At the end of November, I applied to join the MicroCapClub which has been one of my goals for some time.
I was accepted as a new member in December and ever since announcing my acceptance I have received a lot of requests to read my accepted application.
I appreciate the interest in the application and understand how useful it can be for prospective members to be able to read a recently accepted application. Such insight can allow another to make their own application by knowing what sort of qualities is in a good application.
The following is a copy of my application to MicroCapClub. I have delayed publishing it to my blog in order to comply with MicroCapClub forum rules about simultaneous publishing of my thesis. When the application was published on November 30th, the share price of Solitron Devices was $4.12. The current share price on February 11th, 2.5 months later is now $6.50, representing a gain of +57% since publication.
Disclosure: As will be clear after reading the thesis, a large part of my thesis is based on multiple expansion which requires a broad interest in the company from new investors. Thus, as I have built a large position, I am certainly incentivized to spread the idea around. As always, I reserve the right to change my thesis and holdings at any time.
MicroCapClub Application – $SODI
[Application as of November 30th, 2020]
Solitron Devices (SODI)
Ticker: SODI
Price: $4.12
FD Shares outstanding: 2.08 million
Market Cap: $8.57 million
Cash: $2.9 million
Debt: $0.8 million (All covered under a PPP loan expected to be forgiven)
Enterprise Value: $6.47 million (or $5.67 million if you exclude forgiven loan debt)
Earnings: $1 million (1H 2020)
Business Overview and Stock Thesis
Solitron Devices (SODI) is a profitable, growing, and high-quality manufacturing company operating in the defense industry which is on the cusp of benefiting from massive operating leverage in its business model. Solitron operates a single manufacturing facility in Florida and has the potential for large earnings growth as additional revenue will increasingly fall straight to the bottom line. Solitron has recently completed a 5-year turnaround when new management lead by an activist investor took over in 2015. The year 2020 (Fiscal 2021) will finally signal success for the turnaround as the company becomes solidly profitable and is set up for large, sustainable growth in operating earnings. I believe Solitron Devices represents a potential 5 to 10-bagger as low double-digit revenue growth leads to high double-digit earnings growth for the foreseeable future.
Solitron Devices manufactures semiconductors that are used primarily as part of power chips in various defense projects for the US government. Their primary customer is Raytheon. A key part of the turnaround begun in 2015 by CEO Tim Eriksen was to change the relationship with Raytheon. At the time, Solitron was the sole-source provider for some of Raytheon’s materials and was seeking to replace Solitron as a supplier. Over the last five years, Solitron has instead become a preferred partner of Raytheon and is being sought out for new advanced products to displace some of Raytheon’s other suppliers. In general, Solitron Devices operates as a sole source manufacturer for the products that they produce and charges cost-plus rates as part of standard government contracting practices.
As a result of the work of CEO Tim Eriksen and COO Mark Matson since the activist takeover of 2015, sales have grown 50% from $7m per year to an estimated $10.5m for Fiscal 2021. (Note: Fiscal 2021 refers to most of the calendar year 2020). This growth in sales has been driven by improved customer focus and building better relationships to meet the needs of their customers. Now customers seek them out for new additional products. Why was this necessary? The prior CEO was ousted in part due to personal overcompensation, but also managed to neglect these critical customer relationships. 2020 represents the first year they are rolling out a new line of product which is already seeing demand.
In addition to the customer relationship changes, the internal manufacturing changes have been broad and sweeping. The management team has cut costs by changing the culture of the company. The renewed focus is on taking personal ownership in improving the company and so the manufacturing team now operates at a lower cost and greater focus on improving the product line.
Key Takeaway: This is NOT a turnaround story. The turnaround has already happened. The future is a story of growth, operating leverage, and free cash flow.
Management and Scuttlebutt
As a small nano-cap company, I felt it important to really understand the management team. I’ve spoken on multiple occasions with CEO Tim Eriksen to develop my understanding of the business.
Tim Eriksen (CEO) is a hedge-fund manager who successfully executed an activist takeover in 2015. When you read his investor letters and the original activist campaign it is clear that he understands capital allocation and has skin-in-the-game. Tim Eriksen owns over 13% of the company’s outstanding shares either directly or through his hedge fund. Those shares were acquired primarily in the open market and not through stock grants. As his activist campaign focused on the high executive compensation of the previous CEO, he has intentionally kept a low compensation in his current role.
I believe Tim acquired his stake in the open market at an average market price of around $4 per share in the range of the current price of $4.12. His incentives not only align financially but also reputationally he has a high interest in making this company successful as I believe it to be his first successful activist takeover.
The result of my scuttlebutt is very clear and simple: Solitron Devices is set up for massive earnings growth as revenue continues to climb. Most of Solitron’s expenses are fixed costs which means that each incremental dollar of revenue will increasingly fall to the bottom line. Operating margins will grow and earnings will grow much faster than revenue. My basic thesis is that incremental growth can lead to additional profit at a 50% rate. The company’s earnings are very heavily free cash flow. There is only limited reinvestment needed in the business in order to facilitate revenue growth. The company’s facilities are large enough to accommodate additional sales without much capital input. This means that the growing earnings will be available for distribution to shareholders in the form of dividends or buybacks.
Financials, Risk, and Why does the Opportunity Exist
I believe the current market opportunity exists because of an issue that arose between Solitron and a previous auditor. That issue cost the companies millions of dollars and multiple years to resolve and led to Solitron falling behind on it’s reporting obligations to the SEC. The dispute did not involve any concerns of fraud but was procedural in nature. Solitron’s new CEO eventually replaced the auditor with a new one and that audit review is underway. I expect the audited financials for the last two years, and the first two quarters of 2020 to be released within the next 6 months. The only reason the audited financials have yet to be released is due to COVID related delays on the part of the auditor. [Post Publication Note: Audited financials for 2019 and 2020 were published in a 10k dated 02/10/2021 and are available through SEC Edgar]
The release of the audited financials should be a major catalyst for the company as they come back within full compliance with SEC reporting obligations. One large part of this catalyst is that company management has been prohibited from buying shares in the open market. As you can see here, CEO Tim Eriksen was an active buyer until he was no longer able to do so due to regulations.
All of Solitron’s unaudited financials and reports are available in SEC Edgar and reported on their website: https://solitrondevices.com/investors/
The two most recent are of the most importance: September 25th, 2020 reported balance sheet and earnings for the first half of 2020. November 13th, 2020 gave an upward revision on 1H 2020 earnings to approximately $1 million.
These results indicate two key things:
- The company has net cash of $2.1 million and is self-funding. There is no financing risk and no dilution risk.
- Solitron Devices is highly profitable with $1 m in 1H 2020 earnings and a production run rate capability of $2 million.
The only remaining reason to be concerned from a risk perspective is if you don’t trust management’s public statements on unaudited financials while we await the completion of the audit. I trust management to be telling us the truth based on my scuttlebutt and investigations into the CEO and the company. Yet, even if you lacked that experience, I believe it highly unlikely management would make such easily disproved public statements during the course of an ongoing audit. Such action would create unnecessary legal liability. The November 13th press release shows if anything they were conservative when estimating financial results in their September report.
Valuation, Future Expectations, and Price Target
Solitron Devices has current earnings of $1 million for the first half of Fiscal Year 2021. This is equivalent to $0.48 per share. If we assume the company simply breaks even on the remainder of Fiscal Year 2021 (The calendar Year 2020), I will value the company based on 2020 earnings of $0.48 per share. I believe this to be conservative.
Based on a stock price of $4.12, Solitron is currently trading at a P/E of 8.5 and an EV/E of 5.6. This price is exceptionally low for a company that will likely massively grow its earnings for the foreseeable future.
In Solitron’s September press release, they stated an expected net booking of $11.5 million. Bookings tend to translate into revenues over the course of 12 months, so I expect Fiscal 2022 (CY 2021) revenues of $11.5 million compared to 2020 revenues of $10.5m. With the increase in revenues, I’m assuming Solitron can attain $2 million in Full-year earnings in 2021 or approximately $0.96 per share. This gives no credit for the operating leverage I expect, simply annualizing 1H 2020 results with the higher revenue.
I believe a reasonable, conservative valuation for Solitron Devices to be a Price to Earnings Ratio of 15, normally used for an average company. Solitron is an above-average company growing at an above-average rate. However, if we simply use a P/E of 15, the result is a price target for next year of $14.40 per share (or 3.4x the current stock price). This gives no credit for the cash-on-hand which I expected to be used for buybacks as soon as the company is up-to-date on reported financials. If we add-in the net cash of $2.1 million, we would value the company at $32.1 million or $15.43 per share. (or 3.7 times the current stock price).
Price Target: $15.43
Current Price: $4.12
My future projections include Solitron achieving $3m-$5m in earnings within 3-5 years. I also believe this company has the potential to achieve much higher valuations based on it’s rapid growth, such that you could easily justify a P/E ratio of 20+. At the high-end of these growth rates and valuations, Solitron Devices could achieve a valuation of $60m – $100m ($28.84 – $48.07 per share) within the next 3-5 years and achieve ten-bagger status. Yet, none of those projections are needed to justify the current low stock price of $4.12 or a reasonable price target of $15.43.
Long SODI at $2.38 avg price.
