The share price action since the start of this year has been punctuated by sharp share price rallies, but ones that never hold. In fact, until this week the share price was little changed on when I updated the investment case ('Wafer maker sell-off overdone', 4 February 2014), and a few months later (‘Time to chip in again’, 17 April 2014).
However, a trading update ahead of first half results on 16 September sent the shares down 12 per cent from 23p to 20.5p, and means that they are now sitting on the support level dating back to early February. The main reason for the latest lurch downwards is news that the company’s first half revenues have fallen 17 per cent to £52m, impacted as expected by destocking among major wireless customers due to weakness in the handset market at the end of last year and which continued into the start of 2014. The strength of sterling has proved a headwind too as this had an adverse effect on translation of revenues. In constant currency terms, sales were down 10 per cent.
The good news is that despite these headwinds, IQE’s cash profits are up 5 per cent to £11m in the first six months of 2014 and with the benefit of cost savings, a change in the sales mix to higher margin products, and synergy benefits from acquisitions, the company is still on course to achieve analysts full-year earnings expectations. Analysts Dan Ridsdale and Tom Grady at Edison Investment Research expect IQE to drive up adjusted pre-tax profits from £13m to £14.9m this year and to boost adjusted EPS by 10 per cent to 2.2p. Analysts at broking house N+1 Singer are looking for pre-tax profits of around £14m and EPS of 2.1p this year. On this basis, IQE’s shares trade on a modest 9 times current year forward earnings, around half the rating of rival Visual Photonics Epitaxy and wireless customers RF Micro Devices.
It is also reassuring to note that customer order levels have improved in recent months and the company is “seeing positive customer forecasts for the rest of the year.” This primarily reflects the acceleration of TD-LTE smartphone adoption in China, new handset launches, and the increasing adoption of new dual band wifi.
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 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.
Targeting growth markets
It is comforting to note too that IQE’s photonics business is performing strongly and the company expects to report 20 per cent revenue growth in the year to date, reflecting the move into high volume production and supported by a number of contract wins. For instance, only last month IQE announced a multi-year contract win worth in excess of £1m per year in additional revenues for its photonics business unit. The win is with an existing customer with a significant presence in the Asia-Pacific region, where photonics markets are predicted to experience rapid growth. IQE will manage the customer’s inventory as it does for a number of others, allowing it to manage short-term fluctuations in demand.
Analysts at broking house N+1 Singer were predicting 10 per cent growth in the photonics business this year, pencilling in revenues of £20.5m. Following today’s pre-close trading update, this now looks on the low side, highlighting the growth potential from this specific market. It also highlights how IQE is moving its reliance away from traditional wireless markets (which accounted for 85 per cent of last year’s sales) which are susceptible to greater fluctuations in short-term demand from customers.
The outlook for IQE’s high-efficiency concentrator photovoltaic (CPV) solar cells business is equally promising. IQE has exposure to this market through a venture with Solar Junction, a leading CPV developer and manufacturer. Expect a move into production in the second half this year.
So, despite the revenue shortfall, chief executive Drew Nelson remains positive, and with good reason. He notes that: “In terms of trading, all our lead indicators are pointing in the right direction. The destocking was concluded during the second quarter and customers are forecasting an upbeat second half. Our investment in photonics technology is delivering tangible benefits, and has resulted in multiple contract wins. "
It’s worth pointing out too that IQE’s net debt has been cut by £1.5m to £36m this year even after factoring in restructuring cash costs of £3m and £2m of inventory build. These items mainly relate to the acquisition of Kopin, a company purchased by IQE 18 months ago and one which 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 positioned the business to access the growing Asian semiconductor market. The acquisition still looks a sensible deal in my view and analysts expect IQE’s net debt to be cut by a further £4m to £32m by the year-end, reflecting the company’s cash generation.
Investment case still intact
That said, clearly investors are disappointed by the revenue miss even though profits are still expected to be in line with analysts’ forecasts. The sales shortfall is also detracting 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.
Furthermore, 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.
So, although IQE’s share price is weak, and sentiment is poor, I still feel the company is very undervalued even though a drift to the next support level around 18p can’t be ruled out. This coincides with the support level from June last year and also at the end of 2011. I would expect a strong bounce if this is ever tested.
To kick start the share price, analyst Lorne Daniel at broking house finnCap believes the “key to an improvement will be cash flow generation and reduction of debt”. I would agree and believe that with a better second half performance on the cards, there is more upside potential than downside risk at this point. My fair value target price of 35p may seem miles away with the shares trading on a bid-offer spread of 20p to 20.25p, but I would still be using the current share price weakness as a buying opportunity, albeit IQE is one of the most frustrating companies I have ever covered.
■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'
