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Awaiting a catalyst for a re-rating

Awaiting a catalyst for a re-rating
July 11, 2013
Awaiting a catalyst for a re-rating
IC TIP: Buy at 20.75p

I firmly believe that the market has got this one completely wrong, as do technology analysts Bob Lio and Johnathan Imlah at broker Canaccord Genuity. I will explain why later on, but first it is worth noting when a company has to make an announcement to the market under London Stock Exchange guidelines when there has been a change in its trading performance.

Requirement of directors

As a rule most companies quoted on the UK stock markets do not publish their own earnings guidance, so the role of analysts in forecasting a company's performance is critical in setting market expectations about likely profitability and future growth. Clearly, different analysts will differ in their opinion on a company's future performance, which creates a range of earnings forecasts. By taking an average of all these analysts' forecasts on a particular share, a 'consensus' forecast is reached. Analysts will then compare their forecasts to the consensus number, particularly when they change their forecasts and either bring them more in to line, or diverge further from the consensus number.

In turn, this becomes the benchmark by which companies are judged and it is the duty of the board to be fully conscious of the market's expectations. It is also a requirement for the directors to immediately inform the market if they become aware that earnings are likely to 'diverge materially' from consensus analyst forecasts - in the form of issuing either a profits warning, or an upgrade statement. It is commonly believed by many investors that an announcement has to be made by the board when earnings will diverge by 10 per cent or more from consensus forecasts. However, regulators are clear that there is no '10 per cent rule' and that price movements below that threshold can still be deemed 'significant' in particular cases.

It goes without saying that analysts play a pivotal role in the relationship between a company and investors. That's because although quoted companies do not explicitly set their own forecasts or expectations, they are judged by their ability to meet the market's expectation of their performance, as outlined by the analysts. It's worth noting, too, that nearly all analysts have detailed briefings with the finance director of a company before issuing their estimates, so it is normal for them to be 'guided' in their expectations.

In the circumstances, the requirement of a company's board to issue a regulatory announcement to the London Stock Exchange should be quite simple if there has been a material change in the trading performance. Namely, if a company is going to undershoot or overshoot consensus earnings expectations by a 'significant' margin, the board should issue a statement to the market immediately. If the company fails to do so, then the board are being negligent in their duty as directors as they would be creating a false market in the shares by knowingly misleading investors as to the true operational performance of the company.

Directors have to heed the regulations

Rules to that effect are contained in the Disclosure and Transparency Rules (DTR) applying to companies with a full listing on the London Stock Exchange. The fourth of the Listing Principles ensures adherence to the spirit as well as the letter of the DTR: a listed company must communicate information to holders and potential holders of its listed equity securities in such a way as to avoid the creation or continuation of a false market. Aim companies are under a similar obligation, imposed by rule 11 of the Aim rules.

And as most companies issue pre-close trading statements ahead of their final and half-year results, as well as regular trading updates at their annual meeting and during the financial year, then there is no excuse whatsoever for directors failing to enlighten investors if there has been a material change in the trading performance of the business.

The last point has great importance to me right now, as I alluded to earlier. That's because in the past 16 weeks shares in IQE have slumped by over a third since its full-year results in March, a savage derating in any market, let alone a bull market. In my opinion, this underperformance can only be justified if the company is going to miss consensus earnings estimates by a 'significant' margin.

However, at the annual meeting at the end of May, the board did not make any statement regarding trading, so it is only fair to assume that the business was performing in line with consensus earnings estimates. Moreover, in late April, non-executive director Dr David Grant purchased 215,000 shares in IQE at 23.25p a share. That is hardly the action of a director expecting bad news. In fact, if analysts at Canaccord are correct in their analysis, we can expect an upbeat trading update on 24 July. An analysis of IQE's customers' revenue growth and inventory data certainly suggests the company, which is the leading supplier of epitaxial wafers globally, is on track to meet full-year estimates.

Strong industry drivers

In recent years, IQE has built up a broad portfolio of capabilities across a range of compound semiconductor materials and applications. Wafers for the wireless industry account for over three-quarters of revenues and photonics account for around a fifth. IQE's photonics products are used in a wide variety of applications, including optical fibre communications, optical storage (DVDs and CDs), laser printing, solar cells and solid state lighting. But given that IQE has a market share of between 50 to 60 per cent of the radio frequency wafer market, it is well worth keeping a close eye on revenue trends for IQE's four publicly listed customers (Anadigics, RF Micro Devices, Skyworks and Triquint). The news here is rather good.

According to Canaccord, the cumulative revenue growth of IQE's four publicly listed customers has accelerated over the last two quarters and hit 12 per cent in the fourth quarter of 2012 and 15 per cent in the first quarter of this year. Based on consensus estimates, analysts expect cumulative revenue growth to accelerate to 19 per cent in the second quarter this year, rising to 21 per cent in the third quarter. Canaccord also notes that inventory data is showing a similar trend. Total inventory of these four customers over the past three quarters has improved from a flat performance in the second quarter of 2012 to 10 per cent growth in both the third and fourth quarters. In the first quarter of 2013, aggregate inventory levels rose 11 per cent.

Mr Liao notes that IQE's customers' revenue growth was driven by RF Micro Devices and Skyworks in the first quarter, and predicts that both RFMD and Anadigics are expected to drive sales for the rest of 2013. IQE is a major, if not the primary supplier to all of these companies. In fact, IQE's acquisitions of RF Micro Devices assets and Kopin Wireless have diversified the company's exposure across the radio frequency solution market, according to Canaccord.

It would also appear that investors have overreacted to February's news that Qualcomm, a leading broadband and applications processor vendor in the wireless market, is launching a front end silicon-based radio frequency module to support 3G and 4G phones. If Canaccord is correct in its assumptions, and I have little reason to doubt its analysis, then there has been little detrimental impact so far on IQE's business. There is unlikely to be any, either, since Qualcomm is targeting the lower end of the smartphone market, which at most accounts for 6 per cent of IQE's revenues and, even then, the US giant is unable to offer the same solutions to customers as IQE, given the differences in the technology used.

Earnings estimates

Ahead of IQE's trading update, Canaccord is looking for half-year revenues of £62.5m, cash profits of £9m and net debt of around £40.8m. The revenue forecast equates to 43 per cent of the full-year estimate of £142m. That is sharply up on the £88m of revenues reported in 2012, but also reflects the contribution from the $75m (£51m) acquisition of Nasdaq-listed Kopin Wireless in January. That was a smart deal as it significantly extended IQE's market share and leadership in wireless industry supply; added Skyworks Solutions, which has a long-standing supply agreement with Kopin Wireless, to the customer base; and brought in a Taiwanese manufacturing facility to boost IQE's global manufacturing footprint. It also provided the business with a strong position to access the growing Asian semiconductor market.

On this basis, the broker expects full-year cash profits to rise from £16.4m to £26.6m, and adjusted pre-tax profits to increase from £8.6m to £14.4m. In turn, this drives EPS up by around 40 per cent to 2.1p. The growth assumptions embedded in these forecasts look realistic when you consider Kopin reported cash profits of $10m (£6.75m) in its last financial year. That means Canaccord's cash profit estimates of £26.6m for the combined entity this year only factors in £3.25m of additional cash profits from the enlarged group. Moreover, IQE is aiming for £7m of annual cost savings from the acquisition in 2014, some of which will flow through in 2013.

Furthermore, it's not as if Canaccord is out of line as broker Edison Research is forecasting 2013 revenues of £145m, pre-tax profits of £13.4m and EPS of 2p; Peel Hunt is predicting IQE will report 2013 revenues of £139.5m, pre-tax profits of £14.8m and EPS of 2.3p; and N+1 Singer forecast revenues of £142m, pre-tax profits of £13.5m and EPS of 2p. EPS estimates for Espirito Santo are top of the range.

The bottom line is that IQE's shares are being rated on a ludicrously low nine times consensus earnings estimates. It is also reasonable to assume that the company has been trading in line with consensus given management have had ample opportunity in the 16 weeks since the full-year results on 20 March to inform the market of any 'significant' change in its trading performance, if that were the case.

Positive divergence on the chart

Interestingly, IQE's chart is showing signs of positive divergence. In fact, although the share price made a new low of 18p on 28 June, the 14-day relative strength index (RSI) didn't and was marginally above the RSI reading at the time of the previous price low of 19.25p on 28 May.

True, I am sitting on a loss on this holding, having advised buying IQE's shares at 31.5p ('Tech that and rally', 19 Oct 2012); 28.5p ('Happy capital returns', 17 Dec 2012); 33p ('A tech share worth buying now', 10 Jan 2013); 35p ('Time to dial into profit', 13 Feb 2013) and most recently at 29p ('Qualcomm news hits IQE shares', 22 Feb 2013).

However, with a trading update imminent, and the shares rated on nine times consensus earnings, the valuation is anomalous. I continue to rate IQE's shares a buy on a bid price-to offer price spread of 20.5p to 20.75p. Admittedly, Canaccord's price target of 65p is punchy, but a share price nearer 40p - the equivalent of 12 times 2014 earnings estimates after factoring in the aforementioned costs savings from Kopin - is hardly an exacting valuation. Both N+1 Singer and Peel Hunt have target prices around 45p.

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