IQE’s post-close trading update shows that the short-term dip in production for one of its volume VCSEL programmes had a more severe impact on FY18 performance than management originally estimated. Although we are cutting our FY18 EPS estimate by 10.6%, we note the underperformance compared with management’s guidance given in November appears confined to FY18. Importantly, it does not affect the prospects for photonics growth in the medium term, which are based on multiple VCSEL opportunities. Our revised estimates give an indicative value of 73p/share.
We had previously inferred that the end use for IQE’s first volume VCSEL application was FaceID in new iPhones. Apple has publicly admitted that demand for iPhones has been lower than it expected, which has affected the supply chain. IQE had ramped up VCSEL production during H217, but pulled back output during the first three quarters of FY18 as the inventory overbuild was worked through. IQE began to build up VCSEL inventory again for the application during Q418, but shortly after it was obliged to cut back production. This surplus capacity was reallocated to accelerate VCSEL programme qualifications, which typically generate minimal margin.
We believe that the short-term dip in VCSEL production relates to sales weakness for Apple iPhones and associated inventory destocking. Since management expects shipments to resume during Q119 it has reiterated FY19 and longer-term guidance. We note that IQE is involved in VCSEL ramp-ups for at least eight customers engaged in several market segments, providing alternative sources of photonics growth and reducing the exposure to weakness in product sales for any single OEM. The company is in the process of bringing additional photonics capacity into production at its new Newport foundry with 12 companies already actively qualifying this new volume production facility.
Using our revised estimates as the basis for a DCF analysis gives an indicative valuation of 73p/share (unchanged), which is close to current levels. Modelling segmental growth from FY20 onwards at the low and high ends of management guidance provided in September gives indicative valuations of 53p/share and 122p/share. We see potential for share price improvement should newsflow regarding new VSCEL programmes result in earnings upgrades.