Description

Iteris has something for everyone.  The company is the leading player (50% market share) in a niche market, has a well incentivized CEO with an excellent capital allocation pedigree, is moving past a series of one time events that hurt revenue and margins in their fiscal ‘19 (year end 6.30.18), is primed to exercise operating leverage on fixed costs by growing topline at low double digits organically, with additional growth through tuck in acquisitions, and recent spending on SAAS initiatives are likely to inflect in the near future, resulting in a SAAS product that could enjoy 100%+ CAGR for years to come (off a very low base) as revenue moves more broadly to a recurring model. Additional upside may exist though the monetization of a venture stage business that is unrelated to their core expertise.

What Do They Do

The Company operates three segments (Roadway Sensors, Traffic Systems, and Agriculture & Weather Analytics) which can best be thought of as 2 businesses, Transportation and Agriculture (“Ag”). However, this is a bit misleading because what we call Ag is actually two businesses, one of which (ClearAg Inc) is a wholly owned subsidiary that sells to crop science companies and loses $5M+ a year, while the other, ClearPath, sells to transportation folks in the snow states and is profitable. Thus, in my view ClearPath should really be thought of as part of Transportation. Importantly, ClearAg has been carved into a separate legal entity, meaning that it would be relatively easy to separate from the rest of the business.  While much of the sell side is enamored with ClearAg due to its high growth rate and SAAS model, in my view, the real opportunity with Iteris is the Transportation side, and I will spend the majority of this writeup on Transportation.

The Transportation businesses operate in an attractive niche of the $600B global transportation infrastructure market, and help to alleviate the estimated ~$90B that road traffic costs the U.S. economy per year. From a high level, the Traffic businesses contain all of the tools necessary to monitor, plan and optimize traffic flow across automobiles, bicycles, and pedestrians in addition to providing ancillary services that state DOTs find important.  While historically traffic management has been a pretty boring industry, a lot has changed, and Iteris has been a leading player innovating across software, hardware, and service to bring traffic monitoring and control into the 21st century. The strength of their competitive position is highlighted by ~50% market share in Traffic Sensors, marquee clients in Traffic Systems, and partnerships with companies such as Cisco (CSCO), Qualcomm (QCOM), and Siemens (SIE:GR) that are pushing to lead the Smart City movement.

To get a bit more specific at the segment level:

Roadway Sensors

Traditionally the Traffic Sensors business is an assembler of components into hardware that can be easily installed at intersections in order to count cars, buses, bicyclists, pedestrians, etc through video and radar detection. There are 330,000+ traffic signals in the United States, and Iteris has ~130,000 deployments. The company believes they have ~50% market share, has been a consistent innovator for decades, and as one distributor comments, “The Iteris Vantage brand is the market benchmark, with superior life cycle costing as compared to any other in-ground or non-intrusive sensor.” In sum, it is safe to say that Iteris dominates this niche.

The data generated by the Sensors informs decision making at state, city, and local traffic control centers, and sensors are sold to state, city, and local DoTs. Sensors are a notable upgrade from the traditional methods of gathering this data, which generally fall to some combination of having a human being sitting at an intersection doing manual counts, and digging up the road in order to install a magnetic wire known as an inductive loop that can count cars as the magnetic field is interrupted by big hunks of metal passing overhead. Of note, inductive loop systems cannot detect pedestrians or bicyclists, limiting their usage in population centers, although they are still the standard for purely automotive applications (think highway on ramp). 

It is considered best practice for Traffic signals to be re-timed every 3 to 5 years, with the impetus for retiming largely being constituent complaints. Absent any kind of advanced performance data, historically a town/county/city etcetera has deployed human observers in order to supplement the static data collected by inductive loops in order to re-time signals. In other words, inductive loops can count cars, but they cannot tell you how the cars behave with the intersection (go straight, turn left, turn right, speed, wait time, etc) and they can’t tell you how the cars behave with pedestrians and bicyclists. The human observers attempt to reconcile their observations with inductive loop data, and model a more efficient traffic pattern.

This system is clearly inefficient both in terms of lag (3-5 year cycle rather than real time adjustment) and accuracy (human observers guesstimating impact). It is also expensive due to the labor intensity, which typically falls to outside contractors. As such, the Federal Highway Administration is actively encouraging the adoption of more advanced sensors. Management has guided toward low double digit growth going forward, which should be achievable based on industry trends, the recent adoption of IoT capabilities encouraging upgrades, and innovation on the service side also encouraging adoption of Iteris products.

Not long ago, segment revenue began to be reported in 2 buckets: Product and Service. Not surprisingly given the traditional hardware nature of this segment, FY19 Sensors revenue was 99.5% product. However, we believe that is primed to change in the coming years (more below). Additionally, management has indicated they expect expenses to be stable in this segment, while revenue continues to grow.

Transportation Systems

Traditionally the Systems business has been best thought of as a consulting / business process outsourcing (BPO) hybrid focused on the planning, design and implementation of traffic systems for towns/counties/cities etc. There are also some ancillary services such as commercial vehicle monitoring, and traveler information systems.  However, this segment is increasingly software focused, with approximately 20% of 2019 revenue now SAAS based, and additional hosted software making up 10% of revenue. The traditional software is known as iPeMS and essentially provides the ability to slice and dice the data generated by Iteris and other 3rd party sensors in order to monitor, plan, and improve traffic flow, removing the need to have human observers combining their inputs with inductive loop data in order to guestimate optimal signal timing and coordination.

ClearGuide is the newer SAAS offering which iPeMS customers are being guided to, and management has indicated that they expect the percentage of revenue that is SAAS related to continue to grow, as the pie itself continues to grow at double digit rates.  Given the sheer volume of data generated by sensors monitoring multiple variables 24/7, a SAAS model seems like a natural fit. This increasing shift toward SAAS is likely to be accelerated by the company’s new Signal Performance Measurement (SPM) offering, which is essentially “Intersection as a Service” (more below).

Returning to growing the total pie, in fiscal Q3’19 Iteris established a presence in Chicago in order to drive activity in the MidWest, and in Q1’20 the company made an acquisition that will strengthen their presence in Florida.  Texas is also a large area of opportunity as Iteris’s Sensors business has long dominated the Texas market, but cross selling Systems work was not prioritized. On the Q1’20 call, it was noted that Systems backlog improved 22% YoY, and management has indicated they expect segment level expenses to be steady going forward, while revenue should grow.

Management

CEO Joe Bergera joined Iteris in 2015, and in our view is a reason for confidence. Prior to joining Iteris, Bergera was Group Vice President Software at Roper Technologies (ROP), a company that is likely familiar to many VIC members as it has compounded at ~20% per year over the last 30 years through excellent capital allocation in niche verticals. While ordinarily I would give little weight to pedigree, Roper appears to be an excellent training ground. For context:

We have 50 separate businesses and those are 50 Presidents, 50 CFOs, 50 pretty much everything. So you have business leaders that are accountable, separate P&L and balance sheet, no corporate allocation. So if you're running a Roper business, you are running that business, you're accountable and you can have a wonderful career, which many of our Presidents have been with us for a very, very long time and have been very successful.

Roper CFO at 2018 Raymond James conference.

However, while Bergera did run one of those 50 businesses (iTrade), he actually had a larger role overseeing software aspects of the 50 different businesses.  iTrade was purchased by ROP in 2010 and as noted by the Roper 10K iTrade was specifically used as a vehicle to “complement and expand software at other Roper businesses.” If the cost of capitalized software on ROP’s balance sheet is any indication, Roper’s reliance on software tripled under Bergera’s watch.  This may explain why he was specifically called out by legendary former ROP CEO Brian Jellison as a key part of Roper’s success:

Q4’2011 Roper Conference Call

 Deane Dray, Citigroup - Analyst [23]

 Just in terms of expectations, how close do you think you are to making some announcements on the M&A side?

 Brian Jellison, Roper Industries Inc - Chairman, President, CEO [24]

 You never know. You just never know. I mean we're sitting here with a lot of capacity which is matched by a lot of patience. So our goal is to buy things at the right price at the right time and have the right people in place to monitor them. One of the things we did last year which is very important strategically, is add two new very senior resources.

  We brought Neil Hunn in to focus on Medical activity. Neil is an M&A pro former CFO of a publicly-traded company running a revenue business in Medical; just a world-class guy. But we wanted to marry him up with a world-class software guy. We brought Joe Bergera in who was worked for Wolters Kluwer and Sage for his career. Joe's domain expert around architecture, platforms and software and trying to get our software to leaders. More capable, doing more bolt-ons and activities. So we have dramatically enhanced our internal capability to assimilate both software and Medical companies which we really needed to do. I think the rest of us here in Sarasota were only interested in doing transactions that brought world-class management teams and didn't take too much more of our time. So now that we've really beefed up our capability in this area, we have a lot more firepower intellectually than we did in the past and then fortunately that matches our balance sheet. (emphasis ours)

And importantly, Bergera was identified as someone who really understands the Roper culture:

3/10/14 JPM Aviation, Transportation, and Industrials

Unidentified Audience Member [31]

 Brian, this is the first time I've heard you speak, and it is very impressive. So thank you.

 You know, a lot of the change in this organization has really come from you. And we haven't heard about much in terms of management depth (inaudible) your colleague over there. But I'm trying to understand -- I think you are 67. What is the management succession plan here?

 Brian Jellison, Roper Industries, Inc. - Chairman, President, CEO [32]

 I don't know. When we were talking to the Berkshire guys, they wanted to know if I would sign up for 82. And I said, I don't think so. I've got no plans to leave. We don't have any pension plan; there's no retirement. I have got to get off the Board at 75. I've got 7 or 8 years ahead.

 Now, in terms of that, the thing that happens -- you have this culture that is ubiquitous. So I am nowhere near as important as somebody might think.

 So what I'm talking about -- maybe I could be a little more concise. But everybody in the room -- Rob can get up and go through everything I said with these slides and say the same thing. And much more importantly, he believes that.

And that is true of Neul Hunn, who runs our medical and software businesses; its true of Joe Bergera, who runs iTrade; it is true of Tract, who runs TransCore; it is true of Chuck DiLaura, who runs Neptune; it is true of Robert Ray, tha runs Cornell. Every one of our people is totally embedded in this. They are the ones that are creating the value. We're just showing and teaching them the pathway for how you do it.  (emphasis ours)

Our conversations with Bergera have reinforced the message sent by Jellison, and we believe Bergera is well positioned to run the Roper playbook at Iteris in the years to come. However, to his credit he is not very promotional, and tends to play the future opportunity cards close to his vest.  We do not believe Bergera would have left a very senior position at Roper where he was surely well paid – and where his equity grants likely have tremendous future value - unless he thought the opportunity at Iteris was very substantial. The fact that he personally owns ~1.5M shares through an option grant at the time of his hiring, and that he bought shares in the company’s recent capital raise add to our confidence.  While he no doubt did well at Roper, as a first time CEO we believe this equity position is material to his net worth

Why Now

There are several reasons that the time is right for an investment in Iteris, some of them mundane, and some of them exciting. On the boring side:

Fiscal 2019, a Perfect Storm

The company reports fiscal year end at the end of calendar Q2. Fiscal 2019 saw multiple challenges for the business, as well as the stock. 

Starting with the business, on the Sensors side, the company suffered from the effects of Hurricane Harvey (September of 2017), which led to wid- spread destruction in Houston.  As a result, over the following year+ much of Texas’s transportation budget was routed away from upgrade and improvement projects and toward disaster recovery. The Texas business only normalized in Q1’F20, and FY19 saw a ~2% decline in Sensors revenue.

On the Systems side, effective Q1 of F19 Iteris moved down to a subcontractor role on a large contract with the Virgina Dept. of Transportation (VDOT).  If this reduced role was a result of performance issues it would clearly be cause for concern. However, Iteris saw its position decline due to a decision by VDOT to bundle the contract with other services, for which Iteris did not wish to compete. As such, Iteris willingly stepped into a subcontractor roll under Aecom (ACM).  This revenue hit is just now being lapped, and FY’19 Systems revenue declined 8.6% as a result of this contract change. As a result of their reduced role, the company had an opportunity to reduce headcount, but chose to endure the margin hit instead in anticipation of future growth opportunities.

On the stock side, microcap super investor Lloyd Miller was formerly Iteris’s largest shareholder. Upon his death, his estate began liquidating the position which acted as an overhang on the stock until the position was exited just a few months ago.

Recent Capital Raise and Acquisition

The company recently completed a secondary offering that raised ~$29M at $4.65/share in order to fortify the balance sheet and finance an acquisition. The acquired company, Albeck Gerken (AG), was purchased for $10.7M in cash and stock with the potential for a $2.3M earn out over 3 years.  In FY’18 AG generated revenue of $8.1M and $2.0M of EBITDA. The acquisition will be part of the Systems segment, and will improve Iteris’ position in the Florida, Virginia, and Pennsylvania market, and provide an improved base from which Iteris can peddle its software offerings. Following the acquisition, the company should be cash flow positive going forward.

The above are all rather ordinary and backward looking, while looking forward there are exciting opportunities to consider:

VantageLive!

While traditionally the nature of Iteris’s business was such that splitting the business into Sensors and Systems made sense, as the technology has advanced, those distinctions have become less relevant, and the lines have begun to blur.

This can perhaps be best illustrated through the company’s new VantageLive! offering. VantageLive! leans on the Vantage name which is well known in the industry through Iteris Vantage sensors, and is reported under the Sensors segment, but VantageLive! is a SAAS offering that allows users to process and analyze the data collected at the intersection level.

In Bergera’s words:

Today [VantageLive!] addresses 2 business use cases: one, it's being used by agencies to do longitudinal planning or long-term planning. It does longitudinal analysis. That is critical for all agencies in order to provide performance measures which are necessary for that annual budgeting process at both the state and at the federal level. And then in addition, agencies are using the data to do real-time optimization work in their operation centers. Q2’18 call

VantageLive was first introduced in 2017, and at present accounts for approximately $1M in revenue. This is obviously a slow start, as sales conversion has taken longer than expected, and revenue recognition has also taken longer than expected. The initial hurdle causing the slow start was that the Iteris sales force had to be upgraded/trained to more software enabled people, rather than the traditional hardware sales person. The next hurdle on the sales side has been that customers – municipal traffic agencies – are fairly unsophisticated, and are typically captive to a capital purchasing model, which means recognizing the merits of a SAAS system is slow going because SAAS is paid out of the operating budget, not the capital budget.  That then becomes an issue of local budget politics, which as one can imagine, are not designed for speed or efficiency. However, management has indicated – and our channel checks have confirmed – that there is genuine excitement surrounding the product from the sales team, and that there are “a lot” of orders that have not yet produced recognized or deferred revenue. The problem is that because the customer is subscribing to a system which encompasses many intersections, revenue cannot be accounted for until the entire system is live. Because government moves slow, that means that if a municipality signs up for coverage of 20 intersections, they are likely to deploy in phases, and until all phases are complete, revenue cannot be accounted for. On the Q1’20 call management noted they recently signed their largest VantageLive! deal to date, which encompasses 58 intersections, and that thus far the renewal rate has been 94%. Returning to the capital budget issue and local politics, the upside of this dynamic is that if a municipality signs a 3 year commitment, the line item can be capitalized rather than run through the operating budget, which suggests that longer term contracts may be the norm here as the offering matures.

In any case, management has commented that they believe VantageLive! sales can be on par with hardware sales in 5 years, which implies a CAGR of 112% for this SAAS offering assuming only moderate growth of hardware.. This target of ~$50M fits well within a TAM that has been identified as $350-400M, and the company notes that they believe they can double that TAM by adding additional capabilities. However, when one takes a look at industry trends as well as the economics of switching to a SAAS model for municipal transportation authorities, it seems very likely that hardware sales will grow somewhere between mid single and high double digits in the years to come (more below).  Of course, the S curve has not yet begun to inflect, but in the meantime, as VantageLive! is a one of a kind offering attached to best in class hardware (although it can be overlaid on 3rd party hardware), our diligence suggests that the offering has been a difference maker in competitive bid situations, helping to drive hardware sales.

This sort of opportunity is admittedly difficult to value, but for reference, Shot Spotter (SSTI), a company that sells sensors under a SAAS model to governments, has traded as high as 9x revenue on lower sales numbers and slower growth, although obviously they are much further along in their progression.

Intersection as a Service

We've also introduced this service called intersection-as-a-service, where we provide connectivity to the intersection software monitor, not only our own IoT devices, but other IoT devices, and then the ability to manage those intersections remotely, that, which has tremendous economic value for these agencies. And we believe it's -- can be a very attractive business at scale.  Bergera JMP February 2019 (emphasis ours)

“Intersection as a service,” is accounted for under the Systems segment, and essentially allows municipal traffic departments to outsource their traffic monitoring needs to Iteris at a remote location.

Drilling down on the “tremendous economic value,” we can look at some rough numbers.  As a general rule, within a municipality every 2,000 people necessitate 1 traffic light, and generally speaking when you get to 25 traffic lights, you need a full time traffic engineer to monitor them. However, generally speaking, when you need a full time traffic engineer, you really need 2 full time traffic engineers because people go on vacation, call in sick, etc.

Internet research shows that annual salary for someone in this job is somewhere around $70k, and then you have to factor in healthcare and other benefits, pension contributions and liabilities, plus the hardware and software that these people need to actually do their job. These are of course all rough numbers, but generally speaking, the cost of having 25 or more traffic lights is around $250,000 per year for municipalities.

Iteris believes there is a sweet spot for them to win much of this business on a per intersection per year basis under a remote monitoring program that will service population centers of between 50,000 to 250,000 people.  That is not to say they cannot win bigger business – in fact, they are currently having discussions with at least one target that has 1,000 traffic lights. In terms of the economic value for the agencies, the list price per intersection per year is $1,000 dollars, which in our opinion is laughably compelling.

There are a few reasons for this low low pricing. First, Iteris learned some lessons with the slow adoption of their VantageLive! offering. As noted previously, municipal traffic departments are not exactly efficient organizations. The low price and drastic cost savings are meant to be eye popping in order to accelerate adoption. 

Second, IoT enabled traffic sensors are key to taking advantage of Intersection as a Service, and IoT enabled sensors are a relatively new offering.  The low price of Intersection as a Service is meant to put Iteris in pole position when competing for upgrade cycle work on the hardware side. For example, Iteris’ first intersection as a service customer is Georgetown, Texas (suburb of Austin).  Our research suggests that in addition to signing up for Intersection as a Service, Georgetown purchased nearly $400,000 worth of sensors. 

Lastly, Iteris’ offering is compliant with the Purdue model, which means that technologically speaking, it should be relatively easy to layer on control of other IoT devices that municipalities need to manage in the future, which can then be charged for as add on services, increasing ARPUs.  In other words, there is likely a first mover advantage here where whoever gets a municipality to start outsourcing this sort of thing first can then try to win additional business in other verticals. This TAM could be huge, and while at present Iteris is the only company offering Intersection as a Service, there are likely to be others before long offering similar and related services.

Again, it is difficult to know what this sort of thing is worth, but as the market leader in sensors with 130,000 installed sensors, Iteris is well positioned to realize $130,000,000 in recurring high margin revenue.  Assuming 100% penetration on their existing base is clearly not realistic - and will not happen over night, but it is a relevant reference point as Iteris’ Intersection as a Service offering is not limited to Iteris sensors, so the real opportunity is the 330,000+ traffic signals in the U.S.

Regardless, the industry S curve hasn’t even started yet, although Iteris has indicated they have 5 existing customers and a 7 figure pipeline. In our opinion, valuing this sort of opportunity is very much a finger in the air exercise, but it is not unreasonable to think that as the market leader with the largest installed base, and given the compelling economics for municipalities, Iteris could ultimately wind up with 65,000 intersections under management (50% of their installed base, 20% of U.S. total). This may however be conservative, because there should be value in regional contiguity. In other words, in today’s world, coordinating traffic across jurisdictional boundaries is a time-consuming manual process. However, if one community outsources their traffic lights to Iteris intersection as a service, and the next town over does the same, then those two towns can easily be in synch minimizing rolling traffic delays across borders.

Regardless, finger in the air if they wind up with 65,000 deployments at a list price of $1,000 that would equate to $65 million of annual recurring revenue.  Of course, that is assuming no pricing power, while the pricing power here should be real given the cost to a municipality of employing traffic engineers, and that assumes no add ons being layered on, which we believe could ultimately add quite a bit to ARPUs.

In summary, between VantageLive!, Intersection as a Service, ClearGuide and other smaller SAAS businesses, it is not inconceivable that within 4-5 years or so Iteris will be well on their way to $100M of annual recurring revenue in their transportation businesses, with limited cannibalization of their existing business.

A Note on the Board

Iteris – formerly known as Odetics – came public in 1989.  The original vision was that of a “tech incubator” which essentially meant make VC type investments and dilute equity to fund it.  While Iteris was born out of that system and is a clear success amongst a sea of failure, there are still some legacy board members hanging around, and at the moment we think there is massive room for improvement at the board level.  Following a recent public “vote no” letter which detailed some of the problems with the legacy board, one long tenured member has agreed to step down, and we believe a second is likely to do so in the coming months. This suggests the board is about to be refreshed and upgraded with higher quality members.  Specifically, we have stressed to the board that capital allocation experience is a must, and we are hopeful that Bergera can recruit some individuals from the Roper sphere to join. It is also worth noting that the board has agreed to look at ways to more fully align management’s long term incentive comp with performance measures, while it has thus far been purely a time vest model.

A Note on the Agriculture Business

ClearAg, which is accounted for in the Agriculture and Weather segment, has its roots in ClearPath, the other half of the Agriculture and Weather segment.  Essentially, ClearPath provides hyper localized weather information to state and local DoTs in the snow states in order to inform decision making around where to deploy salt/sand etcetera in order to manage traffic safety during winter storms. The technology behind ClearPath was then expanded and adapted in order to inform decision making related to agriculture.  For example, when to plant, when to harvest, when to water, when to fertilize etc. based on optimal weather conditions. At the time, it made perfect sense to leverage the existing technology into agricultural applications. The idea was to create a product that could be sold on a per acre basis, and the fact that Monsanto bought comparable company Climate Corp for almost $1 billion at a time when Climate Corp reportedly had $5M in revenue illustrates there was quite a bit of excitement.

Needless to say, Monsanto top ticked the market, and this area has proven to be mostly a disappointment vs. initial expectations.  It turns out that farmers are cheap, and don’t want to pay up for better weather info than they can get for free. As such, the model for ClearAg has shifted where they are now selling not to farmers per acre, but rather to assorted enterprises at the segment level, that can then incorporate ClearAg data into their farm OMS etc.  As ClearAg is not broken out specifically the financial characteristics of the business are not exactly clear, but we believe it generates $4-5M in revenue and should lose about $4M this year. FY19 revenue growth was approximately 20%, while net bookings have grown 30%. Off such a low base these numbers do not overly excite us, but management has been indicating for some time that a large enterprise level deal with a likely $5M revenue contribution is close, and they believe that this segment could ultimately generate $50M in revenue.

While this may be true, in our view the Traffic businesses are the better opportunity as Iteris has superior competitive positioning, and the use cases for Iteris offering is more readily apparent. The fact that the company has separated ClearAg into a separate legal entity suggests that on some level they realize this as well, and we are of the view that the best path forward would be a sale of ClearAg.  Valuing this sort of thing is difficult, but the sell side seems to think it should be worth somewhere between 3x and 7x revenues. From our perspective, if there is an enterprise considering paying $5M per year for access to the technology, it would not be crazy to assume they would buy the business for 3x.

But wait! What about Google/WAZE?!?

Common pushback against the sensors business is that Google/WAZE etc. should be able to obviate the need for physical sensors. There are a couple of problems with this idea however.

On the performance side, first is the latency issue.  Have you ever been driving toward a yellow light thinking there is no way you were going to make it, but then the light seems to stay yellow forever and you make it?  That is a traffic sensor taking note of your approach and speed, and deciding to hold the yellow to avoid a collision. Have you ever been following WAZE and missed a turn?  And then it took 5, 10, or 15 seconds to re-route you? When you are approaching an intersection at 30, 40, or 50 MPH, you don’t have 5+ seconds. This fits with the yellow light example, but also of note Iteris is experimenting with Sirius XM and Siemans to develop a system that generates in vehicle warnings to inform drivers if there are pedestrians, bikes, or on coming traffic making a perpendicular approach to an intersection, which could be particularly useful in more urban settings where buildings prevent visibility around the corner of an intersection.

On the data side, the data generated by WAZE is geotagged to the car, whereas the data generated by a traffic sensor stays with the intersection. While it would be theoretically possible to isolate the data generated by a car as it travels through X intersections a day and geo-tag that data to each intersection, doing so for the thousands or tens of thousands of cars that pass through each intersection 24/7 creates a very complicated problem.  It is just much easier to record data within the intersection, and then allow the cars to roll on without further involvement.

Lastly, not everyone uses WAZE, most notably pedestrians and bicyclists, and there are privacy concerns around just tracking people by their phone.

Valuation

Relying on current financial characteristics would overly punish Iteris for their decision to invest in the future at the expense of margins, and fail to capture the future opportunity. Specifically, as the company has shifted its focus from its traditional business toward a SAAS future, corporate level expenses have roughly doubled from $8 to $15M, while over the last few years segment level margins have declined ~500 bps at both Sensors and Systems. The increase in corporate expenses has been undertaken in anticipation of supporting a much bigger business, while segment level margins have compressed due to growth initiatives, as well as the temporary issues previously referenced. In terms of the growth initiatives, part of the problem is investing in SAAS and incurring CAC up front, while part of the problem has been that this is historically a consulting business. In other words, if consultants are engaged on a project, they are generating revenue. However, if they are engaged in answering RFPs, they are a cost center. As the company has been receiving more RFPs, and focusing on larger scale longer term projects, utilization has temporarily suffered.

It seems likely that the shift to SAAS and larger scale projects will ultimately bear fruit, but combined with the company’s lack of scale the recent decision to sacrifice margin has rendered tradition valuation methods such as P/E or P/FCF largely ineffective.  At the same time, the S curve on what should eventually be sticky recurring revenues – much of them in a SAAS model – has not yet inflected, meaning that relying on P/Sales multiples will not capture the whole picture. Of course, one could attempt to build out a DCF, but the problems surrounding sensitivity to inputs are well known, and particularly amplified when talking about a company that seems as if it is about to embark on a 100+% CAGR SAAS journey.

Given these complications, and recognizing that strategic value is not typically the best place to start, reviewing recent transactions can be useful.

Recent Transactions

There are three things that are clear.  First, “smart cities” are coming. Second, no one knows exactly what that is going to mean.  Third, street lights and intersections are going to matter to smart cities.

There are two recent transactions that illustrate the strategic value that is being assigned to companies such as Iteris that are attached to intelligent transportation.  In both cases, the buyer was Cubic Corp (CUB) whose traditional business is focused around mobility related to things like collecting tolls for public transportation etcetera. 

GRIDSMART

The first transaction to consider is Cubic’s purchase of GRIDSMART, which is a traffic sensor company.  While Iteris has a market leading position and ~130,000 installs under their belt, Cubic is more of an upstart with ~12,000 installs.  The product is different than Iteris’s in that it relies on a fish eye lens that in theory allows one camera to cover an entire intersection, while Iteris solutions typically rely on multiple cameras.  While the fisheye reduces the cost, it also restricts the use cases, and limits the data that can be collected. For example, a fisheye maybe isn’t so bad at the intersection of two single lane roads, but as the number of lanes goes up, the distortion of the fisheye rapidly degrades the output.  This is worth noting because logically more lanes suggest more volume, and more volume suggests greater importance for monitoring and understanding that volume. Additionally, the fish eye limits the depth that the camera can capture beyond the stop bar (industry speak for the 18” painted white line that marks where you stop at a red light), reducing the ability to track cars that are waiting at a red light.  Lastly, in terms of the software, one industry insider commented, “they can tell you when there are pedestrians, but they can’t tell you how many people. And as for bicyclists, they kinda suck.”

No two companies are perfect comps, but GRIDSMART is reasonably comparable to Iteris’s Sensors segment.  Cubic has suggested that on a forward basis, GRIDSMART should generate $35M in revenue, and $8M of adjusted EBITDA. The purchase price of $87M suggests a multiple of 2.5x forward sales, and 10.9x forward adjusted EBITDA. It should be noted however that this EBITDA multiple is likely understated as we have heard that GRIDSMART clearly dressed themselves up for a sale, cutting every expense and running extra lean etc., suggesting that the multiple of “real” EBITDA was higher than the headline.

TrafficWare

The second transaction to consider is Cubic’s purchase of TrafficWare, which is comparable to Iteris’s System business, although operating in a slightly different part of a traffic center’s food chain.  Iteris actually considers TrafficWare more of a collaborator than a competitor. According to Cubic, they expect $50M in revenue and $14- $15M of adjusted EBITDA from TrafficWare in FY19, and for this they paid $236 million.  That equates to 4.7x forward sales, and 16.2x adjusted EBITDA. 

What is most interesting about this transaction however is how competitive the auction process was. Our diligence suggests – and the 4.7x sales multiple seems to confirm – that interest was high from multiple companies from multiple walks of life.  We believe potential buyers included big tech companies such as GOOG, CSCO, and IBM, all of which have nascent smart city efforts, the companies that will control the pipes that will power smart cities (VZ, CMCSA, etc.), more traditional E&C companies (JEC, ACM), traditional government services players (BAH, CACI, SAIC, LDOS) as well as other conglomerates or quirky companies that are trying to figure out what smart cities are going to mean such (FLIR, ROP, Sieman’s, ITRI).

Taken together, Cubic’s purchase of TrafficWare and GRIDSMART makes it obvious that they think having a systems element and a sensors element will be key to success in trying to get their piece of the traffic related smart city pie.  Given Iteris’ superior competitive position in the sensors world, and recognizing that Systems deserves a higher multiple than Sensors, it seems as if the 2.5x sales that CUB paid for GRIDSMART should be a reliable indicator of the potential value within Iteris. Yet, at present, ITI trades for ~1.7x forward EV/Transportation Sales assuming no value for the Agriculture business.  At 2.5x EV/sales ITI would be a ~$7.50 stock, and at 3.0x sales ITI would be an $8.75 stock. 

Of course, as ITI seems primed to have an additional ~$100M in annual recurring revenue through VantageLive! and Intersection as a Service over the next ~5 years, one could argue that a significantly higher multiple is warranted

Present Transportation Normalized Strategic Cash Flow

“Our transportation business is two different segments [and generates] free cash flow of about $8 million to $9 million a year.”

CFO Andy Schmidt, Needham Growth Conference 1/15/19

Moving beyond EV/Sales multiples, another way to look at Iteris would be the segment level free cash flow that the transportation businesses generate. The quote above is a good place to start, but is more than a bit misleading for a few reasons.  First, Schmidt referenced two different segments as transportation, but in reality, ClearPath Weather which is accounted for under the Weather and Ag segment, is really more of a transportation business. As ClearPath is not broken out from the Ag business it is impossible to know what the financials look like, but management has indicated that this business is profitable, which likely adds ~$1M to FCF. 

Second, organic growth should be low double digits, with management recently indicating they see FY20  Sensors revenue growth of “more than 10%,” and Systems revenue growth of “at least 10%” despite the full impact of the VDOT contract not being lapped until the 2nd half and Q1 backlog representing a 22% increase YoY.

Third, the acquisition of AG (discussed above) should add $2M of FCF. 

And lastly, there should be room for significant margin expansion in the not too distant future. For example, in 2019 Sensors segment EBIT margin was ~16%, down from as high as 23.2% in 2017 with the culprit being increased spend on SAAS initiatives that will soon bear fruit, as well as mix (TX is generally lower margin due to 3rd party distribution costs). For reference, GRIDSMART was generating ~23% adjusted EBITDA margins, and this is a low capex business, which suggests a return to 21% EBIT margins for Iteris is not unreasonable. For the systems segment, 2019 EBIT margins were ~12%, down from over 17% in 2017 with an increase in selling expenses tied to a “very robust RFP cycle” largely responsible, although increasing focus on SAAS played a role as well.  This will of course work its way through as backlog translates to revenue, and margins should normalize higher. Across both segments, I believe that 400-500 bps of EBIT margin over FY’19 should be possible as the investments in sales efforts and technology pay off in the not too distant future 

Combining all of the above, run rate FCF from transportation including ClearPath should be somewhere in the range of $15-19M vs a current EV of $200M, or ~12x at the midpoint.  Of course, this ignores ~$15M in corporate expense, much of which would go away within a larger organization. As the company has indicated they will generate cash this year on a consolidated basis and the Agriculture business should burn ~$4M, the higher end of the range below may be more appropriate.

There are no great public comps for ITI, but slower growing government service peers that have nowhere near the potential strategic value of Iteris trade at high teens/low 20s FCF multiples, and if you think that the Sensors business deserves a lower multiple than Systems, I would point out that FLIR (which also has a traffic business) trades at 25x FCF, and SSTI – which is admittedly much more SAASY than ITI – trades at 8x sales…  all of which is to say that I think 20x run rate FCF of the transportation business is reasonable, which gets you to a ~$9 stock assuming the Ag business is worth $0.

Of course, as ITI seems primed to have an additional ~$100M in annual recurring revenue through VantageLive! and Intersection as a Service over the next ~5 years, one could argue that a significantly higher multiple is warranted.

Going Concern Value

Considering Iteris’ small size and leading position in a very attractive niche market, we think it is really only a matter of time before the business is bought by a larger competitor.  Existing partnerships with mega caps such as Siemens AG (SIE:GR), Cisco (CSCO), and Qualcomm (QCOM) seem to make this outcome more logical as these company’s could easily swallow ITI.

However, one should of course not put all the eggs in the takeout basket, so it is worth considering what Iteris could look like in a standalone scenario. As noted previously, we are not big fans of DCFs, so we more rely on a back of the envelope approach. As a base we believe that Iteris can reach $200M in revenue within 5 years, and that at that level the business can generate ~30% segment level EBITDA margins.  This is somewhat finger in the air, but we believe conservative based on run rate Traffic revenue of $115M, low double digit organic growth, management’s comments that in 5 years they expect “service” revenues to equal hardware revenue in the Sensors segment through VantageLive! (implies ~50M+), the expansion of Intersection as a Service, the ability to bolt on ~$10M revenue traffic businesses similar to AG, and the company’s history of finding unique ancillary businesses to participate in such as commercial vehicle tracking. On the margin side, looking at historical segment margins as well as looking at GRIDSMART and TrafficWare, suggests a strong base, and given the clear shift toward higher margin SAAS solutions that is underway, 30% does not seem unreasonable.  Management has further indicated that their current corporate spend should be able to support $200M in revenue, so we are left with $44M in EBITDA. 

For a business that should be 50+% recurring revenue led by a CEO who understands capital allocation while growing a SAAS product more ~100% per year in an interesting niche vertical, an EBITDA multiple of 15x seems conservative, and 20x does not seem unreasonable.

This of course assumes no value for any cash accumulation, and no value for the Agriculture business.

In sum, Iteris is an opportunity to own a niche dominating player that is about to transition to a recurring revenue/SAAS model at a fraction of the price that comp companies with similar strategic value have traded hands. 

Catalyst

transition to recurring revenue

M&A target