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Electro-Sense - an interesting special situation

March 20, 2013 | About:
whopper investments

whopper investments

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One of my favorite places to look for new, interesting ideas is in activists involved in other names I like. So I’ve been actively following Nicholas Swenson, who has big stakes in both Solitron (SODI) and AIRT (AIRT). That made this filing on Electro-Sense (ELSE) interesting to me- Swenson has increased his stake in the company to almost 15% and made an offer to tender for shares at $4.73 per share. Shares have risen almost 15% since the offer, but they’re still trading at a 5% or so discount to the offer. This discount makes it interesting on a couple of levels. First, if the tender goes through in the next few months, that discount alone would represent a strong IRR. Second, if the board has any negotiating skills, the tender price might get raised before it finally goes through.

So with that I decided to dig into the company.

The company has three sources of value.

First, it owns 343k shares of Rudolph Technologies (RTEC). At today’s prices, that’s worth ~$3.8m, or roughly $1.10 per share.

Second, the company has roughly $1.67 per share in net cash.

Third, the company’s core business will earn roughly $700-750k in operating income this year on about $6m in sales, and this will be the third year in a row it’s done so. There’s some operating leverage in the business, as before the financial crisis they were doing over $7m in sales and over $1.3m in operating income, but sales were crushed by the recession. If we value the core business at $6-7m, it would be worth between $1.75 – $2.00 per share.

Put it all together and I’m getting a value of $4.50-$4.75 per share. Obviously, there’s some room for upside- the business is showing signs of recovery, as sales have been growing at roughly 10% per year the past few years as they head back towards pre-recession levels. Concerningly, however, the increase in sales has not lead to an increase increase in operating income.

My first thought when I see a divergence between sales growth and operating income like that is the company is making big investments. But that’s not the case here- R&D spend seems roughly flat, and I’m not seeing any other big investments that would be responsible for the divergence.

Overall, I’m not sure what Swenson is seeing here. It seems his bid is at roughly fair value for the company. However, I can think of one explanation. Looking at the shareholder roster, the wife of a deceased ex-board member owns 37% of the company. Other insiders and directors own basically nothing. It’s possible the wife is looking for liquidity and approached the company about getting it. Perhaps the company turned her down, so she approached Swenson. If Swenson bought out all her shares, he’d own over 50%; his last round of shares increased his ownership to 14%, just enough to push him over 50% if he bought her shares- coincidence?

If Swenson controlled over 50%, he could make a bunch of changes to increase value. First, the company specifically mentions increased public filing costs caused by XBRL requirement in their past few filings. I’ve previously estimated the costs of a small company being public at roughly $300k, though I’ve seen estimates as low as $100k and as high as $1m. If Swenson saved those costs, that would represent an increase in value of $2m or so (you can flex the estimate up or down depending on how much costs you think he can save, but I like $2m), or roughly $0.60 per share.

In addition, Swenson would be able to control the cash flow of the company, as well as taking control of the excess cash and the shares of RTEC. He could use that cash and investment to take buyout the remaining shareholders or or simply make more investments.

Overall, I think it’s a bit speculative at these levels. Maybe Swenson can pull all of those levers and create a bit of value above the tender offer for himself, but I can’t see how an investment at these levels qualifies as anything more than a “slight bargain” for outside shareholders. That said, I’ll certainly keep my eye on the company, and it’ll be interesting to see how this all plays out.

Disclosure: Long SODI, AIRT.


Rating: 3.8/5 (4 votes)

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