The company said that revenue for 2013 is likely to be at least £126m, representing an all-time high and an increase of 43 per cent compared with 2012. Strong sales growth and improved operational efficiencies are expected to deliver cash profits of at least £24.5m, up from £16.4m in 2012, yet another record. In turn, this bumper performance will lift adjusted EPS by a third year-on-year to 2p.
Moreover, the company’s high conversion of operating profit into cash means that net borrowings are now below £35m, down from £37.7m in June, and that was after making £8m of payments in deferred consideration in the second half of 2013 (and £14m over the course of the year) relating to previous acquisitions. The amount of deferred consideration payable is predicted to fall from now on, so expect net borrowings to reduce sharply this year.
Exciting product development
The news on product development was equally promising. To recap, IQE uses advanced crystal growth technology to make and supply bespoke semiconductor wafers to major chip manufacturers, who then use them to make the chips that form the key components of virtually all high-technology systems. The company also manufactures advanced optoelectronic and photonic components such as semiconductor lasers and optical sensors for a range of applications, including: DVD and Blu-ray storage; thermal imaging; ultra-high-brightness LEDs; and high-efficiency concentrator photovoltaic (CPV) solar cells. IQE has exposure to this market through a venture with Solar Junction, a leading CPV developer and manufacturer.
And the news in all these areas has been very positive. For instance, towards the end of 2013, in addition to successfully renewing its existing contractual relationships with key wireless customers, IQE also extended its contractual share of future business. As anticipated, the company continues to diversify its business across non-wireless applications and has made impressive progress in photonics through a major contractual agreement with Philips, announced in October 2013; made technical progress in CPV solar cells, where a powerful supply chain has been established and is being fully qualified; and has made significant breakthroughs on power and LED materials employing gallium nitride (GaN) on Silicon (Si) technology. In fact, since the financial year-end, IQE's strong position in GaN on Si has been endorsed by its inclusion in a significant US energy initiative announced a few weeks ago by US President Obama.
Attractive valuation
However, despite this upbeat news shares in IQE have fallen back once again to test the December lows around 23p and are now only priced on 11.5 times 2013 earnings. True, weak guidance for the first quarter of 2014 from a number of the company’s wireless customers, and a strengthening sterling/dollar exchange rate, have not helped sentiment. That said, the current valuation in effect prices in nil growth in earnings this year which seems harsh considering that the combination of operational savings resulting from acquisitions made in the past 18 months, combined with earnings from the product launches of smartphones Samsung S5 and the iPhone6, should help drive profits ahead as analysts predict.
For instance, Pia Tapley at brokerage N+1 Singer and Lorne Daniel at finnCap both expect IQE to report revenues of £138m this year and lift cash profits by around 25 per cent to above £30m. On this basis, pre-tax profits of over £16m are expected to produce EPS of 2.4p. Bob Liao at Canaccord Genuity has similar forecasts.
Investor overreaction to guidance from IQE’s top customers
It’s worth flagging that although two of IQE’s top three customers, RFMD (NSQ: RFMD) and Triquint (TQNT), have issued weaker guidance than anticipated, recent quarterly results and earnings guidance from the company’s largest customer Skyworks (US: SWKS) were ahead of Espirito Santo analyst Vijay Anand’s forecasts.
Interestingly, in the earnings call with analysts, Skyworks chief executive noted that to date there has been limited traction from the launch last year of a front end silicon-based radio frequency (RF) module to support 3G and 4G phones by Qualcomm, a leading broadband and applications processor vendor in the wireless market. That's reassuring given that investors were spooked a year ago by the entry of Qualcomm into IQE's market segment. But it's hardly surprising that the impact on IQE has been minimal because the Qualcomm product is an off-the-shelf one limiting the ability for handset manufacturers to differentiate whereas the products from IQE’s customers are customised to the requirements of handset makers.
Also, Qualcomm largely targets the low-end of the smartphone market, whereas high-end smartphones have between four and six times as much compound semiconductor content versus a low-end phone. In any case, Qualcomm’s product has inherent physical limitations (it consumes higher power at higher frequencies) in comparison to compound semiconductors used by IQE. As a result the threat to IQE's business looks overdone in my opinion, although it also partly explains why the shares have failed to make any progress in the past year.
Cash profitability underpins valuation
So, as frustrating as the holding in IQE has proved, the company is being deeply undervalued. Factor in net borrowings of £35m to a market capitalisation of £150m, and the company’s enterprise value of £185m is only 7.5 times the cash profits reported for 2013, and a miserly six times the forecasts of finnCap, Canaccord and N+1 Singer for 2014. And it’s not as if the anticipated rise in IQE's profits this year is pie in the sky as £3.5m of the £5.7m increase embedded in analyst cash profit estimates should easily come from acquisition costs savings by the second half of 2014. Moreover, cashflow generation has clearly been strong and is expected to remain so.
True, sentiment is negative right now. But I have little reason to change my positive stance even though IQE shares have drifted down from 24.5p since my last update at the end of October (‘A conundrum to solve’, 29 October 2013). Trading on a bid offer spread of 22.75p to 23p, I would be a buyer of the shares ahead of the forthcoming full-year results next month.
