Buy into the XP Power struggle

XP Power designs power supplies for blue-chip customers, and its operations can be broken down into four segments: semiconductor equipment, technology, industrial and healthcare. In the first half of 2019, pre-tax profits fell 30 per cent as semiconductor revenues tumbled more than a third, and gross profit margins fell 150 basis points to 44.6 per cent. XP has been unable to fully recover the costs of so-called Section 301 tariffs on Chinese exports into the US at a rate of 10 per cent from September 2018 and 25 per cent since May 2019. The company's bosses don't envisage any recovery in the semiconductor market before 2020, which may have deterred some investors. But this setback doesn’t tell the whole story. Also in the first half XP’s technology, industrial and healthcare segments, which together made up 83 per cent of the group’s sales, saw revenue growth of 12 per cent, 13 per cent and 8 per cent, respectively.  

Granted, with 17 per cent of turnover, XP’s semiconductor work is significant, and we have cautioned against investing in similar businesses (see IQE) over their exposure to the US-China turmoil. In addition, the majority of XP’s customers have China-based manufacturing facilities, “which puts them at a significant commercial disadvantage if they are selling into the US”, the company acknowledges. 

Yet to balance that, XP began producing its first magnetic components in Vietnam back in 2012. Since 2014, its Vietnamese facility has been producing complete power converters of the same standard as its Chinese facility. XP went on to add a second factory on its Vietnamese site in the first quarter of 2019, which is expected to add over £100m of manufacturing capacity per year, and take XP’s overall annual capacity up to about £250m. Of the 779,800 power converters it manufactured in the first half, 619,600 were made in Vietnam. Some customers still need to approve the transfer of certain products from China to Vietnam, but “we’re seeing a lot of customers in the US now saying, ‘we will not design in any Chinese-sourced products’,” says chief executive Duncan Penny. The move is expected to yield £4m of annual savings from June 2020.

While recovery isn’t expected imminently, cyclical downturn is a feature of businesses in this sector, although, admittedly, it has become harder to predict downturns because of the erratic nature of US trade policy. Meanwhile, growth in XP’s other divisions is resilient, which can partly be attributed to a decision taken in recent years to ratchet up the power levels used in its components, along with more focus on connectivity. Historically high returns on capital, operating profit margins and, until recently, growth in cash profits look like evidence of a good company keeping its head above choppy waters. Its chief executive is undeterred by the way the markets are affecting XP, and places the company at the trough of a cycle. “We see that [cyclicality] as jam on top of the underlying performance,” Mr Penny says.