IQE - A Cloud of Scepticism

http://www.iqep.com/

IQE Logo

Profitable technology companies operating in high-growth market segments often trade on premium valuation metrics, as investors price in future growth, and also because sentiment tends to be towards the bull side. Unfortunately for shareholders in IQE, that is not proving to be the case, as the company has struggled to trade on a high rating, and has essentially been fluctuating within a circa 50% horizontal share price range for the best part of three years. That compares to a wider market backdrop of strong equity prices, and general financial improvements - perhaps more perplexing is that IQE has seen a strong financial improvement over those years. As it stands, IQE is back at the lower end of the range, and is trading at 19p (meaning it is capitalised at £123.3m). A cloud of uncertainty and weak sentiment currently hangs over IQE and it is difficult to tell whether that will lift over the rest of 2014.

This article is a follow-on from the below post. For full context and information, read this article first:
http://www.theel1tetrader.com/2013/06/iqe-entering-transition-phase.html


The technical position of IQE has deteriorated since a return to 30p back in July 2013. At that time, I noted that the rise had been particularly quick, and that it made sense to put IQE back on a No Rating tag, having placed a Buy tag on it back around 20p a number of weeks before. Since then, the share price has trended downwards in a series of lower highs, towards 19p currently. A lacklustre trading update in July was sufficient to send the shares through important 20p support, and potentially back towards 18p support again. Taking a long-term chart, the 18p level has been pivotal, and on numerous occasions the share price has rebounded off the level. However, circumstances are slightly different this time, in that the decline has not been as sharp, and sentiment is currently weak. Therefore, a return to the lower support level seems highly likely (even if only on an intra-day basis), and whether or not that support holds is particularly important. Given the low RSI reading, it is definitely possible that 18p will hold up again, and head back above 20p, where it would be fair to assume consolidation. Summing up, as it stands, there are two scenarios. If the share price breaches 18p support (over a few days), then the share price could be heading to as low as 15p. On the other hand, if it rebounds off 18p or above, then a return towards the upper resistance is likely. I would expect a breach of the downward resistance if that happens, and the start of a new move towards 30p.

There is one caveat to that, and that rests with the wider markets. The wider markets have rallied strongly over the comparable period shown in the chart, so if they do correct, it would not shield IQE from a further decline. Combining the technicals with the fundamentals (as I will later), the risk-reward currently looks skewed to the upside, but investors should be very cautious regarding the 18p level. It may be worth seeing confirmation of a sustained bullish close back above 20p.

The spread on IQE is favourable for traders, and that is likely to have contributed to past movements. It currently spans 18.75p - 19.00p. IQE also has strong institutional backing (as it has enjoyed historically) with the top three combined institutional holdings totalling over a quarter of the shares in issue. That does however mean that retail investors are largely at the hands of institutional movements. CEO Nelson has a material stake in the company, although other director holdings leave much to be desired. The lack of director buys over the past year (despite arguable undervaluation) is particularly disappointing since the total remuneration of the three executive directors was £1.42m in 2013 versus £0.77m in 2012. Obviously closed periods and price-sensitive arguments can be made, but there no doubt would have been clear periods.

However, it is actually another part of institutional activity that is more concerning and that is casting a cloud of uncertainty. BlackRock and Ennismore are both heavily short IQE, to the extent that IQE is one of the most shorted stocks listed on the LSE (as a percentage of stock). Between them, their shorts total a highly significant 5.44% of the shares in issue. That is concerning as it begs the question: "What do they know that retail investors don't?" Of course, the answer could be nothing, but when a company has a valuation that appears low, it is a cause for concern. On the contrary, if either BlackRock or Ennismore decide to close their shorts in the coming months, that could be the catalyst required to boost the stock back to a more respectable valuation. It is definitely a point to keep a close eye on.

As it has been roughly a year since the initial review of IQE, I will quickly re-cover who IQE are, and what IQE does. IQE is essentially a Wales-based chip designed and manufacturer, with a focus on the wireless and photonics markets. Wireless accounted for the vast majority of revenues in 2013 (85%) with the majority of the rest being contributed by photonics, which includes market segments such as infrared and solar. The wireless division revolves around intellectual property that IQE owns in the creation of epitaxy semiconductor wafers. Semiconductor wafers are used in almost all technological systems nowadays - in particular, the number demanded by industry have soared as smartphones have increased in popularity, and demand is likely to increase further as demand for increasingly sophistic systems and features on technology, grows. Epitaxy involves the use of specialised crystal growth technology on the wafers.

Unsurprisingly, research and development is at the heart of the industry, so IQE is a very forward-looking business with cutting-edge technological propositions. Indeed, IQE has a very large market share in the provision of wafers to wireless chip industries, estimated at between 50% and 60%. It caters for a range of global clients through a number of business bases worldwide, although the majority of revenues are derived from manufacturers based in the USA. The large market share has both positives and negatives. On the plus side, it means that IQE has certain barriers to entry in the form of patents and IP, and theoretically it should demand a premium market rating. On the minus side, it means that research and development is integral, otherwise there is the potential for competitors to make inroads and take away market share.


Skyworks share price
In reality, the premium market valuation has not materialised despite many industry customers pushing out very impressive figures. One of the most recent in a long line was wireless hand chip supplier, Skyworks Solutions Inc, who are a major customer of Kopin Wireless (a business IQE acquired relatively recently). The results were reflected in what has been an excellent share price performance from Skyworks, on the back of very strong US equity markets. That said, there is a reason why IQE has not responded as well. As noted before, IQE is heavily dependent on revenues from its wireless division and smartphone sales became more sluggish during the latter part of 2013 and the early part of 2014. That was as a result of market saturation, but also oversupply and increased competition. In turn, that led to a temporary decline in demand for new smartphone parts earlier in the year, whilst excess stock was cleared.

Taking a longer-term viewpoint, although it is a high-growth sector, there will always be risks associated with that. In particular if a competitor creates a new, superior technology, it may render IQE's far less valuable. Concerns over one form of that stemmed from Qualcomm back in 2013, details of which can be found in the initial review. That said, IQE itself remains at the forefront of innovation and it has a number of new technologies that look increasingly promising and should help diversify away from wireless revenues, which has been the crux of the recent headwinds facing the company.

In particular, it has:
- CPV technology for the solar market. IQE is the exclusive supplier of materials to Solar Junction, who recently had a strategic investor acquire key technology. Production is expected to commence in H2 2014
- Vertical-cavity surface-emitting laser technology (VCSEL)
- Gallium Nitride (GaN) technology
These could and probably will all contribute materially to future revenues, albeit they do little to alleviate the current structure of revenue derivation.

A brief scan of the results over the past five years shows an encouraging trend at the revenue and post-tax profit levels, although these do obviously not reflect upon a number of underlying measures.


Revenues grew strongly from just over £50m to almost £130m at the last reading, and post-tax profits tracked higher from just under £4m to almost £15m in 2013. That is undeniably a good record at both the top and bottom lines, but as before, it doesn't reflect upon a variety of other metrics, that help explain why the share price has failed to make progress to match. For example, net debt over the period more than doubled to £34.4m (through the funding of acquisitions to drive sales growth) whilst cash flows have consequently remained inconsistent. Taking those into account, the company has benefited from the acquisitions (of Kopin Wireless in particular), as it has enabled IQE to cement a solid foothold in the wireless industry and allowed them to take advantage of synergies and enhanced economies of scale - the latter being particular important in being able to access bulk purchase discounts and not having margins squeezed as easily by major customers. The cost reductions arising from resource duplication is still filtering through to the financial results, with £3.5m in savings expected during the second half of 2014.

In 2013, aside from the rapid rise in revenues, IQE boosted its adjusted pre-tax profits to around £13m from £8.6m, albeit that is aided by a series of tax losses that are now being used to offset tax payments, and actually gain a credit. There should be sufficient tax losses in place for at least the next few years. Adjusted earnings per share were booked at 2.09p vs. 1.47p. If we adjust the current market cap for the net debt at year-end, then the adjusted share price rises to approximately 24.3p. That means that IQE is valued on a trailing price-earnings ratio (PER) of 11.6, which is not at all demanding for a market leader, and especially not for a technology company. A base PER of 15 would be a fairer figure, which would imply upside of nearly 30% on a trailing basis. However, the question has to be asked as to why the market has not been willing to price IQE favourably in the past, and particularly why institutions would feel compelled to form a very large short position in IQE.

The balance sheet is in decent shape, albeit it is not particularly strong when combined with cash flows. Although total assets are 2.17x total liabilities, and that would imply a net asset value (NAV) of 17.3p, there is a large amount of intangibles, which in IQE's case is predominantly goodwill, which should be stripped out to form a more accurate picture. Tangible assets then fall to 1.2x total liabilities and there is not a great amount of asset backing. That is largely as a result of the high level of borrowings, albeit they are taken out at respectably low interest rates, which is what you would expect given the sector of operation and established financial performance. All but £1.55m of net borrowings are non-current, although current assets are only 46% of total liabilities - that emphasises that debt is a lingering background problem.

Net cash generation from operations during the year amounted to £10.5m although that was overshadowed by the large amount of cash shelled out to acquire Kopin Wireless. IQE also capitalised over £4m of development spend, so the underlying net cash generation was quite a bit lower. That is an ongoing spend given the need for research and development. There is a further $15m payable for Kopin as deferred consideration that will become unlocked during 2016, which could hamper efforts to re-pay the debt, so it is likely to prevent the payment of a dividend during 2015 at the very least (barring a considerable uplift in trading). That is a shame as the market would be a lot more comfortable with IQE if it was able to pay a dividend with a yield around 2% - as it stands, that doesn't look likely for a couple of years minimum.

Further to the need to diversify revenue streams, is the need to expand the customer base. Whilst the main customers are well established, the top three accounted for a very substantial 58% of wireless revenues in 2013. That is a concern as if one of those customers changes supplier (for any reason), then IQE would experience a sharp decline in revenues, thus profits too. That makes it difficult to place IQE on a particularly high PER, despite the market leading position, and even when accounting for the high quality nature of these customers. I would therefore cap any prospective 1-year forward PER at 17 on that reason alone, until IQE expands the photonics side of the business more considerably, and the 85% reliance on wireless falls back. Still, an adjusted trailing PER less than 12 is certainly on the low side.

What has dampened sentiment over the past week was the release of a trading update. H1 revenues were down more than forecast at 17% as a result of currency headwinds affecting the majority of overseas exporters, combined with wireless customer destocking - this was alluded to in updated previously, so was not a surprise. On a constant currency basis, revenues were down by 10%. However, the scale of the decline caused concern as it effectively puts IQE ex-growth over 2014, with minimal revenue growth forecast in 2015. That will hamper efforts to pay down the debt pile. Net debt also climbed slightly to just under £36m from £34.4m at year-end, although crucially, £3m of restructuring costs were incurred during the period - therefore, net debt would have actually fallen had the costs not been taken.

The outlook statement was relatively positive, with the company noting that Q2 wireless demand had recovered, photonics was growing strongly (+20% on constant currency basis), and the company was still on track to meet full-year estimates after EBITDA came in marginally higher than expectations at £11m. Consensus estimates for 2014 include 2.18p in EPS, rising to 2.54p next year. Not accounting for current debt, those figures equate to PERs of 8.72 and 7.48 respectively. Accounting for debt, the PERs rise to 11.2 and 9.7. Once again, those numbers are not high by any stretch, and the company looks very undervalued should those levels be met. Upside to the share price based on the 2014 EPS figure using a PER cap of 17 suggests upside of around 50%. The market clearly does have concerns about the achievability of those figures though, hence why the share price was marked down significantly on the day of release. The low PERs do give a level of downside protection though. Applying a PER of 15 to forecast 2014 EPS and accounting for debt, a price target of 27.2p is generated, which implies 43% upside if the company can hit full-year targets and rekindle market confidence. That suggests a market cap of circa £176m.

Net debt is not forecast to reduce significantly during the rest of the year, although increased operating cash flows are expected to allow for a material decrease next year.

On the trading update, CEO Drew Nelson commented, "IQE is in good shape and our expectations for the year remain positive. The improvement in profitability reflects the work we have done to improve efficiencies and deliver economies of scale.  In terms of trading all our lead indicators are pointing in the right direction. The destocking was concluded during Q2 and customers are forecasting an upbeat second half. Our investment in photonics technology is delivering tangible benefits, and has resulted in multiple contract wins. Our CPV business is in the final stages of qualification and remains on track to move from final development and customer qualification to production in H2."

Despite the drop in revenues, it is ultimately the profit performance that matters, albeit EBITDA is not the favoured method for a number of investors. Price targets from brokers are all for levels higher than the current price, albeit there have been price downgrades across the board over the past twelve months, which underscores that progress has perhaps not met expectations. Liberum have the lowest price target, at 22p, whilst Canaccord, N+1 Singer and Espirito Santo have buy ratings with targets between 28p and 35p.

Although the low current rating is attractive in an absolute sense, there are a number of points to consider that leave me erring on the side of caution. The first revolves around the open short positions with the institutions and their apparent reluctance to close them off (over the past 6 months+). The second concerns the state of the overall markets - after all, if IQE cannot perform well during a period of market uplift, then they are unlikely to fare well during a period of moderate decline (should one materialise). Sentiment towards IQE has been damaged over the past few years as a result of a lacklustre share price performance, and more recently through the trading statement. That will take time and operational delivery from the company, to repair - directors buys post-results could speed up that process. The final point rests with the technical scenario and the breach of the 20p support level. 18p needs to hold to signal the start of any sort of reversal, and it needs to hold convincingly - that is an indicator to watch over the coming fortnight.

The bottom line is that there is a very strong and innovative underlying business, but the company is clearly facing headwinds. Although those are noted to have subsided and the outlook for the rest of the year is positive, it makes sense to wait for either a technical base to be formed, or to view the full set of financial results, which are set to be released in mid-September. Those results should give a clearer picture of how the company performed during the first half of the year, and will give an updated outlook statement. Forward metrics point to a very low valuation and attractive upside, but the market remains sceptical and sluggish on IQE at the moment. One to add to the watchlist. No Rating.

4 comments:

  1. First comment!

    Great article and very nicely balanced. I am increasing my amount of cash because I think we are near a market top but many investors disagree and say the cape measure is not very useful and the normal pe ratios are better. The problem I have is that market tops seem to come when economies are on the brink of disaster and the uk economy is motoring along so maybe we are not?

    IQE has been shorted to death by the looks of it. Poor souls. but I cant imagine blackrock would short for no reason?

    Fab article anyways

    James

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  2. Nice piece el1te :0). Thank you for the pointer

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  3. A thought provoking piece. Well done. I follow investors chronicle and Simon Thompson descibes IQE as the most frustrating company he has looked at! That takes some beating

    CraigJ

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  4. Great. Subscribed to emails

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