XP Power (XPP:LSE) is a London-listed, Singapore-registered company providing power supply solutions to the electronics industry in the USA, Europe and Asia.
Business
Let me add nuance to the above description and explain what makes XP Power a great company. Dare I say a hidden champion? XP Power designs, manufactures and sells particular power control solutions (power supplies and converters) to the healthcare, military, railway, aerospace and other industries. Examples of the machines which use XPP’s products are:
- Life support equipment
- Medical imaging equipment (MRI, CT Scanners, X-rays, etc.)
- Blood processing equipment
- Satellites and spacecraft
- 3D printers
Not everyone can become a supplier to the companies manufacturing these. They need to approve you. Your product has to top quality and extremely reliable. But once approved, it is highly unlikely that you would be replaced.
Put simply, the company sells a vital-but-cheap component that goes into very sophisticated and expensive, mission-critical machinery. Who would risk putting an unreliable component – a component that costs a tiny fraction of the value of the machine – into life support equipment? Even if a competitor sells it at half price but has a 5% higher failure rate, is it worth considering?
XP Power has a great business as evidenced by the sustained high margins – 50% gross and 15-20% net. Some have compared it to Apple. Moreover, it has annuity characteristics in that once approved for use and placed into a piece of equipment the company’s products enjoy a revenue stream from support and maintenance that lasts on average 7 years.
While power supplies are not a growth industry by any means and investment in capital goods has been subdued ever since the Great Recession, XP Power has managed to grow sales at a healthy 4% rate over the past 10 years. This might seem unimpressive until you look at operating profit, which compounded at 12%. The company has been able to achieve these results while investing only 4-5% of revenue in R&D. Yet XPP’s engineers have proven that they can develop the products that best address the clients’ needs. Thanks to its close relationships with clients and the desire to meet and exceed their expectations, XP Power has been able to grow very efficiently and very profitably. It is persistently increasing its market share in a fragmented market.
Management is focused on keeping both customers and shareholders happy. XP Power has added manufacturing capacity in Vietnam to “mitigate the continued rise of Chinese labour costs and the appreciation of the Chinese Renminbi.” Currently, a quarter of the company’s power converters are produced in the Vietnam facility, which was officially opened in mid-2012. At first, I was a bit concerned XP Power, which was already manufacturing cheaply in China, would be looking to do it even cheaper in Vietnam. Wouldn’t it be at the expense of quality? It doesn’t seem so. The company is serious about its top-notch manufacturing facilities. It is introducing lean principles in both China and Vietnam. The core philosophy is to “create more value for customers with fewer resources.” Among other things, it minimizes waste and optimizes processes throughout the organization. XP Power is in a good position to be successful in this thanks to its dedication to and close relationships with its customers. Another reason for the company’s laser focus on costs is that it fears competition from Asia. Ever conscious of the power of low-lost competitors, who are gradually improving the quality of their products, XP Power’s focus on driving costs down and building a strong reputation is understandable.
Apart from improving and increasing capacity organically, XP Power does the occasional acquisition of a related business. The most recent one was California-based EMCO High Voltage, which, as the name suggests, is a leader in high voltage DC power supplies. It was acquired in late 2015 for $12m, which was 1.5x sales. These bolt-on acquisitions are another mark of hidden champions.
XP Power has been very generous and shareholder-friendly, paying out 60% of its profits in dividends. The compound average growth rate in dividends over the past 10 years has been 15%. This is a clear indication of the company’s cash-generation abilities and business quality. Unlike other companies, XP Power doesn’t have significant reinvestment needs. It can be argued that it is doing this at the expense of future growth and quality. If it is achieving these results with just 5% R&D spend, imagine what it could do with double that, right? I don’t believe this is the correct way to think about it. More likely, the improvements to the power supplies and converters the company manufactures are incremental and customer-specific. Throwing tons of money at it is unlikely to generate breakthroughs. Even if it did, such amounts are unlikely to come out of companies like XP Power. The problems that require tons of money are tackled by industry giants such as Emerson and ABB. The problems that XP Power’s engineers solve are based on the better understanding, coming from the close relationship, of the customer’s needs and the ability to be flexible in solving these. XPP’s customers rely on the company to solve problems that are not scalable and thus of no interest to the big guys.
In the first six months of 2016, XP Power generated £60m (51% US, 41% Europe, 8% Asia), £13m operating profit (60% US, 34% Europe, 6% Asia), and £10m net. This was accomplished with £113m capital employed (calculated as total assets minus cash, deferred tax assets, and loans to employees) and £90m equity. Both point to a return of 22-23%. Return on equity has been around 30% historically, but has come down in recent years, partially attributable to operational and partially to financial reasons. Leverage has come down from 2.2x to 1.3x.
Risk
XP Power relies mainly on its reputation and relationships with customers. The most critical risk is damaging them. A major product failure can potentially bury the company. Losing a major customer due to quality issues will inevitably cause others to withdraw. However, this is the reality for any business in a position of trust. You either trust management will run a tight ship or you stay away.
There has been a lot of speculation around the word “moat” ever since Buffett popularized it. Everyone seems to be looking for moats nowadays. Do you know why the housing market isn’t recovering? Simple, houses don’t have moats. It is hard for me to say whether XP Power has a moat. I look at the margins and I say it does. Does it have mind share? Yes, probably – in the minds of electric engineers.
It bothers me that management seems a little too fixated on increasing the dividend. This never ends well in a cyclical industry. As already mentioned, the company’s products are built into capital equipment. Revenues are subject to the capital equipment cycle. They will come down and the dividend will have to be cut. I would be happier if they didn’t point to the dividend growth rate in every annual report.
Finally, not a risk in itself, but I don’t particularly like the 50% institutional ownership of the company. All else being equal I would prefer undiscovered companies.
Valuation
How much is a business generating 20m on a little over 100m invested worth given that it is not expecting stellar growth? I’ll leave this one to you.
Today, Mr. Market says 338m. At the start of the year, he was happy with 270m. Over the past 5 years, he has even been willing to part with his shares for 150m.
Be sure to let me know what you think.