Universal Electronic Payment System (UEPS)
UEPS is a financial transaction system offered by Net1 which utilizes its patented Funds Transfer System and secure smart cards to provide real-time but offline payment solutions for un-banked/under-banked populations. These cards store all necessary information – available funds, user identity, etc. – and allows for transactions to take place without a connection to a host mainframe. As such, the cards are particularly useful to countries with under developed infrastructure.

As you may have guessed, Net1 does most of its business in developing countries, primarily South Africa, where it provides cards and point of sale equipment to governments which use the cards as a medium to distribute grants and other social welfare payments.

Investment Strengths

• Proven, cost effective technology serving a large niche – Unlike traditional debit cards or credit cards, UEPS offers a proprietary technology which does not require always on connection to a primary host or even a bank account. Data is stored on the card and information transferred at the point of sale.
• Adoption reaching critical mass – The Company has long been used by the South African Social Security Administration to distribute entitlement payments to citizens and Net1 has recently leveraged this success into a national contract with Ghana as well as a roll out of its technology in Iraq.
• Operating leverage and free cash flow generation – The Company’s equipment and cards are generally paid for by national governments which have chosen its system. Further, as additional customers are enrolled and begin using their cards for payments, the Company generates incremental transaction fees without significant incremental investment. Operating margins in the transaction processing segment are near 60%.

Investment Risks

• Exposure to South African Social Security Administration Contract – 65% of revenues are currently generated through five provincal contracts with the SASSA. This contract has been on one-year renewal terms for the last three years as SASSA attempts to bid the contract through a formal RFP process. The last RFP process ended almost a year ago without a resolution and Net1′s current contract in South Africa is set to expire on March 31, 2010.
• Exposure to South African Rand – The majority of the Company’s costs and revenues are denominated in South African Rands. While exchange rate fluctuations will not have a major impact on cash flow or liquidity, it can have a significant impact on valuation for USD investors. The Rand is currently trading at 7.65 per USD and has traded in a range from 6 to 12 historically.
• Political Risk – The Company’s growth plan relies on entering developing nations with sometimes tenuous governmental structures.
• Technological Risk – While the Company’s smart cards and other payment technologies appear to be quite forward thinking, the increasing availability of wireless communications infrastructure and cell phones poses a potential disruptive threat for a motivated competitor.

Quick and Dirty Valuation
Despite guidance of 20% yoy growth in EPS (constant currency) and long term catalysts for significant growth through new market entry internationally, the Company trades at 12.0x P/E and, in fact, represents a significant discount based on my analysis of PEG which has traditionally approached 1-1.2.

Further, for a smaller, growing company, UEPS generates significant free cash flow. As defined as operating cash flow minus capital expenditures and investments, the Company has averaged approximately $110 million in free cash flow over its 2008 and 2009 fiscal years good for a 13.75% free cash flow yield. Put differently, at no growth and a 10% discount rate this would justify a stock price of ~$24.00/share vs. its current price of $17.65/share. Obviously, with significant headline risk involved in the Company’s 65% concentration in South African Social Security payments, this discount rate may not be appropriate.

The Company, however, currently has ~$2.00/share in net net working capital and $3.35/share in cash on hand and management has shown a willingness to redistribute value to shareholders having recently approved a $50 million share buyback to be funded entirely from cash on hand. Netting the entire value of cash out of the shares, the Company’s cash yield would actually be closer to 17%, enough to pay back shareholders in less than 6 years if fully redistributed. Is this worth the risk of annual renewals of the South African contracts? I believe so.

Full disclosure: Author is long shares of UEPS at the time of writing.

In a classic merger arbitrage, the investor ought to short the acquiror (ARCC) and buy the target (ALD). That is because, assuming that the deal closes, the target and acquiror shares are now representative of the same asset. Consequently, any price discrepancy between the two stocks represents a fundamental disconnect with underlying value*. In the case of ARCC and ALD, I posited that the proposed exchange rate of .325 ARCC shares for each ALD share creates an opportunity based on current closing prices.

*Those familiar with the concept of arbitrage will see my description of merger arbitrage as a flawed definition of arbitrage. Officially, merger arbitrage is a risk arbitrage and is not the same as a traditional riskless arbitrage opportunity. I intend to write a follow up post for those who have less experience with this concept later this week.

At Ares’ closing price of $10.46/share, ALD shareholders would be entitled to approximately $3.40/share in value. This represents a 7.9% premium versus ALD’s closing price of $3.15. In a classic merger arbitrage, however, shorting ARCC would require the investor to pay upwards of two quarters worth of dividends (the ARCC/ALD merger is expected to close by Q1 2010). ARCC currently pays a 13.4% annual dividend yield. Two dividends would equate to roughly 6.7% in yield. As such, the true spread between ALD and ARCC is closer to 1% than the 7.9% that is initially seen when only comparing stock prices.

Merger arbitrage does contain some risk. The deal may not close in time which could result in an arbitrageur missing more of ARCC’s dividends. The deal may not close at all which could have completely unpredictable results on stock movements, thus destroying the pair trade (short ARCC/long ALD) opportunity. As such, the minute 1% spread is a good sign that the market is pricing a near definite probability of this transaction closing and believes just 1% in return over the next 6 months is adequate compensation for the risk.

In this sense, a classic merger arbitrage of ALD and ARCC seems much less worthwhile to us retail investors who don’t have massive balance sheets to throw at small percentage gains. Despite this, I believe the initial thesis of my prior post on the opportunity to purchase Allied Capital stock holds true. Prior to this acquisition, Allied Capital’s auditors were issuing going concern warnings. With the balance sheet and liquidity provided by Ares, Allied Capital’s undervalued portfolio definitely looks much more attractive. That being said, on a risk adjusted basis, it would seem much more prudent to outright purchase ARCC at this juncture as you would be “guaranteed” dividends over the next few quarters and you won’t have to worry about the risk of the transaction not being confirmed.

Full disclosure: Author has no positions in the stocks mentioned in this post.

I, the author of The Curious Investor, am currently long Apple stock. In fact, it makes up nearly 10% of my personal portfolio. In my apartment are multiple Apple products including several iPhones, several iterations of the iPod, a MacBook, and an Airport Express. I believe Apple is more than just a trendy consumer products maker and that the iPhone truly represents a new growth engine as the world embraces mobile computing. As an investor, however, I understand that stocks do not only move in one direction. Valuations will overshoot and undershoot true value in the short term and a prudent investor must be aware of this and make decisions with this phenomenon in mind. It is possible for a great company to possess a not very great stock valuation (see: CSCO circa 1999-2000). So, please, leave your hate mail unsent.

Take a look at the chart below:

Apple’s stock gapped up through the psychologically significant barrier of $200/share following Apple’s earnings announcement last Monday. A headline related pop typically signals a breakaway gap, a stock gap which is typically followed by a continuation but, in this case, Apple’s gap was more suspicious. While related to good news, Apple’s Q4 2009 (FYE 9/26) results were not so much of an upside surprise as previous quarters and investors all but dismissed another characteristically conservative guidance. Moreover, volume doubled prior to the gap up and remained elevated during the stock’s near immediate fall over the last five trading periods, a tell tale signal of an exhaustion gap.

Exhaustion gaps are defined as stock price gaps which follow in the direction of the prevailing trend. A textbook exhaustion gap should be followed by a reversal soon after the gap and then move to fill the original gap. A reversal is confirmed when the gap is filled and price breaches the level prior to the gap.

I realize that I may be early to call this reversal. After all, technical analysis is not clairvoyance. Trends and reversals must be confirmed through chart movements as opposed to “predicted” by the apparent formation of patterns. Traditional technical analysts will always miss the exact top or bottom of a price movement in preference to investing with the certitude of a confirmed trend or reversal. As such, it would seem that the seeming formation of an exhaustion gap here is just a red flag. Apple’s stock has yet to fill the gap, but it has breached the initial gap and looks to be on its way to filling the gap. If so, could it be possible that the Company’s stock is headed for a reversal of its uptrend? Or, possibly entering a consolidation period following an aggressive upward move? If so, it may be time to take some gains off the table and wait for a re-entry point.

Full disclosure: Author is currently long shares of AAPL.

On Monday, a major shakeup was announced within the BDC industry. Ares Capital (ARCC), one of a few BDCs which has managed through the recession while maintaining a substantial dividend, announced that it was acquiring a former giant of the industry, Allied Capital (ALD). The acquisition is expected to be an all-stock deal where ALD shareholders will receive 0.325 shares of ARCC for each share of ALD they own.

ALD, which had breached the asset coverage covenants on its debt, has not been able to pay a dividend since the third quarter of 2008. Allied, in fact, has taken almost a year to restructure its debt agreements leading its auditors to issue a “going concern” warning in its 10Qs in each of the last few quarters. While concerns regarding the Company’s debt agreements has weighed down the stock’s value, the Company’s net asset value per share was reported as $7.49 on June 30, 2009 which includes serious write downs taken by the company over the last year.

Why then does the stock trade at 43% of NAV/share? For one, questions about the Company’s continued ability to access financing make it difficult to handicap whether or not Allied will ever have the luxury of time to “wait” for its investments to mature and be refinanced. In fact, pressure to de-lever has already forced the Company to make hundreds of millions in distressed investment sales over the year. Further, the Company has a history of questions being raised over the quality of Allied’s investments and its methodology for establishing fair value for its reporting. (See David Einhorn’s Fooling Some of the People All of the Time)

With all these headwinds facing the Company and the difficulty that the average investor would have verifying the Company’s portfolio quality, Allied was more likely a value trap than a good value investment even at <45% of NAV. But, all that has changed now that Ares Capital has decided to swoop in and acquire Allied. Ares Capital Corporation is one of few BDCs which has weathered the recent recession without having to suspend its dividend and has not seen outsized portfolio market value depreciation. Further, it is managed by Ares Management, a distant descendant of Leon Black’s famed private equity shop, Apollo Management. While a good investor should always do his own due diligence, Ares’ vote of confidence likely goes a long way to provide an investor some comfort with Allied’s current stock valuation.

Further, given Allied’s troubles securing affordable financing and continued  portfolio difficulties, Allied has little incentive not to close this transaction (though some shareholders seem to disagree). As there’s a high likelihood of completion (currently expected to close 1Q 2010), there seems to be a quasi-arbitrage opportunity presented by ALD shares and value investor’s dream opportunity to enter into ARCC shares.

As mentioned above each ALD share will be exchanged for 0.325 shares of ARCC. ARCC and ALD closed today at $10.61 and $3.20, respectively. As such, if the deal were completed today, ALD shareholders should receive the equivalent of $3.44 per share in ARCC stock which implies that ALD is currently trading at a 7.75% discount. Now, if you’re not interested in investing in the BDC space and simply would like to take advantage of this pricing irregularity, you could buy ALD and short ARCC and simply wait to pocket the spread – a “riskless” arbitrage of this merger. (Caveat being that if the merger falls apart the whole these blows up in your face.)

But, I believe that ALD’s current discount is even more compelling from a value standpoint. By my estimates based on June 30, 2009 reporting, the combined Allied and Ares should have a net asset value around $15.30/share. At today’s $10.61 closing price, Ares is trading at just 70% of combined entity NAV and at 95% of its own reported NAV of $11.05 (post a recent dilutive share offering). This would seem a pretty good discount for a BDC which has proven its ability to manage through a very difficult market environment and a demonstrated ability to access financing, the key trait necessary to realize value from Allied Capital’s portfolio.

But, you don’t have to settle for ARCC’s discount to NAV. As mentioned earlier, ALD trades at a near 8% discount to its conversion price. So, by just purchasing ALD shares today, you can enter ARCC at a below market value discount at a significant discount simply for taking on 6 months of risk as the merger approaches its closing. Is it worth it? More diligence probably needs to be given to Ares’ debt portfolio, but I would say on the surface ALD shares have gotten significantly more appealing.

Full Disclosure: Author has no position in the stocks mentioned in this post.

The Mobile Productivity Device
In my post on the Apple Tablet, I talked about my image of the perfect mobile device being shaped by the viral Microsoft Origami Project videos circa 2006. Well, leave it to Microsoft to drop yet another follow on which I think once again targets my mobile productivity desires – the Microsoft Courier.

E-mail, a quick and simple input system, and a large enough format for reading larger amounts of text, editing pictures, and watching videos. It’s just the type of device I’d like to add to my tech tool belt.

Apple’s Media Tablet
It seems that recent rumors show Apple to be taking a slightly different tact with regards to the tablet. According to iLounge, the Apple Tablet is slated to be, for all intents and purposes, a large format iPhone. It will run iPhone OS and is meant as a slate-like replacement for books and magazines with the added functionalities of an iPhone.

Should this be written off? Well, I don’t think it’s as powerful or as compelling a consumer product as the Courier (which is no where near production ready). But, this product does seem to fit Apple’s business model very well. They’ve struck gold once with a personal media player and content ecosystem (iPod + iTunes) and e-reading has gained much more momentum through the release of Amazon’s Kindle. With an increasing amount of browsing and video watching being done on iPhones, maybe a large format device is just what the doctor ordered. Further, Apple will have the benefit of being able to add more content for sale through its iTunes distribution channel.

Granted, there’s no news on an input system, and if it is through a on-screen keyboard, this device will be severely handicapped from a productivity standpoint. At a $700 price range, I just don’t know that I’d be interested in purchasing such a piece of hardware.

So, now it’s your turn! What do readers out there think? Which product would you like better? Do you see more potential in one approach versus another?