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Why Intellidex rates Net1 as a ‘sell’

Solid performance overshadowed by excessive risk.

The excessive level of risk facing Net1 overshadows its actual financial performance, which has been solid. Its main revenue stream hangs on a thread: it has had to re-tender for the SA Social Security Agency (Sassa) social grants contract – which is one of its core business areas – after the Constitutional Court ruled in November 2013 that the tender process was marred with irregularities and invalid.

A new tender was issued in October last year but that has now become embroiled in further court challenges. It is unclear when any progress will take place. Separately, investigations by the US Department of Justice and the Securities and Exchange Commission are taking place into the original tender.

With its primary listing on the Nasdaq, the company is subject to the US Foreign Corrupt Practices Act, which could lead to it facing fines. Furthermore, a number of US-based law firms have filed class action suits on behalf of shareholders alleging the company issued misleading statements about its true business and financial condition.

Another Net1 subsidiary, Moneyline Financial Services, is being accused by SA’s National Credit Regulator (NCR) of breaching the National Credit Act and the NCR has put in an application with the National Consumer Tribunal to cancel the company’s licence as a credit provider. The importance of the Sassa contract has diminished but is still a major part of the company’s future. Net 1 boasts more than 30-million cards it has issued in more than ten developing countries around the world, putting it in a unique position to participate in the growth potential of these countries

Operationally, results have been solid. Net 1 reports quarterly in dollars but generates 75% of its revenue in SA. Although the dollar strengthened against the rand in the six months to end-December, revenue still grew 19% to $311 million. Operating profit climbed 82% to $64m and headline earnings soared 87% to $0.99/share. Another critical issue is the company’s embedded high business risk profile. Net1’s degree of operating leverage is more than 400% (higher and extremely varied in the past) and this contributes to a high degree of combined business leverage of more than 500%. In principle, this means the company has low marginal costs but a high fixed cost structure. If sales change by R1, headline earnings per share will change by more than R5.

This is an exciting picture if sales are rising but could severely jeopardise operations if sales fall. And it is quite possible that Sassa contract revenue could fall away. Although the basic operations of the business are profitable and indicate there is value in the share, the uncertainty means this has to be heavily discounted. In our view there is high legal and business risk to the firm, more than what is being reflected in the share price. That is why we believe investors should get out of this counter, even though a basic valuation may reflect value.

Bull factors

  • Competitive intellectual property
  • Low penetration levels in emerging markets provide scope for growth

Bear factors

  • Sassa contract, its core revenue stream, is at risk
  • Litigation on various fronts
  • High customer concentration
  • Weak rand translates to lower reported earnings in dollars, its reporting currency

Nature of business: Net1 is a provider of alternative payment systems that leverage its Universal Electronic Payment System (UEPS) to facilitate biometrically secure, real time electronic transaction processing to unbanked and under-banked populations in an online or offline environment. In addition to payments, UEPS can be used for banking, health-care management, payroll, remittances, voting and identification. It provides payment solution platforms in SA and the Republic of Korea. It also offers financial services and hardware and software sales. The group has a primary listing on the Nasdaq board in the US and a secondary listing on the JSE.

Analyst: Phibion Makuwerere ¦ Editor: Colin Anthony

Disclosures: The analyst has no financial exposure to the instrument discussed. The opinion represents his true view. For Intellidex’s full disclaimer, methodologies and definitions please click here.

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