Electrify your portfolio with XP Power

XP Power (XPP) is a manufacturer and distributor of specialist power converters – these are essential products that convert the electrical current from the mains supply to the correct voltage required by a piece of equipment. Serving more than 4,500 customers, including a growing number of blue-chip companies, the group has four end markets – industrials, semiconductor fabricators, healthcare and technology. Its products have a wide variety of applications in everything from 3D printing and robotics to MRI machines and ventilators.  

The group serves some markets that are sensitive to the economy, with industrials and semiconductors accounting for 35 per cent and 27 per cent of revenue, respectively, in the six months to 30 June. But these markets follow different demand cycles. Meanwhile, healthcare offers a more defensive revenue stream. It’s worth noting that XP Power has no direct exposure to more variable consumer electronics, meaning that during the last recession, both revenue and orders only dipped 3 per cent in 2009 before rebounding strongly in 2010.

Last year was a challenge owing to the cyclical downturn in the semiconductor industry. But while Covid-19 has hit industrial activity this year, a recovery from semiconductors means that XP Power’s outlook looks more promising. Indeed, analysts have been turning more bullish on the group’s prospects, particularly following an October trading update guiding that full-year results would be at the top end of consensus expectations. The announcement revealed that revenue for the three months to 30 September had surged by almost 30 per cent year on year thanks to the “exceptionally strong” order intake during the first half of the year. This reflects high demand for Covid-19-related medical devices during the peak of the pandemic, which pulled in a net additional £15m-£20m of healthcare orders. New healthcare orders have returned to normal levels meaning that the book-to-bill ratio has dipped from 1.39 at the half-year stage to 0.82. But as orders from semiconductor manufacturers continue to grow, the group is sitting on a backlog of £126m.

Looking further ahead, XP Power will benefit from long-term structural growth trends across its end markets, including rising safety regulation and demand for more energy efficient devices. Ageing populations and chronic diseases such as cancer should also drive long-term healthcare spending. The proliferation of technology will require more semiconductor chips tapping into digital mega-trends such as the shift towards 5G, data centres, the ‘Internet of Things’ and artificial intelligence.

A savvy switch to design

The group sells directly to customers rather than through third party distributors enabling it to develop sticky long-term customer relationships. This has also been aided by its engineering services whereby it designs a power converter for a particular customer application. XP Power started out life as a simple distributor, but it has moved up the value chain to design and manufacture its own products. The design process can be long, but once a product is incorporated into a customer’s product, it provides recurring revenue over a period of seven to eight years. Revenue tends to ramp up across the product’s lifetime, meaning there is still growth to come from new converters introduced over the past three years.

This business model has made XP Power a popular small cap pick among UK fund managers. The group is a top 10 holding of the Aberdeen Standard UK Smaller Companies Fund (GB0004331236), which has held the shares since XP Power listed in 2000. “There’s a strong visibility and predictability to its earnings,” says manager the trust veteran, star manager Harry Nimmo.

Meanwhile, the Henderson Smaller Companies Investment Trust (GB0009065060) likes the “strong repeat customer use” and barriers to entry. The trust’s management team point out that once a converter is “‘designed in’, it’s difficult to replace given the equipment is used in regulated industries and approvals are required on modifications”. Customer ‘stickiness’ also comes from the fact that the cost of equipment failure in these industries is often high – medical device manufacturers, for example, are likely to prioritise quality and reliability from a trusted partner over cheaper pricing from a competitor.

Healthy margins have been supported by these high value engineering services as well as low manufacturing costs and investment in product innovation. Spending on research and development has grown at a compound annual rate of more than 12 per cent since 2002.

The adjusted operating margin was squeezed last year by component price inflation and US tariffs on goods imported from China. It dropped from 22 per cent in 2018 to 18 per cent in 2019. The profitability of revenue has also been weakened by the group’s investments to improve its engineering, manufacturing and sales operations. But as this spending is completed, analysts predict that the operating margin will track back upwards towards 22 per cent. While the exact trade policy of the incoming Biden administration remains unclear, even if trade war pressures persist, XP Power’s Vietnam manufacturing plant – which was completed last year – will help bypass this hurdle and also bring down production costs further.

Amped up for further growth

As industrial markets recover, analysts at Liberum believe that XP Power’s earnings growth will accelerate with adjusted operating profit rising at a compound annual rate of 15 per cent between 2019 and 2022. That compares with a compound annual growth rate (CAGR) of 9 per cent between 2012 to 2019. According to the broker, this would leave it growing faster than other high-quality industrial favourites such as Halma (HLMA) and Spirax-Sarco (SPX). XP Power stacks up well against these peers, with its solid margins underpinning a superior return on capital employed (ROCE) over the last 12 months at a lower valuation (see table).

XP Power was sitting on £34m of net debt at the end of June, down almost a fifth from the December year-end position and equivalent to just 0.7 times adjusted cash profits. It had fallen further to £28m at the end of September and the group is aiming for leverage to come down to 0.5 times cash profits by the end of the year. A good track record of generating free cash flow has underpinned its dividend payments. While the final payout for 2019 and first quarter dividend for 2020 were cancelled amid pandemic uncertainty, the group has reinstated the second- and third-quarter dividends.

The healthy balance sheet should enable growth through acquisitions. XP Power operates in a highly-fragmented industry and consolidation could help increase its 5 per cent share of the high-voltage market. It has spent $80m on three acquisitions since 2015, extending its reach in the high-voltage and radio-frequency power markets and expanding the size of its addressable market by almost three-quarters to $4.7bn. The shift away from more generic low-voltage power products should also help counteract the threat from low-cost competition in Asia.

Change is afoot as chief executive Duncan Penny – who has been at the helm since 2003 – is stepping down at the end of the year. We don’t anticipate much upheaval from his departure, however, as he is being replaced by current chief financial officer Gavin Griggs who has been with the group for three years. Meanwhile, the group’s chairman is founder James Peters who is also XP Power’s second largest shareholder with just over 6 per cent.

Worth the price tag?

The shares have recovered strongly from the ‘Covid crunch’, bouncing back to well above their pre-pandemic levels. While they have pulled back from an all-time high, they still have what on the surface may appear a punchy rating at 23 times consensus 2021 earnings and an enterprise value-to-operating profits ratio of 20.

“We’re more relaxed about the valuation,” says Mr Nimmo. “The company did get a bit of a hammering in 2018 and 2019 as the semiconductor cycle went against them, but they’re definitely on the up after quite a difficult period and I would say that that will continue for some time. It’s a high-quality company and in many ways, you get what you pay for.”

Indeed, the group has proved its resilience during this tumultuous year. With margin improvement on the way, an industrial recovery to come and long-term structural tailwinds propelling further momentum, the future looks bright for XP Power.

Last IC View: Hold, 4,320p, 03 Aug 2020