Itex Is Cheap And Has An Obvious Catalyst

| About: ITEX Corp. (ITEX)

Summary

Cash buildup means another tender is probably coming.

Franchise business is very capital light with high return on equity.

Large national network provides a moat against new competitors.

Itex Corporation (OTCPK:ITEX) is a barter company. They run a payments network for all transactions using their barter currency "Itex dollars." Essentially, businesses (mostly small) can sell their goods and services for Itex dollars and then use those Itex dollars for supplies, advertising or other things they need. Because not all businesses are signed up for Itex, the network provides marketing value to those who participate. So although they receive Itex dollars instead of cash, they are probably getting business they would not have otherwise received. The company's continuing financial success suggests that at least some of their customers are getting value from the company and their franchisees.

Business Model

My favorite thing bar none about this company is their business model. They operate through franchisees, which keeps the company extremely capital light. Essentially, the franchisees pay a start-up franchise fee, and then go out and sign up small businesses to use the Itex platform. The small businesses pay a monthly fee, and also a fee on every buy/sell transaction. The franchisee keeps 75% of the transaction fees and 30-35% of the monthly fees, and Itex gets the rest.

The fee split gives the franchisees a strong incentive to drive business to their members, as that will drive their transaction fees higher and results in more satisfied members, which helps retention. So the franchisees will often try to dig up customers from their existing base for new Itex members, operating as a de facto outside sales organization, which has value to small businesses. Since Itex isn't paying any of these people, or covering their overhead, they can have a nationwide sales presence with very little overhead. That helps the business to have the ability to scale without requiring much capital investment, and the lack of operating costs means the company has very high gross margins.

Competitive Moat

The company's competitive moat is twofold. The first portion of the moat is the capital light nature of the company as mentioned. That allows them to operate and grow at a large scale without the need to raise money. Additionally, they can use their balance sheet to purchase local or regional barter networks, which they add to their system and then resell to franchisees over time. The second advantage is the size of their network. A new member will have access to a material group of prospects eager to spend their existing Itex dollars, and a large network of places to spend any Itex dollars they receive. A competitive start up does not have this feature and would be at a material disadvantage.

Risks

One risk that always comes up whenever I talk about this idea is the potential for barter currencies to be replaced by other alternative currencies such as Bitcoin. I think this is unlikely, as I believe Bitcoin serves a different purpose. Its main features are security and anonymity. That makes it an excellent substitute for gold or physical cash for anonymous transactions and holding wealth in a form that is liquid and cannot be inflated by central bankers.

Barter currencies like Itex dollars are not anonymous, so are not a good choice for buying contraband off the dark web. However, they do come with a few advantages that Bitcoin lacks. The first is the built-in marketing. Bitcoin users don't have the de facto sales force and marketing department of Itex listing. These features aren't free, they're paid for with the fees, but they can add significant value to the users. Also, the lack of convertibility to cash of Itex dollars is both a feature and a drawback, as those who have Itex currency will naturally be drawn towards businesses that accept it, which makes them easier to convert to customers. Bitcoin is easily convertible to cash, which makes its users less locked into the network, but that liquidity is also what has allowed Bitcoin to grow much larger than any barter network.

So I don't believe that Bitcoin will displace the Itex network, but the lack of liquidity of Itex dollars does mean that the Itex network is likely to remain a niche market. That is fine with me, as a relatively small business earning excellent returns on capital is an excellent way to build wealth, especially if the business is returning capital for reinvestment. In many ways, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) is built on cash flow from See's Candy that Warren Buffett re-invested, and since Itex returns capital to its owners regularly, they have the potential to do something similar.

The other risks are endemic to any small capitalization stock, namely there is key man risk related to management as the company is small. Also, liquidity is not as good as a large cap company, so a combination of limit orders and patience should be used when opening or closing a position.

All that said, the company's revenue did decrease by 6% in the most recent quarter from the same quarter a year ago. The company indicated that membership had a small decline, which they attributed to competition from other marketing sources. Impressively, net income was up 17%, as the company's cost structure was able to flex with the reduction in revenues. Because the franchisees pay effectively all the operating costs of the company, their operating cost base scales down with revenue very effectively, and with the CEO owning a huge percentage of the company he is very motivated to keep G&A under control.

Returns of Capital

Itex has been regularly returning capital to its shareholders for years now. The company has paid out $0.20 in dividends in the last year, at a current share price of $3.76, that is over a 5% yield.

The company has also been returning a substantial amount of cash to shareholders through buybacks. The company completed a tender offer for over 25% of the outstanding shares at $4. They had a cash balance of $4 MM when they decided to do this tender offer, compared to a current cash balance of $2.7 MM. They had operating earnings (which are effectively cash earnings since the company has no debt payments and isn't cash taxable due to NOLs) of $360k last quarter. That suggests to me that another tender for stock is about a year out.

It may be sooner than that, however, as the company did tender for a quarter of the company in 2012 as well, but that was 1,000,000 shares instead of 750,000 as in the 2015 tender, as the share count is coming down. Assuming they tender for a quarter of the shares at $4, they will need just under $2 MM, which would likely require only one quarter of additional cash flow to leave the company the $1 MM buffer they left last time. Of course, it may take longer if the company decides to tender at a higher price, which they may, as the shares are not that far below $4 at present.

The likelihood of a tender occurring is important from a risk management point of view, as it gives investors a potential "out" if they end up building too big a position to liquidate in an orderly fashion through the markets. The company also has strong price momentum, being up 39% since July 30th when I profiled them for subscribers of the Microcap Review. Although subscribers have had the opportunity for a great return already, there is still material upside here as you'll see below.

Valuation

There are two components to valuing this business, the excess cash on the balance sheet and the ongoing earnings stream the company is generating. The cash on the balance sheet is easy. Given that current assets other than cash (the largest of which is receivables) materially exceed total liabilities and the company has no debt, I'm comfortable saying all of the cash is excess to their needs, which adds $2.6 MM to the valuation.

The other portion of the business value is the ongoing operating earnings. As the business is capital light and has a high amount of recurring revenue, the earnings are quite valuable, so I believe a 10X earnings multiple is reasonable. With trailing twelve month earnings of $812k, that would imply a value to the earnings stream of $8.1 MM.

Finally, the earnings mentioned above are after a deduction for income tax at the statutory rate. However, the company has net operating loss carry forwards from past years available. They expire in their entirety by 2024, and will shelter slightly over $9 MM in taxable income. Based on the company's taxable income assumptions, they have booked a non-current tax asset of $3.1 MM. Assuming they save $350k per year in taxes (as they did in 2015) for the next 9 years and discounting that cash flow stream at 10% suggests the tax asset has a present value of $2.1 MM. Given that earnings are up from 2015, that should prove conservative.

The sum of the three sources of value is $12.8 MM, or $6.14 per share given the 2.08 MM shares outstanding. Additionally, if the company does continue to complete buybacks at low valuations, that will be accretive to the remaining shareholders, adding incremental value.

I have a few qualitative factors to mention in conclusion. Firstly, the company has significant insider ownership, with the CEO owning 28% of the company. Additionally, with Sardar Biglari of Biglari Holdings (NYSE:BH) having 16% in his hedge fund and the Pagidipati Family having 9%, there is a counterweight to shareholder-unfriendly actions in the form of significant outside owners. The relationship between the large holders and the CEO has been adversarial in the past, which has the potential to provide benefits to minority shareholders in the form of activist inspired shareholder friendly actions. The company is cheap enough and has enough potential both as a business and as a stock to be strongly considered for investment at current prices, and this author is long.

Disclosure: I am/we are long ITEX.

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.

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