"If something cannot go on forever, it will stop."

-Herbert Stein

Smith-Midland Corp. (SMID) trades for $1.89/share with a market capitalization of $8.8m (making this a PA idea).  The business trades at ridiculous multiples (approx. 1.7x 2010E EBITDA with a 34% 2010E pre-tax return on equity and a 65% increase in tangible book value over the past 2 years) and the price seems likely to correct itself in the future, if for no other reason than the accumulation of cash on the balance sheet and the growth of the earnings power in the business. 

Someone once said that if they wrote a book, it would be called "Value is its Own Catalyst."  While I might not necessarily buy that book - at some price value is its own catalyst and I believe that Smith Midland is a good enough and cheap enough business to provide very attractive returns on a low risk investment.

SMID manufactures, leases, and licenses precast concrete products for the construction, utility and farming industries in the Mid- Atlantic, Northeastern, and Midwestern regions of the United States. It designs and produces a variety of proprietary products for general contractors; municipal utilities; and federal and state governments, manufacturing such family favorite products as the Easi-Set Slenderwall^TM Lightweight Construction Panels, Easi-Set Sierra Walls^TM, Easi-Set J- J Hooks® Highway Safety Barriers, Easi-Set Precast Buildings, Softsound^TM Soundwall Panels, and last but certainly not least the H2Out^TM Secondary Drainage System. Needless to say, this is not the industry every ambitious college student dreams of revolutionizing. 

The SMID business is geographically segmented, and although their products are advertised and marketed on a national basis through its licensees, it primarily markets manufacturing capabilities within a 250-mile radius of its two facilities.  The closer the job site, the larger their competitive advantage since they can capture the savings on shipment. 

Additionally, SMID has an asset light "toll road" like business, which is quite remarkable given its industry and size.  In fact, SMID literally gets checks in the mail on defensible royalties every month. 

Toll Road Segment of Business

SMID licenses the manufacturing and distribution rights to its proprietary products, specifically to the J-J Hooks highway barriers and the Easi-Set and Easi-Span Precast Buildings products.  Licensing allows for the "franchisee" to utilize SMID's customized websites (above) outlining the products technical specifications and benefits and to use SMID's premade advertising materials.  Importantly, licensing also conveys the rights to use safety test data gathered by SMID to qualify these branded products for various industrial uses and government projects.  It is a profitable proposition for precast concrete manufacturers to license SMID's branded and tested products rather than to recreate all of these elements themselves.   Licenses are granted for an initial one-time administration and training fee of approx. $40k and future royalties in the range of 4% to 6% of the products net sales.  Easi-Set buildings and Slenderwall licensees also pay SMID a flat monthly fee for co-op advertising and promotional programs.  

SMID has entered into 47 licensing agreements in the United States; five in Canada; and one in Belgium, New Zealand and Mexico with sub-licensees in Canada and Australia (total of 58 licensees).  SMID has consistently grown this business and expects to increase its licensing activities going forward.           

In the last twelve months this business has produced $1.6 million of royalty payments.  Given the quality of this revenue stream and its growing nature, a value of 7 times its annual cash flow stream seems appropriate, which would already surpass the current enterprise value of the business. 

Overstated Working Capital

SMID currently has an unusually high working capital level which should convert into cash by the end of the year and further highlight the mispriced nature of SMID.  The below is taken from their latest 10-Q.

The decrease in cash is a result of an increase in unbilled receivables in the total amount of $3,296,879 for the nine months ended September 30, 2010.  The increase in unbilled receivables is a result of several large projects that are currently in production but have not been invoiced to the customer as of September 30, 2010.  As the unbilled receivables are invoiced during the final quarter of 2010, the receivables are expected to convert to cash consistent with our normal collection period.

Combined with profits from the fourth quarter, this cash conversion should reveal the true enterprise value of the business, likely adding approximately $3.5 million cash to the balance sheet. 

Ballpark Valuation

Assuming $0.5 million of operating income during Q4 (SMID experiences reduced revenues from December through February) and an additional $3.5 million of cash on the balance sheet, the valuation of SMID could appear to be attractive.

Of course you should use whichever method or metric you feel is appropriate to value this business, but the point to take away is not any sense of precision but rather that this is cheap and should have relatively little downside with substantial upside.

Insider Ownership and Management

Management in incentivized to create value for shareholders given the CEO and Chairman, Rodney Smith's 16% ownership of the business.  His son, Ashley (owns 3.4%), has been with the company since 1990.  They understand the benefits of their more capital light royalty operations and would like to focus much of their effort on this division going forward.  Together with other managers they devote substantial effort to improving the business on a day to day basis, with multiple meetings per week devoted to creating leaner manufacturing facilities.  

SMID's various websites (and YouTube channel)

Company Home Site

http://www.smithmidland.com/index.html

Separate Investors Relations Page (Complete with letters to shareholders)

http://www.smithdelaware.com/

SlenderWall

http://www.slenderwall.com/

J-J Hooks

http://www.jjhooks.com/

Precast Buildings

http://www.smcprecastbuildings.com/ 

YouTube Channel - Updated 4 days ago

http://www.youtube.com/user/smithmidland#p/a/u/1/u9O2XqzTuuI 

Risks

• You are investing in a nano-cap stock... but I assume if you read this far that you are capable of getting over that
• Decreased government spending
• Patent on J-J Hooks rolling off (so rely more heavily on safety data and advertising for that product)
• Not as much working capital comes back as one might hope
• Something happens to the operators (Rodney Smith is getting up there in the years)
• The managers are not exactly Henry Singleton when it comes to capital allocation

Side Note

• As a side note, SMID's primary manufacturing operations are conducted in a 44,000 square foot manufacturing plant on approximately 22 acres of land in Midland, Virginia, of which the company owns approximately 19. This has specialty zoning and likely has a value of approximately a couple million dollars.

DISCLOSURE

• I have an ownership interest in Smith-Midland at the time of this write-up that can change at any time without notice. There are no plans to provide future updates on the authors buying or selling activities for this or other stocks. The author may buy or sell shares of Smith-Midland without notice for any reason at any time.