Given its relatively insignificant $650 million market cap, odds are you don't know Net1 UEPS
Do I have your attention?
Net1 is a South African company that provides smart card technology to people in parts of the world without plentiful banking services. These cards enable the users to save money, pay bills, and buy goods without having to carry around cash -- a potentially dangerous move in those countries.
What sets Net1's product apart from traditional credit cards like those offered by MasterCard
One of these countries happens to be South Africa, where Net1 has gotten a contract from the South African Social Security Agency (SASSA), a government department, to process pension and welfare payments for more than 3 million South Africans. The Net1 subsidiary that operates this line of business is called Cash Paymaster Services, and it accounted for 65% of Net1's revenues in fiscal 2009.
SASSA, in other words, is a major customer for the company, and the deal with major customers is that they're not a problem until they are. Right now, SASSA is a problem for Net1.
The nature of the beast
The problem is that the relationship between SASSA and Net1 has become more unstable than either Net1 or the company's investor's would like. Although Net1 previously enjoyed a multiyear contract in South Africa, it has more recently been operating under one-year extensions -- with SASSA saying that it would like to conduct a new tender process for this large account. Most recently, Net1 and SASSA extended the contract for just three months, with the company saying that it expects to conclude negotiations on a new contract with SASSA before the extension expires on June 30.
This uncertainty surrounding the status of Net1's largest revenue source has caused the stock to decline some 20% over the past few months. Is this a buying opportunity, or are Net1 and its investors about to get the rug pulled out from under them?
All things end badly, or else they wouldn't end
Although Net1 CEO Serge Belamant said on the company's recent conference call that "we are and expect to remain an integral supplier to the South African government," there appear to be myriad obstacles to the successful resolution of these negotiations. These include pricing, contract duration, and the strategic direction that SASSA would like to take benefits distribution in South Africa.
First, it's clear that SASSA would like to pay Net1 less -- and potentially much less -- for its services. According to SASSA's new three-year strategic plan, the agency has been running $50 million annual deficits since 2007, with 53% of its costs representing payments to contractors. Representatives from SASSA have said they would like to cut these costs in order to get the agency back into the black.
If Net1 has to accept a decrease in revenues, it would clearly like to secure a longer-term contract in return. This, however, does not appear to be in the cards. Again, according to SASSA's strategic plan, while the agency does expect to negotiate new contracts that "should bring about a reduction in price," it also plans to issue a tender in 2010 for "a new social grant payment system." Thus, while the agency will likely maintain its relationship with Net1 in the near-term to make sure there is no disruption in benefits (the new Jacob Zuma-led government in South Africa is pro-benefits and popular with the poor), it is hinting that it would like to move in another direction longer-term. It also noted in a recent meeting with its relevant parliamentary committee that "there was risk that SASSA's service providers had the upper hand in terms of managing SASSA's own business."
Finally, there's the question of what direction SASSA would like to take benefits distribution. Net1's solution at present allows beneficiaries to remain somewhat off the grid. They don't need bank accounts to get their benefits, which are distributed in a decentralized way. That's expensive for SASSA even if it carries less cost for the beneficiary. SASSA has said that over the "medium-term" it expects to "centralize payment data and at the same time move beneficiaries to an effective electronic payment system while facilitating their integration into the economy of the country." This could mean requiring beneficiaries to set up accounts so SASSA can transfer benefits at lower cost over Internet or telephone lines -- effectively cutting out the need for Net1. With South Africa's mobile penetration rate now sitting near 100%, this could now be more technologically feasible than when Net1 originally set up its benefits distribution system in the country.
What happens next
Although these are real and significant challenges for Net1, there's also reason to believe that the company's fate is not so dire as the market seems to believe. First, according to our estimates, the current stock price is anticipating a 20% to 30% decline in SASSA revenues. While this is possible, SASSA's budget shows that the agency plans to hold payments to contractors steady over the next three years. Although this is less than the 10% annual increase they were previously paying, it would not be game over for Net1.
Second, it's clear that while SASSA would like to investigate other benefits distributions mechanisms, it would also like to retain Net1's services in the near-term. Again, this is not a government that wants to see a disruption in benefits -- particularly with the attention it's getting as host of this summer's 2010 World Cup -- so I would not expect this business to disappear overnight. Further, the agency also seems enthusiastic about several of Net1's technologies, including biometrics, which means the company could maintain a longer-term relationship with SASSA even as its responsibilities change.
Finally, although it's clear that SASSA would like to experiment with new technologies and introduce a new payment system, its strategic plan predicts that only 40% of beneficiaries will be receiving benefits via this new system in fiscal 2013. In other words, although Net1's business is being challenged here, SASSA does not appear to be planning to suddenly cut ties with the company, its technology, or its particular solutions.
Investing is an expectations game
It's for these reasons that Net1 is a worthy buy at current prices. Although the company's Cash Paymaster Services business may be entering run-off, it looks to have several years of cash-generating operations ahead of it. This cash has value, even if the business is not growing, and Net1's entrenched infrastructure in South Africa means that its legacy period could be quite long even if SASSA decides to move in another direction.
Assuming no growth in the company's South African business his year and a 3% decline in perpetuity thereafter, the current business looks to be worth $14 to $16 per share. Add to that the company's $4 per share in cash, and fair value looks to be between $18 and $20. And that's without ascribing any value to Net1's nascent Virtual Credit Card technology, a solution that could be attractive to the likes of Visa or MasterCard.
The market seems to be expecting much worse. As long as Net1 announces a new contract that's better than those low expectations, buyers here should be rewarded.
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