Solitron Devices ($SODI)
A Quality Micro-cap in the Defense Industry
My goal in this 2000-word article is to present the key facts about why I think Solitron Devices can deliver market-beating returns. However, like all stocks, there are potential risks to consider. This is not financial advice or a recommendation to buy or sell any security but merely my thoughts and opinions. All investments carry risk and the potential for loss of capital. Please consult a licensed financial advisor before making any investment decisions.
Key Data
Thesis Date: 07/23/2024
Stock Price: ~$18
Market Cap: ~ $37.5 million
Shares Outstanding: 2,083,436
GAAP EPS: 2.78
P/E Ratio: 6.5
Solitron Devices Inc. (SODI) manufactures and markets semiconductor components and related devices for the aerospace and defense industries. Over 85% of Solitron's sales are from application-specific devices. These custom-made products are designed specifically to meet the needs of a customer’s particular program. The price of components they make varies, but let's just assume they cost $170 on average. In comparison, the end products their customers make (that are then sold to the government) can cost millions to hundreds of millions of dollars. But without the $170 piece, the entire thing won’t work. So you can see how mission-critical these components are. As a result, customers place far more importance on component quality and manufacturer reputation than they do on price. Once Solitron is locked into long-duration contracts, they have nearly zero competition, as their customers would find it very costly and time-consuming to switch suppliers. From their viewpoint, it doesn’t make much sense to switch and put the success of their products at risk.
Solitron’s components have been used in some of the most important military and space programs in our country’s history, for example, the Moon Lunar Roving Vehicle, the Galileo spacecraft, the Mars Global Surveyor, and the Mars rover. However, similar to many companies in the defense industry they face a lot of customer concentration, with 35% of sales coming from one company, Raytheon Technologies. Usually, about 80-90% of their total sales come from just 10 companies. As explained earlier, their excellent product economics means that customer concentration is not a massive risk in my eyes as long as the company is not mismanaged. Additionally, the business model also has a lot of inherent operating leverage. The majority of expenses are fixed costs, meaning profit margins can grow way faster than revenues. Even marginal revenue growth has a material impact on earnings as it can hit the bottom line at 40-50% margins.
Recently, they acquired a new company, Micro Engineering, which produces electrical components for the medical industry, using the cash they had on their balance sheet. The total consideration paid (if revenue targets are met) is $4.35, about 4-5 times earnings. In my eyes, this is great capital allocation, allowing the excess cash to pile up on the balance sheet until it is used for a worthwhile cause, such as acquiring a business for cheap, adding to the earnings power.
Solitron itself generated $5.8 million in profit for the year or $2.78 per share. However, this included many one-time items, which boosted the number, including the effects of the MEI acquisition. Based on management commentary and earnings from prior years, I expect true earnings power to be closer to $2 per share or about $4.2 million. This number is arguably very conservative, so something closer to $2.5 per share would not surprise me. In the future, they will begin paying taxes (they currently aren’t) as the NOLs they are using right now to offset taxable income will run out. By this point, future earnings growth coming from higher revenue and operating leverage should more than offset it.
Solitron’s management team is highly skilled and well-aligned with outside shareholders. The CEO, Tim Eriksen, is a value fund manager who came in as an activist in 2016 and has successfully turned the business around, growing revenues and materially increasing earnings power. His recent capital allocation decisions around moving their manufacturing facility and acquiring MEI have been excellent for shareholders. The yearly salary he takes from Solitron is just $90,000 compared to his stock ownership of $5.8m through his investment fund and personal holdings. In my eyes, the way he has run the company has been excellent, as well as the time he has taken to engage with shareholders and even answer my emails. Outside of Solitron, his fund has returned 14.4% per year since inception (2006), and his value investment philosophy is strong.
The COO, Mark Matson, takes a total compensation of $295,000 compared to his stock ownership of $3.1m. His role is more around the day-to-day operations of Solitron, which are likely more time-consuming, reflected in his total compensation. The four directors on the board are compensated between $20,000 and $36,000 and have proven very helpful in managing and growing the company. Altogether, insiders own 26.3% of the company and have bought additional shares in the past few months and years. This means they are highly aligned with shareholders and incentivized to perform well.
In terms of capital allocation, based on management’s commentary in the past, I expect the company to continue using cash for accretive acquisitions such as the most recent one they made or return it to shareholders via dividends and buybacks. All of these factors will serve as catalysts for a higher share price.
Lastly, the balance sheet is strong, with a growing pile of cash and securities that are currently worth $3.1, a mortgage loan of $2.6m on their manufacturing facility, and no other long-term debt. The business produces very high returns on capital as they are focused on maximizing operating earnings by using the least amount of assets possible.
Looking forward, Solitron is poised for growth as it becomes involved in new contracts. For example, a recent article by Defense News stated, "Amid a significant use of missiles in Ukraine and the Middle East, customers are ramping up independent production of some of the weapons the Patriot air defense system can launch at an unprecedented scale." If new orders come through, Solitron Devices would see higher revenue as they supply components to the Patriot Air Defense System built by Raytheon and to PAC-3 missiles built by Lockheed Martin. This is just one example of how Solitron can grow revenues. As it benefits from escalating global tensions, it also can provide insulation to a portfolio of stocks sensitive to geopolitical risks.
Another potential opportunity is through the $1.7 trillion omnibus spending bill that President Biden signed in 2022, which included provisions for increased spending on military supplies to replenish the stockpile. Solitron supplies components for several of these programs, and in a press release management stated that they expect $20 million in increased sales spread over five years ($4m per year). An additional $4m of revenue per year for 5 years could add $1-2 million of earnings for Solitron each year, which would add to the cash pile on the balance sheet.
Beyond this, Solitron is developing silicon carbide products that possess a lot of potential to win new contracts. They have secured two designs with Haliburton and BAE and have one contract for a test phase military program. These could be great opportunities for Solitron, adding a couple million dollars of incremental sales each year and opening doors for even more contracts. Due to Solitron’s operating leverage and size, any big contract won would increase earnings per share substantially, creating significant upside for shareholders.
Quickly going over valuation, as I mentioned earlier Solitron has a market cap of $37.5 million with a share price of $18. I expect true earnings power to be $2 per share or more, reflecting a P/E multiple of 9 or less. Current fair value could be in the range of $30-$35 per share (15-17.5x multiple) or even more. Within the next few years, I expect earnings to come in at $2.5-3 per share, with a path to $4 per share in the medium term, depending on how many new contracts Solitron wins. The future earnings are hard to predict, but the main point is that they should come in much higher. Just as an exercise, if I take the $4 per share number and put a multiple of 15x on it, which is still arguably low for a business of this quality, the share price could be $60 or 3.3x the current price.
Not much is needed for a good return when paying such a low current multiple. It seems like there is essentially zero growth priced in, leaving lots of room for surprises to the upside. In the current market, I guarantee it's not that easy to find a business of comparable quality with solid growth potential at such a low multiple. Given all of the information covered, I think Solitron has the setup for excellent returns in the years ahead, depending on how everything plays out, and could even be a multi-decade hold. Of course, as with every stock I’ll analyze, it doesn’t come without some risks. Firstly, for the thesis to fully play out, a lot of execution is still required from the management team, mainly in growing the business. Customer concentration can pose a risk if relationships are not managed well, as we have seen in the past. This is just the nature of the defense industry, as there is essentially only one end consumer - the U.S. government. So going forward, I’m looking to continue researching Solitron while keeping my eye on developments and waiting for future earnings to come through.
To wrap it up, As you can probably already tell from the countless times I’ve said it, I think this is a well above-average business trading at a significantly below-average multiple. Regarding ratings, I would give it a 9/10 on business quality and an 8/10 on cheapness, with my overall interest level being a 10/10. You might think I’m being stingy with my ratings, but hardly anything would get a 10/10 perfect rating considering the competitive nature of capitalism and the inherent risks every business possesses. A 10/10 on cheapness would probably mean you’re selling the company to me for free, and I don’t foresee that happening anytime soon. Whether or not you pursue further research on this name depends on your financial situation, risk tolerance, and level of experience in the industry. But for me, it’s a no-brainer. I’m excited to see how this turns out, and in the case that my thesis fails, I’d be very interested to review what happened.
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Please feel free to reach out with any questions about Solitron Devices or anything else investing-related you have for me. Although this write-up was quite long, some less important information was omitted from the original draft for the sake of keeping it close to 2000 words. I was pretty careful in making sure the points most important to the thesis remained.
