Value Investors Club / Meta Financial Group (CASH)

Description

META FINANCIAL GROUP

Meta Financial Group is the combination of a profitable, fast-growing (150% growth TTM) prepaid card services provider and a poorly run community bank. At a market cap below $100mm, the company is clearly "undiscovered". The hidden value within the prepaid business (“MPS”) is far greater than the value of the community bank (“the bank”) and the current market cap. At current prices and netting out the bank, it is possible to buy MPS at 8.5x NOPLAT.

Industry. Prepaid cards are the fastest growing sector of the payments market. While closed-loop giftcards have clearly been growing at extremely high YoY rates, the bigger opportunity lies in open-loop cards. While closed-looped cards are only usable within a given store or network, open-loop cards function like debit or check cards usable anywhere a Visa or Mastercard is, but are not linked to a bank account. They are being promoted as a method to reward or pay employees, monitor healthcare spending, lower cross-border remittance fees, replace travelers checks, and provide the unbanked and underbanked with an easy way to make reservations or shop online. While the Mercator Advisory Group (one of three specialist consultancies that have put out research) estimates $150B was loaded on closed-loop cards in 2005, only $15B was loaded on open-loop cards. Estimates vary, but it appears the next few years will yield 50% or greater growth in open-loop cards as various possible uses become mainstream and the US economy becomes even more "cashless." While fees may seem high ($4.95 card initiation, $2 maintenance fee per month, etc), they are not substantially higher than your average low balance checking account including ATM fees. In addition, they offer a payments solution to the unbanked and underbanked. A rough guess at the spending power of the unbanked and underbanked would lead to numbers as large as $1 trillion per year (80mm times $12.5k income per capita).

Current Valuation.
Shares outstanding: 2.88mm (assuming exercise of 374k options @ 19.88)
Stock price: $30.3
Market capitalization: $87.3mm
Cash received from option exercises discounted by 20%: $5.9mm

Net Market Cap: $81.4mm

MPS is worth at least $110mm ($200mm is my best estimate). The bank is worth $35mm or more.

MPS. Meta Payment Systems is a rapidly growing market leader in the issuance of open-loop prepaid cards. Open-loop prepaid cards are cards that function just like debit cards – they are usable everywhere the network (Visa, Mastercard, etc) is accepted. For example, Simon Malls has an agreement with MPS whereby MPS issues their Internet-purchased and breast cancer awareness prepaid cards. Simon collects the funds and fees and sends the cash on to Metabank for storage.

MPS started this business in late 2004. The business is dependent on one entrepreneur, Brad Hanson, and his team which he brought over from another leader in the space, BankFirst. According to Hanson, he made Bankfirst a leader in the prepaid space early on (which is corroborated by findings such as Western Union and H&R Block’s prepaid cards being “issued by Bankfirst”). However, because Bankfirst ran into issues regarding subprime credit card lending, the company was unwilling to pursue the prepaid space as aggressively as Hanson envisioned. Hanson joined MPS because it afforded him maximum freedom and growth. Why Meta? Hanson was the next door neighbor of a member of the controlling family and leveraged that relationship.

Due to limited disclose, the economics of MPS are difficult to break down to a very granular level. In contracts like the one with Simon Malls, MPS makes money four general ways: 1) interest on no-cost deposit balances 2) card issuance fees 3) interchange fees and 4) card breakage (cardholder loses or does not fully empty her card). On a quarterly basis since inception, the segment financials are as follows (note that their business year ends Sep 30 so the 1Q sees the swell in Christmas-linked deposits):

       Int inc    Non-int inc   Non-int exp   Oper inc   Deposits
3Q05: $0.00mm    $0.54mm       $0.77mm      -$0.23mm    $ 16mm
4Q05:  $0.05mm    $1.13mm       $1.08mm       $0.10mm    $ 71mm
1Q06:  $0.76mm    $1.24mm       $1.24mm       $0.76mm    $104mm
2Q06:  $1.23mm    $1.50mm       $2.19mm       $0.54mm    $118mm
3Q06:  $0.98mm    $2.58mm       $1.98mm       $1.58mm    $165mm
4Q06: $1.07mm    $2.85mm       $2.70mm       $1.22mm    $163mm
1Q07: $1.39mm    $3.46mm       $3.95mm       $0.90mm    $234mm

Importantly, interest income is artificially low because they book income to that unit at the average rate that the bank borrows. If MPS earned interest income at the full value of the MPS deposits, it is likely the interest income figures would be roughly double these levels. Adjusting for the transfer pricing between the business segments, MPS would show operating income of roughly $8.5mm over the last twelve months (average balance of $170mm times 5.25% short-term funds rate plus non-interest income minus non-interest expense). Given seasonality and large initial contracts, it is difficult to tell the expected organic growth rate of the business. For instance, while 3Q06 and 4Q06 were flat in terms of deposits, it is not clear to me that the growth rate changed during that period. Another take on growth going forward comes from Visa: Visa, who refers a significant amount of business to MPS, expects the open-loop prepaid market to more than double next year; MPS expects to do better than that.

MPS's expense structure should scale well. Currently a great deal of the segment's $3.95mm in 1Q07 expenses are employees, and many of these employees are investments in future revenue (and would more properly be capitalized). Of the non-interest expense in the 1Q07, only $1.65mm was related to card processing. The core business of issuing new cards is highly automated, and beyond legal and compliance folks (about 50 of these at MPS) the remainder of employees are either client reps, salespeople, software developers or new business development. The company is working to become a marketer in certain situations so that it can capture a larger portion of the value of these cards in the future. For instance, they currently supply thousands of small banks private label branded prepaid solutions to sell in branches. It isn't clear how much deposit volume this brings, but the terms of these deals are better than deals with Simon Malls and similar large companies with their own marketing. Company management has a long list of projects that will allow them to leverage their position as a leading issuer to add additional services for clients. Furthermore, they are very visible within the industry - there is a prepaid card expo in late February where MPS is one of the four primary sponsors (the other three are Galileo, Visa and GreenDot). http://www.prepaidcardexpo.com/

Competition and future margins. There are a handful of issuers of prepaid cards: Columbus Bank and Trust, Bankfirst, BofA, Fifth-Third, JP Morgan, and US Bancorp are other leading issuers. MPS believes that they are competitive in volume with these companies, and growing much faster because of a competitive cost structure and the ability to move quickly. My due diligence leads me to believe this is true. Two different companies seeking venture capital with whom I have spoken chose MPS after performing due diligence on multiple potential issuance partners. Simon entered into a contract with MPS despite a pre-existing relationship with US Bancorp due to MPS's ability to help them handle a legal issue regarding state laws in NY and NH (Metabank's federal thrift charter allows them to avoid state regulation). According to management, MPS likely would've received the whole contract if Metabank's balance sheet was larger.

MPS is an unexpected contender in this space. As mentioned above, the reason is Metabank's proximity to an early leader in the space looking for a new company. MPS started off with the strategy of being a low-cost provider and as the unit has scaled, they have been adding additional services. It is obviously difficult to tell how pricing, growth and margins work out going forward a few years in open-loop cards. It appears MPS is successfully building their book of clients rapidly, and as the clients scale MPS will as well. MPS's initiatives to add additional services will hopefully add stickiness to MPS's relationships with its clients yielding long-term value. The legal complexities of prepaid cards and MPS's initial success at building a profitable business are confidence inspiring.

The bank. Assets are $750mm and book is $43.6mm. While most banks like this might deserve a slight premium to book, the bank has lost value for the past 3 years due to abnormally high credit losses in its commercial portfolio. The CFO believes they “have a good credit culture," but I doubt their ability to make that judgement. In fact, his comment suggests the bank may not be taking corrective action regarding their credit underwriting practices. The three large provisions over the last three years are from 1) a fraudulent car dealership loan where they were the lead on a syndicate ($8mm or so in 2005) 2) a loan to a road paving company ($1.5mm in late 2006) and 3) a purchaser of a syndicate loan backed by a charter airline, airplanes, and the entrepreneurs home ($5.4mm in late 2006).

On a positive note, as MPS has brought in low cost deposits the bank has not expanded the asset side of their balance sheet but rather has focused on kicking out high cost liabilities. In addition, the bank recently sold four branches for a slight gain which is a good sign (they should shut down most/all the branches, in my opinion). One worry is that, as MPS generates deposits in quantities such that the bank no longer has any high cost liabilities, they will attempt to grow the balance sheet through originating more loans. Management believes they can be appropriately compensated for their risk in writing loans at a spread to treasuries. I disagree and would prefer to see them hold safe, liquid, securities.

In summary, the bank segment has management that has not shown great skill in running a bank, but still wants to be running a bank. Furthermore, the bank appears to display more nepotism than is appropriate for a publicly held company. The CEO is son of the Chairman. The COO is the son-in-law of the chairman. While a small cap run as a family business is not surprising, it is usually not additive to value. Erring on the side of conservatism, the bank is worth 80% of book.

Management incentives. Brad Hanson, SVP of MPS, has an incentive package of roughly 80k (3%) shares/options vesting over the next 5 years. The company's Employee Stock Option Plan owns 15.2% of the shares. Family members (Chairman, CEO and COO) own 20.1%. Accordingly, incentives are predominantly aligned between shareholders and management.

Risks. The bank trips its regulatory capital limits or otherwise discredits MPS. Unfortunately there is a real risk, based on the bank's faulty underwriting in the past and the presence of $80mm in corporate loans on their balance sheet, that the bank takes more provisions for credit losses. If this occurs, it is possible the bank is no longer "well-capitalized" according to banking regulations. A dilutive equity financing would likely follow.

New business. MPS is a new rapidly growing business in a rapidly growing industry. That being said, there are much larger and better capitalized competitors who have longer experience in the payments industry and a well-established list of clients. While MPS's success thus far seems even more improbable than their future success, it is important to realize that part of the thesis is that MPS will be able to grab a large market share profitably and hold it and this is not guaranteed.

Regulatory Changes. Breakage is when a prepaid card either expires or goes unused for a period of time that leads the issuer to believe it will not be used. It is estimated that 10-20% of value loaded on prepaid cards is never used. For open-loop cards, the system ensures a bit of breakage by rejecting any charge that creates a negative balance (leaving people to wonder how much is left on an almost emptied card and likely to discard it or be charged with a balance inquiry fee). There is a sense among many state and federal politicians that money is being "given" to retailers through prepaid breakage, and there is a movement to protect consumers. So far, most of the anger has been directed toward the idea of prepaid cards "expiring." People think of the cards as a cash substitute and scour at the idea of cash expiring. Luckily, whether the cards formally expire or not has little effect on breakage fees. MPS has been able to help some clients (Simon) avoid regulatory complications over these issues by changing the jurisdiction from state to federal. However, it is unclear where the fight against breakage will head. An example of a bad outcome would be the establishment of public trusts to hold abandoned funds. Anti-money laundering and anti-terrorist concerns (Patriot Act) will also need to be addressed conclusively with respect to these cards. This is another source of uncertainty.

In addition to being a business risk, the regulatory complexity of prepaid banking has emerged as source of competitive advantage for MPS due to their already substantial expertise in this area. Overall, the obvious progressive possibilities for the unbanked and underbanked argue against any regulatory constraints that may stall the growth of the market.

Valuation.
One take on the valuation outside the bank is to apply a multiple to normalized trailing twelve month operating income of $8.5mm. Taxing that to $5.5mm, and then applying a conservative multiple (for a business whose growth rate is 100%ish) of 20x yields my lower bound of $110mm in value at MPS.

An alternative view might be to say the most likely case is this business grows 80% this coming year, 40% the year after that, and 20% the year after that. Valuing the company then at a 20x multiple might yield interest income of $25mm (5.25% on $480mm average deposits), non-interest income of $30mm (growing this year's fees at 1.8 * 1.4 * 1.2) and likely costs of $25mm (slightly more than double trailing twelve months). This would yield a net income of $19mm or a value of $380mm then. Bring it back at 15% per year and you have a value of $250mm now.

Finally, it is worth noting that, net of the bank at 0.8x book, the stock is trading at a value of $46.5mm. This is an 8.5x multiple of the NOPLAT of MPS - a business growing at triple digit rates. Even though a long-term moat is not readily apparent in this business (although the absence of moats is not apparent either), the growth and modest multiple of the stock make it very attractive here.

Catalyst

Growth in prepaid deposits
Sell-side attention at some point
Earnings growth causes bank to show up on value screens

show sort by

			2007	2008
Price:	29.38	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	75	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT