James Faulkner on IQE – re-rating has quite a way to go

IQE (IQE) has been through a tough time of late, with industry de-stocking putting a major dint in its performance. But all that now looks to be behind the supplier of advanced wafer products and wafer services, which announced a very upbeat trading statement this week. The shares are now back where they were at the time I reviewed the company in our Technology Special back in June 2014, and the stage looks set for a re-rating.

Revenue for the year ended 31st December 2014 is expected to be approximately £112 million, with second half revenues of c.£60 million indicating a pick-up in trading momentum. EBITDA is projected to be up by c.8% year-on-year at approximately £27 million, with second half EBITDA of approximately £16 million. Adjusted, fully diluted EPS for the year is expected to be up c.20% at approximately 2.4p.

Furthermore, management also anticipates net debt at 31st December 2014 will be roughly £31 million, down from £34.4 million at 31st December 2013 despite £5 million of cash restructuring costs and £8 million of contingent deferred consideration payments. There is no doubt that this update will have reassured investors, as the numbers are in line with consensus forecasts. And with FY14 in the bag, the market can now look to FY15 – and the numbers leave plenty of room for upside.

In the Wireless business – which remains the largest division (c.80% of sales) and where the group commands a global market share of more than 50% – there was “double digit” sequential growth in H2 over H1, and the group made a cracking start to the year by securing a major contract renewal, estimated to be worth over $50 million, with an important tier 1 customer. The Wireless division continues to enjoy a robust market backdrop driven by increasing adoption of 4G and LTE globally. However, a key factor in the investment proposition for IQE at this stage is its penetration of new markets, which will help to diversify the firm away from its reliance on the Wireless market.

Chief among these new markets is Photonics, which grew revenues by 20% year-on-year. Demand for photonics products is continuing to grow as new and emerging technologies increasingly rely on the properties of light for a growing range of technological applications. InP (indium phosphide) is the material of choice due to its advantageous photonic properties, particularly in the short wavelength infrared (IR) range commonly used for a host of sensing applications as well as high speed optical communications, high definition night vision and gesture recognition.

Photonics growth in 2014 was driven by demand for vertical cavity surface emitting lasers, or VCSELs. VCSELs are semiconductor laser chips which can be produced in mass scale, in a similar process flow to LED chips, thus opening the way for a very cost effective, high performance laser devices, which can be used in a wide variety of applications – including optical data communication, industrial sensing, illumination, gesture recognition and heating applications. IQE uses advanced crystal growth technology (epitaxy) to manufacture and supply bespoke epi-wafers to major laser manufacturing companies. IQE is also unique in being able to supply wafers using all of the leading crystal growth technology platforms.

It is widely recognised that the expanding growth in data communications is rapidly approaching a serious bottleneck as demand for higher performance battles with the need to reduce power consumption, particularly in increasingly large data centres. This is driving the move from copper cables to optical fibre communications, which is essential in enabling the transmission of the high data volumes demanded from cloud computing, big data and the internet of things. Furthermore, the efficiencies achieved with VCSELs is a critical factor in reducing the overall energy consumption of optical interconnects used in data centres. During 2014, IQE further strengthened its relationships with major tier 1 photonic companies with additional long term supply agreements, and made “excellent progress” on its range of VCSEL products, both technically and commercially.

Another area where IQE is looking to generate growth is Solar Compound Photo Voltaic (CPV) technology. Although this opportunity has taken much longer to develop than initially expected, IQE has moved from a development phase into pilot production, with initial orders received in Q4 2014, and wafers now being shipped into the field. Lux Research expects the CPV system market to grow at a compound annual growth rate (CAGR) of 31% to $1.6 billion in 2017. Within the system market, IQE expects the epiwafer market to reach $150 million by 2015. IQE, via its partner Solar Junction, stands at the forefront of this nascent market, with its dilute nitride materials uniquely providing CPV system manufacturers the foundation to deliver the most efficient conversion of solar to electrical energy.

What’s it worth?

Photonics looks set to make a meaningful contribution in the current year, and CPV and gallium nitride could start to chip-in from FY16 onwards. Researcher Edison is forecasting pre-tax profits of £17 million in FY15 on revenues of £117.4 million, although it admits that its estimates for flat Wireless revenues in FY15 “may be conservative”. Anyhow, the EPS estimate of 2.5p implies a current rating of just 8.8 times for what is a market leader in an attractive sector.

I also note that Intel, who have been rumoured to have considered a bid for IQE in the past, are looking to build exposure in the mobile & tablet chips market. If they are interested in IQE, better to table a bid sooner rather than later, as this re-rating looks to have quite a way to go.

* The author owns shares in IQE.