XP Power Ltd: Stick, twist, or fold (LSE:XPP)

A fellow investor is in a dilemma about one of her holdings: “Not sure what to do with the shares…” she writes. XP Power Ltd faces unanticipated challenges and the share price has more than halved. What should she do?

ac dc power supplies range

An email from a reader has prompted me to think hard about XP Power. She writes:

“Not sure what to do with the shares I hold.

Be very interested to hear what you think is the best strategy or your advice going forward.”

Advice is tricky because it has a legal definition in a financial context and only regulated financial advisers can give it. It implies knowledge of the other parties’ circumstances and goals.

I cannot give advice in that sense, but I like to be helpful and supportive of other investors thinking things through, and since I own XP Power shares myself and hold them in the model portfolio I run for Interactive Investor, I have a perspective.

I do not know why my reader owns shares in XP Power, or what bothers her most about its plight, but I can describe the situation as I see it and how I intend to “play” it myself…

The good

First of all, the good.

This is a company that I have greatly admired. So much so, I used it in case studies on what to look for when working out how a company makes money, and what could go wrong.

It makes power converters, the component in a machine that converts the AC power used in electricity transmission to DC power used in a machine, or steps up or steps down the power.

Converters are a small part of the overall cost of a machine, but machines cannot work without them. In industry and healthcare, a failure can mean the interruption of a production line or an operation, so reliability is important.

Because of its origins as a distributor, XP Power has great insight into the changing requirements of its customers, manufacturers of industrial, semiconductor and healthcare equipment.

Over a decade ago, it grasped the opportunity to design and manufacture more intelligent, more efficient and greener power converters as the machines became more sophisticated and the demands they made on converters increased.

It invented families of converters that could be easily customised and designed into a customer’s machine, solving a problem for them and making collaboration and the sale more efficient.

Coincident with the strategic shift, XP Power’s financial results improved dramatically and more than a decade of profitable growth followed.

XP Power’s meat and drink is low voltage power supplies, the converters that power the machines, but thanks to a string of acquisitions starting with EMCO in 2015, XP Power has amassed a portfolio of high voltage and Radio Frequency (RF) power products.

These power processes in the machines. For example, RF generators create plasma for the etching and deposition processes during the manufacture of semiconductors.

Since the newer products are often components in machines powered by XP Power’s low power adapters, the strategy is attractive because it can sell high voltage and RF products to the same good customers.

While I admire the development of the company and the coherence of the strategy, I also admire the clarity with which the company has communicated it to shareholders.

The bad

But in March there was unexpected news, unexpected at least by me, and apparently by XP Power.

In addition to a number of trading problems (component shortages, the closure of XP Power’s Chinese factory during a Covid lockdown, and the additional costs of air freight as the company struggled to fulfil a burgeoning order book), XP Power announced that it had lost a court case it expected to win.

The case was brought in California by a Swiss rival, Comet. A jury found the company guilty of misappropriating trade secrets, and awarded $40 million in damages.

Before the Jury’s verdict, the company said it believed the case had no merit. Now it has lost, the company says it disagrees with the verdict but is waiting for the Judge to file a ruling before deciding what to do next.

As I understand it, the judge cannot increase the damages but he may be able to reduce them, and XP Power can appeal the ruling, which would involve racking up more legal costs.

The company’s legal and trading woes led to a dramatic loss of confidence among traders. The share price has more than halved since the beginning of the year:

Buys and sells relate to the model Share Sleuth portfolio I run for Interactive Investor. The sale in 2020 was partial. The portfolio still holds XP Power.

This situation is a bit of a nightmare. We are outsiders. We probably do not have extensive knowledge of intellectual property (IP) law so we are reliant on what the company tells us. But the company is in the middle of a legal process so however communicative it normally is, it must be circumspect.

Anyway, it does not know what the Judge is going to rule, and that determines what XP Power does next.

The not so ugly scenario

It might help to list out what we know, and what we might tentatively conclude.

The court case relates to Radio Frequency (RF) technology, which has only been part of the business since the acquisition of Comdel in 2017, coincidentally the year the IP theft took place.

XP Power tells me it has not withdrawn any products from sale and has no plans to do so. Although it does not believe it has used Comet IP in its new designs, it may be prevented from selling any that uses IP judged to have been misappropriated and has written off capitalised investment costs related to these products.

It is tempting to believe that if the verdict stands, it was a one-off, something that happened in a new acquisition that XP Power had not fully integrated. A bad thing, but not something that necessarily tarnishes the rest of the business, or indeed the existing RF product range.

The damages amount to about a year’s adjusted operating profit, although the total bill is higher due to legal costs. They come at a bad time because XP Power has recently financed two acquisitions and started building a new factory in Malaysia.

As a result, debt has risen to unaccustomed levels, although the company forecasts that it will remain well within its bank covenants for the rest of the year.

If XP Power can put the court case behind it, growing profits should reduce the debt as component supply eases and the company fulfils its order book more quickly.

The other big calls on XP Power’s cash in 2022 are positive. The acquisitions are a continuation of its policy to acquire manufacturers of high voltage and RF power converters so it can sell more products to its blue chip customer base.

In addition to its two factories in Vietnam, the Malaysia factory further diversifies XP Power’s low-cost manufacturing capability so it is less dependent on China, which has an increasingly fractious trading and geopolitical relationship with the West.

They will also provide XP Power with more manufacturing capacity to support the growth of what has hitherto been a very successful business.

If I were a betting man, I would gamble that the sell-off is overdone, back up the truck and load it with XP Power shares.

But I am not a betting man.

This is why we diversify

I recognise that even if the scenario I have described seems the most likely one, there is an awful lot we do not know. Where I have made assumptions, and leaps of faith, they are informed by XP Power’s previous good behaviour and management’s bullishness in recent interviews and statements.

Maybe there are more legal skeletons in XP Power’s closet. There seems to be a fair amount of pent-up demand, but maybe its big customers in Europe and the USA will experience a recession, orders will dry up and XP Power will fly closer to its debt covenants than it expects. Maybe XP Power will fight on, incur more costs, and lose the Comet case any way.

In most respects, I am as clueless as my correspondent, but unlike her, I do not feel that I need to do anything.

This is where the final part of her question comes in, strategy. The problem with strategy is it needs to be in place before the crisis.

If I had not been jolted into action by my correspondent’s email, I would not have taken the trouble to lay the facts out yet. It has taken quite a while, as they have come out in dribs and drabs, and I have swapped emails with XP Power to clarify what I can.

This is something I only normally do once a year, after a company has published its annual report. XP Power should publish its next annual report in March 2023 and by then we might know more.

I can wait because XP Power is not a big part of my portfolio or the model portfolio that I run for Interactive Investor.

Currently the value of that portfolio’s XP Power holding is 3% of its total value, although its importance has been diminished by the collapse in the share price. It was a bigger holding in February.

But I have rules that govern the size of my holdings. They are based on my confidence in the investment, which is derived from the quality of the enterprise and its price in comparison to normalised profit.

In practice the limit is about 8 or 9% for the very best companies at the cheapest prices, but it is rare that holdings get that big and the typical holding size must be about 3.5% as the portfolio has 28 holdings.

On podcasts and twitter I often hear people talking about holding much bigger proportions of their portfolios in the shares in which they have the most confidence.

Backing your own judgement to the hilt sounds good. But as you can tell, and hopefully temporarily, I have less conviction in XP Power than I used to. In fact, when I reduced the portfolio’s holding in the company in 2020 it was one of my favourite businesses, but it had breached the holding size I had determined for it.

If I had been a gambling man, I would have loaded the truck up then too and the damage to my portfolios would be much worse now.

Richard Beddard

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