Regulatory tightening, a topic covered in depth by Investors Chronicle’s cover feature last week, can sometimes mean opportunity as well as threat for companies. This appears to be true in the case of sustainable building materials specialist, Alumasc (ALU), which has exploited the niche for its business created by more stringent environmental standards.
The shares top this week’s IC Alpha FTSE All Small dividend yield screen, the only company to pass all eight of our expert Algy Hall’s screening criteria. With a dividend yield of 4.2 per cent (as of market close on Friday 9 March), Alumasc meets the first requirement of the small-cap “Dividend Diamond” screen, which is to have a dividend yield in the top third of companies in the FTSE All Small Index and this is without making any special payments to shareholders.
Of course, a high dividend yield can warn investors of a value trap but Alumasc also passes all the screen’s quality measures. The dividend is covered 2.4 times by earnings and free cash flow is positive at nearly £700.000. Furthermore interest expense on the company’s £3m debts is covered multiple times by operating profit and, with £5m cash on the balance sheet, solvency doesn’t appear to be an issue.
Another question for investors is whether demand for sustainable buildings materials and solutions can support an expansive dividend policy. The forecast earnings growth rate is above 5 per cent for the next full year and for a further 16 per cent increase in EPS over the following twelve months.
These numbers may paint a rosy picture but the share price has not seen very strong momentum over the past three months, up just 3.1 per cent. There are reasons for the market to exercise caution. Although cash flows are positive the cash conversion ratio, which shows how successful the business turns operating profit into cash, is only 29 per cent. Added to the fact that 87 per cent of revenues are derived from the UK, this could lead earnings forecasts to be revised downwards if the UK economy hits the skids and future orders dry up.
When we last covered the company, at the beginning of February, the order book remained healthy at £25m and along with passing tests of the dividend diamond screen, the group’s manageable post-tax pension liability (at £17.1m a not daunting 1.3 times cash profits) attests to a company on a sure financial footing.
Will Alumasc make the IC Alpha portfolios?
According to the peer group analysis on Bloomberg, there is a 14 per cent discount implied by the shares’ historic enterprise/cash-profit (EV/EBITDA) multiple relative to peers. Does this mean there is further upside for shares which have risen nearly 30 per cent since Investors Chronicle first tipped them in February 2015? Possibly, but the Bloomberg peer group did include companies with a much larger market cap, so perhaps we’re not comparing apples with apples.
In any case, the point to consider from a portfolio management perspective, is what role do we want the shares to play for us? The company scores well on our dividend screen but are we really including a £60m market cap company for income? In analysis carried out by London Business School for the Numis Small Company Index (NSCI) review, on the NSCI small companies index the annualised premium for income since 2008 has been 2.8 per cent. Compare that to the momentum premium over the same period, which is 14.2 per cent. So although Alumasc is clearly a well-run company, for the Alpha portfolios we’d rather use our smaller company risk allocations to target shares with more momentum and growth potential.
View all of Algy Hall’s Alpha dividend diamond screens output here
Read our Alpha Quarterly Asset Allocation overview here
*Update*
What timing! In a perfect reminder that stock screens are a starting point for investment ideas, having topped our Small cap dividend diamond screen on Monday, on Wednesday morning Alumasc shares fell 26 per cent on a profit warning. The board forecast group revenues for the year ending 30 June 2018 will be 4-5 per cent below previous expectations with underlying profit before tax around 15 per cent lower.
Management cite continuing delays in building contractor customers committing to new work, exacerbated by the insolvency of Carillion, and slowing construction output in the commercial new build sector. These factors mean a more pessimistic outlook for the Levolux Solar Shading business, the Roofing & Walling division, and the Gatic business within the Water Management division.
Longer term, the board remain upbeat about prospects for growing overseas markets and for integrating their acquisition of Wade, the specialist drainage business. The UK focus is significant, however, and longer term growth strategy depends on large capital investments making good, which with the slower turnover of inventories is a concern.
As mentioned before the warning was issued, we were not going to consider Alumasc for inclusion in the IC Alpha portfolios. Although it scored impressively on the Alpha dividend screen criteria, it’s essentially a value stock, with the yield a signal of future price upside potential. We highlighted that the company was probably too small to be regarded as an essential component of an income strategy and that we would be looking for a different style of premium based on the realisation of value from productive capacity.
We flagged the low cash conversion ratio (the ratio of operating profit converted to cash) as a warning sign and the shares’ weak price momentum of late demonstrated the market also had concerns.
So, are the screens’ quality criteria stringent enough? Well, the smaller cap rules are purposefully less rigorous on metrics such as cash conversion because at this end of the market cap scale, they are value rather than income strategy screens. When looking for companies with the potential to re-rate, it is counter intuitive to penalise those which are not already scoring highly as quality stocks.
What Alumasc’s bad news highlights, is the need to either dismiss a company if it does not meet your investing criteria, as we explained we would do, or conduct further research before buying.
