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.

Near-term Daily Chart

Around August 10, ISIS began a sell off which brought the stock back towards its 50-day moving average (the MA which I believe signals interim trend support). I opportunistically purchased here knowing that I was investing prior to a confirmatory bullish bounce from this pullback. As such, I’ve taken the tact that I may be wrong in my intuition and have watched the stock’s performance very carefully since this pullback.

The stock made a textbook advance after its sell off, however, this was on week volume and ultimately re-encountered resistance at its 50-day moving average. For some, this may have been enough to force a sale, but I am a long term investor and am not averse to dollar cost averaging should I prove to have entered a stock too early. So, how does one determine whether to purchase more in hopes of dollar cost averaging or to sell and preserve capital for another day?

Long Term Weekly Chart

Above, we take a look at ISIS’ 3-year weekly price chart. Here, you’ll see that ISIS has been on an up trend since bottoming in mid-October of 2008. Moreover, through these three years, the stock has held a rather strong uptrend which has never breached its 200-week moving average. In recent weeks, however, ISIS has both breached its recent up trend and, as of last week, has once again breached its 50-week moving average. It would seem that the stock is more likely in a high-level consolidation phase as opposed to ready to resume its bullish trend. As such, a retest of the 200-week moving average is not out of the question especially given the stock’s complete lack of any identifiable interim support in its near-term daily chart displayed above this section. With a potential 15-20% additional value at risk, I’m not willing to buy additional shares and continue averaging down.

Full Disclosure: Author was previously long shares of ISIS, but no longer holds any shares of the stock.

Above is a 5-year weekly chart for McDonald’s (MCD). As described by David Gordon of The Deipnosophist, MCD seems to have entered a hesitation after a strong, multi-year bull run. Over the last year, however, a symmetrical triangle seems to have formed which is a type of intermediate term base which is expected to end in a breakout or breakdown, though usually symmetrical triangles signal a brief pause before the continuation of the primary trend. But, I’ll leave the discussion of technical analysis for another post. If you’re interested in an extensive analysis of MCD’s chart patterns do follow the above link to David’s post.

While this technical strength as well as McDonald’s 3.7% dividend are tempting to me, I am typically reticent to invest in a stock which has had such a profound bullish move in just the last few years. Truth is, however, McDonald’s reached its current valuation levels in 2007 and it would seem that the stock’s nearly two year long hesistation may have given more than enough time for earnings and cash flow to come in line with market perception. Let’s take a deeper look.

On a relative basis, McDonald’s seems to trade roughly in line with peers on a price to earnings basis. Admittedly, this is not a very large sample size, but it does represent the market’s most comparable competitors. As a franchiser which does not rely on its own assets to generate cash flow, I would expect most of these types of businesses to trade at a premium to book value and, as a result, I focus more on the P/E numbers. Generally speaking, I believe a mature business with stable earnings like McDonald’s should earn a baseline P/E of 10x. 10x earnings would generall be equivalent to the Company’s no-growth earnings power value at a standard discount rate of 10%. As such, McDonald’s seems to be trading at a slight premium to this which implies that there market is pricing in a modest growth premium.

Above, I’m using my “patented” 5-year to Maturity DCF Model. The growth rates row contains the annualized growth rate for the first five years of the model. After five years, the model assumes that the business will “mature” and become a standard 2.5% growth per year type of business. The total value of the DCF is then divided by current shares outstanding to give a valuation table in $/share. MCD is currently priced at $54.23/share. The baseline free cash flows that the model grows off of are trailing twelve months operating cash minus capital expenditures.

What we see is that McDonald’s is trading at levels implying essentially no growth when assuming an 8% discount rate. At a more normal 10% discount rate, MCD’s current price implies annual growth in excess of 8.0%/year. Is this reasonable? McDonald’s has significant international exposure with over 60% of revenues coming from overseas. As such, realistic long term growth rates are likely in the neighborhood of 4% as opposed to 2.5% and near term (5 years-ish) growth is likely easily in the 5-6% range if not better. In fact, over the last five years, McDonald’s has grown its rolling average five-year free cash flows* at a 10% CAGR.

All told, it would seem that McDonald’s while not trading at an extreme value, does offer relatively fair value while also paying a significant dividend and exhibiting technical strength. It would seem that this is a stock worth holding, or possibly even accumulating on weakness as its symmetrical triangle continues to form in anticipation of an upside breakout and continuation of the primary trend. Should the pattern break down, however, I would put in as stop-loss at $50/share and then look to reacquire shares at a true value price  below $45/share, preferably closer to $40/share.

* Rolling average five year free cash flows are defined as, for year n, the average of the year n cash flows and the previous four years’ free cash flows.

Full Disclosure: Author is long shares of MCD at the time of writing. No positions in other stocks mentioned in this article.

My method of determining whether or not a stock is trading at a “value” is to determine the market’s implied valuation. Rather than attempt to model and predict a company’s operating performance, I use the current market value to back into implied growth rates. Then, I try to make a decision as far as how realistic the market implied growth rate actually is. In the end, we retail investor without the ability to control the company’s we invest in are merely trying to determine reasonable prices at which to “buy growth.”

Calculating Apple’s Market Implied Growth Rate

Step 1: Excess asset value
The foundation for a stock’s value is the intrinsic value of the Company’s assets. Not all of the Company’s assets are distributable. Obviously, some baseline level of assets are necessary in order for the Company to operate as going concern. As such, we’ll leave long term assets alone and focus instead on current assets and working capital.

As of June 27, 2009, Apple reported negative net working capital (exclusive of cash) of -$5.8 billion. This implies that the Company is able to generate cash through its operations. As such, it is possible that the company could finance its growth through operations and this would mean that, as a going concern, Apple has no immediate need for cash on its balance sheet. Thus, the $24.3 billion in cash and short term equivalents on the Company’s balance sheet is effectively distributable.

To be conservative, however, let’s discount this cash. After all, management has shown no intention of distributing cash to shareholders and as long as this value held at Apple, there is risk to investor’s ability to realize it. Most conservatively, Apple should hold enough cash to cover the entirety of its liabilities in excess of other current assets. This implies $11.4 billion of the $24.3 billion should be reserved. Thus, Apple’s excess distributable asset value is between $12.9 billion and $24.3 billion.

Step 2: Value of Cash Flows
Now, we begin a “reverse” DCF analysis on Apple. Over the trailing twelve months, Apple has generated free cash flow (defined for simplicity as operating cash flow minus capital expenditures) of $10.3 billion.

At zero growth and a 12% discount rate, the present value of cash flows is worth $85.5 billion.

At zero growth, Apple’s cash flows in addition to excess distributable asset value would be somewhere between $85.5 billion and $109.8 billion.

This implies upwards of a 27.5% downside to Apple’s current valuation ($151.5 billion market cap) if it growth were to stall indefinitely.

Step 3: Market implied growth rate
This is where the analysis can get tricky. I typically, like to make the simplifying assumption that most company’s will have about 5-years of additional growth before slowing to a growth rate closer to GDP (2-3%).

Assuming that Apple will mature in five years and reach a baseline 2% growth rate, the 5-year implied growth which would justify Apple’s current $151.5 billion market cap would be 14%.

Does 14% seem like a reasonable year-over-year cash flow growth rate for Apple’s next five years? That would be the “over/under” necessary if you’re willing to invest new money in Apple today. Next time someone tells you Apple is “fairly valued,” you’ll know they don’t think significant performance beyond this level is likely.

Full Disclosure: Long shares of AAPL at the time of writing.