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Executives

Bill Weissman - CFO

Raja Parvez - President and CEO

Analysts

Jed Dorsheimer - Canaccord

Chris Blansett - JPMorgan

Stephen Chin - UBS

Anil Doradla - William Blair

Avinash Kant - D. A. Davidson & Co.

Yair Reiner - Oppenheimer & Co.

Ahmar Zaman - Piper Jaffray

Andrew Abrams - Avian Securities

Bill Ong - Merriman Capital

Andrew Huang - Sterne Agee

Rubicon Technology Inc. (RBCN) Q3 2010 Earnings Call November 4, 2010 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2010 Rubicon Technology earnings conference call. (Operator Instructions)

I'll now turn the presentation over to your host for today's conference, Mr. Bill Weissman, CFO.

Bill Weissman

Good afternoon, everyone. We are pleased you could join us today for Rubicon's third quarter 2010 earnings conference call. My name is Bill Weissman, and I'm Rubicon's Chief Financial Officer. With me today is Raja Parvez, Rubicon's President and Chief Executive Officer.

We have allotted one hour for our call this afternoon. Raja will provide an overview of third quarter results of operations and discuss the current market environment. And then I will review our financial results in detail as well as discuss our outlook for the fourth quarter of 2010. We will then be happy to take your questions.

Today's call is being simulcast through our Investor Relations section of our website located at www.rubicon-es2.com. A replay of this call will be available for eight days and the webcast will be archived in the Investor Relations section of the website. As a reminder, our press release and preliminary financial statements are also available in the Investor Relations section of our website.

Before we begin, please be advised that certain statements in this presentation relate to future results that are forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, the accuracy of which are necessarily subject to risks, uncertainties and assumptions as to future events that may prove not to be accurate. Factors that could cause actual results to differ materially from those expressed or implied include general economic conditions and factors discussed in our most recent Form 10-K and other filings with the Securities and Exchange Commission. We undertake no obligation to update or revise any forward-looking statements whether as a result of new information, future events, or otherwise.

Now, I'd like to introduce our President and CEO, Raja Parvez.

Raja Parvez

Thank you, Bill. Good afternoon, everyone, and thank you for joining us today. The third quarter was another very strong quarter for Rubicon with revenue increasing 30% sequentially to $20.5 million and gross margin rising another 8 percentage points to 54%. Diluted earnings per share in the quarter reached $0.35, a sequential increase of $0.17 per share.

Demand continued to be strong from the LED market with chip manufacturers continuing to add significant capacity as they install new MOCVD reactors in response to the projected rapid growth in the LED industry.

As a result of this strong demand, average selling prices for our substrates increased approximately 30% sequentially. While overall demand remained strong, there has been an increased level of inventory of LCD TV panels in the supply chain, which has resulted in some softening of demand for sapphire substrates in certain geographies.

So far, this has concentrated around a few customers that are more heavily focused on TV backlighting. Demand in most geographies and for the most applications has more than offset the temporary easing of demand for our TV backlighting in the third quarter.

We anticipate a similar situation in the fourth quarter and expect substrate pricing to increase in Q4 by at least 15% sequentially. Bill will comment more on our outlook for the fourth quarter in a few minutes.

Regarding the LED TV market, our customers expect the current excess panel inventories to clear out in the next few months. We could see some continued weakness in this segment in the short term. But again, demand from other applications has thus far more than compensated for this.

It is also important to remember that the penetration rate of LEDs in televisions is still quite low. Some analysts estimate the penetration rate of LED backlighting in LCD televisions in 2010 to be approximately 20% moving to 50% in 2011, indicating that there is still significant growth expected from this market segment in 2011 and subsequent years.

Revenue for 6-inch wafers increased from $4.4 million in the second quarter to $4.7 million in the third quarter. Demand for our 6-inch polished wafers continues to strengthen, and our polishing operation in the U.S. was operating at full capacity in the third quarter.

As our additional capacity begins to come online, we expect revenue from this product to become a larger percentage of our total revenue, with $71 million of sales already contracted through 2011.

Prices of all products increased in the quarter, with pricing for 2-inch sapphire core increasing the most. There are two key reasons for this. First, additional MOCVD reactor installations in Taiwan and China increased demand for 2-inch sapphire. And second, some of the larger 4-inch users are more focused on TV backlighting, which experienced some softness in the third quarter.

While three and 4-inch core pricing also increased in the quarter, there was greater imbalance in the supply and demand for 2-inch sapphire, resulting in a larger increase in pricing for that product. Consequently, 2-inch sales represented 46% of our substrate revenue in the third quarter as compared to 28% in the previous quarter.

On of the advantages of our bulk crystal growth technology is the flexibility it offers our production planning. Our crystal growth technology platform is independent of product size, which allows us to respond quickly to shifts in customer order patterns.

While we continue to support our SOS, RFIC and Optical customers, we have been allocating the majority of our production to customers in the strategically important solid state lighting market. However, with additional capacity coming online, we'll be able to better support these markets going forward.

In order to address the strong long term growth prospects for sapphire products, we have been working on expanding our capacity both in the United States and in Asia. As planned, our two new manufacturing facilities are now open, and we have begun to install equipment.

In Illinois, our 135,000 sq. foot next generation crystal growth facility now has the necessary power and cooling infrastructure in place and we have started installing our in-house custom-built furnaces. While it will take a full year for all furnaces to be constructed and installed, we are on track to add crystal growth capacity in the fourth quarter.

The new crystal growth facility will be producing primarily 85 kilograms boules which will extend our leadership in large diameter sapphire as it will significantly enhance our high volume capability in six and 8-inch substrates.

As I mentioned earlier, our crystal growth platform is not product specific, so we can take any diameter or crystal orientation from the boules produced in this new facility, but the larger boules will give us greater flexibility in addressing the large diameter market. Demand for our 6-inch polished wafers is increasing, and I believe we could begin to see some adoption of 8-inch substrates in the LED markets as soon as 2012. This facility allows us to continue to stay well ahead of the market.

Our new state-of-the-art post crystal growth facility in Malaysia is also now open, and is processing and shipping sapphire cores. We expect to begin processing polished wafers in this facility by the end of the year.

Our Malaysia facility will be responsible for the more labor-intensive crystal fabrication processes, and also allows us to significantly expand our strong capabilities in larger diameter wafer polishing. Large diameter sapphire polishing is very challenging, given the hardness of the material and the tight tolerances that must be maintained.

Rubicon has extensive experience in polishing both 6-inch and 8-inch wafers for both SOS RFIC and LED markets. Our Malaysia facility will have the capability to polish 4, 6 and 8-inch wafers, but our current expectation is that the majority of the added polishing capacity will be dedicated to 6-inch in 2011, with small amounts of 8-inch. In 2012, we believe we will see increasing 8-inch volumes as well as continued strengthen of 6-inch demand.

Combined these two facilities give us a significant advantage in the marketplace. I believe that this combination of high volume, high quality, large diameter crystal growth and polishing capability makes us unique in the marketplace today and positions us very well to maintain our leadership position for years to come.

I would now like to turn the call over to Bill, who will provide you with greater details on the financial results for the third quarter and our guidance for the fourth quarter 2010.

Bill Weissman

Thank you, Raja. Revenue for the third quarter was $20.5 million as compared to $15.8 million in the previous quarter and $5.7 million in the same period last year. Revenue growth has been driven by strong demand from the LED market, as Raja described. Our revenue from the LED market in the third quarter was $19.4 million, up 39% from second quarter 2010 LED revenue of $14 million.

Given that we have been operating at full capacity, the sequential increase came from increased ASPs and changes in product mix. ASPs from substrates increased approximately 30% sequentially with prices increasing for all diameters.

As Raja mentioned, our polishing operation was at full capacity in the third quarter. Total revenue from 6-inch polished wafers in the third quarter was $4.7 million, up from $4.4 million in the prior quarter. We directed more of our polishing capacity for the LED market in the quarter. As a result, 6-inch polished wafer sales into the LED market increased by $1 million sequentially, going from $3.5 million in the second quarter to $4.5 million in the third quarter.

6-inch sales into the SOS market decreased $700,000 sequentially, going from $900,000 in Q2 to $200,000 in Q3. We expect revenue from 6-inch polished wafers to increase in the fourth quarter, as our additional capacity begins to come online. Demand for 2-inch material was particularly strong in the quarter for the reasons Raja provided. Subsequently 2-inch sales represented 46% of our substrate from revenues in the third quarter as compared to 28% in the previous quarter. 3-inch and 4-inch core represented 30% of substrate sales in the third quarter with the 6-inch wafers accounting for 24%.

Revenue from the optical markets in the third quarter was consistent with the prior quarter at $900,000. Both the optical and the SOS RFIC markets continue to be important to us. And we will begin allocating more material to both of these markets as additional production capacity comes online.

Our gross margin in the third quarter increased eight percentage points sequentially to 54%. This increase is primarily attributable to the increased selling prices for our substrates. Operating expenses in the third quarter were consistent with the prior quarter at $3 million resulting in an operating profit of $8.1 million and an operating margin of 40%. In the quarter, we reduced our tax accrual by $126,000 with the conformation that we would not be subject to alternative minimum tax this year.

Net income totaled $8.3 million resulting in a diluted EPS in the third quarter of $0.35 on an average diluted share count of just under 24 million shares. This compares to a diluted EPS of $0.18 in the prior quarter and a loss of $0.10 per share in the third quarter of last year.

Turing to the balance sheet and cash flow, we maintain a very strong cash position with $84 million in cash and short-term investments at September 30. We generated cash from operations in the quarter totaling $4.4 million and capital expenditures totaled $15.2 million. Capital expenditures were heavy in the quarter with the continued execution of our expansion plans. Our expansion plans remain on schedule and on budget.

Our costs receivable remain of high quality. DSO at the end of the third quarter was 56 days, three days higher than the DSO at the end of the prior quarter and two days higher than at the end of the third quarter of 2009.

Inventory at September 30 was $8.4 million as compared to $6.8 million at June 30, 2010. The increase was largely due to increased inventory of raw material which accounted for approximately $5 million of our total inventory at September 30. With the rapid growth of the business, we want to make sure we have ample raw material in stock. Inventory at the end of the third quarter of 2009 totaled $7.2 million.

Our spare parts inventory, which is included in our other current assets, increased from $4.4 million at June 30 to $6.1 million at September 30, as we took delivery on additional parts to be used for continued construction of our new furnaces.

Regarding our outlook for the fourth quarter 2010, we expect continued strong demand resulting in revenue growing approximately 27% sequentially to between $25 million and $27 million. We expect our substrate prices to increase at least 15% sequentially, and we are expecting to add some capacity in both crystal growth and polishing in the quarter.

We anticipate gross margin in the fourth quarter to reach the high 50% range and operating margin to be in the mid-40% range. Based on our projected diluted share count of 24 million shares, we expect diluted earnings per share in the fourth quarter of between $0.47 and $0.49.

I would like to turn the call back over to Raja for some closing comments, and then we will be happy to take your questions.

Raja Parvez

In summary, the markets we serve continue to grow rapidly. And as a result, demand for our products remains strong. Our two new manufacturing facilities are now operational as planned, and this additional capacity allows us to further differentiate ourselves from the competition.

Large-diameter substrates are becoming increasingly important in the LED market, and our high-volume competency in both high-quality large-diameter crystal growth and large-diameter wafer polishing is unmatched in the marketplace. As the LED industry continues to grow and evolve, I believe Rubicon is extremely well positioned to remain a key enabler of this technology.

I want to thank you all for joining us today and thank you for your continued support. And now, operator, may we take our first question?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line Jed Dorsheimer of Canaccord.

Jed Dorsheimer - Canaccord

Last quarter, you said pricing would be up at least 20%. It came at 30% sequential increase. How should we read into this increase? Should we add 10% on there or is there something else going on?

Bill Weissman

You kind of broke up at the end there, Jed. What can we read into what exactly?

Jed Dorsheimer - Canaccord

Sure, last quarter you said up at least 20%. You came at 30%. This quarter you're saying up at least 15%. Should we view it as just sort of the same type of band? In other words, you are looking at sort of 20% to 25%, or is there something else going on that's causing you to be more conservative in terms of the pricing?

Bill Weissman

No, there is some movement within the quarter. We have good visibility on the quarter ahead, but there is always some movement, and we try to be conservative in our estimates of what the increase would be. But that's our best guess at this point.

Jed Dorsheimer - Canaccord

And then in terms of your variability, is it more on pricing or is it more on the timing of bringing on new capacity?

Raja Parvez

It's both.

Jed Dorsheimer - Canaccord

In terms of pricing, you've done a great job of taking advantage of a strong pricing environment. But as the new capacity does start to come on, are you are at all concerned about the customers that have seen such great price increases, and are you starting to enter discussions in terms of some more longer-term contracts?

Raja Parvez

No, we are not concerned, because we still remain the only company which has ability to produce the largest volume and best quality and the largest diameter in the industry, as it is proven with our contracts in the 6-inch area and our ability to produce and supply. Yes, more capacity will come online, but we are confident based on our long-term relationship and our sustained confidence that we can supply to these customers, I believe that we will very well continue to be ahead of the competition.

Jed Dorsheimer - Canaccord

Raja, if we can push back a little bit, when you talk about long-term relationships, in your 6-inch, you're not locked into any long-term contracts with your customers. In fact most of your pricing seems to be more of a spot sort of long quarter in advance. So that's why I was asking the question are you starting to engage customers in more of a formal long-term type of relationship?

Raja Parvez

While we continue to discuss with our customers, as you know, we have one major contract which is the largest ever sapphire contract issued by any corporation to any corporation. But as I believe, a few more customers will be moving from their development to production, and of course we'll continue to discuss with them all these potential possibilities as we continue to bring online new Malaysia facility which will be capable of producing more high volume 6-inch products.

Jed Dorsheimer - Canaccord

Last question and then I'll jump in the queue. Did the 6-inch volume that you shipped this quarter come as a bit of a surprise to you in terms of the amount, or was that in line with the contracted figure?

Raja Pervez

No, that's in-line with the contracted figure.

Bill Weissman

Remind you that the 6-inch contract begins in November and goes through the end of next year.

Operator

Your next question comes from the line of Chris Blansett of JPMorgan.

Chris Blansett - JPMorgan

Wanted to have a question about 6-inch demand and thoughts on, you know if you had more capacity would you have actually sold more of those wafers, meaning that there is simply more demand than capacity out there?

Raja Pervez

Well, demand on the 6-inch continues to be strong, and one of the reasons is this that our major LED chip manufacturers who are technologically rich and has a capital to support it are moving toward 6-inch diameter wafers because of the performance and the cost competitiveness it applies to this product.

So we are working with a number of customers on the 6-inch product. But as you know that we have an X amount of capacity in our Chicago facility, which we have been operating at maximum capacity. And we believe that this Malaysia facility will add some capacity in Q4, but most of the capacity will be added throughout 2011, which will be consistent with what we believe will be the demand on the 6-inch from many, many different customers.

Chris Blansett - JPMorgan

And then, second question I had was related to your comments you made about reallocating toward LED-related products. And it sounds like you are almost starving your other markets. Is that kind of the way we should characterize this that some of your other application markets are actually undersupplied at this time?

Raja Pervez

Well, obviously our main focus is on the LED industry, but we are still maintaining a good healthy relationship with the other two markets. And we are not supplying as much as they like but we still maintain a healthy relationship with them, and supplying some products to some of those markets. And we are constantly in discussion with them, updating them the progress of the company, both the new crystal growth facility and the polishing facility. And they are fully engaged with us. As more capacity comes online, we certainly plan to support those two businesses as well.

Chris Blansett - JPMorgan

And then one question for Bill. You had very good profitability during the quarter and it looks to get even better in the fourth quarter. So what are your remaining deferred tax assets from here, and kind of maybe trajectory for when they are going to run out?

Bill Weissman

We had 55 million of NOLs at at the beginning of this year, and so we will use obviously a good piece of them this year and use the rest of them probably the first half of next year. And then we're still working on our transfer pricing with Malaysia. We have a 10-year tax holiday. Current expectations are, the tax rate would be around 30%, but we have some more work to do and we will give you better guidance on that probably next quarter.

Operator

Your next question comes from the line of Stephen Chin of UBS.

Stephen Chin - UBS

A follow-up question on the sapphire pricing. Can you share any color on how the pricing trends are looking into the first half of next year, Raja? And there has been a lot of concern of when the industry can get back to sapphire supply/demand balance. Any color you could provide there would be great.

Raja Parvez

As you know that this industry continues to grow, and different applications of that continue to grow. And obviously it is very hard to predict the pricing for next year, but I believe based on the projected growth of the different applications, i.e. general illumination, automotive and backlighting for many different applications from small to large displays, and especially is the ability of the sapphire producer to grow larger volume, I believe still there are few sapphire producers who produce a decent volume, we being the largest and we'll continue to increase on this one. I believe that entire 2011 will be strong for the LED industry based on the applications, and I am quite comfortable that the pricing environment will be stable as well.

Stephen Chin - UBS

And a follow up question on the 6-inch customer sales. How many 6-inch LED customers you think you'll have in the fourth quarter? Can it be more than one? And are you seeing any competitor selling other 6-inch products?

Raja Parvez

We have quite a few already. We have much more than one. All of them except one are in R&D at various stages, and a couple of them are getting quite close to production. We are hopeful that we'll have one or two customers moving to production on 6-inch next year, hopefully even early next year.

No, notably no other competitor has the kind of capability we do, but yet there are small number of wafers that are being produced by some. And I believe that they are also addressing that market. But I have not seen anything which is very notable. We continue to be the most preferred vendor for 6-inch because of our ability and capability and our quality in terms of sapphire, and our integration capability that we possess.

Stephen Chin - UBS

My last question is just about the volume ramp of the new capacity. As far as the guidance in this fourth quarter implies, volumes are up about 15% sequentially in this fourth quarter, so can we assume a steady 15% sequential volume increase every quarter through fourth quarter of next year to get you the full ramp, is that kind of the right way to think of the ramp?

Bill Weissman

Well, we said all along that the ramp would be fairly linear throughout the end of next year. Crystal growth is a bit of a step function in the beginning because we've been obviously building out the furnaces and got a little headstart on that. But it will be fairly linear between now and the end of next year.

Operator

Your next question comes from the line of Anil Doradla of William Blair.

Anil Doradla - William Blair

Can you talk about your revenue exposure from this TV market? How much of your revenues are derived from that particular end-market?

Bill Weissman

Well, it's difficult to know. As you know, we sell our 2-inch to 4-inch core to polishers in Asia and slice of polish in Celadon. In general, our sales are reflective of the overall split LED applications out there. Difficult to know for sure, but we know certain markets are more heavily focused on TV backlighting and we've seen softness in those markets.

But as Raja said in his comments, very strong demand elsewhere and no issue with overall demand in the quarter, and don't expect any in the fourth quarter also. In the first quarter, I think we expect to see the backlighting market pick up again, plus we have all the new MOCVD reactors being installed currently in Taiwan and China and expect very strong demand going into next year as well.

Anil Doradla - William Blair

So the inventory weakness on the TV side may be a couple of quarters, is that what you're saying? And so, as that comes back, that's an incremental demand on top of the demand environment?

Bill Weissman

Correct.

Anil Doradla - William Blair

Can you comment about the linearity during the quarter? How did it look?

Bill Weissman

Can you ask it in another way? I didn't quite understand the question.

Anil Doradla - William Blair

I mean in terms of your demand, was it consistent especially with the weakness on the TV side, did you see the month of September from an order flow any weaker than August? The three months, can you talk about how the demand trends were?

Raja Parvez

No, it's very consistent and very strong demand in Q4.

Operator

Your next question comes from the line of Avinash Kant of D. A. Davidson & Co.

Avinash Kant - D. A. Davidson & Co.

A few questions. On the wafer pricing front when you talk about like 30% sequential improvement in the third quarter and then another 15% in Q4. You qualitatively mentioned that it looks like 2-inch wafer pricing was up more than the other size of wafers. How do you think about that going into Q4? Is it that the 2-inch is going to be again higher than the other two?

Bill Weissman

Well I think 2-inch will be stronger in Q4 as well, and then Q1 will probably see changed to that as a backlighting market picks up again. Again, as we said earlier, there is some of the large 4-inch users are focused more TV backlighting and that should start to pick up at some point in Q1.

Avinash Kant - D. A. Davidson & Co.

So when you say, Bill that 15% increase in pricing in Q4, how should we think of that maybe like for 2-inch and 4-inch and 3-inch?

Bill Weissman

We talked about those increases that's across the board for us. And you have to keep in mind that our 6-inch pricing we keep constant intentionally to faster adoption of 6-inch. So the overall increase may be a little less than what you might be hearing in the market for that reason. But in the fourth quarter, pricing 2, 3, 4-inch should be roughly comparable on one product or the other.

Avinash Kant - D. A. Davidson & Co.

In the fourth quarter it should become comparable, assuming that 6-inch stays flat, right?

Bill Weissman

Right.

Avinash Kant - D. A. Davidson & Co.

And could you talk a little bit about your CapEx plan. What's your latest assumption for CapEx in '010 and '011?

Bill Weissman

Well, these two facilities we said will cost about $65 million, and we'll spend the rest of that obviously in the next year, the bulk of it in the first half of next year. And then we really need to start planning our next phase of expansion in the second half. So I think at a high level CapEx, we should expect to be similar to this year.

Avinash Kant - D. A. Davidson & Co.

And this year, you have said it was close to $50 million?

Bill Weissman

About 45.

Avinash Kant - D. A. Davidson & Co.

$45 million, and it should be similar in '011 also, right?

Bill Weissman

Right.

Avinash Kant - D. A. Davidson & Co.

And you commented a little about pricing, so when you negotiate your 6-inch contracts, how do you negotiate pricing? Is it variable, is it fixed or is it based on some economic data points going forward?

Bill Weissman

It's fixed.

Avinash Kant - D. A. Davidson & Co.

And I know at some point, a few quarters ago during the downturn you were not willing to negotiate long-term contracts with customers. Are you kind of willing to do that or maybe especially on 6-inch? And should we expect more of those contracts coming forward?

Bill Weissman

The reason why we signed this first 6-inch contract was more at the request of the customer, because they wanted some comfort that they'd have availability of sapphire before they'd move to production on 6-inch. And we're assuming the next one or two to get into the 6-inch market and production levels who want to do the same. So we'll be happy to entertain that.

We really avoided longer-term contracts with the smaller diameter material. Firstly, the price has been increasing. And secondly, the reality is that turns of business for those products and the way to keep that business is to provide consistent quality at a good market price. And that's what we're doing.

Raja Parvez

And also remember that we are the market leader in this large diameter, especially 6-inch and 8-inch. And because of that capacity, this customer requested and we honor that. But of course we continue to work on these kinds of activities with various customers.

Avinash Kant - D. A. Davidson & Co.

Maybe in 2011, as we have this polishing capability now, how do you see the mix of your wafer sales between the polished wafers, unpolished wafers and cores? How should we think of it going forward?

Bill Weissman

Well, it's our intention to only polish for 4-inch through 8-inch, with really the emphasis on 6-inch and 8-inch. We'll polish 4-inch to the extent that if there wasn't enough demand for the other two larger substrate to keep our polishing facility in Malaysia busy, we don't see that being the case by the way. We think it'll be 4-inch or 6-inch. The 2-inch to 4-inch materials would continue to be sold in core forms to the polishing partners in Asia.

Avinash Kant - D. A. Davidson & Co.

So basically we can think of anything 6-inch and 8-inch is polished and anything below that pretty much is not polished?

Bill Weissman

Correct.

Operator

Your next question comes from the line of Yair Reiner of Oppenheimer & Co.

Yair Reiner - Oppenheimer & Co.

Can you speak to your geographical mix and speak about a bit perhaps of how the shift from 4-inch to 2-inch also impacted what markets you're selling into? And if you can give us any details on Asia, that would be very helpful.

Bill Weissman

Asia represented close to 94% of revenue in the quarter. The rest was obviously between North America and Europe. Within Asia, round numbers about 15% in Japan, 43% in Taiwan and 37% in Korea. That's kind of how it broke out. To give you similar numbers for the prior quarter, it will be about 8% Japan, 38% each in Taiwan and Korea.

Yair Reiner - Oppenheimer & Co.

And there has been a lot of talk obviously about competitors, new and old, ramping capacity in this market. From where you sit, how convinced are you of this capacity? And as you analyze your competitors, how much do you expect total capacity in the market to increase over the next 12 months?

Raja Parvez

There are many rumors regarding competitors increasing capacity. There are a handful of sapphire producers, we being the largest, who have a volume capability. There are many companies working on small volumes, but I have not seen any evidence where I can see that there is any large volume producers are coming online.

There's lot of chatter. There are lots of rumors, because it is a very attractive market and people try to enter. But remember the complex nature and the degree of difficulty to produce a crystal gold sapphire is pretty significant. Producing a high volume is very, very difficult beyond that. And maintaining, especially the hygiene, so that we stay competitive becomes more challenging.

That is why Rubicon Technology has the largest market share in the 6-inch product, because we have the ability to not only produce the large diameter and best quality, but very large volume as well. So even though you will see that newcomers are maybe existing, while adding capacity, but our differentiation continues to be the larger diameter which further protects us because that is much harder.

And also not only crystal growth, polishing the 6-inch and 8-inch wafers is also challenging because of the hardness of the material and the tight tolerance it requires by the chip manufacturers. That is why I mentioned that our combined capability both in crystal growth and polishing of the large sapphires is truly unmatched. You will see more people coming in, but I have not seen any major evidence yet.

Yair Reiner - Oppenheimer & Co.

At this point, have you locked in pricing for the first quarter with any of your customers? And if not, as you negotiate prices right now, do you expect prices in the first quarter to be flat, up, down? What's your initial read right now?

Bill Weissman

Sales force will be actually meeting with customers in about a week or two. Preliminary indications are that they certainly would not be down and probably be up a little bit.

Operator

Your next question comes from the line of Ahmar Zaman of Piper Jaffray.

Ahmar Zaman - Piper Jaffray

What would you say is your share in the 6-inch and greater substrate size?

Bill Weissman

We'd estimate it to be about 80%.

Ahmar Zaman - Piper Jaffray

Raja, you mentioned that pricing should remain fairly stable through next year. If we were to look at it in terms of first half versus second half, do you have better visibility in the first half? And if so, what do you think about pricing in the first half versus the second half?

Raja Parvez

Well, as I mentioned, it is a function of many factors. It is the penetration rate of new applications. It also depends on the growth rate of general illumination. But based on the projected growth rate and me talking to the customers, I believe that demand will continue to be strong, and you will see some changes between one segment versus the other segment. But remember, our technology is product non-specific. So we can divert our products of different sizes to any application which is more in demand.

So because of that, I believe that the pricing at least in the first half of 2011 will remain healthy. It is very difficult to predict at this point for the second half of 2011. But I can say, based on what I see today, that 2011 will be a good growth year for us and for the industry and a healthy year.

Bill Weissman

For the next year, the 6-inch contracts we have, the $71 million, a vast majority of that is for 2011. And as the volumes ramp every quarter, the significant piece of that is in the second half of next year. So we have good visibility on revenue in the second half of next year at very good margins already.

Ahmar Zaman - Piper Jaffray

Some Taiwanese chip manufacturers are talking about the cost of materials increasing and compressing gross margins. Are you concerned about that, and do you think that you would begin to get pushed back from downstream chip manufacturers on your pricing?

Raja Parvez

As you know, it is customarily that customers always push back on the pricing, but I am not concerned because of our ability to produce large diameter where we have more visibility, more control because we are the only one who can provide the high-volume capability. But we'll work with our customers and I am not concerned of that.

Ahmar Zaman - Piper Jaffray

There are some LED companies who have begun to commercially produce LEDs on silicon. Are you seeing that? What are you seeing in terms of competition from non-sapphire substrates?

Raja Parvez

So far, based on the data that I have seen from the entire industry, which is Europe, North America, Asia, I have not seen any evidence where there is any material which can come close to sapphire.

Operator

(Operator Instructions) Your next question comes from the line of Daniel Amir of LCM.

Unidentified Analyst

This is (inaudible) for Daniel. I was just wondering if you guys could give us an idea of what your long-term growth margin profile might look like? I know it's probably hard because you've been capacity-constrained for the last few quarters here, and it seems like gross margins are at the will of average prices. So wondering if you could give us an idea.

Bill Weissman

Well, it is difficult to say. Before the recession and before we really had confidence in things building to larger diameter, our targets of that time were high 30s gross margin, low 20s operating margin. We're certainly very comfortable with that longer term. And obviously, now they are much higher than that. I can't imagine they'd be anywhere lower than our old targets and should be higher than that.

Unidentified Analyst

And then with the ramping of capacity, are there any milestones that we can look for, say, when you'll meet 25% of the overall capacity, or will there be startup costs or anything of that nature that we should know about?

Bill Weissman

If you take what we said we would be adding by the end of next year and draw that linearly, that gives you where our targets are for capacity add.

Unidentified Analyst

Startup costs or anything else that we should know about?

Bill Weissman

We're actually incurring most of those now. So that would have actually a lesser impact going forward. It probably had a couple of percentage point impact on us in the third quarter, and we'll probably have about the same in the fourth quarter and then improve from there.

Unidentified Analyst

How should we model your R&D going forward? It looks like it came a down a little bit. Is this going to hop around like that through the next six to eight quarters?

Bill Weissman

Well, the SG&A was the same in Q3 as it was in Q2. So our expectation for operating expenses is that it will stay roughly in that range.

Unidentified Analyst

Of the 2,400.

Bill Weissman

For G&A alone, yes.

Operator

Your next question comes from the line of the Andrew Abrams of Avian Securities.

Andrew Abrams - Avian Securities

Is the bulk of the new capacity that you're bringing on, 85-kilograms, are you doing anything larger than that or is this all going to be 85?

Raja Parvez

Well, majority of the capacity that we have within our next generation new crystal growth facility in Batavia is the 85-kilogram, but we have some 200-kilogram also.

Andrew Abrams - Avian Securities

I know you're capacity-constrained now, so this is kind of a move point at this point. But would you expect to expand your customer base as we start to get into first quarter and second quarter of next year when things loosen up a little bit for you in terms of capacity? And in keeping with that, is this sort of the 80-20 rule you're still going to be doing 80% of your business with the top couple of guys that you have been working with, or do you expect this kind of spread out as you get through second or third quarter.

Bill Weissman

Well, our customer profile is changing, because the entry and expansion into the large diameter wafer business, we're selling those directly to the chip guys as opposed to really all of our revenue used to be with the polishers in Asia. So going forward, our revenue is going to be diversified across a broader customer base, and that will continue throughout next year.

Raja Parvez

Even with our current very well defined capacity both in crystal growth and polishing, we still continue to gain more market share and new customers, because we are planning to add and we are currently adding more capacity. So we continue to diversify our customer base in all different countries, and we are making a very good progress on that. And I believe that as we add more capacity, we'll be able to provide more volume to those customers and we will continue to focus on those activities.

Andrew Abrams - Avian Securities

Also, are there any other large scale 6-inch polishers that can handle 6-inch or 8-inch polishing besides you guys to a large degree? I know other guys can do it, but in high volume.

Raja Parvez

There are few companies who have the capability to do some of it. But I have not seen any company which has an integrated solution that produce large volume high quality crystals and polish them. But there are few companies, especially in Japan who have the capability. But majority of these companies are private companies, very difficult to know or they are embedded in large corporations and their LED divisions are much, much smaller.

Andrew Abrams - Avian Securities

Just last on OpEx, as we go into 2011, I mean, Bill you said it was probably going to be relatively flat in fourth quarter. What kind of increase would you expect now that you've got the additional capacity coming on in 2011 on a kind of general basis?

Bill Weissman

We're not giving guidance on next year yet, but I wouldn't anticipate it growing much more than 20% next year.

Operator

Your next question comes from the line of Bill Ong of Merriman Capital.

Bill Ong - Merriman Capital

Now, with the addition of two new manufacturing sites how would the gross margins will play out next year, as these facilities start to ramp up in production?

Bill Weissman

Well, as I said it earlier that they really took kind of the hit on the margins already in Q3 and Q4, couple of percentage points by having the facilities open, but not really being fully utilized. So that should only improve next year. So as far as the new facilities go there should not be any drain on the gross margin for the next year. Next year's margins will give you a better sense on that when we guidance on next year.

But as Raja said, in pricing we expect to remain strong. Product mix should even strengthen further. So it should be a very solid year, next year in terms of gross margin.

Raja Parvez

The facility in Malaysia, as you know is the post crystal growth facility. Main focus will be slicing and polishing large diameter wafers anywhere from 4, 6, and 8-inch. Our current expectation is that majority and the effect will be failed with the 6-inch. And we build that facility over there, because of the cost competitiveness.

And also be closer to the customer in the sort of same time zone, which is also providing us an additional capability to reach out to customers in the same time zone as well. And coupled with all that we believe that it will be very competitive environment for us in terms of moving forward cost-to-cost and as will be our operational capability.

Bill Ong - Merriman Capital

And then my last question is, just given the current sapphire tightness, can you qualitatively maybe describe how much of a pricing increase can a market absorb before there's a pushback from customers? At what point would high substrate prices start to hurt demand?

Bill Weissman

Well, it's difficult to say. I mean it's been pushed back up for long in the process of increasing prices. And sapphire has traditionally been a small percentage of the build material. Obviously a bigger percentage now with these increases, but it's really impossible for us to say at what point how much is too much.

Raja Parvez

And I also remember, as Bill mentioned, we have a very diverse customer base not only by the geographies, but also their applications. We sell mainly 2-inch to 4-inch core products to traditionally polishing customers in all countries and whereas 6-inches plus polished wafers to LED chip manufacturers and also electronics companies which have internal LED chip capabilities.

And when you look at the chip bill of material, it is still relatively smaller portion is sapphire, but when you look at the bill of material of a fixture or on a end application, then it becomes even smaller.

Operator

Your next question is a follow-up question from the line of Chris Blansett of JP Morgan.

Chris Blansett - JP Morgan

I wanted to ask you about the technical progress some of your customers are making towards qualifying 6-inch. This is kind of a different question from maybe their financial decision to do for before they go to six. How do you judge this? Obviously, if one customer who signed a contract for these large wafers, how do you view may be the second, third and fourth LED makers to come online and where they stand in qualifying 6-inch internally?

Raja Parvez

First, as I mentioned earlier, those companies which are either major electronics or well known LED chip companies which are technologically savvy and also have a capital to support it are moving towards 6-inch. We are working with a number of customers at various stages from early valuation to R&D to prototype to large volume.

And I believe because this 6-inch capability does provide them the cost advantage and also in many cases, performance advantage and ease of manufacturing and all the attributes associated with that. And so far, I believe that many of those companies who have those capabilities are focusing on the larger diameter.

And especially, some companies have a major decision to move from 2-inch to 6-inch without going to 4-inch, of course those companies which had a product development of already 4-inch, they plan to move 4-inch to 6-inch. So it's a mixture of it. But we feel very strongly that there are a number of major companies who we are working with and we are in various stages of qualification process. And we feel strongly that this trend will continue because of the advantages of what the large diameter provides to the electronics or the chip companies.

Chris Blansett - JP Morgan

And just kind of if you had to take a guess today about how many leading LED makers would be in some sort of volume production in 6-inch by the end of next year, what would you come up with?

Raja Parvez

I will believe that in addition to our current customers, I believe at least two other customers will be in a volume product.

Operator

Your next question is a follow up question from the line of Yair Reiner of Oppenheimer & Co.

Yair Reiner - Oppenheimer & Co.

Yes. Just a quick question on the OpEx. If I read your guidance right, you are assuming that OpEx goes up by close to $1 million next quarter. Is that right? And what's the figure going forward in 2011?

Bill Weissman

No that's not what we are expecting now. And as I mentioned previously, we haven't given guidance on next year yet, but wouldn't expect it go 20% more than what we've been currently running, which is around $3 million a quarter.

Yair Reiner - Oppenheimer & Co.

The $3 million is still ballpark figure for the fourth quarter?

Bill Weissman

It will be a little higher than that, but not dramatically higher.

Operator

Your next question comes from the line of Andrew Huang of Sterne Agee.

Andrew Huang - Sterne Agee

I missed when you gave the sales breakdown by geography. Could you please repeat that?

Bill Weissman

Sure. For the third quarter of this year, 94% was within Asia; rough numbers 14% Japan, 43% Taiwan, 37% Korea.

Andrew Huang - Sterne Agee

So the question I have is, I am sure you are aware that (inaudible) are shipping all these tools to China. People are taking about 200 tools this year. Can you help us understand where China is getting their Sapphire from?

Bill Weissman

They typically get it from polishers in Taiwan.

Raja Parvez

And quite a significant number of our wafers go to China, and we have recently entered also China market directly because before there were not many polishing companies in China. As you know, majority of the China market is still very weak in terms of the technology, and especially are focusing only on 2-inch. But we have recently entered China directly, but we have been providing 2-inch material via Taiwan for many, many years. So quite a significant number of our products goes to China.

Andrew Huang - Sterne Agee

So when you said that 43% of your sales goes to Taiwan, there could be polishers there who in turn sell polished wafers to China?

Bill Weissman

That's right.

Andrew Huang - Sterne Agee

Okay. And then going back to 6-inch for one second, do you expect pricing for 6-inch to increase or decrease throughout 2011?

Bill Weissman

Difficult to say. It'll probably be stable through 2011. It will probably come down eventually, but our cost is going to come down considerably with the Malaysia operation once we get the yields up. But don't see any significant change in it through next year at this point.

Andrew Huang - Sterne Agee

This might be a sensitive question, but I've been hearing price is somewhere in the range of $450 to $500 for a 6-inch polished wafer. Is that kind of the ballpark that we should be thinking about?

Bill Weissman

We don't give out product prices.

Andrew Huang - Sterne Agee

Okay. Thank you.

Bill Weissman

I believe we are out of time. So thank you all for joining us today. We appreciate your interest in Rubicon and we look forward to talking to you all soon.

Raja Parvez

And thank you and good evening.

Operator

Thank you for your participation in today's conference. This concludes the presentation and you may now disconnect.

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