Markets are gradually re-engaging with growth stocks as inflation and supply chain pressures ease and economic data shows signs of promise. We believe XP Power (XPP) stands to benefit, and analysts agree – Berenberg sees earnings doubling within five years thanks to end-market structural growth and market share gains.

XP Power is an electronics engineering gem, a science-based designer of complex power switching and controls solutions. Its kit is used when off-the-shelf solutions simply won’t do, such as AC-DC (alternating current – direct current) power supplies, DC-DC converters, high voltage power and radio frequency power capability. Target markets include defence, aerospace, healthcare, rail, and a few other custom power niches.

Semiconductor manufacturing has become a meaningful part of the business mix, worth an estimated 30% of revenue.

The company’s gross margins are typically over 40%, impressive for a hardware manufacturer. Returns on investment and equity consistently run in the mid-teens (around 14% and 17% respectively over five years) and it throws off plenty of cash.

Interestingly for retail investors, large chunks of free cash flow are handed out annually as dividends (even during the pandemic), with an implied 2023 yield of more than 4%. The 2023 price to earnings multiple is 13.8 which looks good value.

The stock has returned an average 10.8% a year across the last decade, according to Morningstar data. If you’d invested £5,000 in the shares in 2012, your stake today would be worth approximately £13,918.

So, what’s the catch? First, its balance sheet is uncharacteristically stretched at present. Debt to equity ballooned to 146% in 2022 due to acquisitions and, principally, $44 million set aside for a lawsuit. This relates to a claim over radio frequency technology, a case XP Power has lost, with the company ordered to pay $40 million in damages. XP Power has not given up but it’s probably sensible to mentally write-off that money.

The important point is that this information is already in the public domain and reflected in analyst calculations, as are higher borrowing costs, and it should not trouble borrowing covenants. In the past, debt to equity has run nearer the 10% to 20% mark, so expect those excess borrowings to be paid down quickly.

Previous order flow weakness is easing (fourth-quarter 2022 revenue rose 30%) and the company has a backlog of work worth around £300 million, according to Numis. Expectations have now been reset, providing a platform for XP Power to return to its historical operational excellence, and that should drive the share price
in the months ahead.

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