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Iinvestment Thesis on Floris Oliemans on Solitron Devices Inc (SODI)

December 15, 2009 | About:
Greenbackd

Greenbackd

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We have a guest post today on Solitron Devices Inc (SODI) from Floris Oliemans. Floris is a recent graduate of the University of Maastricht in the Netherlands with a MSc in Finance. He also holds a BSc in Economics. He wrote his masters thesis on the performance of Net Current Asset Value stocks. He currently works as a financial analyst for a Dutch multinational. He is very interested in applying the value concepts proposed by Graham, Whitman and Buffett, for the portfolio of his family and where ever it may be used professionally. Here his view of Solitron Devices Inc (SODI):

Solitron Devices is a manufacturer of Semiconductors for military, extraorbital and industrial purposes. It produces analog vs digital semiconductors (I dont quite know the difference, I lack a BA in engineering).

The reason I bought this stock is because it is trading at a 30% discount to NCAV. I believe the assets in place are of high quality. Its current market cap is 4,97 million. After subtracting all liabilities it has (roughly) 3,5 million in net cash. The remainder of the assets is tied up in 1 million of acc. rec (very high acc rev turnover) and 2,71 mio of inventory. The inventory consists mostly of raw materials and of goods already ordered by customers. It does not produce products that the customer has not ordered, therefore inventory can and should be liquidated at near 100% of nominal value. Furthermore it has an inventory reserve of nearly 1,4 mio which might or might not be too conservative.

The company is tiny, but it has been profitable for the last decade. Based on last years earnings the firm is yielding 16%. The reason for this high earnings yield is because it has a large tax loss carryforward worth 8 million. This tax loss carry forward is due to the bankruptcy of the firm in 1993, and lasts until 2023. With net income of 900,000 last year, and a tax rate of 30%, it will not be able to use the tax loss carryforward completely. This is one reason why the tax loss carryforward is only listed in the footnotes and not on the balance sheet. One can be safe to assume that the firm will not be required to pay taxes for the foreseeable future. This is an offbalance sheet asset that can definitely add value to the current shareholder.

I do not expect a massive increase in earnings but there are a couple of factors which could act as a catalyst to the firm:

1. The large tax loss carryforward. By buying this firm, a larger competitor could use this tax loss carryforward to lower incometaxes for the entire firm. This would unlock the value of this hidden asset. A cautionary note: The annual report states that a new majority owner of the firm might not be able to use all of the tax loss carryfowards.

2. A wrapping up of all bankruptcy proceedings. The firm has promised all previous creditors that it will not pay any dividends until all the bankruptcy obligations have been paid. As far as I can deduct, the firm is still obliged to pay 1.1 mio in accrued liabilities. At the current scheduled payment rate the firm will be done paying in 4 years. After this, the built up cash reserve could be used to redistribute to shareholders.

3. An increase in business due to the new ISO certification. The company recently received an ISO certification allowing it to produce semiconducters suitable for space. What the impact on the business will be, I have no clue, but it might be positive.

4. An increase in margins. Recently a large competitor left the market, motorola. A decrease in competition lifts the bargaining power of the firm and could increase margin. It could also increase its market share.

Risks:

1. The backlog has decreased over the last 12 months. This could imply a sharp decrease in demand and lower sales volume/margins. The company has relatively few fixed assets in place, thus the risk of a decrease in NAV is minimal.

2. Fraud. Altough I have no reason to suspect fraud (the firms accounting is pretty simple), the majority shareholders could be misrepresenting the figures.

3. Majority shareholders abusing their voting rights. Majority shareholders could abuse their position to siphon of shareholder value and take Something Off the Top (SOTT). There are some options outstanding but they have not increased significantly.

4. I dont understand the business. I have no idea how a semiconductor is made or what function it has. I could be buying into a dying company and/or industry and not know about it.

Conclusion:

The high quality of assets in place, the consistent earnings and the large tax loss carryforward make this a confident invesment. Something could happen that I have not foreseen in my analysis, but this is always a risk. I am just going to leave this stock for the next 2 years and see what happens. As Pabrai says “Low Risk, High Uncertainty”.

The stock is very thinly traded, so, if you’re inclined to do so, take care getting set.

[Full Disclosure: I do not have a holding in SODI. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

Greenbackd

http://greenbackd.com/

About the author:

Greenbackd
Greenbackd is a former corporate advisory and securities lawyer working in value-oriented activist funds management.

Rating: 3.2/5 (17 votes)

Comments

tkervin
Tkervin - 4 years ago
The troubling portion of this is ......"I don't understand the business....." Perhaps the difference between analog and digital is a key? Will sales fall off the cliff because of this or other factors related to the actual functioning of the business that are not understood? Why are the assets of high quality and how would you know if the business in not understood? Why will the earnings continue to be consistent if you do not understand why the earnings are being generated in the first place? How can the competition be assessed?

The tax loss carry forward is a known plus.

I have a great fear of putting my hard earned money to work unless I understand how the business I am buying into operates.
batbeer2
Batbeer2 premium member - 4 years ago
A few points from the 10k:

1) 8. Income Taxes

At February 28, 2009, the Company has net operating loss carryforwards of approximately $8,680,000 that expire through 2022. Such net operating losses are available to offset future taxable income, if any. As the utilization of such net operating losses for tax purposes is not assured, the deferred tax asset has been mostly reserved through the recording of a 100% valuation allowance.


2) They have basically agreed not to pay a dividend until 2013. This is when they pay the final setllement with USEPA. This to me explains the cash building up. They could of course negotiate an accelerated settlement.

3) The CEO, Shevach Saraf, makes about 600k and is 66. To a strategic buyer, part of that goes to earnings.

-EDIT- This is a Graham stock if I ever saw one.
batbeer2
Batbeer2 premium member - 4 years ago
Given that I have nothing to add to the excellent quantitative analysis above, I shall try to adress some qualitative points. Tkervin asked some important questions.

Solitron makes batches of commodity products to order. The design is provided by the client and Solitron builds a batch to a very high specification on short notice. Sometimes the design is altered marginally. These products are used in missiles, satelites, extraterestrial vehicles.... situations where failure is costly.

Perhaps the difference between analog and digital is a key?

IMO the key to future profitability is the ability of the company to keep its quality and flexibility high at low cost. The NOL helps. Imagine you have to compete in this niche against someone with no debt or taxes.

Will sales fall off the cliff because of this or other factors related to the actual functioning of the business that are not understood?

I believe Solitron is sensitive to fluctations in defense spending. Management builds up an inventory of low margin commodity items in down periods. They switch to the high margin special products in response to demand.

Why are the assets of high quality and how would you know if the business in not understood?

If one thinks of Solitron as a company providing an essential service, the most important assets are its mountain of cash, its NOL, its reputation and sales network and its certifications. Let's say a foreign company needed these certifications to land a major contract.... What would they be willing to pay for Solitron just for the certificates ?

Why will the earnings continue to be consistent if you do not understand why the earnings are being generated in the first place?

This company should be able to survive long dry spells (probably better than most) due to its high level of cash and proven variabe cost structure. I have no opinion about the future of defense spending.

One risk specific to this company are its liabilities to enviromental agencies. This is what sent them into bankruptcy 18 years ago. My review of the proceedings in the SEC filings leads me to believe the quantitative analysis is conservative in this regard.

Any and all questions welcome as usual. Feel especially free to point out any flaws in my reasoning as I am long this stock.
aldandrea
Aldandrea premium member - 4 years ago
Solitron goes back a long ways. Back in the 1960s the company appears to have been much larger and was involved in a fairly large take over bid of Amphenol. A search on Google seems to indicate that the company did something wrong, although I have not researched this issue.

If you read the 10Qs, there is reference to Solitron's "pre-bankruptcy reorganization". What is that about? It may be nothing, but those things make me real nervous and I'd want to know more before buying shares.

Can anyone shed light on this? I would think that any thorough analysis of the stock would have addressed these issues if they are real.
batbeer2
Batbeer2 premium member - 4 years ago
Yes, these issues are very real. Old solitron was forced into bankruptcy by liabilities as a result of (ground water) polution at a number of its production sites.

In short, the current solitron is just a division of the old company, the rest was liquidated. This division was allowed to emerge from bankruptcy with limited liabilities.

If you are familiar with the USG story, there are similarities. USG managed to get a judge to put a cap on the magnitude of its asbestos liabilites. Current solitron exists because a judge capped its polution liabilities.

One important effect of their exit from bankruptcy is that they are not allowed to pay a dividend till the last settlement payment to USEPA (fiscal 2013); hence the cash hoard. The grand total of these future payments can now be reasonably estimated at less than 200k.

Don't take my word for it.... you can track the case. Two places to do this are the archives of EPA and FDEP.

http://www.epa.gov/fedrgstr/EPA-WASTE/2003/February/Day-14/f3700.htm
batbeer2
Batbeer2 premium member - 3 years ago
The firm has promised all previous creditors that it will not pay any dividends until all the bankruptcy obligations have been paid. As far as I can deduct, the firm is still obliged to pay 1.1 mio in accrued liabilities. At the current scheduled payment rate the firm will be done paying in 4 years. After this, the built up cash reserve could be used to redistribute to shareholders.

It took me just nine months to find two flaws...

On the balance sheet you will indeed find 1.1m of pre-petition debt. The thing is, Solitron negotiated with the creditors that these liabilities will be repaid at a rate of 7k per quarter; say 30k annually..... Mind you, that is not interest, that is principal. This is interest free, unsecured, debt.

#1 This has nothing to do with the ability to pay a dividend. The restriction on the payment of dividends is limited by the settlement of the post-petition enviromental liabilities. The last settlement payment to USEPA is scheduled for fiscal 2013. Less than 200k of liabilities still left.

From the 10k:

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.

#2 What we have is an interest free loan of ± 1.1m which could probably be settled tomorrow by paying 750k. Creditors presumably would prefer the (secured) debt of say GE yielding 4% to the unsecured debt of Solitron yielding less than 3% with zero value at maturity.

In any case, the present value of that 1.1m liability is significantly less than its book value. In the calculation of NCAV, this liability was valued at book. This is overly conservative.
batbeer2
Batbeer2 premium member - 3 years ago
Found another interesting fragment in the 10k about that unsecured debt......

At the bottom of page 46 of the most recent 10k......

For purposes of the agreement, “pre-tax income” shall mean net income before taxes, excluding (i) all extraordinary gains or losses, (ii) gains resulting from debt forgiven associated with the buyout of unsecured creditors, and (iii) any bonus paid to employee.

So.... a buyout (at a discount) of unsecured creditors is not some hypothetical adjustment of NCAV... it has been identified as a realistic opportunity by directors.

Quickbeam
Quickbeam - 3 years ago
Hey Batbeer,

I posted the original analysis. Great find. I have been holding this stock for almost a year now. While it has done as well as some of my other stocks, you do get an earnings yield of 20% based on current prices. Could be worse for an almost net cash stock.

Do you hold the stock?

Do you have any idea about future triggers?

Reg,

Floris
batbeer2
Batbeer2 premium member - 3 years ago
I posted the original analysis.

I know, I missed it on the usual NCAV screeners but I caught your thesis on oldschoolvalue.com. Good work !

Do you have any idea about future triggers?

Hmmmm.. either they settle the claims and get bought out or we wait till fiscal 2013; calendar 2012, for the enviromental liabilities to be finally settled. It's about time the CEO retires.

I am not expecting anything before 2013.

We probably live less than 25 km apart. Bakkie ? Batbeer(at)hotmail

I'm long; my US holdings: http://www.gurufocus.com/my/func.php?action=overview&uid=35024&id=5018

P.S.

Should interest rates rise, earnings will rise too (income from the short term investments). This may have some effect on the stock.

batbeer2
Batbeer2 premium member - 1 year ago
Like clockwork...... it is now 2013 and Solitron is done with USEPA.

Of course, this was to be expected given the 2009 EPA report.

And the fact that the site was cleaned up and has in fact been in commercial use for years.

As late as 2011, the stock remained beaten down because of the uncertainty regarding the liabilities. Meanwhile the USEPA had long since given the site a clean bill of health.

This was one of the first stocks I ever bought. One thing I learnt is that the SEC is not the only reliable source of information. Now that the 8-k is out investors are finally coming round to the reality of the situation.

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