2023-12-19 12:50:42 ET
Summary
- Revenues rose by 30.9% to $15.6 million in Q3 2023, while net income soared to $1.27 million thanks to strong sales of patented products.
- The sales backlog remains strong, and I expect revenues to remain at a similar level in Q4 2023.
- However, Smith-Midland is trading at an EV/EBITDA ratio of 62.3x on a TTM basis and this is a cyclical business with low barriers to entry.
- In my view, there is a decent short selling opportunity here, but risk-averse investors should avoid this stock.
Introduction
In October, I wrote a bearish article on SA about US precast concrete products firm Smith-Midland (SMID) in which I said that the Q2 2023 financial results were underwhelming as the company hasn't been able to increase the revenues of its high-margin barrier rental business.
In my view, the Q3 2023 financials of Smith-Midland were strong as sales of several key products soared and net income came in at $1.24 million. However, the market valuation has increased by over 83% since my previous article about the company and now I feel comfortable cutting my rating on the stock to strong sell. Let's review.
Overview of the Q3 2023 results
If you're not familiar with Smith-Midland or my earlier coverage, here's a short description of the business. The company is involved in the manufacturing and installation of precast concrete products such as noise walls, highway safety barriers, cladding systems, and architectural panels. It has manufacturing facilities across Virginia, North Carolina, and Columbia and most of its clients are from the construction, highway, utilities, and farming sectors. There is some seasonality here as revenues sometimes dip in the winter months due to lower construction activity in the USA due to adverse weather. It's also an asset-light business with low barriers to entry and therefore operating margins are low. As a result, the gross profit margin of the company has often been below the 30% mark over the past two decades. The EBITDA margin, in turn, has usually been in the mid single digits over that period.
Smith-Midland has several patented products such as the JJ-Hook highway barriers and Easi-Set concrete buildings, but they usually account for a small share of its revenues (see slide 4 here ).
This means the moat for the business is close to nonexistent. The company's strategy to improve its operating margins is to increase the size of its barrier rental business as the gross margin there is in the 25-35% range (see slide 7 here ). This plan hit a snag in Q2 2023 due to a slowdown in barrier rental projects and I was concerned that barrier rental revenues could remain low in the second half of the year as well. Well, it seems that I could be right as barrier rental revenues slumped by 42.7% year-on-year to just $0.78 million in Q3 2023. However, it seems that I could also be right that the improving sales backlog of Smith-Midland would translate into higher total revenues in the second half of 2023.
As you can see from the table above, the growth in revenues came mainly from higher sales of proprietary products such as SlenderWall, and Soundwall and this enabled Smith-Midland to boost its gross profit margin to 22.9% in Q3 2023 from just 17.4% a year earlier. The company has thus returned to the black in terms of net income much sooner than I expected.
Smith-Midland also strengthened its balance sheet during Q3 2023 as its net debt fell to just $0.04 million from $1.31 million three months earlier (see pages 3 and 4 here ). Looking at what to expect for the future, I think that Q4 revenues could be at a similar level to Q3 as the sales backlog continues to be strong. As of November 1, it was at $60.2 million compared to $51.4 million a year earlier (see page 16 here ). However, I think that net income for the quarter could dip below $1 million due to a shift to lower margin products. Smith-Midland revealed in its Q3 2023 financial report that SlenderWall sales are expected to trend lower throughout the remainder of 2023 (same page).
Overall, I think that Q3 2023 was a strong quarter for Smith-Midland and that we could see similar revenues and slightly lower net income for Q4. That being said, there are no signs that barrier rental revenues could rebound soon, and I think the company is starting to look significantly overvalued based on fundamentals. The market capitalization of Smith-Midland has almost doubled since the Q3 results were released and the company is currently trading at an EV/EBITDA ratio of 62.3x on a TTM basis. Even if average quarterly net income remained close to $1.27 million in the coming years, this translates into a forward P/E ratio of 37.4x, which seems a lot for a low-margin cyclical business. Considering the trading volume has increased significantly over the past few weeks, I think that there could be increased retail investor interest here which I doubt will last much longer than a few months. These sudden share price increases are not unusual in the microcap stocks space, and I think that over the coming months we could see a crash in the share price similar to the one in January 2022. Back then, Smith-Midland slumped from $47 per share to below $27 per share in the span of a single month on heavy volume as investors rushed for the exits.
In my view, the share price could dive below $25 by the middle of 2024 and this creates a good short-selling opportunity here. Data from Fintel shows that the short borrow fee rate is 14.49% as of the time of writing, which is somewhat high, but the short squeeze risk seems low as the short interest is just 0.57% of the float. However, there are no options available, which means that you can't buy call options for hedging purposes. In light of this, it could be best for risk-averse investors to avoid this stock.
Looking at the upside risks, I think that the major one is that the share prices of microcap companies can soar for spurious and unknown reasons and that we could see Smith-Midland above $40 per share once again soon. It's also possible that SlenderWall sales exceed expectations for Q4 2023 or that we see a recovery in barrier rental revenues. This could provide a boost for the share price.
Investor takeaway
Smith-Midland booked solid Q3 2023 results thanks to strong sales of patented products, but I think the company is looking overvalued at the moment as its market capitalization hovers near $190 million. It's a cyclical business with low barriers to entry and the operating margins usually don't remain high for long periods of time. In my view, there is a viable short selling opportunity here but the short borrow fee rate is somewhat high and there are no call options available.
For further details see:
Smith-Midland: Strong Q3 2023 Results But The Valuation Is Stretched (Rating Downgrade)