NEW YORK ( TheStreet) -- Rubicon Technology ( RBCN - Get Report) has been a short seller favorite among LED stocks, and shorts weren't exactly running scared after another easy beat and raise by Rubicon, which it posted on Thursday after the market close.

Rubicon produces the sapphire substrate required for production of LEDs, and it's business has risen rapidly as Asian LED manufacturers ramp, among them, the LED manufacturers fostered by Chinese government subsidies. At the same time, though, more competition is coming into the sapphire substrate market, including U.S. solar equipment vendor GT Solar ( SOLR).

While Rubicon shares rallied in Thursday's after-market trading, by Friday morning Rubicon shares were down by 4% on heavy volume -- it had surpassed double its average volume by the mid-day mark.

How can a company that keeps beating the average analyst estimate easily trade down? There are probably three reasons why pressure remains on Rubicon shares: the peak gross margin argument, pricing pressure, and a new tax rate for the company which could negatively impact earnings per share estimates.

Rubicon reported first quarter earnings per share of 80 cents on revenues of $38 million (up 29% from the fourth quarter and up 230% from the first quarter.) The first quarter earnings surpassed the consensus expectation for 66 cents EPS on revenue of $36 million.

Gross margin improved to 63% in the first quarter, versus a consensus expectations of 55%, as pricing remained strong.

Second quarter guidance from Rubicon calls for earnings per share of 82 cents to 86 cents on revenue of $40 million to $43 million, again, above the consensus of 68 cents earnings on $41 million in revenue.

Yet even beating and raising, Rubicon guided to lower gross margin, in the high 50% range and for pricing to be down by 2%.

Gross margin declines and pricing pressure have been staples of the bear case on Rubicon, but D.A. Davidson analyst Avinash Kant noted in his reiteration of a buy on Rubicon on Friday that the reduced gross margin guidance is still above the average analyst estimate of 52% for the second quarter, and Rubicon's expectation for a 2% decline in pricing is much better than expectations.

"Several industry experts have been talking about a precipitous decline in wafer pricing. While we agree that pricing will be coming down eventually, we have argued that some of the assumptions regarding price declines have been too aggressive," said D.A. Davidson in an earnings review of Rubicon. In fact, analysts described a 2% pricing decline as "bullish" given the LED sector environment.

Reports from LED manufacturers Cree ( CREE - Get Report) and SemiLEDs ( LEDS - Get Report) have shown the weak pricing environment and inventory glut. Cree shares are down 40% this year, and the reaction to its recent earnings was fear that things get worse before they get better. SemiLEDs is down 60% this year.

Ross Young, senior v.p. at IMS Research for the LED sector, said that the consultant's recent review of LED market conditions doesn't indicate any immediate problems for Rubicon. Young expects a continued healthy environment for Rubicon, and noted that many of the Chinese companies that will pressure pricing won't be coming online until 2012. "2011 looks healthy in sapphire, though I do expect more capacity coming online from the major players in the second half of the year and some price reductions. But in no way are we moving to a glut," Young said.

A data point that the IMS Research executive pointed to was the consultant's first quarter survey of MOCVD tool buyers. The MOCVD tools made by the LED market duopoly of Veeco Instruments ( VECO - Get Report) and Aixtron ( AIXG) support the further buying of sapphire substrates as China ramps up its domestic LED industry. Veeco's recent earnings were strong and shares of both Veeco and Aixtron have held up well even as the bear case against both companies' remains dedicated.

Young said that IMS is still seeing huge amounts of MOCVD tools being ordered, and the strength in the market has been somewhat surprising. In IMS Research's latest survey, it expected a forecast for MOCVD tool orders at 1,100 to decline, as orders get delayed and China becomes more stringent about subsidies. Yet the IMS Research official said its latest survey doesn't show a decline, and in fact, the 1,100 tool forecast could actually increase slightly.

The IMS Research official noted that the idea Chinese subsidies were ending was seen as a potential cause for a decline in tool orders. In addition, there have been reports that smaller companies in China would see subsidies weighted to the time when they reach mass production, which supported the argument that deliveries would be pushed out until these new players had the business lined up to support larger scale operations.

Nevertheless, "We're not seeing that yet for calendar year 2011. The good news is that it still looks good for MOCVD tools, and it seems like it could be a record year for the MOCVD guys. Sapphire companies have to support all that capacity," Young noted.

Rubicon said its tax rate for the next three quarters could be 40%, and advised analysts to consider the tax guidance in estimates. D.A. Davidson, Canaccord Genuity and Piper Jaffray were among Wall Street firms which reduced earnings estimates for 2011 based on the tax guidance. D.A. Davidson took 2011 earnings down from $2.70 to $2.41 per share, even as the company beat and raised. While the downward revision on earnings is a financial headline negative, analysts didn't think the tax issue was the big issue in pressuring Rubicon shares.

"By all accounts, everything they delivered was great," said an LED sector analyst who didn't have compliance approval, but had reviewed the Rubicon results. Yet the case against Rubicon -- that pricing pressure increases and margins decline - hasn't changed, and is only a matter of timing. The LED analyst said that the incremental capacity coming on line and that could ultimately weigh on Rubicon is not an issue until the second half of 2012 or 2013. Yet for shorts the basic argument of too much supply at some point is still in place.

"I think the action today is a function of what could be construed as an early indication of the peaking scenario, so why cover if you're a short? For the first time, Rubicon is talking about pricing being down," the LED analyst said.

On the other hand, if Rubicon can expand its 6-inch wafer business, the company may be able to offset some of the pressure on margins, an effort from Rubicon that first came into focus after last quarter's earnings, when shares rallied on a beat. IMS Research's Young said that sales in the 6-inch wafer market haven't been brisk, but that as the market moves to the 6-inch wafer, it will benefit Rubicon since they are early into this opportunity.

On the potential for 6-inch wafers, analysts state the case simply: if it takes off, there is upside to the Rubicon business and the shorts are wrong. Yet if the 6-inch business stalls, then overall supply demand means quality in the core 2-inch wafer market won't be as important. In this scenario, the peak gross margin and pricing pressure argument rules over Rubicon as new entrants in the two-inch and four-inch wafer market lead to oversupply. Rubicon noted in its earnings commentary on Thursday that it has seen softening in the 2-inch wafer market.

-- Written by Eric Rosenbaum from New York.


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