Summary

Focus on Photonics

Please see my comprehensive previous article for some background on IQE (OTC:IQEPF) and the compound semiconductor market. This report focuses only on the photonics division (circa 20% of 2016 revenue, up 45% in first half and +50% estimated full year 2016 sales of £27m).

Apple's (NASDAQ:AAPL) expected new iPhone8 due for launch later this year might seem a strange place to start, but there is much speculation about possible new features (beyond the scope of this note). The key feature for photonics usage would rest around any sort of sensing camera; below is one analyst's 'guesstimate' of some of the components needed. The key component for IQE are the VCSELs (Vertical Cavity Surface Emitting Laser) where they are the current leading manufacturer of epiwafers in this sector globally.

Assuming that some form of new camera upgrade spearheads the new iPhone, it would be expected to offer secure biometric user verification using a facial recognition technology function and/or using a 3D type image camera that senses depth. This would allow significant photo enhancement opportunities. It's also likely that Infrared Light usage will feature much more heavily to enable 3D imaging and depth understanding. At this stage it's speculation about whether this might be only in a high-end new model or across the range, whether it would cover the front facing camera or rear facing camera or possibly both. These different possibilities are very important for potential market sizes and make a large difference for the amount of VCSELs needed per new phone. It's thought that the Android mass market adoption of these sorts of products is more likely a 2018 time frame rather than 2017 but it's clear the whole smartphone product spectrum is rapidly moving in this direction.

If you look at the Swiss company AMS AG (well known to be a key supplier into Apple) they recently purchased Heptagon (U$550m cost plus possible earn out U$285m) to give them a very strong total solution in optical sensing solutions (see page 8-10 in investor presentation). Sales for Heptagon were previously only a few 10s of millions but are expected to ramp to U$ 300m this year and more in 2018 and beyond.

On Lumentum's conference call 7th Feb 2017 the CEO said '…could imagine quarters of $100m plus type of marketplace growing to over $1Bn' when referring to 3D sensing.

Finisar also made several references to 3D sensing in its December conference call :

"anyway I think the numbers are incredibly exciting…..a good enough bet that we are spending a lot of money on facility expansion. We're spending money to hire people…' and he went on to say 'finally we are adding capacity over the next couple of quarters in our VCSEL laser FAB in Allen, Texas. This will enable us to pursue several new consumer applications for 3D sensing."

In short we believe Apple's new camera((s)) will contain significant VCSEL technology.

How will this impact IQE?

In full year and half year results statements, IQE has repeatedly referenced working closely with OEM's. Investor presentations often have generic slides about where the VCSEL's market is headed regarding mobile handsets. Also, in the December trading update, the company announced "Excellent progress with customer qualifications in photonics during 2016, providing a solid platform for continuing strong growth for this business. In response to this opportunity, the group has increased its capital investment." Whilst it's still speculation, we believe it's quite likely IQE will get a decent chunk of new photonics business from the upcoming new iPhone. In December and January there have been a series of supply chain announcements by companies associated with leading technology in 3D sensing/camera/optics areas. All of these have signaled a 2H 2017 ramp up, and we believe IQE's comments match these.

Total 2017 iPhone shipments will likely be 225-235m units, out of which perhaps 110m are new iPhone8 during 2H2017.

IQE might sell its standard wafer for a few hundred dollars and it might have 8-12 layers in its structure. A photonics wafer though can have up to 300 different layers and contain a huge amount more complexity, hence why the price per wafer is likely to be several fold higher, possibly up to $10,000/wafer. We know that margins are higher in the current photonics division than the rest of IQE. However with any marked increase in volumes around a handset photonics adoption business, it's most likely that the supply chain would push prices and margins down significantly. IQE 2016 group revenues look to be around £130m with £27m from photonics. We think photonics can grow 40% excluding any handset adoption taking sales to £38m. A guesstimate of handset adoption might add £18-£36m on 110m new iPhone8's, and the wafer contribution costs might be 20-40cents per phone (a guess but we think IQE's traditional handset business gets maybe 10cents per phone unit). That calculates to U$22m-U$44m at 100% supplier, however, assuming at least dual sourcing and 60% share to IQE would mean a range of£11m-£22m in extra sales this year. That would give a 2017 photonics range of £49-£60m, circa 40% of group sales, and assuming higher margins perhaps circa 50% of group profits. These would be higher margin products and significantly improve capacity utilization, helping raise group margins.

Full year 2016 results are due to be announced 21st March, alongside this we think analysts will start to factor in much faster photonics growth rates leading to significant upgrades for 2017 earnings expectations.