCE RATES AGAINST U.S. BANK DEPOSITS AND
                             FIXED INCOME SECURITIES




Investment Type                                        Advance Rate
- ---------------                                        ------------
                                                    
U.S. Bank Deposit Account                                  100%
U.S. Governments or Agencies Securities
with less than 5 years to maturity                          90%
Commercial Paper A2/P2 or better                            80%
Bonds BAA or better by Moodys                               80%



                                      -10-

EX-99.1

                                                                    EXHIBIT 99.1

              CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO
                             18 U.S.C. SECTION 1350,
                             AS ADOPTED PURSUANT TO
                  SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of AXT, Inc. (the "Company") on Form
10-Q for the period ending September 30, 2002 as filed with the Securities and
Exchange Commission on the date hereof (the "Report"), Morris S. Young, as Chief
Executive Officer of the Company, hereby certifies, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, that:

      (1) The Report fully complies with the requirements of section 13(a) of
the Securities Exchange Act of 1934; and

      (2) The information contained in the Report fairly presents, in all
material respects, the financial condition and result of operations of the
Company.


November 12, 2002                       /s/ Morris S. Young
                                        -----------------------
                                        Morris S. Young
                                        Chief Executive Officer

EX-99.2

                                                                    EXHIBIT 99.2

              CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO
                             18 U.S.C. SECTION 1350,
                             AS ADOPTED PURSUANT TO
                  SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of AXT, Inc. (the "Company") on Form
10-Q for the period ending September 30, 2002 as filed with the Securities and
Exchange Commission on the date hereof (the "Report"), Donald L. Tatzin, as
Chief Financial Officer of the Company, hereby certifies, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, that:

      (1) The Report fully complies with the requirements of section 13(a) of
the Securities Exchange Act of 1934; and

      (2) The information contained in the Report fairly presents, in all
material respects, the financial condition and result of operations of the
Company.


November 12, 2002                       /s/ Donald L. Tatzin
                                        -----------------------
                                        Donald L. Tatzin
                                        Chief Financial Officer