Shares for the future: will good times return for this cheap stock?

It is with a heavy heart that I score XP Power Ltd (LSE:XPP).

True, the shine wore off last year when the company incurred a massive fine, but the hope that a business with an exemplary strategy might overcome its drift into debt still burned bright...

Scoring XP Power: fluttering red flags

Revenue in the year to December 2023 increased 9%, but adjusted profit fell for the third year running, this time by 10%.

XP Power supplies power converters to equipment manufacturers in three markets: semiconductors, industrial and healthcare.

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In 2023, it endured a slump in the semiconductor market, but buoyant conditions in its other two markets. Uncharacteristically, though, around the end of the financial year orders from less cyclical industrial and healthcare customers fell too.

This is because XP Power’s multinational customers had stockpiled components to mitigate delays and shortages as the global economy recovered from the pandemic. Now they are eating into their stock, rather than ordering power converters.

XP Power is facing a simultaneous decline across all markets at a bad time, when it is strapped for cash.

The Past (dependable) [1]

• Profitable growth: Barely, on a heavily adjusted basis [0.5]
• Strong finances: Net obligations are 69% of capital [0]
• Through thick and thin: Barely, on a heavily adjusted basis [0.5]

The first thing to note is the profit figures are a best-case scenario because they ignore substantial real costs deemed one-off. Including these costs, return on capital was only 8%, 3% less than the adjusted return.

Last year unadjusted return on capital was negative, due mostly to legal costs.

Although Matt Webb, XP Power’s new chief financial officer, says he is determined to keep adjustments to a minimum, his debut set of accounts are riddled with them.

In 2023, the company racked up exceptional restructuring costs as it sought to rebuild its finances, relocation costs for two facilities in California where the company had been unable to extend the leases, costs relating to a new factory in Malaysia, costs incurred in the relocation of work from factories in the West to Asia, and ongoing legal fees.

The legal fees relate to XP Power’s appeal against last year’s US court judgement that it had stolen trade secrets from a Swiss rival.

Despite a “Funding plan”, which is saving the company money through redundancies, reduced capital expenditure, and the suspension of the dividend, and despite £44 million raised by selling new shares to investors, XP Power was still mostly funded by debt at the year end.

XP Power expects lower revenue in 2024, although it says trading should begin to improve in the second half of the year as customer stock levels normalise and demand from semiconductor equipment manufacturers picks up.

The Present (distinctive) [2.5]

• Discernible business: Manufacturer of power converters for critical equipment [1]
• With experienced people: Limited experience at the top [0.5]
• That creates value for customers: Reliable, efficient, easy to design in [1]

Although we use power converters every day when we charge our phones or laptops or use the washing machine, the converters XP Power manufactures power much more complex equipment like industrial robots and surgical tools.

These machines have exacting and multifarious power requirements, and the power converter designs are a result of collaboration between equipment and power converter manufacturer. XP Power is well placed to deliver this because of its large field sales force and broad range of designs.

The company’s strategy is to develop low-power converter families for electronic equipment. These converters can be customised relatively easily so they fit the requirements of customers, mostly in North America and Europe.

Recent acquisitions have allowed XP Power to supply a greater range of converters to the same blue-chip customers, which is an important part of the company’s strategy. These power converters are more complex RF (radio frequency) and high voltage systems. They power processes like plasma etching in semiconductor manufacturing.

Twenty years ago, XP Power was a distributor just starting to develop its own low-power supplies and today it has 8.8% share of this estimated $3.7 billion market, which is quite an achievement. Its newer high-power markets are smaller but potentially lucrative.

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It is too early to say whether buying into the RF and high voltage markets has been a successful strategy, though, because the acquisitions are recent and because the court’s verdict means XP Power cannot use the RF intellectual property it was judged to have stolen.

Overseeing this difficult period for the company is a fairly green board. Chief financial officer Matt Webb joined last October and chair Jamie Pike joined last April.

The elder statesman is chief executive Gavin Griggs whose tenure as chief executive has coincided with XP Power’s troubled years. He joined as chief financial officer in October 2017, around the time the company allegedly stole the trade secrets.

He succeeded long standing chief executive Duncan Penny in January 2021, just as the first pandemic related dents in XP Power’s estimable financial track record were about to appear.

Too often since then, XP Power has been caught off guard by events: the size of the damages awarded against it last year, the slump in demand from semiconductor manufacturers, and most recently the requirement to relocate two facilities in California.

Creditably, in the annual report Mr Griggs accepts that the company should have been financially better prepared for these events.

According to its going concern statement, XP Power expects to be in business in 2026, although the severe downside scenario only gives it “modest headroom”, code for close to breaching the terms agreed with its lenders.

The Future (directed) [1]

• Addressing challenges:Legal dispute, ongoing investment [0.5]
• With coherent actions: Appeal, restructuring [0]
• That reward all stakeholders fairly: Employees, shareholders are suffering, will customers retain faith? [0.5]

The company was well within its banking covenants at the end of 2023, but the problem with the going concern statement is that it addresses individual risks: recession, the loss of a big customer or major manufacturing facility, for example. It was a combination of circumstances that got XP Power into trouble, and it still faces many of them.

On top of that, the cost cutting required to restore the company’s finances is interfering with XP Power’s ability to invest through downturns, a hallmark of its strategy over the last two decades. In the past, its investment led approach has enabled it to win more business when rivals are in trouble.

Although net product development costs increased in 2023 and “design wins” - projects that should one day enter production - are at a record high, XP Power only introduced 11 new product families in 2023, the lowest number in recent times and 19 less than it targets.

Some product families are more valuable than others, so judging the company by quantity alone could be misleading. But the paucity of new families does make me wonder about future design wins, which translate into orders and ultimately sales.

XP Power has deferred the construction of a much-vaunted factory in Malaysia, originally slated for completion this year. Twice as big as its state-of-the art Vietnamese factories and still planned for 2026, this initiative is strategically important for three reasons.

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First, it further reduces XP Power’s dependence on its facilities in China, which may be necessary for geopolitical reasons. Second, it is designed to be environmentally friendly, and XP Power sells itself on its environmental credentials. Third, manufacturing in Malaysia, like China and Vietnam, is relatively low cost.

Layoffs and restructuring suggest these cannot be great times to be working at XP Power. The company's employee engagement score as surveyed by Gallup gives some reassurance. It was 3.99 out of 5 in 2023, slightly above 2022 and broadly typical of the last four years. The company says it is in the 41st percentile of similar sized companies in the Gallup database. Slightly above average, in other words.

The full-time voluntary employee turnover rate is very high, though, at 37%, up from 31% two years ago. In Asia, where the company does most of its manufacturing and employs the majority of its staff, it is 48%.

The price (discounted?) [1]

• Yes. A share price of 991p values the enterprise at about £411 million, 6 times normalised profit.

I used to love XP Power for its predictability, but now virtually the only thing going for it is the low share price and the memory of a good strategy that the company cannot currently afford.

To be a good long-term investment it must rebuild its financial strength while preserving its culture and reputation.

A score of 5.5 out of 10 indicates that I am on the fence. I hope XP Power can do it, but I do not know if it will.

It is ranked 34 out of 40 shares in my Decision Engine.

23 Shares for the future

Here is the ranked list of Decision Engine shares. I review the scores once a year, soon after each company has published its annual report. Scores change daily due to price changes.

Generally, I consider shares that score 7 or more out of 10 to be good value. Shares that score 5 or 6 out of 10 are probably fairly priced.

Bunzl (LSE:BNZL), Howden Joinery Group (LSE:HWDN), Judges Scientific (LSE:JDG) and Macfarlane Group (LSE:MACF) have all published annual reports and are due to be re-scored.

If a share is likely to be downgraded next time I score it, there is a “?” before its name in the table. This is usually because events have revealed something about the company that I had not previously considered adequately.

We will not know for sure until I have scored these companies again, but extra caution may be necessary.

Scores and stats: Richard Beddard. Data: SharePad and annual reports
Shares marked with a question mark are more speculative
Click on a share's name to see a breakdown of the score (scores may have changed due to movements in share price).

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.  

Richard owns XP Power and many shares in the Decision Engine. He weights his portfolio so it owns bigger holdings in the higher-scoring shares.

See our guide to the Decision Engine and the Share Sleuth Portfolio for more information.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard