ITEX: Indifferent Investor Relations And Ultra-Conservative Accounting Create Opportunity For Alert Investors

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About: ITEX Corp. (ITEX)
by: William Matson, CFA

Summary

ITEX’s investor relations strategy may most charitably be described as indifferent to small shareholders. This puts downward pressure on the company’s stock price.

Management is apparently OK with a low stock price, as ITEX has been active in buying back large amounts of its own stock.

Extremely conservative accounting policies with respect to write-offs of goodwill and deferred tax assets have significantly depressed reported earnings since FYE 2016.

A $4 buyback in 2015 was conservatively priced, and the stock is only slightly higher today – despite 26% fewer shares outstanding and 36% greater TTM pre-tax income.

This analysis concludes that $6.70 is a highly conservative “fair” value estimate for ITEX stock – versus its 11/6/18 closing price of $4.00.

An indifferent investor relations strategy

To say that ITEX has little interest in promoting the company’s stock is an understatement. The great majority of publicly traded companies, for instance, make it a point to spread the word when they report their earnings. They typically issue press releases that get republished in places like Seeking Alpha. Other things being equal, the more investors know about a stock, the more comfortable they will be to own it, and the greater the premium they will pay to own it.

News of ITEX’s financial results, on the other hand, is not available through Seeking Alpha’s news feed. Rather than being automatically notified by Seeking Alpha when ITEX earnings are available, it’s necessary for me to get this information through other sources. Since non-earnings news can break at any time, this means giving special attention to ITEX, checking in daily with a non-Seeking Alpha source to reduce the chance of missing something important.

When a company makes its activities harder to follow, as ITEX has done, fewer are the investors interested in taking the extra trouble to make themselves comfortable owning its stock, and the lower the market will price it.

In addition, ITEX appears to be using highly conservative interpretations of GAAP accounting in writing off its goodwill and deferred tax assets. Between 7/31/15 and 7/31/18, the balance sheet value of ITEX’s goodwill was written down from $3.191 million to $1.441 million. Meanwhile, its deferred tax asset declined from $3.899 million to $1.457 million – accounting for $2.442 million of the company’s reported tax expense. As the table below indicates, these write-downs have had a significant effect upon ITEX’s apparent profitability.

Period

Pre-Tax Income Incl. Goodwill Write-off

Pre-Tax Income Before Goodwill Write-off

Tax Expense

Tax Expense % Pre-Tax Income Before Goodwill Write-off

Reported After Tax Income

After Tax Inc. w/ 34.3% Tax Rate, No Goodwill Write-off

1/31-7/31/15

N/A

$650,000

$223,000

34.3%

$427,000

$427,050

FYE 7/31/16

($461,000)

$1,289,000

$1,058,000

82.1%

($1,519,000)

$846,873

FYE 7/31/17

N/A

$1,113,000

$513,000

46.1%

$600,000

$731,241

FYE 7/31/18

N/A

$1,309,000

$755,000

57.7%

$554,000

$860,013

It is appropriate to write down the reported balance sheet values of goodwill and deferred tax assets to the extent that these values are unlikely (i.e. have a less than 50/50 chance) to be realized in the future. Thus, one would normally expect a company to make such write-downs during or immediately preceding periods of deteriorating operating results.

With respect to ITEX's goodwill write-off of $1,750,000 in FYE 2016, this was not the case. ITEX's pre-tax income (excluding this write-off) has been, in fact, remarkably constant between 2015 and mid-2018. As the table above indicates, that figure has averaged roughly $100,000 per month throughout this period.

That table also indicates that ITEX's income tax expense has exceeded the U.S. corporate income tax rate by significant margins since 7/31/15. These differences are largely attributable to write offs of deferred tax assets that the company has deemed unlikely to be realized in the future. Such write-offs could, again, appropriately be triggered by a greater than 50/50 expectation of deteriorating financial results.

Given that ITEX has been writing down significant amounts of deferred tax assets for three years in expectation of deteriorating financial results that have yet to materialize, I believe there to be a greater than 50/50 chance that these write-downs have been excessive.

There are, of course, no precise formulas for calculating the appropriate amounts, if any, by which a company should write down its goodwill and deferred assets. Nor is there any effect upon a company’s bank balance directly attributable to these accounting maneuvers. Once the dust settles, their only lasting result is to weaken the balance sheet and make a company look less profitable than it otherwise might.

What ITEX stock is really worth

First, consider that ITEX repurchased nearly 30% of its common stock in April 2015 at $4/share. ITEX’s three largest shareholders tendered only 6.5% of their own stock. Presumably they were in the best position to know the company’s “true” value, and it is fair to say that $4/share should be considered a conservative valuation at that point.

Since 1/31/15 (the most recent fiscal quarter end as of the buyback date) and 7/31/18, shares outstanding have been reduced 26%, while trailing 12-month pretax income has grown 36%. I would argue that this may be reflected in our calculation of value in the following manner:

$4 divided by (1-.26) times (1+.36) = $7.35

Corporate tax reductions not anticipated in April 2015 further enhance ITEX’s value. The reduction of ITEX’s base federal tax rate from 34% to 21% can be reflected as follows:

$7.35 times (1-.21) divided by (1-.34) = $8.80

Note that this calculation uses the ratio of the respective after tax returns, based on $1 of pre-tax income subjected to tax rates of 21% and 34% (.79/.66 = 1.197) - as opposed to multiplying the $7.35 by 1.13 (i.e. 1 plus the difference between the tax rates). The reason for doing this becomes more apparent when one considers what would have happened had higher tax rates been involved. That is, if the situation in question involved 98% vs. 99% tax rates on $1000 in taxable income, the respective after tax incomes would be $20 and $10, a 2:1 ratio - i.e. (1-.98) divided by (1-.99) = 2.

Multiplying $8.80 by the company’s 1.965 million shares outstanding gives us an unadjusted market cap of $17.291 million. Finally, we adjust for a $4.134 million reduction of shareholders’ equity (between 1/31/15 and 7/31/18).

$17.291 million minus $4.134 million = $13.157 million, which when divided by 1.965 million shares outstanding gives us a per share valuation of $6.70.

This $6.70 figure is extremely conservative due to the assumption that all assets are worth what ITEX’s balance sheets says they are worth. For instance, our analysis assumes that the $3.191 million in goodwill and $3.357 in deferred tax assets on the 1/31/15 balance sheet were, in total, worth $1.418 million more than the $5.130 million held in cash at 7/31/18.

Given ITEX’s aggressiveness in writing off goodwill and deferred tax assets in FYE 2016, 2017 and 2018, there is good reason to believe that a conventional approach would have resulted in the company holding much larger amounts of these assets as of 7/31/18. Accordingly, this would have led to a higher valuation estimate than $6.70.

Prospects for future profitability growth (now vs. at 1/31/15)

Inherent in this analysis is the assumption that prospects for future growth have remained constant since early 2015.

One indication that this assumption might be overly conservative is that the 7/31/18 quarter was very strong, especially on a YOY basis. Its $383,000 in pretax income was 17.1% greater than the $327,000 posted during the 7/31/17 quarter. (There being no separately reported results for ITEX's Q4, these figures were derived by subtracting Q3 YTD numbers from those of the entire year.)

The 1/31/15 quarter, in contrast, was quite weak. Its $163,000 in pretax income was 32.4% less than the $241,000 achieved during the 1/31/14 quarter.

Thus, the current trend in ITEX’s profitability appears to be much stronger now than it was in early 2015.

Risks and illiquidity concerns

There are, however, a variety of negative factors and risks faced by the company. ITEX’s diminutive size renders it vulnerable to the risk of much larger businesses entering the barter industry. This is particularly problematic because the larger a barter network becomes, the more attractive it will become to potential members. A large company willing to commit significant resources to barter or barter alternatives could siphon away members from the ITEX network.

It is also possible that superior technologies and payment methods will evolve in ways that prove too costly or otherwise difficult for ITEX to adopt or compete with.

Note, though, that all of these risks were also present in early 2015.

Finally, bear in mind that ITEX stock is extremely illiquid. Zero volume days are not unusual. Moreover, relatively small trades often move its price by 5% or more. Anyone needing to sell a large ITEX position in a hurry should plan on incurring sizeable losses.

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.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.