IQE — Doubling in photonics revenues drives growth

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IQE

Doubling in photonics revenues drives growth

FY17 results

Tech hardware & equipment

29 March 2018

Price	126.9p
Market cap	£959m

Net cash (£m) at end December 2017		45.6

Shares in issue	756.1m
Free float	90.5%
Code	IQE

Primary exchange	AIM
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	(0.9)	(12.2)	117.9
Rel (local)	1.5	(5.3)	124.1

52-week high/low

178.8p

54.2p

Business description

IQE is the leading supplier of epitaxial compound semiconductor wafers globally. The principal applications include radio frequency semiconductors, devices for optical networks, vertical cavity lasers, infrared semiconductors, power electronics and CPV solar cells.

Next events

AGM	4 June 2018

Analysts

Anne Margaret Crow	+44 (0)20 3077 5700
Dan Ridsdale	+44 (0)20 3077 5729

tech@edisongroup.com

Edison profile page

IQE is a research client of Edison Investment Research Limited

IQE’s FY17 results confirm that the photonics volume ramp-up referred to in the pre-close update has delivered the strong growth in revenues (16%) and PBT (18%) that was expected. Based on management’s guidance for this growth trend to continue, we upgrade our FY18 estimates and note the potential for sustained growth over the next three to five years.

Year end	Revenue (£m)	PBT* (£m)	EPS* (p)	DPS (p)	P/E (x)	Yield (%)
12/16**	132.7	20.6	2.89	0.0	43.9	N/A
12/17	154.5	24.3	3.36	0.0	37.8	N/A
12/18e	174.9	32.8	3.63	0.0	35.0	N/A
12/19e	203.8	42.3	4.63	0.0	27.4	N/A

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments. **Restated.

iPhone X shipments boost H217 revenues

Total revenues rose by 16% to £154.5m y-o-y, slightly ahead of our £150.1m estimate. The 21% rise in wafer sales was predominantly driven by volume ramp-up during H217 of VCSEL programmes which we infer relate to the iPhone X. Photonics revenues doubled while wireless revenues were flat. As we expected, licence fees were significantly lower than in FY16 (£1.9m vs.£6.7m) as the prior year benefited from one-off payments received during the initial phases of the JVs. Adjusted PBT rose by 18% to £24.3m, also slightly ahead of our £23.7m estimate. The group moved from £39.5m net debt at end FY16 to £45.6m net cash at end FY17 following a Placing at 140p/share raising £95m (gross) to finance additional capacity and development work to support expected demand in photonics.

Photonics guidance underpins estimates upgrade

Management estimates that existing volume programmes will deliver 35-60% growth in photonics revenues during FY18. We take a relatively cautious approach, modelling a 40% y-o-y increase in both FY18 and FY19 (FY19 estimates are presented for the first time), but even this necessitates an upwards revision to our FY18 estimates. Management estimates that programmes under development are likely to deliver 40-60% CAGR for photonics revenues over the next three to five years. These include VCSELs for consumer applications such as hand and body tracking, collision avoidance systems, data communications and industrial applications such as heating, indium phosphide wafers for high speed data networks and infrared sensitive wafers for healthcare applications.

Valuation: Growth already priced in

Our analysis of prospective P/E multiples for listed peers indicates that the current price assumes that IQE will perform at the top end of management guidance during FY18 and FY19. It indicates potential for share price appreciation if some of the other programmes under development move into volume production in the next 12-18 months, making management’s guidance appear too conservative.

FY17 results, guidance and changes to estimates

Management guidance

For the first time management has provided detailed guidance of segmental revenue growth for the current year and over a three- to five-year time horizon. This guidance is summarised in Exhibit 1, together with the growth rates adopted in Edison’s estimates, those programmes included in the guidance and those presenting upside to the guidance.

Exhibit 1: Management revenue guidance

	FY18 guidance	Included in guidance	Upside to guidance	FY18e Edison	FY19e Edison
Wireless growth	0-5%	Existing programmes, some restocking, GaN-on-SiC for base-stations	GaN-on-Si for base-stations (H218 onwards)	1.5%	1.5%
Photonics growth	35-60%	Existing programmes	VCSELs for other mobile phone vendors , VCSELs for other volume applications, InP for communications applications (H218 onwards)	40.0%	40.0%
Infrared growth	5-15%	Night vision and other defence applications	Consumer applications (FY19/20 onwards)	7.0%	7.0%
Power growth	N/A	None	None	None	None
Solar growth	N/A	None	Satellite applications (FY19 onwards)	None	None
	3-5 year guidance	Included in guidance	Upside to guidance
Wireless growth	0-10% CAGR	Existing programmes, GaN-on-SiC for base-stations, GaN-on-Si for base-stations	Filters and switches, Integrated front-end modules
Photonics growth	40-60% CAGR	Existing programmes, VCSELs for other mobile phone vendors, VCSELs for other volume applications, InP for communications applications	Integrated optical modules
Infrared growth	5-15% CAGR	Defence and consumer applications	-
Power growth	N/A	None	Power switches
Solar growth	N/A	None	Satellite applications

Source: Edison Investment Research, company statements

FY17 results and changes to estimates

Exhibit 2: Summary of changes to estimates

	FY17			FY18e			FY19e
	Est.	Actual	% change	Old	New	% change
Revenue (£m)	150.1	154.5	2.9%	165.2	174.9	5.8%	203.8
EBITDA (£m)	35.5	38.4	8.2%	40.3	47.9	18.9%	59.0
Adjusted PBT (£m)	23.7	24.3	2.5%	28.3	32.8	16.1%	42.3
Adjusted EPS (p)	3.26	3.36	3.0%	3.56	3.63	2.0%	4.63
Capitalised R&D	15.0	16.9	12.9%	9.0	9.0	0.0%	0.0
Capital Expenditure	20.0	18.0*	-10.0%	26.0	26.0	0.0%	0.0
Net cash	37.1	45.6	22.8%	35.6	48.1	35.1%	68.1

Source: Company accounts, Edison Investment Research. Note: *Including £6.7m funded through finance leases.

Revenues: we have raised our assumptions for photonics growth and infrared growth in FY18 so that both metrics are in line with management’s guidance, leaving our assumption for wireless growth unchanged. This results in changes to FY18 estimates as summarised in Exhibit 2. Since management’s guidance for FY18 includes only those programmes currently in commercial production, we infer that it only includes VCSELs (vertical cavity surface emitting lasers) for the face recognition function on the iPhone X, not the proposed rear-facing camera for capturing details of the surroundings for use in Augmented Reality/Virtual Reality applications. As this rear-facing camera requires a much smaller VCSEL array than the face recognition function, volume ramp-up for this function will not have as significant effect on photonics revenue growth as the current volume programme.

Operating margins: since photonics is growing much more strongly than the other segments, the proportion of revenues attributable to this activity increases in prominence, so we expect photonics sales to become similar to those from the wireless segment by FY19 (Exhibit 3). Management has given detailed information on segmental operating margin for the first time. As photonics revenues generate a substantially higher operating margin than wireless revenues (38% vs 15% in FY17), we expect this shift to have a beneficial effect on margins.

Tax: we apply an effective tax rate of 15% in both FY18 and FY19 (previously 0% in FY18).

Cash conversion: IQE exhibits relatively good levels of cash conversion: 113% in FY17 and 102% in FY16. Our updated model assumes cash conversion in FY18 and FY19 will be maintained at similar levels to FY17.

Capital expenditure: capital expenditure totalled £18.0m (including £6.7m funded through finance leases) in FY17, c £10m of which related to maintenance, as IQE began to add capacity to support further growth in VCSEL production. The first five new reactors are already in place at the new “Mega-Foundry” site in Cardiff and are on track to commence production in H218. A further five reactors (c $3m cost/reactor) are on order for installation and commissioning by the end of Q318. If demand warrants it, a further 10 reactors may be purchased over the next 12 to 18 months. The Mega Foundry premises are being funded through the Cardiff Region City Deal and have the capacity to host up to 100 reactors, which is similar to the number that IQE already has across its sites in Cardiff, Pennsylvania and Singapore (through its JV there). The payback period on a fully utilised reactor is around a year, so as epitaxy requirements increase, the cash generated from existing tools should be sufficient to purchase additional units without recourse to further financing. We expect that the first five new reactors will be used to satisfy iPhone X requirements, but if demand from this programme is lower than management expects, IQE will be able to use the reactors for other VCSEL programmes or indeed other types of epitaxy. We model £26.0m capex (unchanged) in FY18 and £19.0m in FY19.

Investment in intangible assets: during FY17 IQE increased its investment in product development from £6.3m to £14.5m, primarily reflecting development work on VCSEL programmes, only one of which has moved into volume production so far. There was also £2.4m invested in patenting internally generated IP and purchasing patents from third parties, most recently 54 patents relating to Quasi Photonics Crystals in December 2017. These will help IQE integrate complete 3D sensing systems incorporating a VCSEL light source, wafer level optic, diffractive optical element and silicon light sensor on a single chip. We model annual R&D costs at £9.0m in both FY18 and FY19, as each programme IQE works on with a client requires customised epitaxy which must be qualified before it passes into volume production.

Exhibit 3: Segmental revenues

Source: Company accounts, Edison Investment Research

Valuation

The share price has declined from the peak of 178.75p reached in November 2017 but is still more than double the level it was a year ago. At the current price of 126.9p, the shares are trading at a premium to the mean for its peers on all metrics (Exhibit 4).

Exhibit 4: Peer multiple analysis

Name	Market cap ($m)	EV/Sales 1FY (x)	EV/Sales 2FY (x)	EV/EBITDA 1FY (x)	EV/EBITDA 2FY (x)	P/E 1FY (x)	P/E 2FY (x)
Epitaxy
GCS HOLDINGS	211	2.3	-	10.1	-	14.4	-
INTELLIEPI	115	3.2	-	12.8	-	22.2	18.3
LAND MARK OPTOELECTRONICS	1,196	11.5	8.4	19.4	13.0	31.6	21.0
S.O.I.T.E.C.	2,370	6.1	4.6	24.3	16.3	43.2	27.3
VISUAL PHOTONICS EPITAXY CO	704	7.6	6.9	24.0	18.8	35.8	30.0
WIN SEMICONDUCTORS CORP	4,464	5.9	4.9	13.9	11.0	25.3	19.8
Opto-electronics
II-VI INC	2,665	2.6	2.2	-	-	25.7	17.8
EMCORE CORP	156	0.9	0.8	9.4	5.9	31.4	15.3
FINISAR CORPORATION	1,801	1.0	1.0	6.3	5.9	16.8	16.8
LUMENTUM HOLDINGS	4,156	3.2	2.5	12.8	9.5	19.1	14.4
Mean		3.6	3.3	14.8	11.5	26.5	20.1
IQE	1,374m	5.2	4.5	19.1	15.5	35.0	27.4

Source: Bloomberg, Edison Investment Research estimates. Note: Grey shading indicates exclusion from mean. Prices as at 28 March 2018.

The size of this premium reduces if we adopt a higher photonics growth rate. However, even if we adopt a 60% growth rate in both FY18 and FY19, which is at the upper end of management guidance, the shares are trading at a premium to the mean P/E for FY18e (31.6x vs 26.5x for peers vs 35.0x Edison base case) but only slightly above the mean P/E for FY19e (22.0x vs 20.1x peers vs 27.4x Edison base case). This suggests that the share price already assumes that IQE will perform towards the high end of management guidance, presenting a risk to the share price if there are any concerns, founded or otherwise, regarding iPhone X sales. On the other hand, Exhibit 1 identifies several programmes which present upside to guidance, suggesting potential for share price appreciation if any of these move into volume production during our forecast period.

If we restrict the comparison to the three listed companies offering epitaxy for VCSELs: IntelliEPI, LandMark Optoelectronics and Visual Photonics, then IQE is trading on P/E multiples that are in line with those for Landmark, which is at the upper end of the three peers. Given that IQE has a much stronger market position than the other three (44% share compared with 7% for LandMark, 5% for Visual Photonics and less than 5% for IntelliEPI, a rating at the upper range of these three (Visual Photonics’ 35.8x for FY18 and 30.0x for FY19) seems reasonable. Taking this approach, the shares look fairly priced at current levels despite modelling fairly unambitious photonics growth in our estimates.

Exhibit 5: Analysis of effect of photonics growth on key financial metrics

Photonics revenue growth in each of FY18e and FY19e	40%	45%	50%	55%	60%
FY18e total revenues (£m)	174.9	177.2	179.6	182.0	184.4
FY18e adjusted PBT (£m)	32.8	33.8	34.7	35.6	36.5
FY18e adjusted EPS (p)	4.08	4.19	4.30	4.42	4.53
Implied FY18e P/E (x)	35.0	34.1	33.2	32.4	31.6
FY19e total revenues (£m)	203.80	210.6	217.6	224.9	232.4
FY19e adjusted PBT (£m)	42.3	44.8	47.4	50.2	53.0
FY19e adjusted EPS (p)	5.25	5.57	5.89	6.23	6.58
Implied FY19e P/E (x)	27.4	25.9	24.5	23.2	22.0

Source: Edison Investment Research

Exhibit 6: Financial summary

	£'000s	2016	2017	2018e	2019e
Year end 31 December		IFRS	IFRS	IFRS	IFRS
PROFIT & LOSS		Restated
Revenue		132,707	154,480	174,852	203,803
Cost of Sales (Inc D&A + SBP)		(98,538)	(115,857)	(124,304)	(142,976)
Gross Profit		34,169	38,623	50,548	60,827
EBITDA		33,057	38,384	47,910	58,959
Depreciation and Amortisation		(10,938)	(12,025)	(15,166)	(16,699)
Operating Profit (before amort. and except.)		22,119	26,359	32,745	42,261
Acquired Intangible Amortisation		(1,374)	(1,429)	(1,429)	(1,429)
Exceptionals		1,962	(385)	0	0
Share based payments		(2,881)	(7,526)	(7,526)	(7,526)
Operating Profit		19,826	17,019	23,790	33,306
Underlying interest		(1,463)	(2,099)	100	0
Exceptionals		(26)	80	0	0
Profit Before Tax (norm)		20,630	24,340	32,845	42,261
Profit Before Tax (FRS 3)		18,363	14,920	23,890	33,306
Tax		(340)	(435)	(3,583)	(4,996)
Profit After Tax (norm)		20,692	24,823	29,261	37,265
Profit After Tax (FRS 3)		18,023	14,485	20,306	28,310

Average Number of Shares Outstanding (m)		671.5	689.5	756.1	756.1
EPS - normalised (p)		2.89	3.36	3.63	4.63
EPS - (IFRS) (p)		2.66	2.09	2.67	3.73
Dividend per share (p)		0.0	0.0	0.0	0.0

BALANCE SHEET
Fixed Assets		214,043	224,836	243,241	253,114
Intangible Assets		103,972	108,513	108,418	106,791
Tangible Assets		85,001	90,875	109,375	120,875
Other		25,070	25,448	25,448	25,448
Current Assets		64,323	111,559	126,250	163,644
Stocks		28,498	33,707	39,534	46,117
Debtors		30,868	32,240	38,581	49,451
Cash		4,957	45,612	48,135	68,077
Other		0	0	0	0
Current Liabilities		(51,522)	(44,916)	(47,596)	(55,232)
Creditors		(43,870)	(44,916)	(47,596)	(55,232)
Short term borrowings		(7,652)	0	0	0
Long Term Liabilities		(39,021)	(666)	(666)	(666)
Long term borrowings		(36,854)	0	0	0
Other long term liabilities		(2,167)	(666)	(666)	(666)
Net Assets		187,823	290,813	321,229	360,860

CASH FLOW
Operating Cash Flow		22,463	29,717	38,423	49,142
Net Interest		(1,489)	(2,125)	100	0
Tax		(839)	(5,844)	(1,000)	(1,200)
Capex		(19,060)	(28,190)	(35,000)	(28,000)
Acquisitions/disposals		(11,250)	0	0	0
Financing		578	94,912	0	0
Dividends		0	0	0	0
Net Cash Flow		(9,597)	88,470	2,523	19,942
Opening net debt/(cash)		23,223	39,549	(45,612)	(48,135)
HP finance leases initiated		0	0	0	0
Other		(6,729)	(3,309)	0	0
Closing net debt/(cash)		39,549	(45,612)	(48,135)	(68,077)

Source: Company accounts, Edison Investment Research

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