Stockwatch: Lots to like about this tech share

IQE, a manufacturer of advanced materials for microchips, looks poised to benefit from high operational gearing, as mobile devices proliferate and "photonics" related revenues are kicking in.

A recent update cites strong trading across multiple markets, with double-digit 2016 revenue growth, hence operating profit is now due ahead of expectations shown in the table.

This AIM-listed share has traded in a volatile sideways range for at least five years amid concerns the tablet and smartphone market would mature, and a period of handset de-stocking that caused IQE to slump from 27.5p to 12.5p in 2014. After recovering to near 27p, it plunged again at end-2015 and was volatile during the first half of 2016.

However, it has risen strongly from 16p in the second half-year and broken out of its stubborn range to test 40p, currently about 38p. I drew attention last July at 23.5p amid signs of improved trading, and October at just over 30p, saying a December trading statement was potentially able to drive the stock higher, hence the intermediate period worth considering to accumulate.

On the basis that 3p of earnings per share (EPS) now looks the base case forward scenario, steady improvement in the rating as earnings volatility reduces should make the 40p range a medium-term target.

Photonics growth de-risks the business

Volatility has chiefly resulted from periods of weakness and de-stocking in the wireless industry, which supplies smartphones, tablets and base stations.

While IQE derived 75% of 2015 revenue and 65% of profit from its compound semiconductor component for the wireless market, opto-electronic applications or "photonics" have seen revenue advance by 28% last year.

Management believes photonics has long-term scope to beat wireless revenuesThey were up 45% in the first-half of 2016, when it represented 37.6% of adjusted operating profit and 18% of group revenue.

Another 10% of group revenues is generated by infrared and "CMOS++", a new technology for integrated circuits. Management believes it is still early days for technology replacement and photonics has long-term scope to beat wireless revenues.

This leaves the group exposed to cyclicality, even though recent wireless issues should have worked through the industry by now.

The update simply says IQE's wireless business "remains on track for year on year growth" with photonics quantified as double-digit growth, likewise the group as a whole.

In 2015, IQE derived 61% of revenue from the US and only 8% from the UKThere's a challenge to assume exactly how wireless is performing given the aspect of currency translation possibly helping the group achieve double-digit annual growth.

In 2015, IQE derived 61% of revenue from the US and only 8% from the UK - currently many plc's with an international profile say they are benefiting from currency translation and cite constant currency revenues also - e.g. Photo-Me International reporting 19.2% interim revenue growth albeit 4.0% at constant currency.

IQE concedes its revenues have benefited from sterling devaluation (without saying how much, albeit in an update not results) and says most of its costs are also denominated in dollars.

Operational gearing shines through

Non-sterling assets will positively benefit shareholder funds and the dollar-based element of group debt has risen, hence "although the group has de-leveraged its balance sheet during 2016 in underlying dollar terms, the presentation is expected to be distorted adversely in sterling."

Net debt plus deferred consideration (for acquisitions) had fallen 28% to £35.4 million at the end of June and the table shows no onerous interest costs.

IQE was previously a wonder-stock during the 1998-2000 technology bubbleIt's a testament to IQE's operational gearing that operating profit is now declared ahead of a scenario with 25% earnings growth.

Mind this is "normalised" before exceptional items, although the interim results actually benefited from £137,000 profit on disposals and £411,000 adjustments - i.e. "normalised" currently does not mean "before the bad stuff".

IQE was previously a wonder-stock during the 1998-2000 technology bubble. Nowadays it trades on a forward price/earnings (PE) in the low teens for growth to at least £20 million annual pre-tax profit.

So, while it's "been around the block" as a story, operations are more advanced and their rating more measured. On the photonics side, IQE's VCSEL laser chips have varied applications, but the most potential is for indium phosphide technology, which has massive applications across the internet, especially as fibre access to it expands.

Buyers aren't chasing hope value in the stock, even though it exists on fundamentalsYou never know when any technology might be superseded, but as things stand IQE is market leader, and it appears quite the listed successor to ARM Holdings since the latter's takeover by the Japanese.

There are a further four markets in infrared (7% of first-half sales), solar (satellite power and renewable energy), power (switching and LED light applications) and CMOS++.

Quantifying all this remains speculative, but the market is pacing IQE according to financial results - i.e. buyers aren't chasing hope value in the stock, even though it exists on fundamentals.

Smartphones remain the chief risk

IQE estimates the materials market for mobile phone handsets as growing by 5% a year, its supply chain characterised by inventory corrections after the consumer feeding frenzy since the iPhone launch in 2007.

CCS Insight, a global analyser of the mobile, internet and media industries, predicts the global smartphone market to rise from 1.96 billion in 2014 to 2.35 billion in 2019, albeit with growth dependent on emerging markets as Europe and the US peak in 2017, then fall.

Given the rash of takeovers driven by sterling's fall, IQE is a market leader in its fieldOther connected devices now compete for disposable income, but will also require advanced microchips.

If mature markets do peak for smartphones, there is liable to be another ripple effect through the demand chain, even if this is more an opportunity to add IQE shares for the longer term than a 'sell'.

The lack of dividend and good liquidity (normal market size of 20,000) encourages active trading. However, the chart break-out signals real improvement in the underlying story.

Given the rash of takeovers currently driven by sterling's fall, IQE is a market leader in its field and now risky to sell in the hope of buying back lower. Best take a multi-year view and tuck this stock away.

For more information see the website.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.