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Is the IQE share price now too cheap to miss?

It hasn’t been a good year for supplier of semiconductor wafers IQE  (LSE: IQE), or for touch sensors specialist Zytronic  (LSE: ZYT). After a number of years of strong earnings growth, both companies have seen a reversal in 2018. However, their earnings are forecast to resume an upward trajectory in the coming year. And with their shares currently trading near 52-week lows, could now be a great time to invest?

Business mix

Zytronic today posted results for its financial year ended 30 September. Revenue of £22.3m was down 2.6% on the prior year, with growth in sales of touchscreens to the gaming sector only partially offsetting a decline in sales to financial markets.

Group pre-tax profit dropped 23% to £4.2m. The much bigger drop in profit than in revenue was largely due to a fall in gross margin to 37% from 41.1%. Management said the margin contraction was principally down to “labour and material inefficiencies, as new and different products and methods associated with gaming replaced more familiar tried and tested touchscreens for the ATM sector.”

Valuation and outlook

At a current share price of 340p (down 8.1% on the day), Zytronic trades on 15 times earnings per share (EPS) of 22.7p. However, with the company’s balance sheet boasting cash of £14.6m (91p a share) and no debt, the earnings multiple comes down to a much more attractive 11 on a cash-adjusted basis.

Adding to the attraction is a 22.8p dividend, which gives a juicy yield of 6.7%. While the payout isn’t quite covered by EPS, it’s comfortably covered by cash flow. I’m expecting new product launches and improved margins from production efficiencies to drive revenue and earnings (and the dividend) higher for fiscal 2019. I reckon we’re looking at a forward cash-adjusted earnings multiple of below 10 and a prospective dividend yield of over 7%.

Zytronic may be a relatively small company (its market-cap is £55m), but with its strong balance sheet and attractive valuation, I rate it a ‘buy’.

Setback

IQE’s shares hit a high of over 160p just over a year ago, but are currently changing hands at around 70p, giving it a market-cap of £544m. Last month, it had to issue a profit warning for the current year. This was because a major chip company in the supply chain had received notice from one of its largest customers for 3D sensing laser diodes to materially reduce shipments for the fourth quarter.

As a result, IQE said it now expects to deliver revenue of approximately £160m this year (little changed from last year), and earnings before interest, tax, depreciation and amortisation of £31m, from £37m last year. City analysts expect this to translate into a 46% fall in EPS to 1.95p.

Technology leadership

Despite the setback for the current year, analysts forecast revenue increasing over 20% in 2019, and EPS soaring almost 80% to 3.5p. This puts it on an earnings multiple of 20 at the current share price, which is quite a rich rating. Indeed, too rich, according to a number of hedge funds, who have continued to position themselves to profit from the shares falling lower.

Critics have questioned whether the company has the “technology leadership” it claims. In view of this, I’m inclined to avoid the stock until there are signs of a big step-change in revenue that would support the technology-leadership claim and a high earnings rating.

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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.