In-Touch Survey Systems

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In-Touch Survey Systems (INX-X) is a rapidly growing Canadian nano-cap that is under followed,neglected and is trading at a discount to fair value.  It is profitable, trades at a low multiple on most measures of value, has high returns on tangible capital, and has catalysts in place that should allow for a significant increase in share value over the next 2 years.

INX has 3 major business divisions.

1) EDC

The first is electronic data collection (EDC).  This division does event marketing, electronic surveys, data capture and lead generation, including analytics.  If you’ve ever been to a car show, INX would  probably be the ones providing the marketing kiosks/tablets to engage potential customers at the GM booth.   EDC has been operating at less than breakeven the last year, as it has been investing heavily in product development.   This industry is very competitive, and the barriers to enter this industry have further eroded with the introduction of tablets and apps like Survey Monkey.  The business strategy for this division is evolving. It would seem that continued product development in this division would be throwing good money after bad.  However software development in this division has been applied directly to the rapidly growing IMS division (see below), and therefore, if they can keep the operating losses to a minimum, this division should continue to add value.

2) MDC

The second division is called manual data collection (MDC). This division is involved in the retail inventory audit and mystery shopping industry.  This industry is very fragmented, and barriers to entry are very low.  There are hundreds of mystery shopping players in North America, and the majority are very small.  However, this industry has a very low risk of obsolescence.   This industry provides an essential service to retailers which allows them to analyze how they are engaging with their customers.  The competitive advantage of MDC and a few of the large industry players is their investment in electronic and data analytics.  This allows their customers to analyze and correct any problem areas very quickly as a result of the analytics provided by the large industry players.

The MDC division has grown revenues significantly in the last 12 months, as a result of an outsourcing agreement with an American company GSC. The agreement allowed INX to sign up GSC’s Service Intelligence (SI) unit customers, with an upfront payment of about $50,000, and 10% gross royalty on revenues in the first year, dropping to 5% in the second, and none thereafter as INX retains the customer relationships after this period.  The SI software platform was terribly inefficient, and under GCS was generating lower gross margins than In-Touch's mystery shopping customer base. INX management estimates that it will fully migrate the SI customers onto In-Touch products and systems by August. The duplication of costs, and the royalty payments depressed margins in the MDC division in 2011, however, once the SI customers are fully migrated over to the In-Touch platform, and the royalty payments reduce starting in Q3, INX margins for this division should return to historical levels, and if they can retain most of the legacy SI customers, they should see a greater proportion of each revenue dollar flow to the bottom line.

Market Force is the largest MDC competitor in North America, at about $70 million in revenues (including it’s European business), compared to In-Touch at about $5 million.  Market Force has used a roll-up strategy backed by private equity, and recently Market Force acquired one of INX’ main Canadian competitors.  Although INX has a much smaller market share, it is still one of the top players in Canada, and has a very good reputation of supplying it’s mystery shopper contractors with contract work and paying on time, which can’t be said for all it’s competitors.  INX has many of the largest retailers in North America as it’s clients.  The fragmented nature of the industry is both a positive and a negative for INX.  On the negative side a large number of competitors obviously results in a great amount of competition.  However, for a consolidator like INX with one of the top software platforms in the industry, the large number of small competitors results in a large opportunity to acquire these small competitors and move them to the In-Touch platform, and benefit from further economies of scale.

3) IMS

The third division is the new Information Management Systems (IMS) division.  This division has taken much of it’s product development from the EDC division, and used it to sell consulting and services into the public sector.  IMS provides products like mobile forms to be used by the public on government websites, as well audit and regulatory inspection forms/reports used by government employees on mobile devices, as well as the consulting services to implement these products. Public Works and Government Services Canada is it’s largest client, and this division should more than double it’s revenue YOY in 2012, starting from a fairly small base of $1.3 million in ‘11. Management is very optimistic that this division will continue to grow at a brisk pace beyond 2012.  This division is already generating impressive margins, and should have a very bright future.

The IMS division is a tadpole in a very large pond. INX is competing with powerhouses like IBM, HP, and Accenture, as well as many other smaller software and service companies.  However, at this point in time, governments are under severe pressure to cut costs, and there have been a number of recent independent government reports with recommendations on cost cutting at the federal and provincial levels, and these reports have recommended improving value for service when it comes to IT services.  In the last 2 years, the Canadian government has doled out $460 million in contracts to IBM, $80 million to Accenture, and $70 million to HP.  The Canadian government has spent $1.4 billion on software and services as a whole in the last 24 months.

Because INX is small and nimble, it can provide consultants to these government departments for $1,200 or $1,300 a day compared to $3,000 a day for consultants from companies like IBM, HP and Accenture, which results in huge savings.  In addition, these large companies generally are installing software that is proprietary, and comes with recurring license and maintenance fees for little work being performed.  INX does not charge recurring license and maintenance fees, as their products are open source, however, because of the incentives for governments to radically slash costs, INX and similar software providers are likely to win market share from the traditional large software providers going forward.  On the downside, INX does not benefit from recurring maintenance and licensing revenues, and so, if INX were not awarded new RFPs, revenues could dry up.  However, this model should result in greater numbers of RFP’s won by INX and other more nimble software and service providers.

As far as management, CEO Michael Gaffney has taken INX from the brink of failure in 2004 (I spoke to an employee who was around then, and if Gaffney’s group hadn’t come in to rescue the company, this employee felt that he would have been unemployed at the end of that week).  Gaffney brought in a good sales and marketing team, and has invested heavily in product development.   Since then, Gaffney has done a good job navigating the company through the great recession, replacing lost revenues with new customers, increasing total company revenues by seven-fold in the 8 years he has been involved.  He has been willing to make tough decisions to ensure the long term viability of INX (he reduced the headcount by 25% in 2008 and a further 10% in 2009).  Gaffney is incentivized with a 16% holding in INX.  Eric Beutel owns another large chunk of stock.  The Beutels are intelligent value investors who should keep management on the right path.

Management is shooting for 15% EBITDA margins over the medium term, while still investing in marketing and product development.  (I think that is a reasonably achievable, once SI customer migration is complete in August - which would result in a run rate of $1.65 m in EBITDA). Maintenance capex is probably about $0.2-0.3 million (my estimates).  This would result in a rough estimate of $1.35-1.45 million in EBITDA-maint capex (good proxy for EBIT), including EDC operating losses.

   2010    2011      2012 (run rate est.) EBITDA   1.221 m   1.387 m     1.65 m EBITDA - maintenance capex   1.105 m   1.14 m     1.4 m

Another way to look at valuation is to break out EBIT by segment.  MDC margins were soft last quarter, but should be able to generate revenue of at least $5 million in 2012 at a 20% EBIT margin, and probably higher margins once SI customers are migrated over to the INX platform by the summer (INX generated a 24% EBIT margin in 2011 and 29% in 2010 on much lower revenues), This would result in $1 million in EBIT for MDC in 2012.  EDC is currently generating a moderate operating loss.  IMS should do $3 million in revenue this year at a 25% EBIT margin.  I think there might be some software development expenses in EDC that should probably be allocated to IMS, so the true EBIT margins in IMS are probably lower than what is shown in the segmented results table in the financial statements.  Large competitors like Accenture, IBM and HP software and service/consulting divisions run at EBIT margins of 13% - 20%.  However, IMS is much more nimble than these larger competitors.  At a 25% EBIT margin, IMS would add another $0.75 million in EBIT.   I’ll use $0.6 million (or a 20% EBIT margin) to be more conservative, so as to allocate a portion of EDC product development expenses to IMS.

   2010   2011   2012 MDC EBIT    0.707 m   1.01 m   1.0 IMS EBIT    (0.028) m   0.322 m   0.600 EDC EBIT    0.237 m   (0.537) m   (0.400)

So between MDC and IMS, I get a total of $1.6 million in EBIT for 2012.  There is $0.1 million of corporate costs as well. This brings the EBIT from the 2 profitable divisions ex EDC down to $1.5 million. EDC is currently a detractor from EBIT, but if they can get the division to breakeven, the software development in the EDC division should continue to benefit the rapidly growing IMS division. There are also some tax loss assets that should shelter income for a few years at least.  Now at 35 cents a share, adding in net debt, you get to an EV of just over $5.7 million, or an EV/EBIT of 3.8 (5.7/1.5).  This business is not a franchise-type of business with deep competitive moats, however, with pre-tax returns on tangible capital greater than 50%, I think the quality of this business deserves a multiple of more than 0.5X EV/revenues and 3.5X the EBIT of it’s 2 profitable divisions.  The IMS division is growing at over 100% per year, and should generate a profitable $3 million in revenues in 2012 from a standing start 2 years ago.  Anyways, at 35 cents, I think you are paying less than what the MDC division is worth by itself, and you are getting a free option on the IMS division and any turnaround in the EDC division.  

Catalysts:

High interest debt is paid off in 2015 with built up cash flow or refinanced at more attractive rates.

SI royalties end in August 2012 and gross margins return to historical 55-60% and EBIT margins follow.

Continued rapid growth of IMS division.

Large acquisitions/tuck in acquisitions in MDC division.

INX could be an acquisition target, especially if they continue to grow IMS revenues. Or acquisition of a division by someone like a Market Force could bring attention to the valuation discount.

Risks:

SI/MDC customers flee after their short term contracts expire, resulting in fixed costs being spread over smaller revenue base.

IMS division does not win any more gov’t RFPs.

EDC division operating losses worsen.

Cash flow dries up and unable to service small amount of debt.

CEO has stated his intention to acquire small competitors.  There are always risks of integration.  So far, he has done a good job with small acquisitions, but he could bite off more than he can chew.

Continued cash outflow to product development and marketing could fail to produce increased revenues.

MDC division is susceptible to economic conditions.  Most contracts are 1 year or less.  Customers could defect if economy deteriorates.

Disclosure:  The author owns INX shares