Is the *new* Solitron a worthy investment?

It's fitting personally that investment changing news about Solitron Devices (SODI) hit the wire while I'm on vacation at the beach.  When I think of Solitron I can't help but associate the company with the beach.  It was three years ago in June that my wife and I flew down to West Palm for a beach getaway with a short break away from the beach for Solitron's first annual meeting in 20 years.

If I'm honest with myself then Solitron Devices would be considered a hotel stock for small value investors.  It seems like anyone who's ever looked for value in small and micro cap stocks has either looked at or owned the stock over the past decade.  The stock has at times been a net-net, an activist target and at one point in ancient history a high flying growth stock.  If you can believe it Solitron was the Tesla of the 1960s.

The company designs and manufactures integrated chips and components for satellites and military applications.  The company was a stock market darling before they spiraled out of control and into bankruptcy in the 1990s.  It didn't help that their manufacturing process poisoned the soil leaving an EPA disaster in their wake.  In the 90s the company restructured, established a plan to pay for their environmental sins and continued to manufacture specialized chips.

They operated in obscurity for years, so much obscurity that after the financial crisis the company traded for less than their NCAV.  One could in theory liquidate the company at firesale prices and end up with a sizable gain.  There was only one problem.  The company's CEO, Shevach Saraf stood in the way.

Saraf was one of those people who was enamored with titles.  He was the CEO/CFO/COO/Chairman and whatever else he could fit on a nameplate.  He was also stubborn to a fault and it was his way or the highway when it came to Solitron.  Saraf was appointed CEO during the company's restructuring and served in that role until recently.  The man appeared to be insufferable to work for.  At one point all of the titles he accumulated belonged to other employees, but one by one they quit and he took them for himself.

The allure of the company was that it had a considerable amount of cash and securities sitting idle on their balance sheet.  This alone was enticing, but their core business operations weren't bad either.  Almost any investor could day dream about a scenario where the cash was returned to shareholders and the business sold for a gain.  Outside of outright fraud there weren't any scenarios were shareholders did poorly.  The problem was Saraf, the company's largest shareholder and head executive-everything wanted none of it.  Instead of returning cash to shareholders net income was hoarded on the balance sheet as Treasury securities.  Annual reports were marked with language indicating that the company wasn't certain if it could ever turn a profit in the future and there was an outside chance it might disappear into the night.  Saraf was a classic sandbagger.  He'd proclaim doom and then easily surpass his proclaimed dire circumstances.  He paid himself handsomely and owned a substantial amount of stock.  Enough that any attempt to outvote him would be difficult.

I began writing about the company hoping to shed light on an undervalued situation.  Eventually I realized that the only way to create value was to do something myself.  I helped organize shareholders and bring attention to the company all while pushing them to hold an annual meeting.  The unstated goal of the annual meeting was that with an annual meeting an eventual proxy battle to oust insiders could happen.  Without a meeting there could be no proxy battle, and without a proxy battle no change.  In 2013 we succeeded and shareholders had their first meeting and in some ways the rest is history.

Once the company held a meeting activists and proxy battles followed and culminated last week with the company filing an 8-K announcing Saraf's departure from the company.  But if that wasn't enough the company is buying out his shares.  This removes the largest stumbling block to value while at the same time returning cash to investors.  The Board is now firmly under control of activist investors and the CEO is Tim Eriksen, the hedge fund manager who mounted a successful proxy fight last year.

The question is whether Solitron post-stubborn CEO is worth an investment or not.  To decide let's walk through the adjusted balance sheet after the transaction.

Before the transaction the company had $6.48m in securities and $507k in cash on their balance sheet amongst other assets.  The company is debt free and liabilities consist of accounts payable and accrued expenses.  Let's presume that their cash is needed for ongoing operations and their investment securities (treasuries) are excess and can be used to fund their transformation.

The first thing the company did was repurchase all of Saraf's shares at $3.91 per share.  The company spent $1.3m repurchasing 331k shares.  This reduces the number of shares outstanding from 2.2m to 1.9m for a more than 10% reduction in shares at less than book value.  This action alone is highly value accretive itself.  The second action taken was to repurchase all of Saraf's outstanding options for 290k shares for slightly less than $1m, paying $3.43 per option.  This buyback removed the options overhang and reduced the fully diluted share count.

Both of these actions are shareholder friend, the company used $2.3m worth of excess cash to eliminate Saraf's share holding and his option position.  This is the type of thing value investors dream of, a company using their cash to repurchase shares below book value.  While value was created for investors it also eliminated the company's largest shareholder.

Beyond the initial $2.3m share and option repurchase the rest of the buyout can be framed within the context that the buyout expenses were necessary to get rid of a stumbling block for shareholder value.  The company paid $410k in severance costs, $45k for health insurance, $18k to transfer ownership of the company car to Saraf, $96k for earned vacation time and other incidentals such as his cell phone.

In total the company is paying $2.859m to rid Solitron of Saraf, with the bulk of the company's expense being spent towards repurchasing shares and options.  The company is also reimbursing Eriksen Capital $110k for their proxy fight last year.  I know some shareholders antsy about a repayment such as this, but in my mind paying $110k to unlock value is very cheap.  If shareholders could unlock value other management-trap companies for $110k we'd all be a LOT richer.

Once the agreement is executed the company's equity will drop from $11.36m to $8.391m, which is $4.41 per share.  At current prices post transaction the company is trading for 89% of book value, which is cheap in light of recent facts.

One negative is the company has started to report negative earnings.  We could speculate all we want, but it's possible that the earnings drop was the catalyst that pushed Saraf out the door.  Until recently the company had steady revenue and earnings, and suddenly with activists onboard the company's results took a nose dive.  Was this Saraf trying to payback shareholders with bad results?  As a one-man executive and selling machine it's possible.  But if that were the case his plan backfired badly.

At current prices investors have the ability to purchase $4.41 for $4.01 with an activist investor as CEO and shareholder friendly Directors.  The company still has about $3m in excess cash that can be returned to shareholders as a buyback or a dividend and a core business that had a history of earning above average returns.  The best course of action would be for Eriksen to negotiate a sale to a private buyer at an above market price.  It isn't unreasonable to presume that the core company might be worth $5-6 per share plus the additional $1.50 per share in excess cash.  I don't think it's a stretch to say the company is worth 50% more than current prices if not more.

Most readers will brush this writeup off saying that "a 50% gain isn't big enough" but I don't know many other investments that are controlled by activist investors with an upside of 50% or more. Even if it takes Eriksen two years to realize value with Solitron it's still a very respectable 25% a year return.

If you're looking for a cheap investment with a catalyst look no further than Solitron Devices.

Disclosure: Long SODI

16 comments:

  1. I was initially happy -- but after the weekend thinking about it, it seems to me they paid too dear price for him to leave. Sold most of my position, except for a token amount.

    This was/is a bust. Maybe Saraf tanked the operations of the company -- and what did he get? Most of the company's money.

    I feel sorry for the employees.

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    1. What's your thought process on why this is bad?

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  2. Agree with the opinion. On the BV basis looks good, but how much business was connected to former CEO? Will they make profit again or erode the BV. Maybe if they found good CEO who has experience in the industry, it could be kind of turnaround.

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    1. I think the CEO connections are overrated.

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  3. " Eventually I realized that the only way to create value was to do something myself. I helped organize shareholders and bring attention to the company all while pushing them to hold an annual meeting. The unstated goal of the annual meeting was that with an annual meeting an eventual proxy battle to oust insiders could happen. Without a meeting there could be no proxy battle, and without a proxy battle no change. In 2013 we succeeded and shareholders had their first meeting and in some ways the rest is history."

    Nate, could you talk about either in the comments here or in a new post how you went about doing all of this. How to do a proxy battle. How to find fellow shareholders etc. with time line and costs, steps - i.e. do we write to management first? Is email ok or a paper letter? Do we need to file with SEC? Do we need a lawyer?
    Some of us have an activist streak but have no idea how to go about legally promoting change, getting a board seat, etc. I even have a couple of small cap things in my portfolio which I know I can turnaround myself given my business experience but I need to be "in" the company....
    IF you need more questions I have 100 more lol. Is there a book or resource on this topic? How to take over or control a company? I want to learn from the bottom up before I make an ass out of myself...

    Thanks in advance for all this!

    Adam

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    1. ^Nate, I'd also be interested in some of these processes. Could you address them please?

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  4. Should we read anything into the fact that Tim Eriksen has been appointed to the role of CEO? He already was a board member. Mark Matson will now lead things operationally. They could have made Tim Eriksen the Chairman instead and kept David Pointer as a normal board member. With the structure that they've put in place, doesn't it make sense that they're going to look for an acquisition? That would also allow them to better use the NOL's, if those are still valid.

    I mean, you've got a skilled investor in the top position who also happens to have a deep knowledge of all kinds of obscure little businesses given his past experiences at Walker's Manual. Granted, Solitron doesn't have a lot of cash available now for an acquisition, but they could do a rights offering to raise it.

    All in all, I am very happy about these developments. I think Tim Eriksen is a very good investor with high ethical standards. Minority shareholders will be treated fairly while he is CEO. The contrast between him and Saraf could not be much greater.

    I bought some more shares after Saraf's exit was announced. I don't really buy into the whole "Saraf was vital to the business" narrative that I'm hearing from some other investors. I think he is replaceable, like most people in corporate positions are. Saraf wanted people to believe he was irreplaceable and encouraged people to think that way in the public proxy fight that took place. Is that reality though? Perhaps business is just slow currently. I don't think it has much to do with Saraf's exit.

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    1. It is a misallocation of capital to have bought out Saraf. A huge one. Forcing him out via a contested proxy and contesting his contract in court, or forcing him to buy it out would have been much better.

      Buying him out using shareholder money was the least shareholder friendly thing to do.


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    2. Why is it a misallocation? Saraf was going to go, either with a huge exit package from being fired, or with a retirement package (similar amount) where his shares were repurchased. The repurchase option was shareholder friendly.

      Now maybe the person saying this is Saraf, and in that case this comment would be valid..

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  5. Is there anything specific to point to the business being worth $5-6 per share?

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  6. There is downside protection here given the cash and asset value, and SODI may be a good statistical bet a "heads I win, tails I lose very little" kind of set-up.

    Ultimately the outcome will depend on Solitron's core business. Were Saraf's personal connections key to business success? Is the business sun-setting and if so how fast?

    Even if Solitron is in permanent decline value could possibly be created for shareholders through corporate actions (a sale, acquisition, etc). But if Solitron is in decline then actions like buybacks at 80-90% of book value will look foolish before long.

    With SODI currently operating at a loss, I'd suggest investors do their homework and try to get some sense of the future of the industry. And as always, its more important to know the boundaries of your circle of competence than it is to have a large one...

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    1. This is exactly correct.

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    2. As I read this response I have to laugh, Shevach's connections? Really, his lies to them all was what drove them away. The profits are down due to his poor decisions to order piece parts to deliver on time. Also, to make the company go forward, how large is the r&d department? How many engineers or support staff that are not of retirement age? Shevach never broadened his product base which left the company in the dark ages. Glad to see Shevach is not in control but I don't see any real change. I feel for the employees.

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    3. Exactly... The good in this company is all used up.... I also feel for the employees. I see very little actual business acumen on the Board slate.

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  7. Proxy is out. It's worth a read.

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  8. This investment case makes me nervous because it depends on two things: the quality of the underlying business and the activists. I like the basic situation but I would have far preferred to rely less on the turnaround capabilities of the activist and more on the asset protection, which this stock doesn't really have.

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