Description

INTRODUCTION
This idea is a small cap but it is, however, a good story. This company operates a very low capital-intensive business that generates free cash flow, has a zero enterprise value, has a super strong balance sheet, and has had 16 consecutive quarters of operating income. It just had 2002 operating income of $5-6 million, and its operating income will be growing this year. In a recent conference call, management mentioned they have thought about going private, since the costs of being public represent 25 percent of their operating income. In the meantime, they have been buying back shares in private transactions at prices below market. The company announced a 1 million share buyback in 2001. Company completed that and followed through with a 2 million share buyback announcement in 2002. It has since purchased 1 million shares since then.

COMPANY BACKGROUND
From the company’s founding in 1993 until 1999, Traffix used to be known as Quintel Communications, a traditional database and direct marketing company that created and operated the “Psychic Friends” hot-line, the country’s first psychic “900” hot-line which enabled Quintel to gather information about the callers and amass a database of 45 million names, telephone numbers and addresses, to which Quintel would later market goods and services. In 1995, the Company went public and generated approximately $750 million of gross revenues and $60.0 million in EBITDA during the next four years. Management estimates that during the period it operated as Quintel, the Company handled well over 250.0 million inbound telemarketing calls.
During its history as Quintel, management funded projects to explore the internet as a medium to market goods and services. Applying the direct marketing disciplines honed from years of operating in the "off-line" media, management believes it is able to provide significantly enhanced response-based results in a more cost-efficient and scaleable manner via on-line marketing. In addition, the online marketing industry presents more growth opportunities, generates better operating margins, and requires less capital expenditures. In 2000, management made its decision to switch to the online direct marketing model, and changed the name of the company to Traffix to better reflect the company’s new internet focus. The Company sold its traditional business (900 phone line business, postal mail) but retained access to the vast database it had assembled as Quintel.
Traffix’s first product was its data-gathering engine known as the web site, GroupLotto.com, which gave away daily prizes of up to $10 million dollars, and at the same time, gathered marketing information about its visitors. Since introducing the Grouplotto.com web site, Traffix has built an online database of nearly “60 million profiled, permission-based records.” From this database, Traffix derives its revenue from activities such as generating traffic and leads for traditional direct marketing media channels, customized response-based leads, completed applications for products, gathering consumer demographic and psychographic information, and handling inbound and outbound telemarketing and direct mail. The Company has further expanded its product line through strategic acquisitions and new projects funded from its cash flows.
PRODUCTS AND SERVICES
A. Websites.
Traffix owns and operates multiple on-line properties, such as GroupLotto.com, the free on-line lottery, AtlasCreditGroup.com, AtlasEducationGroup.com and iMatchup.com (which commenced operations in December 2002), as well as a number of interactive games (such as Direct Deposit Promotions and Scratch&Win), all supplemented by other web sites and services provided on the Web. These activities are designed to generate real-time response-based marketing results for Traffix’s corporate clients, as well as for Traffix’s own offers. When visiting these on-line properties, consumers are given the opportunity to purchase, sign-up for, ask to be contacted regarding, or simply indicate an interest in, hundreds of offers for various products and services provided by Traffix’ corporate clients and marketing partners. Specifically, through these interactive Web properties Traffix generates a variety of transactional results for its corporate clients ranging from (a) Web traffic, (b) inbound telemarketing calls, (c) outbound telemarketing leads, (d) demographically/psychographically profiled lists of consumers, (e) highly-targeted customized response-based leads, (f) completed applications for products, and (g) actual sales of products and services.
The GroupLotto website offers consumers the opportunity to win up to $10 million daily in a free, on-line lottery. The lottery prizes are indemnified by an independent, third-party agency. In order to play, each consumer must provide complete and accurate registration information and agree to receive ("opt-in") marketing messages from GroupLotto and Traffix’s marketing partners. The interactive media on this website includes registration pages, game banners, and "pop-ups", the purpose of which is to generate web traffic, leads and sales. Revenue is generated at this website from its corporate clients who pay for such traffic, leads and sales. Traffix generates the bulk of Traffix’s consumer traffic to this website through proprietary and third party email marketing programs, emailed to lists of consumers who have indicated an interest in Traffix’s product and service offers by opting in to receive information on such offers. Similar to the GroupLotto website, Traffix generates results for Traffix’s clients through several other interactive games and products. For example, Traffix markets through a "scratch and win" game that offers consumers the chance to win any number of prizes, which range from $100 to $25,000. The consumer plays the game by "scratching" with the mouse certain parts of the entry ticket to uncover the results. These games are presented as "pop-ups" upon browser exit, and can also be "pushed" to consumers by delivering them to the player's email inbox. Traffix also markets credit card offers through Traffix’s "Direct Deposit" sweepstakes game (patent pending), whereby a consumer can win up to $5,000 instantly if a portion of his or her credit card number matches a pre-selected winning number Traffix owns and operates several other websites such as AtlasCreditGroup.com, AtlasEducationGroup.com, prizecade.com and jewelclaimcenter.com. Such websites are deployed to generate revenue for Traffix’s clients in a similar manner as the GroupLotto model described above. Each of these sites is designed to appeal to a specific consumer interest category that Traffix matched with product promotions that appeal to such interest category.
B. Email Marketing. Direct marketing via email is an important business resource. Each program that Traffix markets for Traffix’s clients can be implemented not only through the websites, interactive games and "pop-ups" discussed above, but also, and often, through email marketing. Traffix currently markets to approximately 150 million permission-based records, which are either owned or managed by Traffix under Traffix’s revenue share arrangement. Compared to postal marketing and telemarketing, email marketing is significantly less expensive, offers much faster response times, and, Traffix believes, provides for a richer consumer media experience. Traffix now owns an email delivery system (acquired in December 2001 through the acquisition of the assets of Infiknowledge.com, a privately held Canadian technology company), which reduces Traffix’s dependence on third party vendors and further reduces the expenses associated with delivering Traffix’s monthly commercial email messages and reduces the costs of Traffix’s site maintenance and development costs. One of the attractive features for clients, and, Traffix believes, a significant competitive advantage, is Traffix’s ability to create and test a variety of marketing campaigns for prospective and existing corporate clients at no risk to the client. Since Traffix owns, has access to extensive databases, and manages Traffix’s own internal creative department, and can deliver email at a low cost, Traffix is able to offer prospective and existing clients the opportunity to test market new products, services, price points and creative concepts in order to determine if an on-line campaign works for the client, and which campaigns work most effectively. Even after campaigns are fully implemented, Traffix further analyzes the marketing results to gauge whether the campaigns are continuing to generate adequate results for the client, whether the media is being utilized cost-efficiently, and to determine whether new and different copy is yielding better overall results. These are the traditional direct-marketing disciplines, which Traffix believes (when coupled with Traffix’s proprietary databases, the other databases under Traffix’s management and Traffix’s delivery and reporting systems), distinguish Traffix from its competitors in the on-line marketing industry.
C. Syndication. Traffix expends a significant portion of Traffix’s email resources to generate sales for Traffix’s own products and services and for traffic to Traffix’s websites. After Traffix develops a campaign that works efficiently on Traffix’s own media, Traffix often "syndicates" the program to third-party media. Typically, Traffix has expended time, media and other costs in developing certain campaigns. In exchange for this invested effort, Traffix obtains the right to market those campaigns to a list of other on-line media companies. Traffix enters into agreements with these other on-line media companies to run the campaigns, generally on a fee-share arrangement. Traffix believes such media companies benefit from receiving an immediately marketable, fully-packaged and tested marketing program. As a result, Traffix believes Traffix is able to leverage campaigns Traffix has developed (including Traffix’s own products and services) so that Traffix can generate additional revenue with virtually no costs or risks associated with such business extension.
D. New Products. A new business unit, which Traffix introduced during the three months ended February 28, 2002, is the on-line marketing of Traffix’s own products and services. For example, one of Traffix’s websites, Thanksmuch.com, sells gift items (such as DVDs, CDs and inexpensive jewelry) directly to consumers. When a consumer selects a gift item and tenders his credit card, he is given the opportunity to purchase other, more valuable products and services at special discounts. In addition to the Thanksmuch line of jewelry and gifts, Traffix is developing and testing other products and services for direct marketing to consumers. These products include credit card billed products in the "Voice Over Internet Protocol" area ("TxNET-LD"), dial-up modem ISP back-up systems ("TxNET-ISP"), dating/personal programs conducted over the Internet ("iMatchup.com"), jewelry, voicemail, DVDs and books. One of the additional benefits of these programs is Traffix’s ability to accumulate consumer credit card data, which allows for the subsequent use of its marketing concept of "just-one-click" credit card billing, making on-line purchases easier for the consumer, and allowing Traffix to more easily process additional sales and services in the future. In addition, certain of these services are designed as monthly recurring revenue sources, such as its dating and long-distance service. Further, Traffix anticipates that certain of these services will derive monthly recurring revenue streams through the use of Local Exchange Carrier (LEC) billing.
INDUSTRY ANALYSIS

The Direct Marketing Association (DMA) published a comprehensive report that estimated the size of the interactive media marketing (IMM) expenditures to be approximately $2.8 billion. The report projected that the compounded annual growth rate (CAGR) should be 40.0% through 2005. The study further breaks down the industry between business-to-business (b2b) and business-to-consumer (b2c). Beginning in 2005 b2b marketers are expected to spend $9.1 billion while b2c businesses should spend about $5.5 billion on interactive advertising. With such strong fundamentals, it is no wonder competition has aggressively entered the IMM industry. In addition to companies such as Traffix that dedicate their efforts to focusing on building, managing and monitoring a database to market its client’s products and services, virtually every company now has online transactional capabilities. A majority of the companies within the direct marketing community have e-mail marketing capability (59.0%) and almost half (45.0%) regularly transact business through the Internet. The figure is much higher for b2c transactions (59.0%) than for b2b (35.0%). The trend should continue to accelerate. The same DMA survey indicates that 80.0% of the members and non-members polled plan on using the Internet primarily for marketing and gathering information on their customers. The top three reasons for a company’s web site as ranked in order of importance was marketing and information (78.0%), lead generation (55.0%) and ecommerce (54.0%).
Companies and consumers are just beginning to utilize the web to conduct business and gather information. There still remains little standardization for conducting email marketing, and the range of users remains very wide. Some companies are trying to utilize standard software programs to solicit business through the email system. The lack of customization has made it difficult for these marketers to segment their audience. Many new Internet startups have very little direct marketing experience. I believe online companies with extensive experience in traditional offline direct marketing (e.g. Traffix and Harte-Hanks Interactive) may dominate the online segment due to their extensive understanding of industry. For these companies, I believe there exists an opportunity to transfer their offline success to the Internet. According to the DMA, nearly 80.0% of companies have an email database of their customers, but only 13.0% budgeted email marketing in2000. Overall, companies are becoming much more aware of the power of the Internet to build sales and gather information. However, as the statistic in the previous paragraph indicates, only about 1 in 8 among the Fortune 100 companies, have email marketing in their operating budget. Traffix believes this fact will ultimately increase as companies realize the benefits of the Internet. The trend may accelerate as customers begin to request information such as transaction confirmations, product updates, and recalls be sent to them via email.
MANAGEMENT
Management owns about 41 percent of the shares outstanding. They currently own 1 million exercisable options, and about 275,000 options exercisable at $5.7 per share. Last year, management was granted 230,000 options exercisable at $5.7 per share.

VALUATION ANALYSIS
The online business of Traffix has grown from 36% of revenues in 2000 to 88% of revenues in 2002. In the last quarter of 2002, online business represented substantially all of its revenues. In March 2003, Traffix sold its final piece of the non-online direct marketing business, its stake in Montvale Management, for a capital gain of $1.0 Million. Because of the 100 percent switch to online marketing, it is perfectly reasonable to make a valuation on Traffix by valuing its online direct marketing business.
The online direct marketing business generated 29% EBIT Margins in 2002, versus 40% EBIT Margins in 2001. Management explains that this drop in EBIT Margins is due to the fact that in 2002, compared to 2001, they substantially increased that share of the business where they rent third-party databases and share the revenues on a commission basis. Management says that compared to 2002, EBIT Margins in 2003 should remain the same, if not improve, because of economies of scale.
The reason for the decline of Traffix’ stock price in 2002, besides the general market downdraft, can be attributed to management’s lowered revenue guidance in June 2002. At that time, management halved its operating income guidance from $10 Million to $5 Million due to problems in email delivery. Some ISPs were blocking emails coming from Traffix, viewing them as spam, when in fact, Traffix does have the permission to email its users. These problems have been addressed and are continually being addressed by Traffix.
For 2002, Traffix’s net return on equity is about 6%. However, the figure does not reflect how good business is, since it penalizes Traffix because it is overcapitalized with cash. I estimated that Traffix needs less than 9 million to operate this business, which generates about 5 million operating income. Applying a 40 percent tax rate, this equates to about a 35% return on invested equity.
Current consensus street estimates call for a $7 Million EBIT in 2003 versus EBIT of $4.5 Million in 2002.
I contacted the investor relations and I have the following figures. EBITDA should be about $8 Million. Maintenance capital expenditures will not exceed $1 Million.
There are 14.27 Million diluted shares outstanding
The EV/EBITDA multiples of the trading prices of its peers, as well as acquisition prices for some of the companies in this space, range from as low as 7 to as high as 10. The peers used are John Harland, Harte Hanks, Catalina Marketing, Advo, and Acxiom. For accuracy, I should make an estimate of maintenance capital expenditures for its peers …
Even though Traffix's management has an excellent track record, and a positive outlook for the online marketing industry and for Traffix in particular, I applied a discount multiple of 7 for Traffix.
Assuming Traffix does not do anything unwise with its cash (so far, they have proven to be very prudent with their excess cash), this equates to a one year target market price of $6.14 per share, about a 105% percent return from today’s price. I like the fact that management has stayed disciplined about holding on to their cash until a really good acquisition comes up. In the meantime, they have been buying back their own shares at prices that are better than what the market has offered.
I would also follow closely the progress of its dating business, Imatchup.com. Online dating has proven to be a good business model. It is one of the few services people are willing to buy online. Even Yahoo has generated substantial revenues from its personal dating web site. Furthermore, Traffix recently issued a recent news release about the promising success of its dating business, Imatchup.com. In the earnings press release, management said that during the first quarter of 2003, our new on-line dating business, iMatchup.com, generated approximately $300,000 in revenue, and our ISP service, TXNet, the alternative dial-up Internet access service, generated approximately $200,000. They have seen strong growth in both of these businesses, and look forward to their contribution in succeeding quarters being even more meaningful.

Catalyst

- New promising, products with good business models
- Continued free cash flow generation
- Continued buybacks