Solitron Devices Intrinsic Value Report (SODI) - FREE SAMPLE
NOTE: This business quality report is being provided as a free sample to free subscribers of the type of analysis available exclusively for the paid membership.
Today, I wanted to share with you a special treat for the final “Free Sample” of my launch month. This is the original intrinsic value report that I wrote-up before buying my current largest holding: Solitron Devices. You’ll get an idea of the level of depth and detail put into these intrinsic value reports of the companies that I’m actively buying. I hope you’ll join me as a paid subscriber. Starting in May, the # of free samples will drop significantly as I focus on my paid subscribers for the stock research aspect. Free members will continue to receive other investing related content.
This intrinsic value calculation uses data from public filings and press releases by Solitron Devices as well as my personal estimates. These estimates are subject to error and change in the future. Do your own research to verify any data used. I completed the calculation on June 11th, 2020.
Solitron Devices Intrinsic Value Analysis – Methodology
Solitron Devices is a defense manufacturer focused on providing niche semiconductors as part of United States government projects. For more information on Solitron’s business model, reference my business quality report. Due to Solitron’s recent past as an unprofitable company, I will be estimating Solitron’s intrinsic value through two different conservative methods:
Liquidation value
Going concern value (NPV of discounted cash flows)
The liquidation value analysis will focus primarily on a balance sheet analysis. Solitron has cash, inventory, and some limited liabilities which we will use as the basis of this work. In a liquidation scenario, shareholders should be able to recover some value from their shares.
However, in a more optimistic scenario, investors want to own Solitron as a going concern. During this step we will estimate a very conservative net present value based on discounted cash flows.
Solitron Devices Intrinsic Value Calculation: Liquidation Value
As of the writing of this intrinsic value report, the most recent balance sheet was available in the Fiscal 2020 Third Quarter earnings release. This report was unaudited which introduces some additional risk by using these figures. However, by focusing on a liquidation value, we are attempting to find a good lower bound of potential outcomes.
The 3rd quarter of fiscal 2020 for Solitron ended on November 30th, 2019. The figures I discuss below are as of that date.
Balance Sheet Breakdown
First, we will begin by looking at Solitron Devices assets.
Current assets include:
Cash and Cash equivalents = $1,120,000
Securities = $69,000
Accounts receivable = $1,816,000
Inventories, net = $2,797,000
Prepaid expenses and other current assets = $181,000
Non-Current Assets include:
Property, Plant and Equipment, Net = $437,000
Operating Lease – Right-of-Use Asset = $815,000
Other Assets = $46,000
Total Asset value = $7,281,000
Shares Outstanding = 2,062,949
Valuing Solitron’s Balance Sheet Assets
In a liquidation scenario for Solitron some of their assets will retain value, but most of their assets are going to be heavily impaired. The first decision point is simply to ascribe zero value to the non-current assets.
Solitron’s property, plant, and equipment are likely to be worthless in a liquidation. This equipment is used to make Solitron’s products and any liquidation would be based on Solitron being unable to profitably sell its products. Therefore, it is prudent to simply place their value at zero. The same logic holds true for the operating lease and other non-current assets.
Solitron’s current assets can be valued much more highly. I’ll simply allocate $1 of value to each $1 of cash and securities. I will slightly discount accounts receivable at $0.90 on the dollar and discount inventories at $0.50 on the dollar. Meanwhile, prepaid expenses would be worthless in a liquidation.
The result is that Solitron has liquidation assets of:
Cash and Cash Equivalents = $1,120,000
Securities = $69,000
Accounts Receivables (90%) = $1,634,400
Inventory (50%) = $1,398,500
Total Liquidation Assets = $4,221,900
Next, I’ll subtract total Liabilities to be conservative which is $1.7 million.
Solitron Devices Calculated Liquidation Value
Liquidation Value = $2,498,900
Value per share = $1.21
Note, this represents a 48% downside from the current market price of $2.31 per share. (As of June 11th, 2020)
Solitron Devices Intrinsic Value Calculation: Going Concern
In my opinion, Solitron Devices is worth much more as a going concern than its liquidation value. As they lack current financials and lack a clear history of profitability, this argument will be difficult to make with much precision. Instead, I’ll lay out the key arguments for why Solitron has the potential for a higher valuation.
This intrinsic value calculation will be based on a required rate of return and discount rate of 10%.
Without updated financials, we have to value Solitron using announced top-line numbers and cash flow through the most recent press releases from March 26th, 2020, and January 22nd, 2020. I expect that we will receive a release of audited financials sometime in the calendar year 2020, and hopefully in the next few months. However, the lack of these financials also presents an opportunity. The extra work required may allow me to acquire shares at a good price.
Key components of the valuation
Turnaround nearly complete: Company operating around breakeven for Fiscal 2020 (First positive quarter was Q3 2020)
Net Sales expected to grow $1.3 million in 2021 (from $9.2m to $10.5m).
Sales were $7.5m when management took over in 2016 representing a 50% gain in the last 5 years.
First time above $10m in sales in the last 25 years.
Operating leverage will allow incremental revenue to drop to the bottom line at a rate of a 50% margin.
Non-Capital Intensive, Non-Cyclical business. Therefore, cash can be returned to shareholders.
Multiple costly problems are now in the past and will drop off including:
Prior auditor costs
Wafer Fab Improvement Project
Inventory Management Concerns
Solitron Devices: Valuation Narrative
Unlike the liquidation analysis that was focused on a precise calculation, this valuation will focus on being roughly right but precisely wrong. I am going to round numbers in a conservative manner to try and reach a baseline valuation I can use to buy shares.
Solitron Devices is a niche manufacturer that had bad prior management that was thrown out when Tim Eriksen, current CEO, won a proxy fight to take over the company. Tim is a hedge fund manager who understands capital allocation and is intensely focused on shareholder value. He bought his shares in the open market and his hedge fund owns over 10% of the company. I believe Tim’s average cost basis to be $3 or more.
As a new CEO, Tim found many problems in the business that had to be dealt with. These problems, most notably the auditor issues, delayed the turnaround significantly and used up nearly the entire cash balance that had first attracted Tim to invest in the company originally. However, those problems present new investors with an opportunity.
The stock price is much lower than when Tim Eriksen bought into Solitron Devices and now the turnaround is becoming successful. We are at an inflection point and the stock market hasn’t caught on yet. Over the next 2-3 years, Solitron will begin publishing audited financials again and those financials will demonstrate a rapidly growing and profitable business.
Valuing Solitron Devices on 2021 Financial Results
First, I will value Solitron based on its projected 2021 revenues. These have already been guided for by management and I believe they are conservative. $10.5m in projected 2021 sales is lower than the 2020 bookings of $11.2m. Normally, sales for the following year exceed or equal bookings.
Key Assumption #1: Solitron breaks even on its financial results with $9.5m in sales.
I’m intentionally choosing a number $300,000 higher than 2020 results because I think it improves the conservative nature of the calculation. (Note: Cash flow was positive $1.0m in 2020 based on $9.2m in sales, but this was primarily due to better inventory management.)
Key Assumption #2: Solitron’s incremental gross profit margin is 50%.
This assumption is based on 3 factors:
Solitron’s demonstrated ability to increase gross profit as a % of sales in the last few quarters as revenue has grown.
A focused decrease in SG&A by Solitron as costs are reduced
Scuttlebutt on their operations combined with public disclosures by management on their operating leverage
Key Assumption #3: SG&A won’t need to increase to manage the increased revenue.
This is a fairly reasonable assumption when you can see they are growing revenue and have managed to reduce SG&A so far.
If we simply take those three assumptions we reach an operating profit for 2021 of $500,000 based on $10.5m in revenue. A simple 10x multiple on operating profit (for a 10% discount rate and zero growth) would value Solitron Devices at $5 million. (Or approximately $2.42 per share)
Projecting Solitron Devices’s growth over the next 5 years
If you read between the lines of Solitron’s public releases you can see that Solitron is setup well for future growth. They have R&D which have developed new products that are starting to grow their backlog of bookings. In just six months at the end of 2020, their new product line had bookings of $1.2 million. It would be a mistake to project this over a full year, but you could plausibly be soon seeing $2 million in bookings for their new products.
In addition, Solitron provides a hint in their March 26th, 2020 release that their net bookings for 2021 may be as high as $12 million instead of their guided $10 million. While there are no guarantees, all signs point to growth.
My discussions with management have all led me to believe that Solitron is in good hands and management is well aware of the need for growth to complete this turnaround in the eyes of investors.
Although I think higher numbers are possible, I believe Solitron can easily achieve revenue of $13 million by 2025. Based on my prior analysis, this could mean an operating profit of $1.75 million by 2025. Yet, it is simple to ignore additional SG&A costs or equipment when we discuss only an additional year. Over five years, it is likely this revenue may require additional costs.
It is difficult for me to believe a situation where sustainable costs would rise more than $750,000. Therefore, I’ll subtract $750k from operating profit to be appropriately conservative. In this situation, Solitron would have profit of $1 million per year in 2025 and could be valued at $10 million five years from now. If we discount that back to the present at a 10% discount rate, the value of the company would be $6.21 million or $3.01 per share.
Intrinsic Value by Probability Analysis
The last step in this analysis is to determine how probable each of the above outcomes may be. The probability weighted average would be my intrinsic value estimate. Below you will find each of the considered scenarios with a probability weight.
Outright Bankruptcy = <5% (due to fraud or unexpected disaster)
Liquidation = <5%
No Growth from 2021 expected value = 50%
5-year projected growth to $1 million of earnings = 20%
Growth outperforms expectations = 20%
I’ll then use these values multiplied by the equity value in each scenario to determine the contribution to intrinsic value.
Equity Value in Bankruptcy = $0.00
Liquidation = $1.21 * (5%) = $0.06 per share
No Growth Scenario = $2.42 * (50%) = $1.21 per share
5-year growth scenario = $3.01 * (40%) = $1.20 per share
Note, I did not bother to estimate a higher growth scenario as it would be too precise. Instead, I simply added that probability to my growth scenario itself.
Final Estimate of Solitron Devices Intrinsic Value = $2.47 per share.
Final Notes and References
It is important to make a few key remarks on this analysis. First and foremost, I attempted to always take conservative assumptions versus accurate assumptions. I’m not trying to estimate Solitron’s actual intrinsic value. I simply want to estimate a floor for the intrinsic value. The result of $2.47 per share is the lowest value I think could reasonably be ascribed to the intrinsic value range for Solitron.
An analysis focused more on accuracy may have ended up with a range of say $2.47 – $5 or $2.47 – $4 or something similar. That wasn’t my goal. Instead, I’m trying to determine the highest price I can pay and still be reasonably certain that the intrinsic value is more than my price.
When I discuss bankruptcy and liquidation, 5% increments is the lowest precision I am willing to use to jump between probabilities. If I had to guess, I would say the chance of bankruptcy is exceedingly low. But, how can I say the difference between 5%, 1% or 0.01%? I don’t have that level of skill. The same is true for the other estimates.
Finally, I expect this analysis to be rapidly out-of-date once current financials are released and again once the full fiscal 2021 financials are released. This information would tighten the probabilities and allow for greater future projection. Until the company actually shows a full year profit, it is difficult to accurately estimate. This is the speculative portion of the analysis.
References
I made reference to numerous reports and presentations from Solitron Devices public investor relations page. That page is available here.
In large part, the bulk of the analysis is focused on the most recent financial statement and the most recent press release about non-audited results.
In addition to reviewing public documents, I performed some scuttlebutt about the company and management. I have also previously interviewed CEO Tim Eriksen on my podcast. Management is a large part of my thesis with this company. If I didn’t trust management, I wouldn’t be investing.
Anyone interested in the company should also read a well-written value investors club write-up on Solitron published this year. The author is more optimistic than I am in their assumptions, but I think it illustrates the conservative nature of my analysis.
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