AXT, Inc. (AXTI) Earnings Call Transcript & Summary

Good afternoon, everyone, and thank you for joining our investor update. Leading the call today is Dr. Morris Young, Chief Financial Officer (sic) [ Chief Executive Officer ]. My name is Valarie, and I'll be your coordinator today. [Operator Instructions] As a reminder, this conference call is being recorded. I will now turn the call over to your host, Leslie Green, Investor Relations for AXT.

Thank you, Valerie, and good afternoon, everyone. Before we begin, I would like to remind you that during the course of this conference call, including comments made in response to your questions, we will provide projections or make other forward-looking statements regarding, among other things, our plan to merge Tongmei, our wafer manufacturing company in China with BoYu and JinMei; Tongmei receiving the first tranche of private equity investment funds; signing investment documents to secure the second tranche of private equity investment funds into Tongmei and subsequently receiving such funds; completing other preliminary steps in connection with the proposed listing of shares of Tongmei on the STAR Market; being accepted to list shares of Tongmei on the STAR Market; and the timing and completion of such listing of shares of Tongmei on the STAR market. In addition, we will make other forward-looking statements regarding, among other things, the future financial performance of the company; the future financial structure of the company; market conditions and technology trends, including expected growth in the markets we serve and our positioning with our Tier 1 customers; emerging applications using chips or devices fabricated on our substrates; our ability to ramp production; as well as global economic political conditions. We wish to caution you that such statements deal with future events and are based on management's current expectations and are subject to risks and uncertainties that could cause actual results or events to differ materially. These uncertainties and risks include, but are not limited to, the tax and legal consequences of merging Tongmei with BoYu and JinMei May, the lack of interest private equity funds in China to invest in Tongmei, the withdrawal cancellations or request for redemptions by private equity funds in China of investments in Tongmei, the timing of receipt of private equity funds into Tongmei, the administrative challenges satisfying the requirements of various government agencies in China in connection with the investments in Tongmei and the listing of shares of Tongmei on the STAR Market, continued open access to company to list shares on the STAR Market, investor enthusiasm for listing of new shares on the STAR Market and geopolitical conditions between China and the United States. Additional uncertainties and factors include, but are not limited to, overall conditions in the markets in which the company competes, global financial conditions and uncertainties, COVID-19 and other outbreaks of contagious disease, potential tariffs and trade restrictions, increased environmental regulations in China, market acceptance and demand for the company's products, the financial performance of our partially owned supply chain companies and the impact of delays by our customers on the timing of sales of their products. In addition to the factors that may be discussed in this call, we refer you to the company's periodic reports filed with the Securities and Exchange Commission. These are available online by link from our website and contain additional information on risk factors that could cause actual results to differ materially from our current expectations. This conference call will be available on our website at axt.com through November 22, 2020. Also before we begin, I want to note that shortly following the close of market today, we issued a press release announcing our strategic plan to access China's capital markets. This information is available on the Investor Relations portion of our website at axt.com. We'll begin now by turning the call over to Dr. Morris Young for his comments on the announcement, and then Gary will highlight the steps in the process as well as some of the key financial considerations before we open up the call to your questions. Morris?

Thank you, Leslie, and good afternoon, everybody. Today, we announced a strategic plan to access China's capital markets. This is an exciting step for AXT, and we would like to share with you the driving factors behind this decision; what the likely process will be to list our subsidiary, Beijing Tongmei Xtal Technology, or Tongmei, which is currently wholly owned by AXT on the STAR Market; and what a listing would mean for AXT and our investors. First, the decision. Last year, a new security market was formed in China called the STAR Market based in Shanghai. The STAR Market lists science and technology companies that combine innovation and growth. Significantly, the STAR Market will accept China legal entities, even if that entity is majority-owned by a foreign company. This is new. After the careful review and analysis, we concluded that a unique set of factors was converging that would make Tongmei attractive as a STAR Market-listed company. First, as many of you know, AXT has had a meaningful presence in China for more than 20 years. We founded Tongmei in 1998 to build a competitive cost structure for our business and be closer to our source of raw materials as well as to be closer to the many customers we serve in Asia. Shortly and thereafter, we founded BoYu, which manufactures high-temperature pBN crucibles and other products. And JinMei, which produces 7N purity gallium and other specialty materials. Together today, we have 3 state-of-the-art manufacturing facilities in China, in Beijing, in Beijing, in Dingxing and in Kazuo. And with BoYu and JinMei, we have close to 1,000 employees in China. The second factor we considered is that we have now successfully relocated our gallium arsenide manufacturing lines, and we are ramping our production. Third, there is a broad recognition and agreement that many emerging high-volume applications will require either gallium arsenide or indium phosphide substrate material. And finally, we realized that a strong manufacturing company like Tongmei, enhanced by merging BoYu and JinMei into it and having a history of transparency in terms of annual audits since the date of our own IPO, will likely to be received very well in the China public security market. We also realized that this strategic path held many benefit for AXT, and that this is the right time to begin working towards a STAR Market listing for Tongmei. Over the past 20 years, we've built up our reputation as a leading global supplier of indium phosphide, gallium arsenide and germanium substrates. Today, these materials are intersecting with what we believe to be some of the biggest, most influential technology trends of the next decade. That includes 5G telecommunications, data center connectivity, LED-based lighting and display and laser-based sensing. In addition, we believe new applications are emerging across our portfolio that will create exciting incremental opportunities in 2021 and beyond. These may include world-facing cameras, augmented virtual reality, automotive sensors, biosensors and micro LEDs and more. With so many game-changing applications in indium phosphide, gallium arsenide now emerging, Tier 1 interest and focus down to the substrate level is increasing. AXT is now engaged in multiple significant qualification efforts that can meaningfully impact our business in the coming years. Through these efforts, we have made a concerted investment of time and resources to elevate our business and manufacturing process to meet the rigorous demand or standard of some of the most prestigious companies in the world. Central to our work has been the continued ramp of our Kazuo and Dingxing facilities as well as our investment in bringing to market the larger diameter of indium phosphide and gallium arsenide substrates. In total, we believe we are positioning ourselves for revenue expansion and improving profitability in the year -- coming years. We believe our business model, including owning companies in China, is unique and that various elements of our model are coming together in a very positive way. This is why we believe that not only it is the right time to pursue a listing on the STAR Market for the benefit of our key stakeholders, we believe the combination of our exciting business opportunities with the completion of our new state-of-the-art facilities and successful customer qualifications make Tongmei an attractive listing on the STAR Market and its China-based investors. For AXT, the additional capital will allow us to further strengthen our financial structure, replenish a portion of the cost of building our new facilities and enhancing our overall positioning in Tier 1 customer opportunities. And please note that the fund for the relocation were U.S.-based generated, but there is now some synergy in replenishing with China-based funding. So in summary, for our current stockholders, gaining access to China capital market gives AXT an attractive balance sheet, favorable display and leverage of our consumable assets in China and is a great opportunity to attempt to achieve substantial benefit to our market value with very minimal dilution. With our customers, the additional capital will provide greater confidence in our ability to support at scale the strong and expected demand for our strategic compound semiconductor material. In addition, it confirms our commitment to these projects and signals our confidence in winning their business and delivering on their requirements. And for our employees, it creates excitement, pride and financial opportunity. Tongmei employees from time to time in the past have expressed an interest in going public, but there was no obvious path. The STAR Market now enables the path. This will strengthen retention and triple motivation and commitment to excellence. A slight look back over the last 3 years. AXT has come a long way. After navigating a difficult macroeconomic environment and executing a major relocation of our gallium arsenide manufacturing, we are poised to accelerate our growth. And the timing couldn't be better. Our readiness is aligning with our major technology trend across our portfolio and significant customer interest in our substrate. We believe the next several years will be exciting in our strategy plan, which include access to China's capital market, will allow us to maximize our business potential. I will now turn the call over to Gary Fischer for a review of the process investors can expect as well as the key financial considerations. Gary?

Thank you, Morris, and good afternoon, everybody. As Morris mentioned, this is a very exciting opportunity for AXT and Tongmei. It is worth noting upfront that the process of going public on the STAR Market in Shanghai includes several periods of review, and therefore, is a lengthy processes. We would not expect Tongmei to actually go public until mid-2022. I also want to note that the listing of shares of Tongmei on China STAR Market will not change the status of AXT, Inc. as a U.S. public company. We will remain a U.S. company, headquartered in Fremont, California. We will continue to be listed on the NASDAQ global select market under the symbol of AXTI. And yes, Leslie Green, Morris and I will continue to return your phone calls and meet you at conferences. As Morris mentioned, one change that investors may notice is that 2 of the raw material companies that make up part of the supply chain for AXT, that is BoYu and JinMei, will be merged into Tongmei and therefore, will be included in the offering. We are already consolidating BoYu and JinMei in terms of GAAP accounting. We believe this combination will better position Tongmei as a larger company and open doors for more market penetration. Reciprocally, investors in China will see an enhanced and expanded customer list and more product diversification. Now let's turn and take a look at the listing process. To qualify for a STAR Mrket listing, Tongmei is required to have multiple independent shareholders from China. The first major step in this process is engaging reputable private equity firms within China to invest funds in Tongmei. In exchange for an approximately 7.14% minority interest in Tongmei, private equity firms intend to invest approximately $50 million. Currently, we expect this in 2 steps or tranches. The first tranche investment documents have recently been signed and the process of transferring $22.5 million to Tongmei is underway. We currently expect that the funding will occur in late November, as in this month, or early December. The second tranche of approximately $26.5 million is expected to fund in January 2021. The second tranche invested documents have not yet been executed. It is important to note that I'm using U.S. dollars in this description but the actual transaction will be in Chinese currency, which is renminbi. So what are our other key steps involved in this listing process? One step is a detailed reputable audit firm. Even though Tongmei, BoYu and JinMei are separately audited annually because they're part of AXT's consolidated financial reporting, China rules require an audit on the front end of this process. Another key step or more actually a series of steps deal with the legal entity's forms and with merging BoYu and JinMei into Tongmei. Details, numbers and big concepts fascinate me, but some of you may not care too much about the details. So let me just give you one example. Tongmei's legal entity form, since we formed it in 1998, is an Ltd. But to actually issue stock, it needs to change to what you and I would view as an Inc., that is an Inc. or a corporation. We have engaged an international law firm that has operations in China and has already assisted another company through these steps. These reorganization steps will begin soon, and the goal, which we are advised is a reasonable goal, is to complete them before the end of Q1 2021. Only when these reorganization steps are completed can we submit a filing prospectus to the China equivalent of the SEC. In China, that agency is named China Securities Regulatory Commission. Currently, we plan to do the submission in June of 2021, and that agency takes 6 months before it issues comments and questions, which our lawyers and management would then respond to. This review process could likely spill into 2022. As such, it would be in 2022 that Tongmei would hope to do its initial public offering. In terms of business operations, the manufacturing model will see little or no impact. Morris has been Chairman of Tongmei since its formation in 1998, and will remain as Chairman through this process. Financial controls and audits currently in place will remain the same, and AXT, Inc. in the U.S. will be the majority shareholder. A significant factor of note and one of the reasons we wanted to describe the process is that the private equity investors have an unsecured right to request the redemption of their shares of Tongmei by AXT if we fail to accomplish the key steps, particularly, if Tongmei fails to actually go public by December 31, 2022. The redemption right is not secured and is an at-risk investment. Instead of the investment going directly into equity as paid-in capital, it goes to redeemable noncontrolling interest. It is not listed or added to liabilities, and it is displayed for GAAP purposes in between liabilities and equity. Because of the uniqueness of Tongmei and our long history of transparency, we do not expect to fail in this process, but it is a risk that we must manage and to which we must pay attention. We have been very well managing cash during the relocation, and we'll continue in this regard. And I would like to add that Tongmei, AXT and the private equity investors have shared interest and a common goal. We are all in this together. One other factor that is noteworthy is that the dilution of Tongmei is relatively low. AXT, Inc. will not give up control through dilution. The initial minority interest of Tongmei will be approximately 7.14%. For the IPO, we're only required to sell an additional 10% of Tongmei. As viewed within the context of the vision and scope described by Morris, dilution is about equal to what occurred in our 2017 secondary public offering but we expect to be raising much more capital. I did a quick calculation. In 2017, we raised approximately $34 million and dilution was approximately 16.1% of AXT. That equates to 0.47% dilution per each $1 million raised. I'm going to repeat that because it's a little technical but in 2017, we raised approximately $34 million and dilution was approximately 16.1% of AXT. That equates to 0.47% dilution per each $1 million raised. On this private equity run of Tongmei, Tongmei will raise approximately $50 million and dilution is expected to be 7.14% of Tongmei. That equates to 0.14% dilution per each $1 million raised. It's a very compelling contrast for those of us who make these kinds of calculations. And when I did it, I was kind of blown away by it. We cannot forecast a per each $1 million dilution rate for the IPO since we do not know the IPO market value. But you could make your own estimates. Okay. On that note, we will conclude our prepared comments. Morris and I will be glad to answer your questions. Operator, can we do the questions now?

[Operator Instructions] Our first question comes from Gus Richard of Northland.

A couple of quick ones. What's going to be the impact near-term on SG&A in terms of all the legal fees starting to get the process going?

Okay. I can answer that. The way that GAAP works is when you're incurring expense for raising capital, if you're successful at it, then it doesn't go through the P&L, it goes as a contra-account against the amount of equity that you raised. So this is standard operating procedure and -- so those expenses won't go through the P&L if we properly measure them and capture them. However, if ultimately we fail in the transaction, we don't raise private equity, then they would go to the P&L as expense.

Got it. And then just -- so I'm clear on the structure, AXTI would own some percentage of Tongmei, right?

No. Actually, prior to this, we now own 100% of Tongmei. We own 63% of BoYu, and we own 82.5% -- or 81.5%...

91%.

91.5% of JinMei. That's the ownership presently. But -- yes.

And when you roll all these things together, how much of the entity would you own before the transaction?

We would still own 100% of Tongmei, and then we'll do private equity?

Yes. But then the new Tongmei will have the BoYu and JinMei both into it, okay? And AXT will own part of it in shared ownership with BoYu's management and other shareholders as well as other 8.5% owned by JinMei. With the new cash infusion from private equity, then we will co-own the new Tongmei.

Right. And that's the nature of my question, the new Tongmei, because you don't fully own BoYu and JinMei, when you roll them all up together, how much would you own and then I can figure the dilution from the equity investment?

Well, I'm not sure -- since it's not a change in ownership, we own 63% of BoYu now...

All right. Let me try this one more. What is JinMei and BoYu worth today on a standalone?

How do we measure? I mean, I think book value-wise, JinMei -- I don't know that. We raised a private round of equity financing for BoYu approximately 3 years ago, and an investor from Germany put in $2 million to own 10% of the company. So I guess after cash in, it's worth $20 million. And JinMei, because we've never done any transaction, so I think the value of JinMei is just on the book, how much is its book value.

$600,000, okay.

I guess so, but it has some retained earnings, I think. I don't...

Yes, I don't know the numbers, Gus. But conceptually, the minority shareholders of BoYu, you're correct, they will become a minority shareholder of Tongmei. And the minority shareholders of JinMei, which are basically management and employees of JinMei, will become minority shareholders of Tongmei. The majority shareholder will still be by significant differences and amounts, AXT, Inc.

And I think I remember I calculated, I think BoYu is minority shareholder on somewhere around 3%.

Yes. It's in the single-digit percentage. So the dominant value in the terms of the 3 companies being put together is Tongmei.

Is still Tongmei.

Yes. So...

Okay. Okay. And then just so I'm clear, the structure will be AXTI will be effectively a holding company and Tongmei will be the primary asset plus the other JVs?

I wouldn't use that language because AXTI will -- may not be considered a holding company technically. It depends on where AXTI goes. So -- but I guess in a casual sense, it's similar to what we do now. AXT owns Tongmei. AXT, in Fremont, we have about 25 employees. Here in Tongmei, we have over 700. So the activities will stay the same. The business model will stay the same. So I guess you could say AXT, Inc. is currently a holding company and will stay a holding company. But technically, it's not, and we need to look into that still in terms of the technical stuff. So the management and the organization structure is not going to have much change. So Morris is Chairman of Tongmei, and he'll remain the Chairman of the Tongmei. So...

Our next question comes from Richard Shannon with Craig-Hallum.

I guess one clarification for me. I was just quickly going through the SEC filings on this, it wasn't clear to me whether Tongmei includes all of your crystal growth and polishing and related operations or there's parts that are not included in this new entity here that's going to be on STAR's?

Yes, it includes -- it includes everything, crystal growth as well as polishing. Yes.

Okay. All right. Second question is, I'm not all that familiar with the STAR listing process here, but why is there -- why are there 2 different tranches to this initial placement?

Well, the investment -- private equity investment into this newly formed joint venture, which is ready for IPO or applying IPO in China is going to happen in the next 18 months or so. Why is this private equity coming in 2 tranches? Because they come from 2 different organizations. Each one has its own legal papers to file and they want to negotiate the price. But basically, we're going to give them the same price, approximately the $50 million were equal to 7.14% of the equity ownership of the new Tongmei.

Yes, I can give you a little more color, too. So the first fund to come in wanted to sort of make a statement to the China private equity market and endorse the transaction. They wanted to come in aggressively and early. And we thought that was a good idea. So the second tranche just -- it has a few more players, and there's a few more bureaucratic steps within those private equity funds. So that's why it's 2 tranches. And there is a precedent for this. There's another company who did something similar to this, and they also did 2 tranches. So I think it's the nature of how fast private equity funds can respond. The one that's coming in now that we signed with last week is aggressive and moving very fast. So yes...

Yes. Also the other thing is we like to have a more diversified investor into this private equity round. So we don't want to sell everything to just one investor so we sort of separated into 2 tranches.

Okay. Can you identify the entity, which you've already signed documents with?

No, we cannot.