Investment Horizons / Schmitt Industries Investment Overview
We generally try to stick to posting our thoughts on fundamental analysis of the businesses we are studying and leave the macro commentary to everyone else (there are no shortage of opinions). That being said, the last few weeks have been exceptional in terms of market volatility, so this week we’ll offer a few last thoughts on the recent market environment before returning to our “regularly schedule programming” in the second half of this post – an analysis of a recent investment we’ve made in Schmitt Industries.
How We Sleep Well at Night
Nearly everyone claims to have a long-term investment horizon. It’s very easy to make this claim during a bull market, especially one that moves forward seemingly unimpeded for over a decade. When the market charges higher, it’s easy for investors to claim to have a high tolerance for price fluctuations and an ability to stomach temporary declines in their portfolio.
It turns out over the last month, as is the case during every bear market, many investors have a diminished ability to think longer-term and a much lower tolerance for portfolio fluctuations than they thought during the “good times”.
To be clear – COVID-19 is not to be taken lightly, and the worldwide society needs to collectively ban together to get the furious spread of the virus under control. However, some of the associated pessimism in the market appears to be overdone.
Looking at recent headlines and crashes in prices for businesses across the board, one may conclude that COVID-19 presents the potential permanent end to the American economy as we know it. Headlines on the front page of the Wall Street Journal have recently read things like “Markets Enter New Phase – Where Cash is All That Matters” with quotes such as “(investors) want out. Big Time. The sky is falling. Get out, get out while you can”. All of this signals extreme pessimism.
Given the dramatic headlines and violent price fluctuations, we’ll offer a reminder of three rules that allow us to avoid losing sleep because of temporary stock market declines.
1) Know what you own
a. Investing in businesses we understand allows us to keep a closely held view of the long-term intrinsic value of our holdings. This allows us to ignore Mr. Market’s constantly changing quotes.
i. If negotiated in a private transaction without the distraction of constantly changing stock prices, the agreed upon value for many businesses right now would not come anywhere near where they are being quoted.
2) Study history
a. Though never caused by the same “trigger”, periods of volatility and rapid decline happen repeatedly and with regularity. Similar declines have happened roughly every decade, are happening now, and will happen again. Equity investors should understand this and be prepared to respond and take advantage.
3) Avoid bad businesses and bad balance sheets
a. It’s quite likely there will be businesses where the equity is completely wiped out because of COVID-19; perhaps over-leveraged travel or hospitality companies. Never buy into a business that can’t withstand a couple of rough quarters with low (or no) earnings.
We aren’t calling a market bottom; we have no idea where the market goes over the next few weeks and months. What we do know is there is some excellent long-term value to be found in great businesses at recent prices. It appears many market participants are unwilling to look more than one day out into the future, which is a great way to interrupt compounding and lose money during an emotional time, and something we refuse to do. On compound interest Einstein said, “he who understands it, earns it; he who doesn’t, pays it”. We’ll find out in time who falls into which group.
Now on to an interesting investment in which we recently finished building a position…
Schmitt Industries Investment Summary
At Eagle Point Capital we invest in two situations: temporarily undervalued long-term compounders that have the runway to earn high returns on reinvested capital for many years, and special situations that offer periodic asymmetric upside against a well-protected downside. Schmitt Industries falls squarely in the latter category, and also happens to be one of the more unique investment opportunities we have seen recently.
Schmitt Industries represents an opportunity to buy into an activist-led company at a significant discount to the company’s hard assets. Unsurprisingly, this creates an investment situation with, we believe, 100% upside and a protected downside.
Background
Schmitt Industries, based in Portland, Oregon, has been publicly traded since the mid-‘90s. Until 2019 the company was comprised of two business segments and the associated real estate assets:
- The Balancer segment (SBS) primarily consists of the “SBS” product line which provides vibration control, balancing, and process control systems for grinding applications in the tooling industry.
- The Measurement segment operates two product lines, “Acuity” and “Xact”.
o Acuity – laser and white light distance and dimensional measuring products
o Xact – satellite enabled remote tank monitoring devices and services for “Internet of Things” applications
The SBS segment was sold to a strategic investor in 2019, which is discussed further below. Though the SBS segment was sold, Schmitt retained ownership of the property, and also owns the Acuity and Xact real estate and facilities.
The stock languished under the watch of the previous management team over the past two decades. Schmitt has traded in the low single-digit dollar range since reaching a high of over $40 per share in the mid-‘90s. Enter Mike Zapata in the fall of 2018.
Activist Involvement
Mike Zapata is a former Navy Seal, serving 10 years in the War on Terror prior to founding Sententia Capital Management in 2012. Sententia is a concentrated value-focused hedge fund that emphasizes many of the same principles as Eagle Point Capital. Interestingly, Sententia is backed in part by legendary value investor Mario Gabelli, among other prominent investors. For those interested, a useful podcast interview with Zapata can be accessed here.
Zapata approached Schmitt’s board of directors in 2018 after investing in the stock given its dramatic discount to his appraisal of intrinsic value, spelled out in this presentation. After outlining his value creation plan and receiving little traction, Zapata went directly to the Schmitt shareholders in a proxy contest.
Upon laying out a sum of the parts valuation, shown below, Zapata easily won over the required shareholder votes and became the CEO and Chairman of Schmitt Industries in October of 2018.
Figure 1: Sententia Capital Management Original Sum of the Parts Valuation (Fall 2018).
As shown in the figure above, Sententia believed the company’s hard assets were conservatively worth at least $11M, with 100%+ upside when considering potential value from the operating businesses. Essentially, the market was ascribing zero value to the operating companies, and any value that could be created was pure upside.
Skin in the game is critically important to us when evaluating management teams, and Sententia checked this box very quickly. Sententia amassed nearly a 10% stake in the business before beginning to agitate for change and assuming control of the board. It is abundantly clear that the interests of Sententia and the interest of other shareholders are very much aligned.
SBS Turnaround and Transaction.
Zapata quickly went to work turning around the SBS business over the course of late 2018 and early 2019. First, he turned the board over and brought in new leadership to conduct a thorough supply chain assessment. Zapata subsequently led the management team through an optimization of pricing, inventory, and operations, and drove a culture around data-driven decision making and accountability. Working capital levels went down and margins went up throughout 2019 which generated significant cash (~$400K) for Schmitt.
The SBS business line is a cyclical and capital intensive business, and Zapata realized he had to decide whether to put more capital into the company or find a new home that was more of a strategic fit. After gaining traction on the turnaround he chose the latter option, and in December of 2019 Schmitt announced that the Balancer business was sold to Tosei, an $800M Japanese conglomerate, for roughly $10.5M. Schmitt retained the real estate and subsequently entered into a 10-year, $280,000 per year lease with Tosei.
After executing quickly on the first step of value creation, Zapata released his vision for the next phase of the Schmitt investment during a December shareholders meeting presentation. In a refreshed sum of the parts analysis, and after the SBS transaction and subsequent ~40% rise in market price, the business was more undervalued relative to its hard assets than before the successful transaction. See the table below from the December meeting.
Table 1: Management’s Sum of the Parts Valuation (December 2019)
Zapata laid out his plan for the Xact and Acuity business lines, which is detailed further in the presentation. We had the chance to speak with Zapata about his plans for the business lines and over the next year or two we believe the leadership team will allocate a modest amount of capital and resources to each business in an effort to capture market share and spur growth and profitability improvements.
As any good leadership team should do, they plan to deploy capital based on the most attractive return on investment to shareholders. This could include organic investments, M&A activity, share repurchases, real estate transactions and special dividends. To that end, the board announced a $2M share repurchase authorization in December, which represents approximately 20% of the recent market cap.
Valuation and Expected Returns
It seems clear that, according to the above analysis, the market is not only under-pricing the hard assets but also ascribing zero, if not negative, value to the two operating companies at Schmitt. The key questions for us to become comfortable with this investment were:
- What are the hard assets most likely worth?
o This is the first question because it is what protects our downside which is of primary importance to us.
o It is fairly straight forward and requires an accurate assessment of the real estate value and an understanding of the cash generation (or cash burn) of the business to have an idea of what might happen to the $10M+ of cash from the SBS transaction.
- What are the future earnings of the Xact and Acuity businesses worth?
o If the team is able to execute on modest growth initiatives, there is value in the two businesses, which is all upside from current prices.
- What is the capital allocation strategy?
o How much capital will likely be allocated to buybacks vs. M&A vs. capex in the businesses, and what will the return on those investments look like?
o It’s also important to understand the timeline associated with each capital allocation/ value creation activity in projecting our anticipated annual returns.
Mike Zapata was kind enough to take some time to discuss some of our questions recently, allowing us to go directly to the source in order to crystallize our thoughts. After talking with the CEO and doing our own research on the businesses and real estate markets involved, we are encouraged with the potential of the investment.
In our view, the stated real estate value is quite conservative because of the newly signed lease in the Tosei transaction. The property was originally valued at roughly $4M (with the Acuity and Xact properties at $2.5M), but that was before a long-term lease was signed by a large credit-worthy tenant. With a $280K annual lease, a $4M valuation implies a 7% cap-rate for the property. We believe that based on the new situation, if Schmitt decided to sell that real estate at any point, it would likely be valued closer to a 4-5% cap rate. Using a still conservative 6% cap-rate for the SBS property yields a total real estate value of at least $7.2M ($4.7M for the SBS facility and $2.5M for the remaining property).
Additionally, based on how the management team is running the business, we find it unlikely that cash-burn eats meaningfully into the current $11M cash balance. In the most recent quarter, the two operating businesses actually generated around $500K in cash from operations. It’s reasonable to conclude that after investing in growing the companies that the cash reserve may dwindle a bit, but we think it’s likely in the range of a couple hundred thousand dollars and certainly nothing more than $1M.
Without going into too much detail, there are clear growth opportunities and value in both the Xact and Acuity lines. Dedicating internal personnel to growing each business and partnering with cellular monitoring peers for Xact represent “low hanging fruit” growth opportunities that the team is currently executing. Similar to SBS, there are also margin expansion opportunities for both businesses. We are comfortable that the businesses are worth something to future owners and even assigning conservative valuations to each (outlined in table 2) represent meaningful upside.
Regarding capital allocation, we are confident in the board’s ability to deploy capital for the benefit of shareholders, and are particularly interested in the current buyback given the current market price. There is clear alignment for value creation over the short to medium term, and we don’t believe Sententia plans to continually invest in the business for years in an effort to grow if it fails to create shareholder value. Even if no growth materializes after a year or two, the board can still execute value creating activities with the real estate and cash assets to close the gap between market price and intrinsic value.
Finally, providing further margin of safety, Schmitt recently announced it intends to de-list from the Nasdaq in order to save on the associated costs. It makes little sense for a business of Schmitt’s size to list on an exchange, and it will begin trading over the counter in the near future. For technical reasons, this caused a 15%+ decline on the day of the announcement, and was welcome news to us as we worked to build a position. The reason for the sell-off is simple – institutional investors often cannot hold stocks not listed on exchanges, and therefore must sell. If there’s one dynamic we look for in an investment, it is to buy from those who have to sell, irrespective of price. Due to continued forced selling since this announcement, the company has traded near or below net-cash for the past few weeks.
Taking all of this into account, we see the following outcomes as realistic possibilities.
Table 2: Forward Returns
In a base case, we expect the company to use $2M in cash to execute the buyback program, and otherwise stay relatively cash-neutral. We value the SBS real estate (Tosei leased property) at a 6% cap rate given its location, lease terms, and credit-worthy tenant. Based on comparable transactions and considering their competitive positions we value Acuity and Xact at 1.0x and 2.0x revenue respectively. This scenario results in 100%+ price appreciation potential.
In a more conservative scenario we assign value only to the “hard assets”. We assume the real estate is sold at its current valuation, another $1M of cash is consumed in closing the two operating businesses, and all the proceeds are distributed to shareholders in a liquidation. This still results in around a 30% premium compared to today’s prices, highlighting what appears to be attractive downside protection.
In each case we assume an average price paid of $3.15/share (slightly above where we have been recently buying) and that the current buyback authorization is executed over the course of the investment. Finally, we anticipate realizing value within approximately two years.
Conclusion
Schmitt Industries represents a rare opportunity in today’s markets – even assigning zero value to the operating businesses, the real estate and cash provide 40%+ upside to current prices. Typically when investors find businesses trading below the value of hard assets it’s due to concerns over capital allocation in the future. This is commonly referred to as investing in a melting ice cube or a “value trap”. Given the business is run by a conservative management team and the number of potential catalysts present, we don’t foresee this turning into a value trap. Zapata has been quoted stating that in investing he likes to “buy the assets and sell the earnings” which applies perfectly to Schmitt.
One dynamic worth mentioning is that it seems likely the stock price will not move appreciably in one direction or another while the team works on executing the plan over the next 1-2 years until a value-creating event takes place. Demonstrating meaningful progress on growth, a real estate transaction, completion of the buyback, or an outright sale of the business are a few of the catalysts we think are most likely. Therefore it wouldn’t surprise us if Schmitt appears as “dead money” for a period of time – until it doesn’t. Only time will tell and we are happy to remain patient.
Securities with dynamics that result in others being unable or unwilling to invest (in Schmitt’s case because of size and de-listing) represent less-than efficient markets and usually warrant further investigation. Considering the protected downside, shareholder-friendly management team, and numerous value-creation catalysts, Schmitt represents an attractive investment with a positively skewed risk vs. reward profile. We look forward to investing alongside Sententia Capital Management over the coming years and will provide updates to our thesis in our semi-annual letter to investors.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.