Xaar growth portfolio candidate

Xaar is one of the leading companies in the development of inkjet technology and manufacture of piezoelectric drop-on-demand industrial print heads. It manufactures its printheads in Huntingdon, UK and Järfälla, Sweden, where a range of industrial products are designed and manufactured to meet the customer requirements of a range of print applications in markets which include wide-format graphics, labels, packaging, ceramics and decorative laminates. I do not hold any shares (epic code: XAR)

Market/Index	Full/FTSE smallcap	Industry	Machinery Equipment
Sales	£86.3	Earnings	£12.6m
Market Cap	£381.6m	Share Price	508p
Norm. EPS	14.5p	Historic P/E	35.0
Est. 2013 growth	82.9%	Prospective P/E	19.2
Est. 2014 growth	10.4%	Prospective P/E	17.4
Rolling PEG	0.38	SGR	14.2%
PBV	5.15	Historic Yield	0.97%
ROE	18.6%	Operating Margin	18.0%
5 yr BV + Div return	13.9%	5 yr FCF return on BV	4.0% #

 

The rapid growth in sales over the last two years (25% pa) has been driven by the high level of digitisation of the Chinese ceramics production industry.  It is estimated that this process of digitalisation has only penetrated just over 10% of China’s capacity, with other producers such as Brazil & India below this figure, indicating that there is considerable upside potential for Xaar.  Even at eventual saturation of a market there is a replacement cycle for print heads of every 3-5 years.

Xaar was established in 1990 and floated on the London Stock Exchange in 1997.  They raised additional equity of £14m in November 2010 as part of an investment programme of £22m to increase capacity at its Huntingdon facility.  This is the reason behind the low 5yr FCF return on BV of 4.0% shown above. #

If we exclude the £22m cash outlay on expansion capex, then the 5 yr FCF return becomes 11.5%, much closer to the BV + div return of 13.9%.  The returns are accelerating as the 3 year returns for BV + div and FCF returns are 23.9% and 19.4% (excl. the £22m expansion capex) respectively.

ROE & operating margins are strong at 18.6% & 18.0% respectively, demonstrating the economic moat that exists around its intellectual property; the company has over 550 patents and patent applications.

Following last year’s strong performance the company issued a very positive IMS on 11 April stating that the trading performance in the first quarter, combined with the strength of the forecast for the remainder of 2013, have increased the Board's expectations for the year.

Xaar are looking to increase production capacity further this year, but unlike last time there will be no need to issue new equity that might dilute shareholders, since net cash at 31 March 2013 stood at £41.7m up from £28.9m at 31 December 2012.

The shares are expensive on an historic P/E valuation of 35, but based on forecast earnings will drop to 17.4 by 2014.  My estimate of a fair value for the shares is around 600p, using a cost of equity assumption of 13% and free cash flow growth of 30% pa for the next two years, 20% pa for the next 8 years and then 2.5% in perpetuity.  Some may view that 18% off the fair value price is an insufficient margin of safety considering the growth that is required, especially since the shares are also up 3% this morning at 523p.  One to watch for any weakness, if there is no fundamental reason for any decline.

This white paper provides an overview of the digital print technology for the ceramics sector.