Autoscope Technologies (AATC)

Thesis:

Autoscope’s 40% net margin royalty business has gone unrecognized by the market due to the dilutive effects of a low-margin subsidiary which was sold in September for $4.8M cash. In light of its ability to grow at +10% annually for the next decade, the company is grossly undervalued at a 30% earnings yield less net current assets.

Overview:

Autoscope provides video image vehicle detection and data collection software through its non-intrusive sensors to traffic management systems across the United States. Autoscope’s video software transmits data to intersection signal controllers to change traffic lights. It is also used to manage traffic in real time and can also be saved for traffic planning purposes.

There are two major parts of the sensor traffic management system business:

1. Software - Machine vision, vehicle detection, and data collection offerings are just a few of the offerings required for efficient traffic management. The technical software behind these offerings is complex and has high fixed costs to create. The software is bundled with the hardware and installation when sold to traffic control entities.

2. Distribution - Similar to the marketing processes directed at other government entities, traffic control entities determine the provider(s) of their systems based on price but also on the ease of installation, product support offerings, etc. There is a preference given to companies with a range of desired products offered that has resulted in a few major players in the field succeeding by marketing bundles of related products.

Autoscope has granted an exclusive contract to the leading distributor in the intersection control market, Econolite, for the manufacturing, marketing, and distribution of Autoscope sensors in the United States for a 50/50 split of gross profits. Importantly, Autoscope is only responsible for the software and product support behind its applications. This contract was originally agreed upon over 30 years ago and has been extended several times with a current expiration date of 2031. Econolite is subject to an undisclosed minimum annual sales number which if not hit would allow Autoscope the option to terminate the contract. Additionally, it can be terminated by either party with 3 years' notice.

The contract is very advantageous to both parties because of the overlapping distribution costs of marketing sensors with the rest of Econolite’s offerings. Further, it allows Econolite to upsell additional products in their bundled offerings and Autoscope to integrate their solutions into Econolite systems. We believe there is a strong probability that the contract will be extended beyond 2031.

As a result, Autoscope benefits from a royalty-like business model with gross margins of 95% and only 4-6% of revenue needing to be spent on product support.

Why Now:

Prior to September, Autoscope operated a radar systems subsidiary in which it took on the full role of software production and support, manufacturing, marketing, and distribution. In recent years, this subsidiary contributed $4-$5M to the top-line, nearly all of which was eliminated by product costs which ate up 50-60% of revenue, and sales and marketing which ate up another 30-40%. Simply put, this was a low-margin business that diluted the returns of the pure-software royalty business while contributing little to the bottom-line.

In September, Autoscope announced the sale of the radar systems subsidiary for $4.8M cash, expected to close in the fourth quarter. This will have the effect of expanding gross margins from 80% to 95% and operating margins from 30% to 50-60% as marketing and unneeded R&D for the segment is cut.

Two months later, Autoscope reported $3.8M in revenue, all royalty, and $1.5M in net income, a 46% and 150% increase yoy. With fairly fixed R&D and SG&A, operating margins were driven from 31% to 49%. The last nine months tell a similar story with revenue of $10.5M and net income of $3.4M, a 71% and 7263% increase yoy.

This is a case of significant operating leverage combined with 1) expanding margins and 2) top-line growth — both of which are trends that will be sustained over the long-term.

Secular Tailwinds:

We believe a 10% revenue CAGR is reasonable for the next 10 years because of the accelerating urban congestion post-COVID driving traffic management system replacement and the technological and installation advantages of Autoscope’s non-intrusive sensors versus the inductive loop sensor which has hardly improved since the 1960s. Previously, even with inferior technology, it was difficult to argue for the replacement of city-wide traffic management systems just due to the cost of implementation — this was especially the case during the pandemic with record low traffic. Now, the 2021 infrastructure bill has provided the funds for new municipal traffic management system makeovers, and non-intrusive sensors are increasingly being demanded as a part of it. With 60% of the traffic control sensor market being made up of inductive loop sensors, Autoscope has a long runway for growth. As demand normalizes and infrastructure funds are spent over the next several years, Autoscope’s current rate of growth will be simply unsustainable and will likely decelerate to the 10% area long-term.

Valuation:

A $35M company with $3.4M in net income in the last 9 months, ~4.5M annualized, and a 10% long-term growth rate already seems like a solid investment. Now, add in the fact that it will have over $20M in net current assets post-sale of its subsidiary. You’re now getting ~$4.5M in annualized earnings, with an expectation to grow at 10% annually over the long-term, at a $15M MC less net current assets or a 30% earnings yield.

Even assuming the demand for its products is short-lived, and net income is cut in half this time next year, you’re still getting a 15% earnings yield for a company with a very attractive business model. The much more likely scenario, a deceleration in the revenue growth rate to the 10% level which is sustained for the next decade, would present a 5-year IRR of ~30% assuming a 15x multiple on earnings.

Reason for Opportunity:

A reason this opportunity exists is due to the filtering out of investors unwilling to stick around after the voluntary delisting of the common stock in late 2022 which caused a 30% decrease in the stock price. Despite the unreasonableness of expecting a company of Autoscope’s size and shareholder base (<300 people) to deal with the regulations and expenses associated with listing, it took roughly nine months to get back to the pre-delisting stock price.

Another reason for the mispricing is the supply chain troubles that the company faced over the last two years. Starting in 2020, this had the effect of artificially depressing revenues, and thereby net income until 2022 when it all suddenly jumped +50%. The market seems to be pricing in the assumption that this jump is temporary and that revenue will revert to the 5-year mean of $8-9M in a COVID-beneficiary-like fashion. This is in contrast to the reality: that the jump is representative of two years of pent-up demand for the company’s products, and that this level of demand is sustainable long-term because of secular tailwinds.

Catalysts:

An acquisition of Autoscope by Econolite seems probable considering it could reasonably cut ~20-40% of R&D immediately, as there is no reason R&D should be flat yoy with the subsidiary sold, and likely a similar portion of SG&A, as redundant marketing costs and management layers could be cut. This along with the ownership of the more profitable half of its sensor operations could justify a premium above fair value of +50%. The mispricing of Autoscope’s common stock only makes a takeout that much more likely.

Absent a takeout, market realization of the earnings power and growth profile of the royalty business is the most realistic way that the underlying value is realized by shareholders. Further elimination of vestigial expenses from the radar systems subsidiary could accelerate this realization. Additionally, an increase in the quarterly dividend and/or a stock buyback seems likely.