Description

Net1 UEPS

Company Description:

Net1 UEPS Technologies, Inc. (UEPS) is a global payments company focusing on the world’s nearly five billion un-banked people.  The majority of UEPS’

revenues (approximately 70%) are currently generated in South Africa, while approximately 25% of the company’s revenues are generated in South Korea through

KSNET, a top three Korean card processing and payment gateway network (similar to GPN).  The company also generates about 5% of its revenues in the US

and Europe and has burgeoning start-ups in: India, Nigeria, and Hong Kong. We believe the South Korean payments business, KSNET, may be as valuable

as the entire enterprise value of the company and encourage the company to explore either a sale of this entity and initiate a large stock tender or take

the company private.   

Net1’s key differential is its ability to conduct transactions in both on-line and off-line environments with transactions to be reconciled within a brief period of time.

(Click this link for more information regarding UEPS’ technology.) UEPS employs biometric card technology (finger print and voice) to verify established identities

in a database. The virtual card pay technology (product name is VC Pay) generates transaction codes rather than the transfer of the consumer’s credit card

number and information. (Click this link for UEPS 10K for a further description of the technology, starting on page four of the link.)

Because of its proprietary technology, it has been chosen by the South African Social Security System (SASSA) to deliver benefits to 10 million South Africans

(about 25% of the adult population).  Because SASSA grant recipients are on the lowest rungs of the socioeconomic ladder, correctly identifying and distributing

grant monies to this group of the population (especially in the rural areas) has historically proven difficult for both the South African government as well as prior

competitors to UEPS.  These individuals’ identities are often substantially harder to verify than individuals higher up the socioeconomic spectrum, and UEPS’

biometric card technology allows for a cost effective method to properly identify and disburse funds to the intended recipients.  UEPS has partnered with

MasterCard (MA) to provide the debit cards issued to grant recipients.  These recipients are able to use their MasterCard-branded cards to pay for goods, withdraw

cash, etc. and, importantly, is the first step in the process of bringing the unbanked into the formal banking system. (MasterCard benefits from the partnership

because it brings 10M+ South Africans onto their network.)

UEPS has also partnered with MasterCard and chosen by tender to deliver benefits to 12 African countries for a portion of the UN’s World Food Program. (UEPS

and MasterCard are also currently bidding jointly on over 80 countries worldwide for the World Food Program on a global basis.)  Partnerships have also been

established with Uber in South Africa, Oxigen Wallet in India, Microsoft, and several others. Net1 also has a cooperation agreement with a South African bank

(Grindrod Bank) and owns a 25% interest in South African based Finbond Mutual Bank (Finbond is a $160M USD market cap bank that UEPS holds on the

balance sheet for $6M USD, or approximately 20% of the fair market value of UEPS’ interest). 

Net1 often provides unbanked South Africans (mostly SASSA beneficiaries, but also some higher wage earners) with banking products, such as loans and

insurance, as well as services for pre-paid airtime, electricity, etc.  Lending to beneficiaries AFTER they have received their SASSA benefits has been one of the

fastest growth areas for the company, and they now have one million EasyPay Everywhere bank accounts through Grindrod Bank.  (Note: if the SASSA contract

were to disappear, the company estimates it would only take about two million EasyPay accounts to be earnings neutral.) EasyPay Everywhere is slowly becoming

a competitor to Capitec Bank Holdings (CPI SJ), a South African bank catering to lower income individuals that trades at 20x 2017 earnings and 5x book value.

4.11.16 Addendum: On April 11, 2016 UEPS and the International Finance Corporation (IFC), a member of the World Bank Group, announced that IFC was

purchasing an 18% interest ($107M USD) in the company at a 20% premium to the April 8^th closing share price, or $10.79 per share.  In the associated press

release (link), the IFC indicated that “Net1 has created impressive propriety technology for the delivery of services and demonstrated its effectiveness in South

Africa.  IFC and IFC AMC’s funds’ investments will help Net1 expand regionally, especially into African countries where there is limited banking infrastructure and

availability of financial services for the poorest segments of the population.” It is noteworthy that the IFC has a partnership with MasterCard called “The Partnership

for Financial Inclusion” to expand microfinance and mobile financial services in Africa.  OUR EPS ESTIMATES DO NOT INCLUDE ANY DILUTION OR

ASSOCIATED REVENUE GROWTH FROM THIS INVESMENT AS THE NEWS WAS ANNOUNED ON THE DAY OF PUBLICATION.  THE IFC DEAL WILL

INCREASE UEPS’ SHARECOUNT BY APPROXIMATELY 18%.

The Original Bull Thesis / Why the Author Invested:

In covering global financials, it’s tough to find real barriers to entry.  UEPS has exclusive contracts, notably SASSA and the World Food Program, that are nearly

impossible to be competed away.  When our firm invested in 2012, the SASSA price payments per beneficiary had been cut a second time and a tender was given

for the entire country (versus to companies in 4 regions) to UEPS, as it was substantially better than competitors at providing technology that eliminated fraud

(especially in rural areas).  

Net1 has saved the South African government more in fraud prevention than the program costs: According to SASSA’s 2013/14 annual report,  ZAR 2

billion have been returned to fiscal reserves, versus the ZAR 1.7 billion SASSA pays UEPS (ZAR 14.42 x 10 million x 12 months = ZAR 1.7 billion (link).  This led

to accusations - in both South Africa and the US - by the losing bidder (Allpay) that the bidding contract was not clearly written and that the bidding process was

conducted improperly. The courts have subsequently dismissed all of these claims.  Our belief, which came to fruition, was that all the accusations of improperly

winning the contract would prove false - and indeed they did.  The SEC (link) and Hawks in South Africa (link) have both cleared UEPS of wrongdoing.

Additionally, the South African court system has made various judgements (here, and here) indicating that there was no evidence to support Allpay’s claims of

improper behavior. (There is still a DOJ outstanding investigation.)

The South African courts did rule that a revised SASSA contract had to be re-bid but not necessarily awarded. UEPS chose not to re-bid on a revised contract due

to: 1) more stringent limitations on debit orders; 2) deteriorated economics of the proposal; 3) limitations on providing other products/services through these

“restricted” bank accounts; 4) a restriction that any winning bidder will NOT be permitted to solicit any other business from this customer base directly or indirectly

through a subsidiary/affiliate; and 5) the prohibition of setting up bank accounts for beneficiaries.  Despite Net1 not re-bidding on the SASSA contract, the South

African government ruled that all the bidders for this amended tender were incapable of doing the job and instead asked UEPS to continue with the contract for the

foreseeable future. In short, the South African government believes there is no other company capable of doing the quality work Net1 is doing for the

price it is charging. We also believe it is highly unlikely the government is capable of taking this service in-house anytime soon and risk a disruption in

benefits payments to a quarter of the population.

We note that UEPS has NOT been found guilty of any improper behavior by ANY investigation, and there have been many.  In fact, social grants are the highest

rated “government program” by the population with a 60% satisfaction rate.

Now that the company/management has been exonerated, we believe management marketing in the US and additional sell-side coverage will be forthcoming. 

(Only one sell-side firm covers at present.) We are at a loss to explain why none of the roughly ten investment banks that cover the five major South African banks

are not providing coverage to UEPS - especially when it is 80% cheaper (on both 2017 P/E and price/book value) than its nearest competitor, Capitec Bank.

We believe Capitec is UEPS’ closest competitor in South Africa, as Capitec is focused on the low-end consumer in South Africa (it is estimated that over 60% of

Capitec’s client base is low income). But unlike UEPS, Capitec only has a single product: the Global One account.  This account serves as the access point to

transactional banking, retail savings and unsecured lending.   Unsecured lending makes up about 80% of Capitec’s revenues with transaction fees contributing the

remainder. 

We also believed that NET1’s proprietary technology would be applicable throughout the less-developed world.  Indeed, the partnership with MasterCard for the

World Food Program was a big win as was an emerging relationship in Nigeria to identify the population so that basic banking services can be provided.  Neither of

these are producing material earnings in 2016, but are one part of the growth story for 2017 and beyond.  (The World Food Program contract has only commenced

roll out in one of the twelve awarded countries.) Net1 has also been asked to tender a proposal for an East African nation of approximately 30 million for a contract

similar to SASSA and is bidding to provide further services to the government of South Africa.   

Net1 has met or beat sell-side net income estimates and revenue estimates each quarter over the past year with about 20% year-over-year revenue growth in

constant currency.  UEPS did miss fiscal second quarter 2016 earnings mostly on currency translation (and to a lesser extent, tax and investments on new

program roll outs).  Over the past 12-months the South African rand has depreciated by about 20% against the US Dollar, and troughed at about 30% depreciation

around the time UEPS closed the second fiscal quarter 2016 financial statements (December 2015).

We believe Net1 will earn approximately $2.00 per share ($2.45 in consistent currency of 11.43 rand to dollar this June fiscal year) or up 10% year-over-year in FY

2016.  We believe a real path exists to $4 in constant currency earnings over the next three years. (Management’s 2018 bonus is based on this number.) The path

to $4 will be paved by 10% organic growth, the World Food Program roll out in additional countries, the continued roll-out of insurance products, an additional

contract win (for either an additional African country and/or the South African government), contribution from ZAZOO in Europe, as well as the potential for India

and other new markets to contribute to earnings over the next few years.

The company is a net debt free company ($58.6M gross debt) and aggressively buying back stock at current levels. UEPS has repurchased about 5% of

outstanding shares since November 2015, and has an authorization for 20% of shares outstanding at today’s price level. We believe the potential exists

for Net1 to sell its Korean Business - KSNET.   In fact, KSNET was rumored to have received a bid by a global payments player a few years ago for approximately

$400M - or roughly the enterprise value of UEPS today. CEO Serge Balamant confirmed his belief in this valuation on a Baird hosted conference call in early 2016.

We spoke to a leading investment banker in Asia - who is familiar with both UEPS and KSNET - and he confirmed there is interest in the franchise and believed its

value is $400M+.

The Path to $4 in Earnings Power in FY 2018

Management’s FY 2018 maximum bonus is based on achieving an EPS target of $3.76 in constant currency earnings.  Management will receive a third of their

bonus if UEPS generates $2.85 per share, two-thirds of their targeted bonus at $3.30 per share, and a full bonus at $3.76 per share or higher. There are several

ways to get to this number.  Here is one potential scenario:

FY 2016 earnings (constant currency rand at 11.43) are estimated to be $2.45 (Note this equals roughly $2 with the rand at 15 to the dollar)

1. 10% organic growth or roughly $2.95 for FY 2018.  The build-up to this estimate is as follows: Internal growth of 10% in Korea, 15% for all non-SASSA businesses—including EasyPay Everywhere, which is growing much faster and could alone be $0.25 of additional earnings power if four million accounts are reached (there are currently one million accounts compared to zero a year ago), 0% for SASSA. 

2. Winning major contracts.  Net1 is currently bidding on the South African government contracts for water metering and electricity.  Each of these could add $0.30-0.40 in two

   years.  We assume they win one of the contracts for $0.35 to EPS in 2018. (Note: Net1 is also bidding on a third major payments contract in South Africa outside of the government.)

3. Life insurance is now operational and, in a March 2016 press release, the company stated it had already signed up 57,000 new policies, equating to a 35 million annual run

   rate (in South African rand) of revenues - or about $0.05 per share.  This could add $0.10-0.15 per share in 2018.

4. World Food Program in partnership with MasterCard.  UEPS has won World Food Program in 12 countries and UEPS expects the first country to commence implementation at some point over the next two months. UEPS is currently bidding on the program worldwide - over 80 countries - in a joint bid with MasterCard.  (UEPS provides the technology, MasterCard provides the network.)  We estimate that if just the 12 countries currently won get rolled out to an estimated 7.5 million people, the program is worth about $1.50 fully phased in 5 years.  Based on that, we believe this program will generate earnings of approximately $0.20 in FY 2017 and $0.35-0.40 in FY 2018.  This is what most excites us about the name. IF UEPS WINS THE WORLD FOOD PROGRAM GLOBALLY, THE EARNINGS WOULD BE SUBSTANTIALLY GREATER.

5. UEPS has been exclusively invited by the government of an East African nation to bid on a benefits disbursement business similar to SASSA.  Winning this contract would equate to an additional $0.20 in 2018 earnings (assuming the same pricing as SASSA).

6. EasyPay Everywhere - Universal payments card for people with no credit card that has a MA logo - started up in September 2015 and had 35,000 loans as of December 2015.  EasyPay Everywhere is the company’s transactional banking account that provides all the services UEPS offers in South Africa, including loans and insurance.  This product is enabling non-banked consumers to set up a “web cloud account” - so money can go on their cards and be spent on Uber (proprietary relationship in South Africa) or others – and is similar to Safaricom in Kenya (which trades at 16x forward earnings), as both programs are enabling the unbanked to get credit.  We think this division could do eight million rand in 2018 from two million rand in 2016 with a 35% EBITDA margin. UEPS is in 10 countries now and expects to be in 44 countries by end of next year if they get EU approval.  (UEPS has applied for a bank license in Malta to issue cards.)  This has at least $0.05-0.10 of earnings power in 2018.

7. Nothing for the partnership with Oxigen in India, the 25% interest in a Nigerian credit company, the recently consolidated interest in a Hong Kong based payments company, Transact24 (valued at about $20M USD) or the company’s recently announced acquiring a controlling stake in a German payments company (Masterpay) that will, among other things, provide Net1 with support and banking services required to deploy Net1’s products and services in Europe (Zazoo).

8. Stock buyback - The Company announced in March it had repurchased a total of about 3% of shares outstanding over the prior two months since reporting fiscal second quarter 2015 (December) earnings - for about $13M USD. (UEPS previously bought 2% of shares outstanding last quarter.) This adds about $0.05 per share annually.  There is a repurchase authorization for 100 million US dollars or about 20% of shares outstanding. If it repurchased the whole amount, it would add over $0.50 to 2018 EPS.

    

   Summary

   Current FY $2.45 (constant currency) to $2.95 internal growth by FY 2018

   +new contact in South Africa - $0.30-0.40

   +Life insurance - $0.10-0.15

   +World Food Program roll out in roughly a third of the 12 awarded countries - $0.35-0.40

   +Additional African benefit disbursement contract(s) - $0.20

   + EasyPay Everywhere - $0.05-0.10

   + Stock repurchase - $0.05-0.50+

   + India/Nigeria/Transact24/Masterpay (Unknown)

   Total in FY 2018: between $4 and $4.80 in constant currency earnings or closer to $3 with the rand at 15:1 to the dollar.

Why has UEPS Fallen More than 50% in the Last Six Months?

Soon after UEPS was exonerated of all counts by the US and South African authorities and soon after saying they would NOT bid for a new amended contract with

SASSA (but the government asked UEPS to keep the exiting contract anyway because the government decided NO OTHER ENTITY WAS CAPABLE OF DOING

A COMPETENT JOB), Seeking Alpha sprang into action.  The Seeking Alpha allegations are vast and broad and too many to address here in detail.  (We

encourage investors to read them directly.)  We believe most of the allegations are directionally accurate but factually incorrect. We will address some of the key

charges.  Of the numerous allegations only one - the CEO received a bogus online PhD. from a sham school—has proven correct. The rand has also fallen by

20% in the past 12-months (although strengthened in the past month or two), and this has been a major negative as well as political upheaval in South Africa and a

weakening economic situation.

The key principal allegation from Seeking Alpha is the SASSA contract is ending in March 2017 and the company will lose approximately 70% of its

revenues.  The reality is SASSA directly represents only approximately 25% of total revenues (slightly less of earnings as the SASSA contract has a lower margin

than the rest of UEPS’ business), while the remaining 45% relates to banking services that will only be minimally impacted if the SASSA contract is lost.  SASSA

revenues are also growing at low single digits (they have enrolled the entire eligible population) while non-SASSA Financial Inclusion and Applied Technologies is

growing at 20%+.   Furthermore, the SASSA agreement is for a five-year contract with two one-year renewals. UEPS has won the contract several times

previously.  There are no other companies capable of executing the contract and the chance that it “goes away” and 10 million beneficiaries, representing roughly

25% of the adult population losing their benefits, seems impossible.  We strongly think the contract is not going anywhere and is likely to continually be extended

as the performance has been good. Rather, we think it is likely that UEPS wins an additional utility contract (or two) that is up for bid.  This would be a

huge win, as no one is expecting them to win another contract in South Africa.

Key Allegation Number Two - The debiting of bank accounts by UEPS is improper/should not be allowed—and this is a large portion of their growth in the Umoya

Manje (prepaid airtime) and Moneyline micro lending businesses. There are two key responses to this.  First, UEPS does not debit the account before the

recipient receives funds - it does not debit beforehand even for insurance, which is allowed by law.  UEPS utilizes debit orders post facto, which are

part of the South African banking system.   Second, the National Credit Regulator has already adjudicated the issue as to whether UEPS can open up a

separate bank account at Grindrod Bank and use an EasyPay Everywhere account to do basic banking services. Actually, the NCR ruled that Net1 does not share

any SASSA data in their own Grindrod/EasyPay Everywhere accounts, which was the main charge - that they had an unfair advantage.

We believe poor folks deserve to have basic banking services as well as wealthier folks. If UEPS does not provide this account, most other banks (other than

Capitec) are not interested in low balance accounts.  South Africa has strong usury limits, so the cost of the bank account and interest rate charged are regulated. 

In fact, in May 2016 another price cap on all consumer lending - including UEPS’s Moneyline product - takes effect that lowers the annual APR from 60% to 38%

on consumer loans under six months.

What the “bears” / Seeking Alpha seem to be arguing is that there is a conflict of interest between providing the two services (banking and grant distributions)

and/or these lower income people should not have access to this banking product. The Democratic Alliance - the ANC opposition - recently referred this issue to a

“Competition Commission” to investigate if it was “anti-competitive” that UEPS has some sort of proprietary access by knowing when and how much the monthly

payments from SASSA are due. (NET1 claims they re-underwrite all bank accounts and if it did not provide banking services, most of these people would have no

bank accounts at all.) Remember, the government “created” this monopoly by reducing the SASSA beneficiary distributors from three companies to just UEPS in

order to cut program costs by roughly 50% per beneficiary for distribution. Also, recall the National Credit Regulator already said UEPS’ fees were proper.

The opposition Democratic Alliance has drawn attention to excessive and improper debits being taken out of beneficiaries’ bank accounts by the “loan sharks”.  A

lot of the push back here seems less directed against UEPS, but more against limiting deductions from the bank accounts of beneficiaries to ensure they have

enough funds to survive.  (Recall - Net1 is getting paid no differently from any other bank account that allows debiting after deposit, or ‘automatic’ bill pay.) We can

imagine some maximum deduction allowed each month as a reasonable compromise. We cannot see the prohibition of deductions from bank accounts - how

would these people pay their bills? By using cash in a crime ridden country and standing in long lines at the electricity department? Also, any of the changes listed

above would also require approval from the South African Reserve Bank, Payments Association of South Africa, and other regulators because SASSA/Dept. of

Social Development does not have jurisdiction.

Key Allegation Number Three - The Korean payments business – KSNET - is not using proper accounting and recognizing earnings far faster than cash flow by

capitalizing payments to vendors to incent business.  We are less sure what the proper accounting is here - but it is the same accounting used by other merchant

processors in South Korea and by players in the US, like Heartland Payment Systems (to be acquired by GPN).  Much of the gap between earnings and cash flow

the past year is explained by the widening value of the rand and the South Korean won. Seeking Alpha is correct in that cash up front incentives have accelerated

and the cash flow in this business is less strong than earnings.  To repeat our earlier statement, management and third-party sources we have spoken to value this

segment at $400M using current accounting.

Key Allegation Number Four - Management is completely unethical and cannot be trusted—there have been complaints of people dying standing in line for

benefits, bribery allegations, etc.  Most of the allegations are many (10+) years old, all have been investigated, and the company continues to win contracts in

South Africa and globally. We do note that we were surprised and disappointed by Seeking Alpha’s correct discovery that the CEO received a bogus honorary

PhD, which the company has recently acknowledged (link).  The honorary PhD was awarded in 2003, UEPS was founded in 1989 and Mr. Belamant has several

patents awarded prior to the receipt of the honorary PhD.  Thus, Mr. Belamant’s - and by extension UEPS’ – successful invention, development, and

implementation of IT technology had nothing to do with the honorary PhD. Nonetheless, a PhD is almost always an “earned degree” versus a “doctorate of letters”

which is usually granted as an honorary manner. We believe Mr. Balamant should not have identified himself as “Dr.” Belamant on his business card, as the

policies of institutions of higher learning generally ask recipients of honorary degrees to “refrain from adopting this misleading title” and “restrict the use of the title

Dr.” (Source: Wikipedia)

Key Allegation Number Five - Seeking Alpha claims that new legislation is coming in South Africa that will outlaw the direct deductions of payments from grant

beneficiary accounts.  We have spoken to several people in South Africa who know nothing about any pending legislation of this regards.  We have also checked

the federal registry (which lists upcoming bills), and there is nothing there either.  We find it highly unlikely that there is imminent legislation that will pass both

houses of congress and be signed by the president in short order, especially considering no such bill is even registered yet.

 COMPS

Any payment business globally would be a good place to start in terms of comparable P/E valuations.  Mid-to-upper teens P/E multiples are arguably where this

group trades.  (The SASSA contract - roughly a quarter of earnings today but not growing-- is arguably worth 5-7x earnings due to its limited visibility). The South

African banks—which grow much slower—trade at 9-10x P/E.  Capitec, a South African bank that grows fast and caters toward the lower-end consumer, trades at

20x P/E or 5x book value.  SafariCom, a payment company in Kenya, trades at 16x EPS. If you say the South African business is really a lending and not a

payments business - which we would take issue with – it is still hard to argue for less than 10x.

Our minimum target price is 9x 2016 current rand (15:1) based EPS of $2.00 - or $18 - same as a slow growth South African Banks.

Our maximum target price is 17x 2018 current rand (15:1) based EPS of $3.20 and giving it a global payments/Safaricom multiple of high teens or a

stock north of $50.

Other issues

The short case is well laid out in Seeking Alpha.  We would direct investors to review its allegations.  One point to note is that while we have NOT done a

proprietary background check on management (although we have met and have had countless conversations with senior management and their partners over the

past several years), we don’t believe MasterCard, the International Finance Corporation, the South African Government, Uber, Microsoft, or Oxigen in India, etc.

would partner with Net1 if the allegations of management impropriety had merit.

Disclosures

The author is net long UEPS at the time of this article’s publication. In addition, the author’s officers, directors, employees and/or principals (collectively “Related

Persons”) may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this article.

The author wrote this article itself and it expresses its own opinions.  It is not receiving compensation for this article. In addition, the author has no business

relationship with any company whose stock is mentioned in this article.

The author does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making

any investment decision.  

Disclaimers

There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth in this article. The author will

not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this article, caused in whole or in

part by its negligence in compiling, interpreting, reporting or delivering the content in this article.

Information pertaining to this article is obtained from Yahoo Finance, Google Finance, and the SEC Database, among other sources. If these sources contained

faulty or old information it could be incorporated into this analysis.

No Investment Advice

This article is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This article is

distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment,

or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives,

financial situations, or needs of individual investors. The price and value of securities referred to in this article will fluctuate. Past performance is not a guide to

future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this article may occur. Certain

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Catalyst

Various contract wins, and deployment of capital from recent International Finance Corporation investment.