Schmitt Industries: Annual Update — Eagle Point Capital

We’ve received several good questions regarding Schmitt Industries and thought we’d provide an annual update given the amount of change in the business since we originally discussed the stock last March. For a full background on the company feel free to check out that article. Here I’ll provide an update on each part of the business, and some detail on the recently acquired Ample Hills ice cream brand.

Background

When we initially purchased shares in Schmitt Industries the business consisted of a measurement segment with two business lines, Acuity and Xact, a couple of real estate properties, and $10M of cash from selling the SBS business in 2019. Acuity, which makes laser and white light distance measuring products, and Xact, which provides remote tank monitoring devices and services, generate about $4M of revenue and breakeven profitability.

Our initial thesis hinged on good capital allocation and management from CEO and former Navy Seal Mike Zapata. He took control of the company after winning a proxy contest in 2018. We saw several ways for Zapata to create value. With the stock trading at a substantial discount to its hard assets, it looked like an attractive risk/reward proposition. Substantial buybacks, a real estate transaction, special dividends, and an outright sale of the business were all potential outcomes that could create value for shareholders. But the most important capital allocation decision turned out to be an acquisition. At the nadir of the pandemic, Schmitt bought Ample Hills, a beloved Brooklyn ice cream company, out of bankruptcy.

Source: 2020 Annual Meeting Presentation

Ample Hills

Ample Hills Creamery is a Brooklyn-based ice cream company founded in 2011. Ample Hills’ quirky and imaginative flavors quickly won the hearts of New Yorkers young and old. Celebrities like Oprah Winfrey and Bob Iger (Chairman of Walt Disney) touted Ample Hills as their favorite ice cream, and the brand drew substantial interest from investors as it embarked on a rapid expansion effort in the mid-2010s.

Ample Hills began as an ice cream cart in Prospect Park in 2011. From this humble beginning, it grew to 17 locations by 2019. According to an employee, lines regularly stretched out the door and locations served 100 customers an hour during peak season. Pre-pandemic, Ample Hills was doing more than $10 million in annual sales They raised $19 million in capital between 2015 and 2019. The last round of funding valued Ample Hills at $40 million.

However, growth is not good in and of itself. Growth only makes sense when incremental returns are high and the balance sheet is strong. Ample Hills’ married co-founders Brian Smith and Jackie Cuscuna didn’t understand this. A former screenwriter and school teacher, they pursued top-line growth at any cost. Neglect of the bottom line eventually caught up with them. Despite solid revenue growth and a brand that struck a chord with a loyal customer base, costs far outstripped revenue. Each Ample Hills’ scoop shops were profitable on a stand-alone basis. Excessive corporate overhead wiped out all of these profits and then some. The decision to build a factory in Brooklyn was the nail in the coffin.

Ample Hills built a factory in the historic, and expensive, Red Hook neighborhood. The factory came in 70% over budget and a year behind schedule. Worse, Ample Hills didn’t have enough stores to justify the factory’s production capacity. Instead of producing economies of scale and reducing costs, the factory produced dis-economies of scale and increased production costs.

With almost no financial controls to speak of, the plant quickly drained cash from the business. Simultaneously, the co-founders continued to aggressively sign new leases without regard to price. Some leases cost more than $300,000 per year. This added substantially to overhead. By mid-2019, the company was in real financial trouble.

Ample Hills tried to raise fresh capital, but investors began to tighten their purse-strings as they lost confidence in management’s ability to execute. The founders built an excellent brand and had good intentions, but got in over their heads when it came to day-to-day execution. By March, bankruptcy was their only option.

If not for the pandemic, Ample Hills might have been able to restructure its debt and preserve its equity. Unfortunately for the co-founders, they filed for bankruptcy on March 15, 2020. This was in the midst of New York’s lockdown when financial professionals were scrambling to relocate their operations to their home offices.

The folks who’d normally be interested in buying Ample Hills out of bankruptcy were distracted by the chaos. Fortunately for us, Schmitt’s CEO, Mike Zapata, was on top of his game. As a former Navy SEAL, he undoubtedly made far more consequential decisions in far greater chaos. Zapata submitted the only qualified bid for Ample Hills and won by default. Schmitt bought the company for $1 million, plus $600,000 of lease cures. Schmitt took control in June 2020.

For those interested, this article provides more detail about what happened at Ample Hills. As Zapata put it during the annual meeting, Ample Hills is a strong brand that failed for fixable reasons.

Post-Bankruptcy Ample Hills

Zapata spent the rest of 2020 stabilizing Ample Hills. They reopened ten locations, rehired 90% of employees, and installed financial and operational controls. This was the same playbook Zapata ran on Schmitt’s existing businesses when he took control in 2019.

Zapata retained the key Ample Hills employees that had created the brand and flavors during the company’s early years. He even hired Chuck Green, former VP of Sales at Ben & Jerry’s, to serve as the company’s COO. Green brings a wealth of knowledge and experience to the table. He helped grow Ben and Jerry’s into the national brand it is today. He also engineered its sale to Unilever for $326 million in 2000.

Today Zapata is focused on filling the Red Hook factory’s capacity. He can create substantial shareholder value by merely bringing the factory to a breakeven cost. Zapata plans to offer co-packing services to other food companies to soak up excess capacity.

Zapata’s second priority is measured growth. The plan calls for developing parallel revenue streams.

First, Ample Hills will open more scoop shops. Each store will aim to produce 10-15% EBITDA margins on a stand-alone basis. Zapata expects to open a handful of stores per year. In late 2020 Ample Hill’s opened its first west coast store in southern California. Future stores will cluster in NYC and LA to generate efficiencies of scale.

The second revenue stream will be wholesale and e-commerce. You can already order ice cream for delivery online, which we highly encourage!

We think Ample Hills can generate $8-$10M of revenue today and has a long runway of high-return incremental growth ahead of it. Our friends in NYC confirm the ice cream is one-of-a-kind and among the best they’ve tasted. Most were unaware that the company was bankrupt and changed management. This tells us that management’s transition has been seamless. Most importantly, Zapata has preserved Ample Hill’s brand loyalty.

If Zapata, Green, and the team can expand the brand into new geographies, Ample Hills could be a true compounder. Buying a strong brand with growth potential previously valued at $40-$45M for $1.6M in the depths of a panic is the kind of radical opportunism we want to see in all of our managers.

Measurement Segment

Besides Ample Hills, Schmitt owns two other businesses: Xact and Accuity. Both are in measurement-related fields.

The measurement segment generated around $4M of revenue in 2020, an 8% decline from the previous year. This was mostly due to interruptions in Q2 and Q3 from the pandemic. Zapata aims to double this segment’s revenue over the next five years. To achieve it, Schmitt will invest about $1 million. As a result, we think the measurement segment could do $8 million of sales with 25% EBITDA margins in five years.

We’re optimistic because the measurement segment still has plenty of low-hanging fruit to harvest for improvement. Xact and Acuity were severely undermanaged before Zapata came along. For example, when Zapata arrived it turned out that the company’s lone salesman had passed away several years prior and never been replaced. Increasing sales was as simple as hiring a salesman.

Real Estate

Besides Ample Hills and the measurement businesses, Schmitt owns real estate in Portland, OR. The building is leased to Tosei, a blue-chip Japanese conglomerate, on a long-term triple-net basis. With interest rates at record lows, Zapata has decided to sell.

The property is listed for $5.5M. That’s 25% of Schmitt’s current market cap. If Zapata consummates a sale at that price (not guaranteed), it’d bring in a meaningful amount of cash.

Schmitt also owns two other buildings which Xact and Accuity use. Zapata previously estimated that they’re worth $2.5 million together.

Valuation

Today Schmitt is worth $21 million. To value the company, we sum its hard assets, like cash and real estate, and capitalize its future earnings from Xact, Accuity, and Ample Hills.

Schmitt has $7.4 million in cash and $8 million of real estate. That’s $5.5 million for the building leased to Tosei and $2.5 million for the buildings Xact and Acuity use. Together, this amounts to $15 million of hard assets or $4 per share. Schmitt trades for $6.50 per share today, meaning that hard assets cover the majority of the company’s value.

The measurement segment breaks even on $4 million of sales. If Zapata hits its five-year targets, it will produce $2 million of operating earnings in 2026. Historically, Zapata’s guidance has been conservative. We think these businesses are worth 1-2.5x of sales to a private buyer. That implies that the measurement business could be worth $8 to $20 million in five years. That would be significant relative to Schmitt’s $21 million valuation and could add $2-$5 per share in value.

Ample Hills represents Schmitt’s largest opportunity. Venture capitalists once valued the company at $40-45 million. You can argue whether that price was right or wrong, but investors obviously believed it was worth at least that much. Based on the planned retail expansion, wholesale, ecommerce, and co-packing initiatives, in five years we think the ice cream segment could generate substantially more revenue than its ~$10 million today. Even a 10% margin would produce a meaningful earnings stream.

It’s tough to put a precise value on Ample Hills. It isn’t yet profitable, and it’s still early days for the brand. Fortunately, Schmitt’s valuation provides a wide margin of safety. We’re virtually certain Ample Hills is worth more than the $1.6 million Schmitt paid for it. At 2x sales, half of its prior private-market valuation, Ample Hills would be worth $5 per share. At 4x sales, it’s worth $10 per share.

At $6.50 per share today, we don’t need a spreadsheet to tells us that the company remains cheap.

Capital Allocation

We think more acquisitions lie in Schmitt’s future. If the Tosei real estate sells, Zapata will be sitting on a $12 million cash pile. Zapata has proven himself a skilled and opportunistic capital allocator. Whether he returns to capital via buybacks or makes another acquisition, we think the transaction will enhance intrinsic value. If Zapata could find another deal like Ample Hills, we’d be elated. In his words, he’s always on the lookout for “strong brands that are mismanaged or undermanaged.” Zapata is Schmitt’s largest shareholder and has considerable skin in the game. So far, he’s has done exactly what he said he’d do. We look forward to watching him continue to execute in the years ahead.

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.

Subscribe | Contact Us