IQE has cut its FY19 revenue and profit guidance in response to reduced demand from wireless customers and an internal issue affecting a major photonics (not VCSEL - vertical cavity surface emitting laser) customer. Following a 25% share price fall, the shares are trading within the range created by photonics peers on most metrics.
Customers cutting delivery forecasts
IQE’s customers manufacturing wireless semiconductor chips for the mobile phone industry are cutting back inventory levels in response to the uncertainty regarding future demand caused by lengthening mobile phone replacement cycles. This caution is exacerbated by the impact of Huawei’s addition to the US Bureau of Industry and Security’s Entity List. IQE’s initial assessment of this was focused on customers directly involved in the Huawei supply chain, but the interconnected nature of the semiconductor supply chain means many more of IQE’s customers have been affected indirectly. In addition, a major photonics customer purchasing indium phosphide (InP) epitaxy for laser chips has internal issues. Overall, the company guides FY19 revenue in the £140–160m range at an adjusted operating margin significantly below previously guided 10%.
Long-term prospects sound
IQE’s dominant position in the outsourced compound semiconductor epitaxy market means it has supply relationships with multiple non-US (and US) customers. It is therefore relatively agnostic to any mid- to long-term shifts in market share at either component or OEM level. For example, it is engaged in initial production activities with two Asian customers who stand to benefit from wireless supply chain shifts. On the photonics side, management expects to start mass production for two additional VCSEL customers in H219, with a further 13 customers at the sampling stage. In addition, IQE is engaging with multiple Asian chip companies on 10G and 25G lasers for data comms. These new business opportunities should mitigate the lack of business from the InP laser chip customer in the medium term.
Valuation: Waiting for destocking to complete
If we restrict our peer-based comparison to the three listed companies offering epitaxy for VCSELs then IQE is trading within the valuation range for these stocks on most metrics. IQE has a much stronger market position than the other three, so trading towards the upper end of this smaller sample seems reasonable. Taking this approach, we see scope for share price recovery once semiconductor supply chains have stabilised and the current period of destocking is over.
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 and power electronics.
- Changes to estimates
- We revise our estimates to reflect:
- Change in FY19 wireless revenue guidance from a year-on-year decline of 15% to 20–25% (modelling 22.5%).
- Change in FY19 photonics guidance from over 50% growth year-on-year to less than 30% (modelling 25%).
- Change in FY19 adjusted operating margin guidance from over 10% to ‘significantly below’ that (currently modelling 5%).
- Comment by management on analyst call that it expects net debt at end FY19 to be c £15m at the middle of the revenue guidance range, while remaining within the limits of its revolving credit facility.
- Management has not updated its guidance for FY20 or mid-term growth, as this would be premature before the wireless market has stabilised and there is better visibility of the number and scale of new VCSEL ramp-ups. VCSEL-driven photonics growth should help offset the impact of reduced mobile phone shipments on wireless revenues, as will the transition to 5G, with greater wireless content per device. We model 10% year-on-year growth in FY20 wireless revenues, which assumes the period of destocking is over and the market has stabilised by the end of FY19. This gives FY20 segmental revenues of £83.4m, which is slightly higher than the FY15 level (£79.5m) when demand was also affected by de-stocking and substantially lower than FY16, FY17 or FY18, all of which recorded revenues above £90m. We continue to model 40% year-on-year growth in photonics, albeit from a lower level, partly because of the number of VCSEL projects sampling and partly because IQE is likely to win some new business with alternative suppliers of indium phosphide lasers because of its technical expertise.
- We have not changed our capitalised R&D or PP&E estimates as the bulk of this is associated with new VCSEL ramp-ups, which are not affected by the recent announcement.
Valuation
We moved from a peer-based multiple approach to a DCF analysis in November 2018 because of the volatility of stocks in the sector. Although the DCF remains our preferred approach, this was based on the three- to five-year guidance management provided, which will not be updated until the current supply chain turmoil has abated, so we for now revert to using peer-based multiples.
The share price has declined by over 25% since the trading update and is now trading on 53.25p/share. Based on our revised estimates, the shares are trading on prospective EV/sales ratios that are at a discount to the mean for its epitaxy and opto-electronics peers, but on prospective EV/EBITDA and P/E ratios that are at a premium to the mean. If we restrict the comparison to the three listed companies offering epitaxy for VCSELs: IntelliEPI, LandMark Optoelectronics and Visual Photonics, then IQE is trading within the range for these three stocks on most valuation metrics. IQE has a much stronger market position than the other three, so trading towards the upper end of this smaller sample seems reasonable. Taking this approach, we see scope for share price recovery once semiconductor supply chains have stabilised and the current period of destocking is over.
