Here’s why I’ve put IQE shares on my watchlist

IQE shares have had a torrid time since an attack by short-sellers in 2017. But G A Chester is beginning to see reasons for optimism.

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IQE (LSE: IQE) shares are trading well below their high of earlier this year. And far below their high of 2017. I’ve been bearish on this AIM-listed tech stock in the past. However, it’s been a while since I last looked at it.

There’s an old saying: “When the facts change, I change my mind. What do you do, sir?” Here, I’ll discuss the changes at IQE and explain why I’ve promoted the stock to my watchlist.

Short-sellers attack IQE shares

In 2017, the IQE share price reached as high as 178.75p on 16 November. This gave the company a market capitalisation of £1.35bn. However, short positions (hedge funds betting on the share price falling) increased sharply through the second half of the year. By 23 January, more than 10 funds were shorting 12.4% of IQE’s shares.

In early February, two short-sellers — ShadowFall and Muddy Waters — published research reports claiming IQE was, in the words of Muddy Waters, “an egregious accounting manipulator.” IQE issued rebuttals.

The shares rallied but have never got back to that 178.75p level. Their 2021 high, made on 21 January, was 88.3p, and they’re currently trading at 47.5p. I can now buy 46% cheaper than in January and at a 73% discount to the November 2017 price.

Short-selling and boardroom changes

A few things have changed since the short attack. Only one fund now holds a disclosable short position in IQE shares (Ennismore at 0.91%). IQE has a different chief financial officer, his predecessor having died in tragic circumstances shortly after the ShadowFall and Muddy Waters reports. Finally, IQE’s founder and chief executive officer Dr Drew Nelson is set to handover to a new CEO.

The significantly reduced interest of short-sellers and the executive changes allay some of my past concerns about IQE’s accounting and management.

IQE shares are on my watchlist

Another of my previous concerns was that after two decades as “the global leader in the design and manufacture of advanced semiconductor wafer products,” IQE had generated little in the way of free cash flow (FCF). As I noted in an article in 2019: “Periods of elevated investment and heavily negative FCF have been followed by little meaningful FCF advance in subsequent years.”

At the time of that article, IQE was in a period of heavy investment. Capital expenditure and capitalised research and development totalled £41.8m in 2019 and FCF was negative to the tune of £25.4m.

However, this period of investment does appear to have led to a meaningful FCF advance. In 2020, on lower capital expenditure and capitalised research and development of £10.4m, IQE delivered positive FCF of £22.7m.

It may be the company has now reached a level where economies of scale are beginning to kick in. And with “record revenue of £178m underpinned by the start of the 5G mega-cycle,” the future could be very bright.

I’m not quite confident enough to buy IQE shares just yet. I’m expecting capital expenditure and capitalised R&D in 2021 to be in the region of £30m–£35m. And FCF to be insipid at best. I want to see a bit more evidence that IQE can deliver consistently higher FCF. But I’ve put the stock on my watchlist.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

G A Chester has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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