Friday, August 10, 2012

Advice from the gardening column: XP Power edition

I have a friend - a journalist - who refers to the stock-tipping parts of his newspaper as "the gardening column": full of plants he says.

But the Financial Times is not any ordinary newspaper - and its stock tipping columns should be a little better than that. So I read David Schwartz column on how to manage your investments on holiday with great interest. Fantastic stocks - ones you can put in the bottom drawer and know they will deliver - they are the stuff I need to take the stress out of my life.

Here is what he recommends:

Turning to my own portfolio, I have just bought shares in XP Power (XPP), a designer and manufacturer of power converters. These are devices that allow electronic equipment to operate efficiently.
XP Power shares were in the 1,600-2,000p range during the first half of 2011. But investors ran for cover after the level of new orders began to slip in mid-year. The slowdown eventually caused lower profits in the first half of 2012. 
But the company’s order rate is now spiking higher. I expect second-half results to be much higher than last year’s figures. 
Even better, XP Power is quite optimistic about its future. It recently launched 10 product lines. It brags about its strong design win record in the current year. The share of revenues derived from products manufactured internally is rising. These are more profitable than those manufactured externally. Its new factory in Vietnam has just come on stream, which will also help to increase margins. 
The dividend has just increased and now approaches 5 per cent.

Power converters - the things you plug into your laptop or into the life-sign monitoring equipment in a hospital to feed them nice stable DC current - don't seem to me to be a massively prospective business. There are lots of suppliers. I am not particularly fussed about which one I use. If I want power reliability then I get an "uninterruptable power supply" and even those are a competitive market. I would expect a story of thin margins made good only by lots of product development and fairly large sales.

XP Power confounded my expectations. Completely confounded them. The accounts were nothing like what I expected to see. Here is the P&L from the last annual report:

Revenue was £103.6 million. Gross profit was £50.9 million. The gross margin was 49.1 percent.

Operating profit was £25.3 million. Operating profit margin was 24.4 percent.

Research and development expenditure of a mere £4.2 million pounds. Not a big number - but a moderately healthy 4.1 percent of revenue.

These ratios looked strangely familiar. But I could not quite put my finger on why. And then a light went off in my brain. A light from Cuppertino. Apple! Yes that company.

Here - and on an entirely different scale - is Apple's P&L for the last three years:

The sales last year were $108.2 billion. Gross margin was 43.8 billion. Gross margin was 40.5 percent - a little lower than our humble XP Power. But Apple's operating margin (31.1 percent) is higher than XP Power.

But hey - David Schwarz - writing for the esteemed Financial Times - tells us that XP Power is going to increase its margins. Apple like numbers here we come!

XP Power history

By now I am seriously impressed with XP Power. It makes a seeming commodity electronic product but has a higher gross margin than Apple. Surprisingly despite the fact that it does not advertise much or run all those fancy stores it manages - after SG&A to wind up marginally - and only marginally less profitable than Apple.

Pretty darn impressive.

If it just turned up this way - a new entrant into the realm of super-profitable electronic hardware companies - then I would be surprised - but not stunned. But XP Power has been pushing out astounding numbers for a decade. Larry Tracey - Executive Chairman - is quoted in the last annual report as follows:

Our strategy and its execution  resulted in earnings per share of 106.4p for 2011, an increase of 27% over 2010. The compound average growth rate of earnings per share has been 27% over the last 5 years and 18% over the last 10 years.
It is not Apple - but this is way more impressive than most companies. 18 percent for 10 years is more than 500 percent growth. Previous years are also at very high margins.

Wow. Now I am really wondering why it took a share-tipping column to alert me to this wonder stock.

XP Power products

By this stage I had found a nearly unknown electronics company with margins nearly the match of Apple and with a hugely impressive growth rate. And it did what looked to me like a commodity business.

I had to go looking for their products.

Alas they were harder to Google than you would think - if only because XP Power got mixed up in articles about the Microsoft XP operating system and computer power requirements. Here however is a typical example:

It is a simple 15 watt DC converter (about a quarter of the capacity of the converter for my laptop). It is priced at 28 quid - cheaper in quantity. Still this is more expensive than the cheapest laptop computer DC converters suggesting that higher than normal margins are possible.

The balance sheet puzzle

An electronics company with a proud history (rapid, continuous growth) and margins within a whisker of Apple would normally - I expect - have a balance sheet similar to Apple. Maybe not in size - but I would expect to see a lot of cash - cash being the tangible representation of past profits.

But XP Power does not look like that at all. Here is the balance sheet:

The balance sheet has on it lots of assets representing past profits. Notably it has 31 million pounds of goodwill (they have purchased very well as acquisitions have not diluted profits). They also have 22 million pounds in inventory.

But they have that very un-Apple like thing. Net debt. Strange given their profitability - but with this record - well - you just have to trust them.

But I will not be buying the stock

David Schwartz "holiday buying case" for XP Power is that it will have increasing profitability. That is for a company that is already trading with Apple-like margins.

I am an old fashioned kind of investor. I like to think what a company will look like in five years before I pull the trigger.

To buy this stock I would need to be able to finish the following statement: I believe XP Power will in five years time have margins similar to Apple because...

I can't answer that. Indeed I can't imagine that you can stay this profitable in a seeming commodity business - so I shorted the stock. Maybe I need to find another gardening column.


To clear up confusion with my North American readers who forget there is a stock market in Old Blighty - this stock trades in London measured in pounds. [The Americans who forget there is a world outside the lower 48 know who they are!]


Anonymous said...

Not positive, but I think I have heard of them. Looks to me like most of their products are "internal" converters, intended for use inside a consumer/industrial product, as opposed to something you would sell as a standalone device. My old company used a few 100k a year of such converters, in the 300 to 700 watt range. Your initial thoughts match my experience - highly competitive, low margins, many players, commoditized. Efficiency and price were the important factors. If we were buying a 96% converter and we found another supplier with 96.5%, they would get all our business. We paid about $0.10 to $0.20 per converter in quantity. I just don't see anything that differentiates their products from any of the other 50 suppliers. There does tend to be a fair amount of touch labor involved in production, so maybe manufacturing in Vietnam helps keep the cost low?

Anonymous said...

I thought you shorted frauds primarily. Do you suspect fraud here? If not, while your five year thesis may be correct, it is also true that their 10 year track record is impressive, and assuming they are legitimate, they may perform well for some period of time.

At any rate, I'm surprised you are currently shorting the stock given what you know about the company, which doesn't seem to be much.

A guy said...

It looks like the company dividends a large percentage of the cash flow out to shareholders each year. Sort of hard to fake that. They've also been paying down a little bit of debt each year. It still begs the question, why are margins so high?

Ferry van Asperen said...

I just skimmed through the annual report and it seems to me that they obtain their high margins from customer lock-in. Their engineers are involved in the product design process, which means that a product would have to be redesigned if one of their customers wants to use a different supplier.

P.16 states:
“Although design cycles are often long, once our power converters are approved for use in our customer’s end equipment XP Power enjoys a revenue annuity for the lifetime of the customer’s equipment.”

XP's customers are healthcare and industrial companies, not consumer companies. One way to explain their high margins is that their customers emphasize reliability and design rather than component cost. These are mission critical systems, not toys.

If this is true than you better know that you have timed the product design cycle correctly, which according to their annual report lasts around 5-7 years.

On the same page of the annual report it states:

“The positive aspect of this model is that the large number of product introductions we have made over the past few years should bode well for medium term revenue growth and the design base is strong and secure. This factor enabled the business to perform strongly even during the recessions in 2002 and 2009.”

Insiders have been buying a decent number of shares these past few months.

arr said...

John..a great fan of ur blog..surely one of the best out there..amazed by how much i could learn just by visiting it even though cant really trade on london exchange. Pls keep them coming

Anonymous said...

The balance sheet analysis was a little weak. Really need to look at it year-over-over in conjunction with the Statement of Cash Flows. Was the cash conversion cycle quicker than prior year, etc., etc.

Anonymous said...

Short would seem more reasonable if the dividend yield wasnt 4%+ seems like they pay out north of 50% of FCF in dividends. EBITDA multiple isn't low, but growth would argue that it's a justified multiple

John Hempton said...

Do you really believe these gross margins are available from customer lock-in? Remember most the customers have margins under half this - and they are not stupid - they don't give it away.

Moreover the equipment the customers make (hospital stuff, computers) is more complicated than the DC transformer - so they are asking us to believe that they get high lock-in margins on simple equipment from customers who make more sophisticated equipment.

Add to that the R&D budget is tiny (4 million quid) and they get multi-year fat lock in for that?

It may happen but it cannot be sustainable.


The biggest worm in this short is the dividend. I have wrangled and wrangled and wrangled through the cash flow statement to work out how it is possible to have that really super-profitable business and such a crappy balance sheet.

There is no obvious smoking gun there. It is not like every year the goodwill goes up, they issue stock and pay a dividend.

However it is very strange that a miraculous company with Apple-like margins and lots of growth off no obvious capital demands winds up with a very un-Apple like balance sheet.

This is one of the few small caps where I have been bothered with a decade of cash flow statements...


Ferry van Asperen said...

This company's margins are miracle for sure. I had a closer look at their annual report and concluded that I have no explanation besides customer lock in and book cooking. Although they do say they have a kaizen team :).

XP claim that their customer base is diversified, with no customer accounting for more than five percent of revenues. This rules out a one-time windfall due to a very successful end-product. It also makes it unlikely that their margins disappear overnight as the replacement cycles of the end-products will be diversified too.

The red flags I found relate to bank overdrafts and inventories.

Management praises their short lead times and predictable revenue streams yet they carry six month of inventory on their balance sheet. Ideally, this business model would be run with outsourced manufacturing. XP could have their suppliers stock up on their components so that they can reduce working capital requirements while maintaining those short lead times. Indeed, this used to be part of XP's business model and you'd expect it from their margins, but in 2011 they transferred all manufacturing to their own facilities. Apparently their customers demanded this. Surprisingly their operating cash flows remain very strong.

What also surprises me is that their segmental balance sheet shows that 53% of their inventory is in Asia, yet they only receive 8,8% of their total revenues there. If short lead times are so important why do they keep their inventories in Asia?

If this company is cooking the books then I'd have to guess that they juice their operating cash flows using bank overdrafts. They have -3,3m cash and cash equivalents if you subtract 9,6m in bank overdrafts. They paid 0.6m in interest on their bank overdrafts in 2010 and 2011. Strange, for such a profitable business. Their high margins would derive from understating the true cost of inventories, aided by a transfer to in-house manufacturing. I like a good miracle but book cooking seems to be the more likely explanation.

Ever heard of DFK Vietnam Auditing Company and Shanghai JunFu PCZ/Jiahua CPA? They audit the company's manufacturing subsidiaries in China and Vietnam. Presumably, Vietnam and China is where the inventories are too.

Anonymous said...

VicorPower is the closest comparable company I could find:

VICR on Nasdaq.

Gross margins seem to be more like 40%, but with R&D expenses consistently running about 15% of revenue.

Balance sheet has basically no debt.

longshorttrader said...

One of your better recent pieces, because its wonderful insight is only surpassed by its humor! Well done. Inspiring too.

B said...

John, I look forward to every single post from Bronte Capital.

I love your writing, and your humour.

You are one clever cookie.

Peter Einhoff said...

Its easy to miss this point:

It does not much mater WHY XP Power reports miracle profitability, becuase its company is priced for perfection. Its stock currently trades at 36 x annual free cash flow. And its free cash flow has as spiked in the last three years.

Thus this story may or may not be legitable. But it doesn't matter, becuase there is no value in it. In fact, it's got an long way to fall becuase its flying so high.

Anonymous said...

The only way their margins work is if they are comparable to a mixed signal semiconductor company. These companies make thousands of products with lots of custom design specs that do modest production runs in the 10's of thousands. It's an engineer driven model and it does have lock in, an almost bespoke service.

While the Board seems to have a background with shops like LSI (more a merchant chip co with commodity margins), power supplies components don't seem to be that engineering intensive. If they are and the company's model is closer to a LLTC then you should see the evidence in the start up margins of products as they get layered into revenues - design costs are up front and gross margins gradually move into the 60%+ range.

they have defense and medical cust's, could be design intensive...

bigger question is if this business has such great returns and growth potential, why the dividend? THis part makes no sense.

Kyle said...

first reaction -- you guys are too cynical. Looks to me like a very interesting story -- a combination of factors that you don't find that often and that's why its so disconcerting in my opinion. On the other hand since I have no direct knowledge I could be completely wrong. Here are a few points to consider:
AC to DC converters may be simple devices but they have to deal with the infinite variations of the real world rather than the 0's and 1's of the digital. That variation can often make these parts a pain in the ass for the people trying to design them into their system. The system manufacturers do not have top talent in these areas -- so they have either made do or paid someone like XP to help. That's why the company talks about providing a solution to customers -- its about having the engineering talent to help customers figure out the most effective solution because once XP is designed in -- it ain't leaving.
Why the margins -- paying for that engineering for one but also I suspect their devices are a small cost of the overall system but a key component that must not fail -- that discourages the penny wise pound foolish behavior of price competition. As a small business friend once explained price does not always equal cost. Most companies favor size and growth over profitability. What makes this company different. Their crown jewel is 60%of sales (branded own design)
How sustainable are those margins? Assuming they keep up with the market and are able to keep their engineering talent in the field helping customers with solutions (i.e. don't let someone else into their customers), the answer largely depends on whether management favors growth or margins. There are a finite number of products/applications with the attributes that can drive those margins. Those applications are growing given the on going share gains of electronics into every product but that's a single digit growth rate.
They have identified certain markets that have been underserved and thrown some engineering talent at them to provide customers with better solutions -- that's how they have gained share. The company says they still have small share of the market but they are a cream skimmer. When those higher margin applications are covered then what? Do you do what everyone else does and dilute margins with growth into lower margin products or do you slow growth and maintain profits. A look at the balance sheet provides a vote for the latter.
The balance sheet. Is it really that bad or is it just not over stuffed with cash like most profitable tech companies? You can fault them for running without as much of a cushion. Looks to me like they pay out the cash flow to return the capital to investors -- that used to be a good thing.
Inventory -- companies like this build a lot of inventory because it doesn't rot like most inventory. Their products have life cycles measured in multiple years so having a couple of extra months around to insure short delivery times to customers is an advantage. why is it all in Asia? last I checked that's where a lot of electronics manufacturing occurs.
Dividend versus growth. this one shows how screwed up most investment thinking is -- good businesses generate lots of cash and by definition can't invest it all without diluting returns. so you can either do what the tech leaders have done and let it pile up until you can't drive your stock with growth so you dazzle investors with a dividend. I guarantee you that any large growth company with good free cash flow could pay out a meaningful part of their cash flow in dividends and not change their growth rate -- they aren't investing the money anyway until they decide to do something stupid like a deal to get growth restarted. Perhaps if they would pay out the dividend from the beginning rather than wait unitl growth slowed, dividends wouldn't have such a negative stigma.
I'm sure this sounds crazy to most but if you wanted a more bullish explanation there it is.


Anonymous said...

"They have purchased very well as acquisitions have not diluted profits" - DO WARN NEXT TIME, JOHN!
I almost choked.

Apparently not only they have a miracle business, but also a steady stream of other miracle businesses for acquisition ;)
Which are mostly made up of goodwill, too :0


Clownbucks said...

The bull case|

I do agree with your bear case. I think the low amount of R&D (4% of revenues) is the giveaway. This is not concistent with highly engineered and customized products.

Clownbucks said...
This comment has been removed by the author.
Anonymous said...

Few points:
- even if your analysis is correct, a stock paying 5% divvy w/o massive debt is going to be expensive to short w/o a major external event, unless the company is a fraud in the first place.
- "Moreover the equipment the customers make (hospital stuff, computers) is more complicated than the DC transformer - so they are asking us to believe that they get high lock-in margins on simple equipment from customers who make more sophisticated equipment." I don't understand your reasoning. If my customer sells equipment that costs 10 grand, and I contribute few parts that cost 50quid, is my customer going to care that I've got 50% margin on them (or put it differently, I could make it cheaper by 12.5 basis points)? I doubt it. They will care that I can work with them to get it on time and in the form they want.
- the differentiation with "commodities" is service. If I really wanted to short this, I'd talk to their clients, and ask them why they use XPP and not someone cheaper. If they tell me "because we always did", then short it. If they say "because our R&D people love them", then go long.

o. nate said...

Alas they were harder to Google than you would think - if only because XP Power got mixed up in articles about the Microsoft XP operating system and computer power requirements

Try typing this into Google search box:

xp power -windows

(means exclude any pages with the word "windows")

Eric Titus said...

Given customer lock-in, R&D of 4% seems reasonable. Often customers with specialized needs will handle some of the costs of developing products. A stock with some upside potential and 4% dividend is gold for individual investors (not hedge funds though, of course). On the other hand, there are probably more downsides and things that could go wrong.

I think APPL is a solid point of comparison (or maybe a quality tools/tractors/machinery company like SNHY). One reason they are able to sell goods at high margins is because consumers are willing to pay more for a product that they can rely on. Is it worth it to have an employee spend a few hours finding another equally reliable converter maker who may save you a hundred buck? Probably not.

John Hempton said...

dmitry - send me an email...


Mark said...

(Copy of comment - not sure if previous one went through)

The converter you cite as an example product is NOT YOUR REGULAR power converter.

Note that it converts a range of low voltage DC voltages to a single output DC voltage.

The ones you plug into the wall take high-voltage AC input.

Translating DC to DC is, I think a trickier job, and keeping that output voltage fixed tight as current load changes rapidly is a job which I think might be what commands the high margins.

They may have very few competitors in their market.

Look at Linear Technology - they seem to have

Detlef Guertler said...

Well, Mark,
Maybe "they have very few competitors in their market" of DC DC converters.
If you define "41" as "very few":
If you have to compete with Siemens and ABB and some dozen companies more, there's little chance of maintaining sky-high margins in the long term.

Wally said...

This is what happens when you don't understand a specialised engineering business.

DC-DC power conversion is very widely available, commoditised. Until you get into high reliability products, with high efficiency, going into specialised markets like medical and defence. In those markets, the bar is higher, the design-in (product in-manufacture time) is longer, price is not so much a barrier, etc. Think for example, medical ultrasound machines - who cares if the power converter costs $10 or $8 ?

The web page you showed is also from Farnell / Element 14 where prices are no where close to what a product maker actually pays. Those prices will be anywhere from 2x to 10x what the product can be purchased for in the wholesale electronics market.

It does all still seem a bit too good to be true, but you suffer from the information asymmetry problem - they understand more aout their products and markets than you do.

You need to talk to an electronics engineer who knows a bit about specialised power supply and product design.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.