Is this 'heroic' share a 'buy'?

My train departs Cambridge early on a Spring morning and arrives in King's Lynn in winter. The weather is grizzly and it feels like I've walked on to the set of a period TV drama shot in black and white.

Porvair's headquarters is a small slate coloured office on the fringe of a grey industrial estate at the limits of a town on the edge of England*. A dead blackbird, feet sticking up into the air, guards the entrance to the boulevard that connects the people of King's Lynn to its industry.

There's method in trekking to the nation's periphery to visit companies. Not many people do. Company directors sometimes appreciate the effort. Sometimes they operate good companies the City overlooks. At Porvair, I will be vindicated, at least partially.

Long-serving chief executive Ben Stocks greets a handful of shareholders and potential shareholders, promising the sun will come out when the AGM starts. Before the official business, he gives a presentation, which like the annual report focuses on the important things: what makes the company special.

I'm seeking reassurance. Porvair got into trouble during the Credit Crunch. Stocks had already been chief executive for a decade, having restructured the company to focus on filtration systems, but the consistent profit Porvair sought eluded it because demand for filters at one of its businesses, Selee, fell sharply.

Selee provides filters used by aluminium and steel producers to remove contaminants from molten metal. In 2009, Porvair was forced to renegotiate the agreements it had with its banks and lay off 40% of Selee's staff.

The rest of Porvair, which supplies filtration systems for aircraft, industrial processes, and environmental laboratories, sailed through relatively unhindered. I want to know whether Selee, which accounts for 30% of revenue today, is any more resilient, and what makes the rest of the business so profitable.

Generally the sole supplier

30% of revenue is from patented products, but Stocks says regulation is an even greater impediment to switching filtration systems. Porvair supplies Alcoa's filters, for example. Should the giant aluminum producer change supplier, it would have to re-accredit the quality of all its metals.

Filters protect valuable equipment, like hydraulic, fuel and coolant systems in aircraft from contaminants. They are specified in airframes for up to thirty years. Since Porvair is generally the sole supplier, it should profit from its installed base for decades. These are, it seems, bona fide competitive advantages.

The potential for recurring revenue is also evident in three large gasification projects which have driven Porvair's growth in recent years. Porvair supplies filtration systems that remove abrasive and corrosive "char" produced as coal is converted to synthetic gas. The 16 gasification plants involved will be fitted out by 2018, but the filters will need replacing every year and a half to two years, providing a reduced but ongoing source of profit.

Through specialisation, Porvair has built impressive shares in various markets. Its products are used in all major commercial airframes and it has a 35% share of the market for measuring inorganic contaminants in water.

Selee's new patented filters give it a stronger position in the metals filtration market too. Fifty per cent of aluminium casthouse production by revenue is filtered by Porvair products. Falling demand from companies supplying farmers in 2015, for example John Deere and Caterpillar, serve as a reminder that Selee serves cyclical industries though. The higher profit margins it earns today are still only half those of Porvair's other businesses, and will not be sustained if recession hits its most significant customers in the aluminium and steel industries.

A change in culture

The biggest difference in Porvair may be a change in culture. Referring, perhaps to its ill-fated foray into fuel cell technology, Stocks says the company has tried the "giant leap" strategy before. It was heroic, but it's taking smaller steps now.

The acquisition of TEM just after the year end may be an example. TEM provides filters for etching silicon wafers. It is a highly specialised business and, therefore, potentially difficult to compete with. It's also small, and will benefit from Porvair's international sales capability and technical experience with materials.

Porvair paid less than $5 million (£3.5 million) for the company, less than five times operating profit. Bigger filtration businesses sell to private equity or trade buyers for higher multiples, which the company will not usually entertain, although Stocks would make an exception of six "must have" rivals.

Porvair's new metals filtration operation in China might also be described as heroic. Selling filters to the 50% of aluminium producers that operate there is gruelling because they want to pay as little as possible and they're happy with Porvair's older products. As they produce higher grades of aluminium, Stocks says Chinese producers will come to Porvair for its newer patented filters, but it may not make money from metal filtration in China for some time.

One more heroic factor

There's one more heroic factor I spy in Porvair's accounts. Executive pay. There's little doubt Stocks and finance director Chris Tyler deserve to be paid well but in 2015, Stocks received £1.1 million, including bonuses and so-called long-term incentives (a three-year share plan) that pretty much paid out in full because of Porvair's steady growth in recent years. That's not much less than the company paid in dividends in 2015, and it's 10% of adjusted operating cash flow.

Tromping to the edge of England has lead me to a split decision. It has revealed a thriving business with accommodating executives but I don't think the City has overlooked Porvair. The share price puts the enterprise on a multiple of 18 times adjusted profit (the earnings yield is 6%), which to me implies shareholders expect steady growth in future.

Although Porvair's specialised business entrenched in the operations and products of customers inspires confidence, its increasing dependence on large contracts and the unavoidable cyclicality of Selee's business make me wonder whether growth will be more lumpy.

At the current share price of 330p, I might maintain a small holding.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

*This is head office. Porvair's operations are spread far and wide.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard