Servotronics Inc. (SVT) recently reported 2010 second quarter earnings and the market reacted favorably as the company turned in another solid quarter. The stock price jumped to $10, after trading around $9 for the prior month or two.

Second Quarter Results

Revenues for the 2nd quarter were $8.2M compared to $9.1M in the same period last year, a drop of approx. 10%.

The Consumer Products Group was the source of the decline, with sales dropping 23%, partially offset by a slight increase in revenues for the Advanced Technology Group.

Despite the top-line drop, quarterly net income was up significantly, increasing 10% to $778k compared to $710k in the prior year quarter. For the 6 month period ending June 30, 2010, net income was 68% higher, as the company continues to benefit from an outstanding first quarter.

FCF is $1.6M so far this year, more than doubling the cash flow generated in the same period last year.

Segment Analysis

The ATG division continues to chug along, as operating profit increased for the second consecutive quarter.

The company has also worked to improve the CPG’s product line, allowing margins to increase slightly despite the drop in sales.

Conclusion

With conservative estimates, the business is on track to generate over $3M in owner earnings for the year, close to the record set in 2008.

Management has performed well through the economic downturn – after a small hiccup at the end of 2009 – and the stock should benefit as the aerospace markets turn around (see my post on SIFCO as well).

I’m revising my conservative valuation downward slightly, to $12.50-$13.50, with an upward estimate closer to $15.

Disclosure

Long SVT

SIFCO Industries Inc (SIF) is engaged in the sale of various metalworking products and services, and has been in business since 1916.

The stock price has been volatile over the past three years, touching $24 back in 2007, falling to $4.30 in 2008, and recovering to $17 earlier this year.

The company is heavily dependent on the fortunes of the commercial airline industry (similar to SVT, a Value Uncovered holding), causing a cyclical revenue pattern – the stock price has dropped almost 40% from its yearly highs as the company struggles with weak short-term demand in the airline industry.

Despite the price volatility, the company has improved its financial condition by producing solid operating income and cash flow.

Overview

The company is organized into three different business segments.

Aerospace Component Manufacturing Group

“This segment of the Company’s business consists principally of the manufacture of forged components for aerospace applications.”

This segment is the primary driver for the company’s future growth, producing $68.6M in sales during fiscal 2009, or 73% of total revenues – a percentage that has been increasing each year. The segment also benefits from the highest operating margins of any of the business segments.

Two customers, Rolls-Royce Corporation and United Technologies Corporation account for 18% and 13% of sales respectively. Usually, this type of customer concentration poses a major risk to the business.

However, SIFCO works off of multi-year agreements and has had long-standing customer relationships going back over ten years. That is an incredibly long track record for such a small company, and shows that they provide integral services to some of the world’s largest industrial conglomerates.

Turbine Component Services and Repair Group

“This segment of the Company’s business consists principally of the repair and remanufacture of small aerospace turbine engine components.”

Over the past three years, the Repair Group has contributed between 12-14% of company sales. Although SIF owns several proprietary repair techniques and has to undergo extensive approval processes, the Repair Group segment appears to be turning into a commodity-like business.

Operating margins back up this view, averaging 0.22% over the past three years.

Applied Surface Concepts Group

“The Company’s Applied Surface Concepts Group (“ASC Group”) provides surface enhancement technologies principally related to selective electrochemical finishing and anodizing…the Company believes that the ASC Group is the world’s largest selective electrochemical finishing company”

The ASC Group benefits from a base of over 1,000 customers. Metal finishing products have much shorter lead times and smaller contract values, providing a nice balance to the long-term contracts in the ACM group.

Financials

Revenues hit a high of $101.3M in 2008 before falling to $93.8M last year. Based on fiscal 3rd quarter results, sales have dropped another 15% or so in 2010 as the company continues to deal with weak demand in the aerospace market.

Revenue decreases have also impacted the bottom line, with profits slipping 38%.

The economic downturn has taken its toll on SIF’s customers, who have delayed or reduced build rates for the company’s aircraft. Despite the short-term sales drop, the outlook remains very bright for the industry – sales should return as global demand picks up.

Despite the financial hit, the company remains solidly profitable and has continued to throw off cash. Debt to equity has dropped every year since 2004 (140.9%), and is now down to 41.5%.

Capital expenditures have increased – estimated cap-ex will end up between $5.5-5.6M, much higher than the long-term average of $2.3M – as the company expands production capabilities for its ACM group.

CROIC was a very respectable 16.5% and 18.3% over the past two years. 3-yr ROE is 17.8%, a substantial improvement over the company’s long term average.

Positive Catalysts

Industry Outlook

According to the latest report from the Aerospace Industries Association’s (AIA), the outlook for the aerospace segment is bright:

“A game changer such as the Boeing 787 airliner, as well as pent up demand for environmentally-friendly and fuel efficient aircraft will reinvigorate the aerospace industry and drive demand for years to come.”

While the pace will slow in 2011, it is an optimistic report that bodes well for the long-term success of SIFCO’s business. It also validates the company’s decision to focus on the ACM segment and should lead to higher margins in the future.

Strategic Divesture

In Jan 2009, the company announced that it was exploring strategic alternatives for the Repair Group in order to enhance shareholder value. This is a positive move, as the segment has only been mildly profitable over the past few years.

While there has been no news since the announcement, a sale to a 3rd party would allow SIFCO to concentrate on its core competency and potentially unlock value for shareholders.

Share Buyback

In June 2010, the board of directors announced a share buyback program for up to $1M. At current prices, the buyback could retire approx 2% of the company’s outstanding stock.

While not a huge amount, the buyback would boost EPS, as management believes that the current stock price does not reflect the company’s true value.

SIFCO has built up its cash position to $24.7M, so a special dividend might be a possibility as well.

Negatives

Cyclicality

Obviously, the company needs to stem the bleeding on the sales front and return to top-line growth. The business model is heavily dependent on the fortunes of the airline industry, a notoriously difficult and cyclical business.

Until revenue and profits return, the market will continue to keep the stock price depressed.

Insider Selling

Several insiders, including the corporate controller and CFO, were heavy sellers back in March and April of this year. At the time, the stock was trading at over $17, after gaining over 300% in a little over a year.

The insider trading also forewarned the drop in sales/profits in the subsequent quarter.

While I’d much prefer to see insider buying, there are certainly valid reasons for insiders to sell stocks (the timing was right around income tax season).

Trust Ownership

Currently, two trusts hold over 50% of common shares. Approx 37% is held by a Voting Trust that was entered into in 2007 as a way to

“continue the investment of the signing shareholders in SIFCO and to continue to maintain the stability of SIFCO through the Trustees’ exercise of voting control over the SIFCO Shares in the Voting Trust”

This Voting Trust looks to be at least partially setup by Mr. Smith (Director) and Mr. Gotschall (CEO) for their dependents/descendents.

The other trust seems to be for investment purposes, as most shares were purchased near the stock price lows back in 2008.

Together, they make it very difficult for a merger or acquisition to unlock shareholder value unless it is expressedly approved and in the best interest of these trusts – potentially putting them at odds with the rest of the common shareholders.

Valuation

These valuation assumptions are very conservative as FCF for 2009 was 9.8M, and TTM is $7.8M.  I used a 15% discount rate for the DCF calculation.

Conclusion

The stock is a contrarian play based on the short-term numbers, as many investors will avoid a stock that has reported such poor comparables over the past two quarters.

Short-term, the company will probably suffer through another rough quarter to close out the fiscal year.

Long-term, my normal/aggressive valuation assumptions assume that sales will stabilize as the aerospace market turns around. There are several potential catalysts to help move the stock price along as well.

If the turnaround occurs, the last few quarters could be just a bit of turbulence on the flight towards future long-term gains.

Disclosure

No current positions.

Food Technology Inc. (VIFL) is a tiny micro-cap stock with a market cap of only 5.6M, operating in a unique industry:

“The Company owns and operates an irradiation facility located in Mulberry, Florida that uses gamma radiation to provide contract sterilization services to the medical device, food and consumer goods industries.”

Irradiation is a process of subjecting food to a short burst of high-energy radiation to break down bacteria.

Company sales are broken into three categories – medical devices (72%), food (16%), and consumer goods (12%). According to SEC filings by MDS Nordion[1. VIFL’s main source for Cobalt-60 supplies],

“Approximately 40 per cent of single use medical devices produced worldwide are sterilized using gamma sterilization technologies. Sterilization of medical devices… is a relatively mature industry with 4%-7% annual market growth.”

However, the potential market and growth opportunities for food irradiation is another story…

Debate over Food Irradiation

I think most people would agree that sterilizing medical devices is a good practice but there has been a rather intense debate about the merits of food irradiation.

Many consumers are turned away at the idea of applying radiation to food, despite the fact that academic studies have shown radiation to be a very effective way to kill bacteria and reduce the risk of foodborne illnesses.

Critics argue that irradiated food tastes differently and results in the loss of vitamins. However, most of the worry seems to be around consumer perception and general lack of knowledge regarding the procedure.

Foodborne Illnesses and Irradiation

According to the Centers for Disease Control, “foodborne diseases cause approximately 76 million illnesses, 325,000 hospitalizations, and 5,000 deaths each year in the United States.” [2. The Basics on the Foodfight over Irradiation]

Food irradiation has the potential to reduce these outbreaks and has been approved for use by many organizations including the World Health Organization (WHO), United Nations Food and Agriculture Organization, the FDA, National Aeronautics and Space Administration (NASA) and the American Medical Association (AMA).

The technique has been improved by the FDA for meat products since 1997 – Omaha Steaks, the $320m direct-to-consumer meat distributor, is a big proponent of irradiation. More recently, irradiation use has expanded to include produce such as spinach and iceberg lettuce.

Foodborne illness has been a major news topic of late, as more than 380 million eggs have been recalled due to salmonella threats.

There is no doubt that there is big potential for VIFL if food irradiation goes mainstream.

MDS Nordiron Agreement

As the radioactive materials used in the company’s work are tightly regulated, VIFL signed an agreement to procure Cobalt-60 from a company called MDS Nordiron. As payment, VIFL entered into a convertible debt agreement that allowed MDS Nordiron, at its option, to convert the debt to shares of VIFL stock.

As a result of the convertible option, MDS Nordiron owns approx. 18.2% of the company. As of Dec 2009, the company paid off the debt in full.

Financials

VIFL has been profitable for the past five years, and has shown steady growth in revenues and operating profits.

Revenues have increased from $1.7m in 2005 to $2.5M in 2009. During the same time period, operating profits have risen from $0.2M to $0.6M.

Margins are outstanding. Both gross and operating margins have been on a steady upward trend since 2006, coming in at 79.7% and 27.7% respectively last year.

The latest quarterly report shows an even greater rise, with operating margins jumping to 35.5% for the first six months of 2010.

EPS numbers have been inconsistent, primarily due to variability in income tax carryforwards.

As of Dec 31 2009, the company had unused operating loss carry forwards available of $4,931,966. These benefits can be an asset to the organization by reducing its overall tax burden. However, NOLs can cause variability in net income and EPS numbers due to the timing of the deferred tax assets

The balance sheet is rock solid. The company now has zero debt, with a quick and current ratio of 18.4 and 23.1 respectively.

Risks

MDS Nordiron has been selling off shares on a consistent basis, reducing the stake in VIFL from 23.5% in 2008 to 18.2% in 2009. MDS Nordiron sold off even more shares in June at around $2.05.

It is hard to determine MDS Nordiron’s motives regarding their ownership stake in the company but there is no doubt that consistent selling will put downward pressure on the stock price.

The other big risk for the company is customer concentration. In 2009, three customers accounted for 62% of revenue. If any of these customers were lost, it would substantially impact the business.

With that being said, the company managed to navigate the loss of a major client in 2009 who had accounted for 25% of total sales. Management was able to replace the lost business and report a slight revenue increase during the year, a major accomplishment.

Valuation

Capital expenditures were down significantly in 2009, as historically a major portion of capex expense was the purchase if Cobalt-60 supplies. VIFL has stockpiled approx. 1M curies of Cobalt 60, sufficient for the next 4-5 years at current production volumes.

Conclusion

VIFL’s fundamentals are very solid, but the stock is missing a catalyst to push the stock price substantially higher.

Continued pressure from health organizations or consumer awareness regarding the benefits of food irradiation could lead to a steady rise in revenues and profits.

Alternatively, a governmental mandate or incentives (stemming from an increased outbreak of illnesses perhaps?) might provide the nudge to food producers to aggressively switch over to irradiated foods.

Either option could increase the need for the company’s products in a big way.

I’ll be keeping a close eye on industry news, as well as watching VIFL’s stock price for an opportunity to pick up shares at a greater margin of safety.

But what do you think?  Is the stock cheap enough at current prices?

Disclosure

No position

Notes