Does faltering revenue and a warning on bank covenants from XP Power Ltd (LSE:XPP) constitute a key example of “higher for longer” interest rates now beginning to cause damage to company balance sheets – hence we should steel for more of the same?
This company describes itself as “one of the world’s leading developers and manufacturers of critical power control components to the electronics industry.” Anything related to electrical components tends to be renowned for cyclicality, for example RS Group (LSE:RS1), which used to be known as Electrocomponents.
This latter stock had a strong run on the back of monetary/fiscal stimulus during Covid, but has since fallen back to its level around two years ago. XP, however, is back to where it last traded a decade ago, and at 1,099p has lost 80% of its value since November 2021 when it traded above 5,700p before interest rate fears reared their head.
Relevance for the global economy
XP is a relatively small company with around £300 million revenue; albeit Singapore-based with three geographic areas of sales: North America, Europe and Asia. This makes it a useful international indicator rather than being isolated to UK-specific dilemmas.
XP’s products enable electronics and processes in power systems, for example in healthcare, industrial technology and semiconductor manufacturing. You would think there’d be all sorts of benefits from modernising essential facilities and services; yet anything semiconductor-related can be cyclical.
In my 26 September macro piece, I suggested key issues for investors currently are higher interest rates starting to bear down on economic demand, plus the risks of challenges in China spreading. Forgive me then for a bit of confirmation bias, China being a key excuse in XP’s trading update.
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I also argued it is all very well for fund managers to say UK equities are outstandingly cheap in an international context, but there is no way a stock can shrug off a warning on trading and, implicitly, profit.
Another interesting angle here is how XP failed to attract any real intra-day recovery bounce. After plunging 48% in response to its warning, the stock found a level but eased to close 52% down at 1,150p. It suggests risk-lovers are taking cover in increasingly tough markets, given you normally see at least one bounce, even if it proves to be of the “dead cat” variety.
Order book compromised in only two months
Third-quarter 2023 revenue has only slipped 2% and against a tough comparator; with double-digit operating margins, though that could have softened.
Yet the current order book is cited at around £225 million, which (looking back to the interim results) is a 10% drop on £250 million at end-June. Trading has been “below expectations as weaker end-market demand resulted in some customers deferring shipments into 2024. Economic uncertainty in China has also led to a reduction in demand in that market.
“While we have yet to see a recovery in orders from semiconductor manufacturing, our customers’ outlook for 2024 and 2025 is encouraging, although the timing of overall economic recovery remains uncertain.”
Maybe I’m being overly pessimistic, or they are drinking Kool-Aid, but it remains unclear quite where a base-case scenario for economic recovery derives? In that respect, or unless doing their best to keep the narrative sweet, I wonder at their perception.
Management is being criticised online as not alert, given a 1 August update had declared: “significantly improved performance, full-year outlook unchanged, longer-term outlook very strong.” But I think it exemplifies how managers can indeed get caught out when demand softens, and why updates even from last summer cannot be relied upon.
Enough to drop the ‘dialogue with lenders’ bombshell
Meanwhile, net debt has risen 10% to £163 million over the third quarter (including £6 million foreign exchange impact) and is now expected to rise further by the year-end, due to higher-than-expected costs of a Californian site relocation in late December.
Of itself that is hardly perturbing but comes in context of lower revenue/profit expected, also working capital needs not reducing as much as hoped.
A cash squeeze is manifestly underway. XP says, “to conserve cash, we have temporarily suspended the build for the new Malaysian plant, which will restart when the market outlook becomes clearer.”
Again, of wider relevance, as investment like this gets trimmed, it is going to have some medium-term effect on economic activity. This raises the prospect of a softer 2024 – mainly due to higher interest rates – and possibly into 2025 as well. Not to flag a “slump”, but a rather a subduing effect, and certainly different to hopes for recovery.
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XP’s net debt/EBITDA covenants are thus set to be tested, and there is already “dialogue with lenders to be flexible” – words that always do slam equity values. Consequently, no further dividends will be paid in respect of 2023 after a second-quarter one on 12 October.
The 30 June balance sheet had shown £175 million long-term debt and £55 million leases, generating a finance charge over £6 million on £17 million interim operating profit. Net debt inclusive of leases was £229 million and concerning was how XP only had just over £1 million cash (albeit similarly in June 2022). This is in context of £132 million net assets, of which 57% constituted intangibles (to be expected in technology).
XP is possibly distinguished from a majority of companies, having a balance sheet exposed to material change in the revenue/profit/cash mix. Some companies used the “stimulus years” during Covid to help pay down debt, although plenty of others accumulated it in the cause of “balance sheet efficiency” in the era of ultra-low interest rates.
XP Power - financial summary
Year-end 31 Dec
|Turnover (£ million)||167||195||200||233||240||290|
|Operating margin (%)||19.5||20.1||13.4||16.0||12.4||-8.3|
|Operating profit (£m)||32.5||39.3||26.7||37.4||29.7||-24.1|
|Net profit (£m)||28.3||30.2||20.5||31.5||22.6||-20.0|
|EPS - reported (p)||139||155||105||160||114||-102|
|EPS - normalised (p)||169||158||131||192||191||282|
|Operating cashflow/share (p)||153||137||237||232||183||-10.2|
|Capital expenditure/share (p)||52.1||76.9||83.5||36.6||68.5||58.1|
|Free cashflow/share (p)||101||60.1||154||195||115||-68.3|
|Dividends per share (p)||78.0||85.0||55.0||0.0||94.0||94.0|
|Covered by earnings (x)||1.8||1.8||1.9||0.0||1.2||-1.1|
|Return on total capital (%)||22.2||18.9||13.2||18.0||13.3||-6.4|
|Net debt (£m)||9.0||51.7||47.4||22.5||32.4||203|
|Net assets (£m)||116||136||138||164||172||139|
|Net assets per share (p)||603||709||718||834||873||702|
Source: company accounts
Moderate profit warning clips growth prospects
Again, I find this of general relevance given there is a hit to forecasts which brings down the price/earnings (PE) ratio. Yet forward multiples could range between high single-digits if the market is fearful, to 20 times if confident.
Consensus had looked for a net profit recovery over £30 million on record revenue of £309 million, accelerating to £34 million profit and earnings per share (EPS) of 170p in 2024. Hence, at 2,365p before the warning, the PE was a moderate 14 times, with the expectation of a circa 90p dividend offering a near 4% yield.
Management says: “These conditions are likely to continue for the remainder of the year, leaving the outlook below our prior expectation, with 2023 operating profit now expected to be broadly similar to last year.”
It is possible that if the debt covenant risks are managed through, with lenders’ co-operation, then even a worse-case scenario of downgrading 2024 to around £20 million profit would imply EPS around 100p – hence a PE around 11 times. In this case, the stock currently is a “buy”.
Yet the market is in fear-mode, XP’s price easing another 3% to under 1,100p in early trading today. It squares with the adage how fools-gold exists in cyclical stocks under the cosh, if an economic downturn is still early.
This profit and debt-covenant warning has barely gained any attention given XP is a small-cap stock. But I think its issues offer a mental rehearsal of what we are liable to face in months ahead as economic demand softens. It will also be revealed how robust company finances are to cope.
Furthermore, there’s a dilemma on stock ratings – where “buy” or “sell” may swiftly be discredited and “hold” is merely compromise. I conclude my assessment of XP on the latter, and some analysts might even withdraw forecasts in such a situation.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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