Solitron Devices: A Successful Turnaround With Significant Upside

Overview

Solitron Devices (Ticker: SODI) manufactures semiconductor components that are used primarily for military and aerospace applications. Their customers include Raytheon Technologies (RTX), Lockheed Martin (LMT), L3Harris Technologies (LHX), General Electric Aviation (GE), Northrup Grumman Systems Corporation (NOC). Solitron’s products are used in hundreds of major government military programs such as rockets, aircraft, satellites, fighter jets, missiles, radar shields, etc. 

In this write-up, the following key points will be discussed:

• This is an attractive business and is different from typical semiconductor businesses. 
• Solitron’s products are custom designed into a diversified group of major government military programs which leads to recurring revenue that is long lasting, predictable, high margin and non cyclical. Solitron also benefits from high switching costs.
• The management team is high quality. The current CEO took over the company in 2015 as part of a group of activist investors. The new team combines a top notch business operator in COO Mark Matson and a trustworthy capital allocator in CEO Tim Eriksen. Management and the board are well aligned with outside shareholders and have lots of skin in the game given their significant share ownership. 
• The management team has successfully turned around the company after years of mismanagement by prior leadership. This turnaround was costly and took many years. The company is now at an inflection point and all of that hard work is paying off. Now that the transitory costs associated with the turnaround are behind them, Solitron is demonstrating strong and growing profitability which will continue to accelerate in the years ahead. 
• The stock is very undervalued at the present price. At the current share price of $7.95, Solitron is trading for less than 5 times sustainable and growing FCF. Given the quality of this business and the top notch management team,the stock is worth at least double the current price.

An Attractive Business

Solitron has a number of attributes that make it an attractive business:

• This business is completely mission critical to their customers. Solitron supplies components that cost on average $122. This is immaterial in comparison to the overall cost of producing the equipment they are supplying to such as an advanced fighter jet which costs over $100 million. Solitron’s components are mission critical yet the products have very low unit costs. They compete on quality and reliability rather than price. 
• Solitron’s products are custom designed into specific programs. Once Solitron’s components are designed into a specific program, they become a sole source supplier and are locked in for the entire life of that program. The switching costs are insurmountable for their customers. 
• In the defense industry, programs last an incredibly long time. This creates a highly recurring, long lasting, and non-cyclical revenue base. 
• Solitron supplies to a diversified group of programs so the risk of losing a contract when the US military replaces a program is not an issue as long as Solitron continues to win more business over time which they have been successful doing in recent years. 
• Solitron’s contracts are cost plus which lead to consistent and predictable margins. 

All of the dynamics mentioned above make for both a low risk and highly predictable business. This is not your typical semiconductor business which is generally extremely cyclical. Solitron’s revenue and margins are consistent and predictable. 

A Talented And Well Aligned Management Team

A group of activist fund managers led by Tim Eriksen (Solitron’s CEO) successfully took control of Solitron in 2015. Tim is a successful hedge fund manager and runs Cedar Creek Partners. He owns over 13% of Solitron’s outstanding shares both directly and through his fund. These shares were acquired primarily in the open market, not through stock grants. Furthermore, Tim’s compensation is modest, at just $77,000 per year. He is not milking the company for his own benefit. The rest of the management team including Dave Pointer (Chairman), and Mark Matson (COO) also own a significant amount of shares. There is strong alignment between management and outside shareholders. 

 The Company Was Mismanaged Under the Previous Management Team

Tim Eriksen along with Mark Matson (COO) have completely revamped Solitron's operations in order to position the company for future growth. Solitron had long been mismanaged under the prior management team and the company was destined to decline had the activist investors not taken over and restructured the business. 

Turning around a complex business like Solitron is not easy and this process took years. The company invested a significant amount of money to fix operations and make improvements to the business. The expenses and investments associated with the turnaround resulted in negative net income in recent years. These expenses were transitory and are now completely behind the company. 

A Turnaround That Has Already Turned

This is not a turnaround investment. The turnaround has already happened and it has been successful. This turnaround effort was a heroic task. It was tough and time consuming. It also distracted management from focusing on sales growth initiatives. Now that the turnaround has been successful, management is now able to refocus on business development activities. This renewed focus on sales growth is already bearing fruit. Since the present management team took over in 2015, revenue has grown by 57%, from $7 million annually to an estimated $11 million for Fiscal 2021. Most of this growth has taken place in the last twelve months. Note: Fiscal 2021 refers to the year ended February 28th, 2021.

Revenue growth has been driven by an improved customer focus which has resulted in winning new contracts with their existing customers. For example, Solitron’s largest customer, Raytheon, recently named Solitron as one of their preferred suppliers. This is yet another positive sign. Solitron’s new management team has completely overhauled the company’s operations and positioned the company for future growth. The transitory costs and one-time expenses that Solitron had to incur over the past few years in connection with the turnaround effort are now behind them. The turnaround has been highly successful. Solitron has introduced new products, grown sales, upgraded the quality of their workforce, improved their operations, etc. Most importantly, Solitron is now demonstrating consistent profitability and cash flow. Solitron is a rare example of a successful turnaround. 

Improving Financial Trajectory 

As shown in the chart below, Solitron is demonstrating significantly improved financial performance now that the transitory costs associated with the turnaround have fallen away.  

The year ahead will be a strong year of growth for Solitron. In their December 29th, 2020 8-K, Solitron noted the following about bookings: 

“So far in the month of December we have received bookings in excess of $6.6 million and expect to receive approximately another $1.0 to $1.5 million of additional bookings before the end of the fiscal year in February 2021.” 

When including the estimated bookings noted above, total bookings in FY 2021 will likely exceed $12 million. Bookings convert to sales over the subsequent 12 months, which indicates that sales will be growing materially in FY 2022. Given the increased level of bookings, sales are likely to exceed $12 million in FY 2022. 

At this level of sales, Solitron is likely to produce gross margins in the mid thirty percent range and EBIT margins in the high teens. As a proof point, in the FY 2021 second quarter, Solitron produced $3.1 million of sales (which is $12.4 million annualized). In that quarter, Solitron produced a gross margin of 36% and an EBIT margin of 19.3%. 

It’s important to note that Solitron’s quarterly sales and profits can be volatile based on when they ship orders (as they note in their press releases). It’s best to focus on annual results so the quarterly volatility is smoothed out.  Quarterly results will be lumpy. During slow sales quarters, Solitron will likely generate gross margins in the high twenty percent range and in high sales quarters gross margins will likely be in the mid to high thirty percent range. There is a high degree of operating leverage in this business so any incremental sales carry a 40% - 50% contribution margin. 

Despite The Run Up in Price, The Stock Price It Remains Significantly Undervalued

Given the current level of bookings, Solitron is likely to produce annual sales of $12 million - $13 million in each of the next few years. The table below demonstrates assumptions of normalized profitability at this level of sales: 

Solitron pays no taxes due to significant NOLs and has no interest expense.  At the same time, the business has minimal capex needs which results in net income converting entirely to cash. Based on statements from management, the company plans to return excess cash to shareholders via buybacks and dividends. 

At the current share price of $7.95, Solitron has a market cap of $16.4 million. After netting out cash of $3.7 million, Solitron has an enterprise value of $12.7 million. At the current share price, Solitron is trading for just 4.9 - 6.0x normalized earnings (net of cash). This is astoundingly cheap for a business of this quality. 

At a valuation of 13 - 15x net income plus net cash of $3.7m, Solitron is worth $31 million - $42.4 million or $14.88 - $20.36 per share. At the current share price of $7.95, Solitron’s shares have 87% - 156% upside.