Description

Net1 U.E.P.S Technologies Inc

Net1 (NASDAQ: UEPS) is a company with magic formula attributes offering payment solutions for the unbanked and under-banked populations predominantly in South Africa and other African and Middle Eastern countries.  The company’s legacy products are smartcard-based Universal Electronic Payment System (UEPS) that it developed and marketed for over 20 years.  The company was overshadowed by a major uncertainty for the past five years, depressing the company’s stock price until this month when South African Social Security Agency (SASSA)’s awarded Net1 with a new payment contract with wider scope and across all the provinces of the country.  With the clearing of the storm clouds concerning this contract, investors can now start to focus on Net1’s moat and excellent cash generating ability. The current valuation represents a FCF yield of 15%, making it a still compelling investment despite the recent run-up. [Note: All figures in US dollars, unless otherwise noted.]

Business

The majority of Net1’s revenues are based on its technologies in telecommunication, payroll, banking, retail, healthcare, petroleum, and utility industries.  Management categorizes its business into three broad groups:

First, Established business segment includes Cash Paymaster Services (CPS),  EasyPay and KSNET.  Approximately 80% of pro-forma revenues are attributed to these three segments.  Management considers this as its core group, providing stability to the company’s operations and it expects to generate double-digit growth over time. 

CPS:  Since inception, CPS has been company’s main source of revenues, servicing the distribution of social welfare grants on behalf of South African provincial governments.  SASSA has recently awarded a five-year distribution of social grants to all nine of its provinces, which will increase the company’s scope by three times, although at a lower margin than the previous contracts.  Prior to the award of the contract, the market had completely written off its probability completely.  We believe the appreciation of the intrinsic value of the business is not reflected in the current price per share of the company’s stock.

EasyPay is the largest bank-independent financial switch in Southern Africa.  EasyPay focuses on the provision of high-volume, convenient and secure payment, prepayment and value-added services to the South African market.  EasyPay connects with all the major South African banks and switches both debit and credit card EFT transactions for some leading retailers and petroleum companies. It is also an approved third-party payment processor for the South African Reserve Bank.

KSNET is the second largest payment processor in South Korea and was acquired by Net1 in Oct 2010.  KSNET is the fastest growing and most profitable payment solutions provider in Korea, has the broadest product offering in the country, a base of approximately 200,000 merchants and an extensive direct and indirect sales network. Over 90% of KSNET’s revenue comes from providing payment processing services to merchants and card issuers through its Value Added Network (VAN). Over the past two years, KSNET’s transaction processing volume has increased at a 24% CAGR, and reached 1.4 billion transactions during calendar year 2009.  KSNET was acquired to diversify the revenue stream and reduce excessive reliability on the core CPS business. 

Second, the Growth Business group includes UETS, FIHRST, MediKredit, and XeoHealth.  This group represents 12% of revenues and is expected to grow faster than the Established Business.

UETS:  Focuses on sale of the company’s proprietary UEPS technology.

FIHRST:  Similar business to ADP in providing payroll transaction management service to South African employers.

MediKredit:  Operates Health Transaction Management Systems handles all types of healthcare claims, including pharmacy, doctor, private, and public hospital claims.

Lastly, Start-up Businesses includes scaling up of newer and promising technologies such as Mobile Virtual Card (MVC) and XeoHealth which provides end-to-end electronic processing of medical claims information and operates predominantly in the USA.   Management expects some of these divisions may transform into an Established Business.

Recent Developments

As mentioned earlier, since the expiration of the earlier contract with five provincial governments, Net1 has been serving welfare recipients without a permanent contract.  In 2007, SASSA was tasked to award the welfare distribution contract and RFPs were solicited for the April 2008 contract start date.  Due to internal issues (corruption and misadministration) within the SASSA, the contract was shelved and extensions were temporarily granted to distribute entitlements to welfare recipients. 

Years of uncertainty relating to the SASSA contract and management’s helplessness have frustrated shareholders, who have exited the stock.  The trading history of the company’s stock depicts a lack of interest, in spite of trading at unusually low valuations.  Prominent Wall Street firms have subsequently dropped coverage on Net1.  Even though the company started to invest its internally generated cash into new and performing assets, the legacy contract issue weighed on the stock, dropping from over $30 in 2006 all the way to $6 just a few weeks ago. 

Even though the SASSA deliberated for a long time, we believe that there was no real alternative, especially in the rural and faraway provinces due to following advantages:

• Technology where anyone can be paid anywhere
• 11,000 pay points which no other competitor  offers
• No cost to the social grant beneficiaries’ vs. ZAR 40 to 50 per month to maintain a bank account.
• Biometric validation reduces fraud risk
• Offline transactions eliminates continuous requirement of electric power.

The awarding of the current contract will expand Net1’s reach from five provinces to the entire country, utilizing its interoperable technologies that work in both rural and urban areas.  It will be very hard for any competitor to replicate Net1’s solution when the contract comes out to bid once again in five years, sustaining company’s stable cash generation in the foreseeable future.

Proactively, to diversify the company’s top line from its largest customer, and also to widen its moat further, the company focused on applying its technologies to various verticals like payroll, insurance, retail outlets, petroleum, and healthcare.  Also, the company has utilized its cash flow from operations to make investments in other developing countries that are similar to its success in South Africa.  For example, the company has acquired KSNET, which has a business model like Global Payments (NYSE: GPN) that produces sustainable cash flows at large operating margins.

The SASSA distribution contract was announced on January 18, 2012 and awarded Net1’s CPS unit with a three or more times larger contract, at somewhat lowered margin.  This announcement caused the stock to rise from $7 to $11, where it trades now.

Awarding of the SASSA contract eliminated the uncertainty that clouded the performance of the company. 

Competitive Advantages

The successful application of Net1’s UEPS technology commercially, and lack of a formidable alternative, serves as an unassailable barrier for competitors to enter in the foreseeable future.  Furthermore, over the past 20 years of its application, the technology has built up a large number of loyal customers in rural South Africa, where there is a limited access to formal financial services.  Understanding UEPS’s advantages over its alternatives is important to assessing the durability of Net1’s moat. 

The main strengths of UEPS are its affordability, security, and flexibility.  While the vast majority of financial transactions are performed through checks, credit cards, debit cards, etc, which require a centralized computer to validate them, they are not available to a large majority of the rural masses who reside in under-developed environments, with little or no communications infrastructure.  In the absence of a centralized computer, UEPS smart cards operate as an individual bank account for all types of transactions. 

The transfer of money or other information utilizing UEPS technology can take place without any communication with a centralized computer since all validation, creation of audit records, encryption, decryption, and authorization take place on, or are generated between, the smart cards themselves.  Unlike credit cards and most other banking related operations, UEPS cards are protected through the use of biometric fingerprint identification designed to ensure security of the funds and card holder information.  Instead of exchanging information instantly as in alternative technologies, UEPS relays data in a batch mode and hence can eliminate need of round-the-clock access to issuer’s computers.  Due to this privilege, seamless transactions can be performed even in remote location where there is no reliable power, like in most developing countries in Asia, South America, and Africa. 

The normal functionality required in financial transaction processing, including transparent and automatic recovery of transactions, cancellations, refunds, audit trails, interoperability with other payment systems, etc, is available with the  UEPS technology.  A detailed discussion of this technology is available on the company’s website by clicking on the link below:

http://www.net1.com/resourceLib/downloads/technology/UEPS%20Technical%20Document.pdf

In short; over the past couple of decades, utilization of this technology has created loyal, and increasingly smart card users, who will need continued services in the future as well.  Replacement by a competitive technology may not be easily feasible due to existence of UEPS transactions for over two decades.  Furthermore, the technology embeds biometric validation, which is essential to minimizing fraud that is unusually rampant when distributing welfare benefits by governmental programs.  Very few technologies can boast of these advantages, as most compete for the urban population today.  Awarding of the SASSA contract demonstrates beyond a doubt as to Net1’s strong position, serving approximately four billion rural people in remote areas globally.

Investment Considerations

The investor base pushed the exit button as they waited in agony for the SASSA award over the past 5 years.  Frustration was clearly evident in the management’s earnings conference calls.  Throughout the period, the company generated loads of cash, even from SASSA’s contract extensions.  Also evident was management’s confidence in the strength of its technology of distributing funds to welfare recipients, reducing fraud and the lack of alternatives available to achieve SASSA’s goals.  Even though the fundamentals of the company have been improving throughout the period, investors were fixated with the SASSA contract and were convinced of the worst possible outcome, as discussed in the analyst reports. 

Feeling the pressure from the investor community, management focused on diversifying their revenue streams by 1) expanding the UEPS payment solution to other developing countries in Africa and Iraq.  As the company reaches critical mass, investors will be rewarded with new cash flow streams. 2) Acquiring new business lines in KSNET, EasyPay, MediKredit, Net1 UTA, FIHRST, SmartLife etc.  Not all of the acquisitions were successful, as evident from the impairing millions of dollars in the past couple of years.  KSNET and EasyPay are successful to date and the management team seems confident that the rest will perform well.   In hindsight, we think returning excess cash to shareholders was the better option instead of option 2, while waiting for permanent SASSA contract.

The two new streams, KSNET and EasyPay, have displayed sustainable cash-flow characteristics and will be discussed in the Valuation section.  MediKredit and FIHRST have exhibited massive growth and their progress will be monitored going forward. 

The recent announcement of the SASSA contract for five years and expanding services to 10+ million recipients from the current 3.2 million has eliminated the uncertainty hovering around NET1 for the past 5 years.  While per recipient revenue may have declined, the increased volume should benefit Net1’s stakeholders with increased EBITDA and cash flow.  The company’s conference call currently scheduled for February 10 may provide some specifics; we believe acquiring at least a partial position may be attractive.  Below we provide a discussion on Net1’s estimated valuation.

Valuation

Majority of current cash flows are generated from Net1’s core Established Businesses.  The other two groups, viz., Growth Business and Start-up business will provide upside as they take shape, but we will focus on the core group to guide us in estimating Net1’s intrinsic value.  Also, the recently announced Black Empowerment partnership may provide additional upside, if the company can secure new government contracts.  While we wait for clarity on the SASSA businesses, one thing is certain with the new contract:  EBITDA margins will head lower while revenues from the contract will head significantly higher.  

Credit card transactions in Korea exhibited a solid growth of 23% CAGR over the past three years and KSNET exceeded that rate.  Based on the 2011 annual reporting, where the company’s revenue was $68 MM (for 8 months under Net1,) and assuming continued growth of 20%, we believe it will generate $120MM in revenues for 2012.  At 8x EBITDA (assuming conservative 25% EBITDA margin), we believe KSNET will be worth $240MM.  Ours is a low-ball estimate, considering the company was purchased last year at similar price, and the company continues to perform better than expected.

Management has received bids for EasyPay in the $200MM range.  The company does not provide financial metrics for EasyPay.  Based on our calculation, in 2011, EasyPay’s revenues were $47 MM.  Our due diligence for the trailing twelve months leads us to an EBITDA margin 45% or greater.  Based on the company’s latest earnings call, management is eliminating low margin EasyPay transactions and we believe that EasyPay margins may point higher in next few periods.  Assigning a 8x EBITDA margin to the business suggests a value of EasyPay at $200MM.  Therefore, the combined value of KSNET and EasyPay today is equivalent to company’s current market capitalization, as cash and the debt on the latest balance sheet cancel out.  This implies that market is not assigning any value to company’s Start-up business and Growth Business including MediKredit and FIHRST even though these are growing robustly.   Most importantly, the company’s SASSA contract could record revenues between $250-$300MM annually and even at a reduced EBITDA margin of 27%, down from the current 40%, generates $70 MM EBITDA.  Noteworthy is the fact that, historically, the SASSA business has incurred very low CAPEX once the business is stabilized.  Assigning a multiple of 6x on this business implies an intrinsic value of $400MM.

Our multiple in estimating the value of SASSA business may be conservative, considering that the company has successfully completed the broad-based Black Economic Empowerment (BEE) in compliance with South African regulation and business practice.  Below, Dr. Serge Belemont, CEO of Net1 commented at the announcement of the deal.

“On behalf of the Board, I would like to welcome our new partners to the group. The transaction fulfills our desire to establish a broad-base of BEE shareholders in Net1 and the parties will bring fresh perspective and experience to the table. Importantly, our new partners will help strengthen the long term sustainability of our business in South Africa.”

Even though there will be an eventual 20% dilution when the in-the-money options are exercised, we believe this transaction has boosted the sustainability of the SASSA business, indicating that our multiple may be conservative. 

Adding up the parts, our low-ball estimate of the intrinsic value of Net1 business is approximately $840MM.   Factoring in the BEE dilution, we come up with an intrinsic value of $16.50 per diluted share.   This estimate does not assign any value to company’s Growth or Start-up Businesses. 

Furthermore, management has guided the Street for an EPS of at least $1.6 prior to SASSA award.  Business has historically generated lot of cash and future after the award looks even brighter.  We believe the stock should trade significantly higher than current $11 considering its sustainable cash flow generation, high ROIC, and has large untapped markets.

Risks

• SASSA is the company’s single largest customer with greater than 50% of revenues once the new contract begins.  Clearly, customer concentration is a risk.  However, since the SASSA performs an essential task of the government in distributing welfare funds, we do not feel it is a major risk.  With Net1’s capability to minimize fraud compared to the alternatives and its extensive pay-point network built over two decades, the replacement of Net1 seems unfathomable. 
• The company’s capital allocation has been sub-optimal in the past.  Some of its investments have been low return and written down.  Once again, we are comforted by management’s comments during the latest conference call saying that they are done with large acquisitions for the foreseeable future, although ‘opportunistic’ small tuck-in acquisitions are likely.
• The biggest risk is that management may be distracted by the large number of moving.  During the company’s conference calls over the past couple of years, several investors expressed their displeasure.  To be fair, management may have acted on past investors’ directive to diversify its business to acquire new businesses.  In our view, the company today is over-diversified and the best use of cash is to take advantage of cheap valuation and aggressively purchase shares for the benefit of long-term investors in the company.  Based on our conversations with management, we believe that they are aware of the undervaluation and are determined to work towards the benefit of its long-term shareholders.
• Cap ex may increase in the short-term so as to build out the pay points for the new SASSA contract. However, we feel the risk/reward here is very good.
• Net1 reports in US dollars but majority of business is conducted in South African Rand (ZAR).  Widely fluctuating currencies will impact quarterly results, as hedging is not part of the company’s strategy.

Catalyst

• Recent developments have cleared the path for investors to re-evaluate the company’s intrinsic value based on future cash flows.  The conference call on February 10^th should clarify Net1’s earnings potential in the long-term.  Dr. Belemont has stated in the latest company conference call that the SASSA contract is of the utmost importance for the future of the company.  Even the large KSNET business is a second fiddle to this contract.  The company has admitted to failure in some businesses in the past like BGS and will carefully evaluate any future use of cash.  The company has now sharpened its focus on a transaction-based revenue model and learned from its past mistakes.  The current extreme undervaluation provides an excellent entry point, even if our reading on company’s transformation may not pan out completely.
• Freed of major overhang, we believe that management will be more successful in selling its story to prospective investors. 
• Net1’s board has authorized share buybacks and approximately $98MM is available for open market purchases.  Our due-diligence leads us to believe that the company will continue purchasing shares from the market, which should support the stock.