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Rubicon Technology (RBCN) is one of the leading suppliers of sapphire primarily used in the manufacturing of LEDs and silicon-on-sapphire products. Despite the overall growth of LEDs and the potential for sapphire as a cover glass material in consumer electronics (primarily smart phones) I believe RBCN may have a broken business model that cannot be fixed. After a short period of runaway pricing the sapphire industry as a whole has been suffering from a capacity glut that has caused prices to collapse. This trend has reversed with rising prices this year (off of a very low base), but while this has helped RBCN it hasn't offset the collapse of the company's wafer business.

Highlights:

  1. Despite several quarters of increasing sapphire prices (likely helped by temporary demand for the iPhone 5S) RBCN still had NEGATIVE 57% gross margins in the most recent quarter.
  2. The company's two largest customers are either going away or will be significantly smaller.
  3. GTAT's deal with Apple will give it unprecedented scale, supply chain leverage and financial resources in the sapphire industry.
  4. Cash burn is set to increase after cash flows have been helped by inventory depletion and lower accounts receivable.
  5. Sapphire is primarily used for consumer electronics (LEDs and now smart phones) leaving little room for high margins over the long-term.
  6. RBCN is making a "build it and they will come" bet on larger diameter PSS because they have few other options.
  7. Shelf filing just went effective, I would bet an equity raise is coming soon.

There are very few ways to invest in sapphire via a U.S. listed stock. GT Advanced (GTAT) and RBCN are basically it. GTAT announced a deal with AAPL that is light on details, but the basics are they have reached an agreement where GTAT will produce sapphire out of an AAPL facility in Arizona. Given the size of the prepayment by AAPL it looks like it will be the largest sapphire production facility in the world.

RBCN grows sapphire crystal in Illinois and has a polishing operation in Malaysia. RBCN is much more focused on the LED market where as GTAT has been aggressively pursuing a cover glass strategy for some time. The sapphire market has been plagued by extreme over capacity for the last few years, which is apparent when examining RBCN's financial results. Some analysts estimate that there is still 40% over capacity in the industry. Prices have started to increase over the past few quarters for 2 inch and 4 inch cores due to increased demand for LED general lighting and AAPL buying sapphire for the iPhone 5S. Cores are the step above the raw boules that come out of the furnace. They are in rod shape and are ready to be sliced into wafers.

While GTAT appears to have secured its future, RBCN's business remains dismal with significantly negative gross margins and fairly large losses.

The current operations

RBCN reported Q3 '13 results of $11.1M of revenue and a loss of $0.26. Revenue declined 44% vs the prior year but was up slightly from the previous quarter. The company had a gross margin of negative 57%. This includes an idle plant expense of $2.9M (expenses that would typically be allocated to inventory if plants were operating). Adding that expense back, gross margin would have been negative 31%. The idle plant charge should decrease in the next few quarters as RBCN restarts most of their crystal growth capacity, however, the furnaces in Illinois are only 25% of the charge (according to management on the conference call) while the remainder is mostly from idle cutting, polishing and patterning capacity in Malaysia. It is much less clear when capacity utilization of these assets will increase. It is worth noting that the company is taking a full tax rate benefit every quarter. Without this benefit the reported loss would have been $0.43 per share in the most recent quarter and $1.17 per share for the first nine months.

The dramatic Y-o-Y revenue decrease is almost completely a result of the wafer business. Polished (i.e. wafer) revenue declined from $16.6M last year to $2.1M this year, while the Core (Ingots) business increased from $1.3M to $7.1M. RBCN had a nice business supplying wafers to Peregrine Semi (PSMI) and LG Innotek. We believe PSMI has qualified other suppliers, but has also seen its own business slow and is transitioning away from sapphire. PSMI was 35% of YTD revenue and 29% of 2012 revenue. This disclosure from RBCN's 10-Q makes me think we should not expect an improvement in the PSMI business soon or ever:

The manufacturer of the majority of SoS chips will be introducing new products that will be produced on a substrate other than sapphire starting early next year, therefore, the amount of sapphire wafers sold into that market will be significantly reduced beginning in early 2014.

It is also doubtful that the LG business will ever be as high or profitable again either. In their August earnings call RBCN management stated that LG had started using an internal source for wafers. Generally the 6 inch polished wafer business looks like it will continue to suffer for at least a few more quarters. Again from the most recent 10-Q:

However, we believe six-inch polished wafer prices may decline further in the near-term. We have continued to experience limited demand for LED polished wafers but expect increased adoption of six-inch wafers in the LED market.

So what is the strategy to turn this ship around? Larger diameter polished wafers and PSS (patterned sapphire substrates). RBCN is becoming increasingly vertically integrated and is hoping for adoption of larger wafer sizes for LED manufacturing. The assumption is that this will lower the cost to manufacture LEDs similar to the move to larger diameter wafers in semiconductor manufacturing. The company has spent money in Q3 and will again this quarter to add PSS capacity in Malaysia. They also recently announced PSS in 4, 6 and 8 inch diameters and have started sampling to customers. Management believes this will contribute at least $15M to revenue next year, but mostly in the second half of the year. This strategy is a gamble, but it appears it is the only path forward. Clearly it is difficult to have a profitable business selling 2 and 4 inch cores unless there is a dramatic price increase. Given the displacement at LG and the ramp down of PSMI we believe there is now ample competition in larger diameters which may result in a much less profitable wafer business even if revenue returns to 2012 levels. Not to mention, even if the company does reach management's goal of $15 million of PSS revenue next year it won't even be as much wafer revenue as they generated in Q3 of last year alone. Further, RBCN's management has had a difficult time predicting business especially when it comes to the second half of the year. Below are comments from recent conference calls where they attempted to predict the second half of this year.

Conference call on 11-06-12

Question - Brian Lee: And then just one last one. You are guiding for growth in that segment in the back half of next year. Does that also apply on a year-over-year basis given how backend-loaded you were this year and do you have any sense of potential magnitude?Thanks.

Answer - Bill Weissman: Yes, we would expect it to be over -- growth year over year because remember, the first half of this year was not very indicative, because we had an inventory correction and our one large customer really wasn't taking shipments. The second half of this year is a little bit more typical in terms of the volumes used by both the SoS and LED customer and as we have additional LED customers using six-inch then it will all be -- should be incremental.

Conference call on 2-20-13

Question - Daniel Amir: Okay. And on the SoS side you expect kind of a big bounce back in the second half. I mean, so what type of revenue growth year-over-year should we see in that business?

Answer - Bill Weissman: Well, it's difficult to say. Obviously, I believe our customer has given some guidance on what they expect their growth to be for the full year, and we certainly don't have any reason to believe that we wouldn't be able to mirror that. But it's difficult to say.

Conference call on 5-07-13

Question - Kant Avinash: So, in the guidance that you're giving for revenues in Q2, how should we think of mix between LED and SOS? Would there be any SOS sales, or not?

Answer - Bill Weissman: Yes, there will be. I think in that quarter given the weaker wafer sales, the core will likely be the majority of the revenue in that quarter, but it should flip back in the second half of the year where we have most of our revenue coming from six-inch wafers.

What is the impact of Apple-GTAT?

GTAT announced that they have entered into a pact with Apple (AAPL) to supply sapphire from a facility in Arizona. This is a change in strategy for GTAT who was previously a supplier of growth furnaces for other sapphire material producers. Details are limited, but AAPL advanced GTAT $578M to build the facility and it is expected to start production mid next year. There is plenty of speculation about whether the iPhone 6 will have sapphire cover glass or whether this is for the long rumored iWatch plus home button and camera lens covers.

Trying to think through the short and long-term effects there are many puts and takes. A near-term positive for RBCN may be that GTAT will likely ship a very limited amount of furnaces to potential RBCN competitors. This may be good, but also, every Tier 1 supplier of sapphire does not use GTAT furnaces and this would not limit their ability to add capacity. I also believe GTAT will begin shipping furnaces to third parties as soon as the second half of next year if there is demand. A negative may be that AAPL's use of sapphire for the home button cover and lens cover of the 5S has likely helped sapphire pricing over the last few quarters. Some estimates are that APPL may be consuming 12-15% of the available supply. Not only will this likely slow in Q1 due to seasonality, but the AAPL demand may be completely out of the open market by next summer due to the agreement with GTAT. While growth in LED general lighting and other smart phones using sapphire may offset this it will likely be a negative in the overall pricing environment.

The longer-term impact becomes more difficult to gauge, but I think it has the potential to be overwhelmingly negative for RBCN. The AAPL partnership will give GTAT unprecedented scale in the sapphire industry and along with that will come supply chain leverage and production efficiency that could reduce GTAT's production cost well below RBCN or any other sapphire producer's cost. I believe this is an issue because GTAT will be able to sell sapphire into the LED and industrial markets. Without a similar partnership RBCN will not have the same cost leverage and I don't think there is a similar partnership available. GTAT already has an R&D budget that dwarfs RBCN and now they will be able to sustain that budget if not increase it, which is obviously a long-term favorable dynamic for GTAT.

I think the biggest take-away from this is that AAPL saw something in GTAT that is doesn't see in RBCN. RBCN already has the largest North American crystal growth capacity, but AAPL opted to build a new facility with GTAT. I would assume this has everything to do with technological roadmap and GTAT showing an ability to be the world's low cost producer.

Balance Sheet Protection? Not really.

A common theme in most analyst reports is that the tangible book value you of RBCN will provide downside protection. While this is typically the case and it will ring somewhat true here due to quant funds that buy on such metrics, I believe the number may not prove to be a backstop for shares. First, the book value didn't provide protection when the stock traded down to $4.83 earlier this year. Second, of the $9.33 per share in book value $5.18 is PP&E. A large portion of this is equipment which is likely furnaces, coring, cutting, polishing and patterning equipment. The balance sheet value (cost - depreciation) may not reflect the actual value in a sale. This is especially true for the furnaces that are unique to RBCN and located in a geography that may not be attractive to an acquirer. Third, the book value is constantly eroding every quarter with losses from operations. In the first nine months of 2013 the book value has decline nearly $15 million or $0.66 per share even with the help of a dubious tax benefit. If that trend continues in the current quarter (which the company's guidance implies it will) then they will erode roughly $20 million of book value for the year.

The cash burn hasn't been as bad as the income statement losses during the first nine months as the company has generated $15 million of cash from lowering inventory and accounts receivable. This trending will likely stop in the coming quarters as RBCN restarts its furnaces and AR at least flattens. In fact AR is likely to increase if they begin selling to their traditional customer instead of liquidating their core inventory to cash-in-advance customers in China and elsewhere. We could then see cash burn closer to in line with operating losses which was $26.4 million through nine months of this year and is on pace to be $34-35 million for the full year. With a cash balance of $36.5 million, this could start to become an issue next year without success in the PSS business or a big improvement in commodity core prices.

The company did recently file an S-3 that is now effective so they could tap the market to add cash to their balance sheet. They also registered shares for their largest shareholder who sold some stock earlier this year.

Valuation

What is the appropriate valuation for shares of RBCN? Let's stretch the bounds of logic and give the company a huge benefit of the doubt. Assume that RBCN's business rebounds significantly from the 2013 revenue expectation of $41 million to $90 million on some additional price increases and higher volumes in two years. Then assume that company can, somehow, achieve a 7% EBITDA margin in what is basically a commodity materials business. By the time RBCN reaches profitability I believe their cash balance will be a nominal amount. If I give the company a 7x EBTIDA multiple on 2015 EBITDA and don't even discount it back to today I reach an enterprise value of $44 million. Using 22.6 million shares outstanding (this is the basic, not fully diluted amount and does not assume an equity raise even though I would bet the company will do one soon) I generate a price target of $1.95 per share, or a decline of 78%, again based on assumptions that give the company a large benefit of the doubt given potentially large negative dynamics taking shape in the industry. I assume people that own the stock look back to 2011 and 2010 and hope for a return of those days when sapphire pricing was 5x higher than it is now. The reality is the vast majority of sapphire is used in consumer electronics (LEDs and now smart phones) where pricing typically grinds lower over time and margins are razor thin and we will probably never see a repeat of that sapphire market.

Conclusion

RBCN is clearly struggling with the current sapphire market conditions. Even after several quarters of sapphire price increases the company continues to post significantly negative gross margins due to a collapse of its wafer business. The company has embarked on a strategy to vertically integrate and pursue the larger diameter PSS and wafer market, but expects no real impact to the P&L until the back half of next year. I believe sapphire production is becoming more of a commodity and GTAT's entrance into the market with unprecedented scale could structurally change sapphire cost and price in every end market. In the meantime shares of RBCN have increased nearly 50% this year due in part to excitement around sapphire on smart phones, which I believe will have little impact on the long-term success of RBCN. Investors are clearly pricing in significant optimism about RBCN's future.

Disclosure: The fund I manage is short RBCN and is effectively long GTAT as it is short GTAT puts.

Source: Rubicon Technology: Fundamentally Flawed

Additional disclosure: As I say in the article, the fund I manage is also effectively long GTAT as it is short GTAT puts.