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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

AXT, INC.

4281 Technology Drive, Fremont, California 94538

     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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YES x     NO o

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

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AXT, INC.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

AXT, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
(In thousands, except per share data)

     See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(In thousands, except per share data)

     See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In thousands)

     See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation

     The accompanying condensed consolidated balance sheets as of March 31, 2003 and December 31, 2002, the condensed consolidated income statements for the three months ended March 31, 2003 and 2002, and the condensed consolidated statements of cash flows for the three months ended March 31, 2003 and 2002 have been prepared by AXT, Inc. (“AXT” or the “Company”) and are unaudited. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosure normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary to present fairly the financial position, results of operations and cash flows of AXT and its subsidiaries for all periods presented.

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

     The results of operations are not necessarily indicative of the results to be expected in the future or for the full fiscal year. It is recommended that these condensed consolidated financial statements be read in conjunction with the Company’s consolidated financial statements and the notes thereto included in its 2002 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 21, 2003.

     As a result of the significant revenue declines experienced over the past six quarters, the Company has taken cost reduction measures and continues to pursue additional measures to reduce costs and increase cash flows. At March 31, 2003, the Company had available cash, cash equivalents and liquid short and long-term investments of $29.7 million. The Company believes that its existing cash and liquid investments, cash generated from operations, coupled with additional efforts to reduce expenditures in support of substrate and opto-electronic businesses, will be sufficient to meet working capital expenditure requirements for the next 12 months. However, existing cash and liquid investments could continue to decline during 2003 due to a continued or further weakening of the economy or changes in our planned cash outlay.

     If the Company’s sales continue to decrease, the ability to generate cash from operations will be adversely affected which could adversely affect its future liquidity, requiring it to use cash at a more rapid rate than expected, and require it to seek additional capital. There can be no assurance that such additional capital will be available or, if available it will be at terms acceptable to the Company.

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

Note 2. Accounting for Stock Options

     The Company records compensation expense for employee stock options based upon their intrinsic value on the date of grant pursuant to Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees.” Because the Company establishes the exercise price based on the fair market value of the Company’s stock at the date of grant, the options have no intrinsic value upon grant, and therefore no expense is recorded. Each quarter, the Company reports the potential dilutive impact of stock options in its diluted earnings per share using the treasury-stock method. Out-of-the-money stock options (i.e., the average stock price during the period is below the strike price of the option) are not included in diluted earnings per share.

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     As required under Statement of Financial Accounting Standards No. 123 (FAS 123), “Accounting for Stock-Based Compensation,” and Statement of Financial Accounting Standards No. 148 (FAS 148), “Accounting for Stock-Based Compensation Transition and Disclosure,” the pro forma effects of stock-based compensation on net income and net earnings per common share have been estimated at the date of grant using the Black-Scholes option-pricing model.

     The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no restrictions and are fully transferable and negotiable in a free trading market. Black-Scholes does not consider the employment, transfer or vesting restrictions that are inherent in the Company’s employee options. Use of an option valuation model, as required by FAS 123, includes highly subjective assumptions based on long-term predictions, including the expected stock price volatility and average life of each option grant. Because the Company’s employee options have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect the Company’s estimate of the fair value of those options, in the Company’s opinion, the existing valuation models, including Black-Scholes, are not reliable single measures and may misstate the fair value of the Company’s employee options.

     The Company calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:

     The weighted average grant-date fair value of options granted during the three months ended March 31, 2003 and 2002 were $1.07 and $9.11 respectively.

     Had compensation cost for the Company’s options been determined based on the fair value at the grant dates, as prescribed in SFAS 123 and SFAS 148, the Company’s pro forma net income and net income per share would have been as summarized below (in thousands except per share data):

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Note 3. Investments

     The Company classifies its investment securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards No. 115 or “SFAS 115,” “Accounting for Certain Investments in Debt and Equity Securities.” All investments are carried at fair market value, which is determined based on quoted market prices, with net unrealized gains and losses included in comprehensive income, net of tax. The components of investments at March 31, 2003 are summarized below (in thousands):

Note 4. Asset Held for Sale

During the fourth quarter of 2002, the Company began to market its property located at 4281 Technology Drive, Fremont, California, and in November of 2002, entered into a contract to sell the property to a third party. On March 11, 2003, the Company completed the sale of its property located at 4281 Technology Drive, Fremont, California, for $6.3 million. Net cash proceeds from the sale were $5.2 million. Under the terms of the sale agreement, the Company has agreed to lease back the property for a five-year period. Accordingly, on March 11, 2003, the company signed an operating lease for 4281 Technology Drive through March 2008. Annual rent under this operating lease is approximately $600,000.

Note 5. Inventories

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

Note 6. Net Loss Per Share

     Basic earnings per common share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per common and common equivalent shares include the dilutive effect of common stock equivalents outstanding during

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the period calculated using the treasury stock method. Common stock equivalents consist of the shares issuable upon the exercise of stock options.

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

Note 7. Comprehensive Loss

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

     The Company has two reportable segments: substrates and opto-electronics.

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

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     The Company sells its substrates and opto-electronics products in the United States and in other parts of the world. Also, the Company has operations in Japan and China. Revenues by geographic location based on the country of the customer were as follows (in thousands):

Note 9. Corporate Affiliates

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

     The investment balances for those affiliates accounted for under the equity method are included within “Other assets” in the consolidated balance sheets.

     Undistributed retained earnings relating to the Company’s corporate affiliates was $835,000 at March 31, 2003 and $515,000 at March 31, 2002. Net loss recorded from the Company’s corporate affiliates was $26,000 for the three months ended March 31, 2003 and $164,000 for the three months ended March 31, 2002.

     The Company invested in these companies because each provides materials that are important to the Company’s substrate business, each can provide products at lower cost than other suppliers, and each has a market beyond that provided by the Company. At March 31, 2003, the Company had no obligations to make further investments in any of these companies, although it may choose to do so under certain conditions.

Note 10. Commitments and Contingencies

     From time to time we are involved in judicial or administrative proceedings concerning matters arising in the ordinary course of our business, including matters relating to workers’ compensation claims, claims of unlawful termination or other employee-related claims. 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.

     On May 1, 2001, the Santa Clara Center for Occupational Safety and Health filed a complaint for injunctive relief and civil penalties against the Company in the Superior Court of California, County of Alameda, Hayward Division, Case No. H218237-5. The complaint alleged violations of California Business and Professions Code

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section 17200 et seq., and violations under Proposition 65 and California Health and Safety Code section 25249 et seq. as a result of AXT’s use of arsenic and inorganic arsenic compounds in its workplace. On June 24, 2002, the Company participated in a private mediation, and as a result, reached a settlement of all claims, pursuant to which the Company agreed to pay the Santa Clara Center for Occupational Safety and Health an amount equal to $175,000. The parties have executed a settlement agreement, and the court approved the settlement on December 31, 2002, and dismissal of the case is pending.

     The Company has entered into contracts to supply several large customers with GaAs wafers. The contracts guarantee the delivery of a certain number of wafers between January 1, 2001 and December 31, 2003 with a current contract value of $3.2 million. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, the Company could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. The Company has not received any claims for non-performance penalties due to non-delivery. Partial prepayments received for these supply contracts totaling $1.5 million are included in accrued liabilities at March 31, 2003. As of March 31, 2003, the Company has met all of its delivery obligations under these contracts and expects to do so for the remainder of the contract terms.

Note 11. Recent Accounting Pronouncements

     In November 2002, the FASB issued FASB Interpretation No. 45 ( FIN 45 ), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN No. 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN No. 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. Our adoption of FIN No. 45 did not have a material effect on our consolidated financial statements.

     In January 2003, the FASB issued FASB Interpretation No. 46 ( FIN 46 ), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The adoption of FIN 46 did not have a material impact on the Company’s consolidated statements of income or financial position

Note 12. Foreign Exchange Contracts and Transaction Gains/Losses

     The Company uses short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. The Company has purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of March 31, 2003, the Company’s outstanding commitments with respect to the foreign exchange contracts, which were commitments to sell Japanese yen, had a total contract value of approximately $1.9 million.

     The Company incurred a foreign currency transaction exchange gain of $63,000 for the three months ended March 31, 2003, and a loss of $40,000 for the three months ended March 31, 2002.

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Note 13. Related Party Transactions

     Since January 2002, there has not been, nor is there currently proposed, any transaction or series of similar transactions to which we were or are to be a party in which the amount involved exceeds $60,000, and in which any director, executive officer or holder of more than 5% of any class of our voting securities or members of that person’s immediate family had or will have a direct or indirect material interest other than the transactions described below.

     The Company entered into an operating lease for warehouse space in Fremont, CA with 4160 Business Center, LLC, a real estate holding company, in which Davis Zhang, the president of our substrate division, is the sole shareholder. Lease payments to 4160 Business Center, LLC were approximately $121,000 for the three months ended March 31, 2003. In April of 2003, Mr. Zhang sold this warehouse to a party unrelated to the Company. The Company began leasing this warehouse from the new owner on the date of sale. Mr. Zhang will continue to hold a $3.7 million note on the property through April 2005.

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

     This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based upon management’s current views with respect to future events and financial performance, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. Such risks and uncertainties include those set forth under “Risks Related to our Business” below. Forward-looking statements may be identified by the use of terms such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” and similar expressions. Statements concerning our financial position, business strategy and plans or objectives for future operations are forward-looking statements. These forward-looking statements are not guarantees of future performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002 and the condensed consolidated financial statements included elsewhere in this report.

Overview

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

Critical Accounting Policies and Estimates

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

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

     We believe that the following are our critical accounting policies:

Revenue Recognition

     We recognize revenue upon shipment of products to our customers provided that we have received a signed purchase order, the price is fixed or determinable, title has transferred, collection of resulting receivables is probable, product returns are reasonably estimable, there are no customer acceptance requirements and there are no remaining obligations. We assess the probability of collection based on a number of factors including past history with the customer and credit worthiness. We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized. Except for sales in Japan and some sales in Taiwan, which in both cases are denominated in Japanese yen, we denominate and collect our international sales in U.S. dollars. We do not provide for warranty related exposure as such exposure has historically been immaterial.

Allowance for Doubtful Accounts

     We periodically review the likelihood of collecting our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We provide a 100% allowance for U.S. receivables in excess of 90 days and for foreign receivables in excess of 120 days. At March 31, 2003, our accounts receivable balance was $7.9 million net of an allowance for doubtful accounts of $6.3 million.

Inventory

     Inventories are stated at the lower of cost or net realizable value. Cost is determined using the weighted average cost method. Finished goods and work-in-process inventories include material, labor and manufacturing overhead costs. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory and we provide a valuation allowance for certain inventories based upon the age and quality of the product. The lives of our substrate products are relatively long and accordingly, obsolescence has historically not been a significant factor. We also review our inventory to ensure costs can be realized upon ultimate sale to our customers. If we determine that the value of any items in ending inventory exceeds the sales value less any related selling costs, a reserve is established for the difference.

Impairment of Long-Lived Assets

     We review the carrying value of our long-lived assets and investments in order to identify any impairment. Long-lived assets are written down to their current fair market value when the carrying value of an asset exceeds their related undiscounted future cash flows. To determine the fair market value of our long-lived assets, we obtain appraisals from outside consultants.

Investments

     The Company classifies its investments in marketable securities as available-for-sale securities as prescribed in Financial Accounting Standard No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” All investments are carried at fair market value, which is determined based on quoted market prices, with net unrealized gains and losses included in comprehensive income, net of tax. If a decline in fair value is judged to be other than temporary, the cost basis of the individual security is written down to fair value as a new cost basis with the amount of the write down included in other (income) expense.

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Income Taxes

     The Company accounts for deferred income taxes using the liability method, under which the expected future tax consequences of timing differences between the book and tax basis of assets and liabilities are recognized as deferred tax assets and liabilities. Valuation allowances are established when necessary to reduce net deferred tax assets when management estimates, based on available objective evidence, that it is more likely than not that the future income tax benefit represented by the net deferred tax asset will not be realized. At March 31, 2003, a full valuation allowance has been recorded against our net deferred tax asset.

Results of Operations

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

Three months ended March 31, 2003 compared to three months ended March 31, 2002

     Revenue. Revenue decreased $4.1 million, or 24.6%, to $12.7 million for the three months ended March 31, 2003 compared to $16.8 million for the three months ended March 31, 2002.

     Revenue from our substrate division, which represents 67.4% of total revenue for the three months ended March 31, 2003, decreased $3.3 million, or 27.3%, to $8.5 million compared to $11.8 million for the three months ended March 31, 2002. Total GaAs substrate revenue decreased $630,000, or 8.3%, to $7.0 million for the three months ended March 31, 2003 compared to $7.6 million for the three months ended March 31, 2002. Sales of 5” and 6” GaAs subtrates was unchanged at $1.3 million for the three months ended March 31, 2003 compared to $1.3 million for the three months ended March 31, 2002. InP substrate revenue decreased $2.4 million, or 81.3%, to $564,000 for the three months ended March 31, 2003 compared to $3.0 million for the three months ended March 31, 2002. The decrease in GaAs and InP substrate revenue is due to decreased volume and sales prices as a result of the slowdown in our markets including telecommunications, high speed electronic devices, and short wavelength lasers.

     Revenue from our opto-electronics division, which represents 32.6% of total revenue for the three months ended March 31, 2003, decreased $900,000, or 18.2% to $4.1 million compared to $5.0 million for the three months

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ended March 31, 2002. High-brightness light emitting diode (HBLED) revenue decreased $1.0 million, or 23.3%, to $3.4 million for the three months ended March 31, 2003 compared to $4.4 million for the three months ended March 31, 2002. The decrease in HBLED revenue was primarily due to lower sales volume as a result of losing a large customer in mid-2002 and a decline in average sales prices during the quarter. Vertical cavity surface emitting laser (VCSEL) revenue was unchanged at $160,000 for the three months ended March 31, 2003 and 2002. Laser diode (LD) revenue increased $119,000, or 25.9%, to $578,000 for the three months ended March 31, 2003 compared to $459,000 for the three months ended March 31, 2002.

     International revenue increased to 65.1% of total revenue for the three months ended March 31, 2003 compared to 56.3% of total revenue for the three months ended March 31, 2002. The increase was primarily due to increased sales of HBLED products to customers in Asia.

     The majority of our substrate manufacturing activities are conducted in China, along with a portion of our opto-electronics manufacturing. In addition, we source key raw materials, including gallium, from our joint ventures in China. The SARS outbreak has been most notable in China. One employee at our LED production facility in China contracted SARS in late April prompting us to close the facility for ten days. There was no significant impact to our ability to fill customer orders. If other employees contract SARS, we may be required to temporarily close our manufacturing operations. Similarly, if one of our key suppliers is required to close for an extended period, we may not have enough raw material inventory to continue manufacturing operations. In addition, while we possess management skills among our China staff that enable us to maintain our manufacturing operations with minimal on-site supervision from our US-based staff, our business could also be harmed if travel to or from Asia and the United States is restricted or inadvisable. None of our substrate competitors is and few of our opto-electronics competitors are as dependent on manufacturing facilities in China as we are. If our manufacturing operations were closed for a significant period, we could lose revenue and market share during that period which would depress our financial performance and could be difficult to recapture. Finally, if one of our key customers is required to close for an extended period, we may not be able to ship product to them, our revenue would decline and our financial performance would suffer.

     Gross margin. Gross margin decreased to negative 2.2% of total revenue for the three months ended March 31, 2003 compared to 1.7% of total revenue for the three months ended March 31, 2002. Gross margin at the substrate division increased to 3.2% of substrate revenue for the three months ended March 31, 2003 compared to 1.8% of substrate revenue for the three months ended March 31, 2002. The increase was primarily due to costs reductions implemented to align our costs with lower expected sales volumes and prices. We continue shifting much of our substrate manufacturing to China, where costs are lower, and reducing capacity at our Fremont, California facility. Gross margin at the opto-electronics division decreased to negative 13.4% of opto-electronics revenue for the three months ended March 31, 2003 compared to 1.7% of opto-electronics revenue for the three months ended March 31, 2002. The decrease was primarily due to the decline in revenue and to a decrease in average selling price.

     Selling, general and administrative expenses. Selling, general and administrative expenses decreased $1.9 million, or 36.8%, to $3.3 million for the three months ended March 31, 2003 compared to $5.2 million for the three months ended March 31, 2002. As a percentage of total revenue, selling, general and administrative expenses were 26.0% for the three months ended March 31, 2003 compared to 31.0% for the three months ended March 31, 2002. In order to align our cost structure with the rapid decline in revenues, we have initiated and are aggressively pursuing cost reductions in this area, which led to the decrease.

     Research and development expenses. Research and development expenses decreased $600,000, or 45.0%, to $744,000 for the three months ended March 31, 2003 compared to $1.4 million for the three months ended March 31, 2002. As a percentage of total revenue, research and development expenses were 5.9% for the three months ended March 31, 2003 compared to 8.1% for the three months ended March 31, 2002. Although we reduced research and development expenses as part of our effort to reduce costs, we believe that continued investment in product development is critical to attaining our strategic objectives of maintaining and increasing our technology leadership, and as a result, we expect research and development expenses to remain at current levels in future periods. Research and development efforts during the first quarter of 2003 were focused primarily on improving the yield and surface quality of our GaAs substrates, and improving the brightness, reliability, and yield of our HBLED products.

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     Interest expense. Interest expense decreased $148,000, or 38.4%, to $237,000 for the three months ended March 31, 2003 compared to $385,000 for the three months ended March 31, 2002 due to the repayment of debt and a reduction of rates on our variable interest rate debt.

     Other income and expense, net. Other income decreased $486,000 to $231,000 for the three months ended March 31, 2003 compared to $717,000 for the three months ended March 31, 2002.

     Provision for income taxes. Due to our continuing operating losses and uncertainty regarding future profitability, we recorded a full valuation allowance against our net deferred tax assets of $31.2 million in 2002. As a result, our effective tax rate decreased to 0.0% for the three months ended March 31, 2003 compared to 40% for the three months ended March 31, 2002.

Liquidity and Capital Resources

     Cash and cash equivalents increased $4.5 million to $18.3 million at March 31, 2003 compared to $13.8 million at December 31, 2002.

     Net cash provided by operating activities of $737,000 for the three months ended March 31, 2003 was comprised primarily of our net loss adjusted for non-cash items of $1.8 million, consisting primarily of depreciation expense of $1.7 million, and by a $3.3 million net change in assets and liabilities. The net change in assets and liabilities resulted primarily from decreases in inventory and prepaid expenses.

     Accounts receivable increased $752,000, or 10.0%, to $8.0 million at March 31, 2003 compared to $7.2 million at December 31, 2002. The change reflects higher sales volume, collections of $12.7 million and a decrease in our allowance for doubtful accounts of $412,000. Inventories decreased $3.1 million, or 8.3% to $34.5 million at March 31, 2003 compared to $37.6 million at December 31, 2002. The decrease in inventory is a result of our continued effort to minimize cash outflows utilizing more effective inventory management policies. We expect this trend to continue throughout 2003.

     If our sales continue to decrease, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity and cause us to seek additional capital, if available on acceptable terms or at all.

     Net cash from investing activities of $4.9 million for the three months ended March 31, 2003 includes net proceeds from the sale of property and equipment of $5.2 million and purchases of equipment of $917,000. It also includes $37,000 in purchases of high grade investment securities with maturities of less than two years offset by $700,000 in sales of these securities.

     We do not have any plans to initiate any major new capital spending projects during 2003. We are currently completing certain projects at our China facilities and are continuously constructing minor improvements to our existing production facilities in China and California. We expect to invest an additional $5.1 million in capital projects throughout the remainder of 2003. We believe that our existing and planned facilities and equipment are sufficient to fulfill current and expected future orders.

     In February 2003, our Board of Directors authorized the repurchase of up to 2 million shares of our common stock over a one year period. To date we have not repurchased any shares. When repurchased, repurchased shares will be retired. We expect to sell shares of common stock of Finisar Corporation in connection with our stock repurchase program.

     Net cash used in financing activities of $1.1 million for the three months ended March 31, 2003 includes proceeds of $185,000 from the sale of common stock through our employee stock compensation programs, offset by payments of $248,000 on long-term debt and $1.0 million for capital lease payments.

     We generally finance equipment purchases through secured equipment loans and capital leases over four or five-year terms at interest rates ranging from 3.6% to 8.8% per annum. Our main Fremont, California manufacturing

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facility is financed by long-term borrowings, which were refinanced by taxable variable rate revenue bonds in 1998. These bonds mature in 2023 and bear interest at a variable rate that was 1.6% at March 31, 2003. The bonds are traded in the public market. Repayment of principal and interest under the bonds is supported by a letter of credit from our bank and is paid on a quarterly basis. We have the option to redeem the bonds in whole or in part during their term. At March 31, 2003, $8.9 million was outstanding under these bonds.

     At March 31, 2002 the credit facility maintained by the Company with a bank included a letter of credit supporting repayment of our industrial bonds with an outstanding amount of $8.9 million and foreign exchange obligations in the amount of $570,000. The Company has pledged and placed certain investment securities with the trust department of the bank as additional collateral for this facility. As a result, $10.7 million of our long-term investments are restricted. As of March 31, 2003, we were out of compliance with our tangible net worth covenant. We obtained a waiver from our bank for this covenant default through April 30, 2003. On April 7, 2003, we obtained a credit facility with another bank which includes a letter of credit supporting our industrial revenue bonds. The Company has pledged and placed certain investment securities with the trust department of the bank as additional collateral for this facility.

     As a result of the significant revenue declines that we have experienced over the past six quarters, we have taken cost reduction measures and continue to pursue additional measures to reduce our costs and increase our cash flows. At March 31, 2003, we had available cash, cash equivalents and liquid short and long-term investments of $29.7 million. We believe that our existing cash and liquid investments, cash generated from operations, coupled with additional efforts to reduce our expenditures in support of our substrate and opto-electronic businesses, will be sufficient to meet our working capital expenditure requirements for the next 12 months. However, our existing cash and liquid investments could continue to decline during 2003 due to a continued or further weakening of the economy or changes in our planned cash outlay.

     If our sales continue to decrease, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity, require us to use 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 at terms acceptable to the Company. Cash from operations could be affected by various risks and uncertainties, including, but not limited to those set forth below under “Risks Related to Our Business.”

Risks Related to Our Business

The recent outbreak of Severe Acute Respiratory Syndrome (SARS) may adversely impact our manufacturing operations and some of our key suppliers and customers

     The majority of our substrate manufacturing activities are conducted in China, along with a portion of our opto-electronics manufacturing. In addition, we source key raw materials, including gallium, from our joint ventures in China. The SARS outbreak has been most notable in China. One employee at our LED production facility in China contracted SARS in late April prompting us to close the facility for ten days. There was no significant impact to our ability to fill customer orders. If other employees contract SARS, we may be required to temporarily close our manufacturing operations. Similarly, if one of our key suppliers is required to close for an extended period, we may not have enough raw material inventory to continue manufacturing operations. In addition, while we possess management skills among our China staff that enable us to maintain our manufacturing operations with minimal on-site supervision from our US-based staff, our business could also be harmed if travel to or from Asia and the United States is restricted or inadvisable. None of our substrate competitors is and few of our opto-electronics competitors are as dependent on manufacturing facilities in China as we are. If our manufacturing operations were closed for a significant period, we could lose revenue and market share during that period which would depress our financial performance and could be difficult to recapture. Finally, if one of our key customers is required to close for an extended period, we may not be able to ship product to them, our revenue would decline and our financial performance would suffer.

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Our Inability to Maintain Our Listing on the NASDAQ National Market Will Reduce the Market and Liquidity of our Shares and Damage Our General Reputation

     In connection with our listing on the Nasdaq National Market we must maintain compliance with several requirements related to the trading price of our stock, our financial condition and our board of directors, among other factors. Our stock was trading beneath the $1.00 minimum bid price on the Nasdaq National Market since February 24, 2003 and on April 7, 2003 we received notice from the Nasdaq National Market that we will be delisted if we are unable to meet the continued listing requirements during the 180 days ended October 6, 2003. If we are unable to comply with the continued listing requirements, we would be delisted from the Nasdaq National Market, and, if we qualified, would move to the SmallCap listing of Nasdaq. This could reduce the market and liquidity of our shares and consequently the ability of our stockholders to purchase and sell our shares in an orderly manner. Furthermore, our delisting from the Nasdaq National Market could damage our general business reputation and harm our financial condition and operating results. The trading price of our stock has been over $1.00 since April 25, 2003.

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

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

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

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

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

     We have not over the past year been able to sustain growth, and may not be able to return to historic growth levels in the current economic environment. Our net loss in 2002 is the largest in our history. We have and may continue to experience significant fluctuations in our revenue and earnings. Our quarterly and annual revenue and operating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including:

•		decline in general economic conditions or downturns in the industry in which we compete;
•		fluctuations in demand for our products;
•		expansion of our manufacturing capacity;
•		expansion of our operations in China;
•		limited availability and increased cost of raw materials;
•		the volume and timing of orders from our customers, and cancellations, push outs and delays of customer orders;
•		fluctuation of our manufacturing yields;
•		decreases in the prices of our competitors’ products;
•		costs incurred in connection with any future acquisitions of businesses or technologies;
•		increases in our expenses, including expenses for research and development; and
•		our ability to develop, manufacture and deliver high quality products in a timely and cost-effective manner.

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

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

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

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If the economy recovers and we are again in a period of high demand for our products, we may be unable to expand our manufacturing capacity quickly enough to meet increased demand, and we may be unable to lower our costs or increase revenue.

     Although we are currently in a period of overcapacity, reduced sales, and decreased margins, if the economy recovers, demand may increase rapidly as it has in prior years after other cyclical downturns in the economy and the industries in which we operate. If this happens, in order to meet increased demand and maintain our market share, we may need to increase production, which could require us to build new facilities, expand and modify our existing facilities, purchase additional manufacturing equipment, and add qualified staff. If we are not at that time able to expand our manufacturing capacity, we will be unable to increase production, which may adversely impact our ability to meet increased production demand while reducing unit costs, margins and improving our operating results.

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

•		unforeseen environmental or engineering problems;
•		unavailability or late delivery of production equipment;
•		delays in completing new facilities;
•		delays in bringing production equipment on-line;
•		work stoppages or delays;
•		inability to recruit and train qualified staff;
•		unanticipated cost increases and restrictions imposed by requirements of local, state or federal regulatory agencies in the United States and China.

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

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

     We must manage our inventory of component parts and finished goods effectively to meet changing customer requirements, while keeping inventory costs down and improving gross margins. Some of our products and supplies have in the past and may in the future become obsolete while in inventory due to changing customer specifications, or become excess inventory due to decreased demand for our products and an inability to sell the inventory within a foreseeable period. Furthermore, if current costs of production increase or sales prices drop below the standard prices at which we value inventory, we may need to take a charge for a reduction in inventory values. We have in the past had to take inventory valuation and impairment charges. If we are not successfully able to manage our inventory, we may need to write off unsaleable, obsolete or excess inventory, which could adversely affect our results of operations.

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

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

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

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

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

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

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

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

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

     Some of our competitors have developed a crystal growth technique similar to our VGF technology. As a result, some customers are now allocating their requirements for VGF grown substrates across more competitors and

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we believe that we may have lost revenue and market share as a result of these customer decisions, which we may be unable to recover. If we are unable to retain our market share, our revenue and performance will decline.

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

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

     The markets for our products are intensely competitive. We face competition for our substrate products from other manufacturers of substrates, such as Freiberger, Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor device manufacturers that produce substrates for their own use, and from companies, such as IBM and Motorola, that are actively developing alternative materials to GaAs and some semiconductor devices are being marketed using these materials. We believe that at least two of our competitors are shipping GaAs substrates manufactured using a technique similar to our VGF technique. Other competitors may develop and begin using similar technology. If we are unable to compete effectively, our revenue may not increase and we may be unable to be profitable. We face many competitors that have a number of significant advantages over us, particularly in our compound semiconductor device products, including:

•		greater experience in the business;
•		more manufacturing experience;
•		extensive intellectual property;
•		broader name recognition; and
•		significantly greater financial, technical and marketing resources.

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

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

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

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

•		impurities in the materials used;
•		contamination of the manufacturing environment;

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•		substrate breakage;
•		equipment failure, power outages or variations in the manufacturing process; and
•		performance of personnel involved in the manufacturing process.

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

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

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

•		the competition our customers face in their particular industries;
•		the technical, manufacturing, sales and marketing and management capabilities of our customers;
•		the financial and other resources of our customers; and
•		the inability of our customers to sell their products if they infringe third party intellectual property rights.

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

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

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

     We depend on a limited number of suppliers for certain raw materials, components and equipment used in manufacturing our products, including key materials such as gallium, arsenic, quartz, and parts for our MOCVD reactors. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts and none of our suppliers guarantees supply of raw materials or equipment to us. If we lose any of our key suppliers, our manufacturing efforts could be significantly hampered and we could be prevented from timely producing and delivering products to our customers. We have experienced delays obtaining critical raw materials and spare parts, including gallium, due to shortages of these materials. We may experience delays due to shortages of materials and may be unable to obtain an adequate supply of materials. These shortages and delays could result in

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higher materials costs and cause us to delay or reduce production of our products. If we have to delay or reduce production, we could fail to meet customer delivery schedules, and our revenue and operating results could suffer.

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

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

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

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

     A small number of substrate and HBLED customers have historically accounted for a substantial portion of our total revenue. Five customers accounted for 37.6% of our total revenue for the three months ended March 31, 2003 and 38.9% for the three months ended March 31, 2002. One customer accounted for 16.7% of our revenue for the three months ended March 31, 2003. Our substrate revenue accounted for 67.4% of our total revenue for the three months ended March 31, 2003 and 70% for the three months ended March 31, 2002. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate and HBLED customers. Our customers are not obligated to purchase a specified quantity of our products or to provide us with binding forecasts of product purchases. In addition, our customers may reduce, delay or cancel orders at any time without any significant penalty, and during the past year, we have experienced slower bookings, significant push outs and cancellation of orders. In addition, due to the difficult economic environment, several of our previously large customers have stopped operations entirely. If we lose a major customer or if a customer cancels, reduces or delays orders, our revenue would decline. In addition, customers that have accounted for significant revenue in the past may not continue to generate revenue for us in any future period. Any delay in scheduled shipments of our products could cause net sales to fall below our expectations and the expectations of market analysts or investors, causing our stock price to decline.

Defects in our products could diminish demand for our products.

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

     We are also developing new products and product enhancements, including substrates and compound semiconductor device products. If our new products contain defects when released, our customers may be

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dissatisfied and we may suffer negative publicity or customer claims against us, lose sales or experience delays in market acceptance of our new products.

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

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

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

     In the past, periods of rapid growth and expansion has strained our management and other resources. The expansion of our manufacturing capacity and the shift of manufacturing operations to China has placed and continues to place a significant strain on our operations and management resources, and we are in the process of upgrading our inventory control systems and may implement additional systems relating to consolidation of our financial results. If we fail to manage these changes effectively, our operations may be disrupted. In addition, the Sarbanes-Oxley Act of 2002 requires us to improve the quality of our systems and procedures.

     To manage our business effectively, we may need to implement additional and improved management information systems, further develop our operating, administrative, financial and accounting systems and controls, add experienced senior level managers, and maintain close coordination among our executive, engineering, accounting, marketing, sales and operations organizations.

     If necessary, we will spend substantial sums to support our future growth and shift to China and to comply with the reporting and attestation requirements of the Sarbanes-Oxley Act of 2002. We may incur additional unexpected costs. Our systems, procedures or controls may not be adequate to support our operations, and we may be unable to expand quickly enough to exploit potential market opportunities.

If we fail to manage periodic contractions, we may utilize our cash balances and our existing cash and cash equivalent balances could decline.

     If we fail to manage our contractions successfully we may continue to draw down our cash reserves, which would adversely affect our operating results and financial condition, reduce our value and may impinge our ability to raise debt and equity funding in the future, at a time when we may be required to raise additional cash. As part of our effort to reduce costs, we may lose key staff, production resources, and technology that we will need to grow when end markets recover. These events could reduce our ability to grow profitably as markets recover.

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

     In connection with our efforts to streamline operations, reduce costs and bring staffing and structure in line with current demand for our products, we implemented a corporate restructuring beginning in 2001 and reduced our workforce, shifted production activities to China and reduced capital expenditures. Our restructuring may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce and loss of employee

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morale and decreased performance. In addition, the recent trading levels of our stock have decreased the value of our stock options granted to employees under our stock option plan. As a result of these factors, our remaining personnel may seek employment with larger, more established companies or companies that they perceive as having less volatile stock prices. Continuity of personnel can be very important factors in the sales and production of our products and completion of our research and development efforts.

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

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

•		we may have difficulty assimilating the operations, products and personnel of the acquired businesses;
•		our ongoing business may be disrupted;
•		we may incur unanticipated costs;
•		our management may be unable to manage the financial and strategic position of acquired or developed products, services and technologies;
•		we may be unable to maintain uniform standards, controls and procedures and policies; and
•		our relationships with employees and customers may be impaired as a result of any integration.

     For example, we incurred substantial costs in connection with our acquisition of Lyte Optronics, including the assumption of approximately $10.0 million of debt, much of which has been repaid or renegotiated, resulting in a decline of cash available. We have also incurred consistent operating losses for the business since the acquisition.

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

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

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

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

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

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

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

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

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

     It is possible that pending or future United States or foreign patent applications made by us will not be approved, that our issued patents will not protect our intellectual property, or that third parties will challenge the ownership rights or the validity of our patents. In addition, the laws of some foreign countries may not protect our proprietary rights to as great an extent as do the laws of the United States and it may be more difficult to monitor the use of our intellectual property. Our competitors may be able to legitimately ascertain non-patented proprietary technology embedded in our systems. If this occurs, we may not be able to prevent the development of technology substantially similar to ours.

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

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

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

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

     Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 65.1% of our total revenue for the three months ended March 31, 2003 and 56.3% for the three

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months ended March 31, 2002. We expect that sales to customers outside the U.S. will continue to represent a significant portion of our revenue, particularly sales to customers in Asia.

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

•		changes in tariffs, import or export restrictions and other trade barriers;
•		unexpected changes in regulatory requirements;
•		longer periods to collect accounts receivable;
•		changes in export license requirements;
•		political and economic instability;
•		unexpected changes in diplomatic and trade relationships; and
•		foreign exchange rate fluctuations.

     Our sales are denominated in U.S. dollars, except for sales to our Japanese and some Taiwanese customers, which are denominated in Japanese yen. Thus, increases in the value of the U.S. dollar could increase the price of our products in non-U.S. markets and make our products more expensive than competitors’ products in these markets. Also, denominating some sales in Japanese yen subjects us to fluctuations in the exchange rates between the U.S. dollar and the Japanese yen. The functional currencies of our Japanese and Chinese subsidiaries are the local currencies. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for these subsidiaries, as well as in translation of the assets and liabilities of these assets at each balance sheet date. If we do not effectively manage the risks associated with international sales, our revenue, cash flows and financial condition could be adversely affected.

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

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

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

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

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

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

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

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

     Our stock price has fluctuated significantly since we began trading on the Nasdaq National Market. For the three months ended March 31, 2003, the high and low closing sales prices of our common stock were $1.95 and $0.67, respectively. A number of factors could cause the price of our common stock to continue to fluctuate substantially, including:

•		actual or anticipated fluctuations in our quarterly or annual operating results;
•		changes in expectations about our future financial performance or changes in financial estimates of securities analysts;
•		announcements of technological innovations by us or our competitors;
•		new product introduction by us or our competitors;
•		large customer orders or order cancellations; and
•		the operating and stock price performance of comparable companies.

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

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

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

•		the division of our board of directors into three separate classes, each with three year terms;
•		the right of our board to elect a director to fill a space created by a board vacancy or the expansion of the board;
•		the ability of our board to alter our bylaws;
•		the ability of our board to authorize the issuance of up to 2,000,000 shares of blank check preferred stock; and
•		the requirement that only our board or the holders of at least 10% of our outstanding shares may call a special meeting of our stockholders.

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

•		66 2/3% of the shares of voting stock not owned by these large stockholders approve the merger or combination, or
•		the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of our outstanding voting stock.

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

     Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock, while potentially providing desirable flexibility in connection with possible acquisitions and for other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock.

     Further, on April 24, 2001, our board of directors adopted a preferred stock purchase rights plan intended to guard against certain takeover tactics. The adoption of this plan was not in response to any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation may have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.

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

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

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

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

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Liquidity

     The Company anticipates that its existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. The Company’s liquidity is affected by many factors including, among others, the extent to which the Company pursues additional capital expenditures, the level of the Company’s production efforts, and other factors related to the uncertainties of the industry and global economies. Accordingly, there can be no assurance that events in the future will not require the Company to seek additional capital sooner, or, if so required, that such capital will be available on terms acceptable to the Company if at all.

Item 3.   Qualitative and Quantitative Disclosures About Market Risk

Foreign Currency Risk

     The Company uses short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. The Company has purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of March 31, 2003, the Company’s outstanding commitments with respect to the foreign exchange contracts, which were commitments to sell Japanese yen, had a total contract value of approximately $1.9 million.

     The Company incurred a foreign currency transaction exchange gain of $63,000 for the three months ended March 31, 2003, and a loss of $40,000 for the three months ended March 31, 2002.

Interest Rate Risk

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