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Solitron Devices: The Microcap for Prudent Investors

July 06, 2011 | About:
Business

Solitron Devices is the a company that designs, develops, manufactures and markets solid-state semiconductor components and related devices, primarily for the military and aerospace markets. It manufactures a large variety of bipolar and metal oxide semiconductor, power transistors, power and control hybrids, junction and power MOS field effect transistors, field effect transistors and other related products. Most of the products are custom made pursuant to contracts with customers whose end products are sold to the United States government. Other products, such as Joint Army/Navy transistors, diodes and Standard Military Drawings voltage regulators, are sold as standard or catalogue items.

Customers

Based on the annual report of the company fiscal year 2011, for the last two years, the main products which account the large percentage of the revenue are Hybrids (>50%) and Power MOSFETS (20%). The customized products take around 90% of the total sales, being attributable to contracts with customers whose products are sold to the United States government. The rest of 10% of sales are for non-military, scientific and industrial applications. Custom products are typically sold to the United States government and defense or aerospace companies such as Raytheon Company (RTN), Lockheed Martin (LMT), Smith Industries, Harris Corporation (HRS), General Electric Aviation (GE), and Northrop Grumman Systems Corporation (NOC), while standard products are sold to the same customer base and to the general electronic industry and incorporate such items as power supplies and other electronic control products.

In the most recent fiscal year, the company got total 106 customers, including 36 new customers. Raytheon accounted for 27% of total sales, BAE Systems Australia accounted for 12%, and Harris Corporation, 11%. Fifteen of the company’s customers accounted for 86% of sales. What we can see from here is that the customers are quite concentrated. Relatively small number of customers is what the company has been experiencing for years, and it expects to continue.

Suppliers

The company sources its raw material from multiple suppliers. It has a minimum of two suppliers for most of its material requirements. It purchases raw materials and finished packages from Egide USA, Platronic Sales, Coining Inc. etc. The company itself has reported that it has been obliged to pay higher prices due to declining a number of sources for components and packages, and the sharp rise in raw silicon wafers, precious metals and gold which were used in the finish of the packages).

Operating performance

We will have a look at the operating performance of Solitron Devices for the past 10 years.

1193154019.jpg

As it can be seen, the gross margin, the operating margin and the net margin are at the rising trend. Even though the company reported the rising price in raw silicon wafers, precious metals and gold, the gross margin has been increasing for the past 10 years, standing at around 28.7%, more than double 10 years ago. The operating margin and the net margin stay around 14-15%.

The spike of net margin in the year 2006 is due to the forgiveness of debt settlement to be recorded as other income, including settling debt obligations to unsecured creditors and entering the Ability to Pay Agreement with the United States Environmental Protection Agency (USEPA).

Profitability

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Net Margin -6.52 4 2.13 5.56 23.27 5.57 11.87 11.46 9.97 14.12
Asset Turnover 1.09 1.25 1.26 1.23 1.19 1.03 0.92 0.87 0.77 0.81
Financial Leverage 2.62 2.5 2.32 2.14 1.47 1.36 1.45 1.31 1.25 1.24
Return on Equity -17.64 12.77 6.47 14.62 47.56 8.11 15.38 13.01 9.83 14.25
Figures are in %

The positive thing is that the net margin keeps increasing over time as we can see both from the graph above and this table, and the level of financial leverage is reducing overtime, standing at Asset/Equity of 1.24. However, it is offset by the asset turnover which will be lower over time, fluctuating at 0.7-1 for the last five years.

Financial Health

Solitron Devices are currently in very good shape when it comes to financial strength. The main item in its assets is cash and cash equivalents, taking 58.7% of the total assets, whereas the total liabilities in its balance sheet are around 19%. It has the operating lease, but the amount is not very significant; if we put the operating lease back to its balance sheet, the ratio of debt/asset would be around 22%. Half of the total liabilities is the obligation that the company has to make under the reorganization plan after the company filed voluntary petitions under the Federal Bankruptcy Code.

At the fiscal year of 2011, the company is scheduled to pay approximately $1 millions to holders of allowed unsecured claims in quarterly installments of approximately $7,000.

Free Cash Flow

1578616715.jpg

For the last 10 years, the firm has been experiencing a fluctuating but increasing trend in both operating cash flow and free cash flows. The highest amount of net income in 2006 has been explained above, due to the other income recorded from the forgiveness of debt paid to unsecure debt holders and entrance into the agreement with USEPA.

Enterprise Value

The current market value at the time of writing is at $8.14 million, and the market price per share is $3.59. As of the fiscal year of 2011 (February), the amount of cash in the company is around $6.8 million, whereas the total liabilities (including operating lease) are at $2.7 million. Adjusting for that, the effective price paid for the company currently stands at $4 million.

Management

In the key executive team, there are several important roles incorporated in only one guy, who is Shevach Saraf, chairman of the board, chief executive officer, president, chief financial officer and treasurer. Mr. Shevach Saraf has been president of the company since November 1992, CEO of the company since December 1992, chairman since September 1993 and CFO since 2000. He has 46 years experience in operations and engineering management with electronics and electromechanical manufacturing companies.

According to their annual report filing on fiscal year of 2011, Mr. Shevach effectively owns nearly 27% of the total outstanding shares. There are two other individuals who hold 20.4% of the company, not the key executives or directors. GRT Capital Partners holds nearly 5.2%.

The concentration in the management of one guy, who takes the role of chairman, CEO, CFO and treasurer altogether raises questions. And there might be some potential risks if Mr. Shevach doesn’t have any contingency plan for his successor yet.

Competitors

Solitron Devices has numerous competitors across all of its product lines. Some of the major manufacturers of semiconductors manufactures some of the company’s products. A few major competitors have elected to withdraw from the military market altogether (e.g, On Semiconductors and Fairchild Semiconductor). Other competitors in the military market include International Rectifier (the Omnirel Division), Microsemi Corporation (the NES and APT Divisions), M.S. Kennedy Corporation (a wholly owned subsidiary of Anaren Inc.), Natel Engineering Company and Sensitron Semiconductor.

Below is some listed competitor comparison by Yahoo! Finance

SODI IRF MCRL MSCC Industry
Gross margin 28.70% 39.80% 56.93% 52.32% 44.21%
Operating margin 14.35% 11.53% 24.61% 13.00% 11.58%
Net margin 14.11% 13.73% 16.82% 3.14%
P/E 7.04 12.92 13.41 80.31 10.82


Source: Yahoo! Finance

To compare with its competitors and its industry in general, the table has shown that the gross margin of SODI to be the lowest in the industry and when comparing it to other competitors, however, it’s in the rising trend. The operating margin and the net margin seems to be on the upper side, higher than the industry. For the relative valuation, SODI seems to be the cheapest, even excluding the high cash balances and the low debt for now.

Valuation

For seven years from 2004 to 2011, the growth in free cash flows is around 10.5% compounded annually. We have two scenarios; one is the best case and the other is the worst case.

Worst case

Assumptions
Growth rate for the next 05 years 5%
Discount rate 10%
Terminal Growth rate after 5 years 1%


USD thousands 2011 2012 2013 2014 2015 2016 Terminal year
Cash flows 456 479 503 528 555 582 11,766
PV of CF 456 436 416 397 379 362 6,642
NPV 9,087


For the worst case, the growth rate for the next five years is only at 5%, and 1% for infinity. At that time the enterprise value of SODI would stand around $9.1 million; the market value should be $13.2 million.

Best case

Assumptions
Growth rate for the next 05 years 8%
Discount rate 10%
Terminal Growth rate after 5 years 1%


USD thousands 2011 2012 2013 2014 2015 2016 Terminal year
Cash flows 456 493 532 575 621 671 33,865
PV of CF 456 448 440 432 424 416 19,116
NPV 21,733


We adjust the growth rate for the next five years in free cash flow to 8% as representing our best case. For that, the enterprise value of SODI should be $21.7 million, meaning that the market value should be $25.8 million.

With both worst case and best case, I think SODI is a good business to own for the patient investor, when it increases its value to my calculated range. However, there are some potential downsides relating to the structure of management and the concentration of customers that might drag the company down. Any investors should take great care when taking any positions in this stock.

Disclosure: long SODI

It is not the recommendation for buying, holding and selling the stock. Any investor who wishes to do so should conduct his/her own research for his/her own actions, bearing his/her own risks.

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


Rating: 3.6/5 (80 votes)

Comments

batbeer2
Batbeer2 premium member - 3 years ago
Thanks for the article.

>> However, it is offset by the asset turnover which will be lower over time, fluctuating at 0.7-1 for the last five years.

Why not back out their portfolio of bonds before calculating asset turnover ?

Turnover declines as they build up a mountain of short-term investments. I believe ROA and ROE as reported belie the quality of the core business.

Any thoughts on the environmental liabilities ?
aldandrea
Aldandrea - 3 years ago
What about the environmental clean up cost risk associated with SODI? They are still paying -- and may have additional future liability put on them by the EPA et. al. -- for environmental damage / cleanup at a former northeast manufacturing site. This unknown puts pressure on the stock price. Some feel that the potential liability is small, however, in any case, the matter should be addressed in any thorough analysis of the investment case.
batbeer2
Batbeer2 premium member - 3 years ago
This unknown puts pressure on the stock price.

There is more information available than one would think. The USEPA publishes regular reports on the progress of the cleanup. Solitron has met all the cleanup goals and the sites have been declared clean. They're now just doing regular checks to see if it stays that way. http://www.epa.gov/superfund/sites/fiveyear/f2009040003045.pdf

The Soliton sites are a political "showcase" for USEPA. http://www.epa.gov/region4/waste/sf/sri/success/excellence.html

My 2 cents.
ken_hoang
Ken_hoang - 3 years ago
@ Batbeer: thanks for the remind. for SODI they got quite large % of cash and cash equivalent (including T- bills), instead to using these cash to invest to generate more sales, they are investing in T-bills (increasing the strength of balance sheet but lowering the efficiency turnover ratios in general).

and thanks for the link of UEPA, and the environmental problem is one of the uncertain factor in the future. The sites might be declared clean now, and the firm has managed to do so, so there is high probability that it might continue into the future. However, there are still some probability that some future events that might leads to the environmental issue.

Uncertain events are inevitable in any investment, as long as we keep focusing on high probability success with the margin of safety to account for those uncertainty.

TheBourqueReport
TheBourqueReport - 2 years ago
The man running the show obviously does a great job, keeping everything running smoothly through the business cycles. Solitron Devices earns a steady profit year after year and is very efficient as such a small company. They were even wildly profitable in 2009!

The only thing I find disappointing is how they choose to deploy the excess capital. They didn't buy out any competitors in late 2008/early 09, they didn't invest in stock in other companies in early 09, they didn't pay it out as dividends at that time so shareholders could use the money to buy bargains left right and center, and they are investing in treasury bills which are in an enormous bubble right now as they are paying near 0%.

Now, I'm not saying that this isn't conservative. I'm saying that this is way too conservative. If you expect your business to provide losses for a year or two in the future, sure, save enough money to withstand the possible rocky roads. If not, buy back stock when it's cheap! Buy other securities when they are cheap!

Chris Bourque

TheBourqueReport@gmail.com

batbeer2
Batbeer2 premium member - 2 years ago
>> The only thing I find disappointing is how they choose to deploy the excess capital.

For now, the stash of cash is restricted.

From the 2010 may 2011 10k, p17:

.... 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.

What about the environmental clean up cost risk associated with SODI?

From the feb 2005 10k, p8:

At a meeting with USEPA on March 23, 2001, USEPA contended that the Company’s alleged share of liability at four (4) of the sites totals approximately $7.65 million, which USEPA broke down on a site by site basis as follows: Solitron Microwave, Port Salerno - $3.8 million; Florida Petroleum Reprocessors - $150,000; Casmalia Resources - $2.7 million; and Solitron Devices, Riviera Beach - $1 million.

.....SNIP.....

... the Company is obligated 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 years 3-7 following the effective date of the Agreement. The Company signed the Agreement and returned it to USEPA for execution on January 26, 2004.
TheBourqueReport
TheBourqueReport - 2 years ago
That seems ridiculous to me, especially since they have a liability with a NPV 8.25% of $138 000 and they have a cash minus total liabilties balance of $4.8 million in the 10-k. Why don't they just put $200 000 in a reserved account that USEPA has first rights over, and then the rest of their cash would be unrestricted!?

"

7. LONG-TERM LIABILITIES

As of February 28, 2011 and 2010, long-term liabilities consist of the following items:

2011 2010

Environmental liability $138,000 $148,000

Environmental liability has an estimated payout period of seven years at a discounted interest rate of 8.25%.

Environmental liability is shown net of an interest discount of $54,000.

Contractual or estimated payment requirements on other long-term liabilities excluding amounts representing interest

during the next five years and thereafter are as follows. It is reasonably possible that the estimates could change in the

near term:

Fiscal Year Ending February 28/29 2011

2012 $ 27,000

2013 27,000

2014 27,000

2015 27,000

2016 27,000

Thereafter 3,000

Total $ 138,000"

batbeer2
Batbeer2 premium member - 2 years ago
Why don't they just put $200 000 in a reserved account that USEPA has first rights over, and then the rest of their cash would be unrestricted!?

Yeah.... that question bugged me for a while.

That "liabilty" is an estimate of the present value of future payments; as estimated by the accountant. The precise amount can't be determined. USEPA is probably not one to bet. The judge said 5% of net after tax income so.... we sweat it out. Solitron could probably settle if they really wanted to, but they're very, very ! frugal.

Also.... consider that Solitron has huge tax shelters in the form of NOLs. I do not expect them to declare a big one-time dividend any time soon. It wouldn't be efficient use of capital. A buyback or buyout would be more logical. Should interest rates rise, the income from the T-bills has an impact on earnings and the NOLs allow them to compound that.... A NOL is nice but you want to convert it into cash quickly.
TheBourqueReport
TheBourqueReport - 2 years ago
Yeah, $14 million of NOL or about $4.76 million undiscounted taxes saved if used before 2029. Can these NOL's be used against capital gains? If they can, which I believe they can, they would be well served to have a value investor investing some of their portfolio.

Hell, I would do it as a 0% fees / 25% of profits above 6% compounded annually invested alongside my capital with all investing decisions presented to the CEO if he was interested.

At least invest some in a low fee index fund on occasion, that would be much better than treasuries over a long period of time and I would value this company higher myself if I knew that was the case, even though the index isn't particularly cheap at this time.

Chris Bourque

TheBourqueReport@gmail.com
batbeer2
Batbeer2 premium member - 2 years ago
>> Hell, I would do it as a 0% fees / 25% of profits above 6% compounded annually invested alongside my capital with all investing decisions presented to the CEO if he was interested.

You and me both. If memory serves, the guy from hummingbird or some other well regarded fund is on the board.

Nate from "oddball stocks" has something to say about the matter:

http://oddballstocks.blogspot.com/2011/06/solitron-assets-and-liabilities.html
TheBourqueReport
TheBourqueReport - 2 years ago
If I knew their investment portfolio consisted of 30% treasuries and 70% Berkshire Hathaway stock at today's prices I would be buying Solitron stock in droves. Even more so if I could advice the CEO when NOT to sell the stake.

Hell, given his compensation scheme this would earn him a lot more money too, as he earns 15% of pre-tax income above $500k. One day, 5 years down the road when Berkshire is up 4x from here, he will get a very fat paycheck when he sells the stock and gets 15% of the profits from it! $2 million for no work, anyone (pssssss, CEO)? Shareholders would be served well too!
ivi
Ivi - 2 years ago


Great write up... thanks.
ken_hoang
Ken_hoang - 2 years ago
Sorry for the late reply guys,

Thanks for the discussion Batbeer and TheBourqueReport, very solid points.

More than 50% of the total assets goes into the Treasury Bills, and I agree on the points that the executives of SODI might be well too conservative. However, The value investor like me feel I can enjoy the good sleep at night, and that factor contributed to thinly traded and not so much movement in the stock price. If situations changes, the stock price can shot up pretty quickly or the special dividends might be delivered. Patience will be always serve the investors extremely well.

batbeer2
Batbeer2 premium member - 2 years ago
Heads up !

Solitron currently sells for less than the value of the treasuries on the balance sheet.

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