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Why XP Power Limited Might Outperform Lloyds Banking Group plc and BP plc

Big cyclical firms such as Lloyds Banking Group (LSE: LLOY) and BP (LSE: BP) both operate as commodity-style businesses.

Although they both have large market capitalisations, neither firm produces much added value to their product offerings. We could go to Lloyds Banking Group for a bank account or a loan, but we might as well go to any banking company. Similarly we could buy petrol or oil from any producer and it would be much the same as BP’s.

Cyclically challenged

These giants might feel like safe investments because of their size, but their longer-term share price charts — say, over 10 years — tell a story of disappointed investors.

Perhaps now, with the shares weak, Lloyds Banking Group and BP look attractive as cyclical bets on the next macro-economic up-leg. Maybe. But there are better cyclical options on the stock market down the rankings, with the smaller market capitalisations.

Rather than buying shares in cyclical monoliths with undifferentiated products, maybe it’s better to look for a firm that adds more value to its final product. That’s why I’m looking at power control components manufacturer XP Power (LSE: XPP).

Making stuff work

The firm makes power control solutions for electronic equipment. A lot of equipment doesn’t work from mains power with its high voltage and alternating current. So, XP Power is part of the industry that makes circuit boards featuring power converter components.

The circuitry changes the characteristics of the power from the mains into a form suitable for the electronic equipment being supplied — perhaps by changing the voltage, or changing the current from alternating to direct, or any combination that is required for the equipment.

XP Power’s products are an important cog in the electrical equipment industry. The firm gets involved in making power solutions for equipment areas such as factory automation projects, automated testing, industrial control, test and measurement, instrumentation,  hazardous environments, semiconductor production, audio visual broadcasting, mobile & wireless communications, computing & data processing, and a range of medical applications.

XP Power serves a range of industries internationally, but the firm operates in a competitive market. The directors reckon the global power converter market is highly fragmented and made up of hundreds of thousands of customers. XP Power competes with around fifty manufacturers of power solutions capable of operating on a worldwide basis.

Doing something right

Despite the competition, today’s interim results show that XP Power has carved out a profitable niche for itself in the industry. The order book rose almost 11% on the year-ago figure, revenue increased more than 7% and the operating margin came in around flat at just under 24%.

The chairman reckons orders, revenues and profit before tax for the first six months of 2015 all set new records, while the firm grew its engineering and sales resources to help drive future growth.  He thinks the company’s strong order book should drive further revenue growth for the rest of 2015, because designs won last year will enter their production phase.

A typical customer for XP Power is an original equipment manufacturer (OEM) characterised as having expertise in their particular area, whether it be medical devices, communications or industrial automation, but unlikely to have in-house power supply expertise. XP Power, therefore, provides the necessary expertise and assists its customers to design suitable power supplies from an extensive range of products that meet the customer’s cost and technical requirements.

Such personal and bespoke service strikes me as the key to XP Power’s niche position in the market. My guess is that OEMs might be reluctant to turn their backs on a business relationship nurtured over years to save a few pounds here and there. Sometimes, the outcome of such flighty buying behaviour can be disastrous if a replacement provider fails to satisfy — a small potential saving can end up becoming a large additional cost. With XP Power’s product so critical to a project, customer loyalty could manifest as increased profitability and cash-flow reliability for XP Power.

Added value

At a share price of 1,602p, the firm’s forward dividend yield runs at 4.4% for 2016 and the price-to-earnings ratio at just over 14. City analysts following the firm expect an 8% uplift in earnings per share that year.

There’s no doubt that XP Power’s business is cyclical, too. However, the value the firm adds to its product offering could drive the company to outperform total returns from undifferentiated cyclicals such as Lloyds Banking Group and BP.

XP Power seems well worth further research as a potentially viable alternative to investing in the cyclical mega-companies. If you like XP Power, you'll be interested in another small-cap company that excites our analysts. In a special wealth report, the investment team highlights a little-noticed small-cap share with great potential. You can find out more, free of charge, by clicking here.

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended XP Power. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.