QUALIPORT
Ultraframe: The Conservatory Cash Cow

By Maynard Paton (TMFMayn)
May 14, 2001

Carburton Street, London -- Ultraframe (LSE: UTF) is a company good enough to grace anybody's quality portfolio. It's a dominant player in a growing industry, exhibiting fat margins and great cash flow. Furthermore, a recent performance hiccup has caused Ultraframe shares to fall to a reasonable valuation, something prospective investors have not seen for well over two years. And just one other thing -- don't be put off buy its mundane business: conservatory roofing.

The business

Ultraframe is Europe's leading conservatory roofing specialist, designing, manufacturing and supplying a comprehensive range of products and components for this niche industry. Sales are made to third-party conservatory installers, retail outlets, other branded conservatory manufacturers and house builders.

Independent research indicates that the UK conservatory market is predicted to grow by 53% over the next four years. An increasing number of homeowners and businesses (typically leisure ones, such as restaurants, hotels and pubs) are now using conservatories as a cheap way to enlarge their living or trading floor space. What's more, house builders are increasingly tagging on a conservatory to their larger properties too.

Ultraframe's business strength comes in the form of dominating a fragmented market (the company is said to be ten times as large as its nearest competitor), a raft of patents, all-important industry accreditation (which very few competitors have) and a management team that effectively created the marketplace for specialist conservatory roofing.

The financials

Ultraframe floated in late 1997, and up until the latest set of interim results, the financial record had been excellent.

Year to 30 September         1996     1997    1998   1999    2000

Turnover (£m)                42.4    53.6    61.6    69.1    81.8 
Operating Profit (£m)         7.3    12.6    17.2    20.9    26.4
Pre-tax profit (£m)           7.6    12.8    18.5    22.3    27.6

Earnings per share (p)        6.1     9.5    13.9    16.4    21.0
Dividend per share (p)          -       -     5.4     6.6     9.0

The doubling of sales over the past four years has almost entirely been through organic growth, with only two tiny acquisitions helping to boost the top line. Operating margins have surged from a worthwhile 18% to a staggering 33% since 1996, allowing operating profits to compound at an average annual rate of 38% over that time.

Ultraframe's asset-light nature is highlighted in its cash flow statement. Relatively little cash gets sucked into ongoing working capital and fixed asset requirements.

Year to 30 September         1996    1997    1998    1999    2000

Operating Profit (£m)         7.3    12.6    17.2    20.9    26.4
Working Capital Change (£m)  (2.1)    1.7    (0.9)   (0.6)   (4.7)
Capital Expenditure (£m)     (4.2)   (2.3)   (1.4)   (6.2)   (6.1)

In terms of working capital, 2000 did see an unusual increase in stocks, which perhaps was a forewarning of the sales slowdown experienced in this month's interim numbers. On the fixed asset front, the company recently stated that capital expenditure should return to a more normal £3m for 2001. This comes after a total of £12m was spent on additional manufacturing facilities during 1999 and 2000.

Return on equity

The lack of assets historically needed to generate additional sales and profits creates a mouth-watering return on equity calculation.

Year to 30 September         1996    1997    1998    1999    2000

Earnings (£m)                 5.0     8.1    12.9    15.2    19.5
Shareholders Funds (£m)      13.6    20.3    28.2    37.3    49.5
Incremental ROE (%)                                          40.3

Since 1996, shareholders have provided Ultraframe with an additional £35.9m of capital, which in turn has generated additional profits of £14.5m. The incremental return on equity figure is therefore an eye-popping 40.3%. But the really astonishing part of this calculation is that £30m of Ultraframe's £50m asset base is represented by cash in the bank. Stripping out the cash, and the incremental returns generated from "operating assets" are in the 80% stratosphere.

Interim results and valuation

Interim results published last week highlighted Ultraframe's first setback since flotation. Sales in the six months ending March 2001 improved by just 7% over the comparable 2000 period. Pre-tax profits fell 13%.

Ultraframe blamed the wet weather, which had a "serious impact on the rate of installation of conservatories across the UK", and the increased costs associated with the company's new facilities for the growth slowdown. Ultraframe also stated that they did not "expect to see a resumption of growth until the next financial year".

Assuming Ultraframe's current second half matches the second half of fiscal 2000, earnings per share (EPS) of approximately 19.8p can be expected for the twelve months ending September 2001. At 351p, Ultraframe shares stand on a prospective price to earnings ratio of 17.7. 

On a free cash flow (FCF) basis, replacing the depreciation charge with the anticipated £3m of capital expenditure and using the first-half tax charge of 31.7%, the forward FCF per share figure comes to 18.8p. That indicates a FCF yield of 5.3%. All in all, there's no obvious bargain here, especially with near-term profits remaining flat.

Summary

Ultraframe possesses plenty of wonderful financial characteristics. High margins and low reinvestment requirements mean astonishing returns on shareholders' equity and a company brimming with cash. The juicy accounts indicate a real "business franchise".

And the downside?

Firstly, growth warnings issued by smallish companies (Ultraframe is capitalised at £327m) don't tend to come in ones. Going on my own anecdotal experience, I would not be surprised if there were further issues to address at the full-year stage.

Secondly, there is the cyclical nature of building companies. The first cutback any consumer will make in a recession is buying a fancy conservatory. The favourable high operational gearing (additional sales creating proportionately more profit) seen in the past will be substantially reversed in a recession. Remember how that unexpected sales slowdown helped cause a significant drop in profits at the latest interim stage? Of course, few companies are immune to economic turbulence. However, prospective shareholders should expect Ultrafame's profits to be very economically sensitive over the long-term.

And thirdly, there is, I'm sure, little repeat business. Consumers just don't replace a conservatory (or its roof) every year. That leads to a certain amount of business unpredictability.

Overall though, Ultraframe would be a worthy Qualiport member. The great financials and industry dominance, as expounded throughout the company's discussion board, offsets the charges of economic hypersensitivity and the "one-off purchase" operational uncertainty. However, with the average valuation and the recent slowdown in sales growth in mind, Ultraframe just move onto the portfolio watch list for now.

More: Ultraframe discussion board | website