Solitron Devices, Inc. (SODI.OB) designs, develops, manufactures, and markets solid-state semiconductor components and related devices primarily for the military and aerospace markets in the United States and internationally. The company offers various bipolar and metal oxide semiconductor (MOS) power transistors, power and control hybrids, junction and power MOS field effect transistors, field effect transistors, and other related products. It also provides joint army/navy transistors, diodes, and standard military drawings voltage regulators; and power supplies and other electronic control products to the electronic industry. The company's semiconductor products are used as components of military, commercial, and aerospace electronic equipment, such as ground and airborne radar systems, power distribution systems, missiles, missile control systems, and spacecrafts, as well as for non-military, scientific, and industrial applications. It sells its products directly and through a network of manufacturers representatives and distributors. Solitron Devices, Inc. was incorporated in 1959 and is headquartered in West Palm Beach, Florida. (Source: Yahoo Finance.)
Net Net Working Capital ("NNWC") - "Cigar Butt" investing, as coined by Benjamin Graham, is predicated on the ability to identify firms that are selling in the market place at a price less than the discounted value of a firm's assets less all liabilities. NNWC is calculated as follows:
Cash & Equivalents + Marketable Securities - Account Receivable * 75% - Inventory * 50% - Total Liabilities
Firms that sell on the market place for less than their implied liquidation value, generally offer opportunities to investors with relatively limited downside risk. Naturally, many of these firms are "deep value" investments for a reason, so it is imperative to conduct the appropriate diligence. Fortunately, SODI is currently trading at a discount to a conservative liquidation value.
Exhibit 1: NNWC Model
|+ Cash and Equivalents||$ 7,749||100%||$ 7,749|
|+ Account Receivable||$ 817||75%||$ 613|
|+ Inventory||$ 3,076||50%||$ 1,538|
|- Total Liabilities||$ 2,099||100%||$ 2,099|
|Stock Price (8/12/2012)||$ 3.03|
|Shares Outstanding (Diluted)||2484|
|Market Value||$ 7,526|
|Cash per Share||$ 3.12|
Note: The above table reflects the balance sheet balances for cash and equivalents, accounts receivable, inventory, and total liabilities as of May 31, 2012. Within the cash and equivalents line item, balance sheet cash and equivalents of $.991 million and treasury bills and certificates of deposits of $6.758 million have been consolidated into one item. After consolidation of line items, a risk adjustment was applied to each asset balance to adjust for liquidation risk associated with selling the assets in a relatively short period of time. The adjustment factors were left unchanged from the Graham NNWC calculation reflecting that the profile of SODI assets is neither more nor less risky than the percentages included within the foundational calculation. Management clearly outlines in their 10Q that they mark inventories at the lower of market or cost utilizing the first in first out accounting method (FIFO) indicating that they are already applying conservative estimations to their financial statements - discretionary factor adjustments are not required.
After burdening cash, receivables, and inventories with the adjustment factor and subtracting all balance sheet liabilities, the total NNWC value remaining for shareholders is approximately $7.8 million or $3.14 per share on a diluted basis. At the current market price of $3.03 per share, the NNWC valuation provides a margin of safety of 3.6%, offering complete protection at or below$3.14 per share (including transaction fees).
Discounted Cash Flow (DCF): The discounted cash flow valuation approach is a great way to better understand the future prospects of the firm being evaluated. Analysts generally place a lot of stock in their ability to analyze future cash flows; however, value investors acknowledge that this exercise is often fruitless and even unnecessary. The DCF analysis below offers a view into a very simple approach to calculating the value of the firm and can be conducted within minutes on the back of an envelope if necessary.
Exhibit 2: Discounted Cash Flow
|Fiscal Year End February 29,|
|Net Income||969||770||$ 1,261||$ 746|
|FCF||$ 950||$ 790||$ 1,099||$ 798|
|Diluted Shares Outstanding||2,454||2,453||2,458||2,489|
|Value per Share||$ 5.53||$ 4.60||$ 6.39||$4.58|
|Shares Outstanding Growth||0%||0%||1%|
|** Includes affect of Management dilution|
Note: Within the table above, free cash flows were calculated for the fiscal year end 2009 through 2012. As you can see, the FCF range is relatively concentrated between $.800 million and $1.1 million range. Instead of focusing on estimating the future growth of these flows, the above calculation capitalizes the cash flow at 7%, reflecting an implied discount rate of 10% and long term growth rate of 3%. The capitalized value is then divided by the shares outstanding to arrive at the value per share for the firm.
For SODI, a conservative per share estimate for the firm over the last 4 years has ranged between $4.60 and $6.39, representing an implied margin of safety ranging between 51% and 111%, as of the market close on August 13th, 2012. The strength of these estimations is protected because management has maintained a relatively conservative share issuance program, indicating that future dilution expectations are de minimis.
It is important to note that additional adjustments for off-balance sheet liabilities should be made to the calculation net of any cash balances. Since the cap for off balance sheet activities is approximately $2 million and the total cash balance is over $7 million, no additional adjustments were made to the per share values to account for net cash balances. This adjustment would add over $2.30 per share in additional value to shareholders.
Dividend: Due to restrictions imposed by the Florida Department of Environmental Protection, United States Environmental Protection Agency, and other environmental agencies, SODI is unable to pay a dividend until environmental liabilities are fully reimbursed in 2013. Upon fulfillment of this obligation, it is expected that management will implement a dividend program to disperse the $3.12 per share of cash sitting on the balance sheet. The accrued cash is not currently being deployed to grow the business and is yielding an unsatisfactory return for investors. Management should avoid dispersing a large one time dividend to shareholders, as this may not be the most efficient means of distributing capital. Additionally, a sizable and predictable dividend policy would help to garner additional market interest in the stock.
Share Repurchases: For most large firms, repurchasing shares to boost earnings per share and overall value is a great way to deploy excess cash - assuming that the shares are cheap. For firms like SODI, this approach in and of itself would not be an effective solution to unlocking value. Management should allocate capital for share repurchases as a signal to the market place that the stock is incredibly cheap. Since the stock is trading fairly illiquid, further share repurchases may increase illiquidity in the stock resulting in lower trading volume and larger bid ask spreads.
Liquidity Events: Given that SODI is incredibly small and has limited intellectual property still under patent, the pool of potential acquirers is relatively limited - if not non-existent. Nonetheless, a management signal that a liquidity event is on the table would certainly boost market interest in the stock. (Note: There are specific clauses in the Aritlces of Incorporation which may deter potential acquirers.)
Management: One of the most overlooked factors when investing in micro-caps or NNWC firms is the decision making capacity of management. A management who is acting in their own self interest and not the interest of shareholders may inefficiently allocate capital, dilute share through issuance of stock options and employee incentives, and invest in unprofitable or obsolete business operations.
Environmental Liabilities: SODI has faced environmental litigation in the past and it is expected that this could be a significant component of their business operations in the future.
Off Balance Sheet Liabilities: SODI currently has future minimum lease obligations for $.317 million, $.392 million, $.403 million, and $.415 million for fiscal years ending, 2013, 2014, 2015, and 2016 respectively. A material decline in the firm's business prospects could result in nearly $2 million minimum lease commitments. If the NNWC calculation is burdened with off-balance sheet liabilities, the downside protection shrinks to about 75% recoverability.
Technological Obsolescence: According to the most recent 10K, none of their manufactured technologies are on patent. Any firm with the appropriate facilities could easily replicate their technology without incurring any litigation penalties.
Customer Concentration: According to the most recent 10Q, May 31st, 2012, approximately 44% of SODI's revenue is attributed to two customers: Raytheon Company and Harris Corporation. A loss of any one of these customers would have a material impact on the performance of the firm. Additionally, SODI customers are highly correlated to US Defense spending, so any major deviations in policy may be detrimental to their business.
Net Operating Loss Carry Forwards ("NOL"): As of May 31, 2012, SODI has NOL's of approximately $14.3 million that expire through 2023. These losses are available to offset future taxable income. If a change in ownership of more than 50% were to occur, there could be an annual limitation to the use of the NOLs.
Investment Strategy: I have made one purchase of SODI stock in the last 3 months at an average price of $2.99 per share. I intend to purchase additional shares under $3.10 with a target portfolio allocation between 10% and 20% of my capital fund. I intend to hold this investment until December 31, 2013 or until 1 or more of the following occurs:
- 1 or more of my risks are 70% or more likely to be realized
- HGG catalyzes to 90% of my high range of $6.39 per share
Credits: SODI was originally brought to my attention by Darin Young founder of Valuebull.com. Please visit his website for additional value investing insight or to contact him directly.