First off, I have respect for the Sterne analyst. This Andrew Huang character has some balls standing in front of the RBCN Machine saying it’s going to zero…I mean $10. Despite the obvious failure in his call, he still stands up and says “Yes! It’s going to $10!” I value incorrect conviction much higher than I do some banana leaf blowing in the wind.

Second, am I the only who thinks he is WAY off his rocker?

Nevermind. The sport is too easy if we think about how bad his call on RBCN has turned out so far. Let’s first look at his RBCN  and LED theses. From there we can probably determine he is simply stumping for business with an obviously way-out-of-Consensus call with no real intent to determine a valid price target on any of the stocks he covers.

So. RBCN. A short to $10 within 12mo. Call issued on 10/11/10 when the stock was at 20.54, pretty much the bottom of the range at that time. The stock went lower in 1Q11, but only on the back of totally incorrect rumors to ~18. Original thesis and valuation on the stock is below, and then we can really get into the meat of things. Remember, this was posted in Oct10 and has not been revised:

CAN WE BE NEGATIVE ON RUBICON BUT POSITIVE ON CREE, AIXTRON, AND VEECO?
Many investors will likely question our mixed ratings within the LED sector. If we have a Sell on Rubicon, then why not have a Sell on all the LED stocks in our coverage universe?
Since 2008, pricing for sapphire has swung dramatically in both directions. If the argument against owning Rubicon is that sapphire pricing is at or near a peak (as are Rubicon’s gross margins), wouldn’t that also be the case for Cree, Aixtron, and Veeco? For LED components, pricing does not necessarily increase, but on the other hand, industry-wide ASP erosion has certainly slowed over the past 12 months.
Many believe that the primary reason for Cree’s gross margin improvement has been “a more stable pricing environment for LED chips,” which started in the Jun-09 quarter, and “a more stable pricing environment for LED chips and LED components,” which started in the Sep-09 quarter. We are maintaining our unpopular view that the “more stable pricing environment for LEDs” has always been reason #3 or #4 for gross margin improvement, and not #1 or #2. Over the past five quarters, the primary reasons for gross margin improvement included: strong execution in the factory ramp, benefits for higher volume and scale, better than expected yield improvement, and mix shift in favor of XLamp (which have gross margins above the corporate average) at the expense of LED chips (which have gross margins below the corporate average).
In our view, general lighting and backlighting are two distinct segments of the LED market. Over time, there could be impact from LED makers transitioning production from backlighting to general lighting, but we think the transition happens in 1-2 years, not 1-2 quarters.
In the case of Aixtron and Veeco, we believe many bears believe that orders will peak in the next quarter or two, followed by a dramatic drop-off in orders, dramatic estimate cuts, and the subsequent realization that the stocks are actually not cheap at all. Based on our expectations that MOCVD tool orders will continue to head higher (beyond the next two quarters), it is not clear to us that orders will peak over the next 6-12 months.
VALUATION
As shown in Exhibit 1 on page 2, based on the stock’s limited trading history (IPO on November 16, 2007), gross margin has typically been a good indicator of when to buy and sell Rubicon’s shares. Given the cyclical nature of the sapphire industry (as evidenced by the volatility of Rubicon’s gross margin), we believe investors should be buying the stock when gross margins are low and taking profits when gross margins are high. For those who use valuation as an argument to buy the shares, we believe current estimates do not adequately reflect gross margin pressure. For example, for the Dec-11 quarter, we are modeling gross margin at 30%, while consensus is in the range of 42%. Given our view that gross margins will likely peak as early as Q4 of 2010 (as a result of new supply coming online), we believe there is much greater downside risk than upside potential from current levels. In other words, our model would suggest that the stock is not so inexpensive.
With respect to target price, we are modeling a steep drop-off in gross margin, exiting 2010 at 62%, 2011 at 30%, and 2012 at 22%. We arrive at a $10 target price two different ways. Annualizing our 2011 December quarter EPS estimate of $0.25 implies $1.00 in earnings, and using a 10X multiple for a highly cyclical business would suggest a $10 target price. Alternatively, using a 20X multiple (trough earnings) on our calendar 2012 EPS of $0.50, also implies a $10 target price. Should gross margins return to single-digits, then a stock price below $10, consistent with the stock price in late 2008/mid 2009, would not be out of the question.

1. What are #1, #2, #3 and #4? I don’t normally need to be led by the hand, but maybe this time would be helpful.
2. When looking back at CREE results in relation to this mock Q&A, how would you change your words here in light of CREE’s obvious channel stuffing?
3. Can you explain the difference between CREE and RBCN demand in relation to general lighting and backlighting? Are you saying that RBCN’s valuation/margins/price environment is based upon the assumption general lighting occurs in 1qtr-2qtrs but you think general lighting volume occurs in 1yr-2yrs? Or that to facilitate CREE’s [channel stuffing] margins that substrate pricing must fall?
4. If equipment (VECO/AIXG) orders do not peak until 2H11, and generously assuming it takes 1Q to install and ramp operations of a machine, why would demand for substrates that go through the machines peak before 3Q11?

The single answer to all of these – and evidenced by the focus on news reporting over the past few Qs – is that other folks eye the margins in the business and say “Shit, I’ll be happy to do that for 40%, let alone 50%.” This leads to competition installing more capacity, theoretically leading to price pressure for RBCN. We will save the “price as an indicator of volume” discussion for later.

Real quick, let’s look at charts of RBCN, VECO and AIXG over the past month. RBCN reported declining GM% in 4Q10 (per Captain Sternn: Sell!) and VECO and AIXG both reported “peaking orders.”

Wait a second! Isn’t this where RBCN is supposed to fall off a cliff? And with peaking orders and subsequently declining estimates, why haven’t “oh too expensive VECO and AIXG” gone into the crapper? It must be that Bernanke Put. Right.

So the $10 target is 10x $1 in 2011 or 20x 50c in 2012. Let’s see how the Q1 report and Q2 guide goes to how far down RBCN must fall in 2H11 in order to meet the expected 25c in 4Q11. This is gonna be a good Q1/Q2, so I am expecting some negative EPS in 2H11 to justify this $1 estimate for 2011.

Wait a sec – the Captain is now calling for 62c in 4Q11! and $2.86 in 2011! and still 50c in 2012! Wow, so death in 1Q12. You can almost touch it…almost…there it is…

I really don’t expect Captain Sternn to come off his sell rating. I would be disappointed if he did. But let’s be real, his commentary is totally irrelevant. He covers RBCN to pass on company and industry data points undercover of a sell-side license. And since we know how well datapoints in the LED business translate into actual stock movement, I formally declare Captain Sternn as irrelevant.

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