Photonics – light from a rising star

IQE 13 September 2016 Update

IQE

Photonics – light from a rising star

Interim results

Tech hardware & equipment

13 September 2016

Price

28.3p

Market cap

£190m

Net debt (£m) at end June 2016

33.6

Shares in issue

672.3m

Free float

88%

Code

IQE

Primary exchange

AIM

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

3.7

50.7

10.8

Rel (local)

6.5

38.6

2.1

52-week high/low

28.2p

16.2p

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

Prelims

March 2017

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

IQE’s diversification strategy has delivered a 71% jump in adjusted profit before tax during H116. Strong growth in photonics revenues was a key element of this improvement. This was boosted by a return to growth, albeit modest, in the wireless sector and contribution from licence income. We leave our estimates broadly unchanged, noting that this further confirmation of growth through diversification should support a continued upwards re-rating of the shares.

Year
end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

12/14

112.0

16.2

2.42

0.0

11.7

N/A

12/15

114.0

17.6

2.60

0.0

10.9

N/A

12/16e

122.0

19.0

2.73

0.0

10.4

N/A

12/17e

127.8

21.9

3.12

0.0

9.1

N/A

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

Wireless back on growth track

Revenues increased by 18% year-on-year (£9.8m) during H116 to £63.0m. This resulted from modest growth in the wireless segment, strong growth in photonics and a contribution from licence income, which did not start generating revenues until H215. Adjusted gross margins rose by 4.2bp to 28.4%, offset by a 17% jump in adjusted SG&A expenses ahead of anticipated growth. Adjusted profit before tax rose by 71% (£4.2m) to £10.1m. Net debt increased by £10.4m to £33.6m (19.5% gearing), primarily because of the £10.7m final payment of the deferred consideration for Kopin and because of the adverse impact of the RFMD wafer discounts on cash conversion which end this month.

Photonics demand indicates future growth

The strong performance in H116 provides support for our estimates, which we leave broadly unchanged. Noting the level of photonics activity, a significant amount of which relates to new product development and qualifications, we expect continued growth and see potential for upgrades to our forecasts over the next 1-2 years. In the longer term, we note the potential for IQE to take share in the power switching market, which management estimates is four times larger than the wireless power amplifier market.

Valuation: Re-rating under way

In our March note we identified the catalysts for an upwards re-rating of the shares as continued revenue diversification, improvement in cash conversion as the RFMD wafer discount tapers off (to be completed September 2016) and strengthening of the balance sheet as the final tranche of deferred consideration for Kopin is paid (completed H116). With a return to growth in wireless revenues and all of these three catalysts now present or very close, the deserved re-rating is under way. However, IQE’s rating still remains undemanding on a fundamental basis and relative to its peers, giving scope for further share price appreciation.

Segmental review

The H116 results show continued diversification of revenues, with a combination of strong growth in photonics revenues and contribution from licence revenues. Licence revenue is a relatively new income stream, which did not commence until H215.

Exhibit 1: H115 revenue split

Exhibit 2: H116 revenue split

Source: IQE

Source: IQE

Exhibit 1: H115 revenue split

Source: IQE

Exhibit 2: H116 revenue split

Source: IQE

Wireless

IQE’s wireless revenues increased by 7% year-on-year during H116 to £43.2m, which is in line with management’s estimates of mid-single-digit market growth. The destocking that characterised H215 has stopped. In addition, IQE is winning a higher proportion of clients’ business and benefiting from some new projects with existing clients, which may become volume business in the medium term. Our estimates model H2 sectoral sales at similar levels to H116 (IQE no longer feels that the 45/55 H1/H2 split is valid), followed by a very modest (2%) revenue increase year-on-year during FY17.

Photonics

IQE’s photonics revenues grew by 45% during H116 to £10.7m. Around half of the revenues were from VCSELs (vertical cavity surface emitting lasers), the other half InP (indium phosphide) epitaxy. Both technologies are currently showing strong growth. VCSELs are deployed in a wide range of high-speed communications and precision sensing applications including 3D scanning, gesture recognition and biometric sensing. InP lasers are an essential part of high-data rate FTTx (fibre-to-the-home/fibre-to-the-office) optical networks. IQE has developed a proprietary technology, which has enabled it to take on InP projects that previously customers had to manufacture themselves. Our estimates model H2 sectoral sales at similar levels to H116, followed by an 17% increase during FY17. This FY17 estimate could be revised upwards as development programmes convert to volume deliveries.

Infrared

IQE remains the dominant provider of materials used in high-resolution infrared systems. Sectoral revenues grew by 2% year-on-year to £4.7m. Our estimates model a modest 3% rise in sectoral sales during FY17.

Licence income

Licence income, which totalled £3.5m in H116 (nil H115), is a relatively new income stream for IQE. At present it is generated from two JVs. The one in Wales was formed in July 2015 with Cardiff University. The one in Singapore is with WIN Semiconductors and Nanyang Technological University. Revenues are expected to be relatively lumpy. We expect FY16 licence revenues, which only include recurring elements, to be lower than FY15 revenues (£8.0m), which include upfront elements as well. We model FY17 licence income at FY16 levels. This revenue stream is likely to become more significant in the longer term if IQE’s technology is deployed in volume applications such as general-purpose LED lighting and solar power.

Power

In September 2015, IQE accelerated its development activity in the power segment by acquiring exclusive rights to Translucent’s patented cREO (crystalline rare earth oxide) technology. Importantly, Translucent has 74 granted patents and 13 pending patents, so the agreement also secures IP rights. This puts IQE in a strong position to benefit from the expected growth in the use of GaN (gallium nitride) compound semiconductor material for power electronics applications. This has significant potential if technology companies such as IQE can solve the problem of manufacturing GaN economically. IQE estimate that the market for power switching chips is c $12bn, which is four times the size of the wireless power amplifier chip market. Revenues from this sector were not material in H116. Until IQE begins to ship meaningful volumes of the material, we will treat revenues from this sector as upside to our estimates. A major milestone towards commercialising the material was reached in May 2016, when IQE announced that it had successfully transferred the cREO technology to its facility in North Carolina.

Advanced solar

IQE’s focus in this sector has moved from terrestrial to space applications. For terrestrial applications, the substitution of silicon based photovoltaic (PV) cells by more efficient compound semiconductor based cells was predicated on the extra energy being generated offsetting the additional cost. This has not happened so far because the cost of silicon PV cells has slumped, while the price of electricity (which is linked to oil and gas prices) has fallen. This economic trade-off is less relevant for space applications, where the greater efficiency of compound semiconductor PV cells gives more power, and thus more capacity for data-transmission for the same weight payload. Revenues from this sector were not material in H116, though ongoing development activities encourage management to expect that it is likely that IQE will see good commercial progress in the next one to two years. Until IQE begins to ship meaningful volumes of the material, we will treat revenues from this sector as upside to our estimates.

Financials

H116 results

Revenues increased by 18% year-on-year (£9.8m) during H116 to £63.0m. This resulted from modest growth in the wireless segment, strong growth in photonics and a contribution from licence income, which did not start generating revenues until H215. Adjusted gross margins rose by 4.2bp to 28.4%, reflecting a higher proportion of photonics revenues and licence income. Adjusted sales, general and administrative expenses grew by 17.0%, as management strengthened the engineering resource to provide capacity to support the anticipated growth in photonics and allocated labour to repurpose existing equipment for anticipated photonics production. In addition, while work on early-stage projects for customers yields a relatively high gross margin, it results in low utilisation rates because the equipment is used for very low volume runs. Adjusted profit before tax rose by 71.4% (£4.2m) to £10.1m.

The improved profitability in H116, combined with a further reduction in the ongoing wafer discounts given to Qorvo (the merged RFMD/TriQuint entity), as deferred consideration for the RFMD epitaxy business, resulted in much stronger adjusted cash generation at the operating level (£13.0m vs £5.3m in H115). However, IQE still consumed cash during H116. Net debt increased by £10.4m to £33.6m (19.5% gearing). The main causes of this were: £10.7m final tranche of deferred consideration for Kopin; £2.8m capitalised development expenditure (higher than £2.1m in H115 because of the levels of photonic and other development activity); and £4.3m capex (£1.3m H115) as IQE invested in equipment ahead of the anticipated ramp-up in photonics volumes.

Estimates

The H116 results show that IQE is in good shape to achieve the revenue and profit growth shown in our estimates. Indeed, given management’s investment in equipment for an anticipated ramp-up in volumes for some photonics projects that are at the end of the development phase, it is likely, though by no means certain, that these estimates will be exceeded. We therefore leave our P&L estimates broadly unchanged. We make a small modification to EPS numbers to reflect a small increase in the number of shares in issue (FY16 EPS from 2.75p to 2.73p, FY17 EPS from 3.16p to 3.12p). We also increase gross margins slightly (from 27.0% to 27.4% in FY16) to reflect a slightly higher proportion of revenues attributable to photonics. This is offset by a small increase in operating costs to reflect increased engineering effort as noted earlier.

Noting the relatively high level of capital expenditure during H116, we raise our FY16 estimate of investment in tangible assets from £4.0m to £9.0m. This results in a corresponding increase in net debt to £30.5m (21% gearing) at end FY16 (previously £25.5m). We also raise our FY17 working capital estimate by £2.0m to reflect a more diversified revenue stream, resulting in £10.1m net debt (6% gearing) at end FY17 (previously £3.1m). We note that net debt increases during FY16, despite improved profitability, because of the cash outflow associated with paying the final tranche of deferred consideration for Kopin and the RFMD wafer discount (we estimate £5.5m) deducted from the operating cash flow. In FY17 there are no more wafer discounts or deferred consideration to be paid. The cash generated by operations therefore makes a significant dent in the net debt figure.

Valuation

Peer multiples

The share price has rallied from a low of 16.25p in June. However, IQE’s rating remains undemanding on a fundamental basis and relative to its peers. We believe that a number of factors have contributed to this historically. These include uncertainty over both the prospects for the wireless business and the timing and rate at which revenues in new non-wireless fields will grow. The company’s net debt and deferred consideration liability, and the suppressing effect on cash flows of the RFMD wafer discounts, have probably had an impact as well.

With regards to concerns about the wireless market, the interim results show that the destocking that bedevilled H215 is over and the market is growing again, albeit at a modest rate compared with five or six years ago. In addition, reliance on the wireless sector is reducing because of strong growth in photonics revenues and the creation of a new revenue stream from licence income. The announcement in the interims of another six months of strong growth in photonics gives reassurance that the contribution from this sector is here to stay. While there remains considerable uncertainty as to just how large revenues from this sector could become, our estimates treat the substantial growth that may result from existing photonics development programmes converting to volume deliveries as upside. As revenues from volume photonics projects, as well as material revenues from power electronics or advanced solar are excluded from our estimates, there is no reason, in our opinion, to apply a discounted multiple to reflect downside risk to earnings from these sectors.

Examining the potential cash flow and balance sheet concerns, both of these disappear during H216. The RFMD wafer discount finishes in H216, improving cash conversion. The deferred consideration balance, which was reduced from £17.9m at end December 2015 to £1.7m at end June 2016 following the final tranche of consideration for the Kopin acquisition, will be eliminated in full by the end of September 2016.

Since the reasons why investors have historically applied a discount are being removed, a further re-rating seems justified. Our analysis of peer multiples suggest that a low-to-mid-teens FY16e P/E multiple would be appropriate, suggesting a share price range of 33-41p in the medium term.

Exhibit 3: Multiples of listed peers

Company

Market cap

Current EV/S

Next EV/S

Current P/E

Next P/E

IQE PLC

£182m

1.8x

1.8x

10.4x

9.1x

Epitaxy

 

 

 

 

 

Visual Photonics Epitaxy Co Ltd

£251m

3.5x

3.5x

16.7x

14.9x

IntelliEPI Inc

£84m

3.3x

2.8x

25.3x

18.2x

Land Mark Optoelectronics Corp

£727m

11.2x

8.7x

25.0x

19.8x

SOITEC

£416m

2.6x

2.3x

50.6x

26.1x

Wireless

 

 

 

 

 

Broadcom Ltd

£50,303m

5.2x

4.2x

14.9x

12.5x

Qorvo Inc

£5,330m

2.4x

2.2x

10.8x

9.4x

Skyworks Solutions Inc

£10,070m

3.8x

3.5x

13.0x

11.6x

Opto-electronics

 

 

 

 

 

II-VI Inc

£1,062m

1.6x

1.5x

20.5x

16.5x

EMCORE Corp

£100m

0.2x

0.2x

32.5x

15.6x

Source: Bloomberg, Edison Investment Research. Note: Prices at 9 September 2016.

Exit multiples

Another approach to valuation is provided by the price paid in calendar Q116 for IQE’s small competitor EpiWorks by semiconductor laser specialist II-Vi. Including the deferred element, the transaction valued EpiWorks at 3.5x calendar 2015 revenues.

Exhibit 4: Financial summary

£'000s

2014

2015

2016e

2017e

Year End 31 December

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

 

 

112,011

114,024

122,043

127,836

Cost of Sales (Inc D&A + SBP)

(80,459)

(81,585)

(88,643)

(92,044)

Gross Profit

31,552

32,439

33,400

35,792

EBITDA

 

 

27,009

29,001

31,169

34,469

Depreciation and Amortisation

(9,391)

(10,024)

(10,800)

(11,600)

Operating Profit (before amort. and except.)

 

 

17,618

18,977

20,369

22,869

Acquired Intangible Amortisation

(1,101)

(1,208)

(1,208)

(1,208)

Exceptionals

(7,892)

5,398

0

0

Share based payments

(1,458)

(2,001)

(2,001)

(2,001)

Operating Profit

7,167

21,166

17,160

19,660

Underlying interest

(1,429)

(1,403)

(1,343)

(1,007)

Exceptionals

(495)

(387)

0

0

Profit Before Tax (norm)

 

 

16,189

17,574

19,027

21,862

Profit Before Tax (FRS 3)

 

 

5,243

19,376

15,818

18,653

Tax

(3,247)

773

500

500

Profit After Tax (norm)

16,701

18,066

19,027

21,862

Profit After Tax (FRS 3)

1,996

20,149

16,318

19,153

Average Number of Shares Outstanding (m)

650.8

662.6

669.8

673.2

EPS - normalised fully diluted (p)

 

 

2.42

2.60

2.73

3.12

EPS - (IFRS) (p)

 

 

0.3

3.0

2.4

2.8

Dividend per share (p)

0.0

0.0

0.0

0.0

Gross Margin (%)

28.2

28.4

27.4

28.0

EBITDA Margin (%)

24.1

25.4

25.5

27.0

Operating Margin (before GW and except.) (%)

15.7

16.6

16.7

17.9

BALANCE SHEET

Fixed Assets

 

 

160,999

174,207

176,699

173,391

Intangible Assets

82,079

86,843

87,135

87,027

Tangible Assets

66,588

65,154

67,354

64,154

Other

12,332

22,210

22,210

22,210

Current Assets

 

 

48,323

48,909

46,328

72,690

Stocks

18,276

21,215

22,000

25,900

Debtors

24,463

23,050

24,000

29,000

Cash

5,584

4,644

328

17,790

Other

0

0

0

0

Current Liabilities

 

 

(46,667)

(48,050)

(45,857)

(47,757)

Creditors

(31,947)

(44,809)

(39,616)

(44,516)

Short term borrowings

(14,720)

(3,241)

(6,241)

(3,241)

Long Term Liabilities

 

 

(41,480)

(28,032)

(28,032)

(28,032)

Long term borrowings

(22,115)

(24,626)

(24,626)

(24,626)

Other long term liabilities

(19,365)

(3,406)

(3,406)

(3,406)

Net Assets

 

 

121,175

147,034

149,138

170,292

CASH FLOW

Operating Cash Flow

 

 

14,861

20,971

18,741

30,469

Net Interest

(1,428)

(1,403)

(1,343)

(1,007)

Tax

1,258

(459)

500

500

Capex

(9,426)

(10,002)

(14,500)

(9,500)

Acquisitions/disposals

0

0

(11,691)

0

Financing

278

544

977

0

Dividends

0

0

0

0

Net Cash Flow

5,543

9,651

(7,316)

20,462

Opening net debt/(cash)

 

 

34,351

31,251

23,223

30,539

HP finance leases initiated

0

0

0

0

Other

(2,443)

(1,623)

0

0

Closing net debt/(cash)

 

 

31,251

23,223

30,539

10,077

Source: IQE accounts, Edison Investment Research

Edison, the investment intelligence firm, is the future of investor interaction with corporates. Our team of over 100 analysts and investment professionals work with leading companies, fund managers and investment banks worldwide to support their capital markets activity. We provide services to more than 400 retained corporate and investor clients from our offices in London, New York, Frankfurt, Sydney and Wellington. Edison is authorised and regulated by the Financial Conduct Authority. Edison Investment Research (NZ) Limited (Edison NZ) is the New Zealand subsidiary of Edison. Edison NZ is registered on the New Zealand Financial Service Providers Register (FSP number 247505) and is registered to provide wholesale and/or generic financial adviser services only. Edison Investment Research Inc (Edison US) is the US subsidiary of Edison and is regulated by the Securities and Exchange Commission. Edison Investment Research Limited (Edison Aus) [46085869] is the Australian subsidiary of Edison and is not regulated by the Australian Securities and Investment Commission. Edison Germany is a branch entity of Edison Investment Research Limited [4794244]. www.edisongroup.com

DISCLAIMER
Copyright 2016 Edison Investment Research Limited. All rights reserved. This report has been commissioned by IQE and prepared and issued by Edison for publication globally. 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. Opinions contained in this report represent those of the research department of Edison at the time of publication. The securities described in the Investment Research may not be eligible for sale in all jurisdictions or to certain categories of investors. This research is issued in Australia by Edison Aus and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. The Investment Research is distributed in the United States by Edison US to major US institutional investors only. Edison US is registered as an investment adviser with the Securities and Exchange Commission. Edison US 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. As such, Edison does not offer or provide personalised advice. We publish information about companies in which we believe our readers may be interested and this information reflects our sincere opinions. The information that we provide or that is derived from our website is not intended to be, and should not be construed in any manner whatsoever as, personalised advice. Also, our website and the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. 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. This document is provided 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.
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Edison, the investment intelligence firm, is the future of investor interaction with corporates. Our team of over 100 analysts and investment professionals work with leading companies, fund managers and investment banks worldwide to support their capital markets activity. We provide services to more than 400 retained corporate and investor clients from our offices in London, New York, Frankfurt, Sydney and Wellington. Edison is authorised and regulated by the Financial Conduct Authority. Edison Investment Research (NZ) Limited (Edison NZ) is the New Zealand subsidiary of Edison. Edison NZ is registered on the New Zealand Financial Service Providers Register (FSP number 247505) and is registered to provide wholesale and/or generic financial adviser services only. Edison Investment Research Inc (Edison US) is the US subsidiary of Edison and is regulated by the Securities and Exchange Commission. Edison Investment Research Limited (Edison Aus) [46085869] is the Australian subsidiary of Edison and is not regulated by the Australian Securities and Investment Commission. Edison Germany is a branch entity of Edison Investment Research Limited [4794244]. www.edisongroup.com

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Copyright 2016 Edison Investment Research Limited. All rights reserved. This report has been commissioned by IQE and prepared and issued by Edison for publication globally. 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. Opinions contained in this report represent those of the research department of Edison at the time of publication. The securities described in the Investment Research may not be eligible for sale in all jurisdictions or to certain categories of investors. This research is issued in Australia by Edison Aus and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. The Investment Research is distributed in the United States by Edison US to major US institutional investors only. Edison US is registered as an investment adviser with the Securities and Exchange Commission. Edison US 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. As such, Edison does not offer or provide personalised advice. We publish information about companies in which we believe our readers may be interested and this information reflects our sincere opinions. The information that we provide or that is derived from our website is not intended to be, and should not be construed in any manner whatsoever as, personalised advice. Also, our website and the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. 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. This document is provided 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.
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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

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

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