Disclosure: I have no position in either ISNS or ITI, the two stocks discussed in this report nor due I plan on investing in either company in the near term. Nothing in this report should be considered investment advice.
Introduction
The Intelligent Transportation Systems (ITS) industry is interesting to research, but a difficult industry to invest in. The ITS industry revolves around designing, building, and installing hardware and software that monitors and optimizes traffic on roads and highways. Many of products produced by the industry are video cameras, radar systems, and enterprise software to analyze data from hardware. These products are used to monitor traffic and congestion, sense cars at traffic lights, signal bicycle presence, vehicle presence at highways and on-ramps, wrong-way monitoring systems, and software to analyze data and learn ways to optimize traffic flow. Some of these products (vehicle presence at red lights) are replacing old systems (under pavement wiring) and some are designed to traffic and safety (Arizona Department of Transportation implementation of a wrong-way notification system on their freeways using thermo-video cameras).
This industry has two headwinds that make it difficult to find attractive investment. First, this industry his highly competitive. Both large international companies (IBM, Hitachi, Deere) and small pure plays (ISNS, ITI) compete for business from mostly a single customer type, federal and state government agencies, the second headwind. I will go into more detail later, but the data for the industry’s largest customers does not look attractive.
Pure Play Companies
Two companies that provide pure play options for investing in this industry are Image Sensing Solutions (ISNS) and Iteris (ITI). Both offer similar products and services but approach the market in different ways.
Image Sensing Solutions (ISNS)
ISNS is a nano-cap company with a $20 million market cap as of 10/09/2020. The company’s two main products are its Autoscope video camera and RTMS radar system. The company also sells its IntellitraffiQ enterprise software to integrate with its hardware. The company is in the business of designing image sensing architecture.
Exhibit 1
Source: ISNS 2019 10-K
The company’s Autoscope video product can monitor traffic, measure vehicle speed and congestion, detect the presence of a bicycle, and work with traffic lights as a signal controller. In the signal controller use case, it is in competition with the older system of wiring underneath the street pavement to detect the presence of a vehicle at a traffic light.
ISNS’s radar system can also measure vehicle presence, volume, speed, and classify that information. The system is designed to be installed on highways. It helps cities with on-ramp monitoring and wrong-way detection. The wrong-way detection is not only used to alert the driver of the vehicle but also the cities police and integrated roadside warning system.
ISNS products in North America are sold almost exclusively through a third party, Econolite. Econolite has an exclusive agreement to manufacture, market, and distribute ISNS’s products in North America. Econolite pays INSN a royalty for the products sold and must hit a minimum amount of revenue each year. This arrangement not only creates gross margins of 70% – 80%, it allows the company to focus exclusively on designing and improving its products. This arrangement can also create a large risk for the company. Since Econolite is the sole manufacturer and distributor of INSN, any investment in ISNS is also an investment in Econolite, which is a private company. Econolite manufactures ISNS’s products in Mexico and was forced to stop operations in April due to the COVID-19 pandemic. It is unknown if this issue has been resolved.
ISNS has consistently been profitable and cash flow positive, carries no debt, and recently renegotiated a lower lease rate on their office space. While the pandemic does not create a going concern for the company right now, it is unknown when revenue will get back to normal.
Iteris (ITI)
ITI is a micro-cap company with a $179mm market cap as of 10/09/2020. Like ISNS, the company focuses on road and highway sensors. The company also offers consulting services to customers. Unlike ISNS, ITI assembles, markets, and distributes its own products. Until earlier this year, the company had an agricultural and weather analytics business. Those two businesses were sold to a Swiss based company.
Along with the company’s radar and camera business, it also sells a cloud-based software product called ClearMobility. To quote management,
“It applies cloud computing, artificial intelligence, advanced sensors, advisory services, and managed services to enable cloud-based monitoring and operation of mobility infrastructure.”
For reasons I am about to describe, management sees the software business as the driver of future growth. ITI, because it controls the manufacturing and distribution of its products, is not subject to manufacturing and distribution issues from 3rd parties. It is also able to control the end user selling experience. The downside to this strategy, versus INSN’s distribution model, is that margins are compressed. ITI’s gross margins have been around 38% the last six years, versus ISNS 75% margins. Because of lower gross margins and higher operating expenses, ITI has had negative EBITDA margins every year for the last six years expect for FY2014. The company has only produced positive CFO two out of the last six years. This has occurred while the company has grown revenue every year except for 2019. The negative EBITDA margin is due to high and growing SG&A costs. Part of the issue seem to have been with the agriculture and weather analytics businesses (no revenue growth and increasing expenses year over year). With those two businesses sold, management is determined to continue to grow revenue and improve margins by keeping corporate costs flat. This brings us back to ITI’s ClearMobility product.
Exhibit 2
ClearMobility is ITI’s Saas offering, or more appropriately, Saas Plus a Box. ClearMobility is management’s strategy for increasing margins while still growing revenue. In the fourth quarter, ~50% of the transportation segments bookings are categorized as recurring revenue (22% of overall revenue). This is in-line with what the company has historically done. But it has greater ambitions. From the Q3’20 earnings call:
“But as was alluded to by Joe, there we did start to see continued momentum in several of our SaaS platforms, so we’re expecting that that rate of growth should grow much faster than the overall Company’s revenue growth rate. So, when we talk about low double-digits for the Company we would expect the SaaS growth rate to be substantially more than that as we get more adoption from our customers on these new platforms.”
Assuming the company can grow total revenue annually at 10% (historical average over last 5 years) with recurring revenue growing at 20% (assuming 70% gross margin for recurring revenue), and SG&A stays flat[1], the company should be able to be generate positive operating income. Even if SG&A as percentage of revenue stays flat, ITI will generate positive operating income. There is one problem with the revenue assumption.
Exhibit 3
Exhibit 4
Source: National Conference of State Legislatures 7/7/2020
Government Spending on Infrastructure
State and federal government agencies are far and away the largest customers of ITS. As demonstrated in Exhibit 3, State spending makes up most of the infrastructure spending, but capital is being allocated to maintenance and repairs, rather than new projects. Further, because of the COVID-19 pandemic, States are looking at year over year declines in revenue, which will shrink infrastructure spending budgets.
At the federal level, the Highway Trust Fund (HTF) revenue is collected from gasoline and diesel taxes. Since 1993, the tax rate has remained at 18.4 cents per gallon of gasoline and 24.4 cents per gallon of diesel fuel. With the increase in engine efficiency, the HTF has not kept up with rising demand (increase in miles driven but more efficient engines results in greater wear and tear on roads with less revenue). The deficit the HTF has been running since 2008 is supplemented with other Federal revenue.
At the State level, taxes are also collected on gallons of gasoline and diesel used. States will also source founding from other taxes collected (sales tax, vehicle registration, rental car/hotel taxes, etc.). Using Texas as an example (a state ITI management has mentioned as a location of potential growth), you can see since, basically every tax category is experiencing year over year declines (Exhibit 5). And most states can’t take on extra debt to make up the difference as 40 of the 50 states in the U.S. are required to pass a balanced budget each year.
Summary
The ITS industry is interesting to read about and research. With intense competition for a shrinking TAM, potential returns are not attractive enough for new capital.
[1] From Q4’20 Earnings call: Question
Okay. And so, to be clear that, that’s — let me — flat it in dollar terms, right? So that would represent a pretty significant reversal from this trend, where your overhead has been a growing percentage of revenue for the last several years. You’re saying you can hold that number flat in dollar terms while your revenue grows?
Answer – Douglas Groves
That’s right. That’s the plan.