Stockwatch: A tuck-away AIM growth play

Is AIM-listed IQE a prime example of bubble values in particular sectors of the market? From a 16p low a year ago the stock has seen a parabolic rise to 148p, currently 140p - capitalising IQE at about £950 million or 7 times 2016 sales.

Curiously, it was a glamour stock in the 1999-2000 tech-stock boom that soared and crashed. Nowadays, though, its semiconductor wafers have more substantive prospects.

The photonics side in particular is enjoying double-digit growth and investors are enticed by management-talk of a "massive ramp-up" to serve "the internet of things", where everyday devices get connected online.

IQE is therefore poised to supplant dependability on the smartphone market via its wireless side that contributed 75% of 2015 sales and 65% of profit and that checked growth in 2016 (see table). This potentially catapults its stock into a superior league of growth plays.

Dissonance in approaches to underlying value

The dilemma can be summarised as follows. If IQE is to any extent becoming "the next ARM Holdings" then treat the stock as a tuck-away.

In 1999-2000, microchip developer ARM entertained bubble values of 100 times expected earnings and higher, and did plunge with the spring 2000 bust. For years thereafter, it remained volatile and attracted periodic shorting.

ARM did, however, boast very strong margins and pretty much the strongest long-term financial record of any British company; such that ultimately a Japanese acquirer paid a whopping exit price/earnings (PE) multiple for that, as well as for ARM's strong positioning for "the internet of things".

If you step back from IQE's narrative to focus coldly on its numbers, the five-year record and forecasts are nothing - as yet - to get over-excited about.

A forward P/E in the order of 40 times with no dividend record as yet, is rich. See from the table how cash flow is respectable versus earnings, if largely soaked up by capital expenditure.

Whereas I recall ARM's cash flow being so strong its dividend was quite material, even at high share prices. Its operating margins were nearer 40%, versus IQE in the late teens to 20%.

So, as yet, sceptics may scoff at the suggestion IQE is becoming the London market's successor to ARM. Ultimately, the prospect is speculative - what extent photonics revenues/profits take off - thus a diversified portfolio can justify exposure.

A compromise between these positions (at least for long-term holders) is to lock in some gains along the way.

Directors crystallise profits, short positions rise

Likewise, you have to wrestle conflicting interpretations of directors' sales.

There's a definite pattern to preserve gains from 68p upwards and, while they continue with substantial equity, it was largely acquired at much lower prices (such as before IQE floated) or via share bonuses. Also, the company's broker would have placed an extent of stock with institutions but not enabled directors to sell out.

Thus, even if the directors consider IQE's market rating daft, the amounts sold represent the maximum the market will countenance. In mid-May, the finance director and operations director each sold 1.9 million shares averaging 68.3p, continuing to own just over 1.5 million and 2.4 million shares respectively.

Then in late-July, the chief executive sold a total of 5.8 million shares averaging 106p per share, continuing to own 28.5 million shares, and the chairman sold 1 million shares averaging 105.1p, being left with 2.2 million.

As to short trading positions, on 18 August Ennismore Fund Management raised its exposure by 0.11% to 1.54% and on 21 August Marshall Wace edged up 0.03% to 1.72%.

Certainly, on a chart basis, the stock looks overbought in the near term, but it's quite a challenging short: still a growth company, hence over-valuation can persist for longer.

Classic short-selling focuses on weak industries where companies are stretched in some way, e.g. debt, over-expansion and/or aggressive accounting.

At the end of 2016, IQE had £39.5 million leverage (net debt plus deferred consideration), which accounted for £1.6 million finance costs versus £20.7 million operating profit; thus containable.

Share price rise has tracked guidance in updates

I drew attention in July 2016 at 23p after a bullish trading update cited H1 2016 revenues at least 15% up, helped by diversification of revenues and photonics expected to show double-digit growth amid widening opportunities in consumer products, fibre-optic communications, data centres and industrial processes.

The September 2016 results then showed excellent progress, with operating profit up 61% on revenue up 18%, pre-tax profit up 71%, earnings per share (EPS) up 62% and operational cash flow up 176% - hence my updating to suggest accumulating the stock ahead of a December trading statement.

Expectations were guided higher still, hence my updating again to suggest tucking the stock away - then 38p. I didn't, however expect the stock to multiply nearly four-fold in six months, and there's an aspect of ramping up the stock as well as prospects.

The last update on 20 July proclaimed: "The start of the mass-market ramp for VCSEL wafers... an inflection point in the commercialisation of this technology... multiple, multi-year contracts for this VCSEL ramp which reflects its strong competitive advantages... increased investment during H1 2017... to position the group for the expected ramp up of growth in H2 2017."

Tax losses provide a modest earnings enhancement

Note from the table how IQE's tax rate is substantially negative, also the 2016 results showed a £408,000 tax credit following £773,000 in 2015.

The results don't go into detail, but when previously researching IQE I came across "£139 million accumulated tax losses", likely relating to past investment and operating losses. This may need treating with a pinch of salt because accounting estimates can differ from what HMRC agrees.

But it's fair to say IQE enjoys a substantial earnings shelter, hence its PE rating will be higher as a result; quite whether that helps justify a forward multiple into the forties.

From where will any trigger for correction come?

Edgy shareholders can take comfort it appears less likely IQE will repeat its habit of profit warnings in the medium term.

The macro context remains a risk but, as I explained in a last review, central banks are likely to keep exploring means of stimulus and these will spill over to support equities even if profit warnings do materialise.

The chief near-term risk, therefore, is sentiment: momentum traders have latched onto IQE as a stock in vogue. So, if the 5 September interims add nothing new, mind this could trigger further profit-taking.

Further upward guidance on the numbers is possible if probably more likely by way of narrative, to try and keep speculators happy.

So, if you adhere to investment principles, where capital protection is your priority and a margin of safety is wise, then follow the directors' example.