IQE - Entering a Transition Phase

http://www.iqep.com

IQE Plc Logo

IQE (LSE:IQE) is an AIM listed technology company that focuses upon manufacturing and supplying semiconductor wafers (known as "epi-wafers") to chip manufacturers. The wafers are integral parts of "virtually all high technology systems" and are particularly useful when dealing with wireless technologies. In addition, IQE provides research and development support to third-parties and has centres located across Europe, Asia and North America. Despite industry rivals such as Chinese firm, Visual Photonics Epitaxy (VPEC) announcing impressive sales, IQE's share price has slipped significantly recently, primarily due to the effects of a move by US semiconductor company Qualcomm to rival the widely used GaAs (Gallium Arsenide) that IQE currently employs in its epi-wafers. IQE's share price currently stands at 20.25p. With 646 million shares in issue, this capitalises the company at approximately £131m.


The chart I have used above is a long-term chart. It highlights the successes that shareholders have enjoyed such as the impressive 300% rise during the turn of the decade, but it more importantly holds a key clue to the medium and even long-term technical outlook for the stock. I have left this off the chart as there is a lot that can be said about it. What it is important to first recognise is that this downtrend has been set to occur since as early as February 2013. I have actually been following IQE for a while, but I was relatively bearish on the stock considering what I deemed to be a 'weak chart position'. During the start of the year this outlook was set with a double top at ~36.5p which was cemented by a steep drop off down to sub-30p price levels following the Qualcomm news. What was even more bearish is that the double-top formed on the 'head' of a head and shoulders formation with the neckline just above 26p. The failed breach of 30p on the second shoulder was a significant warning of impending downside.

However, it is the 20p level that is actually what is important. Since 2009 it has provided resistance on four distinct occasions with the latter being towards the end of 2011. In each of these cases the share price rebounded off 20p (or just above) and it took several attempts to breach through it. The importance of this 20p level was then qualified in 2012 and then again just a few weeks ago, with two further touches and sharp rebounds. Considering that the current share price is lingering at 20.25p, the movement of the stock over the next week will likely be of utmost importance. A sustained breach of 20p would see movement towards the next support at 17.75p whereas a swift rebound could target as high as 25p in the short-term. Personally, considering the RSI position I would lean towards a further rebound off 20p as being the more likely scenario although the current negative momentum cannot be discounted.

courtesy of freedigitalphotos.net

In terms of the share structure, directors currently hold over 35m shares with well over a third of the shares in the hands of retail and institutional investors. Whilst very large directors sells were completed in July 2012, the most recent directors transaction came in late April 2013, with a ~£50k purchase from director David Grant. There is a more sinister side to trading in IQE though. Since the start of the year, short positions in the stock have increased rapidly to a current level of 2.3% (according to shorttracker.co.uk) with BlackRock being the major participant in the shorting. Any closing of the short positions would obviously involve re-purchasing IQE shares which would boost the share price, but it is impossible to know when BlackRock are planning to do this. Chart-wise, there is no clear indication of the future direction considering the uncertainty that lies around 20p, but there is reason to be optimistic for a rebound.

Without getting too far into the technical aspects and science behind the epi-wafers, as mentioned before, IQE's epi-wafers utilise GaAs. This is a compound between Gallium and Arsenic and the benefits of using GaAs is that it creates less 'noise' than other types of semiconductor compounds and compared to silicon, for example, GaAs are less prone to heat-generated faults. In January 2013, IQE purchased Kopin Wireless for $75m. The transaction involved a £16.5m placing and this would likely also will have generated a stock overhang which could have further depressed the share price. Nevertheless, the acquisition is said to 'broaden IQE's customer base' and reduce the risk associated with IQE's business model. The acquisition should have strengthened certain ties that were previously weak, such as that with Skyworks Solutions. The acquisitions will also create synergy-based cost reductions amounting to £7m/annum from 2014 onwards reducing expenditure. The reason for the delay is the inherent time lag involved. Whilst a $40m banking facility with HSBC was necessary to complete the acquisition, a trading update that was injected into the news release read:

"For the year ended 31 December 2012, IQE expects revenue to be in the range of £87 million to £88 million, with earnings before interest, tax, depreciation and amortisation in the range of £16 million to £17 million and net debt as at 31 December 2012 of approximately £15.5 million."

CEO Drew Nelson commented: "The transaction marks another major step forward in our risk mitigation strategy, whilst significantly boosting our wireless market share. At the same time, it delivers excellent opportunities for additional business growth, particularly in Taiwan and from there into the Asian semiconductor market."

A good place to start for the analysing the fundamentals of the company is to examine their latest full set of results.
- Revenues rose 17% to £88m (i.e. the top end of the trading update expectations)
- EBITDA at £16.4m
- Net debt of £15.5m which was in line with managements expectations
- Pre-tax profit up 5% to £8.6m from £8.2m for the previous year
- CAPEX of £13.1m. This figure is set to reduce with the 2-year capacity expansion program now complete
- Current assets:Current liabilities surplus of just less than £9m
- H2 revenues soared by 45% to £53.7m

IQE's technology is used in a wide range
of products such as lase printers
Courtesy of Sir Adavis on flickr
The results were strong with the H2 revenues quotes as being 'a glimpse of what is to come'. The three acquisitions that IQE initialled in the full year included Solar Junction, Kopin, and RF Micro Devices. The strong performance of H2 is testament to the high quality of these acquisitions, even though some brokers have hinted that IQE may have overpaid. Whilst post-tax profit dropped by just over 10%, the imminent CAPEX reductions should see this level improved significantly in the long-term.

However it was the Qualcomm news that was released in February rattled investors. The US firm announced that they would become direct competition by entering IQE's radio frequency industry. Qualcomm was effectively able to bypass various barriers to entry due to it's size and through providing an alternative solution to GaAs. This comes in the form of silicon-based CMOS technology (that has been packaged with their RF360 front-end solution). The CMOS technology is beneficial in that it is the first 'envelope power tracker' and boasts increased efficiency and output power. To avoid the scientific jargon, I won't go into this, but a quick explanation can be found on Wikipedia under 'Envelope Tracking'.

Broker Liberum Capital noted: "Importantly for IQE Qualcomm's solution is based on silicon (CMOS) while to date most of the radio frequency chips in mobile phones have relieved on IQE's epi wafers. This is obviously negative for IQE. Qualcomm has not released any detailed specifications at this point." The news is rumoured to have prompted Bank of America Merill Lynch to offload some of their multi-million share holding.

The reaction to the news was initially a circa 5p drop to 29p which appears to be an overreaction in my opinion for a number of reasons. Firstly, Qualcomm is only going to start targeting low-end smartphones primarily within the Chinese market and this realistically will likely only represent a small proportion (x<10%) of IQE's revenues in a worst case scenario. As IQE grows, their dependency on wireless revenues will also fall into other categories such as opticals hence reducing any overall negative impacts in the medium term - their diversity helps in this respect. In addition, UK firm Nujira has argued that further drawbacks exist including OEMs (Original Equipment Manufacturers) will be unable to choose their own band combinations. They concluded that Qualcomm has 'drawn the line in the wrong place' and that 'there is a distinct lack of performance data'. The one-size-fits all approach will restrict Qualcomm's market.

Certain individuals have continued to argue that GaAs systems do actually still have the upper hand in terms of performance and in some cases, cost. This is due to GaAs solutions having being refined and improved for over a decade. Furthermore, GaAs suppliers tend to supply the full front-end package which is beneficial. In my opinion, although the CMOS announcement is potentially a concern for IQE, it only is in the future. Qualcomm are initially targeting the low-end Chinese market which will have immaterial impacts on IQE, plus GaAs systems benefit from being the early-technology. It is proven, widely available and trusted by the market - CMOS currently is not.

In terms of the valuation of IQE, it is currently trading on a P/E ratio of 17.5. A quick table to the right compares this valuation to that of other London listed semiconductor companies. Whilst obviously the valuations don't directly carry across as each company is valued on different merits (e.g. quality of the board of directors and historic performance), it is useful as a rough guide and comparison. IQE is currently trading at just under half the semi-conductor average which stands at 33.7. Dividing the current share price (20.25p) by 17.5 and then multiplying by the industry average retrieves a value of 39p (i.e. what share price equates to a P/E ratio of 33.7). A more modest P/E ratio of 24 gives a share price value of 27.77p which is 37% higher than the current share price.

All the broker views for IQE suggest fair values are higher than the current share price. Investec, Liberum Capital, N+1 Singer, Espirito Santo and Canaccord have targets of 25p, 40p, 45p, 55p and 65p respectively. Furthermore, even the most pessimistic broker (Investec) have publicly stated in a broker note that: "Whilst we have argued that the cash profile of the RFMD deal and the recently-increased debt level need to be taken into consideration in valuing the equity, we believe the extent of the price weakness could mean the shares are due a bounce." The next financial update is likely to come in the form of a mid-July trading update. This has appeared about mid-late July for the past three years so it would be reasonable to assume a similar date range.

There is evidence to conclude that the recent slip in the IQE share price has been chart-driven as opposed to fundamentally driven although the catalyst for the initial drop was news driven. The immediate threat that Qualcomm represents is negligible and hence the 45% drop from the 36p highs seems unjustified especially considering the UK indexes have had a generally strong H1 2013 (excluding the recent sell-off). With the acquisitions that IQE has undertaken, it looks to become increasingly cash generative and thus able to repay the debt associated with it. It is undervalued compared to industry peers plus demand for the GaAs product is only likely to grow as technology improves and requires an increased of parts that are also of higher quality. However, considering the technical position of the stock, to be cautious it would probably be appropriate to use an end-of-day stop loss at the lower support band of 17.75p. That would limit any loss to around 12%. To the upside, the share price could target as high as 30p in the medium-term dependent upon momentum which would equate to nearly 50% upside. Thus the risk-reward is sound. I have put a personal Buy tag on IQE onto the review results page.

UPDATE 22/08/13 - IQE has met my initial target price of 30p in relatively short order. 30p will likely prove to be difficult resistance to break in the short-term, so I have moved IQE from buy to No Rating, locking in a 48% profit

10 comments:

  1. Very nice review. i know a fair bit about the actual technology behind the semiconductors having worked in the sector, but have not heard of Qualcomms CMOS entry before

    thanks Elite. 2013investor

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  2. This is a bloomin brilliant article. very well done!

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  3. Great article! may take a position in IQE very soon. Thanks Elite.

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  4. good effort .

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  5. Very comprehensive. May well look to take a stake later on this week but will delve deeper first. DYOR ;)

    Craig

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  6. thank you excellent Elite

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  7. Has all the elements of a technically well written piece including overview of competition and peer to sector P/E.

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  8. Fantastic review El1te. Now that the results have been released for H1, any further views on which direction you think IQE will take in regards to SP? obviously the results seemed to of been already factored into the SP before they were even released with the rise we saw.

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    1. Thanks, the lower support held which was good news! The results are obviously very encouraging and to be honest I don't think they are factored into the share price. After all, the initial drop was a false one anyway in my view. Therefore, considering there is a long-term double bottom completed at the lows plus a good fundamental picture, my 30p target still stands. I'll re-evaluate if it gets there

      El1te

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