Installux: Switching Cost Competitive Advantage from France

Installux Aluminum is a French aluminum profile system provider. It’s undervalued because it seems to have switching cost competitive advantage, average growth prospects and price tag that doesn’t seem to be outrageous.

Key figures (MEUR, rolling 12m)

Revenue 116
EBITDA 15.6
EBIT 12.0
EBIT after tax 8.0

Market cap 100
Net debt -25
EV 75

EV/EBITDA 4.8
EV/EBIT 6.2
EV/EBIT after tax 9.3

EBIT% 12%
ROIC 25%

1. Switching cost competitive advantage

There are a lot of buildings in the world. Each of those buildings have their own design, size, shape and form. Because buildings are different they also have different doors, windows and facades (and many other parts).

Those doors, windows and facades are typically held together by some kind of profile. The profiles are designed by architect/engineer based on wanted physical qualities (look, measures, strength, insulation etc.).

The profiles can be wooden, aluminum or some other metal, but I will focus on aluminum. Building trends are toward aluminum profiles because of their low weight, visual appeal and because they help in building energy-efficient buildings.

Because each building and therefore their (aluminum) profiles for doors, windows, and facades are different, there are no standardized door, window or facade profiles available on the market. They must be customized to fit the purpose and the building every time.

To get the (aluminum) profiles customized, aluminum profile industry has evolved to separate aluminum profile system providers and to local profile assemblers.

1.1 Aluminum profile system providers

Aluminum profile system providers design, manufacture and distribute aluminum profile systems.

Aluminum profile system is a series of standardized aluminum pieces that can be easily connected to each other to build any kind of profile structure, in Installux’s case customized profiles that hold together doors, windows and facades.

Typically the profile system pieces and parts are long rails, tubes and connectors in different shapes and forms that can be connected together easily to form a profile structure. Think of LEGO or Mechano blocks that can be attached together easily, but for industrial use.

Aluminum profile system providers keep up to date catalog of all the parts they have available, from which the profile assemblers select necessary parts when they are building a profile structure.

There are a lot of aluminum profile system providers which each have their own system of rails, tubes and connectors in addition to that they all have different strength, insulation and other physical qualities, and therefore they cannot be used interchangeably with one other.

LEGO and Mechano blocks don’t mix together, nor does Installux’s and (say) Sapa’s profile systems.

To make it clear, Installux is a profile system provider specialized in door, window and facade systems.

Its main value add operations are the design, manufacturing and distribution of the system and its parts.

Final customers are the some 6000 profile assembler Installux has.

1.2 Profile assemblers

Profile assemblers are typically local small and medium metal shops that serve construction companies.

When construction companies needs window, door or facade profile structures for the building they are building, they use the local profile assemblers to do the job.

The process works in such way that first the construction company sends the drawings of the window, door or facade profile structure they need for the profile assembler, so that the assembler knows what they are supposed to deliver.

Based on the received drawings the profile assembler makes their own assembly drawings/instructions.

The assembly drawings/instructions are done for the production line’s assembly workers so that they know how to assemble the final profile structure, and to calculate how much parts and pieces needs to be ordered from the system provider, and to make sure that the final profile structure satisfies the requirements set by the construction company (measures, strength, thermal, insulation and other qualities).

Nowadays making the assembly instructions/drawings starts to require software with profile system provider specific part library and settings in it.

More over, making the instruction/drawings requires profile system specific knowledge of the profile system’s physical qualities by the assembler’s structural engineers, because different profile systems have different physical qualities and parts.

For example, making assembly instructions/drawings for same kind of facade requires a different amount of aluminum and different parts (rails/tubes/connectors/insulation), depending on whose profile system one is using (from outside each profile systems looks roughly the same, but differences are in the physical qualities and parts for insulation, connectors etc.).

After the assembly drawings are ready, the assembler orders the required parts from the profile system provider’s catalogue.

After the delivery metal shop’s production line employees assemble the profile structures according to the drawings/instructions. The assembly process includes cutting the long rails and tubes to length, drilling holes to them, insulation installations and assembly of the final structure.

Drilling the holes and cutting to the length are done with special machines which requires aluminum profile system provider specific settings in them, especially if there is special software in the machine, again because each profile system have different physical qualities and parts.

1.3 Theory of switching cost competitive advantage

A) Maintaining the profile system provider specific part library and settings in the assembler’s software and machines,

B) learning how to design and calculate the profile system provider specific physical qualities and material needs,

C) learning how to use and assemble the profile structures from the profile system specific parts and pieces efficiently,

D) and the valuable inventory of leftover profile pieces accumulated over time at the assembly lines cutting process,

makes it a hassle for the profile assembler to change the profile system provider.

Learnings to efficiently design in a new profile system, updating to a new design software and machinery settings, learning how to assemble a new profile system, and abolishing the old system’s leftover inventory, would take so much time and cost so much money that the typically small metal shops are reluctant switch their old profile system provider to new one.

Due to the switching costs caused by learning curve and sunk investment cost profile assemblers use only one provider’s systems at once and almost never change. Customer relationships are usually life-long.

I don’t know if the switching cost is source of pricing power relative to competitors but at least it seems to be enough to guarantee repeated business for the profile system providers.

If there is demand for windows, doors or facades, which is function of construction and renovation cycle, there is demand for the small metal shops and therefore there is demand for aluminum profile system providers.

2. Durability of the advantage

The aluminum profile delivery process just explained is based on my studies and vague understanding of the profile industry in Finland, where I’m located. Because I have only elementary understanding of French, I have more or less extrapolated my conclusion from the Finnish market to French market, where Installux is located.

I came up with the switching cost competitive advantage theory as I needed to explain Installux’s stable and high EBIT margins and ROIC over time.

Installux return on operating capital has consistently been over 20% and operating margins 8-12% and I think the switching cost competitive advantage explains most of it.

As the industry dynamics (unique buildings) are same everywhere, my theory would be supported if similar companies in other countries would have to have similar high margins and ROIC.

I was able to come up with few incomplete data points (table above), Sapa from Sweden, and Nordic Aluminum and Purso from Finland, which seems to support my theory.

Sapa’s ROA has been 23-43% and EBT% 10-16% over time, and Nordic Aluminum’s ROIC 32-39% and EBIT% 18-21%, over time.

Purso’s margin’s were only about 4% and ROIC% below 7%. This could be evidence against my theory of switching cost competitive advantage inherent in the industry structure and that the high margins and ROIC of the others are explained by some other factor.

How ever I consider it weak, because Purso has stated in its annual reports it wants to add revenue share of high value-add products implying that currently there is a lot of revenue from low value-add products.

It might be that most of Purso’s revenues come from utilizing their own aluminum extrusion plant for (what I consider) low value-add contracting business and not from the (what I consider) high value-add aluminum profile system business.

In addition to switching cost competitive advantage there is another possible explanation for the Installux’s high profitability.

In addition to traditional door, window and facade profile systems, Installux offers profile systems for awnings, pergolas and gates.

They are used mainly in residential construction, which is smaller and more fragmented market and thus potentially not a key focus area for bigger competitors. I don’t know the revenue share of awning, pergolas or gate systems but if it’s large, Installux might have some pricing power in the small niche with less competition.

It probably also helps to have a what seems to be long-term oriented slightly contrarian owner-operator CEO mr. Christian Canty in the management, who started in his job in 1987 and owns 50% of the company.

His building blocks for Installux are work, humility, adaptation and professionalism. Company doesn’t have option plans but there is profit-sharing agreement for all employees.

Strategy is to focus on aluminum and niche products, which would support the theory that most of the revenues comes from smaller awning, pergola and gate profile system market.

While acknowledging the difficulties in French economy and long recession, Installux still has plan to invest to new capacity which, mr. Canty says, “may seem ambitious in the economic environment we are facing, but we think essential to win tomorrows battles.”

That’s the tone of all Installux’s reports, investing today to win tomorrows battles, not being interested in acquisitions but organic growth and company’s long-term development.

Nevertheless, Installux margin and ROIC are so high and stable, and has been for so long, that it cannot have been an accident.

If not durable competitive advantage, at least it can be said that there are many competitive and other forces (niche focus & good management) that are playing for Installux and not against it, which must have helped it in doing profitable business histprically and if I’m right, will continue to do so in the future.

3. Growth

Installux has been profitable and paid dividends every year since at least 2005. Book value has grown about 7% annually. Although book value growth has been moderate, it hasn’t taken a step back in at least ten years, which is enough for good long-term track record, which is what Installux has.

There is only 2/10 years when revenues dropped, 3.6% in 2009 and 4.2% in 2013. This in period what includes eight consecutive year of recession in the construction and housing market.

Business seems very stable, which is my favorite part of Installux and probably explained by the industry structure, niche market and the good management talked about earlier.

Since 2008 revenues have been growing 1.6% annually, slow but more than the market so Installux has been the winner in the recession, like good companies typically are.

In the latest half-year report management was optimistic that the housing and construction recession might he coming to end. Sales were up 6% and EBIT 14%, but, characteristically for Installux, they were prudent and said that they will wait for “confirmation” if the turnaround is real.

Installux has maintained organizational capacity to absorb higher volumes over the difficult years and hedged their aluminum purchases for 2017 at favorable prices. If the turnaround is real, management expects improving profitability.

Installux also has small operations in the Middle East, about 10 MEUR revenue of the 112 MEUR total. It has grown about 11% annually since 2008. Additionally there has been one segment that has reduced profits somewhat for many years, but that seem to be breaking even now.

So if the French market turns, as the first signs are, Installux near and medium term profit growth prospects look good. Longer term aluminum profiles seems to be the winner in the energy-efficient building, which should provide good tailwind going forward.

4. Valuation

Installux’s current market cap is 100 MEUR, and excluding 25 MEUR net cash, enterprise value 75 MEUR.

Rolling 12m EBIT after tax was 8 MEUR. If the H1’2016 performance is extrapolated to the H2’2016, the 2016 EBIT after tax will be 8.5 MEUR.

Thus the implied forward EBIT after tax is under nine, so Installux’s valuation doesn’t seem outrageous given the high quality business, good growth prospect and high returns on capital. But more importantly, it doesn’t seem to give high probability for the construction sector recovery scenario.

To put some numbers for the “recovery scenario”, in my simple forecast model I assume 5% EBIT after tax growth for next five years, which actually is about the same growth as in the recessionary 2007-2015 period, Installux’s total accumulated after tax operating earnings would be about ~50 MEUR.

With Installux’s stable profit record that’s relevant and at least somewhat dependable forecast, and quite conservatively assumes much lower growth than the 6% revenue and 14% EBIT growth recorded in the H1’2016.

Recovery scenario earnings forecast 2016-2020, 5% CAGR (MEUR)
8.5
8.9
9.4
9.8
10.3
Total 47

The ~50 MEUR operating earnings in the next five years would be used to pay dividends, increase net cash or reinvested back to business.

From valuation point of view each euro used to pay dividends or put to bank account is worth one euro. And each euro reinvested to operations in Installux’s case is worth more than one euro, assuming the future returns on invested capital are the same as historically (20%+).

Therefore, in the recovery scenario the ~50 MEUR earned from operations would increase Installux’s value by ~50 MEUR or more.

Table below summarizes my thoughts on the accumulated exit value in the “recovery” scenario (and “as is” scenario, which I comment later).

With my assumptions in the recovery scenario the total value accumulated for shareholders during the 2016-2020 period would be 215 MEUR, consisting of 140 MEUR exit value for the business, 25 MEUR existing net cash and 50 MEUR accumulated profits from the operations either paid out as dividends, left to bank account of reinvested to business.

The 215 MEUR total value creation by 2020 implies 115% upside relative to the 100 MEUR market cap. If some part of the accumulated earnings would be reinvested with the historical high ROIC, then the upside would be even higher.

Note that the 14x exit-multiple is not my forecast of the 2020 EBIT after tax multiple in the markets, rather my opinion of the fair value multiple based on Installux being average or above average business (therefore deserving ~marketish fair value exit-multiple).

Thus, the table is my forecast of value created, not expected dividends and stock price appreciation during the period. If my valuation is correct however, they should converge.

The 215 MEUR total value in 2020 implies about 16% annualized value generation relative to the 100 MEUR market cap. That’s satisfactory upside from what seems to be stable business with competitive advantage.

More over, if the recovery speed is faster than my 5% profit growth forecast based on historical growth rate, which is quite possible given the 14% growth in the H1’2016, the upside could be even higher.

5. Conclusion

One threat to the potential high upside is that the recovery scenario doesn’t materialize. But per my thinking it wouldn’t cause losses for investor.

The 100 MEUR market cap is so low that even if the earnings remain at the current level, which is probably minimum one can expect based on the historical earnings stability, value generation for shareholders should still be positive and satisfactory.

For, as per the “as is” scenario at the table above, if it is assumed that the historical 5% profit growth stalls and instead the 2016E after tax EBIT (8.5 MEUR) continues for the next 5 years, the accumulated profits would be about 40 MEUR.

Assuming that in this no-growth scenario the fair value exit-multiple would be 10, the upside potential would still be 50% or about 8% annually. The 8% annual return is about the same as Installux’s 7% historical book value growth and 2% dividend yield, which would not be a bad return from reasonable bad case scenario.

Because high probability for good value creation in the upside “recovery” scenario (16% CAGR) and because satisfactory potential returns in the reasonable downside “as is” scenario (8% CAGR), the potential return distribution looks very attractive for me.

There is enough upside if things go well, and there is also enough upside if things won’t go so well, and there is no reasonable scenario which would cause losses.

Outcome distribution seems to me pretty tight and always positive, as opposed to some other turnaround stocks where upside scenarios are high but offset by downside scenarios with heavy losses or dead money. Installux’s earnings stability provides it a lot of safety, because it creates little more value every year.

As long as I’m right on the switching cost competitive advantage, focus on niche market and high quality management, I think it’s safe to assume that the historical profitability and earnings stability is good extrapolation of the future profitability and stability, and therefore that under most scenarios value creation will be good-to-satisfactory, and that Installux will be little more valuable for its owner every year.

Disclosure: Long Installux with 8% position