Wednesday, April 22, 2009

The Marketing Alliance – A Micro Cap with a Network Effect Advantage

Below is an article written by my colleague, Matt Miller, and I about a small company that we think is a good business trading at a significant discount to its intrinsic value.

The Marketing Alliance – A Micro Cap with a Network Effect Advantage

By Joe Koster and Matt Miller

Companies that benefit from the network effect can be a powerful source of investment return when purchased at the right price, especially if one can discover them when they are still relatively small. Businesses like eBay, American Express and Microsoft have grown from something very small to something very large thanks to the compounding effects of their networks.

The basic premise behind a network effect is that the value of the network increases as more users are added. If you’re a seller on eBay, each new person added to the network is another potential buyer of your merchandise or a seller of other merchandise that could bring in other buyers to the network. So the network continues to grow and become more valuable with each and every person/user added to it.

The concept of network effects may sound pretty simple, but it can be very difficult to find companies that benefit from such an advantage and those that are well known (like those companies mentioned above) are often either too desired to buy at a good price or too big to get the full benefit as the network scales. However, there are some companies in the micro-cap world that, although they aren’t in an industry or network capable of getting anywhere near the size of the well known large cap names, benefit from the network effect and derive some level of competitive advantage from that effect. We believe The Marketing Alliance (Ticker:
MAAL.PK) is one of those companies.

The Marketing Alliance, Inc. (TMA), which is fully reporting and traded on the pink sheets, is an aggregator for a network of small, individually owned and operated insurance agents. The agents that the company serves typically offer a variety of products, but TMA specifically focuses on their life and long-term care insurance and annuity businesses. TMA provides marketing support and back-office support that is crucial to the underwriting process. The back-office support includes technology and application processing. TMA also works with and negotiates directly with insurance carriers on behalf of the agents it represents.

Below are the three key features that are attractive to us about the business model:

§ High returns on capital employed
§ Significant benefits from the effects of a network
§ Moderate competitive advantage

TMA manages a network of small agents. At its essence, that is the business—the network. Because there is a limited fixed investment to maintain the network, the company delivers high returns on capital. The bargaining power created by the pooled production of a large network enables TMA to negotiate directly with insurance carriers for better terms than any individual agent could achieve on its own. And, as each agent is added to the network and as each agent grows its business, TMA improves its bargaining position. Though some of the benefits of this increased leverage returns to the agent, TMA also benefits. The company’s advantage comes from this network of small agents. It has successfully built up a captive agency base, something that would take years to develop and scale to achieve. From an agent’s perspective, it is usually not attractive to leave one network for a smaller network. Additionally, because of the demands of automation pushed by the insurance carriers, TMA has integrated their technology, systems and processing with that of the insurance carriers and its agents. Agents prefer not to, and often cannot, make the investments necessary to accomplish this in a cost-effective manner. The scale of the network allows TMA to do it for them.

We believe the attractiveness of TMA’s business is matched by the attractiveness of the valuation at which we have acquired our shares and at which it is currently valued by the market. At $4.00 per share, where the current ask is, here are some statistics relating to the company’s valuation:

Price $4.00
Shares Outstanding 1,945,702
Market Cap $7,782,808
No Debt Outstanding
Excess Capital (estimated) $3,700,000
Net Capitalization $4,082,808
LTM Operating Earnings $2,178,151

Net Capitalization / Operating Earnings 1.87

We believe that the company is worth between $9.00 and $13.00 per share depending on assumptions for future growth. So with little growth the company is worth more than twice its current price.

An astute observer will notice that special attention is required regarding management’s stewardship of the excess cash that the company is generating. TMA is generating so much cash in excess of the company’s needs to grow the business that the problem becomes what to do with that cash. TMA does pay a significant dividend, resulting in a 5.75% yield on the quarter-end price. Unfortunately, the company entered mid-2007 with a substantial portion of its excess capital in the equity markets. As you might expect, the performance of that capital over the last 18 months has not been great. In fact, the company has shown large losses on its investment portfolio, including a loss of approximately $1.8 million on a marked-to-market basis since October 2007. Though the company continues to allocate some capital to equities, its exposure has now declined. We have encouraged the company to store excess capital in a more prudent manner or return more capital to shareholders via dividends and buybacks. Given how well the company’s management team, including CEO Tim Klusas, has positioned the company there is little need for such equity exposure on the company’s balance sheet.

As a note, the company’s stock is fairly illiquid, and so a word of caution is in order. Despite the illiquid nature of the stock, we believe an investor ought to be excited to own a good, small business with attractive prospects for growth at an attractive price. The company’s dividend yield and the fact that it benefits from a network add significantly to the thesis. We believe the recent poor performance of the company’s investments will abate and in time the market will recognize the true intrinsic value of the company.

*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision. The authors of this article both have an indirect interest in the stock of The Marketing Alliance (MAAL.PK).