form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 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 March 31, 2013

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 000-24085


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

DELAWARE
 
94-3031310
(State or other jurisdiction of Incorporation or organization)
 
(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 by check mark whether the registrant has submitted electronically and posted on its Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
 
Accelerated filer x
     
Non-accelerated filer o
 
Smaller reporting company o
(Do not check if a smaller reporting company)
   

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

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 May 3, 2013
Common Stock, $0.001 par value
 
32,654,288



 
 

 

AXT, INC.
FORM 10-Q
TABLE OF CONTENTS

     
Page
PART I. FINANCIAL INFORMATION
3
  Item 1. Financial Statements (unaudited)
3
   
3
   
4
   
5
   
6
   
7
  Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
20
  Item 3. Quantitative and Qualitative Disclosures About Market Risk
29
  Item 4. Controls and Procedures
31
PART II. OTHER INFORMATION
31
  Item 1. Legal Proceedings
31
  Item 1A. Risk Factors
31
  Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
44
  Item 3. Defaults Upon Senior Securities
44
  Item 4. Mine Safety Disclosures
44
  Item 5. Other Information
44
  Item 6. Exhibits
45
   
46

 
2


PART I. FINANCIAL INFORMATION

Item 1.

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

   
March 31,
   
December 31,
 
   
2013
   
2012 (1)
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 25,792     $ 30,634  
Short-term investments
    6,540       10,270  
Accounts receivable, net of allowances of $270 and $245 as of March 31, 2013 and December 31, 2012, respectively
    17,014       17,912  
Inventories
    38,768       40,352  
Related party notes receivable –  current
    2,047       2,036  
Prepaid expenses and other current assets
    7,034       5,268  
Total current assets
    97,195       106,472  
Long-term investments
    17,038       9,191  
Property, plant and equipment, net
    37,477       37,235  
Related party notes receivable – long-term
    418       416  
Other assets
    14,196       14,275  
Total assets
  $ 166,324     $ 167,589  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 6,581     $ 5,894  
Accrued liabilities
    9,434       7,202  
Total current liabilities
    16,015       13,096  
Long-term portion of royalty payments
    3,125       3,325  
Other long-term liabilities
    148       254  
Total liabilities
    19,288       16,675  
Commitments and contingencies (Note 11)
               
Stockholders’ equity:
               
Preferred stock, $0.001 par value; 2,000 shares authorized; 883 shares issued and outstanding as of March 31, 2013 and December 31, 2012 (Liquidation preference of $6.0 million and $5.9 million as of March 31, 2013 and December 31, 2012, respectively)
    3,532       3,532  
Common stock, $0.001 par value per share; 70,000 shares authorized; 32,654 and 32,471 shares issued and outstanding as of March 31, 2013 and December 31, 2012, respectively
    32       32  
Additional paid-in capital
    193,651       193,063  
Accumulated deficit
    (61,447 )     (59,047 )
Accumulated other comprehensive income
    6,366       6,033  
AXT, Inc. stockholders’ equity
    142,134       143,613  
Noncontrolling interests
    4,902       7,301  
Total stockholders’ equity
    147,036       150,914  
Total liabilities and stockholders’ equity
  $ 166,324     $ 167,589  

See accompanying notes to condensed consolidated financial statements.


 
(1)
The condensed consolidated balance sheet at December 31, 2012 has been derived from the audited consolidated financial statements at that date.
 
 
3

 
AXT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share data)

   
Three Months Ended
 
   
March 31,
 
   
2013
   
2012
 
             
Revenue
  $ 22,380     $ 23,486  
Cost of revenue
    18,896       15,292  
Gross profit
    3,484       8,194  
                 
Operating expenses:
               
Selling, general and administrative
    3,925       3,785  
Research and development
    822       835  
Total operating expenses
    4,747       4,620  
Income (loss) from operations
    (1,263 )     3,574  
Interest income, net
    31       88  
Equity in earnings of unconsolidated joint ventures
    282       154  
Other expense, net
    (825 )     (489 )
Income (loss) before provision for income taxes
    (1,775 )     3,327  
Provision for income taxes
    (184 )     (375 )
Net income (loss)
    (1,959 )     2,952  
Less: Net income attributable to noncontrolling interests
    (441 )     (1,317 )
Net income (loss) attributable to AXT, Inc.
  $ (2,400 )   $ 1,635  
                 
Net income (loss) attributable to AXT, Inc. per common share:
               
Basic
  $ (0.08 )   $ 0.05  
Diluted
  $ (0.08 )   $ 0.05  
                 
Weighted average number of common shares outstanding:
               
Basic
    32,297       32,034  
Diluted
    32,297       33,018  

See accompanying notes to condensed consolidated financial statements.

 
4


AXT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited, in thousands)

   
Three Months Ended
 
   
March 31,
 
   
2013
   
2012
 
Net income (loss)
  $ (1,959 )   $ 2,952  
                 
Other comprehensive income (loss), net of tax:
               
Change in foreign currency translation gain, net of tax
    407       338  
Change in unrealized gain (loss) on available-for-sale investments, net of tax
    (17 )     100  
Total other comprehensive income, net of tax
    390       438  
Comprehensive income (loss)
    (1,569 )     3,390  
Less: Comprehensive income attributable to the noncontrolling interests
    (498 )     (1,384 )
Comprehensive income (loss) attributable to AXT, Inc.
  $ (2,067 )   $ 2,006  

See accompanying notes to condensed consolidated financial statements.
 
 
5

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

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
Cash flows from operating activities:
           
Net income (loss)
  $ (1,959 )   $ 2,952  
                 
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
               
Depreciation and amortization
    1,291       907  
Amortization of marketable securities premium
    146       71  
Stock-based compensation
    332       281  
Loss on disposal of property, plant and equipment
          29  
Changes in assets and liabilities:
               
Accounts receivable, net
    922       1,350  
Inventories
    1,649       4,030  
Prepaid expenses and other current assets
    (1,740 )     491  
Other assets
    105       124  
Accounts payable
    664       883  
Accrued liabilities
    (164 )*     (1,108 )*
Other long-term liabilities
    (270 )     (459 )
Net cash provided by operating activities
    976       9,551  
                 
Cash flows from investing activities:
               
Purchases of property, plant and equipment
    (1,349 )     (1,124 )
Purchases of available-for-sale securities
    (12,410 )     (3,079 )
Proceeds from maturities of available-for-sale securities
    8,130       2,700  
Net cash used in investing activities
    (5,629 )     (1,503 )
                 
Cash flows from financing activities:
               
Proceeds from common stock options exercised
    256       219  
Dividends paid by joint ventures
    (532 )     (3,384 )
Net cash used in financing activities
    (276 )     (3,165 )
Effect of exchange rate changes on cash and cash equivalents
    87       117  
Net increase (decrease) in cash and cash equivalents
    (4,842 )     5,000  
Cash and cash equivalents at the beginning of the period
    30,634       26,156  
Cash and cash equivalents at the end of the period
  $ 25,792     $ 31,156  

*Dividends accrued but not paid by joint ventures of $2,365 and $655 was included in accrued liabilities as of March 31, 2013 and March 31, 2012, respectively.

See accompanying notes to condensed consolidated financial statements.
 
 
6

 
AXT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1.
Basis of Presentation

The accompanying condensed consolidated financial statements of AXT, Inc. (“AXT,” the “Company,” “we,” “us,” and “our” refer to AXT, Inc. and all of its consolidated subsidiaries) are unaudited, and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the year-end condensed consolidated balance sheet data was derived from our audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. In the opinion of our 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 our consolidated subsidiaries for all periods presented.

Our management 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 accounting principles generally accepted in the United States of America. 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 our consolidated financial statements and the notes thereto included in our 2012 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 15, 2013.

The consolidated financial statements include the accounts of AXT, our wholly-owned subsidiary, Beijing Tongmei Xtal Technology Co, Ltd., and our majority-owned subsidiaries, Beijing JiYa Semiconductor Material Co., Ltd, Nanjing Jin Mei Gallium Co., Ltd and Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd. All significant inter-company accounts and transactions have been eliminated. Investments in business entities in which we do not have control, but have the ability to exercise significant influence over operating and financial policies (generally 20-50% ownership), are accounted for by the equity method. For majority-owned subsidiaries, we reflect the noncontrolling interest of the portion we do not own on our condensed consolidated balance sheets in stockholders’ equity and in our condensed consolidated statements of operations.

Certain prior period amount in our condensed consolidated statements of operations has been reclassified to conform to the current period presentation. We reclassified $154,000 from “other expense, net” to “equity in earnings of unconsolidated joint ventures” for the three months ended March 31, 2012.
 
 
7

 
Note 2.
Investments and Fair Value Measurements

Our cash, cash equivalents and investments are classified as follows (in thousands):

   
March 31, 2013
   
December 31, 2012
 
         
Gross
   
Gross
               
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
Cost
   
Gain
   
(Loss)
   
Value
   
Cost
   
Gain
   
(Loss)
   
Value
 
Classified as:
                                               
Cash
  $ 25,789     $     $     $ 25,789     $ 26,250     $     $     $ 26,250  
Cash equivalents:
                                                               
Money market fund
    3                   3       4,384                   4,384  
                                                                 
Total cash equivalents
    3                   3       4,384                   4,384  
                                                                 
Total cash and cash equivalents
    25,792                   25,792       30,634                   30,634  
                                                                 
Investments (available for sale):
                                                               
Certificates of deposit
    6,998       8       (7 )     6,999       6,638       9       (2 )     6,645  
Corporate bonds
    16,646       4       (71 )     16,579       12,872       7       (63 )     12,816  
Total investments
    23,644       12       (78 )     23,578       19,510       16       (65 )     19,461  
Total cash, cash equivalents and investments
  $ 49,436     $ 12     $ (78 )   $ 49,370     $ 50,144     $ 16     $ (65 )   $ 50,095  
Contractual maturities on investments:
                                                               
Due within 1 year
  $ 6,536                     $ 6,540     $ 10,288                     $ 10,270  
Due after 1 through 5 years
    17,108                       17,038       9,222                       9,191  
    $ 23,644                     $ 23,578     $ 19,510                     $ 19,461  

We manage our investments as a single portfolio of highly marketable securities that is intended to be available to meet our current cash requirements. We have no investments in auction rate securities. There were no sales of available-for-sales securities and no realized gains and losses for the three months ended March 31, 2013 and 2012. The proceeds from maturities of available-for-sale securities were $8.1 million and $2.7 million for the three months ended March 31, 2013 and 2012, respectively.

The gross unrealized losses related to our portfolio of available-for-sale securities were primarily due to changes in interest rates and market and credit conditions of the underlying securities. We have determined that the gross unrealized losses on some of our available-for-sale securities as of March 31, 2013 are temporary in nature. We periodically review our investment portfolio to identify and evaluate investments that have indications of possible impairment. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value.

The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of March 31, 2013 (in thousands):

   
In Loss Position
< 12 Months
   
In Loss Position
> 12 Months
   
Total In
Loss Position
 
   
Fair
Value
   
Gross
Unrealized
(Loss)
   
Fair
Value
   
Gross
Unrealized
(Loss)
   
Fair
Value
   
Gross
Unrealized
(Loss)
 
Investments:
                                   
Certificates of deposit
  $ 2,953     $ (7 )   $     $     $ 2,953     $ (7 )
Corporate bonds
    12,788       (71 )                 12,788       (71 )
Total in loss position
  $ 15,741     $ (78 )   $     $     $ 15,741     $ (78 )
 
 
8

 
The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2012 (in thousands):

   
In Loss Position
< 12 Months
   
In Loss Position
> 12 Months
   
Total In
Loss Position
 
   
Fair
Value
   
Gross
Unrealized
(Loss)
   
Fair
Value
   
Gross
Unrealized
(Loss)
   
Fair
Value
   
Gross
Unrealized
(Loss)
 
Investments:
                                   
Certificates of deposit
  $ 1,877     $ (1 )   $ 199     $ (1 )   $ 2,076     $ (2 )
Corporate bonds
    6,446       (40 )     1,502       (23 )     7,948       (63 )
Total in loss position
  $ 8,323     $ (41 )   $ 1,701     $ (24 )   $ 10,024     $ (65 )

Investments in Privately-held Companies

We have made strategic investments in private companies located in China in order to gain access at a competitive cost to raw materials that are critical to our substrate business (see Note 6). The investment balances for all these companies, including minority investments in privately-held companies made indirectly through our consolidated joint ventures are accounted for under the equity method and are included in “other assets” in the condensed consolidated balance sheets and totaled $9.5 million and $9.4 million as of March 31, 2013 and December 31, 2012, respectively. We also maintain minority investments in other unconsolidated privately-held companies which are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. Our investments in these privately-held companies are reviewed for other than temporary declines in value on a quarterly basis. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. As of both March 31, 2013 and December 31, 2012, our investments in these unconsolidated privately-held companies had a carrying value of $392,000 and are also included in “other assets” in the condensed consolidated balance sheets.

Fair Value Measurements

ASC topic 820, Fair value measurement (“ASC 820”) establishes three levels of inputs that may be used to measure fair value. Level 1 instrument valuations are obtained from real-time quotes for transactions in active exchange markets involving identical assets. Level 2 instrument valuations are obtained from readily-available pricing sources for comparable instruments. Level 3 instrument valuations are obtained from unobservable inputs in which there is little or no market data, which require us to develop our own assumptions. As of March 31, 2013, we did not have any Level 3 assets or liabilities. On a recurring basis, we measure certain financial assets and liabilities at fair value, primarily consisting of our short-term and long-term investments.

The type of instrument valued based on quoted market prices in active markets include our money market funds, which are generally classified within Level 1 of the fair value hierarchy. We classify all of our available-for-sale securities including certificates of deposit and corporate bonds as having Level 2 inputs. The valuation techniques used to measure the fair value of these financial instruments having Level 2 inputs were derived from quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. There were no changes in valuation techniques or related inputs in the three months ended March 31, 2013. There have been no transfers between fair value measurement levels during the three months ended March 31, 2013.

The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2013 (in thousands):

   
Balance as of
March 31, 2013
   
Quoted Prices in
Active Markets of
Identical Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
 
Assets:
                 
Cash equivalents and investments:
                 
Money market fund
  $ 3     $ 3     $  
Certificates of deposit
    6,999             6,999  
Corporate bonds
    16,579             16,579  
Total
  $ 23,581     $ 3     $ 23,578  
Liabilities
  $     $     $  
 
 
9

 
The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 (in thousands):

   
Balance as of
December 31, 2012
   
Quoted Prices in
Active Markets of
Identical Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
 
Assets:
                 
Cash equivalents and investments:
                 
Money market fund
  $ 4,384     $ 4,384     $  
Certificates of deposit
    6,645             6,645  
Corporate bonds
    12,816             12,816  
Total
  $ 23,845     $ 4,384     $ 19,461  
Liabilities
  $     $     $  

Items Measured at Fair Value on a Nonrecurring Basis

Certain assets that are subject to nonrecurring fair value measurements are not included in the table above. These assets include investments in privately-held companies accounted for by equity and cost method (See Note 6). We did not record other-than-temporary impairment charges for either of these investments during the three months ended March 31, 2013 or 2012.

Note 3.
Inventories

The components of inventories are summarized below (in thousands):

   
March 31,
   
December 31,
 
   
2013
   
2012
 
Inventories:
           
Raw materials
  $ 18,937     $ 20,003  
Work in process
    15,119       15,608  
Finished goods
    4,712       4,741  
    $ 38,768     $ 40,352  

As of March 31, 2013 and December 31, 2012, carrying values of inventories were net of inventory reserve of $9.7 million and $10.1 million, respectively, for excess and obsolete inventory.

Note 4.
Accrued Liabilities
 
The components of accrued liabilities are summarized below (in thousands):
 
   
March 31,
   
December 31,
 
   
2013
   
2012
 
             
Dividends payable by consolidated joint ventures
  $ 2,365     $  
Accrued compensation and related charges
    1,424       2,066  
Current portion of royalty payments
    800       800  
Accrued income taxes
    521       640  
Accrued professional services
    312       609  
Accrued product warranty
    749       588  
Other accrued liabilities
    3,263       2,499  
    $ 9,434     $ 7,202  
 
 
10

 
Note 5.
Related Party Transactions

In August 2011, our consolidated joint venture, Beijing JiYa Semiconductor Material Co., Ltd (JiYa), entered into a non-interest bearing note agreement for $1.7 million (Rmb 10,485,200) with one of its equity investment entities. Under the loan agreement, JiYa loaned $789,000 (Rmb 4,959,000) to its equity investment entity in August 2011 and the remaining amount of $880,000 (Rmb 5,526,200) was loaned during the three months ended March 31, 2012. The original term of the loan was two years and ten months and the loan was payable to JiYa in three installments with the first installment of $417,000 (Rmb 2,620,000) due in December 2012, the second installment of $834,000 (Rmb 5,240,000) due in December 2013, and the last installment of $418,000 (Rmb 2,625,200) due in May 2014. During the three months ended December 31, 2012, the parties signed an addendum to the note agreement to delay the first repayment of $417,000 (Rmb 2,620,000) to June 2013.  As of March 31, 2013, we included $1.3 million (Rmb 7,860,000) in “Related party notes receivable – short term” and $418,000 (Rmb 2,625,200) in “related party notes receivable – long term” in our condensed consolidated balance sheets.
 
In August 2011, our consolidated joint venture, Nanjing Jin Mei Gallium Co., Ltd. (Jin Mei) loaned $796,000 (Rmb 5,000,000) to its equity investment entity for construction purposes. As of March 31, 2013, this balance was included in “related party notes receivable – short term” in our condensed consolidated balance sheets. During the three months ended December 31, 2012, the parties signed a note agreement retroactively to set forth the terms for the loan. The loan bears interest at 6.7% per annum, subject to adjustment to market rate, and the principal is due on December 31, 2013.

Beginning in 2012, JiYa is contractually obligated under an agency sales agreement to sell raw material on behalf of one of its equity investment entities. JiYa bills to the customers and remits the receipts, net of its portions of sales commission, to this equity investment entity. For the three months ended March 31, 2013 and 2012, JiYa has recorded $10,000 and $0 of income from agency sales respectively, which was included in “other expense, net” in our condensed consolidated statements of operations. As of March 31, 2013 and December 31, 2012, amounts payable of $355,000 and $257,000, respectively, to this equity investment entity for delivery in transit was included in “accrued liabilities” in our condensed consolidated balance sheets.

JiYa also purchases raw materials from one of its equity investment entities for production in the ordinary course of business. As of March 31, 2013 and December 31, 2012, amounts payable of $795,000 and $1.1 million, respectively, were included in “accounts payable” in our condensed consolidated balance sheets.

Beginning in 2012, Jin Mei is contractually obligated under an agency sales agreement to sell raw material on behalf of its equity investment entity. Jin Mei bills to the customers and remits the receipts, net of its portions of sales commission, to this equity investment entity.   For the three months ended March 31, 2013 and 2012, Jin Mei has recorded $65,000 and $45,000 of income, respectively, from agency sales, which were included in “other expense, net” in our condensed consolidated statements of operations.

During the three months ended September 30, 2012, Tongmei paid $118,000 (Rmb 740,924) on behalf of Donghai County Dongfang High Purity Electronic Materials Co., Ltd., its unconsolidated joint venture, to purchase materials. As of March 31, 2013, this balance was included in "prepaid expenses and other current assets" in our condensed consolidated balance sheets.
 
Our Related Party Transactions Policy seeks to prohibit all conflicts of interest in transactions between related parties and us, unless they have been approved by our Board of Directors. This policy applies to all of our employees and directors, our subsidiaries and our joint ventures. Our executive officers retain board seats on the Board of Directors of the companies in which we have invested in our China joint ventures. See Note 6 for further details.
 
 
11

 
Note 6.
Investments in Privately-held Companies

We have made strategic investments in private companies located in China in order to gain access to raw materials at a competitive cost that are critical to our substrate business.

Our investments are summarized below (in thousands):

 
   
Investment Balance as of
         
   
March 31,
   
December 31,
 
Accounting
 
Ownership
 
Company
 
2013
   
2012
 
Method
 
Percentage
 
Beijing JiYa Semiconductor Material Co., Ltd
  $ 3,331     $ 3,331  
Consolidated
    46 %
Nanjing Jin Mei Gallium Co., Ltd
    592       592  
Consolidated
    83 %
Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd
    410       410  
Consolidated
    70 %
    $ 4,333     $ 4,333            
                           
Donghai County Dongfang High Purity Electronic Materials Co., Ltd.
  $ 2,011     $ 2,038  
Equity
    46 %
Xilingol Tongli Germanium Co. Ltd
    4,279       4,246  
Equity
    25 %
Emeishan Jia Mei High Purity Metals Co., Ltd
    1,054       1,042  
Equity
    25 %
    $ 7,344     $ 7,326            

Our ownership of Beijing JiYa Semiconductor Material Co., Ltd. (JiYa) is 46%. We continue to consolidate JiYa as we have significant influence in management and have majority control of the board. Our Chief Executive Officer is chairman of the JiYa board, while our president of China operations and our vice president of China administration and our vice president of wafer production are also members of the board.

Our ownership of Nanjing Jin Mei Gallium Co., Ltd. (Jin Mei) is 83%. We continue to consolidate Jin Mei as we have significant influence in management and have majority control of the board. Our Chief Executive Officer is chairman of the Jin Mei board, while our president of China operations and our vice president of China administration are also members of the board.

Our ownership of Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd (BoYu) is 70%. We continue to consolidate BoYu as we have a significant influence in management and have majority control of the board. Our Chief Executive Officer is chairman of the BoYu board, while our president of China operations and our vice president of China administration are also members of the board.

Although we have representation on the boards of directors of each of these companies, the daily operations of each of these companies are managed by local management and not by us. Decisions concerning their respective short term strategy and operations, any capacity expansion and annual capital expenditures, and decisions concerning sales of finished product, are made by local management with some inputs from us.

During the three months ended March 31, 2013 and 2012, the three consolidated joint ventures generated $1.3 million and $2.6 million of income, respectively, of which $441,000 and $1.3 million, respectively, were allocated to minority interests, resulting in $852,000 and $1.3 million of income, respectively, to our net income (loss).

For the three minority investment entities that are not consolidated, the investment balances are included in “other assets” in our condensed consolidated balance sheets and totaled $7.3 million as of both March 31, 2013 and December 31, 2012. We own 46% of the ownership interests in one of these companies and 25% in each of the other two companies.  These three companies are not considered variable interest entities because:

 
all three companies have sustainable businesses of their own;

 
our voting power is proportionate to our ownership interests;

 
we only recognize our respective share of the losses and/or residual returns generated by the companies if they occur; and

 
we do not have controlling financial interest in, do not maintain operational or management control of, do not control the board of directors of, and are not required to provide additional investment or financial support to any of these companies.
 
 
12

 
We also maintain minority investments in privately-held companies made indirectly through our consolidated joint ventures.  These minority investments are accounted for under the equity method in the books of our consolidated joint ventures. As of March 31, 2013 and December 31, 2012, our consolidated joint ventures included these minority investments in “other assets” in the condensed consolidated balance sheets with a carrying value of $2.2 million and $2.0 million, respectively.

All of the minority investment entities that are not consolidated and accounted for under the equity method had the following summarized income information (in thousands) for the three months ended March 31, 2013 and 2012.

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
             
Net Sales
  $ 9,273     $ 6,543  
Gross profit
    3,124       1,950  
Operating income
    1,614       862  
Net income
    1,295       742  

Our gross entity earnings from all the minority investment entities that are not consolidated and accounted for under the equity method were $282,000 and $154,000 for the three months ended March 31, 2013 and 2012, respectively.

We also maintain minority investments directly in two privately-held companies accounted for under the cost method and we do not have the ability to exercise significant influence over their operations. As of March 31, 2013 and December 31, 2012, our investments in these two unconsolidated privately-held companies had a carrying value of $392,000 and are included in “other assets” in the condensed consolidated balance sheets.

Note 7.
Stockholders’ Equity
 
Consolidated Statements of Changes in Equity

   
Preferred
Stock
   
Common
Stock
   
Additional
Paid In Capital
   
Accumulated
Deficit
   
Other
Comprehensive
Income/(loss)
   
AXT, Inc.
stockholders’
equity
   
Noncontrolling
interests
   
Total
stockholders’
equity
 
Balance as of December 31, 2012
  $ 3,532     $ 32     $ 193,063     $ (59,047 )   $ 6,033     $ 143,613     $ 7,301     $ 150,914  
Common stock options exercised
                    256                       256               256  
Stock-based compensation
                    332                       332               332  
Net loss
                            (2,400 )             (2,400 )     441       (1,959 )
Dividends declared by joint ventures
                                                    (2,897 )     (2,897 )
Change in unrealized (loss) gain on marketable securities
                                    (17 )     (17 )             (17 )
Currency translation adjustment
                                    350       350       57       407  
Balance as of March 31, 2013
  $ 3,532     $ 32     $ 193,651     $ (61,447 )   $ 6,366     $ 142,134     $ 4,902     $ 147,036  

There were no reclassification adjustments from accumulated other comprehensive income for the three months ended March 31, 2013 and March 31, 2012.
 
 
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Note 8.
Stock-Based Compensation

We account for stock-based compensation in accordance with the provisions of FASB Accounting Standards Codification (“ASC”) topic 718, Compensation-Stock Compensation (“ASC 718”), which established accounting for stock-based awards exchanged for employee services. Stock-based compensation cost is measured at each grant date, based on the fair value of the award, and is recognized as expense over the employee’s requisite service period of the award. All of our stock compensation is accounted for as an equity instrument.

The following table summarizes compensation costs related to our stock-based awards (in thousands, except per share data):

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
             
Cost of revenue
  $ 6     $ 18  
Selling, general and administrative
    284       238  
Research and development
    42       25  
Total stock-based compensation
    332       281  
Tax effect on stock-based compensation
           
Net effect on net income (loss)
  $ 332     $ 281  
Effect on net income (loss) attributable to AXT, Inc. per common share:
               
Basic
  $ (0.01 )   $ (0.01 )
Diluted
  $ (0.01 )   $ (0.01 )
 
As of March 31, 2013, the unamortized compensation costs related to unvested stock options granted to employees under our stock option plans was approximately $1.9 million, net of estimated forfeitures of $31,000. These costs are amortized on a straight-line basis over a weighted-average period of approximately 2.6 years and will be adjusted for subsequent changes in estimated forfeitures. We did not capitalize any stock-based compensation to inventory as of March 31, 2013 due to the immateriality of the amount.
 
We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of ASC 718. There were zero and 80,000 stock options granted with weighted-average grant date fair value of $0 and $3.05 in the three months ended March 31, 2013 and 2012, respectively. The fair value of our stock options granted to employees for the three months ended March 31, 2012 was estimated using the following weighted-average assumptions:
 
   
Three months ended March 31, 2012
 
Expected term (in years)
    4.0  
Volatility
    73.41 %
Expected dividend
    0 %
Risk-free interest rate
    0.76 %
 
 
14

 
The following table summarizes our stock option activities during the three months ended March 31, 2013 (in thousands, except per share data):

Stock Options
 
Shares
   
Weighted-
average
Exercise
Price
   
Weighted-
average
Remaining
Contractual
Life
(in years)
   
Aggregate
Intrinsic
Value
 
                         
Balance as of January 1, 2013
    2,727     $ 3.28       6.71     $ 1,353  
                                 
Granted
                           
                                 
Exercised
    (183 )     1.40                  
                                 
Canceled and expired
    (26 )     3.80                  
                                 
Balance as of March 31, 2013
    2,518     $ 3.41       6.84     $ 1,239  
                                 
Options vested and expected to vest as of March 31, 2013
    2,502     $ 3.41       6.83     $ 1,238  
                                 
Options exercisable as of March 31, 2013
    1,523     $ 3.14       5.58     $ 1,137  

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing price of $2.94 on March 28, 2013, which would have been received by the option holder had all option holders exercised their options on that date.

Restricted stock awards

A summary of activity related to restricted stock awards for the three months ended March 31, 2013 is presented below:

Stock Awards
 
Shares
 
Weighted-Average
Grant Date Fair Value
 
Non-vested as of January 1, 2013
 
238,723
 
$
4.27
 
Granted
 
 
$
 
Vested
 
 
$
 
Non-vested as of March 31, 2013
 
238,723
 
$
4.27
 

As of March 31, 2013, the unamortized compensation costs related to unvested restricted stock awards was approximately $768,000, which is to be amortized on a straight-line basis over a weighted average period of approximately 2.2 years.
 
 
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Note 9.
Net Income (loss) Per Share

Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the periods less shares of common stock subject to repurchase and non-vested stock awards. Diluted net income (loss) per share is computed using the weighted-average number of common shares outstanding and potentially dilutive common shares outstanding during the periods. The dilutive effect of outstanding stock options and restricted stock awards is reflected in diluted earnings per share by application of the treasury stock method. Potentially dilutive common shares consist of common shares issuable upon the exercise of stock options. Potentially dilutive common shares are excluded in net loss periods, as their effect would be anti-dilutive.
 
A reconciliation of the numerators and denominators of the basic and diluted net income (loss) per share calculations is as follows (in thousands, except per share data):

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
Numerator:
           
Net income (loss) attributable to AXT, Inc.
  $ (2,400 )   $ 1,635  
Less: Preferred stock dividends
    (44 )     (44 )
                 
Net income (loss) available to common stockholders
  $ (2,444 )   $ 1,591  
Denominator:
               
Denominator for basic net income (loss) per share - weighted average common shares
    32,297       32,034  
Effect of dilutive securities:
               
Common stock options
          903  
Restricted stock awards
          81  
Denominator for dilutive net income (loss) per common share
    32,297       33,018  
Net income (loss) attributable to AXT, Inc. per common share:
               
Basic
  $ (0.08 )   $ 0.05  
Diluted
  $ (0.08 )   $ 0.05  
Weighted-average shares:
               
Options excluded from diluted net income (loss) per share as the impact is anti-dilutive
    2,656       878  
Restricted stock excluded from diluted net income (loss) per share as the impact is anti-dilutive
    239       74  

The 883,000 shares of $0.001 par value Series A preferred stock issued and outstanding as of March 31, 2013 and December 31, 2012, valued at $3,532,000 are non-voting and non-convertible preferred stock with a 5.0% cumulative annual dividend rate payable when declared by the board of directors and $4 per share liquidation preference over common stock, and must be paid before any distribution is made to common stockholders. These preferred shares were issued to Lyte Optronics, Inc. stockholders in connection with the completion of our acquisition of Lyte Optronics, Inc. on May 28, 1999.
 
Note 10.
Segment Information and Foreign Operations

Segment Information

We operate in one segment for the design, development, manufacture and distribution of high-performance compound semiconductor substrates and sale of materials. In accordance with ASC topic 280, Segment Reporting, our chief operating decision-maker has been identified as our Chief Executive Officer, who reviews operating results to make decisions about allocating resources and assessing performance for the Company. Since we operate in one segment, all financial segment and product line information can be found in our condensed consolidated financial statements.
 
 
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The following table represents revenue amounts (in thousands) by product type:

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
Product type:
           
GaAs substrates
  $ 11,723     $ 12,231  
InP substrates
    1,849       1,451  
Ge substrates
    2,551       2,630  
Raw materials and other
    6,257       7,174  
Total
  $ 22,380     $ 23,486  

The following table represents revenue amounts (in thousands) reported for products shipped to customers in the corresponding geographic region:

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
Geographical information:
           
China
  $ 6,029     $ 5,774  
Europe (primarily Germany)
    4,689       4,565  
Taiwan
    3,779       2,046  
North America (primarily the United States)
    3,469       5,167  
Japan
    2,282       2,189  
Asia Pacific (excluding China, Japan and Taiwan)
    2,132       3,745  
Total
  $ 22,380     $ 23,486  

Long-lived assets consist primarily of property, plant and equipment, and are attributed to the geographic location in which they are located. Long-lived assets by geographic region were as follows (in thousands):

   
As of
 
   
March 31,
   
December 31,
 
   
2013
   
2012
 
Long-lived assets by geographic region:
           
North America
  $ 337     $ 430  
China
    37,140       36,805  
    $ 37,477     $ 37,235  
 
Significant Customers

No customer represented more than 10% of our revenue for the three months ended March 31, 2013. One customer represented 17% of our revenue for the three months ended March 31, 2012.  Our top five customers, although not the same five customers for each period, represented 34% and 46% of our revenue for the three months ended March 31, 2013 and 2012, respectively.

We perform ongoing credit evaluations of our customers’ financial condition, and limit the amount of credit extended when deemed necessary, but generally do not require collateral. One customer accounted for 18% and 28% of our trade accounts receivable balance as of March 31, 2013 and December 31, 2012, respectively.

Note 11.
Commitments and Contingencies

Indemnification Agreements

We enter into standard indemnification arrangements with our customers in the ordinary course of business. Pursuant to these arrangements, we indemnify, hold harmless, and agree to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, generally their business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual anytime after the execution of the agreement. The maximum potential amount of future payments we could be required to make under these agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal.

We have entered into indemnification agreements with our directors and officers that require us to indemnify our directors and officers against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from willful misconduct of a culpable nature; to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified; and to obtain directors’ and officers’ insurance if available on reasonable terms, which we currently have in place.
 
 
17

 
Product Warranty

We provide warranties for our products for a specific period of time, generally twelve months, against material defects. We provide for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that we expect to incur to repair or replace product parts that fail while still under warranty. The amount of accrued estimated warranty costs are primarily based on historical experience as to product failures as well as current information on repair costs. On a quarterly basis, we review the accrued balances and update these based on the historical warranty cost trends. The following table reflects the change in our warranty accrual which is included in “accrued liabilities” on the condensed consolidated balance sheets, during the three months ended March 31, 2013 and 2012 (in thousands):

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
             
Beginning accrued warranty and related costs
  $ 588     $ 1,003  
Accruals for warranties issued
    264       102  
Adjustments related to pre-existing warranties including expirations and changes in estimates
    166       (8 )
Cost of warranty repair
    (269 )     (100 )
Ending accrued warranty and related costs
  $ 749     $ 997  

Contractual Obligations

We lease certain office space, manufacturing facilities and equipment under long-term operating leases expiring at various dates through February 2016. The majority of our lease obligation relates to our lease agreement for the facility at Fremont, California with approximately 27,760 square feet, which commenced on December 1, 2008 for a term of seven years, with an option by us to cancel the lease after five years, upon forfeiture of the security deposit and payment of one-half of the fifth year’s rent.

We entered into a royalty agreement with a vendor effective December 3, 2010 with a term of eight years, terminating December 31, 2018.  We and our related companies are granted a worldwide, nonexclusive, royalty bearing, irrevocable license to certain patents for the term on the agreement. We shall pay a total of $7.0 million in royalty payments over eight years that began in 2011 based on future royalty bearing sales.

Outstanding contractual obligations as of March 31, 2013 are summarized as follows (in thousands):

   
Payments due by period
 
Contractual Obligations
 
Total
   
Less than 1 year
   
1-3
years
   
4-5
years
   
More than
5 years
 
Operating leases
  $ 917     $ 389     $ 528     $     $  
Royalty agreement
    3,925       800       1,544       1,150       431  
Total
  $ 4,842     $ 1,189     $ 2,072     $ 1,150     $ 431  

Purchase Obligations

In the normal course of business, we purchase or place orders for the necessary materials of our products from various suppliers and we commit to purchase products where we may incur a penalty if the agreement was canceled. As of March 31, 2013, we do not have any outstanding material purchase obligations.
 
 
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Legal Proceedings

From time to time we may be involved in judicial or administrative proceedings concerning matters arising in the ordinary course of business. We do not expect that any of these matters, individually or in the aggregate, will have a material adverse effect on our business, financial condition, cash flows or results of operation.

Note 12.
Foreign Exchange Transaction Losses

We incurred foreign currency transaction exchange losses of $593,000 and $165,000 for the three months ended March 31, 2013 and 2012, respectively. These amounts are included in “Other expense, net” on our condensed consolidated statements of operations.

Note 13.
Income Taxes

We account for income taxes in accordance with ASC topic 740, Income Taxes (“ASC 740”) which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. ASC 740 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized.  We recognize interest and penalties related to uncertain tax positions in income tax expense. As of March 31, 2013, we do not have any gross unrecognized tax benefits, nor any accrued interest and penalties related to uncertain tax positions. As a result of the implementation of ASC 740 on January 1, 2007, we identified $16.4 million in liability for unrecognized tax benefits. Of this amount, none was accounted for as a reduction to the January 1, 2007 balance of retained earnings. The amount decreased the tax loss carry-forwards in the U.S. which are fully offset by a valuation allowance. We file income tax returns in the U.S. federal, various states and foreign jurisdictions. We have substantially concluded all U.S. federal and state income tax matters through December 31, 2011. Provision for income taxes for three months ended March 31, 2013 and 2012 was mostly related to our China subsidiary and our China joint venture operations. We have made a tax election in China whereby certain minimum foreign withholding taxes are treated as an expense and not a tax credit. Besides the state taxes liabilities, no federal income tax benefit or expense has been provided for the three months ended March 31, 2013 or 2012 due to our net loss, our valuation allowance being utilized and uncertainty of future profits in the U.S.

Note 14.
Recent Accounting Pronouncements

In March 2013, the FASB issued ASU No. 2013-05, “Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity.” This standard addresses the accounting for the cumulative translation adjustment when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business within a foreign entity. The standard is effective as of the beginning of a fiscal year that begins after December 15, 2013 and interim and annual periods thereafter. The standard will become effective for us for the three months ending March 31, 2014. We are currently evaluating the potential impact, if any, of the adoption of the standard on our consolidated results of operations and financial condition.

In February 2013, the FASB issued ASU No. 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”. This standard requires entities to present information about reclassification adjustments from accumulated other comprehensive income in the annual financial statements in a single note or on the face of the financial statements. Public companies will also have to provide this information in their interim financial statements.  The new requirements are effective as of the beginning of a fiscal year that begins after December 15, 2012 and interim and annual periods thereafter. The standard is effective for us for the three months ended March 31, 2013 and did not have any significant impact on our condensed consolidated results of operations and footnote disclosures.
 
 
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This quarterly report on Form 10-Q, including the following sections, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, particularly statements relating to our expectations regarding results of operations, customer demand, our ability to expand our markets and increase sales, industry trends, customer qualifications of our products, gross margins, the impact of the adoption of certain accounting pronouncements, our investments in capital projects, and our belief that we have adequate cash and investments to meet our needs over the next 12 months. These forward-looking statements are based upon management’s current views with respect to future events and financial performance, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated in such forward-looking statements. Such risks and uncertainties include those set forth under the section entitled “Risk Factors” below, which identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certain risk factors identified in this Form 10-Q and other filings we have made with the Securities and Exchange Commission. Forward-looking statements may be identified by the use of terms such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” and similar expressions. Statements concerning our future or expected financial results and condition, business strategy and plans or objectives for future operations are forward-looking statements.

These forward-looking statements are not guarantees of future performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2012 and the condensed consolidated financial statements included elsewhere in this report.

Overview

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

Product
     
Substrates
 
Diameter
   
Applications
GaAs (semi-insulating)
 
2”, 3”, 4”, 5”, 6”
 
Power amplifiers and radio frequency integrated circuits for wireless handsets (cell phones)
       
Direct broadcast television
       
High-performance transistors
       
Satellite communications
           
GaAs (semi-conducting)
 
2”, 3”, 4”
 
High brightness light emitting diodes
       
Lasers
       
Optical couplers
           
InP
 
2”, 3”, 4”
 
Broadband and fiber optic communications
           
Ge
 
2”, 4”, 6”
 
Satellite and terrestrial solar cells
       
Optical applications

We manufacture all of our semiconductor substrates using our proprietary vertical gradient freeze (VGF) technology. Most of our revenue is from sales of GaAs substrates. We manufacture all of our products in the People’s Republic of China (PRC or China), which generally has favorable costs for facilities and labor compared to comparable facilities in the United States, Europe or Japan. We also have joint ventures in China which provide us pricing advantages, reliable supply and enhanced sourcing lead-times for key raw materials which are central to our final manufactured products. These joint ventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, pyrolytic boron nitride (pBN) crucibles and boron oxide (B2O3). Our ownership interest in these entities ranges from 20% to 83%. We consolidate, for accounting purposes, the joint ventures in which we have majority or controlling financial interest, and employ equity accounting for the joint ventures in which we have a smaller ownership interest and significant influence on management. We purchase portions of the materials produced by these ventures for our own use and the joint ventures sell the remainder of their production to third parties. We use our direct sales force in the United States and China and independent sales representatives in Europe and other parts of Asia to market and sell our substrates.
 
 
20

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

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

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

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

Accounts Receivable and Allowance for Doubtful Accounts

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

As of March 31, 2013 and December 31, 2012, our accounts receivable, net, balance was $17.0 million and $17.9 million, respectively, with no allowance for doubtful accounts. If actual uncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could have a material impact on our financial results for the affected period.

The allowance for sales returns is also deducted from gross accounts receivable. As of March 31, 2013 and December 31, 2012, our allowance for sales returns was $270,000 and $245,000, respectively.

Warranty Reserve

We maintain a warranty reserve based upon our claims experience during the prior twelve months. Warranty costs are accrued at the time revenue is recognized. As of March 31, 2013 and December 31, 2012, accrued product warranties totaled $749,000 and $588,000, respectively. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financial condition and results of operations for future periods.
 
 
21

 
Inventory Valuation

Inventories are stated at the lower of cost or market. Cost is determined using the weighted-average cost method. Our inventory consists of raw materials as well as finished goods and work-in-process that include material, labor and manufacturing overhead costs. Given the nature of our substrate products, and the materials used in the manufacturing process, the wafers and ingots comprising work-in-process may be held in inventory for up to two years and three years, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory, and we provide a valuation allowance for certain inventories based upon the age and quality of the product and the projections for sale of the completed products. As of March 31, 2013 and December 31, 2012, we had an inventory reserve of $9.7 million and $10.1 million, respectively, for excess and obsolete inventory. If actual demand for our products were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results of operations.

Impairment of Investments

We classify our investments in debt and equity securities as available-for-sale securities in accordance with ASC topic 320, Investments - Debt and Equity Securities (“ASC 320”). All available-for-sale securities with a quoted market value below cost (or adjusted cost) are reviewed in order to determine whether the decline is other-than-temporary. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value.

We invest in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee’s management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in our carrying value. We had no write-downs for the three months ended March 31, 2013 or 2012.
 
Fair Value of Investments

ASC 820, Fair Value Measurement (“ASC 820”) establishes three levels of inputs that may be used to measure fair value.

Level 1 instruments represent quoted prices in active markets. Therefore, determining fair value for Level 1 instruments does not require significant management judgment, and the estimation is not difficult.

Level 2 instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments, including:

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

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

Level 3 instruments include unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities. The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. As of March 31, 2013, we did not have any assets or liabilities without observable market values that would require a high level of judgment to determine fair value (Level 3 assets). There have been no transfers between fair value measurement levels during the three months ended March 31, 2013.

 
22

 
Impairment of Long-Lived Assets

We evaluate the recoverability of property, equipment and intangible assets in accordance with ASC topic 360, Property, Plant and Equipment (“ASC 360”). When events and circumstances indicate that long-lived assets may be impaired, we compare the carrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to these assets. In the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the assets’ fair value. Fair values are determined based on quoted market values, discounted cash flows or internal and external appraisals, as applicable. We had no “Assets held for sale” on the condensed consolidated balance sheet as of March 31, 2013 or December 31, 2012.
 
Stock-based Compensation

We account for stock-based compensation in accordance with ASC topic 718, Stock-based Compensation (“ASC 718”), using the modified prospective method. Share-based awards granted include stock options and restricted stock awards. We utilize the Black-Scholes option pricing model to estimate the grant date fair value of stock options, which requires the input of highly subjective assumptions, including expected volatility and expected term. Historical volatility was used while the expected term for our options was estimated based on historical option exercise behavior and post-vesting forfeitures of options, and the contractual term, the vesting period and the expected term of the outstanding options. Further, we apply an expected forfeiture rate in determining the amount of share-based compensation. We use historical forfeitures to estimate the forfeitures for stock compensation awards that are not expected to vest. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of our stock compensation. The cost of restricted stock awards is determined using the fair value of our common stock on the date of grant.
 
We recognize the compensation costs for stock options net of an estimated forfeiture rate over the requisite service period of the options award, which is generally the vesting term of four years. Compensation expense for restricted stock awards is recognized over the vesting period, which is generally three years or four years. Stock-based compensation expense is recorded in cost of revenue, research and development, and selling, general and administrative expenses.

Income Taxes

We account for income taxes in accordance with ASC topic 740, Income Taxes (“ASC 740”) which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. ASC 740 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized.
 
We provide for income taxes based upon the geographic composition of worldwide earnings and tax regulations governing each region, particularly China. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws, particularly in foreign countries such as China.
 
See Note 13—“Income Taxes” in the notes to condensed financial statements for additional information.
 
 
23

 
Results of Operations

Revenue
   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
GaAs
  $ 11,723     $ 12,231     $ (508 )     (4.2 )%
InP
    1,849       1,451       398       27.4 %
Ge
    2,551       2,630       (79 )     (3.0 )%
Raw materials
    6,257       7,174       (917 )     (12.8 ) %
Total revenue
  $ 22,380     $ 23,486     $ (1,106 )     (4.7 ) %

Revenue decreased $1.1 million, or 4.7%, to $22.4 million for the three months ended March 31, 2013 from $23.5 million for the three months ended March 31, 2012. Total GaAs substrate revenue decreased $508,000, or 4.2%, to $11.7 million for the three months ended March 31, 2013 from $12.2 million for the three months ended March 31, 2012. The decrease in GaAs substrate revenue was primarily due to the softer demand environment from our current customer base in both wireless devices market and the light emitting diode (LED) market.

Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates, which are mainly semi-conducting substrates used in LED applications, decreased $515,000 to $7.5 million for the three months ended March 31, 2013 from $8.0 million for the three months ended March 31, 2012. The decrease in revenue from smaller diameter substrates was primarily due to weaker demand from our current customers in the LED market.

Sales of 5 inch and 6 inch diameter GaAs substrates, which are mainly semi-insulting substrates used in wireless devices, increased slightly by $6,000 to $4.2 million for the three months ended March 31, 2013 from $4.2 million for the three months ended March 31, 2012. The increase in revenue from larger diameter substrates was primarily due to fluctuation in demand for 5 inch semi-insulating GaAs substrate.

InP substrate revenue increased $398,000, or 27.4%, to $1.8 million for the three months ended March 31, 2013 from $1.5 million for the three months ended March 31, 2012 as demand from customers in the optical networking industry increased. We continued to see renewed demand for these substrates as investment in high-speed optical communications increased worldwide.

Ge substrate revenue decreased slightly by $79,000, or 3.0%, to $2.6 million for the three months ended March 31, 2013 from $2.6 million for the three months ended March 31, 2012 due to fluctuation in demand from our customers for satellite applications and for concentrated photovoltaic solar applications.

Raw materials revenue decreased $917,000, or 12.8%, to $6.3 million for the three months ended March 31, 2013 from $7.2 million for the three months ended March 31, 2012 primarily due to decreased selling prices which was partially offset by increased tonnage sold.

 
Revenue by Geographic Region
   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
China
  $ 6,029     $ 5,774     $ 255       4.4 %
% of total revenue
    27 %     25 %                
Europe (primarily Germany)
    4,689       4,565       124       2.7 %
% of total revenue
    21 %     19 %                
Taiwan
    3,779       2,046       1,733       84.7 %
% of total revenue
    17 %     9 %                
North America (primarily the United States)
    3,469       5,167       (1,698 )     (32.9 )%
% of total revenue
    16 %     22 %                
Japan
    2,282       2,189       93       4.2 %
% of total revenue
    10 %     9 %                
Asia Pacific (excluding China, Taiwan and Japan)
    2,132       3,745       (1,613 )     (43.1 ) %
% of total revenue
    9 %     16 %                
Total revenue
  $ 22,380     $ 23,486     $ (1,106 )     (4.7 ) %
 
 
24

 
Revenue from customers in China increased by $255,000, or 4.4%, to $6.0 million for the three months ended March 31, 2013 from $5.8 million for the three months ended March 31, 2012 primarily due to increased GaAs substrate revenue and Ge substrate revenue partially offset by decreased raw materials revenue.

Revenue from customers in Europe increased by $124,000, or 2.7%, to $4.7 million for the three months ended March 31, 2013 from $4.6 million for the three months ended March 31, 2012 primarily due to increased GaAs substrate revenue and raw materials revenue partially offset by decreased Ge substrate revenue.

Revenue from customers in Taiwan increased by $1.7 million, or 84.7%, to $3.8 million for the three months ended March 31, 2013 from $2.0 million for the three months ended March 31, 2012 primarily due to increased semi-insulating GaAs substrate revenue and InP substrate revenue.

Revenue from customers in North America decreased by $1.7 million, or 32.9%, to $3.5 million for the three months ended March 31, 2013 from $5.2 million for the three months ended March 31, 2012 primarily due to decreased raw materials revenue resulting from decreased selling prices of 4N raw gallium and decreased orders from our customers for semi-insulating GaAs substrates.

Revenue from customers in Japan increased by $93,000, or 4.2%, to $2.3 million for the three months ended March 31, 2013 from $2.2 million for the three months ended March 31, 2012 primarily due to increased raw materials revenue partially offset by decreased GaAs substrate revenue.

Revenue from customers in Asia Pacific (excluding China, Taiwan and Japan) decreased by $1.6 million, or 43.1%, to $2.1 million for the three months ended March 31, 2013 from $3.7 million for the three months ended March 31, 2012 primarily due to decreased semi-insulating GaAs substrate revenue from customers in Singapore.
 
Gross Margin
 
   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
Gross profit
  $ 3,484     $ 8,194     $ (4,710 )     (57.5 )%
Gross Margin %
    15.6 %     34.9 %                

Gross margin decreased to 15.6% of total revenue for the three months ended March 31, 2013 from 34.9% of total revenue for the three months ended March 31, 2012. Higher priced raw material in our inventory and overall lower average selling prices negatively impacted the gross margins for all substrates. Gross margins for raw material sales also decreased due to decreased selling prices of 4N raw gallium.
 
Selling, General and Administrative Expenses
 
   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
Selling, general and administrative expenses
  $ 3,925     $ 3,785     $ 140       3.7 %
% of total revenue
    17.5 %     16.1 %                

Selling, general and administrative expenses increased $140,000, or 3.7% to $3.9 million for the three months ended March 31, 2013 from $3.8 million for the three months ended March 31, 2012. The increase was primarily due to higher personnel related costs, higher health insurance from our joint ventures in China and higher stock-based compensation expenses resulting from the options and stock awards granted in 2012 which were expensed over the vesting schedule, offset by lower freight charges.
 
Research and Development
 
   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
Research and development
  $ 822     $ 835     $ (13 )     (1.6 ) %
% of total revenue
    3.7 %     3.6 %                
 
Research and development expenses decreased $13,000, or 1.6% to $822,000 for the three months ended March 31, 2013 from $835,000 for the three months ended March 31, 2012. The decrease was primarily due to lower utility expense at our facilities in China and product testing related costs from our joint ventures in China offset by higher personnel related costs due to the hiring of our Chief Scientist in March 2012.
 
 
25

 
Interest Income, net
 
   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
Interest income, net
  $ 31     $ 88     $ (57 )     (64.8 ) %
% of total revenue
    0.1 %     0.4 %                

Interest income, net decreased $57,000 to $31,000 for the three months ended March 31, 2013 from $88,000 for the three months ended March 31, 2012. The decrease was primarily due to lower returns from the mix of investment securities.
 
Equity in Earnings of Unconsolidated Joint Ventures

   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
Equity in earnings of unconsolidated joint ventures
  $ 282     $ 154     $ 128       83.1 %
% of total revenue
    1.3 %     0.7 %                
 
Equity in earnings of unconsolidated joint ventures increased $128,000 to $282,000 for the three months ended March 31, 2013 from $154,000 for the three months ended March 31, 2012 primarily due to higher net income from our minority-owned joint ventures that are not consolidated.
 
Other Expense, net
 
   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
Other expense, net
  $ 825     $ 489     $ 336       68.7 %
% of total revenue
    3.7 %     2.1 %                
 
Other expense, net increased $336,000 to $825,000 for the three months ended March 31, 2013 from $489,000 for the three months ended March 31, 2012 primarily due to higher foreign exchange losses partially offset by lower withholding tax on foreign dividends from our consolidated joint ventures.
 
Provision for Income Taxes
 
   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
Provision for income taxes
  $ 184     $ 375     $ (191 )     (50.9 ) %
% of total revenue
    0.8 %     1.6 %                
 
Provision for income taxes was mostly related to our China subsidiary and our China joint venture operations and decreased by $191,000 to $184,000 for the three months ended March 31, 2013 from $375,000 for the three months ended March 31, 2012. The decrease in provision for income taxes was primarily due to decreased sales and net income of our foreign subsidiaries as well as lower taxable income for state tax purposes in the U.S. Besides the state tax liabilities, no federal income tax or benefit has been provided for U.S. operations due to our net loss, our available net operating loss carryforwards for the three months ended March 31, 2013 and 2012 and uncertainty of profits in the U.S.

 
26

 
Noncontrolling interests

   
Three Months Ended
March 31,
   
Increase
       
   
2013
   
2012
   
(Decrease)
   
% Change
 
   
($ in thousands)
             
Noncontrolling interests
  $ 441     $ 1,317     $ (876 )     (66.5 ) %
% of total revenue
    2.0 %     5.6 %                

Net income attributable to noncontrolling interests decreased $876,000, or 66.5% to $441,000 for the three months ended March 31, 2013 from $1.3 million for the three months ended March 31, 2012 primarily due to significantly lower profitability from one of our China joint venture operations compared to the same period last year.

Liquidity and Capital Resources

We consider cash and cash equivalents, short-term investments and long-term investments as liquid and available for use within two years in our current operations. Short-term investments and long-term investments are comprised of U.S. government securities and investment-grade corporate notes and bonds. As of March 31, 2013, our principal sources of liquidity were $49.4 million consisting of cash and cash equivalents of $25.8 million, short-term investments of $6.5 million and long-term investments of $17.1 million, of which $12.7 million was held by our consolidated joint ventures.

Cash and cash equivalents of $25.8 million decreased by $4.8 million and short-term and long-term investments of $23.6 million increased by $4.1 million during the three months ended March 31, 2013. Cash and cash equivalents of $31.2 million increased by $5.0 million and short-term and long-term investments of $14.9 million increased by $408,000 during the three months ended March 31, 2012.

Net cash provided by operating activities of $976,000 for the three months ended March 31, 2013 was primarily comprised of our net loss of $2.0 million, adjusted for non-cash items of depreciation of $1.3 million, stock-based compensation of $332,000, amortization of marketable securities premium of $146,000 and a net change of $1.2 million in assets and liabilities. The $1.2 million net change in assets and liabilities primarily resulted from a $1.6 million decrease in inventories, a $922,000 decrease in accounts receivable, a $105,000 decrease in other assets, a $664,000 increase in accounts payable, partially offset by a $1.7 million increase in prepaid expenses and other current assets, a $164,000 decrease in accrued liabilities and a $270,000 decrease in other long-term liabilities.

Net cash provided by operating activities of $9.6 million for the three months ended March 31, 2012 was primarily comprised of our net income of $3.0 million, adjusted for non-cash items of depreciation of $907,000, stock-based compensation of $281,000, amortization of marketable securities premium of $71,000, loss on disposal of property, plant and equipment of $29,000 and a net change of $5.3 million in assets and liabilities. The $5.3 million net change in assets and liabilities primarily resulted from a $4.0 million decrease in inventories, a $1.4 million decrease in accounts receivable, a $491,000 decrease in prepaid expenses and other current assets, a $124,000 decrease in other assets, a $883,000 increase in accounts payable, partially offset by a $1.1 million decrease in accrued liabilities and a $459,000 decrease in other long-term liabilities.

Net cash used in investing activities of $5.6 million for the three months ended March 31, 2013 was primarily from the purchase of property, plant and equipment of $1.3 million and the net purchases of marketable investment securities of $4.3 million.

Net cash used in investing activities of $1.5 million for the three months ended March 31, 2012 was primarily from the purchase of property, plant and equipment of $1.1 million and the net purchases of marketable investment securities of $379,000.

In January 2012, we agreed with the Administrative Commission of Tianjin Economy and Technology Development Zone to establish a second manufacturing facility in Tianjin, China. The arrangement, if completed, would provide us with land use rights for approximately 32 acres of industrial land located in Yixian Scientific and Industrial Park to construct a compound semiconductor substrate manufacturing facility that would be completed in phases over a number of years. We agreed to provide $12.5 million in the first phase of the construction of the facility and have an understanding with our BoYu joint venture that it will provide the RMB 32.0 million, or approximately $5.0 million, that is anticipated to be required for the portion of the project devoted to crystal support, in exchange for land use rights, enterprise and individual income tax rebates, employee hiring and development subsidies, and other benefits. We expect to fund the first phase of the construction of the facility with cash flow generated by our normal operations supplemented by our existing line of credit. However, we have delayed our participation in the project at this time due to the volatility in our substrate business. It is possible that the investment of $5.0 million will still be funded by our BoYu joint venture for crystal support.
 
 
27

 
Net cash used in financing activities of $276,000 for the three months ended March 31, 2013 consisted of $532,000 net dividends paid by our consolidated joint ventures partially offset by net proceeds of $256,000 on the issuance of common stock pursuant to stock option exercises.

Net cash used in financing activities of $3.2 million for the three months ended March 31, 2012 consisted of $3.4 million net dividends paid by joint ventures partially offset by net proceeds of $219,000 on the issuance of common stock pursuant to stock option exercises.

On September 13, 2011, our registration statement on Form S-3 was declared effective by the Securities and Exchange Commission (SEC). We may from time to time offer up to $60.0 million of common stock, preferred stock, depositary shares, warrants, debt securities and/or units in one or more offerings and in any combination. We intend to use the net proceeds from any sale of securities under the shelf registration statement for general corporate purposes, which may include capital expenditures in connection with our planned expansion of our manufacturing facilities in China.  The timing of any offering will be at our discretion and will depend on many factors, including the prevailing market conditions.  Specific terms and share prices of any future offering under the registration statement will be established at the time of any such offering, and will be described in a prospectus supplement that we will file with the SEC.

On February 21, 2013, our Board of Directors approved a stock repurchase program that complies with Rule 10b-18 of the Securities Exchange Act of 1934, as amended, authorizing us to purchase up to $6.0 million of our outstanding common stock through February 27, 2014. The timing, actual number and value of the shares that are repurchased under this program will be dependent on market conditions and other corporate considerations, including price, corporate and regulatory requirements and alternative investment opportunities. The program is expected to be funded from existing cash balances and cash generated from operations. We are not obligated to repurchase any particular amount of common stock during any period and may choose to suspend or discontinue the repurchase program at any time. For the three months ended March 31, 2013, we did not repurchase any shares.

We intend to fund our operating expenses primarily through cash flows from operations. We believe that we have adequate cash and investments to meet our needs over the next 12 months. If our sales decrease, however, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity, require us to use cash at a more rapid rate than expected, and require us to seek additional capital. There can be no assurance that such additional capital will be available or, if available it will be on terms acceptable to us.

Cash from operations could be affected by various risks and uncertainties, including, but not limited to those set forth below under Item 1A “Risks Factors.”

Line of Credit
 
We have an unused credit facility with a bank that provides for a line of credit of $10.0 million, which is secured by marketable securities we have with the bank. There were no outstanding borrowings under this line of credit as of March 31, 2013 and December 31, 2012.
 
Contractual Obligations and Operating Leases
 
We lease certain office space, manufacturing facilities and equipment under long-term operating leases expiring at various dates through February 2016. The lease agreement of the facility at Fremont, California with approximately 27,760 square feet commenced December 1, 2008 for a term of seven years, with an option by us to cancel the lease after five years, upon forfeiture of the security deposit and payment of one-half of the fifth year’s rent.

We entered into a royalty agreement with a vendor effective December 3, 2010 with a term of eight years, terminating December 31, 2018.  We and our related companies are granted a worldwide, nonexclusive, royalty bearing, irrevocable license to certain patents for the term of the agreement. We shall pay a total of $7.0 million royalty payment over eight years that began in 2011 based on future royalty bearing sales.
 
 
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Outstanding contractual obligations as of March 31, 2013 are summarized as follows (in thousands):

   
Payments due by period
 
Contractual Obligations
 
Total
   
Less than 1 year
   
1-3
years
   
4-5
years
   
More than
5 years
 
Operating leases
  $ 917     $ 389     $ 528     $     $  
Royalty agreement
    3,925       800       1,544       1,150       431  
Total
  $ 4,842     $ 1,189     $ 2,072     $ 1,150     $ 431  

Purchase orders or contracts for the purchase of certain goods and services are not included in the preceding table. We cannot determine the aggregate amount of such purchase orders that represent contractual obligations because purchase orders may represent authorizations to purchase rather than binding agreements. For the purposes of this table, contractual obligations for purchase of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current needs and are fulfilled by our vendors within short time horizons. We also enter into contracts for outsourced services; however, the obligations under these contracts were not significant and the contracts generally contain clauses allowing for cancellation without significant penalty. Contractual obligations that are contingent upon the achievement of certain milestones are not included in the table above.

Off-Balance Sheet Arrangements

As of March 31, 2013, we did not have any off-balance sheet financing arrangements and have never established any special purpose entities as defined under SEC Regulation S-K Item 303(a)(4)(ii).

Recent Accounting Pronouncements

For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on our condensed consolidated financial statements, please see “Note 14 - Recent Accounting Pronouncements” in the Notes to Condensed Consolidated Financial Statements of this Form 10-Q.

ITEM 3.

Foreign Currency Risk

A significant portion of our business is conducted in currencies other than the U.S. dollar. The functional currency for our foreign operations is the Renminbi, the local currency of China. Since most of our operations are conducted in China, most of our costs are incurred in Chinese Renminbi, which subjects us to fluctuations in the exchange rates between the U.S. dollar and the Chinese Renminbi. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for our Chinese subsidiaries, including our joint ventures, as well as in translation of the assets and liabilities at each balance sheet date. Our financial results could be adversely affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets, including the revaluation by China of the Renminbi, and any future adjustments that China may make to its currency such as any move it might make to a managed float system with opportunistic interventions. We may also experience foreign exchange losses on our non-functional currency denominated receivables and payables to the extent that we have not mitigated our exposure utilizing foreign currency forward exchange contracts. Foreign exchange losses could have a material adverse effect on our operating results and cash flows. If we do not effectively manage the risks associated with this currency risk, our revenue, cash flows and financial condition could be adversely affected.

We manage against these risks by actively monitoring our exchange rate exposure. Our foreign operations, however, in most instances act as a natural hedge since both operating expenses as well as revenues and both assets and liabilities are generally denominated in their respective local currency. In these instances, although an unfavorable change in the exchange rate of foreign currencies against the U.S. dollar will result in lower revenues when translated into U.S. dollars, the operating expenses will be lower as well. We do not use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. We cannot be certain that any such hedging activities will be effective, or available to us at commercially reasonable rates. As of March 31, 2013 and December 31, 2012, we had no outstanding commitments with respect to foreign exchange contracts.

During the three months ended March 31, 2013, we recorded net foreign exchange losses of $593,000, included as part of “other expense, net” in our condensed consolidated statements of operations. We incurred foreign currency transaction exchange gains and losses due to operations in general. In the future we may experience foreign exchange losses on our non-functional currency denominated receivables and payables to the extent that we have not mitigated our exposure utilizing foreign currency forward exchange contracts. Foreign exchange losses could have a material adverse effect on our operating results and cash flows. During the three months ended March 31, 2013, we recorded unrealized foreign curren