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Net 1 UEPS (NASDAQ:UEPS) has designed a system for electronic payments in the majority of the world that lives "off the grid." UEPS stands for "Universal Electronic Payments System," which deserves a bit of explanation, because it's unfamiliar to most folks that live in developed economies. We take electronic payments for granted now a-days. When you swipe a card at the supermarket, pull money from an ATM, or use PayPal on eBay (NASDAQ:EBAY), we are paying electronically. However, think of how much is involved in this. The credit card terminal connects to a remote computer across a wired data network that is powered by electricity supplied to the supermarket. This may not seem like much, but in much of the world, there is no electricity grid and certainly no telephone or data access. In fact, nearly four billion of the world's seven billion people live in these areas. Not only infrastructure, but also the complete lack of developed banking institutions in these areas prevents sophisticated financial services like credit or debit. This not only takes electronic payment, but also payment by check off the table.

That leaves cash, but cash is a poor solution. An example is a government's need to send welfare payments to the poor members of its society. Imagine the problems cash presents. Cash is attractive to thieves and corrupt officials, as there is no way to attach an audit trail to cash transactions. Paying cash to the recipients leaves them vulnerable to burglary. Obtaining and dividing up large sums of cash is a dubious and slow task, not to mention the problems transporting it. So, with the problem defined, let's take a look at the solution devised by Net 1 UEPS and why the potential for huge growth is very real.

UEPS's system revolves around "smart cards," like a credit card but with more sophisticated electronics. In our previous example, the government would load one of these "smart cards" with the required payment amount, and distribute those cards to recipients. The recipients then can use the smart card at any merchant or service provider with a POS (point-of-service, of course) handheld unit to buy products or obtain cash. The merchant also has a smart card, and the POS device performs the authentication and records the transaction between the cards. The POS unit is run on batteries so there is no electricity requirement, and since the cards themselves have the technology to authenticate and record the transaction records, there is no requirement for data transmission to a central server. At some point, the merchant/service provider does link their POS terminal to a central server, but only for backup and auditing purposes in a batch manner. Theft is prevented by fingerprint authentication.

UEPS earns revenues by charging governments for cards, merchants for POS terminals, and transaction fees. The business is extraordinarily profitable, running over 40% operating margins. It also has the very attractive quality of being able to scale at low cost. Once the initial system is in place, it costs very little for Net 1 UEPS to add additional services like health benefits or to add more cards to reach more people. These low capital expenditure requirements show up in a 30% free cash flow margin and MFI return on capital averaging well over 100%. Financial health is solid too, with $250 million in cash and no long-term debt.

Clearly, there is big potential for growth. Currently, Net 1 UEPS earns most of its revenues from a government contract to distribute South Africa's welfare benefits. Management is targeting several opportunities in less developed countries in areas like Africa, the Middle East, and South America. The company does not currently have any identifiable economic moat, as it's system is only implemented in a small area. However, if UEPS is successful in getting its system accepted in a large number of undeveloped countries, it stands to become a standard that will be accepted quickly by other countries. In this case, UEPS could develop a durable competitive advantage, as well as rapid and exponential growth. Another scenario could lead to acquisition by a major payment provider, like recently public Visa (NYSE:V) or MasterCard (NYSE:MA). In fact, Forbes recently ran an article on Visa's challenges in undeveloped economies due to non-existent infrastructure needed to supply services.

This is exciting, but beware... there are some serious risks to go along with it. Fist, UEPS is critically dependent on the South Africa contract, which provides over 2/3rds of revenue and is up for renewal next year. The government has delayed a decision on renewal a few times now, which obviously makes investors nervous. While it seems reasonable to assume that UEPS will get the renewal (as there is little alternative), it could be at less favorable terms due to the government's strong bargaining position. Net 1 does not have the financial resources to expand in many directions at once, which leaves it vulnerable to a copycat competitor until it builds enough scale. In my opinion, it's still just too early in the game to invest in this one.

Net 1 UEPS is a great "story stock," and for those willing to accept the risks, the potential is there to be handsomely rewarded. But at MagicDiligence, we like to find as close to a sure thing as possible. In today's market, there are better risk/reward stocks than this one.

Disclosure: Steve owns no position in any stocks discussed in this article.

Source: Net 1 Ueps: Risky Investment with Great Potential