Description

Recommendation: Short XPEL at $84; Target price of $41 within an 18-month time horizon (+32% IRR)

Executive Summary:

• XPEL is a global manufacturer of automotive protective films with a history of strong revenue growth (~31% 15-year CAGR).

• The market believes that XPEL has become a secular growth story and has assigned it a premium multiple (33.3x NTM P/E), pricing in nearly 20% of annual organic revenue growth compounded through 2030.

• This has created a compelling opportunity to short the stock given that preliminary work suggests that:

  • Recent growth in the Paint Protection Film ("PPF") segment (58% of TTM revenue) was largely driven by tail winds that are abating, such as: (1) a large share of Tesla owners purchasing PPF to compensate for paint production challenges on earlier models that are being fixed going forward, (2) dealerships liberally applying PPF to new cars as a "freebie" on the back of record high dealer markups that are now receding, and (3) competitors catching up in terms of quality and brand, at a fraction of XPEL's price and with more R&D spend to stay ahead.

  • Margins have peaked and are likely to be pared back as the company doubles down on expanding in a less profitable China market, pursues lower margin installer businesses, and invests behind expanding their Design Access Program (“DAP”) software.

  • Despite the market pricing in durable secular growth, XPEL has historically been very cyclical, with 2008 revenue (-35%) tracking US car sales (-43%). In a moderate recession if revenues begin declining, the multiple may compress significantly as investors re-rate this from a premium compounder to an industrial cyclical.

• While bulls highlight numerous opportunities (such as growth in Architectural Film and lower margin volumes from Rivian), I believe that this misses the forest for the trees – volume demand for the core business (~60% of the business) seems set up to potentially inflect yet the market continues to give the entire business a premium growth multiple based on segments that make up a single digit share of current revenue.

• At more moderate growth levels in its core markets and normalized margin levels, I believe XPEL should trade at ~$41 (-51%) and in a recession could trade down to $21 (-76%). Even if we believe the margin expansion expected by some bulls, Base Case growth at a 22% EBIT margin (+420bps to TTM) would still result in a target price of $55 (-35%).

Company Overview:

XPEL is a global manufacturer and installer of automotive protective films. It has built a strong brand reputation amongst car enthusiasts for its Paint Protection Films (“PPF”; ~58% of TTM revenue) and has increasingly diversified into other products such as window film (~17%), installation services (~14%), and related software (~7%). It has sustained annual revenue growth of ~31% over the past 15 years and has been profitable since 2009, generating ~30-40% ROICs by executing on a capital light manufacturing model.

I won’t spend an enormous amount of time covering the business from scratch given the great previous VIC write-ups from mip14, devo791, and Ares, but will instead focus on recent developments in the business:

• The PPF segment continues to be the largest dollar contributor of growth for the business, expanding meaningfully during COVID from $97mm in 2019 to $206mm on a TTM basis through Q2’23, implying a 24% CAGR in that business. This closely reflects the growth in Google Trends interest for PPF over that time period (24% CAGR).

• China has become a significantly smaller share of sales, falling from ~30% at its peak in 2018 to ~9% on a TTM basis through Q1’23. Management attributes this drop off to post-COVID related lockdowns, port closures, and general slowing of economic activity.

• Inventory levels have grown significantly, rising from an average of ~70 DIO historically to double that at 153 as of Q1’23, before beginning to recover to 129 as of Q2’23. FCF conversion has recently been limited as a result, with TTM CFO / EBITDA finally returning to its roughly ~60% historical level as of Q2’23. Similarly, ROICs have fallen to ~30%, though if you believe this is temporary (rather than structural) and normalize DIO to 70 days, the business continues to deliver ~40% ROICs. Management attributes this largely to their China distributor sending back inventory while expectations for economic growth have receded, but expect for this to normalize over time. Note that they took a $400k inventory write-off that they expect is a one-time event.

• Management has continued executing on a number of smaller inorganic acquisitions that have helped them expand closer to the customer through PPF installers (PermaPlate, Protex Centre, 5 US/Canadian installers, and the PPF business of their Australian distributor), and launch new adjacent products (Veloce Innovation for architectural films, and invisiFRAME for bicycle PPF).

• Management has also executed an impressive partnership with Rivian, offering factory-direct installation of XPEL products on new Rivian orders.

• In July 2019 XPEL became listed on the Nasdaq and in June 2020 it was incorporated into the Russell 2000/3000 indices. Investors certainly took notice of its historical financial profile as it swelled to a max of 76x NTM P/E (+46x premium to the RTY) in 2021 and stayed at elevated levels for most of 2021, before receding to a more normalized Median of 34x NTM P/E (+10x premium to RTY), roughly where it trades today.

  • Despite this elevated price point, management has been disciplined and has not issued any additional shares (remaining at ~27.6mm), has kept a clean balance sheet with no net debt, and established a $125mm revolver.

  • I will note however that management ownership has declined precipitously. Despite owning roughly 40% of shares in late 2020, management has continued to be net sellers of shares in the open market dropping to ~18%. With the retirement of Mark Adams (an 8% holder) at the end of June 2023, shares owned by active insiders have fallen to roughly 10%.

• Consensus estimates 2024 Revenue to be $464mm (19.7% CAGR) at a 20.8% EBIT margin, resulting in a $2.74 2024 EPS. Using a 30-year reverse DCF, I estimate that the market is currently pricing in ~19% annualized growth over the next five years at a 17.8% EBIT margins (in line with TTM EBIT margins), with revenue slowing -3% every 5 years to a terminal growth rate of 3%, a 10x terminal multiple, and a 10% WACC (resulting in only 20% of the value being driven by the terminal multiple).

Despite the impressive historical performance, I believe XPEL faces a much more challenging near-term trajectory than the market is currently pricing in.

Recent disproportionately high interest in PPF products by Electric Vehicle (“EV”) customers has been a temporary tailwind that is unlikely to persist into the future.

Core PPF segment revenue growth is driven primarily by:

1. Global Motor Vehicle Sales: protective film is applied primarily to newly purchase vehicles

2. Attach Rates: share of new vehicle customers that know of the product’s benefits and purchase it

3. Market Share: XPEL has built a premium brand resulting in historically leading market share

4. Amount of Film Used: increasing over time from typically just the hood to the entire front of the car

5. Unit Price of the Film: has largely been unchanged to maintain growth and capture market share

Despite recent weakness in global vehicle sales due to supply chain issues plaguing the automotive industry, XPEL has continued to benefit from the rapidly growing interest in PPF products (+24% CAGR per Google Trends data mentioned earlier). Management has attributed this growth to a broader acceptance of PPF products amongst the non-enthusiast population and disproportionately higher attach rates amongst EV customers, which theoretically should drive significant growth for XPEL and the overall PPF market, given EV’s are expected to represent 23% of all new cars sales by 2025 and 35% by 2030 according to the IEA (1).

Tesla owners do seem to have been a substantial source of interest in protective paint films recently. Google Trends data shows that users searching the key term “PPF” also tend to search topics related to “Tesla”. SimilarWeb traffic data to the XPEL website confirms that site visitors also commonly spend time on the Tesla website. In fact, the Telsa website is such a popular destination for users that search for PPF, that it is listed among XPEL’s primary PPF competitors (3M and Llumar) as the most similar websites.

Tesla owner’s interest in PPF seems to have been driven by early paint production issues. On Tesla Car Enthusiast forums, a very common complaint is that “Tesla’s paint jobs are notoriously the worst in the auto industry. (2)(3)” Elon Musk himself addressed this in an interview where he attributes some of these paint issues to rushing production to meet vehicle quotas early on and not allowing the paint to dry the correct amount of time in the Fremont facility (4). Given the early adopter enthusiasts that sought to purchase a Tesla were doing so largely for the novelty of a fully electric vehicle (as well as a status symbol), this hasn’t necessarily stopped them from making the purchase – but they instead needed to supplement the purchase with paint protection film. Entire dedicated companies have been established to address this issue, such as TesBros, which offers a variety of DIY PPF installation packages and educational videos to help customers protect their Tesla (5).

As Tesla has continued to build out manufacturing capabilities and mature as a company, they have made investments in quality control, including installing the “world’s most advanced paint shop” in their Giga Berlin factory (6). While there are still some complaints on the forums regarding paint jobs, other customer issues that previously required window tinting / protective film have been resolved in newer Tesla models. 

As Tesla continues to iterate on their products, they are likely to resolve these specific paint issues, and customers are going to be less likely to seek expensive PPF solutions to augment their purchase. Additionally, as Tesla continues to ramp up production and it becomes less of a novelty, I believe the incremental electric vehicle customer is unlikely to be willing to make such an expensive purchase if it requires also seeking an aftermarket modification to it, particularly as it grows to be a larger share of the total vehicle’s price given Tesla’s recent price cuts.

As some bulls have pointed out, Rivian could help support EV attach rates given the application at point of sale and the percentage cost relative to the car. Without taking a view on the longevity of an EV company selling vehicles at a loss, I believe that this is possible but will be both de minimus relative to total sales and abate over time (similar to Tesla).

Given these data points, I believe that PPF attach rates for EV customers are temporarily elevated (rather than a structural feature), and will converge to attachment levels for the overall population over time, acting as a headwind to growth in the future.

PPF sales have also been temporarily supported by dealerships offering it as a “freebie” on new car purchases given historical highs in car mark-ups, which are beginning to recede as car inventories recover. 

Bureau of Labor Statistics data for New Car Dealer Vehicle Sales PPI (proxy for dealer mark-ups) shows that mark-ups surged in 2021 and 2022, reaching a peak of nearly 3x since the pre-COVID lows. This was likely driven by tight new car inventories during the recent semiconductor shortages, and pent-up demand for new car purchases from consumers coming out of COVID. Conversations with dealers suggest that they were more likely to apply some kind of car feature (such as PPF or window tinting) to make the customer feel as though they were receiving something in exchange for the higher mark-up price. However, over 2023, dealer mark-ups have receded 30% from 2022 highs, and have significantly lower to go relative to pre-COVID norms. I believe that as these levels further normalize, this will put further pressure on PPF sales for brands that have focused on integrating with dealerships and installers, such as XPEL.

Furthermore, I believe this phenomenon explains the growing attach rates amongst the general population, and I believe this will revert back to largely traditional car enthusiasts regardless of how much XPEL spends on marketing. Anecdotal evidence from discussions with installers suggests that the typical customer inquiring about PPF continues to primarily be a car enthusiast and that there hasn’t been a meaningful change over time.

I’ve seen two arguments for why attach rates for the general population should grow over time, both of which feel like comparing apples to oranges:

• More mature markets including Alberta and Colorado exhibit significantly higher attach rates; as other markets mature, they are also likely to see attach rates grow to these levels as well.

  • Google trends data suggests seasonal interest that can be seen in the winter months, when roads are more likely to have been salted and be abrasive to motor vehicles.

  • Anecdotally, when we drove through Vail Pass in Colorado last winter during a storm (a top market for XPEL), we ended up with a dime sized nick in the window shield. When we returned the car, the Enterprise employee told us not to worry about it because every other car comes back with some kind of minor damage, and that’s par for the course for that time of year.

  • Higher attach rates in geographies with challenging terrain/weather are unlikely to be related to adoption in other more moderate climates, where the typical buyer tends to be a car enthusiast.

• More mature products such as window tinting have significantly higher attach rates for new vehicles; as the market for PPF ages, it should also experience growing levels of attachment to these levels.

  • Window tinting has become much more accepted because it is something that improves customers’ quality of life in terms of both heat management and glare prevention, and in some geographies is even a safety concern in the summer months. Conversations with window tinting customers reveal a much stronger preference for the practical benefits of window tints, rather than preventing minor abrasions and chips (which they viewed as a reality of owning a car, and something they don’t think very often about).

  • Additionally, window treatment options are widely available, are easy to apply in a DIY fashion, and relatively cheap (from ~$20 DIY options to $100-200 for a professional installation, compared to 10x that cost for a common full front installation of XPEL PPF).

Given these datapoints, I believe that the elevated PPF attach rate has been largely driven by historically high dealership mark-ups, rather than any success in marketing PPF products to non-car enthusiast users. I believe that as car inventories loosen and dealership mark-ups recede, PPF attach rates will fall and XPEL will face further revenue headwinds.

Competitors are catching up in terms of quality and brand, at a fraction of XPEL's price and with more R&D spend to stay ahead. 

XPEL has a significant number of competitors who offer comparable PPF products. 3M (MMM US) is a pioneer of PPF and owns a patent that XPEL maintains a perpetual license to. XPEL got the jump on 3M in 2011 by launching Ultimate Plus which has "self-healing" properties that allow minor scratches to effectively be buffed out, but 3M followed shortly in 2014 with the Scotchgard Pro Series which offers a comparable self-healing feature. There have been some general comments on XPEL's PPF being more resistant to turning orange and cracking over time vs. the competition, but with the latest iterations, it seems as though that has become the market standard across the board rather than being limited to just XPEL (e.g., 3M has updated the Scotchgard Pro line 4 times since its launch). Additionally, the 10-year warranty that only XPEL originally offered has now become the market standard (with SunTek even offering a 12-year warranty). SunTek & Llumar (separate brands both owned by Eastman Chemical, EMN US) and Avery Dennison (AVY US) are also established premium competitors, but there is a fairly wide list given there isn't much of a moat around the underlying product itself. 

XPEL continues to be by far the most expensive option, even amongst premium competitors. In comparing a 5x15 foot sheet, 3M is 58% cheaper, and both Avery Dennison and Hexis are 55% cheaper. XPEL pricing is directly from the website, while the rest are from distributors, which suggests the disparity might be even wider if ordered directly from the source.

Additionally, XPEL spends significantly less on R&D than competitors, leaving an avenue open for competitors to potentially get ahead with upgraded features while XPEL falls behind over time. While XPEL spends only ~$400k annually on R&D (0.1% of revenue), 3M spends $1.8bn (5.4%), Eastman Chemical $254mm (2.6%), and Avery Dennison $136mm (1.6%). I suspect this is why XPEL needs to spend so much on marketing the brand. I also suspect this is why XPEL is increasingly pursuing purchasing installers outright - they need captive installers to intake the XPEL products, because independent installers may be going with competitors.

One potentially concerning trend is the emergence of Chinese PPF products on the global stage. Google Trends shows “HOHOFILM” as a rising key phrase for PPF searches, growing significantly over the past year with significant interest out of both Australia and California. Doing a quick google search for the product shows direct distribution through Amazon, eBay, and AliExpress, at significantly cheaper prices than the US competitors. For a similar 5x15 film sleeve to the comparison made earlier, HOHOFILM retails at an 84% discount to XPEL film. While management has attributed the slowdown in China due to an overall post-COVID economic slowdown, I believe it is entirely plausible that the Chinese market has been competed away by cheaper upstarts like HOHOFILM. Given the recent uptick in interest from Australia and California, there is a real risk that cheaper “good-enough” competitors enter the US market and begin to take XPEL’s market share.

One potential counterpoint is that XPEL has created an attractive ecosystem for its installers by offering discounted access to its Design Access Program (“DAP”) software, which benefits installers primarily in increasing the accuracy of the cut (satisfying end-customers), reducing associated film waste, and reducing labor time spent on the installation process. We can estimate the economics of two installers applying a PPF wrap to the entire front of a Tesla Model Y: Installer A that applies XPEL Ultimate Plus film with a $300 monthly DAP cost, vs. Installer B that offers Avery Dennison Supreme Defense (54% discount) but pays 50% higher labor costs (due to additional time to manually cut the film) and 20% additional material (due to more film waste). By my estimates, Installer B can still achieve the same level of gross profit while selling it at an 11% discount to Installer A, driven by significantly lower materials cost. This of course ignores the additional benefit of Avery Dennison also offering Vehicle Design Template (“VDT”) cutting software for a third of the price of DAP (though admittedly offering only “thousands” of available pre-cuts, vs. 80k+ for XPEL). DAP is also set to expand its feature set, including invoice services, appointment scheduling, payroll management, and leads tracking, but conversations with installers suggest that the only feature they tend to use DAP for is the pre-cuts and that they would be unlikely to migrate from existing service providers for other DAP features.

An additional counterpoint is that XPEL offers attractive lead generation for its listed certified installers on their website. However, conversations with installers suggests that the majority of customers opt for PPF installation after seeing it live in person, while online reviews indicate that the most important thing for customers seems to be the quality of the installer rather than the film. 

While XPEL has had a premium brand historically, I believe that the competitor set has already caught up and is much better positioned to stay ahead. While installers have benefited from the growing demand in XPEL, as customers seek similar quality at more affordable prices, I suspect that installers may be less likely to sign up to be an exclusive XPEL dealer, if it means lower volumes at similar profit levels than they could get from competitor offerings.

Margins have peaked and are likely to be pared back as the company doubles down on expanding in a less profitable China market, pursues lower margin installer businesses, and invests behind expanding their DAP software.

Gross margins are at all-time highs and are unlikely to expand meaningfully from here. Recent supplier renegotiations have been a driver of reduced materials cost, and I believe that has already been fully reflected in the gross margin to date. Product margins have also expanded recently driven by shrinking sales from China (where there is a higher cost paid to the distributor). Looking forward, TrendForce estimates that ~33% of new car sales will come from China (particularly EVs), and on the last earnings call management has said they are planning to dedicate significant new resources and building a China dedicated team to go after that market (7). Competition is very high in this geography and online reviews point to existing history with fraudulent activity and intellectual property theft, suggesting the higher margins and ROICs may be a target for increased competition, pressuring gross margins further (8). We are beginning to see that with HOHOFILM’s uptake in California and Australia since 2021. Additionally, product margins have also benefited from price increases in certain markets, which given the growing competition, are unlikely to be repeatable going forward without impacting volumes. Service margins are also likely to compress, as management increases spend on additional DAP features and continues to grow installation labor as a segment.

SG&A is also likely to continue trending upwards. Sales and marketing have grown meaningfully in order to drive new installers on to the XPEL platform and management has focused on increasing brand awareness to grow attach rates. As XPEL has to direct marketing spend across an increasingly diverse product set (autos, marine, architectural windows, and bicycles), across many targeted parties (traditional enthusiast consumers, non-enthusiast consumers, installers, dealerships, OEMs, and distributors), and geographies (US, Canada, China, Europe, Australia, EMEA, and Latin America), I expect sales and marketing spend to grow over time rather than benefit from volume growth.

Despite the market pricing in durable secular growth, XPEL has historically been very cyclical, with 2008 revenue (-35%) tracking US car sales (-43%). In a moderate recession if revenues begin declining, the multiple may compress significantly as investors re-rate this from a premium compounder to an industrial cyclical.

New car sales generally correlate with GDP growth, consumer financial health, and car affordability. Currently, US real GDP is projected to fall over the next two years, with Bloomberg projecting a 60% chance of recession. Consumer savings have fallen dramatically despite growing significantly during COVID and now sit at levels last seen during the GFC. The Keley Blue Book sees vehicle affordability finally stabilizing but continuing to sit at historic lows, with the average consumer needing to pay 43 weeks of their household income to pay off their new car (relative to 33-36 in the decade prior to Covid) (9).

During the last significant recessionary period, the Global Financial Crisis, US new car sales fell (-43%) and Google Trends shows that PPF interest also fell significantly (-41%). During the ensuing recovery, as US car sales began to recover, PPF interest took a significantly longer period to reach pre-GFC levels. XPEL was not immune to this and saw its revenue decline (-35.3%) in 2008 and only grew at low single digits in the two years that followed.

While I don’t have a differentiated view on the odds of a recession occurring, I do believe that it would impact XPEL significantly more than the current valuation would imply. In a moderate recession, I believe revenues could decline (-10%) a year or more, and during that time the multiple may compress significantly as investors re-rate this from a premium compounder to industrial cyclical.

Valuation:

As mentioned earlier, the market fully appreciates XPEL’s historical combination of durable revenue growth and returns on capital. It has historically traded at a wide range to the Russell 2000, on balance achieving a +10x NTM P/E premium, and currently trading at 33.3x NTM P/E. This is likely driven by consensus expectations for XPEL to grow NTM Revenue at 23% vs. 2% for the RTY.

While direct PPF competitors on average trade at a more modest 14.0x NTM P/E, they generally are expected to grow less quickly and have weaker historical ROICs. Additionally, they tend to be more diversified conglomerates which potentially make using their multiples as a less useful valuation tool relative to a DCF projecting expected cash flows at different growth profiles. Generally plotting both direct competitors and other “Automotive Parts & Equipment” sub-sector companies along their NTM P/E vs. NTM expected fundamentals, stronger revenue growth and EBIT margin seem to be most correlated to higher NTM P/E and largely explains XPEL’s heightened valuation relative to peers.

Using a 30-year reverse DCF, the market seems to be pricing ~19% compounded revenue growth at XPEL’s TTM EBIT margin of 17.8% through 2027, and ~17% growth through 2030 (which we will define as long-term revenue growth and attempt to estimate in the “Scenarios” section below).

Scenarios & Risk-Reward:

I believe the risk-reward is skewed towards being short XPEL at this time.

• Bull Case - $138 (+64%) – 20% Long-Term Revenue Growth & 21% EBIT Margins:

  • Assuming XPEL can sustain 20%+ long-term revenue growth over the next 5 years before moderating to high-mid teen growth for the following decade, and eventually settling at 2x GDP growth (6% terminal rate), and that it can further improve its EBIT margins to 21% into perpetuity (+320bps from TTM and >500bps relative to history), I estimate it would deserve a fair value of $138. While I don’t particularly believe this case given all of the reasons highlighted above, I think it makes a reasonable estimation of what historical trends projected into the future might look like.

• Base Case - $41 (-51%) – 11% Long-Term Revenue Growth & 17% EBIT Margins:

  • Using an industry model that leverages the 5 key PPF industry drivers mentioned earlier (Global Motor Vehicle Sales, Attach Rates, Market Share, Average Amount of Car Covered, and Unit Film ASP Increase) and calibrated against the ~20% growth expected in the Bull Case, I believe that XPEL’s Global PPF revenue is more likely to grow at a normalized 8.3% CAGR through 2030, when accounting for my more pessimistic view for terminal attach rates for EVs, market share, and inability to raise ASPs. Given window film is continuing to take market share driven by cross-sell at existing PPF installer locations, I expect it can sustain growth in the mid-teens in the near term despite being in a more mature, slower growing market. I also expect installation labor to continue growing at a higher rate than PPF. As a result, I expect the blended business to grow at ~10.9%, with a more historically normalized EBIT margin (though still elevated) of 17%, which results in a $41 target price.

• Bear Case - $21 (-76%) – 3% Long-Term Revenue Growth & 15% EBIT Margins:

  • If we assume a moderate recession that reduces revenues by 10% for 2 years then normalizes to HSD growth afterwards, and EBIT margins compress to ~15% (which was the case as late as TTM Q1’22), I estimate a target price of $21.

Risks/Mitigants:

• Better than expected attach rates amongst the non-car enthusiasts and/or otherwise better than expected growth for PPF

  • XPEL is priced at a significant premium to a wide array of competitors; as competitors continue to invest in higher quality, lower priced offerings, I believe that market share will materially shift away from XPEL even if the PPF industry continues to grow significantly from here.

• Other business units are able to outgrow any potential slowdown in PPF

  • It’s important to note that despite a wide variety of ancillary revenues growing around PPF (including window film, software, installation labor, etc.) all of those revenues are fundamentally tied to healthy PPF volume performance in the current state.

• Better than expected penetration in China

  • If XPEL is able to find growth in China, it is likely to be materially more expensive and offset any recent margin gains that it has been able to establish, reducing the valuation premium it is receiving.

Catalyst

Continued growth in inventory levels

• If XPEL is unable to continue reducing working capital in the near term it may continue to have poor FCF conversion or additional inventory write-offs and may be a sign of weakening demand. Q2’23 read-throughs from competitors suggest industry wide destocking may be continuing, and in some cases is a sign of falling demand.

Selling pressure from the largest insider stepping down from the board

• Mark Adams, the largest former insider with 8% of shares outstanding, may cause near term sell pressure if he decides to monetize his shares, given he owns 20x ADTV (110k shares traded daily).

Competition beginning to take market share

• If newer competition such as HOLOFILM gains traction or if premium competitors cut prices, there may be meaningful market share loss which would start coming through in earnings numbers.