The Cycle Turns for Smith-Midland - SMID

Smith-Midland Corporation is a Virginia-based manufacturer of precast concrete components for the construction and architectural industries. Smith-Midland provides a broad array of products including building exteriors and panels, highway safety barriers and sound barriers, precast buildings and more. Smith-Midland trades at 78% of book value and has recently been targeted by activist investors.

The precast concrete product market is heavily cyclical and tracks with construction activity, both private and governmental. Revenues are dependent on the construction of new buildings and roadways, as well as investment in repairs and upgrades to existing infrastructure. The market for these products would be completely commoditized but for the fact that concrete products are extremely heavy and bulky. The high cost of transport limits competition to a local level.

Smith-Midland's largest-selling products are its wall panels, which made up 22% of revenues in 2012. Barrier sales, including the company's patented J-J Hooks® highway safety barriers, accounted for 13% of revenues. Easi-Set Precast Buildings, also with a patented design feature, were another 13% of revenues. The remaining revenue consisted of royalties on product lines licensed to other companies, barrier rentals, miscellaneous product sales and transportation and installation revenue.

Smith-Midland's results have been volatile. Revenues and profits peaked in 2010, only to plunge precipitously in 2011. Gross margin fell by nearly 40% as several profitable contracts were completed and could not be replaced. Results rebounded in 2012.

Despite challenging economic conditions, the 2008 to 2012 period resulted in three of Smith-Midland's five highest-selling years. For the period, Smith-Midland averaged earnings of $0.20 per share and free cash flow of $0.23 per share.

Book value per share grew by 12.1% annually from 2007 to 2012, adjusted for a 5 cent special dividend in 2012. Smith-Midland's balance sheet is very strong, with a current ratio of 4.81 at year's end and more cash than debt.

While 2012 was a tough year for Smith-Midland's bottom line, there is evidence that the cycle is turning in Smith-Midland's favor. First quarter 2013 results were significantly improved over 2012, and management included very positive language on market conditions in its 2012 annual report.

Revenues leaped 15% for the quarter ended March 31, 2013, and gross margin increased by a whopping 938 basis points based a 27% increase in wall panel sales and a 29% increase in royalties, rental and transport/installation revenues. Operating leverage resulted in a huge swing in operating income and a nearly 9 cent per share increase in net income.

The outlook for the rest of 2013 is rosy as well, according to management's comments in the 2012 annual report.

Wall Panels - "The Company was recently awarded a large Slenderwall™ project in New Jersey that will start in the second quarter of 2013 and could significantly increase Slenderwall™ sales in 2013."

Easi-Set® Buildings - "Bidding activity for buildings increased somewhat during 2012, leading management to believe building sales could continue to increase in 2013. To aid in the continued increase in building sales, the Company hired two new building salespersons with the first starting in December 2012 and the second starting in February 2013."

Utility and Farm Products - "The Company will be bidding on a large vault project in the first quarter of 2013, which management believes it has a reasonably good chance to prevail. The Company is also seeing more bidding opportunities for utility products as of late and believes this, and the large vault project, may lead to increased sales in 2013."

Also, in an 8-k filing dated May 17, management indicated it was exploring the possibility of buying back shares. Buying back shares below book value is typically an excellent use of capital when debt levels are already low and expansion opportunities are limited. Smith-Midland's intangible assets are minimal, making a repurchase even more likely to create value.

At the end of the first quarter of 2013, Smith-Midland's book value per share was $2.28. A solid year in which the company earns 30 cents or so per share could push book value per share over $2.50 or higher. At some point, the company's discount to book value will become too wide for the market to ignore, and I would expect Smith-Midland to head higher.

On the other hand, Smith-Midland's share price could follow the path of so many other unlisted stocks and languish despite solid performance. I consider that unlikely, given the recent attention given Smith-Midland by multiple activist investors. Two hedge funds have bought up 16.2% of Smith-Midland's shares outstanding and have succeeded in bringing about positive changes, including the payment of a special dividend and leading management to allow a shareholder rights plan to expire. (Shareholder rights plans span a variety of strategies that purport to protect shareholders from abusive takeover offers, but usually serve only to entrench management and discourage acquisition bids.) With the shareholder rights plan out of the way, the company is more likely to be acquired by a competitor or financial bidder. These hedge funds, Henry Partners and JCP Investment Partnership, will certainly keep a close watch on management's activities.

On the topic of management, management compensation takes a large bite out of operating income. CEO and board chairman Rodney Smith co-founded the company's predecessor in 1960 and holds 15.8% of shares outstanding. Mr. Smith's son, Ashley Smith, serves as president and holds 3.4% of shares. In 2012, the father and son team took home $325,225 in compensation. In 2011, they earned $639,477. Rodney Smith also receives $99,000 annually for use of his patents and $24,000 rent on land he leases to the company. If not for these payments to the Rodneys, Smith-Midland's 2012 operating income would have been 78% higher.

Despite high management compensation, Smith-Midland could be ready to rise. Recent results are trending much higher than 2012 and the company is projecting further contract wins. Smith-Midland's already high cash balances could increase further, and JCP Investments and Henry Partners will be watching to make sure management uses it well.

I hold shares of Smith-Midland in an account I manage.