IQE — Multiple VCSEL programmes entering production

The recent work on VCSEL product qualifications has resulted in IQE being in mass production with eight VCSEL chip manufacturers and in final qualification stages with another four. These include facial recognition for mobile phones, short-distance data communications, camera autofocus, proximity sensing and industrial heating. Deliveries for the first volume VCSEL programme, which we have previously inferred is for the iPhone X, began to ramp up in June from a higher base than the corresponding period the previous year. Volumes for the new VCSEL programmes, which include initial production for Android OEMs, have begun to ramp up as well. This reduces IQE’s exposure to a single handset manufacturer or use case. Adoption of facial recognition technology, which uses arrays of VCSELs, by Android users is likely to be driven by use of the technology for authorising mobile phone payments, promoting adoption in mid- and low-tier phones rather than just high-end models.

The construction and fit-out of the new foundry in Newport, UK, is on schedule to commence production by the end of FY18. Five reactors were installed during H118, a further two were delivered in August and three more will be delivered during H218. Commissioning and qualifications are ongoing. The staff required to operate the facility 24/7 have all been recruited and are being trained. The factory already has dedicated bays for 20 reactors, enabling IQE to double capacity if required to meet demand. The additional capacity is critical for IQE to maintain its dominant position in the VCSEL market as it grows.

IQE has developed a proprietary NIL technology, which delivers the complex diffraction gratings associated with DFB (distributed feedback) lasers at higher quality, much lower cost and much higher throughput. In July 2018 it announced that this technology had been production qualified by a leading supplier of DFB lasers to the telecoms and datacentre markets, and that work on the first production order (for US$0.25m) had commenced. During the qualification process, the customer established that using IQE’s proprietary NIL technology to create embedded gratings gave greater precision and dimensional control and therefore superior performance compared with conventional DFB laser manufacturing techniques using electron beam processing. In addition to DFB applications, IQE is also engaged in multiple other NIL qualification programmes across a range of wafer sizes and end-applications.

As flagged in the pre-close trading update, total revenues grew by 4% year-on-year to £73.4m, as double-digit sales growth on a constant currency basis in each of the three primary markets was tempered by a c 10% currency headwind. The segmental split was distorted by inventory management factors. During both H117 and H217, significant production capacity was allocated to the initial VCSEL ramp-up for the iPhone X. During H118, sales to the chip manufacturer servicing this application were similar to H117, as the supply chain absorbed inventory, enabling the group to replenish wireless inventory channels and start work on a significant number of VCSEL production qualifications. On a constant currency basis, wireless revenues grew by 11% year-on-year to 65% of the total, photonics by 30% to 26% of the total and infrared by 11%. Unlike H117, which benefited from £1.0m licence income from the JVs, there was no licence income as management opted to reinvest cash generated by the two JVs back into the infant businesses.

Adjusted profit before tax fell by 21% to £7.6m, depressed by several factors. These were the currency headwind (£2.0m), the cost of multiple low-margin VCSEL qualification programmes (£0.6m) and the cost of staffing the new Newport facility prior to commencing production (£0.9m), which is scheduled for H218. Collectively, these one-off effects totalled £3.5m. If these costs are stripped out, adjusted profit before tax becomes £11.1m, a 14% improvement on the prior year period. In addition, the cost of converting reactors from photonics applications to wireless and back again was c £0.5m. We note that management has authorised an expansion of wireless capacity in the Taiwan facility to reduce the need to requalify reactors for different technologies in the future. Management estimates that reactor conversions cost c £3m over the last 18 months.

Net cash reduced by £5.0m during the period to £40.6m at the end of June. Working capital increased by £6.6m compared with end FY17, capitalised development expenditure totalled £9.4m as the group continued work on multiple innovative technologies, and capex totalled £5.8m, half of which related to the new Newport foundry.

Management has updated its guidance of segmental revenue growth for the current year and over a three- to five-year time horizon, adding guidance for FY19 as well. This guidance is summarised in Exhibit 1, together with the growth rates adopted in our estimates, those programmes included in the guidance and those presenting upside to the guidance. The main changes to guidance are: (1) a reining in of the top end of FY18 photonics revenue growth from 60% to 50%; (2) a reduction in FY18 photonics operating margin from 38% to 35% to reflect the one-off costs experienced in H118; (3) putting FY18 licence income guidance at the bottom end of the previous guidance, which was £0-2m; and (4) raising the FY18 tax rate from 15% to 18%.

Following the changes to management guidance, we adjust our estimates as follows:

The share price has declined from the peak of 178.75p reached in November 2017 and is now trading at 91.6p/share. Based on our current estimates, which assume photonics growth at the lower end of management guidance, the shares are trading at a premium to the mean for its peers on all metrics (Exhibit 3). The size of this premium reduces if we adopt a higher photonics growth rate (Exhibit 4). If we adopt a 50% growth rate in FY18 and 60% in FY19, which is at the upper end of management guidance, the shares are still trading at a premium to the mean P/E for FY18e (29.6x vs 22.6x for peers) and the mean P/E for FY19e (19.5x vs 17.0x for peers). This might suggest that the shares are already pricing in some upgrades to management guidance.

If we restrict the comparison to the three listed companies offering epitaxy for VCSELs: IntelliEPI, LandMark Optoelectronics and Visual Photonics, then based on our current estimates IQE is trading on prospective P/E multiples that are in line with those for LandMark and below that for Visual Photonics. IQE has a much stronger market position than the other three, so trading towards the upper end of this smaller sample seems reasonable. Taking this approach, the shares look fairly priced at current levels, although investors should note that this is based on estimates that are towards the lower end of management guidance.