Stockwatch: Where next for this triple-bagger?

Can IQE continue to re-rate? Last summer, the AIM-listed shares in this developer of advanced semiconductor materials, drifted from 24p to 16p, which proved the final bottom of a persistent volatile-sideways channel.

Then, a 20 July trading statement cited like-for-like H1 2016 revenues at least 15% higher with the photonics side in double-digit growth and offering substantial long-term upside e.g. in fibre optic communications.

I drew attention at 23p to buy, given the price/earnings (PE) rating had over-discounted this prospect amid historic volatility for IQE's main wireless-related side, averaging as low as 8.4 times for 2015. In mid-October I targeted a 40p price range after strong interims, noting how ARM Holdings used to sustain PE multiples of 20-40 times, despite cyclicality of the semiconductor industry weighing on the business occasionally. A 14 December update then revealed consistently strong progress across multiple markets, especially photonics, thus profit advancing ahead of expectations.

With revenues booked in US dollars (albeit the majority of costs also) IQE has benefited from sterling's devaluation, the 2016 prelims clarifying this as a net 10% enhancement, in which context the wireless side delivered 15% revenue growth to £91.3 million, photonics 43% to £22.8 million and infra-red 19% to £10.6 million.

The operational story has appeared to steadily strengthen since management began guiding expectations higher, the 2017 outlook now described as "very positive with good upside potential." While IQE has historically been prone to talk bullishly only for upsets to cause its shares to drop, wireless industry de-stocking appears over and photonics are now kicking in.

It is rational, therefore, for the stock to re-rate, and a PE testing 20 times is now quite similar to peer companies. Mind these are principally US-listed where the market looks richly valued after Federal Reserve stimulus and hopes for further inflationary measures from the Trump administration.

Expectations continue to shift towards photonics

On a medium-term view it's possible the story continues to evolve well, IQE being an industry leader in photonics. Forecasts by Edison Investment Research (sponsored by the company) are cautious, anticipating 6% growth for wireless in 2017, slipping to just 0.6% in 2018 (despite IQE continuing to take market share) based on a latest industry report that anticipates revenue flattening from the specific devices involved.

Edison has tended to be conservative and its 2016 forecasts were beaten, although their approach is fair considering IQE's focused product/customer profile on its wireless side. Balancing this risk are twin technology drivers in photonics where another industry report suggests a compound annual growth rate of 17.3% to 2022.

It projects a 5% revenue rise here in 2017 and 10% in 2018, albeit at the group level just 3.2% revenue growth to £137 million this year and 2.3% to £140 million in 2018. Operational gearing helps explain Edison's normalised pre-tax profit forecasts of £22.5 million for earnings per share (EPS) of 3.15p and £24 million for EPS of 3.37p in 2018 (in line with consensus forecasts).

Such a growth profile may be below what current buyers of the stock around 65p are anticipating, however. At this price level the forward price/earnings-growth (PEG) is 1.5 to 1.9 versus 1.0 being ideal on a medium term view.

Edison does, however, leave its forecasts open to upwards revision e.g. as regards discussions underway with various OEMs (manufacturers who re-sell under another company's branding) on potential high-volume work in photonics, where there are also higher margins relative to wireless.

Edison's projections appear prudently conservative as Photonics represented just 17% of 2016 group revenue, so will take a few years to predominate, if fair to point out it serves a corporate client best to leave scope for upgrades than raise any risk of the client needing to caution publicly.

Watch the market technical position

IQE has trebled in seven months, hence momentum traders will be involved besides those sitting on large profits. Newsflow has had an "ahead of expectations" theme and, if this moderates to "in line", then enough holders may become edgy.

In a five-year context, the chart has taken off like a rocket, implying an aspect of hot money besides re-appraisal of fundamentals. In which context mind also how US equities are looking exposed versus whether President Trump can deliver on hopes for tax cuts and infrastructure spending. Borrowing to buy stocks on margin is also at a record high.

As I explained in my 30 March macro piece, this is the now the chief risk for equities, especially situations with hot money. With the Fed talking of reducing its $4.5 trillion balance sheet, US stocks staged a 1.2% downturn on 5 April putting indices close to their 50-day moving averages, a key chart level.

Shaping up as an industry bid target

Despite current market risks, long-term investors can take heart. IQE's leading status in photonics means potential acquirers will be watching progress: the twin technologies being materials for vertical cavity surface emitting lasers (VCSEL) and Indium Phosphide (InP), enabling "fibre to the premises" for homes and offices.

If you're tired of BT's sales pitches for sports TV while your broadband connection suffers, then you appreciate just one of the major opportunities ahead. Growth in data traffic means copper cables can't cope with high-definition imaging, video streaming, the Internet of Things and cloud computing; hence, a switch to optical communication, enabling higher-speed data transfers over much longer distances.

IQE's 90.6% leap in capital investment to £19.1 million versus £22.5 million cash generated from operations, is chiefly for the photonics side. Some investors may bemoan this compromises dividend prospects, while others perceive a classic long-term growth play, and takeover target. Almost £40 million of accumulated tax losses are another attraction in this regard. A lesson from ARM Holdings' takeover was never knowing exactly when such a move may happen, but "you have to be in it to win it."

IQE also has a dominant share of an infrared technology market even if Edison projects its growth rate at just 2% in 2017 and 2018. The application has historically been night-vision military systems.

With fresh money, it looks sensible to await volatility. Some holders may prefer to (part) sell after a major rally to what appears fair value on current evidence. Yet IQE's story remains promising and unless future results barely affirm a growth company there will be buyers of dips.

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.