IQE — Well positioned to withstand near-term uncertainty

Although IQE and its auditor had not encountered any practical challenges in preparing for the FY19 results announcement, on 23 March the Financial Reporting Council advised not to sign any opinions for a short period or for two weeks. IQE has therefore delayed publishing its full FY19 results as intended on 24 March and instead issued a comprehensive trading update based on summary unaudited financial accounts covering FY19 financial performance and an update on Q120 trading. Since this research note has been prepared using the information from the trading update, which does not contain full details of the FY19 results, the financial table on the front page and commentary in the note refers to the released summary of the FY19 performance, while the financial summary table on page 6 still refers to our full FY19 estimates, which were last updated in November.

During FY19, group revenues decreased by 10% year-on-year to £140.0m, in line with the reduced guidance of £136–142m provided by management in November. Wireless revenues decreased by 23% as wireless customers cut back on inventory levels in response to the uncertainty regarding future demand caused by lengthening mobile phone replacement cycles and the potential impact of Huawei’s addition to the US Bureau of Industry and Security’s Entity List. The interconnected nature of the semiconductor supply chain meant that many of IQE’s customers were affected indirectly by this situation. The total percentage reduction in wireless revenues was substantially greater than the decline in handset volumes, which industry analyst Gartner notes fell by 1% during calendar 2019 to 1.5bn units. Photonics revenues increased by 4%. Sectoral growth was lower than our estimates because demand for indium phosphide lasers for the datacom/telecom market, which we estimate were c 35% of FY18 photonics revenues, particularly from a single US customer, was weak. Encouragingly, orders from IQE’s major vertical cavity surface emitting laser (VCSEL) customer, which we have previously inferred is engaged in the Apple supply chain, were consistently strong throughout FY19.

As the business is highly operationally geared, the drop in revenue caused the group to move from £16.0m adjusted operating profit in FY18 to a £4.7m adjusted operating loss in FY19.

Operating cash flow adjusted for exceptional items was similar to the previous year (£16.5m in FY19 vs £17.0m in FY18). Capex totalled £31.9m (FY18: £30.3m). This included completing the infrastructure phase at the Mega Foundry in Newport, South Wales, as well as capacity expansion in Taiwan and Massachusetts. Excluding finance leases associated with the introduction of IFRS 16, the group moved from £20.8m net cash at end December 2018 to £16.0m net debt at end December 2019, towards the lower bound of management’s £15–20m guidance. During H219 management agreed a £30m asset financing facility, increasing total available facilities to around £57m, providing support if the economic impact of the COVID-19 pandemic is prolonged. The Newport Mega Foundry already has bays for an additional 10 reactors, so future investment will be primarily only in reactors rather than the supporting infrastructure and thus proportional to incremental revenue development.

Given the uncertainty presented by the COVID-19 pandemic, management is not providing any guidance at present. IQE’s production has not been affected either by any disruption or by a material reduction in demand so far and the business has traded in line with management expectations for Q120. However, there remains some risk that production may be affected, though we note that production has continued at IQE’s facilities in Massachusetts and Pennsylvania where the US Department of Homeland Security deems IQE to have a ‘special responsibility to maintain (its) normal work schedule’. We note that IQE is more resilient than peers such as VPEC whose facilities are all located in Taiwan, because it has facilities in the US, the UK, Taiwan and Singapore. IQE is also relatively resilient with regards to materials because it sources the substrates used from multiple suppliers. The key risk is a reduction in demand for smartphones, the level of which will depend on the severity of the economic downturn caused by the COVID-19 virus. Given the unusual levels of uncertainty, we are adjusting our estimates as follows:

If we assume that the overall smartphone market contraction will be about 15% in FY20, IQE should experience a somewhat lower rate of decline for two reasons. Firstly, as discussed above, IQE suffered from severe inventory destocking during FY19, which has reversed in Q120. Secondly five new production tools at IQE’s facility in Taiwan have been qualified by a major Taiwanese foundry, four of which are already in production. This customer will be supplying semiconductor chains in China and elsewhere in Asia, in effect increasing the number of smartphone models that IQE has epitaxy in. As a result, we provisionally model a 10% reduction in wireless revenues for FY20 followed by 11% growth in FY21, supported by the roll-out of 5G networks.

Earlier this month, Apple announced that it would be incorporating a LiDAR (light detection and ranging) system in the rear camera of the new iPad Pro to give more accurate readings of surrounding for augmented reality applications. This has led to renewed press speculation that the as yet unannounced iPhone12 will also contain a LiDAR system. If so, this would be a significant development for IQE, because the number of VCSEL per phone increases by around 1.5x if a LiDAR system is included. If the rumour is founded and the launch this autumn is not delayed by the COVID-19 virus, this could represent upside or additional support to our estimates.

Given that future demand for both wireless and photonics epitaxy will be determined by the length of the COVID-19 outbreak, which is not known at present, we have prepared a sensitivity analysis showing the impact on FY20 adjusted operating loss of alternative year-on-year changes in wireless and photonics revenues. This is shown in Exhibit 3.

We include a comparative valuation of IQE versus its broader (if imperfect) peer group below. In common with all of its peers, IQE’s shares have collapsed since the beginning of calendar 2020. At current levels IQE is trading at a substantial discount on an EV/sales basis with regards to the year 1 and year 2 means for both the broader sample and the sample of companies engaged in manufacturing VCSEL epitaxy. Looking at the prospective year 1 and year 2 EV/EBITDA multiples of its peers manufacturing VCSEL epitaxy, IQE is trading at a discount to the mean. It is trading at the upper bound of the sample of VCSEL peers with regards to year two P/E multiples.

Given the volatility in the stock market at present and the possibility of guidance and earnings downgrades across the peer group in the near future, it is difficult to draw any precise conclusions from this comparison. That being said, given IQE’s broader product portfolio than its VCSEL peers, as well as its ability to manufacture VCSELs on 6” rather than 3” wafers, which confers cost-competitive advantages, and its ability to manufacture on multiple sites, which gives some relative resilience to both COVID-19 shutdowns and US-China trade disputes, we believe it is reasonable for IQE to trade on multiples that are at the upper bound of the VCSEL sample.

Re-establishing investor confidence will be key to a share price recovery for both IQE and for its peers. For IQE this will require further evidence that it is ramping up volume deliveries in the Asian/Android supply chain, thus helping return the group to profitability and reducing the dependence on the Apple supply chain. For the sector more generally, investors will probably require evidence that handset demand is recovering as economies recover from the COVID-19 pandemic, with the switch to 5G providing the motivation for cash-strapped consumers to justify upgrading their handsets.

By way of comparison, the last time IQE’s share price was at around the current level was August 2016 when it sank to 16.5p with a year 1 EV/sales multiple of 1.2x following a period of weakness in the global handset market as smartphone penetration peaked, which resulted in a drop in IQE’s wireless revenues. IQE’s year 1 EV/sales multiple was close to that level earlier in the week but has picked up since the trading update.