A transformational deal
Kopin is without doubt a strategically smart deal as it significantly extends IQE's market share and leadership in wireless industry supply; adds Skyworks Solutions, which has a longstanding supply agreement with Kopin Wireless, to the customer base; and brings in a Taiwanese manufacturing facility to boost IQE's global manufacturing footprint and provide the business with a strong position to access the growing Asian semiconductor market.
To finance the $75m (£47m) consideration, IQE raised £16.5m by placing 8.8 per cent of its share capital at 29p a share, has agreed a $40m (£25m) banking facility with HSBC to fund the balance and is deferring $15m, or a fifth of the consideration, for three years. Importantly, IQE shareholders are not being diluted. In fact, the deal is expected to boost EPS from the 2013 financial year onwards and generate annual cost savings of at least £7m from 2014.
For instance, analyst Pia Tapley at broking house N+1 Singer predicts that IQE will make adjusted pre-tax profits of £13.2m in 2013, up from £8.1m in 2012, based on a rise in turnover from £87.8m to £142m after factoring in £25m of additional revenues in the period. On this basis, EPS estimates are maintained at 2.11p for 2013, up from 1.55p in 2012. But earnings are set to ramp up as the combination of a further rise in revenues to £156m in 2014, and the benefit from £7m of cost savings, are forecast to boost pre-tax profits to £21.5m and produce EPS of 3.25p. On that basis, the shares, at 35p, are trading on a very modest 2014 PE ratio of 11. These adjusted EPS estimates are in line with those of broking house Canaccord Genuity, which also notes that the acquisition price - at 7.5 times Kopin's forecast 2012 cash profits of $10m - is in line with the industry average multiple of 7.8 times for epiwafer customers.
Significant cost savings and sound finances
The earnings growth assumptions embedded in these forecasts look realistic when you consider the significance of the cost savings. To put this into perspective, for the year ending 31 December 2012, the company's chief executive, Drew Nelson, expects "IQE's revenue to be in the range of £87m to £88m and cash profits of between £16m to £17m". Add this to Kopin's cash profits of $10m (£6.4m), and Canaccord's cash profit estimates of £26.6m for the combined entity this year in effect only factors in £3.6m of additional cash profits from the enlarged group. That hardly looks exacting when you consider the growth in other parts of IQE's business (see 'strong industry dynamics' below). Moreover, the £10m step up in cash profits in 2014 underpinning analysts forecasts will be aided by a hefty chunk of the £7m annual cost savings mentioned above.
It's worth pointing out that IQE's finances are very comfortable. At the end of 2012, net debt was around £15.4m, which represented gearing of 17 per cent of shareholders' funds of £94m and analysts at N+1 Singer predict net borrowings will be around £33m at the end of 2013, accounting for only a quarter of IQE's shareholder funds of £124m.
Strong industry dynamics
The heady earnings growth rate and the positive drivers underpinning growth in IQE's end markets were the main reasons I suggested buying the shares and with good reason as the business is clearly benefiting from the rapid adoption of smartphones and tablet devices.
For instance, industry analysts at Gartner and iSuppli note that smartphones accounted for almost 40 per cent of the total shipments of phones in the third quarter of 2012, up 47 per cent on the same period in 2011. And these impressive growth rates are expected to be maintained for some time yet as analysts forecast that smartphone sales will grow at 28 per cent a year on average over the next three years, surpassing 1bn annual units by 2015. The popularity of tablet PCs is proving a boon for wafer makers, too, as annual sales of mobile broadband devices are forecast to exceed 350m units by 2015. And, as wireless operators roll out 4G networks and devices, this will underpin demand for 4G LTE handsets.
All of this is rather good news for IQE, which 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 is exposed to this area of the market through a venture with Solar Junction, a leading CPV developer and manufacturer.
Compelling valuation
Assuming IQE delivers on analyst forecasts, the shares, at 35p, are modestly priced at 16.5 times current-year earnings estimates, dropping sharply to 11 times 2014 estimates as the benefits of the Kopin acquisition and ongoing growth in the tablet and smartphone market feed through to net earnings. That compares rather favourably with industry giant Arm Holdings (ARM), which is rated on a 2013 prospective PE ratio of 48, according to brokerage Peel Hunt, dropping to a PE ratio of 39 in 2014. From my lens, IQE's current share price of 34.5p is a very attractive entry point to gain exposure to a business that has potential to double EPS over the next two financial years.
Moreover, given the valuation anomaly with other industry players, I believe there is a strong chance IQE's share price will run up in the next six weeks ahead of the company's financial results in late March. My new price target is 45p on a three-month basis, and I rate IQE shares - priced on a spread of 34.75p to 35p - a strong buy.
■ Please note that I released a triple whammy of online articles on Monday: 'A share set to hit the jackpot', 'A highly profitable arbitrage play and 'Seeking Alpha among the housebuilders'. On Tuesday, I highlighted a residential property company benefiting from the London housing boom: 'Chart break out for a solid income play'..
Finally, I will be taking a four-week break during April to complete a book on 'Profitable stockpicking', my follow-up to Trading Secrets: 20 Hard and Fast Rules to Help You Beat the Stock Market. The book will be published in early summer.
MORE FROM SIMON THOMPSON ONLINE...
Since the start of this year I have written no fewer than 28 online articles, all of which are available on my homepage. These include articles on the following companies or investment strategies:
Mountview Estates ('Chart break out for a solid income play', 12 February 2013)
Bellway (Seeking Alpha, 11 February 2013)
Marwyn Value Investors (A highly profitable arbitrage play, 11 February 2013)
Netplay TV (A share set to hit the jackpot, 11 February 2013)
Oakley Capital, Randall & Quilter, Inland, Terrace Hill, Heritage Oil, Cairn Energy, Polo Resources, Trifast, Noble Investments, Fairpoint (Bargain Shares for 2013, 8 February 2013)
Telford Homes, MJ Gleeson, Stanley Gibbons, Molins, Indigovision, Trading Emissions, Mallett, Bloomsbury Publishing, Rugby Estates, Eurovestech (How the 2012 Bargain Shares fared, 8 February 2013)
Future (Decision time after a bright start, 5 February 2013)
Sanderson (An 'app' online investment, 5 February 2013)
Aurora Russia ('Time to play Russian Roulette', 4 Feb 2013)
BP Marsh & Partners ('Hyper value gains', 31 Jan 2013)
Bellway ('Profit from the London property boom', 30 Jan 2013)
Telford Homes, MJ Gleeson, Mallett, Rugby Estates ('Taking profits after a winning streak', 28 Jan 2013)
Market timing ('Lessons to learn', 24 Jan 2013)
Communisis, Netcall ('Bumper trading gains', 23 Jan 2013)
Crystal Amber, API, Sutton Harbour ('More upside to come', 22 Jan 2013)
PV Crystalox Solar ('Seeing the light', 21 Jan 2013)
Bloomsbury Publishing ('A publisher for the digital age', 18 Jan 2013)
Housebuilders first-quarter effect and performance table on all my recommendations from the final quarter of 2012 ('Stockpicking Marvels, 16 Jan 2013)
Eros ('A share firmly in the picture', 15 Jan 2013)
Netcall ('Jumping the gun: take two', 15 Jan 2013)
Moss Bros, Communisis ('Jumping the gun', 14 Jan 2013)
Stanley Gibbons, MJ Gleeson, Spark Ventures ('Small cap wonders', 11 Jan 2013)
IQE, Trading Emissions ('A tech share worth buying now', 10 Jan 2013)
S&P 500 portfolio of dog shares ('Dog shares barking back', 8 Jan 2013)
Air Partner ('A share ready to take off', 7 Jan 2012)
FTSE 100 traded options strategy ('Highly profitable options', 3 Jan 2012)
Telford Homes, MJ Gleeson, Molins, Noble Investments ('Rampant bargain shares', 31 Dec 2012)
