Company Background

IAAC provides transaction-based services to clients with a specialty in emerging market countries and other small, innefficient markets.  The company does not take directional market bets but rather seeks to earn a reasonable spread on its transactions and hedges out all macro variables.  The company has a diverse set of growing revenue streams and is led by a strong management team who pooled their personal assets in 2002 to take a controlling position after successfuly building similar businesses at Standard Bank of South Africa, a bank specializing in international, niche markets.  The company has five main business units:

·         Equities market making (unlisted ADRs and local common shares)

·         Debt capital markets

·         Foreign exchange trading (exotic currencies)

·         Commodities trading

·         Asset management

The common thread is that all of the businesses focus on markets that are non-commoditized and under the radar of the major banks.  IAAC facilitates transactions in these markets for a wide range of clients, from charitable organizations that need access to non-liquid currencies to battery manufacturers that want to secure a supply of lead for the future. 

Respected value investor Leucadia National is the largest outside shareholder and has a seat on the board of directors, with almost 17% of the company.  At over $34 mm IAAC is Leucadia’s largest reported public equity holding, although they do have a large number of private and foreign positions (i.e. Fortescue Metals) that do not show up on SEC filings.  IAAC management and directors own an additional 41% of the company so incentives are closely aligned with investors.  

GAAP vs. Economic Earnings

GAAP earnings have decreased this year and the stock has fallen from $49 to $25, despite the fact that GAAP does not accurately represent the economic health of this business because of the way it treats IAAC’s metals trading business.  The company holds a significant amount of metals, primarily lead, on its balance sheet for future delivery to clients, which it keeps fully hedged in the futures market.  According to GAAP the company must keep the value of the metal on its balance sheet at the lower of cost or market, while the offsetting futures position is kept at the prevailing market price.  When lead prices rise the company takes a loss because the futures positions that they are short get marked up while the metal they own stays at the same price (cost). 

If IAAC changed this unit to a subsidiary of its securities broker dealer and was treated from an accounting standpoint like a commodities group at a major bank is, it would immediately report a $30 mm pre-tax profit just for marking up these metals from their cost to the current market price. This phantom $30 mm loss has already flowed through the income statement during the past two years.

With lead prices up 145% in the company’s last fiscal year (9/30/06 – 9/30/07) this accounting rule has had a devestating impact on the GAAP numbers despite no effect on the actual economics of the company.  Adjusting the past two years’ numbers to include market prices shows how large the discrepancy is:

With a current market cap of $206 mm the company is trading at 7.5x trailing EBITDA and 18.9x trailing earnings despite exhibiting triple-digit growth rates for the past 5 years and having plenty of opportunity for future growth.  Better yet, after 5 quarters of consistently moving up lead prices have fallen 27% since 9/30/07 so the accounting rule’s effect will not only stop being negative for the GAAP numbers, but will actually work in reverse and benefit the net income that the company reports.

Just to show the effect that the lead price alone can have in both directions on GAAP earnings, by assuming that the company does not grow at all next quarter but that the effect of metal prices on its unrealized inventory is the inverse of what it was last quarter (lead prices were up 29% last quarter and are down -27% so far this quarter), the company would report $9.25 mm in earnings next quarter alone (vs. a $206 mm market cap).  This is not a prediction of what will happen since both lead prices and the company’s short-term results are hard to predict with any precision, but does show how the GAAP idiosyncrancy can work in both ways. 

The most important number above is the adjusted net income since that reflects the actual economics of the company.  If the recent quarter is repeated throughout next year the company is currently trading at 11x adjusted earnings.  While perhaps not a conservative estimate since the last quarter was an extremely good one, the company has been consistently growing and sees plenty of opportunity for growth ahead.    

It’s also important to note that the company manages the business and its compensation on this “adjusted” basis, so expenses have been relatively high the past few years despite the GAAP numbers looking bad.  In the situation above its not unrealisitic to assume a similar level of expenses in Q4 since the “adjusted” numbers stay the same.  Given the nature of the business the bulk of expenses are comp-based, with a significant portion of those being variable and depending on the success of the individual business lines.  In addition, the company has $16 mm in loss carryforwards in the U.S. that it can use to offset some of the taxes, which I’ve assumed are 37.5%.  Finally, the company has been investing a large amount of capital in growth initiatives that have not yet begun to pay off, so run-rate earnings are likely higher than the current numbers (although the company is likely to continue to grow).  

Growth

The company has been firing on all cylindars lately, with all 5 business lines reporting record numbers in the quarter ending 9/30/07.  The recent market volatility has been a net positive for the company and has shown the effectiveness of its hedging programs.  

While the rapid growth of the business is an obvious risk, management has successfully built large businesses in their previous careers.  CEO Sean O’Conner was a founding exectuve at Standard Bank London, which during his 10 years grew from 6 to 1300 employees.  He established Standard’s operation in the America’s from scratch, including debt capital markets in Latin American and project finance and commodities trading for the mining sector.  President Scott Branch was at Standard for 7 years where he was the General Manager for the Eastern Mediterranean Region, and built a successful capital markets business in Turkey and the Middle East. 

Overall I have been impressed by management.  They have had a singular focus since the day they took control of the company and have thus far accomplished what they set out to do.  They constantly speak of return on equity, have quoted Buffett on conference calls, and have proven to be successful capital allocators.  

Risk Management

Given the nature of the business risk management is incredibly important, and I feel comfortable with IAAC given their experience, transparency, and strong management team.  IAAC closely monitors its overall exposure levels in addition to its long and short exposures by sub-asset class, and discloses the average and maximum levels of these exposures for each fiscal year.  The company does not take directional views on markets but looks to earn a steady stream of transaction-based spreads.  In fiscal year 2007 it recorded the following levels of daily revenue, which shows a high level of consistency: 

Primary Risks

• Organizational growth – IAAC nearly doubled its headcount in the past year (89 to 170) and now has 11 offices throughout the world, up from 4 at the end of 2006
• Access to capital – the company plans on expanding in the near future and will likely need additional capital to do so
• Lead prices rise after the recent pullback and sentiment remains negative

Summary

I believe that IAAC is significantly undervalued given its rapid growth, underlying profitability, strong management team, and its competitive advantage focusing on underserved, innefficicent markets.  There is a clear reason why it is mispriced and that factor is not only going away but will likely work in the stock’s favor beginning this quarter.