Servotronics, Inc (SVT) is a small aerospace stock that has maintained profitability through the recession and in 9 out of the last 10 years.

The company’s financial metrics are decent but not extraordinary, and should benefit from strong tailwinds in the global aircraft industry.

While the economics of airlines have been dismal, many aircraft suppliers have benefited from strong growth in the aerospace market.

If SVT can capture some of this momentum – and be recognized by the broader market – the stock could appreciate to 2007 levels.

Company Breakdown

Servotronics is split into two operating segments:

Advanced Technology Products

ATG designs and manufactures servo-control components such as torque motors, hydraulic valves, and electronmagnetic actuators.

These are high-tech components with stringent safety standards, as they are primarily sold to aerospace, missile, and governmental industries.

This division is the prime asset at SVT, producing the vast majority of operating profits over the years, and has the most potential for future growth.

Consumer Products Group

CPG designs and manufactures cutlery products – knives for household use and hunting/fishing expeditions, along with products like machetes and bayonets for the U.S. government.

Unlike the ATG segment, the CPG division is moderately seasonal, and operates at much lower margins. Despite bringing in almost 40% of revenues, it contributes almost zero profit.

As an outside investor looking in, the combination of the two segments doesn’t make much sense – aircraft components + knives? – and could result in making less-than-ideal capital investment decisions.

Financial Results

2010 revenues fell 4.09% to $31.7m from $33.0m in 2009, with a $2.6m decrease in the CPG segment offset by a $1.3m gain the ATG division.

Both segments saw margin improvement, with ATG increasing its operating margin by 103 basis points, while CPG saw a leap of 121 basis points.

Despite the improvement, Consumer Products is still running at extremely low margins, just 1.47% in 2010.

In comparison, ATG’s margins came in at 14.61%, an increase over 2009, but still below the company’s long-term average, leaving room for additional margin improvement.

In total, operating income increased 9.6% to $3.0m compared to $2.5m for the prior year. This is the 3rd highest operating income in the company’s history, trailing only 2007-2008.

Net income increased 11.8% to $2.1m or $1.08 EPS.

SVT maintains a cash balance of $4.4m offset by $3.4m in debt. The majority of this debt is for Industrial Development bonds issued by a governmental agency to build the company’s headquarters and advanced technology facility.

This property has 82,000 square feet of building space and sits on 38.4 acres.

As the bonds are paid back in full (a lump sum payment is due in 2014), the company will own the property outright after paying a nominal final fee.

Until that time, this debt is a very attractive form of leverage, with current interest rates at only 0.54%.

Management

Servotronics is a family-run business that has been around since 1959. The company’s founder and CEO, Dr. Nicholas D. Trbovich, has been at the helm for the past five decades.

His son has also been on the board of directors since 1990.

Together, the Trbovichs own 28.5% of the outstanding stock through direct ownership and options. They also vote unallocated shares of the Employee Stock Ownership Trust (ESOP), another 8.6%.

Effectively, they control the company, making it hard for outsiders to affect change.

Executive compensation is high – maybe excessively so – with a large portion made up of base salary.

In 2009, SVT earned total net profits of $1.9m yet paid $1.3m in total compensation to its top 3 executives.

Corporate Governance

In addition to the high annual pay, the two family members also have employment agreements which trigger on any change in control, requiring a payment of 2.99x of average annual compensation over the past 5 years.

This would trigger a severance payment of over $3m, a significant hurdle for a potential acquirer when they are buying a company with a market cap of $17.8m.

Making it even harder, SVT has a shareholder rights plan in price that triggers if someone acquirers more than 25% of the company. It effectively dilutes the stake by offering new preferred stock and an option to purchase additional common.

While management often frames shareholder rights plans as a benefit, they often hinder sources for unlocking shareholder value such as selling the company or replacing management.

Positives

Share Repurchases

The board has authorized a share repurchase plan and the company has purchased a total of 238,088 shares – but only 943 of those shares were bought during the past two years.

Buybacks can be effective when management repurchases stock when it’s trading at a discount to its intrinsic value.

Looking at SVT’s buyback history, a significant number of shares were purchased at much higher multiples of earnings and book value compared to current prices.

I’d much rather see management repurchase additional shares now, when the stock is trading at a ~20% discount to book value.

Special Dividends

Instead of repurchasing shares, management has returned cash to shareholders via a special dividend. This past year marked the third consecutive year that a dividend has been paid, at $0.15 per year.

This payment represents a 3.3% dividend yield.

Industry Tailwinds

Finally, the company should benefit from strong industry tailwinds in the aerospace market (and I try to avoid industry headwinds whenever possible).

Air traffic, especially in Asia, is expected to continue growing at a rapid pace, and aircraft manufactures are churning out new planes to meet this demand.

As the company mentioned in its press release,

“certain major manufacturers of commercial aircraft have publicly announced that they have initiated plans to ramp-up production to support their customers’ forecasted increases in aircraft deliveries in 2011 and 2012. Aircraft component suppliers are being advised to increase their manufacturing capabilities to support this forecasted accelerated aircraft production.”

Suppliers such as SVT should benefit from this boost going forward.

Stock Valuation

No matter which way you look at the company, SVT appears to be an undervalued stock.

At current prices, the stock is selling at a discount to book value (P/B is 0.8x) despite earning respectable if not unspectacular ROE and CROIC of 10% and 10.9% respectively.

A DCF calculation using extremely conservative inputs ($2.1m in FCF, 3% growth, 9% discount rate) yields an intrinsic value estimate around $14, almost 40% upside based upon current prices.

On a multiple basis, SVT trades at 5.2x EV/EBIT and 6.9x EV/FCF.

The company is small, float is tiny, and it operates in two completely unrelated business segments, so finding comparables is difficult.

However, even assigning a conservative multiple of 8x EBIT and 10x FCF would see the stock trading around $12-13.

Conclusion

Servotronics has a solid and extremely profitable business segment that is being held back by the low-margin barely profitable consumer division.

Consider this: The CPG segment has done $73m in sales over the past six years but only earned $811,000 in total profit!

Despite this inefficient capital allocation, the Trbovichs pay themselves a considerable compensation package.

The harsh truth at many public companies is that the larger the company (based on revenue), the more executive pay packages can be justified – reducing the likelihood of a divesture even if it’s in the best interest of minority shareholders.

I have all of the respect in the world for company founders and entrepreneurs in general, and Dr. Trbovich should be properly applauded for his work in building up the company over the past five decades.

Shareholders would be better served by spinning off or divesting the low-performing unit, which is currently taking away capital investment and management focus that could be better served by the company’s core competency.

Maybe then the market will realize the mispricing – and everyone will benefit.

Disclosure

Long SVT

After a steady decline from mid-February, the S&P bottomed out on March 16 – roughly break-even for the year at that point – before rallying strongly to close out the first quarter of 2011 up 5.9%.

The ValueUncovered model portfolio has continued to fare well, outperforming the S&P by 5.53% since inception.

While I am pleased with this performance, it is becoming harder to track this model portfolio – see additional thoughts below.

Holdings

I’ve updated the Holdings page to reflect the current positions and prices as of March 31, 2011. The portfolio currently holdings 12 standard positions, along with 2 work-outs (TNFG, NEXC).

Nine out of the twelve long positions are currently in positive territory, but only seven of those nine are outperforming the S&P.

Interestingly enough, the laggards in the portfolio are primarily my oldest positions, going back to late 2009 and early 2010.

My investment philosophy has changed a great deal since starting this blog, and hopefully my analytical skills and business sense have improved as well, reflecting in the better performance for newer positions.

(That’s what’s I tell myself at least, even though it’s probably just random!)

Lowlights

New Frontier Media (NOOF) is currently the biggest loser in the portfolio, down 12.81%, although the price is up slightly since 12/31.

NOOF reported a significant revenue increase in the fiscal third quarter, and should benefit from an upcoming office move and equipment investment.

Not to be outdone, APT fell sharply during the quarter after reporting an 85% decrease in annual earnings. I knew the company would be facing difficult QoQ comparables as it made the transition to the lower-margin building supply segment, but the market reacted more strongly than I thought to the news.

APT’s balance sheet remains strong.

In January, NEXC surprisingly reported a substantial restatement of its estimated liquidation distribution, from the initial $0.12 – $0.16 per share to no more than $0.09 per share.

I am shocked by the news, as I thought that incentive arrangement would be a catalyst for the company to rapidly and efficiently wind down operations.

This was my first liquidation work-out, and it doesn’t appear like it’s going to work out very well.

Highlights

Access Plans (APNC) and Techprecision (TPCS) continue to lead the way, with gains of 109% and 72% since the original write-ups.

APNC reported a whopping 69% increase in first quarter earnings, and continues to explore strategic alternatives. While the stock is up significantly, earnings should continue to improve throughout the year and further potential exists to unlock shareholder value.

TPCS is one of my favorite stocks, and the company continues to execute superbly at the hands of the new CEO. The new Chinese subsidiary has already contributed millions of dollars in new sales and appears to just be getting started.

AML Communications (AMLJ) was bought out at $2.10 per share, allowing for a 60 day turnaround and a 64% gain.

Pink Sheets Project

During the quarter, I completed a major research project, going through 3,698 pink sheets stocks individually in the search of bargains.

It has been the most commented post so far on ValueUncovered, and I received quite a few emails from readers praising the accomplishment.

I learned a great deal during the experience, and now have a nice watchlist of stocks for further review.

While all of them are cheap, I’m really trying to understand the business models, and determine if there are any upcoming catalysts to quickly reach intrinsic value – many of them have been cheap for years, so I’ve been selective with my purchases so far.

Portfolio Tracking

Due to the Pink Sheets project and a general focus on even more obscure and illiquid securities, I’m having second thoughts about continuing to track my positions in the Value Uncovered model portfolio.

Many of the stocks I’m currently buying are extremely small, and it is not uncommon for prices to change by dozens of percentage points with a single trade.

For example, one of my largest (still undisclosed) positions dropped nearly 50% on a $99 trade. Only a few days ago, ELST fell 16% on a 369 share purchase (the total volume for the day!) before recovering several days later.

Other stocks require patience over weeks or months to pick up enough shares for a decent-sized position.

All of these factors combine to make tracking in my current format very difficult, and causes the model portfolio to significantly trail my personal performance.

Suggestions

I’m definitely open to suggestions regarding the current model portfolio.

Should it be scrapped all together? Is it better to just announce my average entry points for particular positions rather than using a specific close price?

Or should I just post my actual portfolio results, even though some positions are not disclosed?

I initially started the tracking portfolio as a way to keep a public record of my stock selections. As I continue down the path, I’m finding that this disclosure (at least in the current manner) might not be the best route.

What do you think?

Disclosure

Long all stocks in this article, except closed positions.

Advant-E is a small e-commerce software company that is showing strong growth while remaining undervalued by the general market.

As a tiny player in the huge Information Technology field, ADVC has managed to carve out a solid niche and continues to throw off cash at impressive margins.

While many software companies trade at outsized multiples which reflect the general attractiveness of the industry (margins are certainly impressive in the software business), ADVC trades with a P/E ratio of under 10.

Despite increases in revenue, EBIT, and net income during this past year, the stock price actually declined in 2010, closing the year trading at multiples below its long-term averages.

Industry and Technology Overview

Sales are broken out into two reporting segments:

Edict Systems

Edict Systems offers Software-as-a-Service (SaaS) solutions primarily to small and medium businesses to assist in Electronic Data Interchange (EDI), a fancy term for the act of sending and receiving business documents (such as purchase orders) electronically using a standardized format.

In the retail space in general, large purchasers have significant power over the wide array of small and medium suppliers that hope to gain their business.

Once a large purchaser starts conducting business via EDI – an attractive ROI proposition for a big company – they force their suppliers to comply or face significant financial penalties.

Edict Systems provides an easy-to-use web-based EDI solution at a low price point, ranging from $50 – $250 per month, for suppliers to convert and send their documents electronically.

Unusually, Edict charges the suppliers, and allows the large purchaser to get the benefits for free.

This means other suppliers must pay to stay competitive, or potentially lose a large customer.

As more documents are sent using EDI – signifying that the supplier is theoretically making sales – ADVC shares in that success via their volume pricing, a nice business model.

Merkur Group

The Merkur Group is more of a traditional IT business, offering software and services that are delivered on-site and hooked into existing Supply Chain Management (SCM), Customer Relationship Management (CRM), and Enterprise Resource Planning (ERP) systems – the lifeblood of any decent-sized retail organization.

Merkur offers a number of different services around document delivery such as fax automation, sales orders, and accounts payable processing.

Integration with existing enterprise toolsets is not cheap, usually requiring services work to complete the installation. Merkur therefore has lower margins than the internet side of the business.

Financial Results

Overall, revenues were up 8% in 2010 to $9.3m compared to $8.6m in 2009, with the majority of the increase driven by Edict Systems.

Edict Systems showed strong growth among its various product lines, with the Grocery and Automotive products seeing 11% increases respectively compared to 2009.

Fourth quarter results were down slightly from the 3rd quarter, but the company has still managed an impressive track record of sequential growth:

The Merkur Group managed to squeak out a 2% sales increase.

Despite a rough showing in the first quarter of the year (sales were down $140k from the same quarter in 2009), the Merkur segment showed 3 consecutive QoQ revenue increases to finish out the year.

The company has set a target of 20% pre-tax margins across the business units. Combined, the two segments earned $2.4m in operating income, for a pre-tax margin of 25.8%.

Reported net income was $1.59m, up 33% from the $1.19m in 2009, for an annual EPS of $0.024 based on 66.7m shares outstanding.

Management

Avant-E is a closely held corporation, with the CEO and founder Jason Wadzinski owning 54.8% of shares outstanding.

He has been at the company for over 20 years, and struggled through the hard times before the company started taking off in 2003 after making the transition to the SaaS model.

In a profile last year, Wadzinski describes the challenges of growing the business and the importance of taking a long-term view.

There is no doubt that ADVC is Mr. Wadzinski’s company, but he seems to be a prudent manager and draws a very reasonable salary.

In fact, despite a record year in 2010, his annual salary actually declined from $220k to $160k.

He has already demonstrated a commitment to returning cash to shareholders by paying a special dividend last year, saying

“The purpose of the cash dividend is to reward the Company’s shareholders, many of whom have been shareholders for a very long time, and to enable them to likely take advantage of favorable Federal income tax treatment that is scheduled to expire at the end of 2010.”

Valuation

Many acquisitions in the software industry are based on a sales multiple.

As a group, stocks within the computer software sector trade for 3.4x EV/Sales ; ADVC is currently trading at a 1.3x multiple.

While some discount is warranted due to the closely held nature of the firm and small size, even a 2x multiple would translate into a fair value of $0.32, or nearly 40% upside from current prices.

Traditional metrics are low as well, with the company trading at an EV/EBIT of 5.2 and EV/FCF of 7.8.

Assigning more realistic multiples of 10x EV/EBIT and 15x/EBIT would allows room for 100% upside from the stock’s current market price.

Negatives

Software is a rapidly changing field and notoriously difficult for value investors.

There is a long list of software companies that relied on once-promising technology only to be quickly obsolete when faced with an upstart competitor with a new twist.

In addition, the company’s founder, Jason Wadzinski, controls ADVC without a group of independent directors assigned to look after shareholders’ interests.

Theoretically, large insider ownership helps align interests, but this is an extreme case where the CEO holds most of the power and could make decisions at odds with the best interest of minority holders.

Conclusion

Advant-E is a stock that has effectively captured a nice market niche, and an example of the powerful economics and attractiveness of software companies.

Average ROE of 30% and CROIC of 65% show-off the tremendous power of a well-run software company, and the stock currently has a FCF yield over 10%.

Despite these phenomenal numbers, the stock should still appeal to value investors looking for a solid business at a low price.

ADVC boasts over 4000 customers, and the business does not show any signs of slowing down.

The latest press release hits on some of the high points from 2010:

• Edict Systems revenue increased for the tenth consecutive year
• Net income exceeded $1 million for fourth consecutive year
• 2010 marked the eighth consecutive year the company has reported a net profit
• Exceeded goal of 20% pre-tax profitability in 6 out of last 7 years

Looking into 2011, the company is making an investment in upgrading its Web EDI platform to add superior functionality and greater customer value, which could temporarily depress earnings during the migration period.

Although this initiative might depress earnings over the next few quarters, it is another example of making investments with the eye towards the future.

The company now sits on $2.9m in cash offset by no outstanding debt. Hopefully management can find a way to continue re-investing that cash into the business at attractive rates of return.

Although as a shareholder, I wouldn’t complain about another special dividend!

Disclosure

Long ADVC