Shares in semiconductor supplier IQE (LSE: IQE) have fallen by about 30% this week after the firm warned profits would be lower than expected this year. The slump means that the firm’s stock is now down by more than 50% in 2018.
This week’s warning was triggered by a fall in orders for 3D sensing laser diodes. From what I understand, the main use of these is as part of the face recognition systems fitted to top-end smartphones like the iPhone.
IQE didn’t specify the end user for the diodes, but I suspect this is another example of a company that’s been hit by a reduction in orders from Apple. The US giant is the largest customer for many of its component suppliers, creating what’s known as concentration risk — having all your eggs in one basket.
What should you do now?
Another risk facing shareholders is that IQE is capital intensive. Regular investment in new factories and equipment is required to scale up production.
This is a specialist business and my understanding of the firm’s products and their potential markets is limited. Given this, I’d want to see a very compelling financial picture if I was to consider owning the shares.
I don’t see this at the moment. The company has cut its financial guidance for the year and now expects to report sales of around £160m, broadly unchanged from last year. Earnings before interest, tax, depreciation and amortisation (EBITDA) are expected to fall to £31m, from £37m last year.
Broker earnings forecasts have been cut 20% to 2.8p per share for 2018, leaving the stock on a pricey forecast P/E of 21. Although a recovery is expected in 2019, in my view it’s probably too soon to be confident of this.
With no dividend and an uncertain outlook, this is a stock I’ll be avoiding unless it becomes much cheaper.
One I would buy
One specialist manufacturer I would be happy to own is Avon Rubber (LSE: AVON). This company has two main product lines — protective face masks for military and emergency services personnel, and rubber fittings used for milking cows.
The company appears to enjoy a decent market share in both of these niche areas. As a result, this is a bigger business than you might expect. According to figures published today, sales rose by 8.7% to £165.5m during the year to 30 September. The group’s operating profit was 23.4% higher, at £22.8m, giving an attractive 13.8% operating margin.
Shareholders will enjoy a 30% pay rise, as the dividend will rise to 16.02p per share. This big increase is the result of continued strong cash generation. Avon’s net cash balance rose by £21.8m to £46.5m last year, so it now represents more than 10% of the group’s share price.
Is the price right?
My sums indicate the group generated a return on capital employed (ROCE) of 18.3% last year. This suggests that the firm’s investment in acquisitions and new products are continuing to deliver attractive returns.
Avon shares are up by 5% at the time of writing today. This leaves the stock on a forecast price/earnings ratio of about 18, with a dividend yield of 1.2%.
This valuation is probably fair, but it doesn’t leave much room for disappointment. I’d like to invest, but I plan to wait for the next market sell-off in the hope of picking up some stock more cheaply.
