Ituran Location And Control: Recurring-Revenue Automotive IoT Trading At Steep Discount (NASDAQ:ITRN)

Company Overview

Founded in 1995, Ituran Location and Control (ITRN) is a $420M market cap, location-based telematic service provider headquartered in Israel (40% revenue) with also significant presence in Brazil (35%) and rest of the Americas (25%). The company’s core business is the commercialization of a subscription-based stolen vehicle recovery (SVR) technology that was originally developed for the Israeli Defense Forces to locate downed pilots. The company makes money through both subscription fees (70% of revenue, 30% EBIT margin) and one-time product sales (30% of revenue, 8% EBIT margin). As of 3Q20, Ituran has in total 1.78M OEM and aftermarket subscribers, of which around 600K from Israel, 480K from Brazil, and the rest 700K from other Western-hemisphere countries such as United States, Argentina, and Mexico. In Israel, Ituran is a monopoly and has maintained 80% market share over the years due to long-term agreements in place with most of the car importers and insurance companies. While in Latin America, the company was the first mover in its product niche and is currently the largest OEM telematic provider.

WholeCo revenue mix by business segment and segment revenue mix by geography

Some background is helpful to understand why Ituran operates in these geographies. As the birthplace for successful mobility startups like Waze (acquired by Google for $1bn) and Mobileye (by Intel for $15bn), Israel is one of the leading countries on the edge of automotive tech. Israel’s history of innovating through struggles fosters Israelis an unique proclivity for entrepreneurship, while the country’s compulsory military service and focus on STEM education has built a generation of local industry talents. Tier 1 automakers like GM, BMW, Hyundai, Bosch, Ford, all have established R&D centers on the ground since as early as 2008. The area around Tel Aviv, where many of the automotive startups are headquartered, is even referred to as Silicon Wadi (Wadi as Valley in Arabic). Many autonomous technologies – e.g. radar sensors and cybersecurity systems – have come from military applications for the Israeli Defense Force. Ituran is no exception, as its history traces back to a defense telecom manufacturer whose original mission was to adapt military-grade technology for civilian market, both domestic and abroad in place like Brazil.

According to UNODC, Israel and Brazil have some of the highest motor vehicle theft rates in the world per capita, ranked 2nd and 16th among all countries with at least 5m population respectively (1st is Malaysia). This is despite that car ownership rates for both countries are not even half of that of the United States (394/364 per 1,000 vs 838) as of 2020. High auto crime rates in these end markets make Ituran’s capabilities a particularly enticing addition for local governments, auto insurers, and car OEMs. Brazil’s Federal Department for Transportation even passed a legislature in 2009 known as Contran 245 to require fitment of a tracking device on all personal cars, trucks and motorcycles. Though eventually suspended in 2015, the law shined a spotlight on the severity of the vehicle theft crisis, and drawn considerable eyeball to the value of SVR technologies.

Business Model, ARPU, and Subscriber Trends

Ituran runs a high-margin, capital-light, recurring-fee business model. Their telematics products are manufactured and assembled by manufacturers in Israel and China with whom they engage on a full turn-key basis. Ituran supplies detailed production files and materials list and receives final products that are sold directly to clients. For this reason, capital expenditure have been <6-8% of annual revenue (compares to 25% EBIT margin), and Ituran has never sought external financing except for the US$82m loan in 2018 used for Road Track Holdings (NASDAQ:RTH) acquisition. Currently, $56.8m remains to be paid out in the next 3 years ($18m, $18m, and $14m respectively). As of 3Q20, Ituran is in a net cash position of $5m.

Company has generated positive FCF (CFO less Capex) every year since 2005 IPO on average of 15% revenue, with 9 out of most recent 10 years above USD20m. This is because of the stickiness of its subscription customers who most would be willing to pay a small cost to insure their valuable cars against theft. This fee is automatically deducted at the beginning of every month and provides Ituran with upfront cashflow. In recent years Ituran have launched lower priced packages to enter the mass market segment, namely Ituran Com Seguro (NYSE:ICS) and Usage based insurance (UBI). Consequently, monthly ARPU have come down from $13 in 2014 to $9 range in recent quarters after adjusting for FX. Management is aware of this decline and have made a point to highlight both program’s higher margins that offset the lower unit prices. For example, even though UBI is a single-digit-ARPU business (lower than core SVR), almost 100% of its revenue flow directly to EBIT as the B2B nature eliminates the need for control center, customer support etc. So the ARPU impact is offset by lower costs, and at EBIT level, margin is maintained.

Ituran launched Ituran Com Seguro (ICS) in Brazil in 2016. Targeting the mass market and previously uninsured, it is a basic, discounted, direct-to-consumer version of the SVR service originally offered to big insurers. After 2 years since 2018, it has become a well-known name in Sau Paulo according to management. On the other front, User Based Insurance (UBI) is a service that allows insurers to bill customers based on usage (accumulated mileage) and user behaviour, a much fairer arrangement than the simple, outdated approach currently employed by majority auto insurers in emerging economies. These two initiatives exemplifies the cross-selling opportunities afforded by the mass subscriber base and wide geographic reach of the company (20+ countries). According to recent company earning calls, after their initial success in Brazil where they were the first mover, Ituran is expanding ICS to Mexico and started building the infrastructure in 3Q19. Similarly, after signing up multiple insurers in Israel (Haral, Shlomo, Biyuach Yahir, Akshara, AIG), they are taking UBI to Argentina and Brazil.

On the subscriber front, Ituran currently has 1.78m monthly paying subscribers, a number it has maintained since 2018 after consolidating 550,000 additional subscribers from Road Track Holdings (RTH). In 2019, because of general LATAM auto slowdown, Ituran’s OEM customers reduced Ituran software’s free trial period from 6 month to 3, then to 1. Consequently, 2019 was a challenging year for Ituran and its subscriber growth stagnated. Nonetheless, monthly churn stayed stably at 3% over the years, and never in a year had Ituran organically lost any significant amount of subscribers. Managements cite new car purchase (disposal) as the biggest reasons for subscriber gain (loss). As long as car ownership keeps growing in Ituran’s end markets, its subscriber count should continue to increase given its market positions.

3Q20 subscriber count ended at 17.5m compared to 17.7m end of 2019. All the subscriber churn happened during Q2 as Q1/Q2/Q3 subscriber growth came to 1.4%/-2.4%/0.1%. 3Q20 revenue / EBITDA growth in local currency terms were a mere -2%/-3% YoY, in other words already recovered to levels similar to 3Q19. This fundamental resilience is due to partially the nature of the business, partially management prudence. Ituran renegotiated key supplier contracts and cut employee salaries at the onset of COVID to ensure costs are always in line with revenue.

Co-CEO Eyal Sheratzky at 2Q20 earnings call:

We prepared ourselves in advance to weather the storm, and we are consistently ensuring that our expense level is matched to our revenue levels. Even during such unusual times and the most severe global crisis in 100 years, we are able to remain profitable and generate cash, and we expect that this will continue to be the case in the coming quarters, while the pandemic is still with us.

Since 2005 US IPO, Ituran has had no M&A or external capital raising (debt/equity) except RTH transaction 2018, of which Ituran paid at fair price of 5.4x EV/EBITDA & $205/subscriber, much lower than valuations on some prior comparable transactions (see below).

Since 2008 company has been paying out 50% net income as dividends. In fact 68% (260/390m) of net profit has been paid out in total since 2005. However this longstanding custom was suspended in 1Q20 on the cusp of COVID. We believe this was one of the primary reasons the stock is cheap, as the long dividend track record have over the years accrued shareholder base to yield seeking dividend investors that left the stock this year.

Baupost/Klarman held at much as 8% of the company from 2007 to 2013. Currently the company’s second largest shareholder is Vulcan Value Partners, a concentrated value fund. Top 5 shareholders own 60% of shares. All seems to be sticky long term capital.

Valuation

We conservatively values the company only by its recurring services revenue by region under a no-growth scenario. Comforted by a strong 3Q20 results that compares to FY19 on local currency terms despite the pandemic, we benchmark Ituran’s steady state to FY19, which was already a challenging year.

In our model, we assume 2019 ending subscriber counts and average monthly ARPU to be maintained into the future, while cash margins are determined by each region’s FY19 services EBIT margin adjusted by tax rates. Under a multiples approach, we apply 20x / 8x / 5x EV/FCF for Ituran’s cashflow generated from Israel / Brazil / Other Countries respectively. 20x FCF multiple for Israel reflects the segment’s cashflow certainty and is based on where the company was traded before 2019. 8x / 5x for Brazil / Other Countries adjust for the regulatory, macroeconomic, and foreign exchange risks in those markets.

Data by YCharts

Under a DCF approach, we apply 5% / 15% / 20% discount rates to Israel / Brazil / Other Countries and assumes these cashflow grow at 0% to perpetuity. Though 5% – the current implied US equity market return – seems very generous, it again reflects our confidence in Israeli cashflow’s certainty due to Ituran’s local market position. For reference, Ituran pays only 2.25% interest on 5-year acquisition loan it borrowed from Israeli bank in 2018. 10% for Brazil is based on current implied Brazil equity market return + 5% company risk premium, and 20% for rest of the countries (mostly Mexico, Argentina, Ecuador, Colombia) is 5% premium on Brazil’s 10% discount rate. The blended cost of equity (weighted by regional cashflow) for WholeCo is then 11%.

For simplicity, we ignore the $5m net cash on the company’s balance sheet at of 3Q20. Accordingly, our valuation from two approaches converges to around $30/share, representing a 67% upside from the current $18 share price. Note that in our model, we completely left out the product revenues (which relies on business growth), as well as any upside from subscriber count or exchange rates. Ituran is also cheap from a precedent transaction’s perspective (as shown in previous comparable transactions table), even after considering its more low-growth value stock characteristics. Thus, we believe the current discount is a sizable margin of safety to hedge any unaccounted risks in our model assumptions and creates an asymmetrical risk/return opportunity.

Foreign Exchange Return Correlations: A Long-Term Holding Risk to Consider

Due to exposure to foreign currencies – primarily Brazilian Real (BRL) and Israeli New Shekels (ILS), Ituran stock is sensitive to exchange rate fluctuations, which we think is the biggest risk for holding the stock. We summarized the stock return with BRL & ILS movements for the past five years, presented in table below. Except for 2016 the year of Rio Olympics, BRL has depreciated -12% / -54% / -17% / -16% / -24% YoY against USD for 2014 / 2015 / 2018 / 2019 / 2020YTD. The depreciation of BRL (among other LATAM currencies) in the past two years has been particularly wounding for Ituran, which declined -21% / -23% over the period.

To take a step further, we ran 7 regression models on Ituran price returns in relation to returns on USDILS (ILS), USDBZL (BRL), a 50/50 weighted average of the two currency pairs (ILSBRL), and Russell 2000 (RUT) using both daily and weekly data from the past five years (see table below). 3 models used same day returns (Daily 1-3), 1 used next day Ituran returns (Daily 4), and 3 used same week returns (weekly 1-3). Note that USDILS expresses the price of US dollar quoted by ILS, so an increase in ILS means the depreciation of Israeli currency; same goes for Brazilian Real. Looking at Daily 1, from a pure statistical standpoint, per 1 percentage point move on USDILS / USDBRL / Russell 2000 correlates with -0.4% / -0.08% / 0.63% Ituran daily returns respectively. Other models also confirms such strong correlations.

Despite such foreign exchange risks, we think in the near term, the worst has passed, and multitudes of upside catalysts supported by fundamental reversion to mean merits buying of the stock.

Catalysts

1. Further strengthening of BRL and other crushed LATAM currencies (doubles as a FX risk mitigant). LATAM currencies were still at historically elevated levels in relation to USD as late as 6 months into the pandemic crash. However, since November, exchange rate recovery has visibly picked up pace. A significant reversion of this trend, that is, further depreciation to the magnitude we witnessed, is unlikely given the general bearish sentiment on USD among investment community and the belief that capital flow will come back to EM in 2021. Shall the current trend continues, it is positive for Ituran’s headline financials.
2. Increased Wall Street coverage. Lack of exposure on this stock is a point previous SA author Otzar Capital Advisors have pounded on in 2016, but it sadly still remains true today. Ituran lists only 1 coverage analyst on IR website and its earnings calls are still poorly attended. Because of low needs of capital raising or M&A, Ituran has historically attracted few institutional relationships. As price and liquidity improve on the stock, it should draw more investor attention.
3. 4Q20 / 1Q21 dividend resumption. To cut costs Ituran renegotiated key supplier contracts and cut employee salaries. Management has expressed the view that after these two things are back to normal, the customary 50% dividend payout will resume.

Co-CEO Eyal Sheratzky at 3Q20 earnings call:

I think that we need a little bit more time to feel more confident. As I said, we are very conservative, and the Board is very conservative, maybe it’s required a little bit more patience from investor. But as we did more than 15 years, when we making positive cash and when the company is confident and don’t see a specific goal to keep excess cash, we always pay dividend. I think that as a management, we see that it’s something that in the close future, we will ask the Board to do it. Of course, it depends on the Board. But I assume that soon, beginning of next year, we will push the Board to both for going back and pay dividend or going for a buyback, et cetera. And I must add, again, that one of the values that we are holding here in Ituran is that since there is still a large portion of management team, hundreds of those that volunteer together with the company and support the company these days by decreasing their salaries. And we have suppliers of many years also suffering… dividend will be back once all the employees and the suppliers to be in a position that the company is confident in a good shape to go to the next level.

Take Home Message

Ituran is a recurring-revenue Israeli automotive IoT business that has consistently generated recurring free cashflow for last 15 years and returned majority of them to shareholders through dividends. Shares have declined since FY19 because of exposure to auto industry cyclicality, 1Q20 dividend cut, and significant depreciation of LATAM currencies since COVID. However, business fundamentals remained resilient through the pandemic due to the company’s predictable subscription revenue model. High margin of safety imbedded in current price, combined with dividend resumption and continued strengthening of LATAM currencies as specific catalysts, presents a compelling buy opportunity.

Disclosure: I am/we are long ITRN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.