Interactive Investor

Stockwatch: Time to buy ARM's successor

14th October 2016 09:41

Edmond Jackson from interactive investor

Growth stock or cyclical? AIM-listed producer of advanced semiconductor wafers IQE (IQE) recently declared strong and promising interim results, but a forward price/earnings (PE) multiple of 10 suggests that investors remain sceptical.

In one sense, the £200 million-capitalised company ought to be a listed successor to ARM Holdings now this behemoth of a microchip developer has been acquired by the Japanese; although IQE has had a bumpier history going back to the 1998-2000 tech-stock boom and has no dividend policy.

ARM used to sustain PE multiples of 20 to 40 times, despite the cyclicality of the semiconductor industry weighing on business occasionally. The five-year table does show IQE enjoying an historic PE of 17-22 times in 2011-12, but this rating wasn't sustained when profits softened in terms of headline IFRS3 accounting, and were bumpy even when normalised (for exceptional factors).

Then there is the cash flow linked to dividends. While growth investors aren't really interested in yield, ARM used to pay dividends partly because institutional investors regard payouts as proof of cash flow. Looking again at the five-year table, IQE's cash flow record has lagged earnings, which raises questions over accounting for profit.

But, if cash flow improves, then it should help the stock's rating. Also, IQE's return on capital employed was about 17% in 2015, which should ideally be higher if earnings are being retained.

Better earnings quality

In July I drew attention to IQE at 23p to buy, posing the question, "Does a bullish trading update and 40% jump in its stock price from 16.5p, mark a genuine breakout?"

This is a genuine international business; the UK accounts for just 8% of group

This was in the context of a one-year trading range of 16.5p-27.5p. Since September's interim results, the stock has consolidated just over 30p after the numbers showed strong double-digit progress in revenues, profits and cash generation.

On a normalised basis, operating profit leapt 61% to £10.8 million on revenue up 18% to £63.0 million, with pre-tax profit up 71% to £10.1 million. Earnings per share (EPS) rose 62% to 1.46p and operational cash flow jumped 176% to £12.4 million. Management says it's "in line" with expectations for EPS of 2.8p this year and, if IQE really is gaining momentum, then 3.0p for 2017 can be surpassed.

This company is operationally geared - changes in revenue impacts the bottom-line - and with over 60% of 2015's revenue derived from the US, a stronger dollar/sterling exchange rate will be helping reported performance. This is a genuine international business; the UK accounts for just 8% of group.

Cyclicality aspect

As the wireless business generates three-quarters of revenue and 65% of profit, fears that smartphone sales were slowing caused the shares to fall from 27p to 17p at the end of 2015. As demand for components reduce, industry stock piles increase and take time to clear - thus there's an inherent aspect of cyclicality.

Broker comment from September's interims still include caution that wireless is liable to decline; but this isn't management's message at all. Indeed, reading across to ARM Holdings again, a chief rationale for the Japanese takeover (on a colossal PE) was "the internet of things". As everyday objects gain network connectivity - controlling your home from your phone, for example - wireless demand should revolutionise in a long-lasting way.

The smaller businesses hold potential and are effectively in the share price for nothing

So, while IQE's interims showed wireless revenues up only a modest 7%, reflecting a lull in smartphone sales (with the industry materials market growing at just 5% annualised), there are other drivers.

Management expects wireless growth to refresh on demand for new handset technologies, 5G communication, base station upgrades, and the internet of things. Meanwhile IQE's photonics side (lasers and sensors within semiconductor applications) is growing relatively faster and represents 17% of sales, up from 14% in the first half of 2015.

Management reckon: "The photonics market is at an early stage in the growth cycle; we expect our photonics business to continue to grow strongly for the foreseeable future."

IQE has other strings to its bow: infra-red systems, where it enjoys an 80% market share and which represented 7% of first half 2016 sales; power switching and LED lighting applications; and advanced solar panels, with good commercial progress expected over the next couple of years.

The stockmarket is likely to focus on results for IQE's main wireless and photonics activities, yet these smaller elements also hold potential while effectively being in the share price for nothing.

Cash reducing leverage

Strong working capital management and profits growth helped drive a three-fold rise in net cash to £11.0 million, reducing bank borrowings plus deferred considerations for acquisitions by 28%, June-to-June. After paying off its final deferred consideration in the period, there will be no further related liabilities, unless IQE acquires again.

It's worth considering accumulating before the December update

Total borrowings are worth £37.9 million, and are principally long-term, versus £4.3 million of cash in the context of £171.9 million net assets - 55.8% of which are intangibles.

Net finance costs clipped a modest 7.1% off interim operating profit so debt-funded development can be seen as appropriate amid low interest rates.

IQE's £139 million accumulated tax losses will genuinely help shield future profits; another factor besides operational gearing that should squeeze profits higher. IQE has shown it can achieve a growth rating and, with reasonably consistent results, it's fair to target a PE in the mid-teens - implying a 40p range for the stock.

The next important update will likely be a mid-December trading statement, which has the potential to drive the stock higher again, so it's worth considering to accumulating in the intermediate period.

For more information, see here.

IQE - financial summaryConsensus estimates
year ended 31 Dec2011201220132014201520162017
Turnover (£ million)75.388127112114  
IFRS3 pre-tax profit (£m)6.96.15.25.219.4  
Normalised pre-tax profit (£m)6.86.711.821.614.319.421.9
Operating margin (%)9.78.310.520.613.8  
IFRS3 earnings/share (p)1.51.10.90.22.9  
Normalised earnings/share (p)1.51.21.92.72.22.83.1
Earnings per share growth (%)6.4-20.757.142.8-19.127.211
Price/earnings multiple (x)    14.511.210.1
Historic annual average P/E (x)17.422.611.18.410.2  
Cash flow/share (p)20.81.62.32.9  
Capex/share3.72.81.61.51.5  
Net tangible assets per share (p)7.66.15.45.68.7  
Source: Company REFS

 

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