This latest announcement underlines how the company has been successfully diversifying its revenues streams including non-wireless applications; photonics through a major contractual agreement with Philips, announced in October 2013; CPV solar cells, where a powerful supply chain has been established and is being fully qualified; and in power and LED materials employing gallium nitride (GaN) on Silicon (Si) technology.
To recap, IQE uses advanced crystal growth technology to manufacture 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 makes 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.
Business drivers
A key driver of the business over the next few years will clearly be from the wireless market, accounting for 85 per cent of sales last year, with demand underpinned by the proliferation of wireless applications and the need for sophisticated gallium arsenide (GaAs) chips to deal with the explosive growth in data traffic. Looking further ahead, the next wave of innovation - which will drive handset replacement cycles - are likely to include lasers and sensors using compound semiconductor technology, for gaming, 3D image capture, gesture recognition, and sensing for a variety of applications including healthcare monitoring devices. IQE's investment in product development was around £4.3m last year, up £300,000 on the prior year, reflecting ongoing investment in new products to access new and emerging markets.
And with the benefit of an innovative outsourced foundry services portfolio that allows IQE to provide a 'one stop shop' for the wafer needs of the world's leading semiconductor manufacturers, the company has been able to tap the demand created by this technological change. In the second half last year, photonic sales were up 12 per cent compared with the first half, albeit wireless sales were up only rose 3 per cent (see below).
The upside from IQE's acquisition of Kopin are being seen, too. Kopin was acquired in a $75m (£47m) deal in mid-January last year and has 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 has also strongly positioned the business to access the growing Asian semiconductor market.
There are also significant financial benefits, too, as IQE's revenues soared to a record high of £126m in 2013, or 44 per cent higher than in 2012, and adjusted pre-tax profits were up over half to £13m. On this basis, fully diluted EPS rose from 1.4p to 2p. This robust growth in profits was mainly aided by the costs savings generated from Kopin. IQE's goal is to realise at least £7m of cost savings per annum, and is on target to do so having made savings of £3.5m by the second half of last year.
Understanding the wireless market
True, the softening in the smartphone market dampened IQE's second-half performance as new smartphone launches no longer attracted the same 'feeding frenzy' seen in previous years, and replacement cycles slowed. This headwind resulted in wireless sales only increasing by 3 per cent in the second half and partly explains why IQE shares are trading on sub market average PE ratio of 11.5 even though the company reported robust earnings growth.
IQE's short-term demand was also impacted by inventory build and depletion cycles at the wireless chip companies. Analysts believe this softness will have fed through to the early months of 2013, but that should not detract from the medium-term industry dynamics which underpin IQE's business model. These include the global roll-out of 4G and LTE, the evolution of WiFi, new wireless devices including wearable technology, and the incorporation of sensors and laser projection, which are largely enabled by compound semiconductor photonics technology.
Moreover, smartphone shipments are forecast to continue to grow in the coming years driven by new features, apps, social networking, entertainment and location based services. To put this in perspective, 1.8bn mobile handsets were sold globally in 2013, of which more than 1bn were smartphones that carry significantly more compound semiconductor materials. US market research company IDC predict smartphone shipments will hit 1.7bn handsets by 2017.
It's also worth pointing out that high-speed connectivity will drive the requirement for the advanced properties offered by compound semiconductor epiwafers. The global roll-out of wireless broadband networks such as 4G/LTE devices increasingly rely on higher levels of compound semiconductor content with 5G expected to demand a quantum leap in speed, power and efficiency. And the migration to new higher frequency WiFi standards is another major driver for radio frequency (RF) components and is expected to boost demand for compound semiconductor based RF devices.
Profit estimates
Taking all the above factors into consideration, analysts Dan Ridsdale and Tom Grady at Edison Investment Research still expect IQE to drive up adjusted pre-tax profits from £13m to £14.9m this year and to increase adjusted EPS by 10 per cent to 2.2p. On this basis, the shares trade on little over 10 times current year forward earnings, a massive discounts to its nearest rival Visual Photonics Epitaxy (18 times) and wireless customers including Skyworks (14 times) and RF Micro Devices (18 times).
Furthermore, if IQE hits Edison's EPS estimate of 2.5p for 2015, based on pre-tax profits rising to £17m, then the shares are trading on little over half the rating of peers. That still looks an anomalous rating to me. So although the shares are little changed on when I last updated the investment case ('Wafer maker sell-off overdone', 4 February 2014), I still feel that a target price of 35p is not unreasonable.
My target is inline with that of analyst Bob Liao at brokerage Canaccord Genuity, but well below the 43p fair value target of Alex Jarvis at broking house Peel Hunt. Technology analyst Pia Tapley at N+1 Singer has a lower target of 28p, but notes that "our revenue growth expectations are conservative, with constant currency revenue growth of circa four per cent in 2014. However, the planned cost saving mean our forecast earnings growth is substantial, equal to a compound annual growth rate of 17 per cent between 2013 to 2016. This improvement should be completely within IQE’s control, with the potential for further cost savings to be identified. The valuation in this context looks attractive." I could not agree more.
And it's not as if the technical set up is not starting to look favourable once again. The 14-day RSI is around 50 so is not overbought, the share price has regained the 20-day moving average and also appears to be coiling up for an upwards move to take out the 200-day moving average at 25p. Beyond that the next resistance is the March highs around 27.5p. Trading on a bid offer spread of 23p to 23.25p, I continue to rate IQE shares a value buy.
Please note that I am working my way through a long list of companies on my watchlist that have reported results or made announcements recently including: Pure Wafer (PUR), Eros (EROS), Inland (INL), Netplay TV (NPT), API (API), H&T (HAT) and Record (REC).
