IQE — New CEO – new engagement with markets

IQE is the largest supplier of compound semiconductor epitaxy wafers globally and has the most comprehensive product offering. This extensive technology range has helped it gain around a 50% share of the wireless market (management estimates), where its wafers are used to make radio frequency chips, primarily for use in mobile handsets and associated infrastructure. Segmental growth is dependent on the volume of smartphones delivered globally and the rate of roll-out of 5G infrastructure. Investment in its technology portfolio and wafer manufacturing capacity has also enabled IQE to take a major share in the outsourced photonics market. Segmental growth here is dependent on the deployment of VCSELs in premium handsets for facial recognition systems and world-facing time-of-flight (ToF) devices used to create more compelling augmented reality (AR) experiences. IQE’s newer technologies give scope for growing wireless and photonics revenues substantially more quickly than the handset market and reducing the group’s dependence on it.

H121 performance was consistent with the guidance management issued in March that H121 revenue and EBITDA would be similar to H120 levels on a constant currency basis. However, FX headwinds resulted in a £10.3m reduction in reported group revenues compared with H120 (which was a record) to £79.5m and a £4.7m decline in reported adjusted EBITDA to £11.6m. We downgraded both our FY21 and FY22 estimates in November, reflecting management commentary that growth in the volumes of GaAs epiwafers in Q421 was lower than it expected, resulting in revised guidance of full-year reported revenues of c £152m generating c £18m EBITDA. This represents an 8% year-on-year decline in constant currency from the record revenues reported in FY20. Our FY22 estimates assume a recovery in both the global handset market, which declined in Q321, and the wireless infrastructure market, which was weak throughout FY21, as well as a ramp-up in sales of a new type of epitaxy for DFB (distributed feedback) lasers.

At current levels, IQE’s shares are trading at a discount to the mean EV/EBITDA multiples of the sample of companies engaged in manufacturing VCSEL epitaxy. IQE has a broader product portfolio than its VCSEL peers. In addition, it can manufacture in multiple geographies, which gives it relative resilience to US-China trade disputes. For these reasons, we believe it is not reasonable for IQE to trade on EV/EBITDA multiples that are at a discount to the VCSEL sample. However, we believe share price recovery will require greater visibility of the timing of the recovery in the smartphone market and of 5G infrastructure roll-out as these factors will determine the level of demand for wireless and VCSEL epitaxy in FY22.

IQE’s financial performance remains heavily influenced by the health and inventory cycle of the handset industry and the market share of several key customers within this industry, and the rate of 5G infrastructure roll-out globally. IQE is affected indirectly if the unavailability of components means that smartphone production is reduced. Sales and earnings are also affected by the US dollar/sterling exchange rate.

IQE was founded in 1988, employs around 660 people and its headquarters are in Cardiff, Wales. The shares were admitted to the London Stock Exchange in 2000.

IQE has grown organically and through acquisition to become the largest outsourced supplier of advanced wafer products and wafer services to the compound semiconductor industry. Its wafer foundries take very thin discs of substrate (compound semiconductor, silicon or silicon carbide) up to 150mm in diameter and deposit a succession of thin layers on them. Up to 400 epitaxial layers may be deposited, each of which may be only a few atoms thick. Each separate epitaxial layer contains a different combination of elements to give specific electrical or optical properties. By precisely controlling the thickness and composition of the layers deposited on the substrate, IQE provides customised epitaxial wafers (epiwafers) that meet each customer’s specific electrical and optical requirements. The finished epiwafers are sold to manufacturers of radio-frequency (RF) chipsets and laser chips. These carry out further processing steps to create finished chips, which are then integrated into products such as mobile phones, datacomms equipment and automobiles.

IQE is able to offer a wider range of technologies than its competitors and many in-house epitaxy units. This gives the group a strong competitive advantage and means it can benefit from growth in multiple markets. The group is continually refining its advanced epitaxy skills to create innovative, value-added, materials-based solutions for its customers. As its IP portfolio of over 150 patents and a rich pool of trade secrets has expanded, the dynamics of customer engagement have changed from an outsourced epitaxy manufacturer to a sought-after technology adviser. This shift is particularly valuable now that supply chain shocks are encouraging IQE’s customers to put a high priority on security of supply, a trend that management hopes will result in greater order book visibility.

The group has a presence in all three major semiconductor manufacturing regions, with facilities in Europe, the US and Asia giving it supporting relationships with multiple non-US and US customers. Its manufacturing base in Asia means it has been able to gain business with the Asian chip manufacturers that are picking up work from US chip manufacturers banned from supplying Huawei. This geographic diversity should make IQE relatively resilient to any mid- to long-term shifts in market share between component manufacturers or OEMs.

Unlike silicon semiconductors, which as the name suggests, are based on just one chemical element, silicon, compound semiconductors are made from a mixture of elements. By combining elements such as gallium, arsenic, indium, antimony, phosphorus and aluminium in different proportions, IQE can make compound semiconductor materials with a diverse range of optoelectronic and electronic properties, each optimised for a particular market segment. These include materials that transmit and receive wireless, RF or infrared (IR) signals or convert electrical energy to light and vice versa (photovoltaics). This diversity contrasts with silicon semiconductors, which have a fixed set of electronic characteristics, limiting their performance in key optical and RF applications.

IQE is engaged in multiple markets, each with different growth trajectories. The wireless segment was the principal driver in the decade from 2004 and at 52% of H121 revenues remains IQE’s largest segment. Management estimates IQE has around 50% of the global merchant wireless epitaxy market. Around two-thirds of wireless revenues are attributable to GaAs epiwafers used primarily for power amplifiers in smartphones. The other third is attributable to gallium nitride (GaN) epiwafers used primarily in mobile phone infrastructure. Consequently, IQE’s prospects are still heavily influenced by the number of smartphones sold globally as well as the rate of 5G infrastructure roll-out. Photonics (46% of H121 revenues) has taken over as the primary growth engine and we expect it to retain this role during the rest of the forecast period. Around half of photonics revenues are attributable to VCSEL epitaxy. Much of this output is used in smartphone sensing devices, although longer-term longer wavelength VCSELs are likely to be used for LiDAR in autonomous vehicles.

Wireless activity dependent on rate of 5G roll-out

The transmit and receive functions in smartphones typically use GaAs chips, especially higher-specification handsets. This is because GaAs power amplifiers operate at higher frequencies and are more efficient than their silicon counterparts, thus enabling longer times between battery charges. IQE has been supplying GaAs wafers to manufacturers of the power amplifier chips used in handsets for over two decades.

IQE’s newer technologies give scope for growing wireless revenues substantially more quickly than the handset market. In February 2021 IQE announced that customer tests on RF filters they had made using IQE’s IQepiMo technology, which is based on its cREO platform, had demonstrated improved performance when compared to the incumbent technology, potentially enabling IQE to enter the RF filter market longer term. IQE also intends to deploy several of its new technologies including cREO and porous silicon in an integrated front-end module combining power amplifiers, filters and switches on a single chip longer term. Based on estimates of the potential market size in 2023 from Yole Développement, expansion into the global filter and switch markets would more than quadruple IQE’s total available market related to wireless handsets.

Waiting for renewed roll-out of 5G networks

The transmit and receive functions in mobile phone base stations are also made from a compound semiconductor material, typically GaN-on-silicon carbide (SiC). IQE has been supplying GaN-on-SiC for low-volume, price-insensitive applications, primarily military communications and radar, and high-end base stations, which are an essential part of 5G networks, for several years. In September 2021 Verified Market Research predicted that the global 5G infrastructure market would grow at a CAGR of 42.7% between 2021 and 2028 when it would reach US$49.6bn. Growth would be driven by demand for high-speed data to support vehicle connectivity, tele-healthcare, delivery of ultra-high-definition video, seamless video calls and AR/virtual reality gaming. In our opinion, this makes deployment a question of ‘when’, not ‘if’.

As well as GaN-on-SiC, IQE offers a newer, less expensive GaN-on-silicon (Si) technology. This potentially opens up various more price-sensitive applications in the wireless infrastructure market in the medium term, displacing the incumbent silicon technology. The availability of GaN-on-Si becomes particularly significant as the wireless market shifts to 5G applications because not only do GaN devices consume less power and last longer than their silicon counterparts, they also enable the creation of smaller, denser arrays operating at higher frequencies. This is essential for 5G base stations, which need to be more compact than their 4G predecessors and handle the transmission and reception of multiple inputs and outputs in parallel to cope with the processing requirements of the internet of things (IoT), Industry 4.0 and autonomous vehicles.

In October 2021, IQE announced it had commenced a long-term strategic collaboration with global contract semiconductor manufacturer and designer GlobalFoundries to develop GaN on Si technologies for mobile and wireless infrastructure applications. The goal of this collaboration will be a GaN on Si offering at GlobalFoundries’ Fab 9 facility in Vermont, using wafers supplied by IQE. Management believes that other silicon foundries are likely to seek similar collaborations with IQE, as partnering gives them a route for differentiating their own product offers.

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 epitaxy for 5G handsets and Wi-Fi 6/6E routers offset a 53% year-on-year reduction in GaN-on-SiC materials for 5G infrastructure related to a slowdown in new deployments in China. This revenue development is consistent with third-party market data. IDC reported global handset shipment growth of 19% year-on-year during H121 and a 12% increase compared with H119. A report published by Grand View Research in July 2021 noted the coronavirus pandemic had 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 had postponed their 5G spectrum auctions.

Supply chain issues

Component shortages finally caught up with the smartphone industry in Q321. As manufacturers could not obtain all the components they needed to build sufficient smartphones to meet consumer demand, their output was lower than they had anticipated, resulting in lower demand for IQE’s wireless epiwafers. Consequently, in late November, the company announced that year-on-year growth in the volumes of GaAs epiwafers was lower in Q421 than it had previously expected. This news echoed comments from the companies we believe are IQE’s major wireless customers and market analysts IDC. Skyworks’ guidance for the quarter ending December 2021 was for revenues of US$1,475–1,525m compared with US$1,510m during the corresponding quarter in the prior year. Qorvo expects revenues in the quarter ending December 2021 to decrease sequentially, citing supply challenges and other factors affecting global smartphone demand. Qorvo expects these challenges to moderate in the quarter ending March 2022. In late October IDC noted that supply chain and component shortage issues resulted in a 6.7% year-on-year decline in global handset shipments during Q321. In December IDC predicted that all regions would show a single digit decline during Q421, adding that although there was a slowdown in consumer demand in China, demand remained strong in all other regions and exceeded supply, with the unmet demand contributing to future growth. Noting continued component shortages and logistical challenges, which may not improve until mid-2022, IDC lowered its growth forecast for 2021 and 2022 from 7.4% and 3.4% to 5.3% and 3.0% respectively. With regards to 2023 and beyond, IDC continued to expect a modest but healthy 3.5% five-year compound annual growth rate (CAGR).

Signs of a slowing down in consumer demand

According to Bloomberg, in early December Apple told its component suppliers that demand for the iPhone 13 line up had weakened so the catch-up in production anticipated in H122 as component shortages eased might not materialise. Weaker demand may be related to consumer concerns about inflation and the new omicron coronavirus variant; this may encourage them to delay purchases until the iPhone 14 range, which is rumoured to have more new features than the iPhone 13, is available. Weakness in consumer demand for smartphones could result in a slower recovery in demand for epitaxy than if only supply chain shortages are the issue. While IDC observes that the weakness in consumer demand is confined to China, this will disproportionately affect shipments of 5G phones such as the iPhone 12 and iPhone 13, since IDC predicts that 46.9% of 5G smartphone shipment will be to this region in 2021. Despite this trend, IDC expects 5G device shipments to show 117% year-on-year growth in 2021.

Our estimates have not been changed since the downgrade in November. We model a 23% segmental decline year-in-year during FY21 in reported currency, namely a more severe fall in the second half. (FY20 segmental revenues were the highest since 2013.) This is followed by 12% year-on-year growth in FY22, assuming a recovery in both the global smartphone and 5G infrastructure markets.

Photonics

IQE has developed a range of epitaxial wafers and substrates that may be used to either emit or detect visible light and light in the IR part of the spectrum. Wafer prices for photonic applications are at least twice that for wireless applications and typically command higher margins even though there are many more processing steps required than for wireless epitaxy. As discussed in our thematic report ‘Laser diodes – may the force be with you’, photonics devices are used in many different markets, including data communications, consumer devices, medical diagnostics, environmental monitoring and autonomous driving. Involvement in the photonics market should reduce IQE’s reliance on the health of the handset market in the longer term.

VCSEL demand is key factor in segmental performance

Demand for a specific type of photonics emitter, the VCSEL, has supported segmental growth from FY17 and will continue to have a major influence on segmental performance in future. Until 2017, the VCSEL market was driven by datacom applications, with photonics devices being used in links of up to 500m in data centres, enterprise and campus networks. Since 2017 3D sensing has become the dominant driver, especially since Apple began to use Face ID in the iPhone X, followed by a world-facing ToF device to improve AR experiences in the iPhone 12 Pro in 2020. We have previously inferred that IQE is engaged in the Apple VCSEL supply chain. IQE has also qualified VCSEL epitaxy for use in Android devices, although uptake so far has been modest. In July 2021 Yole Développement predicted the global VCSEL market would grow from US$1.2bn in 2021 to US$2.4bn in 2026, which equates to a 13.6% CAGR over the forecast period. Yole expects market growth overall will be driven by mobile and consumer applications, which it predicts will show a 16.4% CAGR over the forecast period.

There is demand from OEMs to shift from near infra-red to longer short wave infra-red wavelength VCSELs so LiDAR can be made eye-safe and, in the case of mobile phones, may be located under the OLED screen rather than a cutaway or ‘notch’. There is also interest in longer-wavelength VCSELs for data communications applications. As discussed in detail in our photonics report cited earlier, the transition to longer wavelengths is not trivial. Typically, shorter wavelength VCSELs are formed on GaAs wafers while longer-wavelength VCSELs are formed on indium phosphide (InP) wafers, although not in high volumes yet because of processing issues. IQE is developing an alternative solution based on adding small amounts of nitrogen to a gallium indium arsenide active layer formed on a GaAs substrate. In March 2021 IQE announced it had achieved key power and reliability milestones using this IQDN-VCSEL technology for advanced sensing applications at longer wavelengths, meeting the development requirements for multiple Tier 1 customers. IQE is engaged in customer-funded development programmes with key Tier 1 customers to refine this technology for qualification in future 3D sensing applications, potentially leading to volume manufacture medium term.

The Yole report cited above notes that the VCSEL market is dominated by two companies, Lumentum and II-VI, which held shares of 42% and 37% respectively in 2020. Both companies supply VCSELs used in iPhones. Lumentum outsources production of compound semiconductor epiwafers. Industry sources infer this is to IQE. II-VI manufactures epiwafers in-house following the acquisition of Finisar, which completed in September 2019. Apple invested US$390m in Finisar in December 2017 to create a 700,000 sq ft VCSEL manufacturing plant in Texas. In May 2021 Apple announced a further US$410m investment in the parent company, II-VI. Taiwan-based Visual Photonics also makes VCSEL wafers. So far, IQE has maintained its share of the VCSEL epitaxy market. With regards to maintaining its competitive advantage, IQE has substantially more experience of manufacture on 150mm wafers than its competitors, which should, in our opinion, manifest in higher yields. Moreover, it is already making progress on transitioning to VCSEL production on 200mm diameter germanium wafers, which would confer further cost advantages (see thematic report referred to above for details) and potentially provide a route for manufacturing VCSELs in a germanium layer on top of 300mm diameter silicon wafers. As discussed above, IQE also has a route for manufacturing longer wavelength VCSELs, which Finisar does not have.

Improved economics extends IR epitaxy offer into high volume markets

The use of compound semiconductor materials tuned to IR frequencies revolutionised image sensing, providing images that are eight times sharper and can be generated four times more quickly. These higher-resolution images are key for AI applications that analyse visual data. IQE has an over 80% share (management estimates) of the global IR substrate market, supplying indium antimonide wafers for defence applications such as night vision equipment. This is a high margin market, but one that requires relatively low volumes of epiwafers.

IQE is working on techniques for manufacturing larger diameter indium antimonide wafers. Moving to larger diameter wafers medium term will significantly reduce the cost per mm2, enabling IQE to supply IR epiwafers for more price-sensitive applications such as the sensors used in optical diagnostic systems. These systems provide a way of monitoring a patient’s condition without having to take samples of blood. The systems send pulses of laser light through a patient’s skin and measure the amount of absorption and scattering that has occurred. The light can be tuned to a specific wavelength for detecting the levels of different molecules in the patient’s blood: 575nm for haemoglobin, which indicates the amount of oxygen in the blood; 455nm for bilirubin, which indicates liver function; and 1,650nm for glucose, which helps diabetics monitor the amount of insulin required. Other sensors tuned to IR frequencies can be used in environmental monitoring to check on carbon dioxide levels. Being able to offer IR epiwafers to a much larger market represents a significant growth opportunity. We note that, at least to start with, this market could be supplied using relatively under-utilised molecular beam epitaxy (MBE) equipment located in IQE’s North Carolina facility.

Nanoimprint lithography technology data rate fibre-optic communications

InP laser diodes are a key part of optical communications networks, converting electrical signals to optical ones. Demand for electro-optical components is being driven by 5G connectivity and the adoption of IoT because optical networks can deliver the much higher data rates that are essential for distribution of video and other internet services. IQE is looking to its nanoimprint lithography technology to accelerate growth in this segment as it reduces the cost of DFB lasers used in short- and long-haul networks and improves their data throughput. Customers are testing samples of devices based on IQE’s epitaxy for 10G and 25G networks and optical detectors. Management expects this to result in volume sales from FY22 onwards.

Photonics segmental performance and outlook

Photonics revenues dropped by £7.0m year-on-year during H121 to £36.4m on a reported basis but the decline was only 7.6% in constant currency. Management notes 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. Consequently, VCSEL revenues fell by 26% year-on-year in H121. This reduction was partly offset by continued strong demand for epitaxy used in advanced sensing applications in the defence and security markets.

The supply-chain shortages affecting the global smartphone industry also affected demand for VCSEL epitaxy during Q4, which typically tails off towards the year end. In addition, sales of other photonics epitaxy during Q421 will be lower than management expectations because of the rephasing of some defence and security orders and a slow introduction of epitaxy for making DFB lasers.

We model a 5% segmental decline year-in-year during FY21 in reported currency. This is not as severe as the wireless segment, where performance has also been affected by weak demand for epitaxy used in 5G infrastructure. This is followed by 9% year-on-year growth in FY22, based on a recovery in global handset deliveries, phasing of defence and security orders and ramp-up in epitaxy for DFB lasers.

IQE is continually refining its advanced epitaxy skills to create innovative, value-added, materials-based solutions for its customers, helping it maintain share in established markets and to penetrate new ones. In our opinion, it would be difficult and time consuming for a competitor to replicate the breadth of the product portfolio. In addition to the examples of technology innovation discussed earlier in the note, in May 2021 IQE expanded its VCSEL portfolio with a value-added solution including device design provided by a third party, making it easier for customers without in-house design expertise to bring products to market.

IQE continues to invest in capacity at its facility in Taiwan, which is the focus of the group’s wireless activity, in response to the shift in wireless chip production to Asia resulting from US-China trade issues. Management is investing in eight new and refurbished tools for its Taiwan facility including three new Aixtron reactors which we estimate cost more than £9m in total and are currently being commissioned on-site. Utilisation of the group’s Taiwan facility has been high throughout FY21, despite the dip in global handset shipments so the additional reactors, which will increase capacity at the Taiwan facility by over 20%, should support wireless growth from FY22 onwards. The group is also investing in capacity to support the multi-year strategic partnership with a major semiconductor foundry (which we infer is GlobalFoundries) to develop epitaxy for 5G small cells and to support production of longer wavelength VCSELs. This additional capacity is not expected to generate material revenues until FY23.

Management is taking steps to reduce costs while creating a platform able to respond to the anticipated growth in both the wireless and photonics markets. It is creating a centre of excellence for MBE production at its North Carolina site, transferring most of the MBE production from its site in Singapore to North Carolina by mid-2022 (the remainder will be transferred to its site in Taiwan) and from its site in Pennsylvania by 2024 and closing both the Singapore and Pennsylvania sites. Closing the Singapore site will generate estimated annualised cash cost savings of c £4.8m. MBE technology is key for making longer wavelength VCSELs.

Americo Lemos took up the position of CEO earlier this month. Prior to joining IQE, Mr Lemos was on the executive team of the semiconductor designer and manufacture GlobalFoundries, where he was senior vice president of business development for Asia Pacific and China country president, responsible for growing business in these markets. Previous roles include senior VP Qualcomm Datacenter Technologies, VP Platform Engineering Group at Intel, VP Mobile Design Organisation at Flextronics and director of 3G Programs at Texas Instruments. We believe his priority now he has joined IQE will be aligning the group’s technology roadmap to market opportunities, thus improving returns on the investment in IP and capital equipment for investors. His knowledge of customer requirements and their technology roadmaps, together with his extensive network of contacts should, in our view, be invaluable in achieving this goal, supporting the formation of long-term strategic collaborations with customers such as the one announced in October 2021 with GlobalFoundries.

Dr Drew Nelson, IQE’s founder and previous CEO has become a non-executive board member with the title of president, acting in an advisory and ambassadorial role for the business. He is also devoting more time to the development of the Compound Semiconductor Cluster in South Wales.

Handset exposure: With 52% of H121 revenues coming from wireless, IQE’s financial performance remains exposed to changes in dynamics in this segment. In the medium term, we expect IQE’s reliance on the handset market to diminish as VCSEL programmes for applications such as autonomous vehicles move to volume production and IR epitaxy is used in high volume applications such as blood monitoring. In the short term, however, both IQE’s wireless and photonics segments are heavily exposed to the global handset market.

Supply chain issues: While IQE has not been directly affected by semiconductor component shortages, as noted above, it has been affected indirectly by the unavailability of components resulting in a reduction in smartphone production.

Impact of individual programmes: Several of the programmes in which IQE is involved are sufficiently large to have a distorting effect on short-term revenue trends. These include two US customers making wireless chips for handsets (33.7% and 31.4% of FY20 wireless revenues respectively), the major VCSEL customer (35.0% of FY20 photonic revenues) and the major InP customer. We believe the main problems with this customer concentration is the big impact that changes in demand for phones for an individual smartphone vendor can have on IQE’s revenues. This is more significant than the risk of a major customer changing to a different supplier, which we believe is relatively low because once a customer has qualified an epitaxy vendor, it is extremely unlikely to risk compromising device performance by switching to an alternative supplier for the sake of saving several cents on a device that could be worth $1,000. IQE has direct experience of chip vendors being reluctant to change epitaxy supplier. For example, it purchased Kopin’s epitaxy activity in 2013 to secure key customers that would not risk switching suppliers. While Finisar has started manufacturing VSELs for the Apple supply chain over a year ago, IQE’s share of VCSEL epitaxy appears to have been stable during FY21. We note that if IQE’s major VCSEL customer increases the share of epitaxy made by Finisar, this could be mitigated by the introduction of ToF functionality in Android devices. IQE is well positioned to benefit from this as it has completed multiple VCSEL product qualifications for Android supply chains.

Currency: IQE’s presentational currency is sterling, but the company earns the large majority of revenues in US dollars. Translational risk is therefore unavoidable. Transactional risk is reduced, where possible by matching input costs with revenues, although a proportion of costs is in sterling. Debt is denominated primarily in dollars. We note the company uses a typical layered hedging approach to smooth out 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.

Uncertainties in markets that are still not yet developed: IQE has opportunities in many end markets including autonomous vehicles, environmental monitoring and non-invasive blood monitoring. The timing and rate at which revenues from these applications could grow is difficult to gauge.

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.

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 because 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 (see section on Scaling the business for growth), 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 focused approach to this long-term but strategic activity too.)

As discussed, component shortages finally caught up with the global smartphone industry in Q321, causing lower growth in the volumes of GaAs epiwafers in Q421 than management had expected and lower demand for VCSEL epiwafers. In addition, Q421 sales of other photonics epitaxy are being adversely affected by the rephasing of some defence and security orders and a slower than expected introduction of epitaxy for making DFB lasers. Management consequently revised FY21 guidance downwards in November. The revised guidance was for full-year reported revenues of c £152m generating c £18m EBITDA. This is equivalent to c £164m revenues and c £25m adjusted EBITDA in constant currency, representing an 8% year-on-year decline (constant currency) from the record revenues reported in FY20 and an EBITDA margin of 15% on a constant currency basis (17% in FY20). In January, management reiterated its FY21 guidance of c £164m revenues in constant currency and FY21 capital expenditure of £14–17m, and advised that it expected net debt to be c £6m excluding lease liabilities at end FY21.

We downgraded our FY21 and FY22 estimates in our November update. Our FY21 estimates reflect management guidance given in November and January. We have not changed them since November, except to reduce FY21 capital expenditure and working capital to bring net debt at the year end in line with management guidance given in January (ie cut from £9.6m to £6.0m). Our FY22 estimates, which have not been changed except for the net debt position at the year end, which has been cut from £13.8m to £12.8m, are based on the following assumptions:

We include a comparative valuation of IQE versus its broader (but imperfect) peer group above, although prefer a comparison with the other companies engaged in VCSEL production because of the growth potential associated with involvement in VCSELs. At current levels, IQE is trading at a discount on an EV/sales and EV/EBITDA basis with regards to the sample of companies engaged in manufacturing VCSEL epitaxy. IQE has a broader product portfolio than its VCSEL peers. In addition, it can manufacture in multiple geographies, which gives it relative resilience to US-China trade disputes. For these reasons, we believe it is not reasonable for IQE to trade on EV/EBITDA multiples that are at a discount to the VCSEL sample. However, we believe share price recovery will require greater visibility of the timing of the recovery in the smartphone market and of 5G infrastructure roll-out as these factors will determine the level of demand for wireless and VCSEL epitaxy in FY22.