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Why I’d sell IQE plc in favour of this hidden tech gem

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After surging from a price per share of 40p at the beginning of 2017 to over 170p near the end of the year, IQE (LSE: IQE) has fallen just as quickly to trade at around 115p. That comes after a handful of short sellers launched very public broadsides against the semiconductor manufacturer.

Whether you view short sellers as an integral part of a healthy capital market or opportunistic parasites, the accusations have likely done interested investors on the outside looking in a favour. IQE’s once astronomical valuation has now come down to a more palatable 38 times forward earnings. But this valuation still prices in several years of expected growth, which is always risky with fast-moving tech firms.

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An additional worry is that the short sellers’ reports do raise valid questions about the group’s corporate governance structure. Now these could be nothing more than growing pains of a previously tiny and obscure company that is now unexpectedly in the limelight. But I’ve seen too many AIM-listed stocks wilt under poor corporate governance standards to invest in IQE right now due to questions surrounding its relationship with joint ventures and accounting practices.

Another issue giving me pause is the group’s rapid expansion. In November, it issued shares representing 9.9% of its previously issued capital to raise £95m for expansion purposes including a significant increase in the volume of machinery at its new foundry. While the group’s sales are currently rising at a brisk pace and it’s good to see management investing to meet demand anticipated several years out, there’s always the risk that changes in the industry could see the company saddled with excess capacity.  

Likewise, while IQE supplies a series of chip makers rather than just one or two, its sales are still fairly concentrated. The industry is also undergoing rapid changes with a series of acquisitions, business model shakeups and customers squeezing suppliers’ margins. As a small player in the wider industry, these changes risk buffeting IQE’s fortunes, which together with short sellers’ concerns make the company’s valuation too high for me to invest in the stock right now.

This recent market entrant makes a splash 

I’m much more interested in Alfa Financial Software (LSE: ALFA), which designs and supplies software for the asset financing sector. Like IQE, Alfa trades at a lofty valuation of 38 times forward earnings. But I believe the sticky nature of its product — which is used by financial institutions such as RBS and carmakers such as Mercedes-Benz North America — and rapid growth warrant such a premium.

In the half year to June, the group’s sales leapt 29% year-on-year in constant currency terms to £45.1m as it landed two new contracts, completed three software implementation programmes, and increased recurring revenue streams from existing clients. Looking forward, there’s still plenty of room to grow as its software is in high demand from a range of lenders looking for an easy-to-use, unified programme to keep track of and service loans.

With the founder-led management team investing in building up the company’s developer ranks, the group’s large sales pipeline should be quickly converted into cold hard cash. And with a large net cash position, high profitability and plenty of room to grow, I think Alfa could be a great long-term holding. 

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Ian Pierce 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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