Servotronics (SVT) – An attractive microcap
I was sick last week, but I have returned and I brought a promising microcap company called Servotronics (SVT) with me.
Servotronics is a small company; daily volume averages only about 1200 shares, but it offers excellent figures. It operates in two sectors, one of which is, obviously, making servos such as torque motors, electromagnetic actuators, and valves for use in the aerospace and missile industries. 21% of Servotronics’s servo sales in 2010 were made, directly or indirectly, to the US government. Servotronics’s other sector is the cutlery business, from cooking knives to utility knives to machetes and bayonets. 21% of Servotronic’s 2010 sales of cutlery were also to the US government, although this is down from 28% in 2009.
The balance sheet of Servotronics is attractive; almost in a net-net situation. The company has a market cap of $18.8 million and has $4.4 million in cash, $5.4 million in receivables, and $11 million in inventory, total $21 million, set against $7.2 million in total liabilities. At any rate, because noncash current assets cover current liabilities (in fact, they cover total liabilities), the cash on the balance sheet can be considered excess.
In terms of earnings, in 2010 sales were $32 million, reported operating income was $3.1 million, excess depreciation was $160 thousand, producing operating cash flow of $3.3 million. After interest expense of $74 thousand, and taxes of 35%, we have free cash flow to equity of $2.1 million. Based on the current market cap this is a free cash flow yield of 11.1% before excess cash is taken into account, or 14.6% when the excess cash is taken into account. The company has very low interest rates because the bulk of its long-term debt, $3.1 million, consists of Industrial Development Revenue Bonds issued through a government agency and carrying an interest rate of .54%. Given Servotronics’s sensibly modest use of debt, I do not anticipate the situation will worsen when the bonds fall due in 2014.
In 2009, sales were $33 million, reported operating income was $2.6 million, excess depreciation was $118 thousand, producing operating cash flow of $2.7 million. After interest expense of $84 thousand and taxes, the company produced $1.7 million in free cash flow.
In 2008, sales were $34 million, reported operating income was $4.7 million, excess depreciation was $42 thousand, producing operating cash flow of $4.8 million. Interest expense was $178 thousand, and after taxes we have a free cash flow of $3 million.
In 2007, sales were $31 million, reported operating income was $3.5 million, excess depreciation was $66 thousand, producing operating cash flow of $3.6 million. After interest expense of $255 thousand, and taxes, we have free cash flow of $2.1 million.
As we see, then, the earnings history of Servotronics is reasonably stable, which gives us confidence that the free cash flow figures are a reliable indicator of a company’s future earnings power. Servotronics also pays a modest annual dividend of 1.6%.
I do need to address, however, the liquidity aspect. Obviously, it would be unwise to use market orders instead of limit orders, but even so, market participants place an importance on liquidity and may insist on a higher return from microcaps like this one. Damodaran, in his useful Damodaran on Valuation, estimates that this premium could reach 30% or more, although many of his examples are drawn from private equity firms, where the market is nonexistent, rather than the stock market where the market is simply thin.
As for this matter, I would first remind us all that liquidity is often an illusion, as we discovered with auction rate securities in 2008, and furthermore, I am reminded of what Ben Graham said about liquidity in his Security Analysis, that it is the sine qua non of speculators, while investors, who if they follow sensible financial policies will hardly ever be forced by circumstances or margin calls into liquidating in a hurry, should find liquidity of secondary concern to value. Even so, the bid-ask spread for Servotronics, from what I’ve observed, can be 1-3% of the share price, which can be a difficult hit even when spread over a long holding period.
At any rate, I find Servotronics to produce stable earnings that are ample relative to the company’s price, and with a little caution and trading skill, one could easily build a position that can produce satisfactory returns.
this is definitely an interesting idea. my only concern at the moment is how the inventory has seemingly been stockpiled so much over the past 4 yrs. will they ever need to write down that inventory?
This seems to be the major factor in the actual operating cash flow being below the earnings over the past 4 yrs.
Inventory turns may have declined from four years ago when they were a smaller company, but levels seem to have stabilized. The company also notes that it has to purchase steel in the quantity that steel producers find economic to sell, so it may lead to stockpiles, for which they have charged a reserve.
thanks for the info. I think this is a very interesting find, and I will be digging closer into the SEC filings to try to fully allay my fears about the working capital situation.
another concern is corporate governance. the management seems to be helping itself to very nice salaries, and they have put into place a sleazy shareholder’s “rights” plan, to make sure they can keep on drawing those salaries.