Another position exit: Solitron Devices

I have owned Solitron Devices for more than two years. When I bought it I saw a profitable company trading at the value of the cash on the balance sheet while I was blissfully unaware about the corporate governance issues facing the company. Since that time some progress has been made on the corporate governance front. The company held it first shareholder meeting in decades last year, and the next meeting will be held in July. Solitron also paid its first ever dividend last month, although it was a very small one. The $0.05/share represent a yield of 1.2% and cost the company a bit more than $100 thousand while they have almost $7 million in cash and equivalents on the balance sheet.

Unfortunately I don’t think there will be a lot more progress anytime soon. In the past few years a couple of activist hedge funds bought a stake in the company and pressed for changes, but last week Groveland Capital exited their stake. Their stake was bought by a small hedge fund located in the Netherlands that is run by a 26-year old manager. I doubt that he can achieve more than Groveland Capital. He doesn’t have the experience, and his location will also be a handicap.

In the mean time I don’t think Solitron is trading at a big discount to it’s potential intrinsic value anymore. When we look at the historical earnings we see the following picture:

Historical earnings Solitron

Last years operating income of $718 thousand is close to the average of the past years and in my opinion a good number to use in a base case valuation. Since the company doesn’t pay taxes because of significant NOLs carryforwards we can simply throw a multiple on operating income to estimate the value of the operating business. A 10x multiple seems pretty fair to me. Add the cash balance to this number and account for the dilutive effect of the outstanding options and I get a fair value per share of $5.48. Use a 8.5x multiple and fair value is $5.07 per share.

This represent an upside potential between 22% and 32%, but this is not what the stock should be worth today. That is what the stock could be worth if the management team (read: Shevach Saraf) would suddenly deploy capital in a more sensible manner instead of just letting it sit idle on the balance sheet. At the moment the stock deserves to trade at a discount to its potential value even if at some point in the future the strategy is changed because the return on the cash will be near zero in the mean time. You could argue that that is a fair risk adjusted return, but you also need to consider your opportunity cost.

Because of that I think that Solitron is currently more or less valued at the right price, and while this has been and probably will be an interesting stock to own just to see how the story will unfold I don’t think that is a good reason to own the stock. So I sold my position yesterday for a 36.2% gain versus my entry price: a reasonable result.

Disclosure

No position in Solitron anymore

16 thoughts on “Another position exit: Solitron Devices

      1. Arvosijoittaja

        I agree with your decision:)

        I’ve exited my position already last summer, when nothing happened in the AGM.

        I think this one has the same problem as ASFI. If the mgmt does not want to allocate owner’s capital rationally, there is not much a small shareholder can do. In most cases, the company becomes a value trap.

        Reply
  1. itwillfluctuate

    I agree with your numbers, but also think that, as you put it, it’s a fair risk adjusted return:

    Barring some very unlikely cataclysmic scenario, the most probable negative outcome is that the company continues to accumulate $700k or so year after year, until, a very long time from now, the money is returned/an acquisition is made/etc. In that case an investor would get a 7% yearly return, which isn’t bad for a pessimistic scenario.

    And good things could happen. For one, the shareholders have been too docile, and since many of the larger ones are unhappy with the status quo, it shouldn’t be too difficult for them to effect change. If they get on with it, value might surface much earlier. The tricky part there is to avoid acting as a group, which could threaten the NOLs and trigger the poison pill.

    Reply
    1. Alpha Vulture Post author

      Have shareholders been too docile? Perhaps when I first bought Solitron, but in the past two years I think the shareholder base has been pretty active and they have effected some change. But I don’t think it will be that easy for them to do more. The poison pill, the staggered board and the large number of options that the CEO could convert in voting shares will make things hard (and this would also put the NOLs at significant risk).

      At the same time the question for activist investors is how hard they want to play. For a small company like Solitron it’s easy to spend a significant amount of money on defenses against activists, and you have to wonder how Solitron will run without Shevach Saraf. He has been CEO/CFO and a bunch of other things for decades: how easy is it to replace him?

      Reply
      1. pietje

        What really makes or breaks the case is imho: why is Saraf doing what he is doing? That would be a question I would really like to have answered during the AGM. Why is he fighting the activist shareholders? They are not trying to take over the company so why the poison pill? Why no buybacks? Why the small dividend? What’s his vision of capital allocation? He’s making life hard for everybody, including himself. But maybe I’m looking for a rational answer where there isn’t one ..

        As long as these questions are left unanswered the upside isn’t spectacular, I agree with that.

        Reply
        1. Alpha Vulture Post author

          Yes, that’s indeed a good question. I really don’t know. Since he owns a significant part of the business it would also be in his best interest to maximize value.

          Reply
      2. itwillfluctuate

        What last year’s meeting demonstrated is that there are a bunch of shareholders who want change and can outvote Saraf, at least as long as he doesn’t convert his options. Shareholders voted against him just on the election of directors, because nothing else of importance was up for a vote. But what if, say, a shareholder vote on a big special dividend was proposed?

        It might not be easy to replace Saraf, but you might still want to because: (1) he is 71 and will have to retire in a few years anyway; (2) it’s almost always true that you can find someone to do any job decently; (3) the cash pile is worth half of the business, and Saraf manages that half very poorly, so if you replaced him with someone who can manage the money half of the business well, and who can do a mediocre job of managing the operating business, you’d still be better off.

        Reply
        1. Alpha Vulture Post author

          But don’t underestimate how long it can take and how expensive it can be (for both the activists and the company) to go through this process if Saraf puts up a fight. Solitron claimed to have almost $250K in costs last year related to the shareholder lawsuit and the AGM. You might be able to replace the board and CEO, but you might not be happy with what you get.

          Reply
        2. pietje

          Exactly. I perceive the upside here to be mainly in the fact that Saraf starts gradually working together with shareholders instead of us having to oust him. A golden parachute and/or legals costs can easily cost a few years of income for such a small company and that’s not even the worst scenario for shareholders.

          Reply
  2. Josh

    I don’t think anyone is unhappy with how Saraf has run the business, investors are are just unhappy with capital allocation. Seems obvious but maybe Saraf doesn’t realize that.

    The dividend announced and paid is a start but $0.05 is what I would consider the minimum per quarter, not on an annual basis. Throw in a 10b-5 buyback program and everyone is happy.

    Reply
    1. Alpha Vulture Post author

      Yes, I think you are absolutely right that most investors are happy with how the company is going from an operational perspective and only want change w.r.t. capital allocation. But if you want to force change w.r.t. capital allocation and the CEO doesn’t want to cooperate, what then?

      P.S. To be honest I’m surprised that SODI started paying a dividend at all. The CEO owns the biggest part of his stake through options so he won’t get paid the dividend on that part of his stake. Exercising those options will probably invalidate the NOLs.

      Reply
      1. NeverLoseMoney

        I think the dividend was only paid to get Groveland Capital off Saraf’s back. They have discussed capital allocation with the Board. Perhaps the dividend is some kind of implicit compromise as a result of this discussion.

        Anyway, the result of the dividend was that the stock went up a little and liquidity also improved thanks to this “positive” development. This allowed Groveland Capital to exit at a decent price.

        For ~$100k Saraf got rid of an activist who has successfully forced change at a few other micro caps. Looks like a great result for Saraf. Not a good deal for minority shareholders IMO. I would much rather still have Groveland on board than a $0.05 dividend. They were willing to get their hands dirty if necessary. Many of the remaining large holders have been pretty passive so far. That’s not going to work here. If you have a large position in SODI, you’d better have a good plan. Even if activists really put the pressure on Saraf, the end result is in all likelihood not going to be ideal.

        I agree with your post. I’m still holding a small position in SODI, but there’s not really a good reason for holding on at this point.

        Reply

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