The business model of UEPS is phenomenal and should throw off free cash flow. Over the past years it has been a tremendous cash generator. From 2006-2010, the business earned an average of $45m a year (high of $86m and a low of $39m which includes a $37m impairment charge), usually maintaining a large portion of its market capitalization in cash. Its primary business is administering social benefits in several South African provinces, although it has a nascent project in Iraq and has been selling hardware to other African governments. It manufactures and distributes electronic readers and cards that create a network and charges transaction fees – a fundamentally similar business model to Visa or Mastercard.
Where it differs is that its survival is based on the South African Social Security Agency’s (SASSA) willingness to allow it to administer social benefits. The SASSA is looking to enact a nationwide system that would deal with only one business as opposed to the current 3. The bidding process has been mired in delays and the past years business has only resulted from 3 and 6-month extensions on their old contracts. The company recently reported that while it was previously expected to run out their extensions by March 31, 2011, a 6-month extension has been granted until September. The company has projected earnings of $1.50 if they maintain the contract for the year, and with the stock trading at $12/share, that is 8 times earnings for a company that requires little capital expenditures and could possibly become an entrenched network in South Africa.
UEPS has a potential moat in its technology that allows for off-the-grid and secure processing of payments – a major plus in a region of the world that can’t guarantee consistent power supplies – but the patents have been expiring and continue to expire 2010-2012. There is the potential to develop a network that achieves critical mass and becomes a necessity for different places of business in South Africa – a potentially profitable outcome, but speculative at this point. While UEPS administers benefits in the largest number of provinces, there are 2 other competitors, and it is possible they might be willing to implement UEPS's technology at a lower price. On the plus side, it has by far the largest position with >50% of the market and a presence in the most number of provinces. It is not guaranteed to become the sole provider of SASSA benefits.
I am not an expert on South African politics, but there appear to be wildcards in the bidding process stated in the company’s filings. As a result of the apartheid, the government follows the policy of Black Economic Empowerment (BEE), which means economic decisions can be heavily influenced a company’s management’s representation of different races. Factors like this make UEPS an investment that would require a substantial margin of safety in order to be a comfortable investment.
Up until recently, a big safety net for the company existed in a $200m net cash position, making up close to half the market capitalization. UEPS purchased a Korean payment processing company for $240m, not only erasing the cash position, but also adding to fixed costs through debt. While the Korean company may offer value, it may not have been the best use of cash in light of such uncertainty. The risk that the SASSA contact becomes worthless would leave the company dependent on the Korean business and the scraps of a couple nascent initiatives that have yet to gain traction, such as mobile banking – a field that has plenty of competitors. If the pre-merger business becomes worth very little – $0 for arguments sake – that leaves about $240m of value (the Korean business), while the company currently trades at a market capitalization of $540m. If the company can get the SASSA contract for the entire country, substantial upside exists, but there is ample downside to make purchasing the stock a speculative venture rather than an investment.
Talk to Andrew about UEPS