Alumasc: Building a better future?

When I looked at this building products company last summer, it had some interesting features. It was a cheap Superstock with a reduced pension deficit and delivering in-line trading under challenging market conditions. I had some concerns over the possibility of empire-building and the sector itself. Last week’s Interim Results prompted me to take a second look.

Summary

• On the surface, Alumasc (LON:ALU) is a cheaply-rated company trading on a forward P/E of around seven and a dividend yield approaching 6%.
• The company has been transformed by jettisoning its loss-making Levolux subsidiary and, in recent years, has generated returns on capital above 20%, suggesting it possesses a competitive advantage in its core sectors.
• The company operates in competitive, cyclical industries. However, the company has outperformed their weak end markets, generating modest revenue growth.
• The company’s Housebuilding Products division is actually the highest margin part of the business, as their modern manufacturing gives them a cost advantage. If this can be replicated across other divisions, then this could lead to higher margins and a further step change in profitability.
• However, investors will want to adjust the figures to account for the pension deficit and “non-underlying” costs that are sizable and occur almost every year. This adjustment may mean that the price-earnings ratio is closer to ten, hence not as cheap as an initial look suggests.
• The share price has been range-bound for the last 20 years, as the company has acquired and sold various subsidiaries. Their latest acquisition is not obviously a bargain. Cautious investors may want to wait until there is evidence that the company can generate top-line growth before investing.

Profile

Alumasc is an AIM-listed building products manufacturer. It traces its history back to the mid-20th Century when it sold aluminium beer casks. In 1960, it became part of the mining giant Consolidated Gold Fields. In 1984, it was taken private by former Chairman John McCall. A stock market flotation followed in 1986. During the 1980s & 1990s, Alumasc focussed on the manufacture of precision engineering components as well as aluminium beer casks. Out of these skills, the Group developed aluminium rainwater and drainage products. As the UK became less competitive for non-precision manufacturing, these businesses became the bulk of the company, and the Building Products division became the larger of the Group’s two divisions. By 2007, all the non-precision engineering businesses had been sold off.

In the same year, Alumasc acquired Levolux, the UK’s leading solar shading company, with the aim of creating a sustainable building products division. For many years, this performed well, but latterly had been a millstone around the company’s neck and had become loss-making. In 2022, this was sold off for £1, with the company having to give the acquirer the £1.7m of cash on the Levolux balance sheet for the “acquirer” to take it off their hands.

The company has made a few other acquisitions over the years but has not been a prolific acquirer. In 2008, they acquired Blackdown Greenroofs and Rainclear Systems. In 2018, they acquired Wade, a leading manufacturer and supplier of quality drainage products. Most recently, they acquired ARP Group at the end of last year, a manufacturer and distributor of specialist metal rainwater and architectural aluminium products.

Business Model

The Group now consists of three divisions. Water Management, Building Envelope and Housebuilding Products. Water management accounted for almost half the revenue in the half-year just reported:

This will increase further in the future as the recent acquisition of ARP Group sits within water management. Operating profit is a little more balanced since Housebuilding Products has a much higher margin:

Still, this is dominated by the Water Management division when ARP Group is added in. The company’s products are used in many places in non-residential construction:

One of the recent growth areas has been airport drainage, where narrow draining channels are an important feature:

In Building Envelope, typical products look like this:

Housebuilding Products are sold under the Timloc brand:

Despite structural changes in the business, the shares have been largely range-bound over the last 20 years:

The market cap of £66m makes it a small cap share.

While the net debt is relatively modest despite spending on the recent ARP acquisition:

However, it may be noted that gross debt stands at £14.5m, so this may represent a favourable working capital position. No average net debt position is given.

On top of this, there is a Pension Deficit, which currently has a liability of £4.8m, according to accounting calculations. Current recovery payments are set at £1.2m per annum, so £4.8m probably represents a good estimate of the current liability. However, this is a very large scheme compared to the size of the company. In the 2023 Annual Report, they said:

Lower valuations led to scheme assets decreasing in the year, by £15.8 million, to £71.5 million. Scheme liabilities decreased by £13.6 million to £75.8 million, due to an increase in the discount rate.

So, any fall in interest rates may lead to a bigger deficit and higher recovery payments. On top of this are £2.3m of Provisions on the balance sheet, consisting of dilapidations, warranty and restructuring. As costs that have gone through the P&L but are yet to be settled in cash, it would be prudent to treat these as debt. This gives a “real EV of £80.8m excluding lease liabilities and £85.6m including them.

The company is a Superstock:

However, compared to the last time I looked at the company, the Quality Rank has declined, but the Value Rank has risen. It is worth looking into these changes in more detail.

Competitive Landscape

Strategy

The company has four strategic priorities: accelerating sales growth by developing new products and expanding their sales geographies, driving margin improvement, championing sustainable building products and Value-enhancing investment. The company is willing to invest organically and via acquisition to achieve these aims.

Competitive Advantage

Despite the declining Quality Rank, the company has excellent returns on capital:

The historical values are more volatile, with the company struggling in 2019, even before COVID-19 hit.

This is primarily due to the performance drag of Levolux, which was already struggling. They never managed to turn this business around, and the classification of this business as discontinued and subsequent “sale” led to a step change in performance for the Group.

After removing Levolux, the operating margin figures hide quite different business performances between divisions:

Despite having the lowest revenues, the Housebuilding Products division appears to be the jewel in the crown, with consistently higher operating margins. Given the weak housebuilding sector, this is an excellent performance. On the recent results presentation, I asked management what meant they could maintain such a high margin here, and their answer was that they had developed high-quality products that are in demand for their environmental benefits and that Timloc was leading the way for the Group in terms of manufacturing excellence, including increased automation. They also mentioned that their merchant sales model worked well as they maintained a niche of next-day-delivery sales and could deliver directly to site.

Water management is consistent but has a lower margin, and Building Envelope is lower and more volatile, reflecting a much more cyclical business. There is the potential to mimic the success of Timloc and drive further margin improvement in these businesses in the long term.

When I last reviewed the company, the quality rank was 93 and has now fallen to 63. This looks ominous, but when I look into the details, the only significant change I can see is the drop in the Piotroski F-Score from seven down to four. However, this looks a little harsh to me. For example, debt has increased only very slightly despite an acquisition, leading to this condition failing:

Likewise, a 1% drop in Gross Margin causes this failure:

Fundamentally, I don’t believe the quality of this company has declined recently, and it pays to look into the details when assessing factors like this.

Financials

Growth and Profitability

Revenue growth has been unimpressive and is essentially flat over five years:

However, this is forecast to grow modestly over the next few years, primarily due to the acquisition of the ARP Group rather than organic growth. EPS growth has been far better than sales:

But again, this is largely due to the gains from exiting the Levolux business. Breaking this down into divisions, the Building Envelope division has been the most volatile, with little growth. Growth in the other divisions has been modest but more predictable:

In the Interim Results commentary, management say:

The Board remains confident in achieving full year expectations, despite the expected continuation of UK demand headwinds and the further delay of a significant export contract in Hong Kong.

So, it appears that trading may be a little ahead overall. Brokers have certainly taken this as such, with some small upgrades to EPS:

Balance Sheet

The balance sheet isn’t the strongest:

And the gross gearing is perhaps a little high, especially when the pension deficit is included:

But overall, there is little sign of financial distress, and shareholders shouldn’t be scared away from holding the equity here by the rest of the capital structure:

Cashflow

Cash flow is one of the strongest areas, although this is only rated amber by the Stockopedia algos, 5.6x Price to Free Cash Flow is an outstanding figure:

This is perhaps a little flattered by recent performance:

And partly due to lower working capital requirements that may not repeat:

The trend is positive, which counts for a lot, particularly as the recent acquisition was largely funded from operating cash flow.

Dividends/Buybacks

The company pays a dividend that has been increased by a few per cent each year, recently, apart from the COVID-impacted 2020, when they choose to retain the cash:

The company doesn’t currently engage in a buyback, preferring to retain cash for any future acquisitions.

Ownership Structure

The largest shareholder remains former Chairman John McCall:

A few smaller institutions on the register have been reducing recently, perhaps reflecting the outflows from small cap funds.

Although recent director buys are not particularly sizable, since 2022, directors have not been selling to cover taxes and costs when they have exercised options:

This perhaps suggests that directors see some value at current levels. Although a director exercised options and sold around half of the shares yesterday, that has yet to appear in the summary above, suggesting any short-term positive trading may be viewed as in the price by the board.

Valuation

The company is very cheaply rated on a number of metrics:

However, this is not a tangible book value play, so this provides little downside protection. As I have commented before, this is often the price that investors pay for high returns on capital, and this is a trade-off shareholders should be willing to make.

I am more concerned about these metrics hiding some factors that shareholders would consider relevant. The first is the pension deficit. One way to adjust for this would be to add the £4.8m deficit to the Enterprise Value. However, this figure changes rapidly based on assumptions, and we don’t get any correction to the P/E. Perhaps it would be fairer to take the £1.2m annual cash contribution from Net Profit to give a forecast of £7.75m, 21.5p EPS and a P/E of 8.8.

On top of this, this company likes to present adjusted figures. Here is the recent history of those adjustments:

Excluding intangibles seems to be par for the course these days, but I note that this is a company that is still capitalising additional organically generated intangibles. Acquisition costs appear to be a genuine one-off. However, pension scheme interest is an ongoing cost as long as they have a scheme. Most obviously, restructuring appears to be anything but a one-off for this business. In the last five years, they have only had two halves without restructuring costs. Restructuring costs average £565k/year.

I am sure these costs have been signed off by their auditors, but for me, they have rather blotted their copybook by suggesting shareholders ignore what appears to be real and ongoing costs of doing business in a highly competitive sector. If I include the average figures, then this decreases the EPS to 19.9 and increases the P/E to 9.5. This may still represent good value, but the bull case is less obvious when I include these ongoing business costs in my value assessment.

This business isn’t alone in utilising the leeway that accounting regulations afford them in order to put their best foot forward. Companies such as Strix (LON:KETL) , MPAC (LON:MPAC) , and Portmeirion (LON:PMP) perhaps ask investors to accept even larger gaps between the figures they present and economic reality. But our role as investors is to see through this hand-waving.

Risks

The most significant risk for me is the company pursuing acquisitions at any cost. Their track record with acquisitions has been patchy, as the recent abandonment of Levolux has shown. Their other acquisitions don’t appear to have driven a step change in growth or profitability. In this light, there is a risk that they have overpaid for ARP. They said:

The acquisition multiple based on the initial consideration is approximately 6.8x, which is expected to reduce to below 5.0x over the medium term, assuming full payment of the earn out consideration, and achievement of expected operating synergies.

These multiples don’t look enticing and are above what Alumasc is trading on. This may partially reflect how cheaply priced UK small cap equities are, but as always with acquisitions, the risk of empire-building or something going wrong remains. The alternative would have been to use the capital on a share buyback program. This would have enhanced earnings more and without the risk of uncertain operating synergies.

The other risk is the cyclicality of the business. However, it seems that many sectors in which the company operates are now close to cyclical lows. No one knows when a recovery may occur, but this will eventually be a tailwind, not a headwind for the business.

Recent Trading

The company reported H1 results to 31st December 2023 earlier this month. These showed modest sales growth and improving margins, apart from Building Envelope:

· Group revenues up by 6.4% to £47.8m (H1 FY23: £45.0m)…

· Underlying Group operating margin of 14.1% (H1 FY23: 13.4%).

The outlook for the sector is weak, but the company expects to outperform, in line with expectations:

The Board does not expect the current demand headwinds to alleviate significantly in the second half of the year. However Alumasc has a proven track record of outperforming its UK construction end markets through product innovation, experienced management teams and its focus on best in class service and operational excellence. The Board therefore remains confident in the Group achieving its full year expectations.

Their NOMAD, Cavendish, kept the forecast the same, but it looks like Peel Hunt (whose notes are not available to individual investors) may have upgraded their forecasts:

The interesting thing is that a large project for CLK airport in Hong Kong has been delayed. There are no guarantees that this will be delivered in 2025, but if it is, it could lead to further upgrades.

Sentiment

The Momentum Rank is excellent:

This reflects positive relative strength over all recent periods:

And is helped by those minor recent broker upgrades:

Conclusion

There is a lot to like about this company. It has created a niche of products that deliver environmental benefits to customers and are price-competitive despite being manufactured in the UK. This is reflected in their high operating margins and excellent return on capital. The housebuilding products division appears to be the jewel in the crown. If the other divisions can replicate its manufacturing excellence, then there may be scope to improve margins further.

In light of this, it would appear to be a bargain on such a low Price Earnings ratio, particularly since current trading may represent a cyclical low for most of their markets rather than a high. However, despite its profitable niche, the company has struggled to grow organically over the long term, and its acquisition record is patchy. When investors make their own adjustments rather than relying on the surface view, the company may not be as cheap as it first appears. More worryingly, management presenting heavily adjusted figures may indicate a poor underlying corporate culture. This takes the shine off an otherwise great set of results in current market conditions.

The returns on capital are excellent, suggesting that the company has developed a strong competitive advantage within their product niche. However, the company has been unable to deploy additional capital to grow sales, meaning that this high return on capital has not generated additional shareholder value. Shareholders may want to wait for signs that the company can generate long-term sales growth before investing. Otherwise, despite positive recent share price momentum, they may suffer the range-bound returns that have plagued the company over the past few decades.