The growth trajectory of AXT, Inc. (NASDAQ:AXTI) needs to be reconsidered in light of ongoing softness in the semiconductor sector, where the company designs, develops, manufactures, and distributes compound and single element substrates to customers in the industry.
Even though the company did okay in the third quarter as reflected in its latest earnings report, it showed signs of increasing headwinds having a negative impact on its short-term performance in 2023, many of which will take time to mitigate.
And if things get worse before they get better, it’s going to put further downward pressure on its share price as elevated inventory in the semiconductor sector in general, and the company specifically, could extend the time period before customers start ordering new product in response to excess inventory levels being worked down to the point they need to be replenished.
With demand in the sector continuing to decline and uncertainties surrounding the global economy in 2023, there is little visibility in regard to when things will improve to the point of the semiconductor industry turning around and demand for AXTI’s products to increase.
In this article we’ll look at the latest numbers from its earnings report, the probably impact of heightened inventory levels, and why indium phosphide needs to continue to do well in order to keep the stock price of the company from collapsing further.
Some of the numbers
Revenue in the third quarter of 2022 was $35.2 million, down from $39.5 million in the prior quarter, and slightly up from revenue of $34.6 million in the third quarter of 2021.
Revenue in the first nine months of 2022 was $114.3 million, compared to revenue of $99.7 million in the third quarter of 2021.
Of the $35.2 million in revenue in the reporting period, indium phosphide accounted for $17.7 million, making up a little over half of total revenue. Gallium arsenide was the second-largest contributor to revenue, generating $8.1 million in the quarter, down approximately $4 million sequentially. A drop in market demand was the reason for the drop in gallium arsenide sales.
Revenue from germanium substrate was only $1.1 million, down approximately $2.7 million from the prior quarter. That was attributed to the weakening market, but also payment issues with one of its customers.
Revenue from its joint venture with two companies in relationship to raw materials was $8.3 million. With demand softening, the company expects a lower revenue contribution from the joint venture in the fourth quarter, and possibly further into calendar 2023.
Non-GAAP gross margin in the third quarter of 2022 was 42.2 percent, and on a GAAP basis it was 42 percent. Considering the drop in revenue this was a good result. The reasons given for the solid percentage was a new recycling program for indium phosphide, improved yields, and a more favorable product mix.
I think the most impact came from the favorable product mix, which likely came from the drop in revenue from gallium arsenide, and secondarily from germanium substrate. Why I believe that’s important is because an increase in gross margin, while important, was probably done at the expense of the decline in revenue, rather than primarily for the other reasons given.
If that’s accurate, then the improvement in gross margin could have come at the expense of net income, meaning a lower gross margin with much higher revenue could have generated more net income for the company. In other words, the improvement in gross margin may have primarily come from the drop in sales rather than a new recycling program for indium phosphide and improved yields.
The significance of that is when revenue starts to grow again, it’s probable that gross margin will decline. The good news in that regard if my thesis is correct, is net income could improve based upon an increase in revenue, even it comes at the expense of some gross margin.
Net income in the third quarter of 2022 was $6.7 million or $0.13 per diluted share, compared to $4.5 million or $0.09 per diluted share in the third quarter of 2021. For the first nine months of 2022 net income was $17.2 million, or $0.34 per diluted share, compared to $12.9 million, or $0.27 per diluted share in the first nine months of 2021.
Cash and cash equivalents at the end of the third quarter of 2022 was $48.2 million, compared to $36.8 million in cash and cash equivalents the company had at the end of calendar 2021.
Inventory levels
As of September 30, 2022, AXTI has inventory levels of $88.5 million, with raw materials accounting for 50 percent of that; WiP 46 percent; and finished goods the remaining four percent.
Taking into account customers and the company needing to continue to work down inventory levels, AxTI guided for revenue in the fourth quarter to drop to a range of $26 million to $29 million.
I agree with that assessment, but also think it could take longer for inventory to fall to levels it’ll trigger a significant spend on new inventory. For that reason, I think the headwind will remain in place for at least the first half of 2023, and possibly as long as the last quarter of the calendar year.
Keep in mind that not only does AXTI’s customers have elevated inventory, but so does the company. Considering the strong probability that the sector will remain under pressure in the first half of 2023, it would mean it could take longer to work through inventory levels for longer than expected, which would result in some difficult quarters ahead for the company.
That’s especially true in the near term where the company guides for all of its products to be down. Again, I think that’s going to continue on because of current weakness in the sector.
Indium phosphide
Indium phosphide accounted for a little over 50 percent of the company’s revenue in the third quarter, and it’s expected to continue to be a significant part of sales in the quarters ahead.
In the third quarter its $17.7 million in revenue was a quarterly record for the segment; it was up 12 percent sequentially, and up 48 percent year-over-year.
The catalysts for growth from indium phosphide were two consumer applications. The “first is the proximity sensor for audio devices and the second is the endo-gas sensor for high end headsets.”
Based upon guidance, we can expect this to not perform as well as it did in the third quarter, but if sales vastly underperform, it’s going to put a lot of downward pressure on the stock price of the company because of it representing slightly over 50 percent of sales.
Conclusion
AXTI competes in a market sector that continues to be under pressure from low demand and economic uncertainty in 2023.
While the company has done a good job of removing costs out of the operations by improving efficiencies, it’s not going to offset what appears to be an ongoing trend of slowing demand in at least the first half of 2023, and possibly longer.
It’s going to take time to work through excess inventory levels and could take longer if the sector remains under pressure going forward.
The two major metrics to watch in my opinion are the performance of indium phosphide and the pace of inventory drawdowns which will give a snapshot into industry demand.
I don’t anticipate anything in the near term improving those areas, and they could even get worse in the near term if conditions worsen. With that in mind, I think the share price of AXTI could drop a lot further before it finally finds a bottom. To what degree will demand upon its numbers from the fourth quarter and how the sector looks for the remainder of 2023.
Further out, if AXTI can continue to operate with solid margins, it could be poised for a nice run once sector and economic conditions improve; that’s not going to happen anytime soon.
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