Description

Summary

Solitron Devices (Ticker: SODI) is an electronics component manufacturer that was founded in 1959. Solitron is a mission critical supplier to the aerospace and defense industry and their components are used in quite a few major government military programs. Recently, some one-off costs have obscured what has otherwise been a solidly profitable and non-cyclical business. I expect the one-off costs will roll off within the next few quarters. At that point, Solitron's earnings power will show in the GAAP financial statements and I expect the stock to trade up significantly. Pro forma for these one-time costs, Solitron is trading for just 4.1 – 5.8x current net income, net of cash. This is very cheap both on an absolute basis and in relation to where the company has historically traded. I expect the stock to trade back up to $4 or higher once their true earnings power shows through in the GAAP financial statements. These transitory expenses will trail off within one or two quarters. Furthermore, once these transitory costs roll off, I expect Solitron to begin returning cash to shareholders via dividends and buybacks. 

Business

Solitron has a long and storied history. They were founded in 1959 and their products have been critical components in a number of well-known aerospace programs including the first quad power transistor module, which was used to drive the wheels of the Lunar Rover vehicle on the moon. Solitron also developed custom components for the NASA space shuttle, the Galileo spacecraft, as well as both the Mars Global Surveyor and Mars Sojourner.  

Approximately 90% of Solitron’s products are custom made for their customers.  Solitron’s products are engineered into these programs and are a mission critical component to some of the most important programs in the United States military.  Solitron does not disclose what programs they are in but it has been publicly disclosed that they supply to the A10 Warthog as well as the Patriot Missile System program produced by Raytheon. 

It is challenging to get into a new program, but once Solitron is engineered into a new program they are essentially locked in for the life of the contract. Solitron’s business is extremely “sticky” and these programs have a very long duration. For example, Boeing won the contract for the B-52 Bomber in 1946 and it is still flying today. Although the United States Air Force is working on a replacement, the B-52 is expected to continue flying through the 2050s. Once the Air Force eventually retires its fleet of B-52s, they will have been in service for nearly 100 years. Another example is the Patriot Missile System which is a program that Solitron supplies to. It was developed in the 1970's and remains a mainstay for the United States military and our allies. 

The risk for Solitron comes when a program ends and is replaced. However, Solitron is diversified into a large number of programs so this is not a risk as long as they continue investing in R&D to get into new programs. Only one program makes up a meaningful portion of their business. That program is with Raytheon and I believe it is the Patriot Missile System which has a long life ahead of it.  In conversations with Solitron's management team, they are not aware of any major programs that end in the next decade. Even when a program ends, Solitron will continue to supply parts and replacements to US allies around the world who continue to use that equipment. Furthermore, Solitron has the opportunity to be integrated into the replacement program. 

Another aspect I like about Solitron is the non-cyclical nature of their business. They are impacted by the federal defense budget appropriations, but their results have been quite steady over time. In the past when defense budgets were cut, it did not seem to affect Solitron’s results materially. 

Background 

The present management team became involved after running a proxy contest in FY 2016 (see source #10 below). Tim Eriksen was named CEO and David Pointer became Chairman. Both Tim and David are hedge fund managers out of Washington state. 

Management has made the right long-term adjustments to the business by upgrading personnel, improving the flow of production in the manufacturing process, bolstering the sales process, investing in R&D and successfully expanding the product line and bringing in new customers, etc. These improvements take time to get right. We believe the company is at an inflection point and these operational improvements will bear fruit for shareholders going forward. 

Both Solitron’s board and the management team are highly aligned with shareholders. The CEO, Chairman, and President (Mark Matson) all own a meaningful number of shares and their ownership stakes were purchased at a price materially above the current price. Furthermore, there has been significant insider buying in the past year by the Chairman, CEO and the President. 

The prior management team mismanaged the business and it has not been easy for the new management team to fix this company. There were some inventory accounting issues identified that have caused the audit of the financial statements to be delayed. The protracted audit became costly and impaired their cash balance. Based on our analysis, as well as consultations with a former accountant at a Big Four firm, we believe BDO botched the audit process and we think Solitron made the correct decision to fire BDO over all the delays and escalating costs of the audit. The consultant we brought in to help us understand the accounting issues reviewed the 8-K's Solitron filed in early 2019 detailing their disagreement with BDO. Our consultant concluded that this makes BDO look "very bad." I provided links to all these documents (see sources 11-20 below). 

BDO disagreed with Solitron’s inventory classification method. During the process to audit Solitron's financial statements, Solitron retained Marcum LLP as an outside consultant. Marcum has reviewed Solitron's policies and confirmed that Solitron's policies are consistent with ("GAAP").  Marcum’s conclusion also gives us comfort that nothing nefarious is going on. While it is unfortunate that Solitron incurred substantial costs related to the audit disagreement and we recognize that audit issues never provide for good optics, we have no reason to believe there are any further issues here. 

Solitron has brought in MaloneBailey LLP to complete the audit (see source #20 below). Presumably, MaloneBailey reviewed the disagreement with BDO and concluded they could conduct the audit without any issue. The completion of the audit by MaloneBailey will help reassure investors. While we recognize the negative optics of a long audit delay, it has also given us the opportunity to purchase shares in Solitron at an outstanding price. 

Normalized Earnings Power

The thesis for investing in Solitron is simple. Solitron is solidly profitable but those profits have been obscured by transitory costs. I expect the one-time costs to roll of within one or two quarters. Here are my expectations for Solitron in a normal year, without these one-time costs: 

How I arrive at the assumptions above:

Revenue: 

All sales first come through bookings and nearly all bookings will convert to sales within 12 months. Therefore, the level of bookings gives us a reliable indicator of what sales will look like over the next 12 months. For the 2nd quarter in a row management has increased their estimate of FY 2020 bookings. This leads me to believe the next 4 quarters will show a meaningful increase in sales. From the FY2020 Q2 press release: “We are increasing our estimate for fiscal 2020 bookings from a range of $9.5 to $10.5 million to $10.0 million to $11.0 million" (see source #1 and #2 below). Since bookings flow into sales within 12 months it is a safe assumption that the current sales level is in the range of $10-$11 million.   

Gross Margin: 

The gross margin during the quarter was 26.3% (after adding back the $175,000 inventory expense). According to management’s statements in the recent press releases, GAAP results will continue to be impacted by the inventory expense of $175,000 per quarter through Q4. Net of the temporary inventory expenses, I consider gross margins of 26.3% to be normal at their current level of sales. This is consistent with what the business has earned in past periods at this sales level. 

SG&A:

I expect normal SG&A to run at $425,000 - $450,000 per quarter or about $1.8 million per year inclusive of the ongoing audit costs. This is consistent with recent results, during the second quarter of FY 2020, SG&A (excluding non-recurring items) was $447,000.   

Taxes: 

As of August 31, 2019, the Company estimates it had approximately $12 million of Federal and state net operating loss (“NOL”) carryforwards (see source #1 below).  As a result, Solitron will not be paying any cash taxes for a long time. 

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Let’s compare these assumptions against the latest quarterly results to verify these assumptions make sense. Here are the figures for the 2nd quarter of FY 2020 (see source #1 and #2 below):

As shown above, once the transitory costs are backed out, Solitron is producing profits within the range I expect. 

What are the one-time costs?

During the quarter, the company issued both options and restricted stock to key executives (see source #1 and #2 below). This is the first time they have issued such a bonus. I expect normal options & bonus expense of $50,000 - $75,000 per year and I have included this in my SG&A assumptions above. 

There was an inventory expense of $175,000 in both the 1st and 2nd quarter of FY 2020. As noted in the Q2 press release (see source #2 below) this expense will continue in the fiscal 3rd and 4th quarter of FY 2020. This expense will not affect cash flow and I expect FCF to be in line with adjusted net income. 

Valuation

Base Case

At the current share price of $2.40 with 2,062,959 shares outstanding, Solitron is trading at a market cap of $4,951,101. Cash on the balance sheet is $878,000, resulting in an enterprise value of $4,073,101. 

Therefore, Solitron is trading at 4.1 – 5.8x earnings, net of cash. At a 10x earnings multiple plus cash, Solitron is worth $3.82 - $5.27 per share today. Furthermore, as a result of strong FCF conversion, I expect all of net income to convert to cash which results in $.34 - $.48 in cash accumulated per share annually.

All of Solitron's net income should be converting to cash and in a year (August 31st, 2019 quarter) I expect the company to have over $1.5 million in net cash on the balance sheet. Applying a 10X multiple and adding net cash results in a price per share of $4.12 - $5.57, upside of 72% - 132% from the current market price. 

Buyout Scenario

Solitron would make a great bolt on acquisition for a larger semiconductor manufacturer. Based on our research on past acquisitions in the industry as well as discussions with a contact of ours in the private equity space who focuses on this industry, we believe a buyout at 1x sales plus cash would be at the lower end of the range if Solitron were to be acquired. This would result in a price per share of $5.50 (129% premium to the current market price). 

An acquirer could pull out all the public company costs at Solitron and would be able to eliminate the audit costs, OTC market listing fees, transfer agent fees, lawyer costs for SEC filing review, SEC filing software, board of directors’ fees, reduce accounting personnel headcount, and eliminate the CEO (Tim Eriksen). Altogether, an acquirer could pull out at least $400,000 a year in expenses. These costs would drop off day one in an acquisition scenario. Any synergies would be on top of this.

After adding back the public company costs, Solitron would produce annual FCF of $1.1 - $1.4 million per year. An acquisition at 1x sales plus cash would be at 7.5 – 9.5x earnings after deducting public company costs. I believe this would be an attractive acquisition at this price for a strategic acquirer in the space. 

Strong insider ownership and heavy insider buying

Tim Eriksen owns 221,022 shares through his hedge fund as well as personally. The majority of these shares were acquired at much higher prices back in 2015 - 2017 at north of $4 per share. I feel comfortable buying at a large discount from the price the CEO purchased, and I believe Tim is heavily incentivized to get the share price higher and show a profit on the investment to his investors.  

David Pointer (Chairman) owns 67,034 shares and purchased those shares back in 2016 and 2017 at north of $4 per share. Once again, I feel comfortable buying at a large discount from the price management purchased their ownership stake. 

Mark Matson (President) owns 138,604 shares. A meaningful portion of these shares were from a restricted stock grant. But he has also been buying on the open market and acquired approximately 15,000 of those shares back in 2017 at an average price north of $4. Matson has also been granted 220,000 options with half of those options at a strike price of $4.25 (77% premium to the current market price) and the remaining half have a strike price of $5 per share (108% premium to the current market price).  

It is quite clear that the board, the CEO, and the President are all highly incentivize to grow per share value and get the share price higher. The share price would need to appreciate by more than 50% for insiders to break even on their shares. 

See source #9 below for insider ownership and insider buying activity. 

Return of cash to shareholders

Solitron has always been a very cash generative business. Once these transitory costs roll off within a few quarters, I expect Solitron’s cash balance to once again start growing. This is a business that needs only ~$1 million in cash on the balance sheet to handle working capital needs. In a few quarters, once the cash level has risen, I expect Solitron to begin returning cash to shareholders via dividends or buybacks. 

Here is what CEO Tim Eriksen has said about his capital allocation plans for Solitron:

“Instead of just sitting on excess cash we would determine the best course of action, whether it is the investment of the excess cash into securities, evaluating an acquisition, proceeding with a tender offer, paying out regular dividends or a special dividend, or evaluating the proper price in the sale of the company” (See source #10 below).

Note: those comments were from back in 2015, however, based on my discussions with management, I do not believe there is any change in the capital allocation plans. 

Notes

- All numbers are based on the 1/13/2020 closing share price of $2.40. 

- Solitron has a February 28/29th fiscal year end. 

Sources

Earnings Results

1. Fiscal 2020 Second Quarter Results:  https://solitrondevices.com/wp-content/uploads/2019/10/fiscal_2020_q2_unaudited_results_final.pdf 

2. Fiscal 2020 Second Quarter Results Press Release: https://solitrondevices.com/wp-content/uploads/2019/10/press_release_102019.pdf 

3. June 28th 2019 8-K detailing the stock incentive plan: https://www.sec.gov/Archives/edgar/data/91668/000165495419007938/sodi_8k.htm

4. August 2nd 2018 press release announcing Q1 FY 2019 sales and bookings and an update on the audit: https://www.sec.gov/Archives/edgar/data/91668/000165495418008363/sodi_ex991.htm

5. February 27th 2018 Press Release Announcing Preliminary Unaudited Third Quarter Results, Employment Agreement With Its President and COO, and an Update on Its Inventory Adjustment: https://www.sec.gov/Archives/edgar/data/91668/000121390018002574/f8k022718_solitrondevices.htm

6. July 26th 2018 8-K announcing FY 2020 Q1 earnings, the inventory E&O charge as well as the $175,000 charge due the reduced wafer fab production level: https://www.sec.gov/Archives/edgar/data/91668/000165495419008554/sodi_ex991.htm 

Other

7. Where to learn more: https://solitrondevices.com/investors/ 

8. Retirement of Shevach Saraf: https://solitrondevices.com/PDF/Solitron_Form_8-K_072216.pdf  

9. Insider Transactions and Insider Ownership: http://www.j3sg.com/Reports/Stock-Insider/xxxgen.php?tickerLookUp=SODI&sortBy=date_D&descending=1#  

10. “Shareholders for a Better Solitron” filed on July 17th, 2015: https://www.sec.gov/Archives/edgar/data/91668/000114420415042933/v415679_dfan14a.htm

Audit Delay   

11. August 16th, 2016 8-K: https://www.sec.gov/Archives/edgar/data/91668/000121390016016327/f8k081616_solitrondevicesinc.htm 

12. August 25th, 2016 8-K: https://www.sec.gov/Archives/edgar/data/91668/000121390016016512/f8k082516_solitrondevices.htm

13. October 24th, 2016 8-K: https://www.sec.gov/Archives/edgar/data/91668/000121390016017685/f8k102416_solitrondevices.htm

14. May 31st, 2017 press release announcing inventory charge: https://www.sec.gov/Archives/edgar/data/91668/000121390017006055/f8k053117ex99i_solitron.htm

15. July 14th, 2017 8-K with more details on the inventory charge. The inventory charge off was $400,000: https://www.sec.gov/Archives/edgar/data/91668/000121390017007828/f8k071417_solitrondevices.htm

16. February 21st 2018 8-K: https://www.sec.gov/Archives/edgar/data/91668/000121390018002338/f8k022118_solitron.htm

17. January 11th, 2019 8-K announcing the termination of BDO as Solitron’s auditor: https://www.sec.gov/Archives/edgar/data/91668/000165495419000565/sodi_8k.htm

18. January 31st 2019 8-K, letter from BDO: https://www.sec.gov/Archives/edgar/data/91668/000165495419000972/sodi_8k.htm

19. January 31st 2019 8-K, Solitron’s response to BDO’s letter: https://www.sec.gov/Archives/edgar/data/91668/000165495419001660/sodi_8k.htm

20. October 2 2019 8-K announcing the engagement of MaloneBailey as the new auditor: https://www.sec.gov/Archives/edgar/data/91668/000165495419011509/sodi_8k.htm

Important Disclaimer: 

This report has been prepared solely for informational purposes. Information herein is not intended to be complete, and such information is qualified in its entirety. This is not an offering or the solicitation of an offer to purchase an interest in any fund, and it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security. Nothing herein should be construed as investment advice, an opinion regarding the appropriateness or suitability of any investment, on an investment recommendation. No representation is made that the objectives or goals of any investment or strategy will be met or that an investment or strategy will be profitable or will not incur losses. Past performance is no guarantee of future results. Reliable methods were used to obtain information for this presentation but the information herein cannot be guaranteed for accuracy or reliability; the information in this presentation may be out of date or inaccurate. The information contained in this summary is and may not be distributed without permission. Securities described in this report were selected to represent an example of our investment strategy and their inclusion does not imply any historical performance or future projections of performance for such securities.

Catalyst

- Earnings power showing up in the GAAP financial statements as transitory costs roll off within a few quarters. 

- Return of capital to shareholders via buybacks or dividends.   

- Completion of the delayed audit for fiscal 2019 and 2020 financial results by MaloneBailey.

- An annual meeting which I expect to be held in early 2020.