Gemalto Offers Growth With Security

| About: Gemalto NV (GTOMY)
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When it comes to technology, France doesn't get much love. Apart from a handful of companies like Alcatel-Lucent (ALU), Dassault, and Bull SAS, it's pretty slim pickings for the most part. Gemalto (OTCPK:GTOMY) is a notable exception, though, as this company is a world leader in smart cards and SIM cards and a leading player in the emerging near field communication (NFC)/mobile payment opportunity. Investors already prize Gemalto's growth potential, but these shares are worth a spot on investors' watchlists and may be more interesting to those who believe in a faster adoption curve for mobile payments and smart cards in the U.S. and China.

The Mobile Business - A Race Between Capabilities And Commoditization

Gemalto is an increasingly diverse digital security company, but the company's strongest/largest business has been its mobile communications efforts. Gemalto gets about half of its revenue from the mobile segment, where it has about one-third global share in SIM cards (with about one-quarter of the market in 2G, nearly half in 3G, and about 70% in LTE).

The mobile market isn't exactly a growth market anymore in terms of total handsets, which leaves Gemalto dependent on migrations to more advanced technologies. In the 2G market, for instance, Gemalto has lost share to a host of Asian rivals who compete principally on price. On the higher end (LTE), though, Gemalto has secured the business of companies like Vodafone (NASDAQ:VOD), Deutsche Telekom's T-Mobile, and Verizon (NYSE:VZ) on the strength of its offerings - including increased memory capacity, better security, and increased/enhanced features.

Right now, Gemalto is able to charge about two to three times as much for an LTE SIM card as for a standard 3G SIM. Unfortunately, only about 4% of the handsets in use in 2012 were LTE. That percentage is expected to increase to 15% by 2014 (and the percentage is much higher in tablets), but ongoing LTE adoption is key if Gemalto is going to stay ahead of commodity-type rivals as well as more capable rivals like Oberthur, Giesecke & Devrient (G&D), and Safran Morpho. It should be noted that these three rivals all basically compete for the #2 slot, with about 15-16% share each, meaning the top four companies have about 80% of the global SIM card market.

It should be noted, though, that Gemalto is not a chip company. Most SIM cards are manufactured by Samsung, Renesas, and STMicrolectronics (NYSE:STM) (with whom Gemalto has a partnership). Gemalto essentially offers the security programming for these cards, and the switch from pre-loaded cards to remote functionality (essentially layering in the security remotely when the card is activated) has reduced the company's reliance on any particular manufacturer.

Secure Payments Is The Real Growth Opportunity

While Gemalto will benefit from the increasing penetration of LTE phones, sooner or later its rivals will step up their presence and compete those prices down. Consequently, I see the core mobile business as an ongoing up-and-down cycle.

Where I see more growth potential is in securing commercial transactions. Gemalto enables debit and credit smart cards that carry significantly enhanced security features, including so called "chip-and-PIN" combinations.

So far, this has not been a huge opportunity for the company (though it is about one-quarter of revenue), as Europeans are not big users of debit and credit cards relative to Americans and Chinese. While the U.S. has been slow to adopt more secure cards, that may be about to change. Not only do services like LifeLock highlight the risks to consumers of unsecure cards falling prey to skimming, but Visa (NYSE:V) and MasterCard (NYSE:MA) are both pushing for the adoption of smart cards - threatening to shift fraud liability from themselves to retailers if they won't adopt/install smart card readers.

With about 650 million Visa debit and credit cards alone in circulation in the U.S. in 2012, there is a very large market opportunity here - both from bank card issuers like U.S. Bancorp (NYSE:USB) and card reader companies like VeriFone (NYSE:PAY) and Ingenico.

The bigger long-term opportunity may actually be in card-free mobile payments, and near field communications in particular. Gemalto is the only company today with an integrated LTE/NFC card solution, but advanced SIM cards are only part of the opportunity. Due in part to the efforts of Broadcom (BRCM) to introduce combo chips including NFC, the costs are coming down quickly and the penetration of NFC-capable phones should grow quickly from the 16% level in 2012.

Gemalto not only supplies technology and software relevant at the phone level, but also capabilities that make it a player in the Trusted Service Manager (TSM) space. TSMs basically sit between mobile network operators, account-issuers like banks, and merchants allowing for the secure distribution, provisioning, and management of NFC applications and uses. Basically, TSMs are the secure center to a ring of interested parties all involved in the mobile payment ecosystem.

So far, Gemalto's capabilities and reputation have served it well. While First Data is also looking to build itself as a TSM (and boosts Google (NASDAQ:GOOG) as a customer), Gemalto boasts partners like AT&T (NYSE:T), Deutsche Telekom, Orange, Telefonica (NYSE:TEF), Telus, Verizon, and Vodafone - all told, Gemalto has TSM contracts in place covering about two-thirds of the mobile subscribers in the world.

Clearly there are ample unknowns in the mobile payment world today - including whether NFC will become the dominant methodology. eBay's (NASDAQ:EBAY) PayPal is advancing a different approach, and nobody really knows where Apple (NASDAQ:AAPL) is going to come down in this market (or whether they'll develop their own approach/technology). So investors can count on a lot of uncertainty as this market grows and evolves - it may be the case that companies like Square become rivals to Gemalto, but it's just as likely that Square becomes a customer/partner of Gemalto and takes advantage of Gemalto's security expertise.

Solid Growth Potential, But Ample Competition And Uncertainty

The idea of collecting a small toll on a sizable percentage of every advanced phone, every payment card, and/or every mobile transaction is certainly appealing. At the same time, investors can't ignore the risk of a major hacking/security breach harming the company's reputation. Likewise, Gemalto has one-quarter of the machine-to-machine market, one-third of the SIM card market, and half of the smart card market today, but may end up on the wrong side of the technology fence in mobile payments.

Likewise, Gemalto's strong share in e-passports and secure national IDs may be hard to monetize if global usage doesn't increase significantly from its current 10% penetration rate. And then there's also the risk of commoditization - will other players in the ecosystem allow Gemalto both fat prices and sizable market share on an ongoing basis, or will they try to capture more of the pie for themselves?

The end result of all of this is that I see Gemalto's revenue growing around 7% a year for the long term. Certainly, the potential is there to grow much, much faster, but I think a number in the mid-to-high single-digits is a good risk-weighted estimate.

Gemalto has not historically posted great margins or free cash flow, but I believe the company has reached a point of critical mass (both in terms of operating leverage and technology) where the margins and cash flows will improve significantly in the coming years. That's particularly true if LTE adoption continues to accelerate (supporting Gemalto's premium-priced SIM cards) and Gemalto maintains its position as a go-to TSM. Consequently, I see the margins moving into the mid-teens in relatively short order and then into the high teens within five years. With that margin improvement, I see Gemalto logging free cash flow growth in the low teens (around 12%).

The Bottom Line

Gemalto is perhaps not the easiest stock for American investors to own. Although Gemalto sponsors a Level 1 ADR program (and provides ample information in English), the liquidity on the stock is not great (using limit orders is a must). Investing in Europe has gotten increasingly easy and cost-effective, though, so owning the European shares is an option worth exploring. It's also important to note that Gemalto reports like a European company - meaning that investors are not going to get the same level of quarter-to-quarter information that they're accustomed to with American companies or foreign companies with larger American shareholder bases.

A growth rate of around 12% implies a fair value in the mid-$40s for the ADR. That's not great undervaluation, but I'd remind readers that the significant year-by-year growth potential also speaks to meaningful ongoing year-to-year appreciation potential. So it's not as though saying it is fairly valued near $45 is tantamount to saying the stock isn't going to keep going up.

There are a lot of risks and unknowns about how the mobile payments world will evolve, but Gemalto's strong security technology gives it a leg up on players like eBay, VeriFone, and so on. As commerce goes more and more digital, Gemalto could be on the cusp of significant multi-year growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.