UK-listed homegrown tech companies are a dwindling group. Many of the good (see Arm) and the bad (see Imagination Technologies) have been snapped up by international peers and private equity groups, seeking to capitalise on their top-class intellectual property, or in the latter case take advantage of share price weakness.
IQE (IQE) has flitted between good and bad during the last six months. In August 2017, investors were clamouring for a slice of the company amid speculation that its Vertical Cavity Surface Emitting Laser (VCSEL) products were being used by Apple (US:AAPL) in the iPhone X. By November, concerns had begun to mount that the group was perhaps relying too heavily on the US tech giant. And in February, sentiment took a turn for the worst when two short sellers accused the company of a “fundamental misrepresentation of its profit and cash generation”.
But the company’s founder and chief executive, Drew Nelson, wants IQE to carve out a new category: a great British tech company. That, he says, is one of the reasons the group developed its partnership with Cardiff University. The 50:50 joint venture – known as CS Connected – was founded in 2015 with “the aim of creating and sustaining over 2,000 high-skilled jobs”. Mr Nelson explains that the joint venture gives IQE access to new technology, while IQE in turn has provided the joint venture with initial business to “limit its start-up losses”.
For ShadowFall and Muddy Waters – the short sellers whose scathing reports dented IQE’s share price in February – that relationship is a cause for concern. The two groups have claimed that IQE has a cyclical affiliation with CS Connected, which allowed it to inflate its own profits in 2015 and 2016. Muddy Waters suggested that IQE has hidden some of the costs of tech development in CS Connected by booking licence fee revenue from the joint venture, but not recognising its losses. The short seller even goes as far as suggesting that the group's accounting is “possibly designed to deceive investors”.
Mr Nelson fervently denies these allegations and said that the two companies released their reports to profit from their short positions. Muddy Waters published its report shortly before the markets closed on Thursday 8 February, which sent the group’s share price down 11 per cent on the day, although they have since rebounded. That was shortly after the release of ShadowFall's report on 5 February.
Nevertheless, the reports did raise some eyebrows in the City. According to the Financial Times, one analyst was spurred into visiting IQE’s facilities following the release of the Muddy Waters analysis, “to confirm the authenticity of the CS Connected joint venture”. An analyst at Citigroup agreed that both reports contained points that were “valid from an accounting standpoint”. Meanwhile, five funds have increased their short positions since the allegations were published.
However, analysts at Peel Hunt argue that “the accounting for joint ventures is often complex and this has given an angle to those wishing to interpret the results as negatively as possible”. Broker Stifel explains that IQE followed accounting regulations by writing the joint venture down to a zero net book value on its balance sheet once its losses exceeded the initial investment, and thus isn’t obliged to account for any further losses. Meanwhile, Canaccord Genuity has removed joint-venture licence sales from its forecasts from 2018 onwards. CS Connected is no longer reliant on IQE now that it has developed its own technology and built up a cluster of external customers, Mr Nelson says.
It looks unlikely that IQE is going to be swept away by UK investors due to an accounting scandal. But we do still harbour concerns that it might go the same way as Imagination Technologies: too reliant on one company to thrive. Indeed, the majority of the 23 per cent forecast uptick in pre-tax profits between 2017 and 2018 is expected to come from the photonics business, of which Apple is thought to be its only customer at present. But Mr Nelson has dismissed those concerns: “the photonics market is set to explode and IQE is in a premium position to benefit”.
