Benefiting from start of 5G mega-cycle

IQE 25 March 2021 Update
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IQE

Benefiting from start of 5G mega-cycle

FY20 results

Tech hardware & equipment

25 March 2021

Price

72.6p

Market cap

£582m

Net cash (£m) at end December 2020 (excluding finance leases)

1.9

Shares in issue

801.1m

Free float

86.8%

Code

IQE

Primary exchange

AIM

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(1.8)

0.8

164

Rel (local)

(2.6)

(2.7)

104.9

52-week high/low

88.3p

26.0p

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 surface emitting lasers and infrared semiconductors.

Next event

AGM

June 2021

Analysts

Anne Margaret Crow

+44 (0)20 3077 5700

Dan Ridsdale

+44 (0)20 3077 5729

IQE is a research client of Edison Investment Research Limited

As flagged in IQE’s January trading update, FY20 revenue rose to a record £178.0m, taking the company from an adjusted operating loss of £4.7m to £5.4m profit. This excellent performance was the result of 5G roll-out boosting demand for IQE’s epitaxy in both infrastructure and handsets, combined with consistent demand for photonics epitaxy from IQE’s longstanding VCSEL customer. While these favourable trends have continued into FY21, we are cutting our FY21 revenue estimate by £8.3m and PBT by £9.5m to reflect the strengthening of sterling against the US$.

Year end

Revenue (£m)

EBITDA
(£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

12/19

140.0

16.2

(7.0)

(2.46)

0.00

N/A

12/20

178.0

29.9

3.2

0.29

0.00

N/A

12/21e

175.0

30.3

2.5

0.21

0.00

N/A

12/22e

185.4

39.0

6.8

0.63

0.00

N/A

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

Record revenues return group to profit

In line with January’s guidance, group revenues grew by 27% year-on-year during FY20 to a record £178.0m, in line with our £178.3m estimate. Wireless revenues jumped by 38% to £94.2m, benefiting from 5G infrastructure deployments in Asia and 5G handset adoption. Photonics revenues rose by 17% to £81.6m. Production for IQE’s major vertical cavity surface emitting laser (VCSEL) customer was consistently strong throughout the year. Given the high proportion of fixed costs, the strong year-on-year revenue growth took the group from a £4.7m adjusted operating loss in FY19 to a £5.4m adjusted operating profit, behind our £8.5m estimate. Strong cash generation enabled IQE to move from £16.0m net debt at end FY19 to £1.9m net cash at end FY20 (ex-of £47.0m in IFRS 16 lease liabilities).

5G adoption continues to drive epitaxy demand

These favourable trends have continued into FY21. Industry pundits predict a recovery in global handset sales during FY21, which for IQE means that demand for wireless epiwafers for handsets has been strong so far this year, and demand for photonics wafers for 3D sensing applications remains positive. We have left our FY21 estimates broadly unchanged on a constant currency basis, but have reduced them to reflect sterling strengthening against the US dollar.

Valuation: Dependent on handset market growth

At current levels, IQE is trading in line with the mean EV/EBITDA multiples of the sample of companies engaged in manufacturing VCSEL epitaxy. Given IQE’s broader product portfolio, we believe it is reasonable for it to trade on multiples that are at the upper bound of this sample. However, we believe share price improvement will require greater visibility of how handset demand will be affected by any pandemic-related recession in 2021, and whether the switch to 5G and the availability of ‘must-have’ AR apps will be sufficient motivation for cash-constrained consumers to justify upgrading their handsets.

FY20 performance

Record revenues return group to profit

In line with the January trading update, group revenues grew by 27% year-on-year during FY20 to a record £178.0m. The total was in line with our estimate, but with a higher proportion of wireless revenues and lower proportion of photonics revenues. There was no disruption to production from coronavirus-related lockdowns or any significant impact on the supply of materials. Wireless revenues jumped by 38% to £94.2m. Wireless revenues had decreased by 23% during FY19 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. In addition, there was a modest decline in handset volumes in FY19, which industry analyst Gartner notes fell by 1% during calendar 2019 to 1.5bn units. In contrast, during FY20 wireless revenues benefited from initial 5G infrastructure deployments in Asia, particularly gallium nitride on silicon carbide (GaN-on-SiC) for massive multiple-input and multiple-output (mMIMO) base stations, consumer appetite for 5G-ready handsets and demand for high-performance GaN-on-SiC wafers for advanced RF applications. Photonics revenues rose by 17% to £81.6m. Production for IQE’s major VCSEL customer, which we have previously inferred is involved in the Apple supply chain, was consistently strong throughout the year. Demand for VCSELs was boosted by the introduction of a world-facing direct time of flight (ToF) device to improve augmented reality (AR) experiences in the new iPhone 12 Pro, which increased the VCSEL content per phone by 1.5 times. In addition, strong demand continued for the high-performance gallium antimonide (GaSb) wafers used in advanced IR (infrared) sensing applications. The revenue total was depressed by £0.5m of FX headwind.

Given the high proportion of fixed costs, the strong revenue growth took the group from a £4.7m adjusted operating loss in FY19 to a £5.4m adjusted operating profit. This was lower than our £8.5m estimate because the additional direct costs associated with incremental sales were higher than we had modelled. Adjusted gross margin improved from 14.9% to 18.7%, demonstrating the benefit of better utilisation rates. Adjusted indirect costs rose by £2.0m to £27.8m, reflecting higher depreciation following the commissioning of additional manufacturing capacity in the UK, Taiwan and Massachusetts as well as increased numbers of employees to support growth. The group incurred net £7.1m exceptional costs, which are described in Exhibit 1.

Exhibit 1: FY20 P&L breakdown of exceptional items

Category

Value* (£m)

Details

Share-based payments

(0.3)

Restructuring

(0.2)

Employee retention bonus costs relating to the announced closure of the group’s manufacturing facility in Pennsylvania, US. Non-cash.

Settlement of patent dispute

1.7

Settlement agreement (net) associated with legal costs incurred by IQE. Arbitration panel ruled in favour of IQE in January 2020. Cash to be received in FY21.

Impairment of intangible assets

(6.5)

Impairment of cREO patent and development costs that are not related to filters, following a decision to focus cREO activity on the filter market.

Onerous contract provision

(1.8)

Cost of minimum guaranteed future royalty payments to Translucent agreed when the cREO technology was acquired. These are still payable, although the date when IQE will start to generate revenues from commercial exploitation of the technology has been delayed.

Source: IQE. Note: *Before adjustment for tax.

Strongly cash generative now expansion programme complete

Cash generated from operations quadrupled year-on-year to £35.5m, while capital expenditure was only £5.0m. This is because the programmes to build infrastructure at the Mega Foundry in Newport, South Wales, and expand capacity in Taiwan and Massachusetts all completed in FY19. The group moved from £16.0m net debt at end FY19 to £1.9m net cash at end FY20 (excluding £47.0m in IFRS 16 lease liabilities). Cash outflow included £1.4m acquiring the outstanding 9.8% stake in the group’s subsidiary in Taiwan during October 2020. During H120, management negotiated an agreement with HSBC to relax debt covenants in December 2020 and June 2021. This was a precautionary measure to ensure continued access to debt facilities in severe downside scenarios.

Outlook and estimates: FY21 hit by $/£; recovery in FY22

Management has not provided any guidance for FY21, but notes that while trading has continued positively so far in FY21, with H121 revenue and adjusted EBITDA expected to be similar to H120 on a constant currency basis, it is experiencing a foreign exchange headwind because its revenues are predominantly earned in US dollars but reported in sterling. This has a significant impact on profitability because around half the costs are denominated in sterling and half in US$. We are making changes to our FY21 estimates to reflect the movement in exchange rates as well as new investment in wireless capacity at the Taiwan facility. We present FY22 estimates for the first time, which assume no change in FX between FY21 and FY22.

Exhibit 2: Changes to estimates

FY20

FY21e

FY22e

Old

Actual

% change

Old

New

% change

New

Revenue (£m)

178.3

178.0

-0.2%

183.3

175.0

-4.5%

185.4

Adjusted PBT (£m)

6.6

3.2

-51.5%

12.0

2.5

-79.0%

6.8

Adjusted EPS (p)

0.6

0.3

-54.1%

1.2

0.2

-81.9%

0.6

Capitalised R&D (£m)

6.0

5.4

-9.9%

6.0

8.0

33.3%

6.0

PPE (£m)

7.0

5.0

-28.7%

10.0

25.0

150.0%

10.0

Net (cash)/debt excluding finance leases at year end (£m)

(1.9)

(1.9)

2.7%

(10.8)

4.7

-143.8%

(11.8)

Source: Edison Investment Research

The individual adjustments are:

Wireless revenues: we had previously modelled £85.4m wireless revenues for FY21 because we had underestimated the scale of wireless growth in FY20. IQE notes that demand for epiwafers for 5G-ready handsets continues to be strong. This is consistent with a forecast from International Data Corp in March, which forecast that global smartphone shipments would grow by 5.5% year-on-year during 2021, 13.9% year-on-year during Q121. The report noted that growth would be driven by continued recovery in demand, the success of the recently launched iPhones and a supply-side push of 5G devices. However, deployment of 5G infrastructure in China is likely to be held up during H121 by restrictions on sourcing items from the United States, although other regions are rolling out 5G networks as well. Around one-third of IQE’s wireless revenues are derived from sales for infrastructure applications, so this geopolitical situation is likely to dampen wireless revenue growth in the short term. On a constant currency basis we model a 1.4% year-on-year increase in wireless revenues to £95.5m. Noting the reference to FX tailwinds, we assume a US$/£ exchange rate of 1.32 (previously 1.26), which reduces wireless revenues to £91.2m, a 3.2% drop year-on-year. We model a 7.0% increase in revenues during FY22 to £97.5m, supported by a recovery in infrastructure-related revenues.

Photonics revenues: we had previously modelled £95.8m photonics revenues for FY21, because we had overestimated the rate of photonics growth in FY20. IQE notes that demand for 3D and advanced sensing applications remains positive. This is consistent with industry news. Citing supply chain sources, a Nikkei report published in December 2020 noted that strong iPhone 12 demand had led Apple to boost iPhone production plans for 2021 by between 20% and 30%, while initial full-year production targets were up by 20% to hit 230m phones, assuming that output was not affected by industry-wide shortages of key components. A report published by JP Morgan in February also estimated a 2021 output of 230m, representing a 13% rise from 2020. This is positive for IQE. As 2021 progresses, VCSEL production will depend on the functionality of the as yet unnamed iPhones scheduled for launch later in the year. Some industry pundits predict that all four types of new iPhone will have LiDAR scanners, not just the Pro models as for the iPhone12, others predict that Apple may choose to reserve this feature for its Pro models. The potential upswing in VCSEL demand from the Apple supply chain needs to be balanced against the potential for IQE to lose share to Finisar, which is also supplying VCSEL epitaxy for the Apple supply chain. On the positive side, we note that ongoing qualification of nanoimprint lithography (NIL) technology for distributed feedback lasers used in high-speed communications networks could result in meaningful revenues from H221 onwards. In addition, the ability to integrate more accurate information about a handset user’s physical environment into the AR world is beginning to catalyse the launch of ‘must-have’ AR apps. It is likely that this will encourage Android handset manufacturers, several of which already use modest amounts of IQE’s VCSEL epitaxy, to add LiDAR to their devices. This could potentially boost IQE’s photonics revenues by the end of FY21 as well. We model a modest 4.9% increase in photonics revenues to £85.6m during FY21 in constant currency (ie an unchanged revenue total). Adjusting for a change in exchange rate as above, this equates to photonics revenues remaining close to FY20 levels at £81.7m. We model 5.0% segmental growth in FY22 to £85.8m.

Direct and indirect costs: we make adjustments to these because around half of IQE’s costs are denominated in dollars, half in sterling.

Capital expenditure: we have previously noted that future investment will be primarily only in reactors rather than the supporting infrastructure and thus proportional to incremental revenue development. IQE has advised that it expects expenditure on equipment to be £20–30m during FY21 as it resumes investment in capacity for specific growth platforms, including three new Aixtron reactors, we estimate totalling over £9m, for expanding wireless gallium arsenide (GaAs) production for handset applications in Taiwan. We raise our FY21 capex estimate from £10.0m to £25.0m.

Underlying interest: we have raised our estimate of finance payments for FY21 to reflect the additional capital expenditure, as well as higher than expected finance lease payments in FY20.

Valuation: Further share price appreciation dependent on pace of global handset market growth

We include a comparative valuation of IQE versus its broader (but imperfect) peer group below. At current levels, IQE is trading at a premium on an EV/EBITDA basis with regards to the mean of the larger sample and in line with the mean of the sample of companies engaged in manufacturing VCSEL epitaxy. It is trading above the upper bound of the sample of VCSEL peers 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 further share price improvement will require greater visibility of how handset demand, including that for iPhones, will be affected by any potential pandemic-related recession in FY21 and whether the switch to 5G and the availability of ‘must-have’ AR apps will be sufficient motivation for cash-constrained consumers to justify upgrading their handsets.

Exhibit 3: Peer valuation

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

162

2.3

-

-

-

-

-

LandMark Optoelectronics

871

8.1

6.5

14.9

12.4

28.2

22.6

Soitec

6,440

8.9

6.8

30.3

22.2

-

-

Visual Photonics Epitaxy

726

7.8

6.5

21.4

17.7

38.8

28.5

WIN Semiconductors

5,737

5.9

5.2

13.2

11.5

23.9

20.8

Opto-electronics

II-VI

7,235

2.7

2.4

9.8

8.6

18.6

16.2

EMCORE

236

1.5

1.4

10.7

10.2

14.0

12.3

Lumentum Holdings

6,324

3.2

2.9

8.3

7.3

13.0

12.1

Mean - epitaxy and opto-electronics

5.1

4.5

15.5

12.8

22.8

18.7

LandMark Optoelectronics

871

8.1

6.5

14.9

12.4

28.2

22.6

Visual Photonics Epitaxy

726

7.8

6.5

21.4

17.7

38.8

28.5

Mean – VCSELs

7.9

6.5

18.1

15.1

33.5

25.5

IQE

$723m

3.2

3.1

18.7

14.6

338.3

112.8

Source: Refinitiv, Edison Investment Research. Note: Prices at 22 March 2021.

Exhibit 4: Financial summary

£'000s

2019

2020

2021e

2022e

Year end 31 December

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

 

 

140,015

178,016

174,975

185,442

Adjusted Cost of Sales

(119,145)

(144,689)

(142,994)

(148,227)

Adjusted Gross Profit

20,870

33,327

31,981

37,215

EBITDA

 

 

16,246

29,919

30,324

38,953

Depreciation and Amortisation

(22,289)

(24,533)

(26,000)

(30,000)

Operating Profit (before amort. and except.)

 

 

(4,676)

5,386

4,324

8,953

Acquired Intangible Amortisation

0

0

0

0

Exceptionals

(14,897)

(10,638)

0

0

Share based payments

771

(265)

(265)

(265)

Operating Profit

(18,802)

(5,517)

4,059

8,688

Underlying interest

(1,606)

(2,165)

(1,800)

(2,200)

Exceptionals and losses from JVs

(4,540)

3,788

0

0

Profit Before Tax (norm)

 

 

(7,019)

3,221

2,524

6,753

Profit Before Tax (FRS 3)

 

 

(24,948)

(3,894)

2,259

6,488

Reported tax

(10,180)

1,001

(480)

(1,283)

Profit After Tax (norm)

(19,010)

2,702

2,044

5,470

Profit After Tax (FRS 3)

(35,128)

(2,893)

1,779

5,205

Average Number of Shares Outstanding (m)

787.2

797.2

801.0

801.1

EPS - normalised (p)

 

 

(2.46)

0.29

0.21

0.63

EPS - (IFRS) (p)

 

 

(4.51)

(0.41)

0.18

0.61

Dividend per share (p)

0.0

0.0

0.0

0.0

BALANCE SHEET

Fixed Assets

 

 

300,047

277,161

284,161

270,161

Intangible Assets

118,456

105,772

106,272

104,772

Tangible Assets

136,557

126,229

132,729

120,229

Other

45,034

45,160

45,160

45,160

Current Assets

 

 

72,533

94,125

88,000

110,760

Stocks

30,668

30,887

31,639

35,564

Debtors

33,065

38,575

38,351

40,645

Cash

8,800

24,663

18,010

34,550

Other

0

0

0

0

Current Liabilities

 

 

(32,646)

(48,545)

(45,071)

(47,078)

Creditors

(27,529)

(37,546)

(34,072)

(36,079)

Short term borrowings (including lease liabilities)

(5,117)

(10,999)

(10,999)

(10,999)

Long Term Liabilities

 

 

(69,491)

(62,306)

(62,306)

(62,306)

Long term borrowings*

(67,631)

(58,765)

(58,765)

(58,765)

Other long term liabilities

(1,860)

(3,541)

(3,541)

(3,541)

Net Assets

 

 

270,443

260,435

264,784

271,536

CASH FLOW

Operating Cash Flow

 

 

8,948

35,457

28,147

34,741

Net Interest

(671)

(1,142)

(1,800)

(2,200)

Tax

(151)

(993)

0

0

Capital expenditure and capitalised R&D

(41,834)

(10,402)

(33,000)

(16,000)

Acquisitions/disposals

10

(1,363)

0

0

Financing

712

240

0

0

Dividends

0

0

0

0

Net Cash Flow

(32,986)

21,797

(6,653)

16,541

Opening net debt/(cash)*

 

 

(20,807)

63,948

45,101

51,754

HP finance leases initiated

0

0

0

0

Other

(51,769)

(2,950)

0

0

Closing net debt/(cash)

 

 

63,948

45,101

51,754

35,214

Closing net debt/(cash) excluding finance leases

 

15,970

(1,923)

4,730

(11,810)

Source: IQE accounts, Edison Investment Research


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This report has been commissioned by IQE and prepared and issued by Edison, in consideration of a fee payable by IQE. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

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Copyright: Copyright 2021 Edison Investment Research Limited (Edison).

Australia

Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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