Selling Xaar: Why Heavy R&D And Cyclicality Are Not A Good Mix

Despite volatile 2012-2015 results, Xaar seemed to have produced long-term growth

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 which 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 £220 million 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).

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 £52 million.

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 £39 million. That was a major blow and any thoughts of Xaar achieving its goal of £220 million 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:

1. why Xaar had collapsed,
2. whether I’d missed any red flags in my purchase review and
3. 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:

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 £4.7 million (about 10% of revenues) on R&D. By 2013, revenues had grown to £137 million and R&D investment had increased to £16.4 million, or 12% of revenues.

By 2016, R&D had climbed to £22.4 million. However, revenues had declined to £76.2 million as the ceramic tile market’s transition to digital printing came to an end.

£22.4 million of R&D was clearly unsustainable as the company was only generating £10 million of operating cash. In fact, investment in R&D, acquisitions and capex was running at more than £30 million.

As a result of this excessive R&D, Xaar’s cash reserves were shrinking.

By mid-2019 it became clear to management that:

1. revenues were going to decline to around £50 million
2. profits from Thin Film printheads were years away
3. 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 £220 million 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 £220 million 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 £220 million 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.

There were two main drivers of Xaar’s collapse:

1. dramatically declining revenues and
2. 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.

In my original purchase review of Xaar (PDF), I said the boom and bust in the ceramic tile printing market could lead to “massive investment in supply capacity (factories, machinery, etc.) which is then left underutilised once demand collapses, with the risk that it becomes an expensive white elephant”.

That’s a pretty good description of what eventually happened.

To me, it suggested that management were possibly over-optimistic, short-sighted or too focused on their growth target.

I would call this a mild red flag and with hindsight I should have paid more attention to it.

A much larger red flag was the dramatic decline in revenues and earnings after 2013.

My investment checklist (as it was in 2018) included the question:

Does the company operate in markets where demand is expected to grow?

I answered yes, and said that in aggregate I thought Xaar’s end markets would grow over the next ten years.

I still think that’s right. But what I didn’t think deeply enough about was whether Xaar was likely to hold onto its share of those markets.

With hindsight, what I should have done (which I’ll do in a moment) is look at Xaar’s underlying markets to see how it had performed in each one over the previous ten or fifteen years.

That would have given me a better insight into Xaar’s ability to retain market share captured during a market’s initial transition to digital printing.

As a general rule though, and somewhat obviously, defensive investors should be wary of companies where revenues and earnings are obviously very cyclical.

I was, but I wasn’t wary enough.

For several years, most of Xaar’s revenues were generated by a single product (the Xaar 1001) sold into a single market (ceramic tile printing). This was an obvious example of concentration risk.

I thought Xaar’s patents would protect it from competing products, somewhat reducing the risk of obsolescence, but that wasn’t the case.

Once purchased, a Xaar printhead might last five or ten years. That gives competitors a lot of time to develop better and/or cheaper printheads which don’t infringe Xaar’s patents.

As a result, Xaar’s printheads were often replaced with alternatives as they became available.

One of the most important changes to my investment checklist is that it now begins with a clear question:

Has the company demonstrated consistent earnings power?

In other words, has the company produced revenues and earnings which have trended upwards, reasonably steadily, for many years?

Xaar clearly fails at that first hurdle. Its earnings per share went from virtually zero in 2009 to more than 40p in 2013 and then back down to about 10p in 2017.

That is not what I’d call consistent earnings power and its revenues have been almost as volatile.

While Xaar’s volatile results are not ideal for a defensive value portfolio, the real problem is what they say about the company’s competitive strengths and its ability to retain market share over time.

To show you what I mean, we need to look under the covers by separating out Xaar’s revenues by primary end market. These are: graphic arts, packaging and industrial.