Description

Itex (ITEX) recently announced a tender offer where the company is buying nearly 30% of its shares outstanding for $4.20 vs. the current share price of $4.06. The tender offer expires this Friday (4/13/12), and the tiny arbitrage opportunity is obviously not the reason to be interested in Itex. The reason to buy Itex is that pro-forma for the tender, the shares offer a stable ~ 25% unlevered FCF yield under talented management with meaningful equity ownership (16% before the tender, 23% after), strong capital allocation under the watchful eye of activists who are significant shareholders, and a free option that ITEX’s niche industry scales and the company becomes a rapid growth business.

Itex Summary Capitalization Table Pre April 2012 Tender Offer

Itex Summary Capitalization Table Pro-Forma for April 2012 Tender Offer

Core Business:

Itex has been written up once before on VIC in 2008 and that write-up has good background on the business and industry. Essentially, Itex operates the nation’s largest barter system where one business can trade its services with another business in the Itex network without using actual dollars. Instead, Itex dollars are the currency of the network where a floral shop that provides its services to a restaurant can then use the Itex dollars it earns to, for example, buy printing services from another member of the Itex network.

Like any network business, the scale of the network is paramount, and at 20,000+ Itex has more than three times the number of member businesses as its next largest competitor. Given the small business nature of the member businesses, scale in a particular market is crucial, and Itex has the only national network of branches that seek to grow the number of member businesses in any given city.

At a high level, Itex in some way seeks to utilize the basic business principle behind much hotter and prominent companies like GRPN and Air BnB. Itex’s member businesses have fixed cost structures where the incremental expense for say a hotel selling an extra room night is very limited. The hotel may as well ‘barter’ that night for printing or floral services that it needs. Not only does it get real value for little incremental cost, it provides an opportunity for the hotel to showcase its services to potentially new customers and have the opportunity for repeat business.

Despite a good value proposition, barter has had nowhere near the impact that daily deals have had and barter is still very much a cottage industry. The convenience and universal acceptance of cash is just too dominant. As businesses get increasingly comfortable with selling their incremental capacity at low rates, the barter industry may increase its penetration but all that is just upside for the core investment case.

What is central to the core investment case is that Itex is the best company in this cottage industry (because of its network effects and branch network) and that its CEO, Steve White, is the best operator. White became involved in the company since taking control in 2003 in a proxy battle, and as can be seen below, the financial history of the company speaks for itself. As a passing anecdote, we’ve gotten to know White over the last few years, and White seems to be the real deal. He quotes Buffett regularly and chose to live a five minute drive from Itex’s offices so he can easily come in on the weekends (he works most Sundays).

 FYE July 31st

*Boost from acquisition

**Reduction in EBIT largely due to 1x legal costs associated with proxy battle. Ex this, EBIT would have been essentially flat 

***$2.3M ex 1x legal costs

What the above long-term financial history shows is first, prior to White’s involvement, Itex was a money losing operation. In fact, Itex had accumulated over $20M in net operating loss carryforwards by 2003 when White came in. By 2005, White had boosted profitability and free cash flow considerably.

Secondly, it’s clear that Itex is a stable business that is not growing on an organic basis but has consistently produced in the $2.0M to $2.8M range in free cash flow per annum. Note this includes the benefit of the NOLs, but there is $13M remaining so at current pre-tax profit levels, this will shield taxes for another eight years. The difference between EBIT and FCF is Itex has meaningful amort expense but essentially no cap x, so given the tax benefit FCF has been consistently higher than EBIT.

Given the lack of historical organic growth, if we use $2.3M in free cash flow, for the next eight years the free cash flow yield to Itex’s pro-forma market cap is 22% and to its enterprise value is 26%. Even if the tender is not successful, the free cash flow yield to Itex’s market cap is 16% and to its enterprise value is 26%.

White owns 16% of Itex currently (23% pro-forma for the tender, based on our conversations with him he does not plan to tender his shares) and as the tender shows, believes in returning free cash flow to shareholders. Furthermore, Sardar Biglari (of Western Sizzlin’ fame) and the Polonitza Group each own 9% and 6% of the shares respectively. Biglari’s views on corporate governance are well-known, and the Polonitza Group actually launched a proxy contest against White in December 2010. There was not really much substance to their claims and White won handily (VIC readers can view Polonitza’s concerns here: http://www.sec.gov/Archives/edgar/data/860518/000138515210000065/dfan14a_11192010.htm). Biglari has been quiet for several years which is likely both because he has been pleased with the company performance and because he has moved on to larger companies. The most important take-away to my mind from all of this activity is that White will act in shareholders’ interests both because of his ownership and because of the presence of these groups.  

So at a 26% FCF yield to Itex’s enterprise value, it won’t take long before there is again a substantial build up of cash on Itex’ balance sheet and another tender offer or other shareholder friendly action is likely. This high FCF yield provides its own catalyst as in 3-4 years, pro-forma for the tender the cash on the balance sheet will come close to the market cap. If the current EV of $9M stays constant, equity value should nearly double in four years or a 20% IRR. This is before any multiple expansion given the stability/low cap ex nature of Itex’s business. It is also before any upside from Itex growing its top line by finding a way to scale the number of members in its network. White is hard at work on the latter.

Catalyst