Description

Xpel Technologies is the market leader in automotive paint protection film.  They have consistently grown at a 60%+ organic revenue growth rate over the last 3+ years yet trade for only 7.5x 2016 after-tax earnings.  Xpel has an extremely high quality business with recurring revenues, no customer concentration, a dominant market position, high barriers to entry, high customer switching costs, high returns on capital, and a very significant runway for future growth both domestically and abroad.

I posted a report on Xpel a little less than two years ago (and I recommend reviewing that prior post and comment thread for added detail).  Since that time, there have been many very positive developments in the business and the shares remain significantly undervalued.  These developments include:

• The business has almost tripled in size (2-year revenue growth rate of +175%).
  
  

• Market share has risen significantly and I believe is now around 40%, making them the dominant market leader.
  
  

• 3M -- the former market leader -- released their long-awaited updated PPF and it was very poorly received by installers.  This failed product update appears to have accelerated 3M’s demise in the PPF industry, and I believe they have now fallen to #3, behind Suntek as well.

• The only other viable PPF business, Suntek, was acquired by Eastman Chemical for $438 million, or 4.4x revenues.  Based on Q2E run-rate revenues, 4.4x revenues would imply a $9.00+ share price for Xpel.  And Suntek is largely (80%+) a window film business, which is a more mature market with much slower growth, and is significantly less attractive than Xpel’s very high growth, high barrier to entry, market leading PPF franchise.

• Xpel acquired their high-performing Canadian distributor for what appears to have been a bargain price.  This has largely not been reflected in results to date as the acquisition closed in February of this year and made a fairly negligible contribution to Q1 results according to management.
  
  

• Xpel finally expanded to Europe on a direct basis.  Europe is a huge growth opportunity for the company as the market size is very large (car sales are more than double the US), there’s less competition, and up until recently Xpel has had very little revenue in Europe.
  
  

• Xpel finally started leveraging their valuable direct distribution network (I believe ~1000 independent film installers) to enter additional product categories.  Their first launch is a window film/tint, which has significant growth potential due to the large size of the window film market (PPF penetration is only 2-3% of new car sales in the US vs 60% for window film) and Xpel’s strong reputation for customer service and support.  Importantly management expects the product to have margins on par with PPF and it appears to be a major focus for the company.  Management has suggested that they will be launching additional ancillary products.

• They’ve increased both the quantity and quality of the design templates in their proprietary database significantly over the past two years, and as the performance gap between their offering and competitors’ cutting software has widened, they are increasingly using it as a wedge to both gain market share and increase the stickiness of their existing business.  This is a very underappreciated piece of the value proposition that Xpel provides their installers.

In addition to the share price remaining significantly undervalued in spite of major positive developments in the business, the other reason why I wanted to provide an updated report on Xpel is because I believe the investment is very timely and that shares are at a major inflection point.  I believe that the Q2 earnings report that will be out next month should serve as a strong catalyst and drive a significant revaluation in the stock price.  I believe the Q2 earnings report should serve as a strong catalyst for a number of reasons:

• The stock price is actually flat over the last 10 months -- almost a full year -- despite the underlying business having grown TTM revenues by 62%.  On top of that, there have been a number of positive developments that I highlighted above (the Parasol acquisition, launching of European direct operations, launching of a window film product) that make the current growth pipeline a lot stronger than it was a year ago.  Eventually this underlying growth has to be reflected in the stock price, and every quarter that goes by makes this more likely.

• The seasonality in Xpel’s business is very poorly understood by the market.  Although new car sales have relatively muted seasonality, Xpel’s business of selling rolls of PPF has a significantly more pronounced lift in the summer quarters (Q2/Q3).  This is because their customer is essentially a mom-and-pop installer that is relatively capital constrained, and as such tends to make more of its film roll purchases in the summer months when its business is more active and they are flush with cash than during the winter months.  This seasonal pattern is very evident in each of the past four years since the Ultimate film was introduced into the market.

  
  The markets’ lack of understanding of Xpel’s seasonality can be seen clearly in the historical stock chart.  Growth in the business over the last 3+ years has been extremely consistent and TTM revenue growth has been maintained in a relatively tight range of 62% to 83%.  If ever there was a company that should have a smooth upwardly sloping stock chart, this is it.  Instead, in each of the past three years the stock price has been fairly stagnant for a 9 month or so period until Q2 was reported, at which point in both 2013 and 2014 the stock quickly more than doubled.  I expect this pattern to play out once again in 2015 with a similar reaction in the stock price to Q2 results.

• There is significant operating leverage in the business, but it has been masked over the past three years as management has aggressively invested in headcount to put the infrastructure in place needed to drive significant sustained global growth.  The CEO explained on the Q4 CC that they had been playing “catch up” on their cost structure over the past few years, and on the Q1 CC he went as far as saying that they were now even “ahead of their needs” in terms of headcount.  As a result, I believe that operating margins are finally at an inflection point and that we should start to see the significant operating leverage manifest itself in expanding operating margins.  Because Q2 is a seasonally strong quarter, I believe this leverage should be particularly apparent in the upcoming earnings release.
  
  Consider that TTM EBITDA margins are 12%, and that in 2010 and 2011 -- before they started investing heavily in the business -- they had several ~20% EBITDA margin quarters, including a seasonally slow Q4 (2010), and that was with a business that was a tiny fraction of its current size when basic public company costs were a significant % of the overall expense base.  Furthermore, operating margins should also start benefiting in Q2 from the mix shift away from sales to distributors, towards increased direct business.  Part of this should come from the Parasol acquisition which will start to contribute to results, and part should come from the European expansion that is currently ramping up.

• Finally, I think that Q2 results are likely to be a catalyst because of how unusually bullish management was on the Q1 call and how much the CEO’s tone changed from the prior call.  As I posted in the comment thread of the prior writeup:

   

  On March 31st (Q4 call) he said:

"Now it’s important to note that as the numbers get bigger, the revenue growth percentage we’ve seen you know will moderate somewhat, a non-aggressive reduction from the great growth we’ve seen this year. But it's probably unrealistic to consistently deliver growth in excess of 50% as we become larger. With that said, you know we’re still focused on growth, and we’re driving strong, and we complete at very strong momentum in the business."

On June 1st (Q1 call) he said:

"Overall we think that at the size of where we are, if we can drive revenue growth, year over year, in excess of 50%, we think that's a great growth rate, and so we're very pleased with that number."

and later on,

"We know those are big comps and 50% growth on second quarter of last year is a big number, but that's what we're gearing for.  And if we can maintain at that 50% number we're going to be very excited about that, and in excess of that is just a bonus."

So after seeing two quarters of 53-54% growth (Oct 2014 to Mar 2015) he starts to talk down investor expectations on the Q1 call and essentially says to not be surprised if revenue growth dips under 50%.  Then April and May happen and all of a sudden he's feeling bullish again and giving forward guidance of at least 50% growth.  I think it's pretty obvious that April and May, the first 2 months of Q2, must've been especially huge months for him to have changed his tone so dramatically.  And if the CEO is setting the bar going forward at 50%+ growth, you have to think that Q2 is already on pace to significantly exceed those levels considering how conservative management has consistently been in setting expectations.

A few additional things that need to be highlighted:

60%+ organic revenue growth for 3+ years

The company has posted 16 consecutive quarters of 45%+ organic revenue growth, and 13 consecutive quarters of 62%+ TTM organic revenue growth.  This consistency is a direct consequence of the business model and its high quality:

• Revenues are recurring

• The customer base is extremely fragmented with I believe around 1000 independent installers, which are largely single unit locations

• Switching costs are high (once an installer is trained on and experienced with a particular film, trying to switch film suppliers can result in both increase labor and materials costs)

• Industry leading proprietary DAP software/database and lead generation provided by Xpel increase customer captivity

• High barriers to entry from Xpel’s significant scale advantages that give them purchasing cost advantages and allow them to offer superior service and support as they can leverage that infrastructure over a much larger sales base.

Revenue growth and TTM revenue growth, respectively, over the past 3-4 years:

• Q1 2015 +54% +62%

• Q4 2014 +53% +66%

• Q3 2014 +72% +69%

• Q2 2014 +70% +64%

• Q1 2014 +67% +69%

• Q4 2013 +65% +68%

• Q3 2013 +52% +68%

• Q2 2013 +100% +80%

• Q1 2013 +58% +70%

• Q4 2012 +67% +77%

• Q3 2012 +89% +83%

• Q2 2012 +66% +71%

• Q1 2012 +88% +66%

• Q4 2011 +90%

• Q3 2011 +46%

• Q2 2011 +45%

North America PPF adoption is still in the very early innings

While the company is aggressively expanding internationally and launching significant new products like window tint, it is easy to forget that PPF is still in its infancy in North America.  Although PPF penetration rates have increased over the last 18-24 months, I believe they are still only around 2-3% of new car sales, and I continue to believe that they will eventually exceed 20%.  This obviously suggests that there is still a huge runway ahead of the company in its core business, and that international expansion, new products, and retail expansion are incremental to this growth.

In the original report I pointed towards the 60% penetration that window tint has achieved and 30-40% penetration that had been achieved in regions where PPF was more mature like Colorado and Alberta.  Another data point that I’ve heard in recent months from management that further supports this is the performance being achieved by automotive dealers (which are the primary sales channel for the product) with PPF programs in place.  Even today, only 10-20% of new car dealers even offer PPF at all today, and many of those don’t really have a program in place where they are actively promoting the product.  When auto dealers do buy into PPF, however, they are seeing 20%+ attachment rates.

Dealers can typically make $300-$500 in profit from PPF on each sale, so there is a strong economic argument for introducing a PPF program.  As consumer awareness for the product continues to grow, it becomes an increasingly easy sale at the dealership level.   I expect as more and more new car dealers start to offer the product, overall PPF penetration rates in the industry should increase significantly.

Finally, there is a common misconception that this is a product that only appeals to car enthusiasts or luxury vehicle owners, but this is definitely not true.  First of all, the most wrapped car (and they know this because of their DAP software) is the Toyota Camry.  Secondly, I’ve often found even dealers of lower-end nameplates like KIA are successful with programs where they wrap every single vehicle that they sell.  Furthermore, I think the value proposition of the product is simply a lot more compelling than a lot of investors that aren’t familiar with the aftermarket business realize.  Automotive dealers are already very successful selling aftermarket products like paint sealant, rust proofing, and theft protection, that are often not much different in price and are arguably of much more questionable value.  In the case of products like paint sealant and rust proofing, it can be a lot of money to pay for a product that the consumer really has no way of knowing if it was even applied to their car!

Europe is essentially greenfield and has huge growth potential

Although the company has had ~35% of their revenues coming from international markets, what a lot of investors don’t realize is that around 2/3rds of that was from Canada, China, and the Middle East.  The rest of the world: Mexico, South America, Europe, other Asia-Pac markets, etc I believe only combined for around 10% of revenues.  It’s impossible to know with any specificity, but I believe Europe specifically was likely <5% of revenues as a result, and management has emphasized in the past that they had a negligible presence there.

It will take time to get there, but it’s hard to emphasize enough how huge of a growth opportunity this is for the company.  This is a segment of the market that is, let’s say, currently 5% of their existing business, but with European car sales more than double US levels, should probably be closer to 50% with similar penetration rates.  Put differently, if Europe had similar penetration rates for Xpel today as what they are currently achieving in the US, they would have an incremental ~$70 million in annual revenues. And that's just at today's levels -- Xpel's US business has been growing at a 50%+ rate and as highlighted above has a huge runway.

Importantly, this European expansion appears to be doing very well for the company.  Management has specifically said that the UK is performing well and that they have plans to add a presence in continental Europe this year (I suspect either Benelux region or Germany).  As of the last conference call, installer training sessions were already fully booked until September, which is a strong leading indicator for this business.

Lead generation is a significant competitive advantage and switching cost...

I did not write about in my prior report, but lead generation increasingly appears to be a significant competitive advantage and switching cost for Xpel.  Xpel has a dealer locator on their website, and the company generates many, many leads for their installers through this channel.  I have increasingly found that many installers derive a huge percentage of their business through these leads that Xpel generates for them.  It’s hard to imagine a more significant switching cost.  Is an installer really going to switch film providers to try to save 5% on their film purchases when let’s say 50% of their revenues are being generated by leads that Xpel is giving them for free?  An installer in this situation would see a massive decrease in their business if they ever tried to switch film suppliers.  That is what I consider a huge switching cost.

… and adds to their pricing power

Similarly, if Xpel wanted to raise prices by 5%, is that installer really going to switch film suppliers and sacrifice the half of their business that is generated by Xpel’s leads?  Highly unlikely.  I continue to believe that Xpel has significant untapped pricing power (in part from lead generation), but other than in Canada I don’t anticipate any near-term price increases.  Most investors probably don’t realize that Xpel has not raised prices on their film in many years as they have wanted to grow as fast as possible and cement their dominance in the industry.  I agree with this strategy, and this sort of short-term sacrifice for long-term value is very emblematic of how this management team has consistently operated, which perhaps should not be too surprising as insiders own around 50% of the company.  I do think that they will eventually flex that pricing power, and it has the potential to make a very profound impact on their bottom line.  With 10% TTM EBIT margins, even a 5% price increase would drive a 50% increase in earnings.

Valuation

Xpel is a extremely high growth, high quality business, and as such I believe it should trade for at least 30x after-tax earnings.  With Q2 being reported next month, we should be looking at next 12 months earnings of around $0.30 per share.  As such, I believe that Xpel is worth at least $9.00 per share today, which is consistent with the revenue multiple that Suntek, a significantly inferior competitor, was just acquired for.  Should Xpel continue to execute on their growth opportunities as successfully as they have over the past few years, I see the potential for value to grow far in excess of that amount, and as such even today I believe that Xpel still offers realistic 10-bagger potential over the next 3-4 years as the market develops.

Risks

• They are launching the next generation of their film this year. There are always potential operating issues with any new product introduction (quality control or other such supply disruptions)
• An economic downturn would hinder both new car sales and aftermarket products like PPF
• While the business is quite consistent on a 12-month rolling basis, there can be quarter to quarter lumpiness that creates a short-term risk to the stock price (although doesn't really detract from long-term value).

Catalyst

• Reporting of strong Q2 results next month
• Uplisting to a major US stock exchange