SODI Update

Sodi reported earnings last week, and it was abysmal at best. I think most people, like I, have been pricing this as a special situation, so it didn’t have much of a reaction. I wanted to wait until the proxy was released, which according to Tim Eriksen and Mayflower Capital, should be this week to post an update, but it seems the stock is already reacting to the good news, so here it is:

Tim sent me this link on Friday. It hasn’t been filed with the SEC yet, but probably will later this week. Notably:

  • Saraf ‘retired’ as of Friday and his 25% stake in the company was repurchased. He was paid a total of $2.85 million. This likely includes his change of control ‘$1 million’ bonus.
  • The executive board has been reshuffled:
    • Tim Eriksen is now CEO
    • David Pointer is now Chairman of the Board (those roles have been separated)
    • Mark Watson, who was previously a consultant at the company is now the COO

Per my discussions with Mayflower Capital. William De Vocht, who runs the fund, wants the company to be sold to a larger competitor who can utilize its capacity and run it more efficiently:

July 21 at 7:14am

Hi Mayflower,

Sorry for the unaddressed introduction, I’m not sure if I’m messaging Mr. De Vocht or not. I’m a recent shareholder of Solitron Devices, and I know you initially advocated for the use of the NOLs, but then a sale of the company as recently as earlier this year based on your comments on SODI articles on seeking alpha. I’m just curious to see if you have any updates on the timing of this year’s proxy and if or when you think we could see the company sold by.

Regards,

July 21 at 11:38am

Block this person

I have shifted my mind because I am no longer convinced that the company has a durable product line and scale to operate at profit levels of the last few years, since Saraf has chronically underinvested in R&D over time. Additionally, being a publicly traded company with a $8 million market cap and the company’s small revenue base, it is just too costly and eats away too much of the annual operating profits. Therefore, I think that the actual use of NOLs is less than originally thought. This company should be the division of a larger company so that the acquirer can diversify their product lines and use the excess capacity at Solitron.

Additionally, it is impossible for shareholders to sell their shares, and the only meaningful revaluation of the shares will keep from a sale of the company, since there is no organic growth. A sale of the company would be most feasible option at this point, with a subsequent distribution of the excess cash as a special dividend.

I think that the proxy statement will be filed this month, but understand that Saraf will be ousted as the chairman this election (so make sure that you vote against him), so that shareholders can finally take the majority of the board and can push for radical change and review all feasible options. Saraf however tries all kinds of delay tactics to avert the inevitable. I am sure that things will clear up once he is ousted, and a revaluation will take place.

He can no longer claim that he is a good operator given recent results.

As I mentioned earlier, I’ve also been in contact with Tim Eriksen. Tim doesn’t want the company sold per an email he sent last night. Mayflower owns 10% of the shares outstanding, so this should be interesting. The stock is up today on 10x average volume.

Solitron Devices Inc: A classic Ben Graham Net-Net w/ A Catalyst $SODI

Purchase Price: $3.61 (6/24/2016) Market Capitalization: $8.12 Million
Price Target: Special Situation (See Below) Enterprise Value: $0.75 Million
TTM EV/EBITDA: Time Frame: 12 Months

Real-Time price: Unfortunately, we could not get stock quote SODI this time.

Solitron Devices, Inc. (OTSMKTS:SODI), designs, develops, and manufactures components for the Aerospace and Defense Industries. This one falls into the ‘Special Situation’ bucket. Current CEO, Shevach Saraf has run the company since its bankruptcy in 1992.

Solitron Devices 5-year chart
Solitron Devices 5-Year Chart

Mr. Saraf has a history of Shareholder hostility and a lack of corporate governance within Solitron, but hedge fund manager, Tim Eriksen of Eriksen Capital Management (ECM), has been able to rally shareholders through a proxy fight to enact a change within the company. Below are some talking points from Tim Eriksen’s presentation to Solitron shareholders:

  • In the last 15 years, we counted only 7 months where the stock traded at or above book value and 173 where it traded below book.
  • From 1993 to 2012, the company held no annual meetings even though Delaware Corporate law requires it.
  • In 2000, the Board voted to approve a massive 700,000 share stock option plan, primarily for Mr. Saraf’s benefit with a strike price of $0.40 (1/3 of Book value, and 1x FY 2000’s EPS)
  • In 2000, the board voted to approve an employment agreement granting Mr. Saraf 15% of Solitron’s earnings in excess of a fixed $250,000
  • In 2007, the Board approved a second 700,000 share option plan without shareholder approval
  • In Feb 2014, the board unilaterally extended the term of one of its directors by one year by having him resign then be reappointed to a different class. (Board did this to avoid having majority of its directors up for re-election in 2014).

The board, prior to last year’s proxy fight was filled by Mr. Saraf’s appointees, which makes it far from independent. The company has a staggered or classified board which means that only a portion of the board is up for election at any given time. In 2015, Tim Eriksen was successful by a wide margin in the proxy fight. Two ECM backed nominees were elected to the 5-person board – David Pointer, Founder of VI Capital Management and Tim Eriksen himself. Mr. Saraf is up for election this year and given that the majority of shareholders are behind Tim Eriksen and David Pointer, Mr. Saraf is likely going to lose his board seat, and this will give the activists control of the board which should propel the implementation of shareholder friendly initiatives.

The CEO’s obscene pay packages have come a long way. To put this in perspective, in the FY ending Feb 15, Mr. Saraf took home his $321,500 base salary + $105,000 bonus or a total of $426,500. Shareholders made $927,000. Mr. Saraf justifies his salary because he holds the CEO, CFO, COO, President and Chairman titles. I have serious doubt that he has been able to perform all functions efficiently – the company’s top-line has been flat over the past 15 years. A Jack of all trades is clearly a master of none.

RISKS

Concentrated Customer Pool

49% of the company’s revenue come from Raytheon, 13% from the U.S. Government, and just over 10% from Lockheed Martin. The relationship with Raytheon dates back to 1997, and the relationship with Hughes Company, which was acquired by Raytheon from GM in 1997 dates back to 1996 (oldest annual report I could find). I have no reason to doubt that this won’t continue. This is a risk nonetheless since nothing is full-proof.

Backlog

The company’s backlog is a fluctuating risk, but going back to 1999, this has always been the case. The backlog varies year to year based on the product mix so I don’t see this as much of an issue. The obscenely cheap valuation also makes up for it.

Mr Saraf’s Relationships

While Mr. Saraf has blatantly ignored shareholder inquisitions in the past, there’s absolutely no doubt that he does indeed carry some intangible value. Being the face of the company for over 20+ years, he likely has close ties with the current clients and there’s a risk that this could be disrupted if he is fired from his position.

CATALYSTS & VALUATION

Special Dividend + Quarterly Dividend

This is my personal favorite. Dividends are taxed at 15%. Also, I think this could be a situation where the company could pay out a large dividend without capital loss. A payout of 50% of the cash balance would represent a 45% dividend. The company would still have a cash balance of $3.6 million and NCAV 0f $7.39 million. A quarterly dividend (with a decent payout) thereafter would help drive volume into the stock.

Sale of Company

The company carries just over $10 million in NOL’s as of the 2016 10-K. With working capital less liabilities of $11 million + Profitability going forward, I believe the company could command 2x today’s price. The company’s profitability has been partially suppressed because of the costs from last year’s proxy fight. Mr. Saraf’s compensation will also likely be restructured to a more reasonable amount. Upside to book value from today’s price is about 37%, NOL’s should keep taxes low over the next few years – and when you then take the company’s future cash flows into account, 2x today’s price seems reasonable.

Tender Offer

The company could issue a tender offer to repurchase 40% of the shares outstanding at 2x today’s price or higher, this would retire a large amount of shares, driving up EPS.

Acquisition/Investment In Securities (NOL Realization)

I emailed Tim Eriksen to see what his plans are in terms of shareholder value creation and I delightedly received a response:

I believe that in a situation where a company has substantial net operating losses (NOLs) which can be used to shield future income from taxes combined with excess cash, that using the excess cash for an acquisition or investment is the highest and best use.  A return of capital via a tender offer or special dividend is a second best option.  While a dividend or tender has greater certainty, it fails to obtain full value of the NOLs.  Both are certainly better than sitting on the cash. 

Hope this helps,

Tim

Quoting another large shareholder, Willem De Vocht of Mayflower 1776 Value Fund filed the following:

Mayflower acquired shares of Solitron Devices because it deemed the company’s shares to be significantly undervalued. While we believe that the CEO and current management has done an excellent job managing the business operationally, we believe that Solitron Devices continues to trade at a significant discount to intrinsic value due to suboptimal capital allocation over a long period of time. The market barely assigns a value to the Solitron’s core business, as it trades at 1.5x normalized EBITDA, and assigns no value to the $13.4 million in NOLs.

As the largest outside shareholder, we strongly urge the company to make meaningful efforts in allocating capital more effectively, while maximizing the NPV of the company’s NOLs. Instead of diverting capital away in the form of dividends and potential large uneconomic capital expenditures projects, we would advocate a combination of share buybacks (combined with a large reverse stock split), value adding acquisitions in related or unrelated industries that are free cash flow generative and would speed up the utilization of the NOLs and/or investments in undervalued securities (supervised by an independent group of experts). In addition to ineffective capital allocation, we believe that corporate governance remains an important explanatory variable for the stock’s undervaluation. We would recommend the board to remove the poison pill, as it serves as an ineffective measure for protecting the company’s NOLs.

While I agree that realizing the NOLs would maximize shareholder value, there’s another part of the equation that we have to give up: Valuation. Valuations are at obscene levels, I think it’d be difficult to find an acquisition at a decent price. Also, from the Investment side, financial assets in all classes trade at nosebleed valuations as well which would be risky. Nonetheless, these guys are experts with great track records, so I believe we’re in good hands regardless of what happens.

Conclusion

My cost basis on this is $3.61 @ 14% of my portfolio. Results for this year’s proxy should come later this year. If Mr. Saraf is re-elected this year, I’ll sell off my shares.