SMIT has a net current asset value of $7.6mm, and therefore trades at just under 2x net current assets. However, when factoring in the $10.5mm gained from the strategic sale of SBS announced on October 10th, Schmitt stock would trade at a 20% discount to net current assets.
SMIT has only briefly traded below its NCAV, and quickly recovered in share price.
Potential Tax Implications
There may be some tax liability associated with the transaction. It has not yet been filed, but I’ll walk through it here:
Schmitt must pay taxes to both the state of Oregon and the federal government, at marginal rates of 6.6% and 21%, respectively.
However, Schmitt has past net operating losses (NOLs) of $4.7mm and $4.2mm, respectively. These allow Schmitt to reduce taxable income for both levels.
For the state level, this leaves Schmitt Industries with $5.8mm of taxable income after deducting NOLs at a 6.6% rate, or about $383,000 in tax liabilities following the transaction.
At the Federal level, Schmitt has about $5.92mm in federally taxable income after deducting NOLs and state taxes, or a federal tax bill of $1.24mm.
My estimated total tax liability for the divestiture comes out to about $1.623mm, for an effective rate of 15.4% on the transaction. This puts the net proceeds at $8.877mm.
Mr. Market’s Valuation
Mr. Market believes that the transaction only has a time-discounted 32.6% chance of going through.
You can derive this probability from the change in valuation before and after an announcement is made. SMIT stock has only risen by 29.7%, or $2.9 million. Since that change in market cap is just 32.6% of the net transaction value ($8.877mm), Mr. Market has assessed that the business sale has only a 32.6% (time-discounted) chance of going through!
This means one of two things:
Either Mr. Market has priced this deal correctly, and it has a 67.3% chance of falling through, or
Mr. Market is wrong, since SMIT is a nanocap with very little coverage and markets are not always efficient.
Assuming a worst-case downside valuation of 0.9x of today’s net current assets, SMIT’s market cap would fall to $6.84mm, or about 45% lower than today’s prices. This is a true worst-case valuation. It assumes the underlying businesses are worthless (while generating $13.8mm in revenues) and that current assets are discounted below their book value.
My base case for failure is simply a reversion to the pre-announcement valuation of $9.7mm, or a loss of 22.9%. This is not catastrophic, but ought to illustrate the importance of position sizing when playing special situations such as risk arbitrage and deep value stocks.
The upside in this special situation is therefore asymmetrical, offering 25% upside by year-end in the event that the spinoff sale goes through successfully at $10.5mm before taxes. This is a conservative valuation, assuming the stock either reaches net current asset value or chooses to return capital to shareholders in the form of a special dividend.
When we adjust the stock’s valuation baking in this $8.877mm special item, the stock trades at 0.8x adjusted NCAV and 1.0x adjusted net-net working capital – a low point that SMIT stock has never seen (as far as I have seen).
|Current Assets||Total Liabilities||NCAV||Market Cap|
|Before Sale Announcement||8.9mm||1.3mm||7.6mm||9.76mm|
|After Sale Announcement||17.78mm||1.3mm||16.48mm||13.1mm|
|Before Sale P/NCAV||1.28|
|After Sale P/NCAV||0.80|
Furthermore, Schmitt Industries’ SBS business generates 2/3rds of revenue, but less than 28% of net income. This indicates that the sale is strategic and offers strong benefits to both parties; Schmitt can focus on its higher-margin Measurement segment – which makes laser and ultrasonic measurement systems – and the acquirer, Tosei Engineering, can improve and streamline the SBS business.
This valuation indicates that, on a price to sales basis, Schmitt Industries is worth at least $15.75mm based on Tosei’s valuation of the Balancer (“SBS”) segment. From the price to net earnings perspective, Schmitt may be worth upwards of $27mm. Schmitt therefore is trading at a steep discount to intrinsic value by any metric, and offers an exceptionally wide margin of safety even following the recent price run-up.
Despite the wide discount to an “intrinsic value” estimate – derived from Tosei’s bid for the Balancer segment – I will only be playing this as a net current assets stock and plan to sell once the transaction goes through. I may reevaluate the business at a later time if the price remains attractive following the sale.
Following the finalization of the deal with Tosei, SMIT stock may have substantial upside beyond its net current assets. The deal includes a ten-year lease agreement with the acquirer Tosei Engineering Corp, and Schmitt Industries still has substantial continuing operations beyond its SBS business.
I believe that Mr. Market’s 32.6% probability of success represents a substantial mispricing of risk and offers an arbitrage opportunity. As the one-month closing date approaches, I believe this discount will rapidly begin to close – or fall through – in which case I would promptly cut losses hopefully at some price above net current assets.
As an arbitrageur, I’m not necessarily interested in playing out the upside beyond the risk premium of the SBS deal with Tosei and will be quite happy selling at my 25% upside within a fiscal quarter – or over 144% on an annualized basis!
Obviously, the market price can gap up or down quite a bit over the weekend as Mr. Market reassesses the announcement. Take these changes into account in your own calculations, and do your own due diligence.
Disclosure: I am/we are long SMIT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.