We believe in the power of incentives and search for companies where the interests of the management team are aligned with shareholders. In the microcap space, the chief executive officers of many companies are also the founders of the company and have devoted their life’s work to its growth and success. As a result, the founder often also owns a significant portion of the company’s outstanding stock. This can create a powerful alignment of interest with shareholders, as the founder has both a sincere love for the business and strong financial incentives tied to the company’s success. For Smith-Midland Corporation (“SMID” or the “Company”), founder and CEO Rodney Smith not only invented many of the Company’s products but also owns nearly 16% of the Company’s common stock. These incentives, combined with our bullish views of the highway construction space, an attractive valuation, and a considerable margin of safety provided us with the conviction to make Smith-Midland a sizeable position within our portfolio.

Smith-Midland develops, manufactures and sells precast concrete products for the construction, highway, and farming industries. The Company has patented several precast products that provide efficiencies in weight, energy efficiency, and sound absorption. The Company’s products are primarily sold to general contractors and transportation authorities in the Mid-Atlantic with a recent acquisition extending the Company’s market as far south as Georgia. Smith-Midland also licenses its proprietary products to other precast plants both domestically and internationally. The Company is headquartered in Midland, Virginia and has 201 employees.

Smith-Midland currently conducts its operations out of company-owned precast facilities in Midland, VA and Reidsville, NC. In addition, the Company recently purchased a precast facility in Hopkins, SC that expands the Company’s geographic reach as far south as Atlanta. Unlike ready-mix concrete, precast concrete products are poured and cured at the Company’s facilities and are then transported to the job site. This allows for greater efficiency and product consistency by producing the product in a controlled environment. The precast concrete industry is highly fragmented, with an estimated market size of $20 billion split between 2,800 precast manufacturers. Competition in the precast concrete industry is regional as transportation costs limit the economics of selling concrete products over 250 miles from the site of production. The industry was hit very hard during the Great Recession, as precast volumes fell nearly 50% from the peak of the market in 2007. Industry experts estimate that as many as 1/3 of the precast plants in the United States went out of business during this time. Smith-Midland notes with pride that only one of the Company’s licensees went out of business, providing further evidence on the value of the proprietary products. We believe that Smith-Midland should benefit from the industry consolidation and increased demand for its products. The continued improvement seen in both the residential and commercial construction markets have been a boost to the industry, with the Company finally declaring that 2015 was the year that the Company finally emerged from the Great Recession. In addition, the recent passage of a 5-year Federal highway bill should also benefit the Company by increasing demand for highway construction related products.

2016 Q1 - Gate City Capital Management Quarterly Letter

Smith-Midland offers a number of proprietary products that have notable advantages over the competition. The Company’s most popular product is J-J Hooks®, a concrete highway safety barrier that provides superior crash protection along with an expedited assembly process. The patented design has been approved for state and federally funded highway projects in 42 states and numerous foreign countries. The Company’s SlenderWall™ product is a cladding system for external building walls that are 1/3 of the weight of traditional products. SlenderWall™ has recently been used for constructing medical facilities along with hotel chains such as Hyatt and the Holiday Inn. Other notable products for Smith-Midland include soundwalls that reduce noise pollution along roadways and Easi- Set Precast Buildings for quick construction one-story buildings. Smith-Midland also licenses its proprietary products to 64 precast plants across the globe. Smith-Midland charges a royalty of 4-6% of sales and generated over $1.7 million in royalty revenues in 2015.

2016 Q1 - Gate City Capital Management Quarterly Letter

Gate City Capital completed a thorough due diligence process of the Company including multiple visits to the Company’s plants, the attendance of the Company’s annual meeting, and multiple conversations with competitors and suppliers. We have gotten to know Rodney Smith well and believe he is passionate about the industry and committed to the long-term success of the company. While we do not get involved in the day-to-day operations of our portfolio companies like a private equity company would, we do attempt to show appreciation to management teams (as well as our investors) by suggesting areas of potential improvement. As an example, we provided the management team with the names of several precast companies operating in the Bakken shale of Western North Dakota and Eastern Montana that could be attractive licensees of Smith-Midland’s products. While these proved not to be a near-term fit given the decline in energy prices, we attempt to take a partnership mentality with all of our portfolio companies and help their business reach new levels of success whenever possible.

When evaluating any potential investment, Gate City Capital Management considers what it would pay for the entire company. Smith-Midland currently has both a market capitalization and enterprise value of $11.5 million. We expect the company to generate over $30 million in revenues in 2016 with EBITDA in excess of $2.8 million. Our discounted cash flow analysis values the Company at $16.5 million, representing almost 50% upside to the current share price. The Company’s healthy balance sheet, net working capital balance, owned facilities, and intellectual property provide a significant margin of safety. It is also important to note that Smith-Midland has been a long-term holding of the Fund since 2013. Smith-Midland reported very strong results in Q3 2015 when the Company benefitted from a large contract to provide J-J Hooks concrete barriers for the Pope’s visit to Philadelphia and Washington, DC during the quarter. The strong Q3 results led to a sharp increase in the Company’s stock price, and we sold most of our position at prices above $3.35/share. The Company’s Q4 2015 financial results were good but fell well short of the very strong results produced in Q3. We utilized the subsequent sell-off in Smith-Midland’s share price to again build our position at prices between $2.25-$2.35/share and are optimistic that financial results will continue to show improvement in the coming years.

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The above post has been excerpted from a recent letter of Gate City Capital Management.

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