Sunday, July 1, 2012

Why one reader won't invest in Solitron, and my response

I received an excellent email recently from a reader who explained they took a look at Solitron Devices and decided to pass on because they saw too many red flags.  As long time readers know I've held Solitron for a few years and have written the company up in the past.  More recently I wrote the Board a letter urging an annual meeting and a share buyback.

I wanted to respond to the reader's questions publicly because I suspect other investors might have similar questions and my responses would be helpful.  I have taken the following format, the reader's email is in italics and my responses are below in non-italics text.  I have used arrows to break apart each question.

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And the answer I arrive at says no, or at the very least there's simply too many warning signs for my comfort. After all, the wise man did say we never have to swing if the offering is not to our liking.

Where do I start? With some numbers.

Let's first take a look at total compensation of the CEO which, according to the latest 10-K, stood at $379,918 in 2012 compared to $471,182 in 2011. Not too bad in this age of multi-millions employment contracts. 

That is until put in perspective with the net income of the company, which stood at $746K and $1,261K for 2012 and 2011 respectively. In other words, the CEO took home a total amount equivalent to 50% of net income available to shareholders in 2011, and 37% in 2011. Nice work, if you can get it. I probably do not need to mention that any reduction in expenses such as compensation flows directly to the bottom line (after taxes, which are minimal in this case).

Not saying it is the case, but if all you intend to do is ensuring your salary is paid in the upcoming years, parking cash in treasuries would actually make some sense...  

This could be looked at two ways, the first is that the CEO is overpaying himself and it would be nice to get a run of the mill operator in there who'd take the job for $200k.  I would be surprised if you could get a CEO for less than $200k.  My idea situation would be a low salary with a high stock component, not options, but actual stock.

The second view is this CEO is actually running a one man show at Solitron.  Based on his titles I'm inclined to believe this.  For a small company and as an executive wearing many hats it's plausible that Mr. Saraf is holding the whole operation together and his departure could jeopardize client contracts.  

While I would love to see compensation much lower a reasonably compensated CEO is possibly the rarest of creatures in the world if US listed stocks.  I have seen MANY companies the size of Solitron where the CEO is walking away with a million a year.


CEO pay scales up, but it unfortunately doesn't scale down past a certain point, I think that's what we see at Solitron.  


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Then there's the environmental liability. I've read here and on the letter sent to the "Board" (I simply cannot bring myself to write it without quotation marks), that the liability ends in 2013, and elsewhere in 2016. I may be dead wrong, but I read the 10-K differently. Note 2 of the financial statements reads : 

"At February 29, 2012, the Company is scheduled to pay approximately $1,002,000 to holders of allowed unsecured claims in quarterly installments of approximately $7,000. As of February 29, 2012, the amount due to holders of allowed unsecured claims is accrued as a current pre-petition liability."

And lo and behold, this account ("Accounts payable-Pre-petition (Note 2)" in the balance sheet) did indeed decrease to $1,002K from $1,030 in 2012. Consistent with 4 quarterly instalments of $7,000. Which means that at the current rate of payment, it will take Solitron 145 more quarters to pay it off (unless they decide to accelerate payments, which so far they have not).

This is a tricky issue there are actually a number of liabilities and settlements, let me try to break it down.


There are two liabilities, the pre-petition liabilities that you mention, and the environmental liabilities.  Pre-petition liabilities are items the company owed before filing bankruptcy.  During the bankruptcy proceedings they were negotiated down to a level the court believed the company could pay, this is the $1m you see being paid in small dribbles.


I feel that being able to negotiate a $1m liability down to $28,000 installments shows savvy on the CEO's part.  If you do a time value of money on this settlement the creditors are walking away with a few pennies on the dollar.


Here is the line mentioning dividends:


"Pursuant to the Company’s ability to pay its settlement proposal with the USEPA, the Company agreed not to pay dividends on any shares of capital stock until the settlement amount for environmental liabilities is agreed upon and paid in full." (2012 10-K, p17)


The key in this line is the USEPA agreement that Solitron made, so let's look at that agreement.  Here's what it is:


"The Settlement Agreement required the Company to pay to USEPA the sum of $74,000 by February 24, 2008; the Company paid the entire sum of $74,000 to USEPA on February 27, 2006. In addition, the Company is required to pay to USEPA the sum of $10,000 or 5% of Solitron’s net after-tax income over the first $500,000, if any, whichever is greater, for each year from fiscal years 2009-2013." (2012 10-k, p9)


Solitron is required to pay $10,000 or 5% of their net income exceeding $500,000 from 2009 to 2013.  Based on the 2012 annual report Solitron paid out approximately $10,000.  If you look a bit further in the annual report they actually mention they reserved $23,000 for 2012 and 2013 payments.  Once the final payment is sent next year the company has no agreement with any other creditor to not pay dividends.


I also want to highlight that when I look at the liquidation value of the company I presume the entire pre-petition amount is due today, the full $1m and deduct that from assets.  This is not true, but it examines a worst case scenario.  Even under that worse case presuming creditors needed to be paid off today the company is still trading for 33% less than NCAV.

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Then there's the frequent changes of auditors, which in itself is actually quite impressive:

2011-2012  Meeks International LLC
2009-2010  Friedman, Cohen, Tubman & Company LLC
2006-2008  DeLeon & Company PA
2005  Goldstein, Lewin & Co. CPA (could be the same Goldstein as below, who knows?)
2004  Berkovits, Lago & Company LLP
2000-2003  Goldstein Golub Kessler LLP
1997-1999  Milward & Co CPAs
1995-1996  BDO Seidman LLP
1994  Arthur Andersen & Co

This could very well be nothing. But one thing is certain: frequent changes in auditors is never a positive sign. A one-time occurrence can easily be explained to reduce professional servcies costs, but at least in one case the associated costs increased with the change.

This was something I was concerned about when I first came across the company so I called the CEO to ask about it.  It was explained that each switch they were able to squeeze the new auditing firm and get a lower price.  If the CEO doesn't care about shareholders I'm not sure he cares about the impression switching auditing firms would have either.  The checks I made of professional fees supported his claims.  

I think this is where the investor really needs to leverage their own knowledge and skills.  The Chinese reverse merger companies all had clean audits until after they were revealed as frauds.  Enron had a clean audit for years as well.  Auditors are not out to protect against fraud, that's the investor's job.  I've done some quality of earnings checks, and outside of actually calling the bank to verify the Treasuries exist I'm reasonably confident this is an up and up firm.

One other item to consider when the company appealed the environmental claims they had to submit their books to the court and regulators to support their assertion that they couldn't pay the initial claim amount.  I don't know if the court or regulators ever inspected their books, but they looked at something before revising the settlement downward.

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Members of the "Board" whose terms have all expired, lack of annual meetings, late filings with the SEC, 80% vote required to amend company bylaws...

This is a very legitimate claim against the company, something that concerns me as well and a factor that persuaded me to write the company a letter.

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And of course, there's the poison pill you already mentioned being adopted seemingly as a response to the arrival of a new (and currently largest, if not including rights) investor.


It's easy to see a poison pill as a shareholder and jump to the conclusion that management is only out to protect their own job.  There is a second possibility that someone alerted me to, that if an outside shareholder acquires more than 15% of a company's shares within a certain amount of time the target company's net operating losses (NOLs) could be viewed as invalid by the IRS.


Let me try to simplify this a little bit.  Solitron is allowed to carry forward losses they experienced in the 1990s to offset income earned now.  There is a time limit on the NOLs based on IRS rules.  If a shareholder comes along and suddenly buys up 20% of Solitron in the view of the IRS Solitron's NOLs are no longer able to be carried forward.  This would mean any income earned would be taxed.  To prevent this companies have put in place rights offerings at a 15% threshold which protect the NOLs.  The purpose of the rights offering isn't to blunt a takeover attempt, it's to protect the NOLs.


There are a lot of articles on the internet explaining this mechanism, here is a recent ruling where a company set their rights threshold at 4.99%: here


Here's another article with good background on NOLs and poison pills: here

Conclusion

I don't blame you for walking away from Solitron, there are hundreds of cheap companies to choose from so why put your money in something that makes you uncomfortable?  My view is any company selling for less than NCAV is going to have some issues, either management issues, industry issues or external issues, that's why the shares are cheap.  The goal of buying a net-net is that the discount to a private market value is so great even a few errors can be made and the investor will still realize a profit.

The rhetorical question I ask is at what price would these problems be ok?  Is trading below net cash cheap enough?  What about 50% of net cash?  I prefer to look at stocks on the basis of what I think they might be worth to a private businessman.  Buying Solitron for less than liquidation value I believes gives a sufficient margin of safety.

Talk to Nate about Solitron


Disclosure: Long Solitron Devices

1 comment:

  1. Nate. Thanks for the response. And the education in NOL and how a slight movment in ownership can change the ability to use the NOLs.

    USG used to (may still have) have a similar limit in place.

    The time you devote to this blog is much appreciated.

    ReplyDelete