2023-10-14 02:11:21 ET
Summary
- The company’s revenues grew by 10.9% in Q2 2023, but operating income was in the red.
- Smith-Midland booked over $0.7 million in one-off expenses during the quarter, and revenues from the high-margin barrier rental business slumped by 64.3%.
- While the company expects barrier rental revenues to improve in the second half of 2023, I doubt that this will be enough for it to get back in the black.
- In my view, it could be best for risk-averse investors to avoid this stock as the short borrow fee rate is above 16% and there are no call options available.
Introduction
In July, I wrote an article on SA about precast building materials company Smith-Midland ( SMID ) in which I said that 2023 could be a good year in terms of sales thanks to a solid backlog but that I was concerned about the low margins of the business.
On October 11, Smith-Midland released its Q2 2023 financial results , and I think they were underwhelming. While revenues improved by 10.9% year on year, the company swung to a $0.98 million operating loss due to lower barrier rental revenues, additional costs related to a project, and a wire fraud incident. I’m changing my rating on the stock to sell. Let’s review.
Overview of the Q2 2023 financial results
In case you're not familiar with Smith-Midland or my earlier coverage, here's a brief description of the business. The company was established in 1960 under the name of Smith Cattleguard Co and is involved in the development, manufacturing, and installation of a range of precast concrete products, including noise walls, highway safety barriers, cladding systems, and architectural panels. It also has a portfolio of patented products (see slide 4 here ).
Smith-Midland employs about 200 people, and it has production facilities in Virginia, North Carolina, and Columbia that serve mainly the construction, highway, utilities, and farming industries. Most of its clients are general contractors as well as federal, state, and local transportation authorities in the Mid-Atlantic, Northeastern, Midwestern regions of the USA.
Smith-Midland operates in a highly competitive and fragmented market with low barriers to entry, which leads to low operating margins. As you can see from the chart below, the EBITDA margin has rarely surpassed 10% over the past two decades. In order to improve its profitability, the company has been aiming to boost the size of its barrier rental business, where gross margins are 25-35% (see slide 7 here ).
Unfortunately for investors, Q2 2023 marked a step back in this strategy as barrier rental revenues slumped by 64.3% year on year to just $0.7 million. Smith-Midland said the decrease was due to a slowdown in barrier rental projects as well as revenue recognized in Q2 2022 related to a buy-back agreement (see page 18 here ). Barrier rental revenue is expected to improve in the second half of 2023, but the company gave no forecasts by how much.
Declines in architectural panel, and barrier sales as well as shipping and installation revenues were offset by strong revenues from patented products like SlenderWall, and Easi-Set but the gross profit margin of Smith-Midland declined to 12.15% from 24.37% a year earlier. Besides the shift to lower-margin products, the company’s financial performance for the quarter was negatively affected increased material and labor costs; $0.4 million in additional costs for the remaking of panels for a specific project; and a wire fraud incident that boosted general and administrative expenses by $0.34 million (see page 17 here ). However, if we exclude the last two items, operating income for Q2 2023 would still be in the red.
Turning our attention to the balance sheet, I think the situation looks good as net debt was down to $1.31 million as of June 2023 compared to $2.26 million a quarter earlier (see pages 3 and 4 here ). Smith-Midland has an asset-light business model that doesn’t require a lot of CAPEX and purchases of property and equipment were just $2.97 million for the first half of 2023. Yet, net cash provided by operating activities during the period was just $1.08 million, which put free cash flow in the red.
Overall, I think that Q2 2023 was underwhelming for Smith-Midland due to one-off expenses and a sharp decrease in barrier rental revenues. On a positive note, the sales backlog stood at around $60.9 million compared to 35.7 million a year earlier (see page 21 here ). This means that sales are likely to remain strong in the second half of 2023. Yet, I’m concerned that barrier rental revenues could remain low over the period and that Smith-Midland could struggle to get back in the black, which is likely to put pressure on its share price. In my view, the company already looks expensive from a P/BV standpoint as the tangible book value per share is $6.18, less than a third of the current share price.
So, how do you play this one? Well, I think that the best course of action for risk-averse investors could be to stay away from this stock as short-selling seems dangerous. According to data from Fintel , the short borrow fee rate stands at 16.11% as of the time of writing. Looking at risk hedging opportunities, there are no call options available at the moment.
Looking at the upside risks, I think the major one is that I could be underestimating the prospects for the barrier rental business of Smith-Midland. If barrier rental revenues jump to about $2 million per quarter in the near future, quarterly operating income could be back to around $1 million once again. Another risk is that microcap stocks can soar for spurious and unknown reasons.
Investor takeaway
Smith-Midland hasn’t been able to increase the revenues of its high-margin barrier rental business, and operating income is now in the red despite sales growing by double digit percentages in Q2 2023. While the company expects barrier rental revenues to improve in the second half of 2023, I doubt that this will be enough for it to get back in the black and I’m bearish on the stock. Smith-Midland seems expensive at 3.24x price to tangible book value but I think that it could be best for risk-averse investors to avoid this stock as the short borrow fee rate is above 16% and there are no call options available.
For further details see:
Smith-Midland: Underwhelming Q2 2023 Results As Barrier Rental Revenues Slump (Rating Downgrade)