James Faulkner on Xaar (XAR) – Value Opportunity or Falling Knife?

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A month ago I warned that profit warnings usually come in threes, according to the old adage, so I wouldn’t be surprised to see Xaar scale back near-term guidance again, perhaps later in the year. Well, that time has come earlier rather than later, and Xaar shares have fallen by another 132p this morning, to 235p.

At the current price, the entire shares price rally of 2013 has now been wiped off the firm’s valuation. So are we in serious value territory here, or is Xaar now in the grip of some serious long-term problems?

Picking over today’s statement, we see that today’s fall is the result of further reductions in orders from OEMs in the ceramic tile market in China, which seems to be in the grip of a major decline brought on by a slowdown in construction activity. As a consequence, management now expects total revenue for 2014 to be 5%-10% below the bottom of the previously announced range of £115-125 million, and points to visibility for 2015 being “low”. This last point taken together with the fact that management is now taking action to implement cost reductions – including a 15% reduction in operating expenditures, and potentially a total reduction in headcount (subject to consultation) of approximately 20% of the current global workforce of around 800 employees – suggests that Xaar has been surprised by the scope of the current downturn. So what impact has this had on forecasts?

Broker Singer has put through some pretty stonking reductions to its estimates on the back of this profit warning. With the caveat that its revised estimates are set at the bottom of the new range of revenue guidance, its pre-tax profit forecasts have fallen by 25% for 2014, 47% for 2015 and 45% for 2016, despite the c.15% (c.£4 million) reduction in operating expenses in 2015 vs. 2014, reflecting the group’s high operational gearing. On these numbers, the trough year for earnings looks set to be 2015, for which Singer anticipates EPS of 17.3p per share.

So what about the valuation?

With around two-thirds of Xaar’s revenues emanating from a market that appears to be in the grip of a severe cyclical downturn, we can attach little confidence to forecasts, even after today’s downgrades. The Chinese economy has been suffering from excess capacity problems for some time now, and it remains to be seen how the situation will unwind. For Xaar, the real hope now lies in tapping new markets through new product launches, so there is still a growth story here.

I would also point out that the company has the financial muscle to withstand a downturn, given that there is a net cash position of c.£48 million. However, in the meantime, operational gearing could eat further into profits in the even a further weakening of the ceramic market, which means this business is very hard to value. Moreover, while the cash position provides some support, the market cap is still some way above at c.£180 million. I still believe Xaar has an exciting future, but for now at least, the jury’s out as the the extent of the firm’s short-term problems.

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