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Why I’d ditch IQE plc for Royal Dutch Shell plc

Compound wafer manufacturer IQE (LSE: IQE) has been on my radar for some time. I’m attracted by its patent-protected knowledge and its strong competitive positioning in the microchip world. 

Unlike a lot of smaller companies, it is also soundly profitable and racked up an 11% operating margin in the first half of this year. The company trades on a PE of 43 however, leaving little room for error. 

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I had previously been excited by the firm’s licensing model – which was similar to ARM Holding’s approach – because it allows it to generate additional revenue without requiring the heavy investments associated with manufacturing. 

However, profit from this capital-light avenue has been sporadic. Last year IQE earned £6.7m in licensing fees, short of the £8m recorded the year before. I had hoped that licensing could become a larger part of the business because it could boost both margins and cash flows. 

That’s not been the case and the continued reduction in licensing earnings in the first half of this year took the shine off of the 17% increase in the Wafer segment. The company also doubled capital investment to £15m in the half, exceeding the £9.2m cash generated by operations. Growth is not exactly coming cheap. 

That’s not to say this bout of investment won’t bear fruit. The Internet of Things could massively increase demand for IQE’s products, so investing ahead of the curve to ensure services remain top-notch could be a great long-term approach. Some have speculated that IQE could be a major supplier for the new iPhone, which might explain this increase in spend, yet I believe the shares have been pumped up by this presumption and could suffer if it turns out to be hot air. 

I still like it as a business, but I won’t make an investment based on that rumour. I’d struggle to make a purchase until the shares are trading at a significant discount to today’s price. 

Shell’s safer

Despite the ever-present speculative nature of an investment in any oil major – due to the oil price issue – I believe an investment in Royal Dutch Shell (LSE: RDSB) is likely to be a safer than one in IQE. The company’s integration of BG Group has gone off without a hitch and its programme to dispose of non-core assets is having the desired effect.

Q2 cash flow from operations was up 604% in the first half of this year. This is perhaps the most important figure when considering the safety of the dividend. This increased cash flow covered the $3 cash dividend payment and helped reduce gearing to a manageable 25.3%.  

In my opinion, Shell looks like it’s in a good place to keep the oil and dividends flowing. The shares have already recovered significantly since the depths of the oil price crash and I’m not expecting a re-rating in share price anytime soon, but I feel the 6% yield on offer today could represent a solid defensive return in a market that is looking fully valued.

I’d certainly take shares in Shell over IQE today.

As I mentioned earlier, it's becoming harder and harder to find bargains in the current market. That's why I'd advise investors to buy quality companies with defensive business models over the long-term. Given the aforementioned speculative factors, neither Shell nor IQE necessarily fit that bill right now.

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Zach Coffell owns Royal Dutch Shell B shares. The Motley Fool UK has recommended Royal Dutch Shell B. 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.