- Xaar is a relatively young and small leading-edge technology business which I bought in mid-2018
- It’s a good example of how excessive R&D in highly cyclical businesses can produce bad results
- I sold because a 90% increase in Xaar’s share price since November means the company is no longer obviously cheap
- Although Xaar was a bad investment it has helped me define the boundaries of my comfort zone, which is defensive value stocks
When Xaar joined my portfolio in June 2018 I knew it was close to the edge of what I felt comfortable investing in. Unlike most of my investments, which tend to be fairly large, established market leaders, Xaar was a relatively young disruptive technology business with a track record that was relatively short and inconsistent.
It was set up in the 1990s to commercialise digital inkjet printing technology and, by 2013, had grown substantially to peak revenues of £140m. When I invested in Xaar its revenues had declined from that peak, but it looked as if the company had turned a corner and returned to growth.
But I was wrong. Xaar’s results became consistently worse through 2019, eventually leading to massive writedowns, huge losses and the departure of the chairman, CEO and CFO. As a result of Xaar’s rapid decline, I carried out a thorough review of the company and my investment process in November to see where both Xaar and I had gone wrong.
That review reaffirmed my preference for “defensive value investing”, which to me means investing in:
- a diverse portfolio of
- market-leading businesses with
- long track record of consistently high profitability driving
- sustainable inflation-beating growth thanks to
- durable competitive advantages.
In the rest of this post-sale review I’ll outline why I bought Xaar in the first place, what went wrong and why I no longer think Xaar is a suitable holding for a defensive value portfolio.
I bought Xaar because it was highly profitability, had grown substantially and seemed to be attractively valued
As I’ve just mentioned, Xaar was created in the 1990s to commercialise potentially disruptive digital inkjet printing technology. Initially Xaar achieved this by licensing its patented know-how to printer manufacturers for a fee. After a while, Xaar acquired manufacturing facilities and started to manufacture inkjet printheads for commercial and industrial printer OEMs (original equipment manufacturers).
Xaar was successful and grew, somewhat lumpily, to peak revenues of almost £140m in 2013, driven largely by the ceramic tile printing market as it converted to digital printing. When Xaar joined my portfolio in 2018, those revenues had fallen back to £100m as the ceramic tile printing market matured. My assumption at the time was that the ceramic tile market would stabilise, with Xaar retaining significant market share following the initial transition to digital printing.
Here’s a snapshot of Xaar’s financial results when I bought it in mid-2018:
The chart above shows how revenues and especially earnings exploded upwards as the ceramic tile printing market switched to inkjet from around 2010 to 2013. That boom was then followed by an inevitable decline in sales as the transition came to an end. This is normal because once most end users have switched to digital printing, they don’t need to upgrade their printheads for several years. When I bought Xaar in 2018 it looked as if its revenues had already stabilised and started to recover.
The chart also shows that capital employed was the only metric that consistently went up. That was driven by heavy R&D investment into Xaar’s groundbreaking Thin Film technology. Thin Film was supposed to help drive the company towards revenues of £220m by the year 2020, but instead in nearly drove Xaar off a cliff (I’ll have more to say on that shortly).
The rapid increase of capital employed, combined with Xaar’s declining post-2013 earnings, meant that return on capital employed had declined to less than 10% by 2017. At the time that was a mild red flag as I don’t like to invest in companies where return on capital is below 10%.
However, Xaar’s average return on capital for the decade was above 10%, thanks to super-normal earnings from 2012 to 2014, so I wasn’t overly worried about what could be just a short-term decline in profitability. The company also had no debt and few lease liabilities. Both of those are attractive features for most businesses, but they’re near-necessities for relatively young and volatile technology businesses like Xaar.
One other thing I liked about Xaar was its position as the world’s leading pure-play digital inkjet manufacturer. While there were bigger printhead manufacturers out there, none specialised purely in digital inkjet. But what I didn’t realise at the time, was that being the world’s leading pure-play competitor is a relatively useless accolade.
Why? Because it doesn’t necessarily mean you’re the true market leader, so it doesn’t necessarily have any of the advantages of true market leadership (most of which relate to scale and brand awareness).
Xaar soon ran into some very serious problems
Shortly after Xaar joined my portfolio in mid-2018, management announced that sales into the ceramic tile printing market were falling much faster than expected. Soon after that the dividend was suspended, and then in late 2019 Xaar announced a seriously bad set of results. Revenues were down more than 36% and profits had turned to losses of £52m.
More importantly, management announced that they had effectively run out of cash to fund the remaining development and industrialisation activities required to bring Thin Film technology to market. All Thin Film R&D activities were cancelled, and the value of related equipment, inventory and R&D were written down by £39m. That was a major blow and any thoughts of Xaar achieving its goal of £220m of revenues by 2020 went up in smoke.
Unsurprisingly the CEO, CFO and chairman left soon after and a new CEO was given the task of understanding what went wrong, fixing the problems and turning Xaar around.
The speed and severity of Xaar’s decline surprised me, so I decided to review the situation to understand:
- why Xaar had collapsed,
- whether I’d missed any red flags in my purchase review and
- whether Xaar should stay in my portfolio or be sold immediately
What follows is an updated summary of my post-disaster review of Xaar, which I first published in November 2019:
1) Why did Xaar collapse?
The root cause of Xaar’s decline was a mismatch between the amount of cash needed to fund the development of its new Thin Film technology and the amount of cash generated by existing product sales. This mismatch was driven by a rapid decline in Xaar’s revenues after 2013 and a far less rapid decline in its R&D investment.
For example, in 2010 Xaar spent £4.7m (about 10% of revenues) on R&D. By 2013, revenues had grown to £137m and R&D investment had increased to £16.4m, or 12% of revenues. By 2016, R&D had climbed to £22.4m. However, revenues had declined to £76.2m as the ceramic tile market’s transition to digital printing came to an end.
£22.4m of R&D was clearly unsustainable as the company was only generating £10m of operating cash. In fact, investment in R&D, acquisitions and capex was running at more than £30m. As a result of this excessive R&D, Xaar’s cash reserves were shrinking.
By mid-2019 it became clear to management that:
- revenues were going to decline to around £50m
- profits from Thin Film printheads were years away
- Xaar could not afford the remaining Thin Film R&D and industrialisation costs
As a result, the revolutionary Thin Film technology which was supposed to turn Xaar into a £220m revenue company had instead almost killed it. But I don’t think this crisis was even remotely inevitable.
In my opinion, management became fixated on reaching their “vision” of achieving £220m revenue by 2020. To reach that goal, they knew Thin Film products would be absolutely necessary, so they continued to fund Thin Film development even as it became clear that Xaar didn’t have the funds to bring it to market. They then announced that Xaar would need a strategic partner to share the costs (and benefits) of bringing Thin Film to market.
However, as the months ticked by no strategic partner appeared, and yet the company continued to invest heavily in launching Thin Film. They even signed up three major Thin Film customers, even though Xaar lacked the strategic partner it absolutely required.
Soon after that, Xaar simply ran out of cash to fund its Thin Film dream any longer. Many people lost their jobs and Xaar had failed in a very public and brand-damaging way. In my opinion this could have been avoided if management had not been so focused on achieving their goal of £220m in revenues by 2020.
I think Xaar’s management should have scaled back R&D in line with the company’s post-2013 revenue declines. That would have set the Thin Film programme back by several years, but it would have kept it alive and would also have allowed more cash to be reinvested into the existing core business and core products. In addition, I don’t think management should have signed customers up for Thin Film products knowing that they wouldn’t be able to fulfil those orders without a strategic partner, which they didn’t have.
Management were, in effect, crossing their fingers and praying for a knight in shining armour to appear. And unfortunately for everyone involved, their prayers went unanswered.
2) Were any red flags missed in the purchase review?
There were two main drivers of Xaar’s collapse:
- dramatically declining revenues and
- management’s decision not to cut R&D funding
I don’t think it was obvious that management were going to keep funding R&D even when cash flows were obviously insufficient to support it, so I’ll focus on Xaar’s declining revenues.
Red flag 1: Management’s lack of caution during an unsustainable market boom