Share Sleuth: Pension debt is a red flag for investors

Last month, I promised to consider adding more shares in Alumasc to the Share Sleuth portfolio. The portfolio already has a small holding in the company, which designs, manufactures and supplies building products. I think it’s a good business that may have found a way of operating profitably in a capricious industry, and that the shares trade at a reasonable valuation.

In fact, I was all set to add to the portfolio’s holding – and then I bottled it. My decision had nothing to do with the business itself. Alumasc supplies the construction industry, which tends to go through cycles of expansion followed by painful contraction in which many companies make heavy losses or even go bust.

Alumasc was last tested during the multi-year slump that followed the financial crisis a decade ago; although profit from building products was less than half its 2009 peak during the three years following the crisis, the group pulled through without making a loss.

I think it avoided losses because it’s a diverse group of businesses split into four divisions: solar shading and architectural screening, roofing and walling, water management, and housebuilding products. It supplies a wide range of products, in other words, that are used in different kinds of building and installed at different phases of the construction cycle for different kinds of customer: public, private, commercial and residential. Many of these products, it says, are premium, market-leading brands.

Levolux solar shading, for example, is used on large office blocks, hospitals and colleges and is often one of the last things to be completed in a building project. Alumasc also sells external wall insulation, often used to make existing social and private housing developments more energy-efficient – business that is not as closely tied to the construction cycle.

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Timloc, Alumasc’s housebuilding products brand, manufactures and sells products that go into houses as they are built – components for cavity walls, vents and loft hatches. While all of these businesses felt the impact of the slump, they experienced it most forcefully at different times, allowing the group as a whole to muddle through.

Today we’re in a different position. All four divisions are humming along, earning healthy operating profit margins of between 10 and 15 per cent. Having doubled export sales last year, the company is expanding its Levolux sales force in the US to capitalise on a building boom.

Alumasc outsources much of the manufacturing and uses third-party installers, so it doesn’t need as much money tied up in factories, machinery and vehicles as you might think, which means return on capital in the year to June 2017 was 26 per cent, surprisingly high for such a prosaic business. Revenue and profit were at record levels, and although subsequent half-year results showed modest declines compared to the same period in the previous year, Alumasc thinks price rises on its popular brands and a surge in revenue from Levolux will allow it to make good the deficit.

A share price of 172p values the enterprise at £89 million, about 12 times adjusted profit – a modest valuation. Even Alumasc’s directors have bought shares recently. The stars are aligned. So why not add more shares to the portfolio? Alumasc is a good business that owes a lot of money to its two defined benefit pension schemes. This means that a substantial proportion of profit that would otherwise be available for dividends or investment is being diverted into the pension fund, and while the company appears to be very profitable, shareholders are not getting all the benefit.

While it’s possible to factor the cost of repaying the pension deficit into the valuation, I can’t do it with much certainty. I think the shares are good value, but the pension schemes mean I have less confidence in my calculations, so I’m cautious, content to hold 2 per cent of the value of portfolio in Alumasc, but not to add more. 

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