Servotronics reported Q1 results two weeks ago, and the market certainly reacted favorably! Almost 44k shares traded hands – average volume is around 2k – and the stock jumped almost 30% during intraday trading before closing at $10.04, a 19.54% gain. The stock has dipped since then but it’s rising back towards $10.

Back in March, investors will remember that the stock took a 25% hit after reporting a large decrease in net income, as the Consumer Product division barely broke even for the year.  I certainly felt like the March drop was an overreaction and the company’s press release seemed to back up this sentiment:

Notwithstanding the reported reduction in year to year net income, the net income for 2009 was the 3rd highest net income reported by Servotronics during the past 25 years. Also, the 2009 reported net income was approximately 50% higher than the reported net income for the Company’s 4th best year during the same 25 year period. The Company’s 3 best years, as measured by net income during the past 25 years, occurred during the last 3 years (i.e., 2009, 2008 and 2007).

Q1 Financial Numbers

Total revenue increased by 4.6%, with a 13.2% increase in the Consumer Product division. Net income increased a staggering 397.6%, as margins improved across the board due to a better product mix. Although these are obviously very positive results, the company’s product mix constantly shifts from quarter to quarter, especially since a large percentage of sales come from governmental contracts, so it is important to keep these numbers in perspective.

Outlook

The most exciting part of this quarter is management’s cautiously optimistic report on the future of the aerospace industry. Several major aircraft manufacturers have announced plans to increase production in late 2010, 2011, and 2012. As a supplier of ‘servo-control components,’ a necessary part of airplane hydraulics, SVT is well positioned to capitalize on this growth.

I expect the company to continue to deliver impressive operating results as they ramp up production to meet this increased demand.

Valuation

I calculate an intrinsic value between $15 and $17 per share, providing substantial upside at the current price.

Disclosure

Long SVT

Analysis

PBCI & BCBP Merger Analysis

Background

On June 30th, 2009, BCB Bancorp Inc (BCBP), a small community bank with three branches in NJ, offered to purchase Pamrapo Bancorp (PBCI) in a transaction valued at $46.6m. It was a friendly transaction with both company’s board of directors voting for the merger.
Mark Hogan, Chairman of BCBP –

“We believe the partnership will solidify the combined entity’s Hudson County franchise and presents the opportunity to generate earnings and attractive returns to both groups of shareholders. The combination will greatly assist us in developing a more responsive and efficient institution while holding true to our tenet of customer service.”

Kenneth Walter, CEO of PBCI –

“We believe that this transaction is a great opportunity for our shareholders and will benefit our customers, employees and our community. We can continue with our philosophy of providing a high level of customer service and local decision making in our market area but will now have the added benefits of being part of a larger organization with much greater resources, lending limits and convenience for our customers.”

Terms

PBCI shareholders will receive 1.0 share of BCBP.

Shareholder Complaints

Despite friendly management terms, it has been a rough road since the merger announcement. On Dec 2, 2009, PBCI’s former president and largest shareholder, William J. Campbell, filed a complaint that the bank did not fully disclose the cross-ownership between the two entities by members of the board of directors. This joined another shareholder complaint filed by Keith Kube, who argued that the board of PBCI breached its fiduciary duties to shareholders.

Shareholder complaints seem to be common occurrences in many corporate mergers, but they rarely end up changing the outcome. On Feburary 17, 2010, the court of NJ voted to dissolve its injunction that was blocking the merger, opening the door for the shareholder vote.

Shareholder Approval

BCBP Shareholders voted to approve the merger on Dec 17, 2009. PBCI’s shareholders followed suit and voted to approve the merger on February 17, 2010, with 77% of shareholders voting to approve the transaction.

Investigations

To complicate matters even further, it seems that PBCI has been under investigation for quite some time for various issues. The bank received a Cease and Desist Order from the Office of Thrift Supervision back in September of 2008, and received another on Jan 22, 2010 relating to unresolved deficiencies in management and succession plans. The bank had to submit a 3yr business plan and hire 3 outside independent directors to satisfy OTS’s requirements

To make matters worse, the DOJ had been investigating the bank for several years for lax controls around anti-money laundering laws. On March 29, 2010, the bank pled guilty to the DoJ’s charges and was ordered to pay a $5m civil penalty.

Despite the setbacks, PBCI’s 10-Q on May 17, 2010, reports that the merger has received all necessary regulatory approval.

Discussion

It doesn’t appear like anything is stopping the merger from completing in the near future. Although all of the investigations look terrible for PBCI, BCBP has not given any indication that it will back away from the merger. I’ve read through most of the press releases, and it seems like PBCI’s management a) is incompetent or b) disregarded numerous compliance and regulatory rules that come with owning a financial institution.

Another concern with this arbitrage opportunity is the illiquidity of both stocks. PBCI trades roughly 3000 shares a day, while BCBP trades only 1000. It would be difficult to short BCBP, and the large bid/ask spread could eat into profits when exiting the trade after the completion of the merger.

It seems like many investors have been caught up in the bad press surrounding the merger, while the companies have slowly crept closer to completion by satisfying all of the necessary requirements one-by-one.  The spread is very attractive, but only if investors can successfully pull off the trade.  Thoughts on this opportunity?

Supporting Documents:

Document LinkDate Filed
Merger Press Release06/30/2009
Merger Agreement06/30/2009
Shareholder Complaint12/2/2009
BCBP Shareholder Approval12/17/2009
PBCI Cease & Desist Order01/22/2010
Court Injunctions Resolved02/17/2010
PBCI Shareholder Approval02/17/2010
DoJ Press Release03/29/2010
Regulatory Approval05/17/2010

Disclosure

No position in either PBCI or BCBP at the time of this writing.

ELST filed its Q1 results on March 13th and reported a solid, if unspectacular, quarter. Total sales increased by 23% compared to the first quarter of 2009. Domestic sales were basically flat but foreign sales jumped almost 82%, due to higher demand for the company’s products from industrial automation projects in Chile, India, Colombia, and Peru. Operating margins are significantly higher on foreign sales – see chart below:

ELST Q1 Sales Breakdown

Foreign sales accounted for 34% of total sales in 2009, compared to 23% in the previous year. Hopefully management will continue to focus company sales efforts on this segment going forward.

Despite the improved results, management is still very cautious for the rest of 2010 –

“Management believes that the tenuous worldwide economic recovery makes sales revenues during 2010 difficult to predict and prone to potential fluctuation”

As a going concern, I think the business could be worth anywhere from $.75-$1 per share, substantially higher than the latest closing price. Barring a potential catalyst, it is very important to understand the downside risk as well:

ELST NNWC Calculation

Based on the company’s latest closing price of $0.45, the stock is trading for 10% less than the sum of its assets its liquidation value, providing a nice cushion to the downside.

Also, Paul Sonkin of Hummingbird Capital has increased his stake from to 16% to 21.1% of the company. Hummingbird Capital is a very successful hedge fund manager that focuses on nano-cap plays selling at a discount to their intrinsic value. Paul recently spoke at the Value Investing Congress (see a great writeup here: 2010 Value Investing Congress Notes by The Innoculated Investor)

It is always nice to have an expert on your side!

Disclosure

Long ELST