XPEL Inc | Right Stock at Wrong Price?

Future Success Appears Baked Into The Current Price

Company: XPEL Inc (NASDAQ: XPEL)

Date: 15th December 2022

Theme: Small Cap Acquisitive Growth

Assessment: Overbought

Author’s Strategy: Watch / Divest

XPEL Enforces Its Brand Through Racing Sponsorship

---

Disclaimer:

Views, information and opinions expressed in this analysis are those of the author. They should neither be construed as investment advice nor as a recommendation to buy or sell any particular security. Security specific information should not be relied upon as the basis for your own investment decisions. You must do your own research, seek independent advice and reach your own conclusions.

The author may have a position in securities named in this article and may change those position at any time

---

Introduction

XPEL has become the darling of the small cap investing world. From its stock market low in 2009 when Ryan Pape became CEO to the July 2021 high, XPEL was the best performing stock in the S&P1500, rising 33,800% vs. 662% for the broad stock index. (After this year’s draw down it is still up 21,260%. vs 605%).

In only five years, earnings per share on a GAAP basis have risen from 4 cents to an estimated $1.63 this financial year. Very impressive. Small wonder that this stock has attracted so much attention.

But what is the future outlook from the perspective on an investor?

Through my lens it doesn’t look good. That’s not to say that the business will suddenly turn bad. I am confident that it will continue to prosper under the excellent stewardship of Ryan Pape. But even the best company at the wrong price makes for a poor investment. I am looking at this purely as an investment play based on fundamentals. The numbers don’t appear to stack up.

The Business

Founded in 1997 and incorporated in Nevada in 2003, XPEL has grown from an automotive product design software company to a global provider of after-market automotive products, including automotive surface and paint protection, headlight protection, and automotive window films, as well as a provider of complementary proprietary software. More recently it expanded into automotive ceramic coatings and watercraft products plus it has moved into architectural and security window film (both commercial and residential).

XPEL Product Segments

The Management

Ryan Pape has proven himself an exceptional steward of the business. He is tenacious with meticulous attention to detail and the attitude that failure is never an option. Having been with the company for 13 years he is aligned with shareholders by taking the long term view.

The business was staring into the abyss with serious debt and cash flow issues when Pape took control in 2009. It owed $250,000 for unpaid sponsorship, which debt it could not meet. Pape negotiated a lower settlement and paid the debt personally with his own credit card in order to save the company from certain insolvency. This is the kind of CEO that I like to see. Passionate, committed and with skin in the game.

Stock based compensation is relatively inconsequential which is also nice to see in this day and age. For me this means that the management is not minded to exploit shareholders in order to enrich themselves. Great news.

Business Fundamentals

Gross profit margins are robust and appear to be expanding, testament to the pricing power of the business. Most recently the business achieved circa 38% gross margin but historically this has been in the lower 30s and so only time will tell how sustainable these higher gross margins are.

In any event, durable margins above 30% combined with growing sales (more on this below) bodes well for the business.

CAPEX and OPEX are well managed and together run at a relatively constant percentage of sales in a 23% to 28% range.

Long term debt has increased significantly in recent years and this is being used to fund growth by acquisition. The business now has 16 subsidiaries across North and Central America, Australia and in several European countries.

Domestic and international expansion began in 2014 and XPEL has accelerated the pace of acquisitive growth recently. In 2021 alone it announced seven acquisitions. In the US and Canada the new subsidiaries expand upon the existing offerings of the business. It also acquired a UK based provider of custom-tailored bicycle frame protection kits. In 2022 it acquired the assets of an Australian distributor in order to expand its geographic reach. If the company is able to effectively manage the integration of all these acquired companies, then significant future top line growth is assured.

Debt has increased to 1.41x adjusted net earnings up from an average 0.18x in recent years. This isn’t unreasonable, although the days of monetary easing and rock bottom rates are certainly behind us and so the timing of this debt expansion is questionable.

The Asset Turnover ratio has been squeezed to 1.68x due to the newly acquired assets, but if this returns to the 2.25x seen in the past as the acquisitions bed in, then Return on Assets will return to circa 13.5% which more than justifies the financing costs of the acquisitions.

The Investment Fundamentals

Over the past decade top line revenue has grown by an impressive 42% CAGR and, as the result of operational leverage, EBITDA expanded by over 50% CAGR. This is truly impressive by any standard. Better still, this growth is showing no sign of abatement although the rate of growth inevitably slows as a company expands and investors would be unwise to count on anything more than 20% to 25% CAGR as a top line growth rate going forward.

The problem, from an investors perspective, is that the business has become a victim of its own success. When a company sees rapid growth everyone wants a piece of the action. Too many investors are attracted to the company which causes a positive spike in the share price. This results in confirmation bias amongst investors and the stock is seen as a cash cow, a means of getting rich quickly. More investors jump in and the price moves disproportionately higher still. It is not long before the share price is entirely out of kilter with the underlying fundamentals of the business.

In the same ten year period that revenue increased from $9.5m to $316m (42% CAGR) and EBITDA from $1m to $59m (50% CAGR), the market cap has increased from $6m to $1.8bn (77% CAGR). The math simply doesn’t work. The price has run too far ahead of fundamentals.

On a GAAP basis the net earning margins have been boosted to 12%, but that is primarily because more spending is being capitalised rather than expensed. Net CAPEX as a percentage of gross profit averaged 10% until the last couple of years. Now it stands at 29%. At the same time OPEX that historically averaged 65% of gross profit is now down at 51%. Real owner earnings margins have not improved at all, it is simply a question of taking a cost from the left pocket and placing it in the right pocket.

So, using my adjusted number of 5.85% owner earnings profit margin, how does anyone justify paying 5.5x sales for this business? Another sign that this business is vastly over priced. The implied earnings yield of little more than 1% is nowhere near the hurdle rate for any intelligent investor. It would not have made sense during the ZIRP (zero interest rate policy) era and it makes even less sense now that the Fed is tightening monetary policy to fight soaring inflation.

From the chart above it can be seen that the stock price was growing at a durable rate until mid 2020, very much in line with fundamentals, but then it appears that irrational exuberance set in and caused it to explode from circa $14 to over $101 (+665%) by mid 2021, one year later. I don’t like to refer to greater fool theory in relation to such a wonderful business, but I fear that anyone investing at these inflated levels is reliant on greater fools for any investment returns in the near term.

BlackRock evidently disagree with me as they bought 2.9 million XPEL shares in the summer of 2022, which is a 10.6% stake, but different views are what makes a market! I am steadfast in my own view.

Looking at this yet another way and working bottom up in a Charlie Munger style, to justify today’s share price the business would need to see a top line growth of 35% CAGR over the next five years plus a 100bp adjusted profit margin expansion (my adjusted profit margin is 585bp and so I would be looking for 685bp which will be challenging when input costs are soaring due to inflation). The shares outstanding would remain unchanged but we see significant multiple contraction (-66%) to take the GAAP P/E ratio closer to 18.

I see the multiple contraction as being highly likely, while the top line growth requirement and profit margin expansion being exceptionally unlikely. Accordingly, I remain unconvinced at these price levels whichever way I look at it.

It is interesting to note that in the past 12 months insiders have sold $26.6m worth of shares which I would argue supports my assessment that the market price is not aligned with intrinsic value.

Capital Allocation

In terms of capital allocation the business is generating good positive cash flows out of which it has a steady stream of retained earnings. It pays no dividend, nor has it engaged in any share buy-backs both of which are favourable for a growth company trading at a price that is difficult to justify. Capital has instead been used to pay down debt and to fund acquisitions.

While accretive acquisitions are good news, the means of executing them highlights a deficiency in the management’s strategic approach.

The 10Q corporate filing that reports Q3 2022 explains that as part of its acquisition strategy, the company may use a combination of cash and unsecured non-interest bearing promissory notes to fund its business acquisitions.

Why?

When a company is trading at a huge premium to intrinsic value the best strategy, as far as shareholders are concerned, is to finance acquisitions by using the inflated currency that is the company stock to fund the deal. Pape has missed a trick here and would do well to take a leaf out of the Henry Singleton and Warren Buffett playbook.

Risks

Despite its recent diversification, XPEL remains highly dependent upon the automotive industry. Automotive sales and production are highly cyclical, and the cyclical nature of the industry has been, and could continue to be, compounded by the on-going low inventories of new vehicles resulting primarily due to the global semiconductor shortage. As long as the semiconductor shortage persists and leads to low dealership inventories, there could be a material adverse impact on the business.

The extraordinary inflationary environment seen globally during 2022 has created a cost of living crisis which is likely to persist into 2023. Recession is looming large. This means that discretionary spending is often the first to be curtailed and the XPEL product line falls into that bucket.

Finally, the US Dollar has been very strong this year. For a US conglomerate earning revenue overseas, that income now has a far lower Dollar value. This is not good when the company accounts in US Dollars, so this will inevitably impact top line growth.

Conclusion

In short, this is a great company focused on expansion and with a large international TAM (target addressable market). It has high quality management, although there is scope for improvement in terms of how acquisitions are funded.

The business is not without headwinds and it is being valued at eye watering premiums to intrinsic value.

I shall refrain from offering a valuation on the business as we each have our own methods of achieving this and it is more an art than a science in any event. However, I would say that trading at 47x GAAP earnings and 94x my adjusted owner earnings suggests that even if the shares halved in price tomorrow, it still wouldn’t be cheap.

This is a business to add to a watch list. If it sees a large price correction then that is the time to initiate a position. If you have an existing position, perhaps now is the time to divest in order to lock in profit. For me this is a Golden Bullet investment at this time.

Investment Note:

If there is no multiple contraction and the price does not correct, then I fear that the XPEL share price will stagnate for many years until its fundamentals catch up with its market price (Case study click link: Microsoft) ~ investors saw 0% total return from the 2000 peak to 2015. Its top line and earnings expanded consistently year on year throughout that period, but it took 15 years for the business to be able to justify the price at which it traded in the year 2000. Caveat Emptor!