Operating in a niche industry providing small orders (less than $2,500) for physical foreign currency in specific denominations, Currency Exchange International, Corp. ("CXI" or "Company") is a focused operator beginning to achieve scale and associated operational leverage. As CXI’s market cap was ~$30 million earlier this summer (before the warrant issue in September), many investors have not been paying attention to the CXI story. 

Including the warrants exercised in September 2013 which raised $10.4 million, the company is both well capitalized for future growth and increasing liquidity which should allow both US and Canadian institutional investors to access the market. Currency Exchange common stock is currently vastly mispriced in the market. The following outlines the rational thereof:

Excellent Competitive Position

• Currency Exchange is the #3 player in a profitable niche and is winning business from legacy bank customers.
• Competitive advantage in technology & service.  (Please see the “Customers” section below for greater details).
• Focused non-competitive partner of local banks. Regional banks do not want their private data going to rivals such as Bank of America or Wells Fargo who may attempt to compete with profitable branch locations as much as possible.

Niche, Non-Price Competitive Industry:

• Foreign currency procurement is a low capital intensity, recurring revenue service business.
• High returns on capital (~20% as a historical average) with low risk (inventory currency hedged daily).
• There is a reason private-equity has been involved in the industry (Please see precedent transactions on page 12).
• Competitors infrequently compete significantly on price as a way to win new business.
• High barriers to entry for both new entrants and even large banks.  Massive network effect of technology and logistics such that CXI and other current competitors can perform the services much more efficiently than new entrants or even a large bank such as Chase.  (Please see the wholesale section on page 4 for more information).

Attractive Valuation

• Impressive margin profile, with EBITDA margins in excess of 25%.
• The Company currently trades at 8.3x 2014E EBITDA & should be trading for at least 15.0x and arguably higher given CXI’s growth trajectory and precedent transactions.
• CXI is a cash flowing business unlikely to need additional equity capital in the short and intermediate term.

Extremely Steady Cash Flow Model

• The business will be able to utilize financial leverage when EBITDA reaches $10 to $20 million.  While not included in our valuation cases – a dividend recap three or more years out is highly achievable and CEO Mr. Pinna is unlikely to hesitate to leverage his incredibly sticky business.

Operational Leverage Tipping Point:

• With 4 vaults including a 5x increase in vault operations staff, a scalable platform, and a growing cadre of banks working through the sales pipeline, CXI is poised to begin earning new client revenue which will increasingly fall to the bottom line.
  • Note: this will keep getting better and better as CXI gains share and begins servicing ever larger institutions
  • Foreign currency funding costs will decrease 15% to 20% once the banking charter is approved (targeting Q1 2014) as CXI will have the ability to go to the US Federal Reserve banks and the Bank of Canada for currency instead of a large bank acting as in a wholesale capacity.
  • Becoming a banker’s bank will allow CXI to sign large banking clients in both the US and Canada which have been hesitant (compliance etc.) given CXI’s money service business regulatory status.

Owner Operator Model:

• Management is well-versed in the business and aligned with shareholders.
• CEO Randolph Pinna owns just under 25% of the business and is thusly highly incentivized to maximize shareholder return.
• Mr. Pinna started the predecessor business (Foreign Currency Exchange aka “FCE/Wells” – now owned by Wells Fargo) in 1987, sold FCE to the Bank of Ireland in 2003, and led the carve-out of what would become CXI in 2007.

Introduction

Currency Exchange International, Corp. ("CXI" or "Company") is a B-to-B wholesale provider of foreign exchange services to regional and mid-market banks. Think “high-quality technology & logistics that procure desired foreign currency notes for bank customers”. Expressed more formally, CXI provides retail and wholesale currency exchange, and related products to banks, travel companies, and retail clients in North America. Its principal products and services comprise FX exchange: wire transfer payments, purchase and sale of foreign bank drafts, international traveler checks, and foreign check clearing.

CXI’s competitive advantages are significant

(1)  Flexible, scalable technology platform

(2)  Strong customer service & ease of use

(3)  Focused, passionate management and

(4)  Prices in line with large competitors with the service quality of a specialist.

(5)  Customer banks don’t have to partner and thus share valuable branch data with a competitor (i.e. FCE/Wells or Bank of America)

The first two competitive advantages, technology and service, are paramount to CXI’s continued success.

Currently regulated as a money service business (same as Western Union and Travelex), CXI is in the final months of a year-long process to become a banker's bank in Canada. This endeavor (or “endeavour” if you are Canadian!) is expected to conclude shortly. As a “banker’s bank”, CXI will provide FX services to local banks and will not open branches or make loans.

There are two main reasons for CXI to undertake the arduous process of becoming a banker’s bank:

(1)  Increased regulatory oversight which increases the transparency of CXI’s business and gives additional comfort to customer compliance staff and

(2)  a 15 to 20 basis point decrease in the cost of sourcing foreign currency given the access to both the US Federal Reserve window and the Bank of Canada (real costs, although not seen by public investors in the financial statements as they are encapsulated in the revenue line).

There are two main sides to the business: wholesale is the focus of the business while select retail locations allow the Company to make solid margin, source foreign currency as net buyers of currency, and leverage its FX currency logistics network. Note: One of the main reasons CXI is undervalued is the challenges investors face in understanding CXI’s core value proposition as the company appears (when reading historic annual reports) to have roots in retail locations in which Travelex dominates.

Reality is much different: the retail focus ended abruptly in October 2010 when CEO Randolph Pinna’s non-compete agreement with his former division expired (Foreign Currency Exchange or “FCE/Wells”). Note that FCE/Wells is now owned by Wells Fargo yet CXI team is now winning considerable business from FCE/Wells due to their technology & service.

Wholesale Business Primarily comprised of meeting the physical FX currency (< $2,500) customer demands

Centralized Model  (Majority of FX volume goes through this channel)

CXI offers bulk wholesale banknote trading (i.e. giving a customer an order of paper currency in the correct denominations per customer request) at highly competitive best rates and high levels of service. Orders are either phoned in or ordered online through www.ceifx.com.

De-Centralized Model       (Majority of the ~5,700 bank branches fall into this category)

The holy-grail for CXI in terms of customer retention, CXI can place their software directly in a branch and eliminate the step of the branch calling a customer’s order into bank headquarters and having a specialist enter the request to CXI.  The challenge of rolling out the de-centralized model is the high turnover of bank employees & retraining on a system.  CXI has mitigated this impediment by developing an easy-to-use system and provided high class service.

The de-centralized model is not one which customers adopt on day one yet remains a strong upsell potential for customers who are comfortable with CXI’s technology and service levels. The company’s wholesale network has more than doubled in terms of ultimate branch locations in the 13 months ended 10/31/13.

Locations

See PDF for Location Chart

Additionally, CXI places foreign currency note inventory on consignment for branches that have significant volume (70 locations at 6/30/13). CXI also competes in foreign currency wires and foreign check clearing.

While CEO Randolph Pinna completed his 3 year non-compete from October 2007 to October 2010, his team was not resting on their laurels.  Rather, they built out the technology platform (www.ceifx.com) as a flexible, top-notch, web-based FX platform that is now the core of CXI. Don’t bother looking on the balance sheet for this asset, the software development costs were conservatively expensed as incurred.

So what is the software worth? (i.e. how much would it cost to replicate?) Around $5 million dollars.  While that doesn’t sound prohibitively high for a large firm, let’s consider the possible replicators of CXI’s software:

1. Large incumbent FX players (Wells Fargo and Bank of America) have legacy systems which their customers currently are using and are reticent to update. (Banks make vendor changes deliberately – taking a year or more to make a decision on something of this magnitude).

1. Money service business (“MSB”) competitors such as Travelex and Western Union also have little incentive to provide their customers a more flexible tool which allows customers to see & negotiate the fairly high fees they charge. (Note that US Bank does use Western Union for wholesale FX and has Travelex locations in select branches.)

1. In-house FX Department of a large retail bank: Think about the decision if you are Chase. You can build something from scratch that will take a couple years and significantly drain your IT resources all so you can capture all the margin on your customers FX changes. Or you can save yourself the hassle and go with someone like Wells Fargo (legacy system) or CXI (flexible system). Either way you are still going to make a good margin (If Chase charges 5% on FX they net 4% and CXI gets ~1%).  As such, the last 1/5^th of that revenue probably isn’t worth the headache to build out your own technology platform and handle all the logistics.

1. New banker’s bank entrant: While possible for a competitor such as US Exchange House (West coast currency business with no software and a focus on precious metals), the question would be “what is the ROI in the intermediate term? (i.e. how many new clients would a new entrant have to land to make a return on their ~$5 million investment?)  The answer is likely prohibitively high.

Per the above commentary, there are high fixed costs of the technology platform & logistics network that are massive barriers to entry.  This is positive for FCE/Wells, Travelex, and CXI – leaving them to compete with each other on foreign currency information.

At October 31^st, 2013, the retail division was comprised of 26 corporate outlets and 100 affiliate locations. CXI plans to add 4 or 5 new retail locations per year – the CapEx is minimal and the returns are fine given the select locations CXI chooses (reasonable location for low rent with the strategy to robustly withstand any downturns in tourism / travel)

The retail business has higher margins but the wholesale business has significantly more scale (in terms of volume) and can be expanded at a greater pace. The retail businesses involve greater care in selection of locations and require comparatively more management time per volume of currency exchanged.

Retail locations generally act as a net buyer of foreign currency compared with the wholesale business, which is a net seller of currencies. Excess currencies collected by the retail side are then redeployed to the wholesale business - which reduces sourcing costs.

 Affiliated retail locations tend to be highly lucrative as the Company incurs no occupancy or payroll costs. CXI merely provides foreign currency and systems on a consignment basis. Additionally, the Company generates high profit margins on the sale of attraction tickets and phone cards in both affiliated and retail locations.

Wholesale pricing is typically around 100 basis points for CXI while the bank decides what to charge the underlying customer (so if a bank charges 6.5% per transaction, CXI get 1.0% and the bank retains 5.5%). 

Pricing power with respect to the consumer is ultimately the banks.  Pricing power when it comes to CXI & their bank client is more or less a wash (industry competition is more on technology & service with less focus on price). This transparency has aided CXI win business especially against other MSBs who historically have charged a bank’s customers exorbitant fees and kept the lion’s share of the profit.  (i.e. Travelex)

The below chart is highly uncertain as to the validity of the numbers and was compiled by us to estimate the approximate volumes and pricing in the wholesale versus retail channel. For obvious reasons, CXI does not provide this info publically. See PDF for Graph

Vault Network & Logistics

CXI uses two main vaults (in Miami and Toronto) and two “local mini-vaults” (in California and New York) as distribution centers for physical currency. The company uses Federal Express to deliver the currency packages to customer bank branches and customers directly (thus removing one of Travelex’s former competitive advantages).

Background

CXI as it is known today actually began when its founder/CEO Randolph Pinna established Foreign Currency Exchange in 1987. Before being bought by the Bank of Ireland, FCE itself was publicly traded.

After being  a subsidiary of Bank of Ireland for five years, Randolph Pinna formed CXI in 2007 by buying back the retail operation of FCE (netted against an earn-out / earned bonus of a few million), which included retaining 36 employees and key managers. In 2011, the Bank of Ireland disposed of the remaining assets to Wells Fargo for ~$44.0MM. 

In March 2012, CXI IPOed in Canada – selling 1.38 million units to raise $9.2 million Canadian dollars. Each unit was comprised of a common share and one common share purchase warrant. The warrants entitled the shareholder to buy an additional common share at CDN $7.50 and all warrants were exercised before expirations in September 2013.

Canadian Bank Charter

In November 2012, CXI submitted its application to become a banker’s bank in Canada. The new bank will be called "Exchange Bank of Canada" in English and "Banque de Change du Canada" in French and will have its head office in Toronto. Obtaining a Canadian bank charter affords the Company numerous advantages, including banking with Central Banks thereby obtaining a source of stable, cost-effective funds, collateral reductions with corresponding banks, and enhancing existing bank relationships.

CXI chose to become a regulated Canadian bank instead of a US bank due to the relatively less onerous process as well as lower cost of being a Canadian bank.  Either jurisdiction (along with a couple additional steps) will allow the Company to access both the US Federal Reserve window and Bank of Canada to procure desired foreign currency (effectively lowering the cost of CXI’s “inventory”).

While this major step has incurred significant costs – the costs are onetime in nature and the anticipated improved profitability it is anticipated to afford the company outweighs the startup and increased operating costs of the bank. Notably, it is expected to allow CXI to win its biggest revenue generating customers ever, as many larger banks require its wholesale FX provider to be a bank as well.

As a money service business, CXI currently processes their excess foreign currency through large banks. Once they complete their transition to a banker’s bank, they will have access to currency at the Fed window (after another ancillary application).

Employees

At October 31^st 2013, CXI had 161 employees (number naturally higher now).  Many employees (including many vault staff) are part time and the Company utilizes co-ops with local colleges to hire for peak summer periods et al. CXI has no unionized employees and “blocking and tackling” vault labor is plentiful.

Chairman & CEO Randolph Pinna founded CXI’s predecessor Foreign Currency Exchange, and has been the driving force in this niche business for 26 years. Randolph and his father started FCE and served as the President and Chief Executive Officer of Foreign Currency Exchange Corp. Bank of Ireland Group. Mr. Pinna received a Bachelor degree in Finance from the University of Central Florida in Orlando, Florida.

SVP & Chief Risk Officer Stacey Prakash has been Senior Vice President of Currency Exchange International Corp. and Foreign Currency Exchange Corp. since June 2011 after Randolph hired her away from FCE.

Previously, Ms. Prakash served as Vice President, Operations and Assistant Secretary of Foreign Currency Exchange Corp. From 2009 to June 2011, she was the Owner/Manager of MSB Consulting LLC. She served as the Compliance Officer of Foreign Currency Exchange Corp from 1996 to 2009. Ms. Prakash received a Bachelor's degree in Finance from the University of Central Florida in Orlando, Florida and a Political Science degree from the University of Florida in Gainesville, Florida.

CFO Peter Scherer: Peter was hired in May 2013 in Toronto to head up the Canadian bank effort and build out the management team.  Previously, Mr. Scherer served as Senior Vice President and Chief Financial Officer at AGF Trust Company. He served a number of senior financial positions at AGF Management Limited. Mr. Scherer served as Vice President of Finance and Treasurer of AGF Management Ltd. until December 1, 2007. He holds a Chartered Accountant (CA) and Chartered Financial Analyst (CFA) designation. Mr. Scherer received his MBA from the Wharton School, University of Pennsylvania.

“CFO #2” Wade Bracy: While technically controller, Wade Bracy is essentially the US based CFO – having been CFO for years before CXI undertook the Canadian exchange bank task.  Mr. Bracy is close with customers and has been an integral part of the management team for years. Mr. Bracy also worked for Randolph at FCE.

COO Matthew Schillo: COO since October 2007. From 2004 to 2007, Mr. Schillo was the Retail Vice President of Foreign Currency Exchange Corp. Mr. Schillo received his Bachelor's degree in International Business from the University of Akron in Akron, Ohio.

Note: In this day and age of professionals having multiple jobs with various firms through their careers, it is unusual to see a management team this cohesive.

Customers

CXI’s customers are primarily small retail banks with 20 to 200 branches. Please see customer call notes in appendix for additional information. Early on, many of CXI’s bank customers are customers with whom the CXI team had a relationship when they were at FCE.  Initially small regional banks were CXI’s target customer and now they are able to win larger accounts (such as 1,700 bank branch Regions Bank signed last fall.  We expect CXI to continue wining ever increasingly larger banks as they move “upstream” with their clear value proposition.

In terms of revenue generated, there are no customers greater than 10%.  Further customers are diversified by type (banks, MSBs, and retail customers) and geography within both the US and Canada.  Customer concentration risk is low with no customers over 10% of revenue.

Note: While management insists they are winning business away from both BofA and Wells Fargo, I haven’t yet been able to quantify CXI's win-rate against the 800 lbs. gorilla of Bank of America. Regardless, CXI is taking industry share. Please see PDF

Note: Prior to October 2010 CXI was under a non-compete on their main wholesale business per Randolph’s exit agreement with FCE/Wells.  As such numbers prior to 2011 are wholly unrepresentative of true economics of the business today. Additionally, given the year to multi-year sales process for banks, one could argue that 2011 isn’t fully pertinent either. Please see graph

Operating margin is fairly seasonal with the peaks at peak summer months when CXI has the volume to amortize fixed expenses more efficiently. Please see  graph

If you note the operating margin declines in the quarters ending 12/31/12 and 3/31/13 in the above chart you aren’t alone. The driver was increased salary expense as can be seen in the below chart.  This appears to simply be the classic case of a small business hiring to maintain their ability to operate robustly.  Nonetheless, keep an eye on this going forward.

ROE and margins have recently been lagging as the Company has aggressively invested in expansion, the IPO, and the exchange bank. Regardless, ROE and other financial metrics remain strong as shown below: Please see graph

Industry

The FX technology & service industry in the US is a niche market with few competitors.  While banks provide these services (typically cash transactions of $2,500 USD and lower amounts) to their customers, banks make only marginal fees on this business relative to many other services.  As such, providers compete on service and technology ease of use.

The total market will grow in line with bank branches and small FX transactions – likely in the low single digits.  The key for disruptors such as CXI is to gain share against larger bank incumbents as a preferred partners due to premier service and technological efficiency.

Competition

The Company faces competition from established competitors such as Travelex Group, Wells Fargo Bank, Bank of America and American Express, and also from competitors using alternative technologies. While the market for foreign currency exchange is highly fragmented in the United States, there exists little in the way of barriers to entry to this type of business. Please see PDF.

Precedent Transactions

 Please see PDF for graph

Scenario Valuation Analysis - Please see PDF for Excel Charts

Base Case

The base case portrays a reasonable – yet highly achievable case for CXI.  Below are the assumptions used in the base case scenario:

• Sales are expected to grow at a low double digit CAGR for 5 year projected period.

• EBITDA margin expected to incrementally grow towards 40%.

• The Company is not expected to issue a dividend nor repurchase shares during the 5 year period (highly possible in out years along with the aforementioned dividend recapitalization).

 Stress Case

The stress case portrays a weak five-year forecast for the Company.  When compared with the base case sales growth is moderated while lower EBITDA margin is the main difference.  Below are the assumptions used in the upside case scenario:

• Flat sales growth in 2014 yet expansion due to the banker’s bank net revenue increase.  Thereafter, sales decline in 2015 due to an assumed recession.

• EBITDA margins are pressured due to increased competition.

• The Company is not expected to issue a dividend nor repurchase shares during the 5 year period (highly possible in out years along with the aforementioned dividend recapitalization.

Upside Case

The upside case portrays a strong five-year forecast for the Company.  When compared with the base case forecasted sales growth is the main difference.  Below are the assumptions used in the upside case scenario:

• Sales are expected to grow at nearly a 20% CAGR for 5 year projected period.

• EBITDA margin expected to remain in the 33% to 35% range as CXI focuses on top line growth in excess of the base case.

• The Company is not expected to issue a dividend nor repurchase shares during the 5 year period (highly possible in out years along with the aforementioned dividend recapitalization.

 Intrinsic Valuation - Please See PDF

An average of Free Cash Flow to the Firm (“FCFF”) via DCF, EBITDA multiple and price to earnings was used to determine the intrinsic value for all three cases. Using the three cases, our estimate of intrinsic value is ~$22 per share.

So the above discounted cash flow valuation indicates a dramatically undervalued firm. Let’s look at actual historical transactions to ascertain if our valuation makes sense. Using multiples below and in-line with precedent transactions, we obtain a price between $13.9 to $23. Importantly, we only consider $5MM of cash as excess and deduct that from our EV calculation, which may prove to be ultra-conservative given the Company has $34.0MM in cash per the latest financial statements.

So the answer is yes, with a base line multiple of 12.0x EBITDA a safe bet here CXI should be trading at least in the low teens to be in line with historical transaction. Yet, what about 2 to 3 years forward? It’s readily achievable that CXI could generate $10 million of EBITDA – what would the stock valuation be in that case? To summarize the charts in the PDF, we get a per share value from $18.7 to $32.1 per share.

Catalysts to Value Realization

Not every day do investors have a chance to purchase a focused, high-quality business operating in a protected niche at an operational tipping point for ~2/3^rd precedent transaction EBITDA multiples. Yet the opportunity exists currently in shares of Currency Exchange International.

As Warren Buffett says “investors pay a high price for certainty”.  As applied to Currency Exchange, public investors currently have a chance to pay a low price for a business that has a phenomenal probability of performing extremely well over the next few years.

Recommendation: Buy Currency Exchange International stock in the short run and hold for a 2x to 3x return over 3+ years before considering selling.