While it’s comforting to know a business has enjoyed success, long-term investors must also form an opinion on its prospects if we’re to hold the shares through thick and thin.
In How to read an annual report, I identified the sections of a typical annual report that explain how a company has made money, how it plans to make more money, and what might stop it. In this way we can use the annual report and SharePad to help us build a bridge from the past to the future to determine whether a company should prosper.
There is no better place to start than the strategic report.
Strategy 101
While business schools have turned business models and strategy into a vast and complex subject, as investors we don’t need to get too worked up about definitions – at least not at first. A business model is how a company makes money. A strategy is how it plans to make more. To be credible, strategies must make sense, and they must be reflected in the results of the company.
My favourite quote on strategy doesn’t even mention the word. It was written by fund manager Peter Lynch in “One Up on Wall Street”. He prefers the word ‘story’, but I think you will agree we’re talking about the same thing:
“Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path… Once you’re able to tell the story of a stock to your family, your friends, or the dog… so that even a child could understand it, then you have a proper grasp of the situation.”
Determining how XP Power makes money
Not all companies discuss their business models and strategies explicitly in their annual reports, but companies listed on the main market are supposed to and many AIM listed companies do too.
XP Power explains its business model on page 14 of its 2016 annual report (according to SharePad, it will publish its 2017 annual report later this month). It starts with:
Our Customers are at the Heart of What We Do
Our model is to sell directly to our key customers where we can add value, offering excellent service and support combined with class leading products.
We have carved out a leading position in our industry. An up-to-date, high efficiency product offering, delivered to our customers by the largest and most technically competent sales engineering team in the industry, backed up by highly skilled power systems engineers, combined with the safety and reliability benefits of world class manufacturing provide a compelling value proposition to our customers.
You may be wondering if I’ve highlighted every buzzword known to managers for a game of buzzword bingo but actually, no. I’ve highlighted the choices the company has made that reveal the strategy that has got XP to where it is today.
XP Power makes power converters. The simple AC-DC adapter powering your computer is an example of a converter although, as we shall see, XP has chosen not to make them. It doesn’t have to sell direct either. It could use distributors but that would be odd as it used to be a distributor itself and its big strength was, therefore, sales.
It saw an opportunity to put the customer at the heart of what it does because its sales teams were in regular communication with manufacturers of industrial and medical machinery, the customers. XP knew they wanted more efficient adapters to save money and the environment, and more reliability, because if machines stop, the factory or operating theatre stops too.
These key customers, many of the world’s leading medical equipment and semiconductor manufacturers, put quality before price, which is why XP is interested in earning more of their business rather than entering new markets, like consumer goods, which have less demanding requirements.
XP used insights from customers to design a wide and still growing range of class leading products and began manufacturing them in its own world class factories, the first of which it built in China about a decade ago. It doesn’t have to manufacture; many companies these days choose to outsource manufacturing but it wants to be sure the quality of the converters meets customers’ high expectations.
I could go on for a long time, but I hope you see a picture emerging. Once XP decided it could meet its customer’s requirements better, it followed a logical series of actions to make it happen. This should be visible in the company’s results.
We can test this in SharePad. This chart shows the step-change in profitability about a decade ago. XP is adding more value, than it was as a distributor, and that has enabled it to charge more for converters relative to the cost of supplying them (i.e. increase profit margins):
That’s the past. In preliminary results, published in February, XP declared the job done. It’s made the transition from distributor to designer and manufacturer. So what’s next?
How XP will make more money
The company explains its strategy on page 12 of the annual report. You can skip the first six objectives listed below, if you like. Suffice it to say, it’s reassuring to see the company plans to keep doing what’s made it such a good business.
- Develop a broad range of competitive products;
- Target accounts where we can add value;
- Increase vertical penetration of target accounts;
- Enhance brand awareness;
- Accelerate operational excellence
- Lead our industry on environmental matters
- Make selective acquisitions in identified strategic markets or of complementary businesses to expand our product offering.
I’ve highlighted point seven because it’s a more recent addition to the strategy, and we need to come to a view on whether it too will contribute to XP’s prosperity.
One of the things I didn’t appreciate about machinery before I developed an interest in XP Power is that one machine will often contain many converters. Different systems require different voltages. XP’s strength is in AC-DC power conversion but it also wants to become a major supplier of DC-DC converters that step up, or step down, the voltage in a machine. It can grow, therefore, without entering new markets and remain focused on serving the same customers with its leading salesforce. To do that it needs DC-DC and high voltage products and engineers, and it’s decided to acquire them. In fact it has acquired two companies in the year to December 2017.
The newer element in the strategy complements the older ones, and it seems reasonable to conclude that it is more likely to contribute to XP’s prosperity than detract from it.
Having decrypted XP’s business model and strategy, we’re halfway to determining the story. So far so good, I think, but we must also consider what might go wrong and whether the strategy addresses the risks.
In my next article I’ll look for clues buried much later in the strategic report where companies describe the risks they face. We’ll look at XP, and a couple of companies I’m less sure about.
