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Rubicon Technology, Inc. (NASDAQ:RBCN)

J.P. Morgan LED General Lighting Symposium Call

August 30, 2012 9:45 am ET

Executives

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

Unidentified Analyst

So the next session is Rubicon, we have CFO, Bill Weissman coming up. Bill, thanks for coming. We are taking a long here, so we can keep things moving, we are little behind than we started.

Bill, I wanted to talk about a couple of things that seem to be top of mind for most investors. First, in your last earnings call, you’ve indicated that the sapphire inventory levels at your customers, the polishers, and the LED wafer makers had kind of come back down to normal levels, but there were still some sapphire at the sapphire makers themselves. You would indicate that or you largely imagine thought this will come down for the rest of the year, and hopefully improve the pricing dynamics. So you were at good margin since your earnings call, so could you give us maybe an incremental update on where you think sapphire inventory levels have been, and what kind of evidence you’re seeing that they continues to come down.

William F. Weissman

Sure, you’re right. What we see in the marketplace is inventory levels have been normalized, everywhere except for the sapphire producers themselves. And we believe there is another core or two, lots of excess inventory in the system, there’s not a lot of great transparency in this market, but our data comes from our customers and our customers, customers who have relationships with our competitors.

And the volumes picked up significantly in Q2, in fact, we saw a record volume of material in the second quarter, which is evidence that demand has improved and therefore a lot of this excess inventory is being absorbed. We're making a conscious decision in the third quarter, not to sell a small diameter product to focus more on large diameter sales, which are quite strong right now. So we don't exasperate the problem, give our competitors an opportunity to reduce their inventory levels, and hopefully get the pricing up sooner that way. We have a very strong balance sheet, we did clear a lot of our small diameter inventory in the second quarter, so we are in a position to do that.

Unidentified Analyst

When you think about these inventory levels, is it simply bulls, is it cores, as you know are these partially process type of materials out there or how just kind of get a feel for where you think this inventory sits?

William F. Weissman

It’s a combination of bulls and cores, the bulk crystal, there’s really not much wafer inventory out there as far as we know.

Unidentified Analyst

Okay. You mentioned that it’s very interesting that you had a record, not a volume go out in Q2 yet, obviously your revenue levels are greatly suppressed, and your margins were heavily impacted. Have you compared this downturn for sapphire and LED wafers versus even what happened in '09 or prior downturn is it similar, is it worse, how should we think about that?

William F. Weissman

The whole LED industry is new obviously so every cycle has been a little bit different. What's happened in the sapphire part of the supply chain in this latest cycle is, and we saw a very rapid ramp in the LED market throughout 2010. And then early in 2011, the chip manufacturers and therefore our polishing customers that buy our smaller diameter ingots really started to lose visibility. But yet I continue to buy sapphire, because sapphire pricing can be used to this sense of what the pricing did and what the demand change in demand was, pricing for a two inch ingot, back in '09 was about $8 a millimeter. It's shot up to about $25 a millimeter in 2011, which is why we’re generating 65% gross margins.

So our customers continue to buy the sapphire despite having lost its ability, because they couldn't get enough of it for a period of time. Until about halfway through 2011 and they still had no visibility, they had too much sapphire, so they just stop buying completely and price went from $25 to under $4 virtually within two or three months, which is a clear sign of an inventory correction. It’s not a change in the end markets or the competitive landscape, it’s just that the whole supply chain that completely out of work. So this cycle is a little bit different than in the previous cycles, it's taken a long time for inventory levels to come down, they first have to come down at the chip level, and then at the wafer level, and now need to come down at the sapphire producers level.

Unidentified Analyst

On a volume basis, how you compare the volume of sapphire in 2012 versus maybe the last two years?

William F. Weissman

Well, I think where we're now, I think volumes are probably similar to where they were, and about 12 months to 18 months ago obviously there’s more capacity that's come online. Utilization rates at the MOCVD level are improving quite high in Taiwan, but still probably only about 60% elsewhere. So as those utilization rates improve, they will need more sapphire and we’ll see the market tightening the pricing.

Unidentified Analyst

Back in 2011, when sapphire pricing was very high there was obviously a – there was this run for competition, people said, these prices are going to make it or I’m going to make it for myself in order to hedge my costs. I guess, we’ve seen a very dramatic turn of events, it’s difficult to make money selling sapphire right now. Couple of things, how you deal this competition today versus may be 12 months ago, are you more or less concerned about it. I guess maybe just ask what you’ve seen evidence of increased competition, reduce competition from new players.

William F. Weissman

Yeah, there is obviously been a lot of buzzer about the competitive landscape changing for sapphire. With our 65% gross margins that did track a lot of attention. What we saw is competition coming or trying to come from two different perspectives. One is from our polishing partners that buy our small diameter ingots and slice them and sell them on to the chip companies. They wanted to vertically integrate to have some internal sapphire capability so their margins didn’t constantly get squeezed. That’s already getting mitigated. An example of that is, one of the major Taiwanese polishers has established a crystal growth operation in China, and at that time, they issued a press release that said that we are paying $25 a millimeter, we think we can make this stuff for $8 a millimeter. Well, the price is below $4 now and they said, well, even if it doubles it still makes no sense for us. They’ve already written-off that investment and shut down that operation. We’ve seen the same thing happened with one of the Korean polishers. So I think on the polisher side of things, the competition is already getting mitigated.

The other group is kind of a solar company. The guys in China and Korea that were in the business of making polysilicon for the solar industry, wanting to diversify into another material. Obviously sapphire was generating very strong margins, it was a logical choice. So they are trying to enter that by buying some merchant furnaces and what we’ve seen so far is very limited amount of material coming to the market from those sources. We know they have taken some deliveries in furnaces, but we are hearing the yields are low and really not seeing much material coming to the market from them yet. I think time will tell.

Just like in the MOCVD world, obviously China took a lot of delivery of MOCVD tools. It takes lot more than a tool to make product in the MOCVD world. It’s taking a long time for them to develop the process now as to be able to compete. The same thing is going to be true on the sapphire side. It took us many, many years to develop the process knowledge to get to where we are today in terms of high volume, high quality, low cost sapphire production.

Unidentified Analyst

How would you think about the adoption of 6-inch wafers today versus may be which you thought about 12 months ago, ramp in quality, price and also the competitive nature of that market?.

William F. Weissman

Yeah, clearly on the LED side, the movement to 6-inch is slow. It’s really a function of bit of a pause we’ve seen in the industry. We have one major LED chip manufacturer on the 6-inch platform today. We are providing the majority of their needs and we had hoped to see one or two more, but it’s been delayed. The reason is, as utilization rates have been operating 30%, 40%. They are much better now, but really and less utilization rates for MOCVD are high, they are really not going to consider to move. What’s going to happen is, when you are operating at 100% utilization, the chip manufacturer either have to expand their footprint or they have to find a way to get more efficiency out of their existing platform or here I guess most – particularly the Taiwanese do not want to do that. They want to limit their footprint expansion. So what does that mean? They need to convert their existing tools to get higher yield. One way to do that is to migrate to higher larger diameter wafer. So we think it was improved. You will see conversion of existing tools and you will also see expansion into new tools using large diameter capability.

Unidentified Analyst

Now, just one last question kind of on the cyclical nature of this and I wanted to ask about cost controls. Obviously you’ve had a fairly I’d say zero – your gross margin is virtually zero last couple of quarters just from the pricing dynamics. What kind of leverage do you have internally do bring your cost base down to maintain a certain level of profitability, I guess or improving profitability in these tough times and you have a lot of fixed costs. So how do we think about this?

William F. Weissman

We do. We are still working our way from the trough of the market and we’ve guided to positive gross margins in the third quarter, and there’s still a lot of cost to come out. There’s number of initiatives we have under way right now, we have still half of our six inch polishing is done in the U.S. We want to move that to Malaysia, and we’re in qualification with our customer, so that will get done obviously, so that out of your control. It’s really in the customer’s quarters of when they want to move it; we believe will get that move sometime in the first quarter that should reduce our cost considerably.

We have a raw material processing initiative right now, we developed our own in-house capability to process powdered aluminum oxide, which is the base raw material used in sapphire production. That will lower our raw material cost by about 20% once that’s fully rolled out. So those are two of the main initiatives we have underway. We’ve reduced our cost dramatically over the past two years.

As I mentioned, price used to be $8, a millimeter for small diameter at that point we made a lot of money. Today as the price comes up to just $5 or $6, we’ll be making very strong margins on a commodity product. And in the meantime, the six inch product is growing very nicely for us. We have the vast majority of our revenue will come from six inch, in the third quarter. Half of it from the LED market, half of it from the SoS RF market. And the margins on that product are still quite good.

Unidentified Analyst

I want to ask about the SoS, because obviously over the past six months that’s been the positive area for the company. We had tremendous growth just in the past few quarters for that. How do you think about your revenue opportunities say over the next 12 months, should we think of continued growth of this pace, should we expect some seasonality and how should we think about that?

William F. Weissman

That business has grown very strong for us. We doubled sequentially for the past two quarters. We will continue to grow not at that rate, what’s happened is our customers product has been engineered, has gotten a lot of key wins, has grown significantly over the past year. But we’ve also gained market share. We have a significant majority of that business right now. The reason being is SoS while they started at six inch wafers. And Rubicon has an extremely strong position in larger diameter. We have about 70% market share of the word’s six inch wafer business, because of our strong capabilities in terms of crystal growth and polishing. So as far as [revenue] growth from here, I think it will continue to grow with our customer, not at the same rate as Phil. Our customers also looking at other applications for their products, and if they are successful, obviously the growth rate can escalate in further. But it’d always be a very significant part of our revenue probably 30% to 40% of our revenue going forward.

Unidentified Analyst

How do you think about your competitive position for SoS wafers versus LED wafers. Do you think you have a better position, are these more technically challenging to produce, how do we think about this?

William F. Weissman

While always our position is extremely strong there, because it is a six inch platform and Rubicon is the world’s leader in six inch. The competitive landscape for SoS is a little bit different than the LED side of things, the various crystal growers had different technologies, some are better suited for the LED markets, some are better suited for the SoS market, because those wafers are slightly different in terms of the crystal orientation and polishing finish. But we have a very strong position there because of our capabilities, our customer relationships, the customer is a U.S. based customer, and they love the fact that they can just get on the plan and come visit us and their technical team is with us almost constantly. And we have a great relationship with them.

Unidentified Analyst

Recently you now, so the manufacturing technology that would produce large format sapphire, and they likely have indicated that this would likely be used for military applications. So what do you think about, how much you’ve been spending on this today and in general like when should we start to see some revenue come out of this type of new technology?

William F. Weissman

Couple of years ago, the government came to us and said we need very large rectangular windows that are at least an inch thick. There is no sapphire gross technology that exists today that can get that to us; can you help us create that. And we did. We produced a window that was about 2 feet by one foot rectangular that two inches thick and they have recently given us a $4.7 million grant to take that platform and expand it to larger sizes. And so we’ll be spending that money really that $4.7 million grant will cover virtually all of our costs for that development. How quickly revenue will come from that product is probably a couple of years away. But in the meantime, I think it’s a very good illustration of the strength that Rubicon has in sapphire production not only do we understand the existing technologies, but we have the ability within a year and a half period of time, to come up with entirely new platform.

Unidentified Analyst

There has been some discussions lately about using sapphires for the screens of say a smartphone or an iPad or something like that, in tablet. How should we think about this? Is this a real big near-term opportunity? Obviously, sapphire does cost a lot more than a shoe glass. So you have to believe that this is being discussed, the Rubicon’s did involve in some – involved in those, so what do you think about this? Is this something we should think about near-term as a revenue driver?

William F. Weissman

We have been involved in discussions with cellphone manufacturers, what they want to do is two things: one is that use sapphire for the camera lens on the back of the phone and also for the full faceplate. I think, we’ll see sapphire camera lenses in the not too distant future, because the cost points for producing that are relatively close to the current solution. The faceplate that was quite frankly, I think the jewelry sell out on whether the cost points can get low enough to really be a viable solution for them. It’s not the cost of the sapphire itself, it’s the cost of taking the sapphire and fabricating it into that form, which is where all the cost is essentially in that product and we continue to work on it, but I think, I don’t think you’ll see any sapphire faceplates in the next year or so. But we’re all working on trying to get the cost points to the point where it makes sense, but we’re not there yet.

Unidentified Analyst

Is that more – it will rely on growing the sapphire into the appropriate shape in the first place to get to those cost points?

William F. Weissman

Well, it helps. The ideal process for that type of an application is a technology called EFG, which grows sheets. The bulk, it’s a growth methodology. It’s an upward core technology use both. It is not as cheap for that application because you have to cut it into cubes and then slice it and polish it. Rubicon does have the EFG technology, we have the ability to take that platform expanded, but even using EFG, it’s a big question mark as to whether or not we can hit those price points.

Unidentified Analyst

All right, last question from me before I turn to the audience. There has been some discussion about Rubicon adding some plates to the wafers you sell and for those who don’t understand, often when manufacturer gets a wafer they put a pattern on the surface before they actually start depositing materials, so it helps the efficiency or productivity of the product. So I think this is analogous semiworld, (inaudible) sort of getting added on by the wafer maker. So we’ve heard some of your Asian based competitors or mainly even your LED wafer customers are already supplying us or supporting us. So basically when do you make a decision to do or not to do it, what’s it going to cause you and what kind of, what does it do for your margin profile?

William F. Weissman

We are down, there are some of the polishers in Asia that do offer a two-inch pattern product and they’re really outsourcing the patterning to a couple of small firms that can do that today. But no third-party today can pattern a 6 inch substrate. Our customer doesn’t it internally, but nobody else can do it really. Our focus is on the large diameter where our core competency is on the waffering side of things. We think we’ll have that product available for sale in the middle of next year. the price points are to be determined yet, but we’re pretty confident that the margins on that product will be incremental, that are better than this on the substrate itself. But not only it does a number of things, obviously it gives us more revenue margin for the same amount of sapphire, but since we’re using the customers’ pattern to their technology team that makes the revenue a little more sticky and we believe that by offering a six inch patterned substrate, it could facilitate faster adoption, because that’s one last process that the customer needs to worry about in migrating from say two or four inch substrate to six inch substrate.

Unidentified Analyst

Do we have any questions from the audience?

Question-and-Answer Session

Operator

Unidentified Analyst

Yeah.

Unidentified Analyst

We have one here, we’ll bring the mic.

Unidentified Analyst

Can you talk about gross margin progression through the remainder of this year. I know you talked about Q3, but through the remainder of the year and how much of that is in your control versus what is subject to changes in the market?

William F. Weissman

Okay, so our margins have improved. Q1 was a trot and we improved Q2 and we guided to better margins in Q3. we continue to lower our cost, that will take a little bit of time. What we see is for Q4, we’re not guiding to Q4 yet, but we really expect to see some pricing improvement by then in the small diameters end of Q4 and certainly Q1. And very modest pricing improvement on the smaller diameters will have a big impact in the margin. But even it does not happen with a larger diameter substrate as we get the SoS production moved to Malaysia and start working on some of the other process improvements; I think we’ll get our margins improved even without any price improvement.

But, again, pricing for the smaller diameters is – we believe is something at our cost right now. And really it is not sustainable, by dropping from $25 to below $4 in a two-month period of time, that's just a – again that’s an inventory correction, it is not a fundamental change in the competitive landscape, or the applications and we will see some modest price improvements whether it’s Q4 or Q1 (inaudible).

Unidentified Analyst

Bill, when you think about the 6 inch market specifically where your focus is on. We saw a price decline from last year to this year, and when we go into 2013 should we expect a similar decline, a moderation in the decline, how do you think about that heading in the next year?

William F. Weissman

Well, 6 inch is obviously a lot more stable than the small diameters, it’s a – we have – the competitive landscape is much smaller. We did have a bit of a step function down in the beginning of the year because we negotiated a new contract with our major LED customer at that time, the drop of the market. But I don't expect any significant changes in the pricing for 6’s next year, they come down some, but it is not going to be like the adjustment we had last year.

Unidentified Analyst

I think the last question from me is, between now and mid-2013, can we expect any other leading LED makers to start a 6 inch ramp-up production?

William F. Weissman

Our current expectation is that we’d see one or two others in the back half of next year. Obviously, utilization rates will have a big impact on that, but we’ve been working with about a dozen different LED companies on a 6 inch platform, and we think we have one or two of them that are relatively close to moving into production, but again it will depend on their utilization rates.

Unidentified Analyst

All right.

Unidentified Analyst

Do we have any additional questions from the audience? If not, I want to thank Bill. We have one here.

Unidentified Analyst

Could you just talk a little bit about the risk of silicon potentially replace the sapphire in long term?

William F. Weissman

Sure, well sapphire is used to produce vast majority of LED’s today. But there is always those that are working on alternative substrates. In the past, you’ve seen press releases or talk about pure gallium nitride or aluminum nitride. I guess that the big buzz today is silicon, because silicon is much cheaper. But silicon in itself cannot be used because the thermal cohesion of expansion between silicon and gallium nitride layers, you grow on it is vastly different. It will result in cracking and breaking, so they’ve had to try to come up with buffer layers to mitigate that problem. We’ve seen some people have success with that in a lot of environment, those are demonstrated in the production environment that has been successful. In fact those that had success usually say it’s a few years away. And at the end of day, is it any cheaper than sapphire, because again we are not just using silicon, you’re using a modified form of it. So I think time will tell but I don't see there is a threat in the next couple of years.

Unidentified Analyst

Any other questions? If not we’ll thank Bill for coming.

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