It is tempting to call XP Power undervalued. The maker of power converters is historically a good business serving a growing market that is going through a rough patch, which is exactly what value investors want.
Temptation soon turns to doubt, however. The wider market isn’t wrong to worry about further setbacks and no longer views XP as a quality business. A series of blunders has tarnished its reputation and a quick return to past glories can no longer be taken for granted. In this case, the punishment may be just.
A few years ago, investors would have jumped at the chance to buy XP for 11 times forecast earnings. Now they are understandably cautious.
XP, which has its headquarters in Singapore, makes components that regulate the electrical voltage supplied to machines. It started as a distributor then changed path after noticing a gap in the market: manufacturers of industrial and medical machinery wanted converters that were more energy-efficient and reliable enough to prevent sudden power outages.
XP delivered and created a reputation as a leading designer of the essential products. Before long it was churning out sector-leading operating margins in the high teens, return on capital in excess of 20 per cent and double-digit compound annual revenue growth. Then the wheels started to fall off. Numerous challenges appeared, including an expensive lawsuit — when it was ordered to pay $40 million to its rival, Comet Technologies, from whom it had stolen trade secrets — component shortages and tepid demand, which shouldn’t have come as a shock given the uncertain state of the economy and overstocking by customers during the pandemic, yet management kept spending.
Investments in production facilities and acquisitions to strengthen its range of higher-value products were made when being frugal would have been a better option.
Eventually the balance sheet became too strained. Last month XP, alongside another profit warning, said it was close to breaching its lending agreements and had no choice but to aggressively cut costs, beg banks for greater leeway and resort to what many investors dread: a rights issue.
With that messy business out of the way, analysts believe the now-dividendless XP has reached an inflection point. The general view is that it has secured enough funds to survive and is well-placed to capitalise on its strong market position once demand returns.
That narrative is made more appetising by the price. Even after its rally, the shares remain in the kind of territory where the smallest bit of good news could send them soaring.
Potential short-term drivers include an uptick in trading, self-help gains, a successful appeal against the Comet verdict and further takeover speculation. Long-term structural drivers, such as a growing and ageing population, clean energy, automation, the shift towards digitalisation and the increasing reliance on machines, are also very much in play.
Sadly, the risks take some shine off that optimism. One of the biggest concerns is the competency of those in charge. Hopefully, learning from past mistakes and a new chief financial officer will prevent a repeat of lax capital management — but that’s not the only issue.
Getting found guilty of stealing trade secrets is worrying and makes you wonder whether there are other skeletons in the closet. Additionally, negative comments from employees about upper management don’t inspire much confidence.
There are also question marks about whether XP raised enough money from investors. Analysts think net debt will stand at two times earnings before interest, taxes, depreciation and amortisation at the end of next year. That’s still quite high, especially in this environment.
XP remains a cyclical business in a prolonged period of economic uncertainty and a large chunk of its revenues come from low-voltage commoditised power converters. All things considered, the market’s scepticism seems reasonable.
ADVICE Hold
WHY A cheaper valuation is warranted given the risks
Britvic
Britvic is no stranger to challenges. In the year to September 30, inflationary pressures and bad weather were the main contenders to taint its financials. Fortunately, as has come to be expected from the company behind household brands such as Robinsons squash, J2O and Tango, it still found a way to keep growing.
In the midst of a cost of living crisis, consumers could have turned to cheaper alternatives, but they kept buying Britvic brands, even though their average selling price rose 9.1 per cent. Higher prices comfortably offset a dip in volume caused by the wet and windy British summer, with revenues at constant currencies rising an impressive 6.6 per cent.
The performance underlined the loyalty of its consumers and Britvic’s ability to cater to shifting trends. People and regulations are more health-conscious and the soft drinks maker appears to be doing a great job of coming up with attractive solutions and marketing them well.
The FTSE 250 firm’s standout performers were sugar-free Tango drinks and Pepsi Max. It has also been capitalising on premiumisation, with London Essence and Mathieu Teisseire in hot demand.
Another resilient set of results failed to generate much excitement from investors. The muted share price reaction suggests the market is aware of Britvic’s strengths and believes it has been priced accordingly. To take it to the next level and command a higher rating, more is needed.
Profitability remains a sore point. Britvic’s margins are thinner than its peers and a difficult economic environment means they keep on tightening. Management is being disciplined with costs and increasing prices but not enough to completely counter the effects of inflation.
Eventually those pressures should ease but Britvic seems to keep facing obstacles that stop it from thriving.
The fact that the bulk of its sales come from brands it doesn’t own, such as Pepsi, also irks some investors.
ADVICE Hold
WHY Shares are fairly priced
