IQE — Currency headwinds affect H121 performance

Wireless revenues declined by £3.9m year-on-year during H121 to £41.6m on a reported basis but in constant currency segmental revenues were slightly higher (0.9%) than H120. Continued strong growth (30% year-on-year) in GaAs (gallium arsenide) epitaxy for 5G handsets and Wi-Fi 6/6E routers offset a 53% year-on-year reduction in GaN-on-SiC (gallium nitride on silicon carbide)l materials for 5G infrastructure.

Rising demand for material used to make power amplifiers in handsets is consistent with statistics from the International Data Corporation (IDC), which reported global handset shipment growth of 19% year-on-year during H121 and an 12% increase compared with H119. The reduction in demand for 5G infrastructure applications reflects a temporary slowdown in new deployments in China. A report published by Grand View Research in July 2021 notes the coronavirus pandemic has delayed the implementation of 5G infrastructure because of disruption to the trials and testing required for verification of the stability and processing performance of 5G standalone networks and because some telecom regulatory authorities have postponed their 5G spectrum auctions. Despite these delays, the report predicts global market growth with a CAGR of 49.8% between 2021 and 2028, with demand driven by vehicle and connectivity, telehealthcare, delivery of ultra-high definition video, seamless video calls and augmented reality/virtual reality gaming, making deployment a question of ‘when’, not ‘if’.

Photonics revenues dropped by £7.0m year-on-year to £36.4m on a reported basis but the decline was only 7.6% in constant currency. Management notes that the group is maintaining its strong market share in VCSELs. Since adoption of VCSELs in Android phones is still minimal and we have previously inferred that IQE’s major VCSEL customer is involved in the Apple supply chain, we now infer that the group is maintaining its share within the Apple supply chain. However the reduction in the size of VCSEL chips used for facial recognition technology in handsets was only partly offset by deliveries of increasing numbers of VCSEL chips for world-facing LiDAR applications as the application is included in more iPhone models. As a result, VCSEL revenues fell by 26% year-on-year. This reduction was partly offset by continued strong demand for epitaxy used in advanced sensing applications in the defence and security markets.

As flagged in the July trading update, group revenues were £79.5m on a reported basis. The reported result was £10.3m lower than H120, which was a record, reflecting the FX headwinds commented on by management in March. These FX effects reduced reported revenue by £8.1m as the majority of revenues are earned in US$. On a constant currency basis, revenues fell by 2.5% year-on-year. Around half of the group’s costs are denominated in US$, so EBITDA was affected by around £4.7m of FX headwind. Since adjusted EBITDA fell by £4.7m to £11.6m on a reported basis, the result was similar to H120 (£16.3m) on a constant currency basis. Performance was therefore consistent with the guidance management issued in March that H121 revenue and EBITDA would be similar to H120 levels on a constant currency basis. Reported operating loss (after adjusting for share based payments and restructuring costs) was £0.9m (£4.3m profit H120). Taking into consideration c £4.2m FX headwind, this gives a year-on-year drop of c £1.0m, of which c £0.9m was attributable to increased depreciation and amortisation charges. The group would have generated a positive adjusted operating result in constant currency.

We note the company uses a typical layered hedging approach to smooth the effects of FX movements on receipts from customers, which are primarily denominated in dollars, when these are converted to pay for the sterling-denominated part of the cost base. This hedging does not make any difference to the reduction in reported revenues and EBITDA observed in H121, which are reporting variances.

Net cash (excluding finance lease liabilities) reduced by £1.0m during H121 to £0.9m at the period end. Cash generated from operations was £4.7m lower year-on-year at £10.4m as the prior year period was distorted by the reversal of impairments of intangible assets, non-cash provision movements and inventory write-downs. Capital expenditure was substantially higher than the prior year period (£6.1m vs £1.1m) because of advance payments on reactors for delivery in H221, while investment in capitalised R&D was lower (£1.8m vs £2.6m) reflecting a more disciplined approach to resourcing projects. (In this regard, we note that losses from the CMOS++ segment reduced year-on-year, demonstrating a more focussed approach to this long-term but strategic activity as well.) Management has announced that it has placed orders for three new (we estimate totalling more than £9m) and three refurbished Aixtron reactors for delivery in H221. These will increase capacity at the group’s facility in Taiwan by over 20%, supporting wireless growth from FY22 onwards. The group is also investing in capacity to support the multi-year strategic partnership with a major semiconductor foundry to develop epitaxy for 5G small cells and to support production of longer wavelength VCSELs that can be placed under an OLED screen, thus eliminating the “notch” in smartphones. This additional capacity is not expected to generate material revenues until FY23.

In November 2020 Dr Drew Nelson, IQE’s founder and CEO, announced his intention to step aside from his current role once a successor had been found. A preferred candidate with relevant international semiconductor market experience has been identified, so Drew has stepped down as CEO and become a non-executive board member with the title of president, acting in an advisory and ambassadorial role for the business. He will also devote more of his time to the further development of the Compound Semiconductor Cluster in South Wales. Chairman Phil Smith has temporarily moved from a non-executive to an executive role to prepare the group for the new CEO appointment.

Management has provided guidance for FY21 for the first time, predicting group revenues and adjusted EBITDA similar to FY20 on a constant basis, that is around £178m revenues and £30m EBITDA on a constant currency basis. This guidance assumes that demand for 5G handsets continues to be strong and that production of photonics epitaxy for VCSELs and advanced sensing applications in the defence and security markets is stable. This view is supported by a report issued in June 2021 by IDC, which predicts that the worldwide smartphone market will reach a total of 1.38bn units in 2021, up 7.7% from the 1.28bn units shipped in 2020, following which shipments will reach 1.54bn units in 2025, giving a CAGR of 3.7% between 2020 and 2025. The guidance treats any uplift in VCSEL production related to unusually high uptake of the iPhone 13 as upside. It also assumes that demand for GaN-on-SiC epitaxy will remain subdued until FY22, treating a potential recovery in Q421 as upside. In July we noted potential downside to our estimates if infrastructure roll-outs were delayed to 2022. As this delay now seems the likely outcome, we are reducing our FY21 estimates, while keeping FY22 adjusted numbers broadly unchanged.

We make the following changes to our estimates:

We leave our FY21 capital expenditure estimates unchanged as this is within management’s guidance, which it has reiterated, of £20–30m. We also leave our FY21 estimate of investment in capitalised R&D unchanged as this is within management’s guidance of £5–8m. This guidance was reduced from £7–10m, reflecting management’s more focused approach to R&D.

We include a comparative valuation of IQE versus its broader (but imperfect) peer group below. At current levels, IQE is trading at a discount on an EV/sales and EV/EBITDA basis with regards to both the larger sample and the sample of companies engaged in manufacturing VCSEL epitaxy. It is trading above the upper bound of both samples with regards to P/E multiples. IQE has a broader product portfolio than its VCSEL peers. In addition, it can manufacture on multiple sites, which gives it relative resilience to US-China trade disputes. For these reasons, we believe it is reasonable for IQE to trade on EV/EBITDA and P/E multiples that are at the upper end of the VCSEL sample. However, we believe share price recovery will require greater visibility of the timing of 5G infrastructure roll-out, which will determine when GaN-on-SiC epitaxy sales start to pick up. It will also depend on how many iPhone 13 models launched later this year will have world-facing ToF functionality and when Android phones start adopting the technology, as these factors could potentially boost demand for VCSEL epitaxy.