XP Power — Increasing complexity drives growth

XP Power designs, manufactures and distributes power converter solutions to original equipment manufacturers (OEMs) in the healthcare, technology and industrial markets. The group has its headquarters in Singapore and, to remain close to its global customer base, has a sales, design and engineering presence in the US, Europe and Asia. Unlike many in the industry, XP is vertically integrated; its manufacturing facilities in Asia and the US allow the company to maintain quality control, improve flexibility, reduce product costs and minimise lead times.

XP benefited from a combination of positive trends in FY17: good underlying demand in all of its market segments, market share growth in its healthcare business, positive currency effects and the acquisition of Comdel in Q417. The company has seen a strong order intake during FY17 and enters FY18 in a good position to drive further growth. Efficient manufacturing and good cost control mean that XP continues to report operating margins above 20% and lower ongoing tax rates boost our EPS forecasts in FY18 and FY19. Good cash generation should enable XP to pay down debt, maintain its dividend and consider further acquisitions to broaden its product range.

On a P/E basis, the company is trading at a premium to global power converter companies and at a small discount to UK electronics companies, with a dividend yield at the top end of the range. XP generates EBITDA and EBIT margins at the top end of its peer group. Revenue growth is similar to peers, although as a sterling-reporting company, FY18 underlying revenue growth is masked by the translation from US dollars. We see scope for upgrades to earnings estimates from cross-selling and further market share gains in healthcare. We expect the company to return to a net cash position by the end of FY19 – combined with up to $60m in available debt, the company is in a strong position to make further acquisitions while maintaining its consistently high level of profitability.

XP Power has cyclical exposure to global industrial, technology and healthcare markets and is therefore sensitive to end-demand and product development expenditure in these markets. Visibility of customer volumes is limited and, as such, individual customer orders can be volatile. With the majority of XP’s revenues, manufacturing costs and opex US dollar-denominated, currency will continue to add volatility to XP Power’s reported revenues, although it will have less impact at the net income level. XP competes with large global industrial companies as well as low-cost Asian manufacturers, XP also has more limited exposure to the euro/sterling exchange rate; to minimise this, the company enters into forward contracts. Recent acquisitions add integration risk.

XP Power designs, manufactures and distributes power converter solutions to OEMs in the industrial, healthcare and technology markets. Power converters take the high-voltage alternating current output from the mains supply and convert it into various lower-voltage, stable direct current outputs that are required to drive most electronic equipment. The company has transitioned from being a distributor to designing and manufacturing the majority of its products. In 2015, the company made two acquisitions, EMCO and a South Korean distributor, for a total of £9.1m and in 2017, acquired Comdel for £18.8m. The group has its headquarters in Singapore and has volume manufacturing facilities in China and Vietnam and specialist high-voltage and radio frequency (RF) power product manufacturing in the US.

XP Power was formed as a specialist distributor of power converters in 1988 (based in Pangbourne, UK). Subsequently, the business merged with Foresight (California, US) and IPS (New England, US) on flotation in 2000 to form a distributor with more than $100m of sales. In 2002, the board decided to begin developing its own IP and designs, and bought Switching Systems International (California, US), which designed its own configurable power converters with an outsourced manufacturing model. Since then the group has continued to develop its own products and brand, built out manufacturing capacity in China and Vietnam and completed the transition from distributor to designer and manufacturer. Recent acquisitions have expanded XP’s product range from low power AC/DC and DC/DC converters to include high voltage, low power converters (EMCO) and RF power products (Comdel). The company sells through 27 sales offices and multiple distributors across Europe, Asia and North America. XP has engineering service functions in Northern California, Germany and the UK. FY17 revenues were generated in North America (53%), Europe (38%) and Asia (9%).

XP is focused on developing tailored products for applications with high reliability requirements in the technology, industrial and healthcare equipment markets. It avoids developing commodity products for high volume consumer electronics applications. Products in each end-market can have very different life cycles. For example, a medical device could have a product life cycle of 10 years or more. Once a power converter is designed into this product, it is likely to remain in it for the full life of the product. On average, the product life cycle is five to seven years. XP’s balanced mix of end-customers means it has a fairly high level of revenues that are recurring in nature and exposure to multiple end-markets mitigates the risk of individual industry cyclicality.

XP Power’s business splits along three business lines:

The company had set a target of generating 75% of sales from own-designed product. It hit this target in FY17, growing from 73% of sales in FY16 to 76% in FY17. Management believes this could still trend higher.

The company manufactures power converters and magnetic components in two locations, China and Vietnam, with smaller US facilities acquired through the EMCO and Comdel deals.

XP built a manufacturing facility in Kunshan, China (near Shanghai) and started production there in 2006. By the end of 2017, the Chinese facility was operating at c 90% capacity. In addition to making power converters at this facility, XP introduced small-scale production of magnetic components (these are components that go into the end-product and were previously bought in from third parties). This gives XP more control over the manufacturing process (important for some customers) and assists the design teams by shortening design cycles. At this facility, magnetic components are mainly produced for prototyping and short lead-time contracts.

To reduce XP’s exposure to rising Chinese labour costs and gain more control over the manufacturing process, XP expanded manufacturing into Vietnam, at a site near Ho Chi Minh City. The first phase (approximately the same size as the Chinese facility) was completed in 2011. The facility first started to produce magnetic components – these have a high labour component, hence the decision to manufacture them in a lower labour cost country. XP now manufactures virtually all of its magnetics requirements in house. In FY17, XP manufactured 6.7m magnetic components (+37% y-o-y).

In 2014, the facility also started manufacturing power converters, starting with some of the less complex converters and, once qualified, shifting production entirely from China to Vietnam. The facility continues to qualify additional converter products and runs production in parallel with the Chinese facility until it achieves acceptable yields on those products. This process frees up capacity in China for more complex product. In FY17, this facility manufactured one million power converters (up from 0.4m in FY16), around 60% of XP’s total converter output in the year. To cope with the expected growth in demand, the company has started work on the second facility (Vietnam II) on the same site. Vietnam II is likely to be similar in size to the existing facility. The company broke ground in Q417, with production expected from the end of FY18.

Through the two US acquisitions, XP has facilities in the US for the more complex high voltage and RF products. EMCO has two facilities, Nevada and California, where it manufactures its high-voltage DC/DC converters. It also uses outsourcing partners for some manufacturing. Comdel has a 60,000 square feet manufacturing facility in Gloucester, Massachusetts. The component manufacturing for Comdel’s products is outsourced within the US and final assembly and test is performed in the Comdel facility. We would expect XP to consider shifting some component production for new designs to Asia to reduce the manufacturing cost and to enable the supply of higher volume programmes. As EMCO and Comdel products are typically more complex than XP’s low power products (and therefore higher value), it makes sense to retain the specialist expertise of the US-based manufacturing facilities.

XP’s strategy to drive revenue and profitability growth and to gain market share has been in place for a number of years. The current strategy aims to:

We discuss the progress XP is making below.

Historically, XP designed and manufactured low power AC/DC converters, supplying voltages up to 120V, with the majority of products sold supplying 24V. As competition from low cost Asian suppliers has increased, XP has started moving along the complexity scale. While it is investing in engineering resource to develop higher voltage products, it expects to make the majority of major product additions via acquisition, as this is a much faster route.

In 2015, XP bought EMCO to add high voltage, low power converters to its range. EMCO’s DC/DC converters can supply voltages up to 40kV, with the majority of products in the 5-12kV range.

In 2017, XP acquired Comdel1 to add RF power solutions. Comdel designs RF power supplies, DC power supplies, impedance matching networks, multi-channel synthesisers and electrostatic chuck power supplies. It supplies standard, modified and custom products – due to the complexity of the products we understand that there is a higher proportion of custom work compared to XP’s product range. Its RF power supplies are sold to the semiconductor production equipment (SPE), thin film, photovoltaics and induction heating industries.

XP aims to have the most comprehensive and up-to-date product range in its target markets. The company introduced 27 new products in 2017 (versus 47 in 2016 which was boosted by the introduction of a new third-party supplier of DC/DC product). In 2017, XP spent £11.5m on R&D (pre-capitalisation and amortisation), up 44% from the £8.0m spent in 2016. The increase was partly due to the addition of Comdel in Q417.

XP splits its R&D activities between developing new standard products and developing modifications to existing products to meet specific customer requirements. With competition tending to come from Asian manufacturers of low-complexity converters, the company is focused on serving customers with more complex requirements and undertakes custom design work for large customers. It is building up its engineering services teams globally to provide this face-to-face support during the design process.

XP Power has more than 5,000 direct active customers, of which no customer makes up greater than 11% of revenues and no single project makes up more than 4% of revenues. In 2017, the top 30 customers made up 48% of revenues. XP Power supplies power converters to three key markets: industrial, healthcare and technology (see Exhibit 2).

XP’s in-house manufacturing helps the company to sign up blue-chip customers, particularly in the medical equipment and semiconductor equipment markets. Stable and secure power supply is so crucial to the operation of these customers’ products that they demand complete control over their supply chain and product manufacture to ensure quality. XP has achieved approved or preferred supplier status at a large number of customers, including all of the main healthcare equipment companies, and is now working to expand its share of business at each customer.

EMCO’s customer base has limited crossover with XP’s existing customer base. As XP’s AC/DC converters often provide the DC input for high-voltage DC/DC converters, there is good cross-selling potential. Currently, the vast majority of Comdel’s revenues are generated from sales to SPE manufacturers (95%), with a limited amount of business from industrial customers. XP already supplies the SPE market, and this acquisition will increase its exposure to that market. XP and Comdel have some customers in common, but they do not overlap in terms of products sold.

XP has generated gross margins approaching 50% and operating margins above 20% since 2010, showing how efficiently the business has been run since shifting to the design and manufacture business model. The company continually looks at ways to maintain and improve on this performance. This includes the focus on lean manufacturing as well as improvements to internal processes to enable the company to share information internally more effectively and to provide better customer service. In 2018, XP will invest in upgrading its SAP ERP software, starting with the China and Vietnam manufacturing facilities.

XP is a full member of the Responsible Business Alliance (RBA). XP incorporated green technologies into the Vietnamese facility and received the Gold Plus rating by the Singapore Building and Construction Authority (BCA) for non-residential buildings in tropical climates. This is the first BCA Green Mark industrial facility in Vietnam and is the industry’s most environmentally friendly building.

Having manufacturing facilities and products that meet high environmental standards helps XP to win approved supplier status with large OEMs, but its main ongoing contribution to sustainability is to design ever-more efficient power converters. For example, a 95% efficient product such as the CCM250 only wastes 5% of the input energy, thereby requiring a lower power input to achieve the same output as a device operating at a lower efficiency. The wasted power is often converted to heat, which in turn requires additional power or physical heat sinks to provide cooling, adding to the upfront and running costs of the product. In FY17, sales of ‘green’ (ie high-efficiency) products grew 31% to make up 24% of revenues, compared to 23% in FY16 and, of the 27 new products introduced in the year, 19 were high efficiency designs.

Exhibit 3 shows the split of revenues by geography and end-market over the last two years. While all three end-markets generated growth in FY17, the growth in the Technology segment over the course of 2017 has resulted in a more even spread of revenues across end markets.

Key drivers of market growth include:

The strength of the industrial market depends on the health of the global economy. In 2017, manufacturing PMI data remained above 50 (the level that implies expansion rather than contraction) in the US, UK, Germany and the Eurozone, and in fact all four regions are at levels not seen for several years. This should imply a positive outlook for XP’s industrial business in FY18.

According to Gartner, the global IT market grew 3.8% in 2017, after a small 0.6% decline in 2016. It is forecasting growth of 4.5% in 2018. The semiconductor market is forecast to grow 7% in 2018, after 20.6% growth in 2017 (source: WSTS). According to SEMI, the semiconductor equipment market surpassed its original forecast for 9.3% growth, instead growing 35.6% in 2017. This was after a year of 8.7% growth in 2016. SEMI is forecasting growth of 7.5% for 2018.

The healthcare technology market is expected to show steady growth in the low single-digit percentage range. Philips estimates that the healthcare technology market was worth c €145bn in 2015 and is likely to show a CAGR of 6-7% to 2019. Within that market, diagnostics and treatment technology (just over a third of the total market) is likely to grow at a CAGR of 4% over the same period. The shorter-term performance from the major healthcare equipment manufacturers mirrors this. In 2017, GE Healthcare saw a 6% increase in equipment orders and a 5% increase in revenues. Philips’s healthcare diagnosis and treatment business saw constant currency revenue growth of 3% in 2017. Siemens’s healthcare business saw constant currency revenue growth of 3% and order growth of 4% in FY17, with order growth of 2% in Q118 (calendar Q417), providing support for steady progress in 2018.

Excluding RF power, XP Power operates in a market that was estimated to be worth c $2.9bn in 2017 (source: Micro-Tech Consultants). The market is fragmented, with no player having more than a 10% global share. Based on Micro-Tech Consultants’ market statistics, XP Power estimates its global market share stands at 7.1% (up from 6.1% in 2016), with 11.4% market share in Europe, 11.1% in North America and 1.2% in Asia. XP Power does not operate in the high-volume, low-value commodity power converter markets that supply products such as PCs, laptops and cell phone chargers, or in the market for inverters used for renewable energy. The company estimates that the RF power market is worth c $800m – annualising Comdel’s Q417 revenues implies a market share of c 3%. Exhibit 5 summarises the main competitors in each of the product areas that XP operates in. In the low power, low voltage market, XP competes most often with TDK-Lamda and Mean Well as well as with a number of local Asian suppliers.

XP Power is a global electronics company supplying a broad range of end markets. The company is not immune to economic slowdown, but diversification and the low-cost structure afford the company some earnings resilience versus competitors.

As previously highlighted in its January trading update, XP reported revenue growth of 28.5% for FY17. On a constant currency basis, revenues grew 22%, with 3% of this growth contributed by the acquisition of Comdel in Q417. As previously flagged, the gross margin fell year-on-year, mainly due to the effect of the strengthening of the US dollar versus sterling (average rate of 1.28 in FY17 vs 1.38 in FY16). With more than 90% of revenues generated in US dollars, and close to 80% of cost of sales also US dollar denominated, as these are translated to sterling, a stronger dollar results in higher sterling revenues and gross profits, but reduces the gross margin. We expect the opposite effect in FY18 as the dollar has since weakened against the pound. EBITDA and normalised operating profit came in slightly ahead of our forecasts. Operating expenses excluding depreciation and amortisation increased 24% y-o-y, reflecting increased costs from Comdel, as well as the hiring of engineers for R&D and customer support.

Exceptional charges were acquisition–related: £2.8m reported at half-year for an aborted acquisition and £0.5m incurred in the acquisition of Comdel. XP reported two exceptional tax credits in FY17: the first relates to a £1.3m overpayment of tax in Singapore. The second £1.3m credit is a reduction in the deferred tax liability arising from the reduction in US corporate tax rates from 35% to 21% from the start of FY18. These have been excluded from our normalised profit calculations.

The company announced a final quarterly dividend of 29p (vs 26p a year ago) payable on 20 April to shareholders as at 16 March. This resulted in a full year dividend of 78p, ahead of our 76p forecast. Net debt at year-end of £9.0m came in below our £12.6m forecast, mainly due to lower working capital consumption.

At the end of H117, XP had debt of £3.3m owing on a term loan, which was repaid in September 2017. When XP acquired Comdel, it entered into a $40m revolving credit facility with HSBC and Fifth Third Bank, with whom it also has access to a $20m accordion facility. XP is paying interest at LIBOR+1% on the drawn amount (£24m/$32.4m at end FY17) and LIBOR+0.4% on the undrawn amount. With cash of £15.0m, the company closed the year with a net debt position of £9.0m. This equated to a net debt/adjusted EBITDA ratio of 022x.

The company received orders worth £184.3m in FY17 (+38% y-o-y, +31% constant currency, +26% organic), of which £46.8m was received in Q417. This resulted in a book-to-bill of 1.11x for FY17 and 1.09x for Q417. Management expects growth in revenues and profits in FY18. We have made the following changes to our forecasts:

There is a limited number of listed power converter companies, as many businesses are part of larger industrial companies such as TDK or GE. We show below the financial performance of those listed peers as well as a group of UK-listed companies active in the electronics space.

XP clearly generates EBITDA and EBIT margins at the top end of the peer group. Revenue growth is similar, although as a sterling-reporting company, FY18 underlying revenue growth is masked by the translation from US dollars. On a P/E basis, the company is trading at a premium to global power converter companies and at a small discount to UK electronics companies, with a dividend yield at the top end of the range. We see scope for upgrades to earnings estimates from cross-selling and further market share gains in healthcare, and expect to see the company make further acquisitions to drive growth.