6/11/2011

ITEX: Intrinsic Valuation Simplified :Yes and No

We know intrinsic valuation is simple but miscalculate or forecast incorrectly any of the 3 main inputs and the final product is garbage. Take good data and mix it with bad data and the end results is always bad data.  The 3 inputs to value any asset is deceptively simple:
1)Cash Flow
2)Growth

3)Risk

I won't explore additional intricacies now and if additional efforts are made there is no guarantee the results will be more accurate. Slight adjustments to any of the 3 inputs will dramatically change the calculated intrinsic value.

I want to take a quick look at ITEX that appears to be trading significantly below its intrinsic value. There are many other ideas trading at a discount to intrinsic value ideas but tonight ITEX is my choice.

Input 1)Cash Flow

Why I start with EBITDA.

The goal is to determine the amount of cash that operating assets generate. Interest and taxes do not tell us how effective management is using operating assets . The deprecation number can be subject to aggressive accounting to favorably manipulate reported earnings. Asset's useful life can be extended in excess of the asset's market life even though the accounting is supported by GAAP and the auditors. So starting with EBITDA and making the appropriate adjustment to capital requirements to maintain and improve the business is a good place to start.

Most believe the cash flow statement is the best source to measure the operating cash generating capabilities of the firm. I know this is heresy in some investment school of thought but EBIT and estimates for capital requirements needed to sustain and grow the business may be a better approach. Operating Cash flow from operations can be easily and is often manipulated. Non core operation activities like trading / selling securities, money borrowed to finance security trading are examples of non core operational activities that may be run through the CFFO section.Capitalization of expenses boost CFFO but when expensed it can often flow through the financing section.Enron is a extreme example of cash flow manipulation but it's easier and more seductive than people realize. I believe most companies will classify favorable transactions through the operating cash flow section of the cash flow statement when it should be classified in the financing or investing section. External auditors when providing an opinion are focused on the balance sheet given that all transactions must flow through the balance sheet. The income statement is indirectly reviewed when verifying the balance sheet. For example the AR balance that includes accruals for sales is tested with the matching principal alonng with other accounting principals. Expense accruals are also tested and verifies the reasonableness of its impact to the income statement. Confirming all the specific classification on the cash flow section is not a top priority once the balance sheet's material accounts have been tested. Just my opinion as companies love to brag about the quality of their earnings based on the reported CFFO during conference calls.
Companies know the public and street are looking closely at CFFO so they won't resist manipulating the favorable classification on the cash flow statement. The cash flow statement and more specifically the CFFO is not the holy grail of operating performance. In fact using EBITA as a starting point and then subtracting average capital expenditures over let's say the prior 4 years or develop estimate if you know the actual capital requirements for the business is better than relying on reported depreciation expense. If interested speak to management about their current and future capital needs and adjust that number into your model. No need to rely on GAAP accounting rules for management's depreciation estimates.

If you are comfortable with management's reported deprecation estimates use EBIT or better just adjust depreciation higher to a more conservative number when starting with EBITDA. You can also try taking the actual capital expenditure amounts from the cash flow statement and average over a period of time.

So using EBITDA less actual capital expenditures averaged annually over the past let's say 4 years may be a better measure for cash flow generated from operating assets than the CFFO section of the cash flow statement.

More on the benefits of using EBITDA or adjusted EBITDA in future posts .Now back to input 1...

Cash Flow


ITEX Operating income from 2006 to TTM averaged 1,392,000 per year

depreciation and amortization per the cash flow statement averaged 539,833

So my average calculated EBITDA is 1,392,000 (Avg OI)+ 539,833 (Avg Depr & Amort) = 1,931,833

now if i take and trust the capital expenditure reported on the cash flow statement the average amount from 2006 to the TTM was -90,333.

So the 1,931,833 - 90,333 = 1,841,500 my proxy for cash generated per annum based on averages discussed above

If I use the FCF taken from the cash flow statement that average amount would increase to $2,129,167.

I will use the lower number of 1,931,833 as my starting point for annual cash flow.

2)Growth Rate: You can plug in any number over any time period but for ITEX I'm going with 4 % annually a very conservative growth rate for the years 1 to 5, 3% for years 6 to 10 and the remainder 2 then 1 %. Future inflation will impact growth.

3)Risk: the discount rate(cost of capital) is not the risk free rate of let's say 1% but instead my conservative guess is 10%. The risk is the cost of capital and will be higher or lower based on the riskiness of the capital investment. 10 % is significantly higher and gives us a lower present value. Play with the spread sheet provided in the link to see the impact of different risk rates.

Down load the Excel file and play what if. Change growth rates, cash flow, risk (cost of capital).

ITEX Corp. (ITEX.OB)

Company Website:


"Founded in 1982, ITEX is a leading marketplace for cashless businesses transactions across North America. ITEX processes over $270 million a year in transactions across 24,000 member businesses and 90+ franchisees and licensees. Member businesses increase sales and open new markets by utilizing ITEX dollars to exchange goods and services. ITEX is powered by ITEX Payment Systems, the leading payment technology platform for cashless businesses transactions. ITEX is headquartered in Bellevue, Washington"

Price 4.15

EV =3.40 = 4.15(price) - Cash(1.32) +ST Debt (.574) +LT Debt (.001) = 3.40 or 2.82 if you exclude ST debt

Per Share Data

Cash per share = 1.32

ST debt per share = 0.574587162

LT debt per share = .0001

Total Liabilities per share = .576

Cash = 5,904,000 Per share = 1.624

Liabilities Short and Long = 2,086,000 Per Share = .574

Market Cap = 15,720,000 Per share = 4.39

EV = 5,904,000 (cash) - 2,086,000 (Liabilities) + 15,720,000 (Market Cap)

EV Per Share = 3.40 = .574 (liabilities per share) - 1.624 (Cash per share) + 4.39 (Market Cap per share)

Shares outstanding = 3,634,000 fully diluted

My current intrinsic value estimate is about 6 to 8 versus the enterprise value of 3.40
See link to spread sheet for more details

Present value of cash flow from year 1 to 5 with a 4 % growth rate and 10% discount rate is 2.28 per share or 8,188,927 with the starting annual cash flow of 1,931,833

Year 6-11 PV is 1.68  per share or 6,016,617 at a 3% growth rate

Year 11-21 Present Value 7,552,394  or 2.11 per share at a 2 % growth rate

Year 22 - 33 Present Value is 3,260,680 or 0.91 per share at a 1 % growth rate
terminal value of .28

So the estimated intrinsic value is 2.28 + 1.68 + 2.11+.91+.28 = 7.26

This number is just an idea of what kind of cash flow needs to be realized along with the modest growth rate and risk factor/cost of capital/discount rate of 10%. These numbers can be adjusted using the link below

I will post the supporting spreadsheet tomorrow for additional clarity

Long ITEX

Click to View: Historical data supporting numbers used above


Click to View: CF Data and DCF Excel File to Adjust, CF,Growth or Risk

3 comments:

Anonymous said...

Couple of additional points to note:
1. ITEX has a large NOL which means it won't pay taxes for several years to come. This is enormously valuable for ITEX as it is currently generating pre-tax profit;
2. Most of the amortization relates to intangibles recognized when member lists are acquired. Members have been flat (i.e. Not declining) so capex is not required to replace this asset. This is one of the reasons capex is so much lower than D&A.

The other positives or ITEX are
1. The CEO owns a lot of stock an his holding has increased over time
2. ITEX has a $2m buyback program in place. It bought stock last quarter (at higher prices than current) is looking to continue the buyback at current stock prices
3. ITEX pays a quarterly dividend which represents >3% yield at current stock prices
2.

Anonymous said...

How can you predict growth rates out so far in the future?

It is very hard to predict even quarter to quarter, but 6-10 years out? I find it hard to trust a model that depends on growth of cash flows so far out in the future. Generally VI's tend to pay for the company without any growth priced and then any growth they get for free on top of that. Would love your thoughts on this.

-SN

ShadowStock said...

Thanks for the question.

If I use intrinsic value as opposed to relative valuation my goal is to determine the present value of all future cash flows.
The three items listed , Risk, Growth and Cash flow must be estimated. So I'm forced to come up with estimates. Even at a 0 % growth rate the value may be 5.25 with a 10% risk rate. So the stock, ITEX with a 3.20 enterprise value may be selling at a large discount to its intrinsic value. I've included an Excel spread sheet that you can download. The cash per share is 1.32, no long term debt, ~ 4 % div yield, share buybacks, valuable membership lists, recurring revenue on memberships and in my opinion a product and infrastructure (software) to leverage the business in an economy that could explode.
http://www.shadowstock.com/SS_061211_P1.html
So even if the cash flow is not projected with growth the immediate breakup value (terminal value)is much higher than the current price. Hence the intrinsic value only in my estimate is favorable to the current price.

Good luck
John