Description

Xpel Technologies is a high quality automotive paint protection film business that is growing at 100% yet incredibly trades for only 6.7x EBIT. This is an exceptionally cheap valuation considering Xpel’s recurring revenues, strong growth profile, high returns on capital, barriers to entry, and customer diversification.

More importantly, the growth story at Xpel is still in the first inning; only 1-2% of new cars in North America get paint protection film installed today, but recent technological improvements have finally made the product viable and I believe have the industry poised for a 10-fold increase with 20%+ adoption rates as consumer awareness continues to increase. I think the business is easily worth $1.50 per share (12x next 12 months EBIT of $3.0 M), and considering the incredibly strong growth profile here, I believe there is even realistic 10-bagger potential over the next three years as the market develops and operating margins increase. A 5x increase in volumes from current levels and 25% operating margins yields a price of $9.00 per share at 10x EBIT.

Overview

Xpel sells paint protection film predominantly in North America (~70%), although they do have a presence internationally where they go to market through distributors (~30%). The film is sold to local installers/car detailers, who in turn sell the film and install it on cars for end consumers. Installers generally charge around $500 - 1500 for the job, although prices can vary greatly due to the extent of coverage that the consumer desires. The film is applied to protect the body of the car, particular the front-end, from dents and chips often caused by rocks.

The film sold by Xpel is either in the form of bulk sheets or pre-cut kits that they have designed for every make and model combination of car. They also sell access to their database of designs (10,000+ designs) for installers that want to cut their own paint protection kits should they have the necessary plotter already in-house. Overtime, however, Xpel has been shifting the business to encourage purchases of their own film rather than have customers license their Design Access Program software and use 3rd party film. This shift has actually understated the underlying growth in film/kit sales which actually grew at a 130%+ rate in the most recent quarter.

Growth

Xpel’s growth over the past 2-3 years has been consistent and exceptional. The business has posted 9 consecutive quarters of revenue growth in excess of 45%, with 100% year over year revenue growth in the most recently reported quarter. Importantly, as mentioned above, the market for paint protection film is still in the very early stages of the consumer adoption cycle, and so the overall market is poised to increase in size exponentially over the next five years with Xpel Technologies being the prime beneficiary.

Over the last 9 quarters Xpel has posted the following revenues and growth. There is some seasonality from car sales (Q3 strongest, then Q2, then Q4, and with Q1 being the weakest), so the year over year growth is most relevant:

Q2 2013      $4.9 M      +100%
Q1 2013      $3.2 M      +58%
Q4 2012      $3.0 M      +67%
Q3 2012      $3.2 M      +89%
Q2 2012      $2.5 M      +66%
Q1 2012      $2.0 M      +88%
Q4 2011      $1.8 M      +90%
Q3 2011      $1.7 M      +46%
Q2 2011      $1.5 M      +45%

Ultimate Film

Xpel’s growth surge that began two years ago coincided with the release of the Ultimate film, which now comprises around 80% of film sales. The Ultimate film was a quantum improvement over prior films, which thus allowed Xpel to not only gain significant market share but to also grow the overall paint protection market. If you spend any amount of time on the various car enthusiast forums on the internet, you will quickly determine that the Ultimate film is pretty much universally viewed as the best paint protection film in the market.

Historically paint protection films have had a multitude of issues, which become increasingly noticeable with the passage of time -- “orange peel” texture, cloudiness, yellowing, etc. Xpel’s primary competitors, 3M and Avery Dennison, still have similar issues with their films. Furthermore, Ultimate film has a unique property where it is actually self-healing. If the car is scratched, applying hot water to the surface of the car and waiting 30 seconds causes the scratch to magically disappear. The improved quality has also allowed Xpel to provide longer warranty terms than competitors, which obviously resonates well with consumers.

The improvement in film quality is important on two levels. First, it has allowed Xpel to become the quality leader in the industry, gain market share, and build tremendous brand value with both consumers and local installers. More importantly, however, it has dramatically expanded the size of the market. Because of the aforementioned issues that paint protection film used to have, this has historically been a very niche market with low adoption rates. Improvements in technology, however, as evidenced with the Ultimate film, have dramatically increased the size of the market. To put it bluntly, these films basically didn’t work and as of only a few years ago, and now they work exceptionally well. It takes time, however, for consumers to learn about and realize the benefits of having this film applied to their cars.

Market Opportunity

There is limited data on the overall market size in the US, but I believe that currently around 1-2% of new cars are getting paint protection film installed today. Window tinting, in comparison, has a 60% penetration rate. Right now penetration rates vary extremely widely geographically based on consumer awareness of the product. Mountain states like Colorado have penetration of 30-40% whereas in other major states adoption is negligible. The Calgary paint protection film market, for example, is 10-20x larger than Toronto despite being a much smaller metropolitan area by population. While I certainly don’t expect paint protection to achieve the market penetration of window tint, when you consider the cost/benefit of paint protection I can easily see the market eventually reaching 20%+ of all new cars. Clearly an increase in the overall market size by a factor 10-20x bodes well for the future growth potential of Xpel. There is also significant growth potential internationally -- particularly in Western Europe -- but with so much untapped opportunity still in North America, it’s probably not worth delving into in significant detail nor is it likely a near-term focus of management.

Pricing Power

Another interesting aspect to Xpel is that I believe the company has significant untapped pricing power. I believe this would allow the company to double its operating margins from 13% to around 25% and provide another layer of growth on top of the significant volume increases.

While it’s difficult to quantify the magnitude of potential price increases here, I feel confident that Ultimate film could be priced a lot higher if they wanted to. You probably need to speak with a lot of film installers and car enthusiasts to fully appreciate this, but the Ultimate film is far and away better than anything else in the market. Furthermore, film is only around 10% of the cost of an installation -- a $750 install job has around $75 in film. Ultimate Film could easily command a much more significant premium as it’s the only film that’s probably not going to have yellowed in five years, and the longer warranty terms that Xpel is able to offer as a result make it an easier sale to consumers. Finally, because operating margins are “only” 13%, you only need a 10-15% price increase to double operating margins to 25%.

As for why Xpel hasn’t already taken advantage of this pricing power, I think the answer is somewhat obvious. When you’re growing at 100%, there simply isn’t a lot of incentive to milk even more money out of the business through price increases. Instead, management has been doing the smart thing by keeping prices relatively low in order to scale the business rapidly and widen the moat. In the meanwhile the company continues to expand their distribution network of trained installers and build considerable brand value, both of which will serve them well when it comes time to start taking advantage of some of this untapped pricing power.

Recurring, Low Risk Operating Model

On top of the attractive growth profile, I think it’s important to appreciate just how high quality Xpel’s business is:

• Revenues are very recurring because they are tied to new car sales which are around 15 M units annually in the US, but do not fluctuate significantly on an annual basis. From 2001 to 2007 they were actually consistently in a tight band of 16-17 M units; there is probably upside to the current 15 M unit levels, although you obviously don’t need to count on it here.

• There is no customer concentration at either the end consumer or installer/dealer level. There isn’t even any meaningful geographic concentration. It is a very diversified business.

• It’s a capital light business that doesn’t require additional capital to grow. Returns on capital are over 100%. As a result, cash will continue to pile up on the balance sheet at a rapid rate even if the business was to double or triple in size.

• They have a number of competitive advantages that create a barrier to entry: a large dealer network that has been trained to install their product, a very strong brand, and a database of tens of thousands of individual kit designs that competitors need to recreate. If you research the industry, there have been many companies that have tried to enter the business and failed.

Transition Away From DAP’s Gross Margin Impact

One thing that I wanted to clarify because I’m sure it will get asked about are Xpel’s gross margins. While operating margins have consistently been flat-to-up-slightly, gross margins have fallen from over 50% to 30%. This is simply due to the transition away from Design Access Program fees to film sales that I referred to above, and for the purposes of margins the transition is pretty much done.

If a customer wants to use their database of designs but not their films -- they have the best design database in the industry, so there used to be a lot of installers that did this -- they understandably have to pay very hefty design fees to Xpel. In large part to the Ultimate film’s success, you had a lot of these installers over the past 2 years just shift their film purchases to Xpel. As a result, the company was trading off the 100% margin design fee revenue for 35% margin film sales. The company gets more margin dollars by doing this, but a lower margin percentage. Furthermore, it’s clearly a stronger, stickier business model for the company to have both the design and film business of a given installer, and not just design fees. DAP fees have become so small now that the shift is no longer impacting gross margins and you can see that they have stabilized in the 30-33% range over the past four quarter.

Management/Ownership

The CEO, Ryan Pape, has done a terrific job at commercializing the Ultimate film, and he is well incented with share ownership of around 6% of the company. I have been impressed by Ryan and feel confident in his ability to take advantage of the huge growth opportunity in front of Xpel. The COO owns 4% of the company. Another 33% of the company is owned by three of the directors. In total, inside ownership is over 43% and so the float is relatively small. Management has acted very prudently and like true owners with no stock options or dilution of any sort.

Conclusion

I think it’s very rare to find a high quality business like Xpel, growing at a 100% rate, in a market poised to increase potentially 10-fold, trading for only 6.7x EBIT.

Due to the strong growth and operating model detailed above, I believe the company will eventually trade for a very, very high multiple once it gets discovered by investors, which I think is on the verge of happening now. This is a US listed company trading on a Canadian exchange and so the stock has languished in obscurity. I believe management understands the importance of a US listing, and this should serve as a catalyst when it happens. The company is also finally getting to the market cap levels (~$20 M) where they are starting to attract the interest of smaller institutional investors. Also, management has never done any investor relations and are finally talking about starting quarterly conference calls as early as Q1 and also potentially presenting at their first investor conference as early as December of this year. The reporting of Q3 results should also serve as a catalyst as this will no doubt be a record breaking quarter considering how strong car sales are during July and August.

Catalyst