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Rubicon Technology, Inc. (NASDAQ:RBCN)

Canaccord Genuity 32nd Annual Growth Conference Call

August 14, 2012 4:00 pm ET

Executives

William F. Weissman – Chief Financial Officer, Treasurer and Secretary

Analysts

Jonathan E. Dorsheimer – Canaccord Genuity

Jonathan E. Dorsheimer – Canaccord Genuity

Okay. Well, I’d like to thank everybody for coming. My name is Jed Dorsheimer. I’m one of the Senior Analysts at Canaccord running the Display and Lighting sectors globally for our firm.

And well for those who saw me at lunch, give a presentation on LEDs and solid-state lighting, one of the key ingredients in manufacturing an LED, which is the basic component for any solid-state light is sapphire technology.

Basically it’s the substrates that’s used in 90% of the growth of LEDs and there is a few incumbent companies that sell into that market and we’re lucky enough to have one of them Rubicon Technology here to tell us more about how they are doing. It’s interesting I actually go back about 11 years when I first did diligence on this company. And so it’s been nice to see them grow and come into the public market.

To just to do a couple of housekeeping items, one, we will have our breakout with all the Q&A across the hall in the – in the London room; and two, I’d point you to our conference materials for important disclosure.

I’d like to introduce Dee Johnson in the back, Head of IR for Rubicon, and Bill too, CFO of Rubicon to tell us more about their story and how they are going with the LED and also more recently the Silicon-on-Sapphire.

So with that, I’ll turn it over to Bill Weissman. Thanks.

William F. Weissman

Thanks, Jed. Good afternoon, everyone. So Rubicon is the world’s leading provider of sapphire products as Jed mentioned. One of the main applications for Sapphire is in the LED market. It uses the substrates of choice in the LED market. But there are also a couple of other key markets we served, the SoS market and the optical market. And I’ll talk more about each one of those.

We are one of the really only fully vertically-integrated sapphire producers in the marketplace, meaning we produced very high grade large-diameter sapphire products from the very base materials of aluminum oxide powder and I’ll explain that a little bit more as well.

Our real strength is in our ability to produce these materials in very large diameters with very tight tolerances, which has enabled several leading industries, the SoS market is one application, which I’ll talk about, which is growing rapidly right now and which has really start out at large-diameter wafers and we’re also helping the LED market progress to larger and larger diameter wafers, which is helping that market kind of lower cost and address the strong demand.

The LED market is the biggest market by far. It is historically been got 80% of our revenue stream, we’re a little less from that right now, but clearly the biggest user of sapphire. The SoS market, which I’ll talk about more, is really the fastest growing segment, we started serving right now and the optical market is our third major market.

Within the LED market, I think everybody is familiar with the main applications, historically, it’s been mostly display, backlighting, signage and that’s been driving the growth for the past couple of years. Of course the Holy Grail in industry is general lighting.

As we’re starting to see some penetration in general lighting is mostly in commercial and industrial settings, street lighting and so on, but we haven’t quite reach the inflection point in general lighting, but Jed and many other analysts had to follow the space thing, that is not too far in a distant future. And automotive is the third sub-segment within the LED market. You are starting to see more and more cars, different models of cars with LED lighting both interior and exterior lighting.

I mentioned the large diameters, the importance of large diameter; in the LED market, we’re starting to see the same path of progression that we saw in the semiconductor world, which has started out with small diameter substrates and for economies of scale grew to larger and larger substrates. In the LED market, it started out with two inches, three and four inch substrates are prevailing right now and we’re starting to see some migration to six inch. This is important as we’ll talk about this little further. Rubicon is the market leader in large diameter sapphire. We have about 70% market share in six inch wafers today both in the SoS and LED market.

In the SoS space, for those of you who are not familiar with it, the antenna switch within your smartphone, which controls the send and receive signal historically has been made with gallium arsenide based chips. Our customer came up with the SoS technology, which provides for one single monolithically grown chip that replaces those multiple gallium arsenide chips resulting in smaller form factor, less power usage, because sapphire is such a good insulator eliminates, virtually eliminates the crosstalk associated with some cell phones.

For that reason, our customer is rapidly gaining market share and has been engineering into all of the major smartphones, the Apple and the Samsung and even in the iPad. And we have seen significant growth. Our revenue from this sub-segment has doubled sequentially over the past two quarters going from $2 million at the end of last year to $4 million to $7 million in the last quarter and we expect it to continue to grow throughout this year and into next year.

The third market is the optical market. Unlike the other two markets, sapphire is used in this market for its physical properties. Sapphire is the second highest material in nature behind the diamond. It’s virtually scratchproof has great optical qualities. So it’s used for windows and lenses in harsh environments whether it’s military or medical or mining. And last week we announced, we just received a $4.7 million grant from the Aeroforce to develop a brand new crystal growth technology.

Sapphire has been produced typically with a few different technologies, none of which can produce very large rectangular windows that are very thick, which is what the military is looking for. We’ve developed our capability to do that. The government is now funding us to take that technology and expand it to larger and larger sizes.

I’ve mentioned our vertical integration. This is a key part of our strategy. There are various players in the sapphire market, some just take the sapphire, but others produce and polish it, some just grow the sapphire, some produce the raw materials. Rubicon really is a fully vertically integrated manufacturer of sapphire.

Recently, we’ve developed our own ability to take powdered aluminum oxide and convert that into the form of crystal and most people are using crystal growth. Nobody else has developed this type of process. It gives us the ability to control the cost. Its going to reduce our raw material cost by about 20%, which is significant considering that 13% of our cost of goods sold is in raw materials and allows us to control the quality better. And that’s been our key strategy is control each step of the manufacturing process, so you can control both quality and cost.

So we create our own raw material. We’ve build our own crystal growth furnaces, that’s our core IP. Nobody else has the furnaces that we use or the process that we follow. And then we fabricate that into cores and wafers. We’ve recently ordered patents for the fabrication process, where we can take our orientation equipment and take it to the machine that’s fabricating the crystal and oriented on-site in-situ to save money and reduce cost, and then slicing and polishing in metrology. So we control the whole process right off the door from raw material to finished product.

We talked about each one of these things already. So, the next step in our vertical integration strategy is to go further downstream. We’ve gone further as far upstream as we can possibly go, we’re as far as you can go up to the mine basically with the powered aluminum oxide. The next step downstream after the polished wafer is to take a polished wafer and etch a pattern into it for the LED market. Most LED chip manufacturers take a substrate and they etch a pattern into it. What the pattern does, it changes how the light is refracted through the sapphire to extract more light, it also facilities the epitaxial growth.

So today many of the sapphire providers provide small diameter pattern substrates or PSS. Nobody in the marketplace today has the ability to do – no third-party has the ability to deliver six-inch pattern substrates, and that’s what we’re developing right now and that’s what we plan to introduce into marketplace in the middle of next year. That gets you closer to the customer. Each of the customers have their own pattern as part of their IP and by then outsourcing that CU it gets you closer to their technology team. It allows us to capture more revenue per square millimeter of sapphire and increase our margins as well.

Our business model really is kind of twofold. Now, we realize we’re a materials company, and as a materials company certain part of our revenue stream is going to come from products that are commoditized. We realize that. Today it’s two inches and three inches and sort of three and four inches. We need to make sure that we have the industry leading cost structure in order to make good margins on that commodity product.

The other part of our revenue stream is going to come from more differentiated products, like today its 6 inch wafers. We already have 8 inch production capability. We’re getting into patterned sapphire, and we may get into 10+ B on that. So that’s the key to make sure we’re blending out of the strong gross margin by delivering good margins on your commodity products and even stronger margins on your differentiated products. The reason why Rubicon is able to maintain a industry leading cost structure, some of those are highlighted here.

As I mentioned, we produce our own raw materials. Our raw material costs are lower than anybody else in the industry. We make our own crystal growth furnaces, we built them ourselves. Cost to produce one of our furnaces is half what somebody would pay to buy a commercial furnace. With a very highly automated process, over the past 10 years we’ve refined the process, we only have five operators for 100 furnaces. So the labor content in crystal growth is very low. We keep our crystal growth operations in the U.S. because the labor content is low, we need to protect the IP and we need very stable power.

Our power costs are actually very low and compared with anywhere else in the world we pay $0.035 per kilowatt hour for our power and it’s very stable. If you get fluctuations in power, if you’ve got (inaudible) power outage, you’d loose two weeks worth of work out of minimum.

And therefore the more labor intensive process is, once the crystal is produced, then it becomes a lot more labor intensive to turn that into cores and wafers. We’ve now built our own facility in Malaysia and move those processes to Malaysia, so we have an Asian based cost structure for the back end of the production process.

Our two new facilities are illustrated here, on the left is our newest crystal growth facility. On the right is our newest polishing operation in Malaysia, also these two facilities are now fully equipped. And not fully utilized at the moment, because of the down cycle in the LED market. But our capital expenditures for expansion should be very low for the next year or so, because we’re now in a position to meet increasing volumes without having to make any additional investments for the next 12 months or so.

This slide, sort of illustrate kind of the importance of both the industry mix and large diameter mix. As you can see in the first half of this year, the SoS segment has grown dramatically from $5 million all of last year to $12 million in the first half of this year. And that just illustrates my comments earlier around how our customers technology is really gaining market share.

The six-inch LED business was slow in the first half of this year mainly because of an inventory adjustment period. Our largest customer on that segment has now rent off their industry. We have inventory, we have a new contract with them and the volumes for six-inch LED will pick up significantly in the second half of the year.

The graphic on the bottom again, we have about 20% overall market share we believe in sapphire in general, but in large diameter, this case six-inch we have 70% market share. And that includes dominant position both in the LED and the SoS side.

It’s been a very vital period of time. If you look at what’s happened in the LED space in particular over the past year, year and a half. 2011 was a very difficult time for the LED market, the chip manufacturers had a tough year for the whole year. As you can see we had a very strong first half of the year. The reason for that is even though the chip manufacturers and the polishers lost visibility on their revenue, early in the year they continue to buy sapphire.

The reason why they did that? Just because there was a severe shortage of sapphire for the past year, which is why gross margins grew to 65% in the middle of last year. So we do that until about half way through the year, then we had too much sapphires, still have limited visibility, so the purchasing stops and pricing drops from on a 2-inch basis it’s about $25 a millimeter to less than $4 in about two or three-month period of time.

So now we kind of going through this inventory adjustment period, there are still excess inventory, no longer at the chip or the polishers, but there is still excess inventory at the sapphire producers themselves like Rubicon and our peers. Things are improving and once the inventory level at the sapphire producers get down, we’ll start to see some pricing recover because pricing doesn’t go from $25 to less than four in a two month period of time because of the change in the competitive landscape or the applications that really was at the inventory levels throughout the supply chain got out and whack and you can see we’re starting to experience that recovery in the second quarter.

So to summarize, Rubicon is serving some very high growth markets, LED, SoS and optical. We have a very strong position based on our IP, not only in the crystal growth area but pre and post crystal growth. We’ve been in business for 10 years or 11 years and we have very, very strong relationships in both the LED and the SoS industry, and the optical industries. And we’re starting to see a recovery on the LED side, very good visibility on the large diameter, in the LED side in the second half of this year. And then we’re really starting to take advantage of the growth that our customer is experiencing on the SoS side of things.

So, things are picking up. We’re expecting significant improvement in margins throughout the course of next year and in the mean time, we have a very strong cash position. We had $52 million of cash at the end of last quarter with no debt and looking forward to a very strong 2013. Thank you.

Question-and-Answer Session

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

Probably those areas that we can probably handle one of the breakout.

William F. Weissman

Okay. Terrific.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

So maybe to start, what’s giving you the confidence in terms of our best, adding to this visibility particularly in LED where things seem to be a bit mixed four months, industry perspective into the back half of this year?

William F. Weissman

Yeah. I wouldn’t say things are strong in the LED market yet, but I think they have improved significantly. So in the first quarter, it’s clearly the bottom. Second quarter, we actually saw record volumes in terms of material, the volume of material, but the pricing particularly for the smaller diameters were still very, very weak.

We now have pretty good visibility. I’d say very good visibility in the second half of the year for the large diameter wafers. So our strategy is, the six inch – the smaller diameter pricing is so bad right now, nobody is making money on it. We have a very strong balance sheet. There is no point in trying to force additional small diameter material into the market place. We’re focused on large diameter in the third quarter, perhaps the fourth quarter.

So our mix will be very highly oriented towards the six inch. And then we will see how the market develops, but we’re seeing increased demand. Utilization rates among the chip manufacturers have increased quite a bit. They’re still not great. They’re about 80% in Taiwan, but probably still around 60% elsewhere, but they are improving. We have our ways to go before we get back to the levels of demand that we saw in 2010, but things are gradually improving.

So we don’t need the key for Rubicon as our cost structure is so low. We don’t need dramatic price increases on the smaller diameter to make good margins. It’s just $1, $1.50 would turn us very profitable in that segment of the market. So pricing will not get to $25 again, but even as they got this $7 or $8 can we be making extremely strong margins on that product. And that’s a commodity product. And then on $0.06, we continue to lower our cost and the margins will strengthen there as well.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

So around what $5 right now is using five to seven in terms of that?

William F. Weissman

Well, for core, we start in core form. For small diameters, we sell it in polishers – excuse me that polishes and sell it off to the chip manufacturers. For six-inch, we sell exclusively wafers. In core form, it’s still below $4. It’s the wafer sales are probably around $8 right now. It cost our polishing partners about $3 to polish it and they get a small margin on top of that, but you know if it went up $1 or $2 we’d be making decent margins.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

So as you talk about our focus on large area, did you core boom your natural byproducts in two-inch and four-inch.

William F. Weissman

Right.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

We shouldn’t expect that you will be selling in that market prices, so we shouldn’t expect to see inventory grow or will you hold back an inventory is, in order to address the six-inch (inaudible) just trying to get a format?

William F. Weissman

Again, we don’t anticipate selling much of the smaller diameter this quarter. So there will be an increase inventory of small diameter core. Now we cleared a lot of that inventory out in the second quarter. Most of our inventory build over the past several quarters has been in raw material. We’ve made the strategic decision to make sure we’re building up at least one-year supply of raw material both in terms of the powder, the powder that we’re now using and the crackle that we used to use. But again, I think we’re in a strong position with our balance sheet to be able to carry a little bit of inventory until pricing environment improves in the small diameter.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

Would it be more beneficial from a margin perspective to sell the product providing its over cash costs versus the (inaudible)?

William F. Weissman

No, not necessary, that is over cash cost. Again, we think pricing will improve, so we’ll carry it for a quarter or two and see if it does. Worst cases and then we sell a lot of cash cost.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

Yeah, is that typically the sound quarter for one, two quarters and we believe that price is increasing and…

William F. Weissman

Well, it depends on the environment. The first half of the year we didn’t have much six inch volumes, especially on the LED side and so we decided to sell some of the core. But then in the second half of this year we have strong 6-inch order, so we’re deciding to hold on to so some of that.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

(inaudible)?

William F. Weissman

The sapphire is typically about 8% to 10% of the build material of the LED chip. So at an LED fixture level it’s a very, very small component. Yes, sir.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

(inaudible)?

William F. Weissman

Yes. We grow bulk crystal and then we core out and ingot out of it.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

(inaudible)?

William F. Weissman

Well, the base raw material is the same.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

Historically?

William F. Weissman

Yes. Historically, what we used and what virtually all the other sapphire producers use is the kind of the polycrystalline form of sapphire. So, somebody has taken the powdered aluminum oxide and put it through typically with BLUs, put it through to crystal growth technology called Burnoil to create what’s called crackle. And now we’ve bypassed that step and now we are using directly using the powder where we don’t actually load the powder into the furnaces, but we converted into that material our selves using a different process.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

(inaudible)?

William F. Weissman

No it’s single crystal for those things, yeah. So there is new technology instead of growing our traditional technology grows a big kind of bodes to around tall rank. The new technology is growing a very flat two-inch thick rectangle that we are trying to scale up to about three feet by two feet, which serves kind of the optical market is not going to serve the LED or the SOS market very well because you need kind of those longer cores to get some efficiencies out of it. Yes sir?

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

(inaudible)?

William F. Weissman

It will be and we acknowledge that. But again the focus is that can be, to make sure you maintain a technology lead, so today it’s six-inch that can been used premium margins, tomorrow it will be eight-inch. We already have volume eight-inch capability. Patterning, especially large diameter patterning, it’s going to be a differentiated new product, so that’s key. The industry eventually in the catch up with few things or get commoditized along the way. They keep investing and staying on the edge so that you have a good base of revenue that’s generating higher margins.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

(inaudible)?

William F. Weissman

Yes, it is. Why were they because the efficiency they gained on it as much as 50% efficiency from using a larger diameter substrate both in terms of how efficiently the MOCVD reactor is used and then the edge loss.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

Where are you in your PSS expansion?

William F. Weissman

We’re still in development. We’ve got some tools on order. The plan is still to introduce our product sometime middle of next year. Yes, sir?

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

Historically your numbers are accurate (inaudible)?

William F. Weissman

Well, I’m not sure what you maybe thinking of gain on silicon, gain on silicon some people theorize me display sapphire and the LED space. Silicon-on-sapphire, and I’ll address that in a minute.

Silicon-on-sapphire is where they take sapphire and put a layer of silicon on it. And then through seamless process to make a chip. There is no thermal coefficient of expansion issue with that. The problem with this alternative technology there are some people who are trying to come up with – to display sapphire from the LED spaces, where they take – the silicon as a substrates. And then they try to grow again on it. Now the thermal coefficients of expansion issues are significant there, because the silicon is expanding at a rapidly different pace in the gain layer, so they try to come up with some buffer layer to accommodate that.

There is lots of people that are working on that, some of the same success most of it – even most of client success say they’re several years away from production, because there is significant technical issues there, and at the end of the day. Who knows if there’s actually going to be any cheaper than a pure sapphire substrate. Yes, sir?

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

(inaudible)?

William F. Weissman

I’m sorry, could you say that.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

(inaudible)?

William F. Weissman

Yeah. Well actually – they were in public last week. So Peregrine Semiconductor in California is the owner of the IP and SoS.

Jonathan E. Dorsheimer – Canaccord Genuity, Inc.

Any other questions? Well, thank you very much and have a good day.

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