In my most recent article on Net 1 UEPS Technologies (UEPS) ("UEPS" or the "Company"), I expressed my concerns over the Company's long history of controversy. For the past 17+ years, UEPS has been dogged by numerous allegations of bribery and mistreatment of grant beneficiaries. In this article, I will turn my attention to concerns that I have over the Company's financial statements. More specifically, I will focus on the highly unusual nature of UEPS's non-trade account receivables.
The Company separates its non-trade receivables into two buckets: (1) prepayments to agents in South Korea and (2) other receivables. Over the past few years, both of these buckets have grown at an accelerated rate. From FY 2011 to FY 2015, receivables related to prepayments to agents in South Korea has grown 218.0% from $16.8mm in FY 2011 to $53.4mm in FY 2015. From FY 2010 to FY 2015, other receivables has grown 370.0% from $9.9mm to $46.4mm. Thus, in just a few years, the Company's non-trade receivables have grown on a combined basis to a total balance of $99.8mm.
The accelerated growth and abnormally large size of the Company's non-trade receivable accounts are concerning. For reasons which I will explain, I believe that the peculiar nature of UEPS's non-trade receivables calls into question the quality of the Company's earnings and the integrity of the Company's financial statements. Given the additional concerns highlighted in this article over the Company's financial reporting, I feel even more strongly that UEPS is an attractive short at the current share price level.
Accelerated Growth in Non-Trade Receivables Since KSNET Acquisition
In November 2010, UEPS acquired KSNET, a payment processing provider in South Korea. I have provided below a figure, which shows the Company's accounts receivable balances from FY 2010 (Pre-KSNET) to FY 2015 (Post-KSNET).
KSNET was acquired in the 2nd quarter of FY 2011 (fiscal year ending June 30th). At the end of FY 2010 (pre-KSNET acquisition), UEPS categorized its account receivables in two separate categories: (1) trade receivables and (2) other receivables. With the acquisition of KSNET, the Company gained an additional non-trade receivable account. As part of its business model, KSNET provides upfront payments to its sales agents in South Korea.
The Company capitalizes this prepayment on its balance sheet in a line item called "prepayment to sales agents in South Korea" (as shown in the table above). This prepayment is then amortized as a marketing expense in the P&L over the life of the contract with the sales agent. For simplicity purposes, I will refer to "prepayment to sales agents in South Korea" as "prepayment receivables" for the rest of this article.
Since the acquisition of KSNET, UEPS's trade receivables balance has continued to fluctuate up and down from year to year. However, by contrast, the Company's non-trade receivable balances have grown at a rapid pace since the acquisition. From FY 2011 to FY 2015, prepayment receivables increased 218.0% from $16.8mm to $53.4mm. From FY 2010 to FY 2015, other receivables increased by 369.7% from $9.9mm to $46.4mm. Thus, whether by coincidence or not, the Company's non-trade receivables have ballooned to almost $100mm on a combined basis since the acquisition.
Potentially Aggressive Capitalization of Prepayment Receivables
The question to be answered now is whether or not the consistent and large increases in UEPS's non-trade receivables is a cause for concern. Based on my analysis of the Company's business model and financial statements, I believe that it is. As mentioned previously, from FY 2011 to FY 2015, UEPS's prepayment receivables increased 218.0%. By comparison, during that same time frame, International Transaction Processing revenue increased 56% from $105.6mm (assuming full-year of KSNET contribution) to $164.6mm.
In other words, UEPS's prepayment receivables is increasing almost four times as fast as International Transaction Processing revenue. Such a large increase in working capital relative to revenue growth is highly unusual. Typically, the growth in a Company's revenue and associated working capital items are strongly correlated. Thus, in this case, the large difference in growth between prepayment receivables and revenue raises red flags.
To be more specific, the fact that prepayment receivables is growing much faster than International Transaction Processing revenue raises concerns that management may be overly aggressive in capitalizing marketing expenses. This means that the Company may not be fully amortizing an appropriate amount of prepayments to agents as a marketing expense in the P&L. This lower than normal amortization of marketing expenses can inflate profitability and cause a large increase in prepayment receivables.
My concerns over the Company's potentially aggressive capitalization of expenses is based on a variety of data points. In addition to the high rate of growth of UEPS's prepayment receivables, the unusually large amount of this receivable relative to the size of the international business is alarming. Since FY 2011, prepayment receivables has increased substantially and to a point where it now represents over 32% of annual International Transaction Processing revenue. The table provided below illustrates the growth in prepayment receivables relative to international revenue:
As shown above, prepayment receivables as a % of revenue more than doubled from FY 2011 to FY 2015. As of FY 2015, the Company's prepayment receivables were $53.4mm, which represented 32.4% of annual International Transaction Processing revenue. I have never come across another business where capitalized marketing expenses amounted to over 32% of its annual revenue. This is simply an enormous amount of marketing expenses to capitalize on the balance sheet. To further my point, consider the following table:
As shown above, at the end of FY 2015, prepayment receivables as a % of operating expenses was 96.3%. Although a breakout of marketing expenses is not available, it is doubtful that marketing expenses account for anywhere close to 96.3% of International Transaction Processing operating expenses. Instead, it is more likely that the amount of prepayment receivables capitalized on the balance sheet far exceeds their annual marketing expenses. Thus, the large size of UEPS's prepayment receivables relative to operating expenses, as well as revenue, further contributes to my concerns over aggressive expense capitalization.
Another point, which supports my concerns over aggressive expense capitalization is the trend in the Company's International Transaction Processing margins. Provided below is a table comparing the growth in prepayment receivables to the International Transaction Processing EBITDA margins from FY 2011 to FY 2015:
From FY 2011 to FY 2015, prepayment receivables more than tripled from $16.8mm to $53.4mm. Given that prepayments to sales agents have increased by $36.6mm in just four years, it is reasonable to expect that amortized marketing expenses in the P&L should have also increased by a significant amount. In turn, it would also be expected that margins should have come under pressure due to this expected increase in marketing expenses.
However, based on actual historical results, this is not what happened. As shown in the table above, despite a tripling of prepayment receivables, International Transaction Processing EBITDA margin actually increased from 23.3% in FY 2011 to 27.1% in FY 2015. I view this significant rise in EBITDA margin despite such a large increase in prepayment receivables with a great deal of skepticism. In my opinion, the Company's ability to not only maintain but meaningfully increase margins over the past four years is another indication of potentially aggressive accounting.
In an email to UEPS investor relations earlier this week, I asked the Company to provide some clarification as to why prepayment receivables has consistently increased by such a large amount. In response to my question, I received the following response from the head of IR:
"…prepayments to sales agents (is related to sales agents) who got cash incentives up front but then had to deliver to contracted volumes or forfeit their incentives. Growth has been due to growth in the business."
As I explained earlier, prepayment receivables has grown at a significantly faster rate than International Transaction Processing revenue. Thus, his explanation that growth in prepayment receivables was simply due to "growth in the business" does not seem to fully explain the dynamics at play here. In my opinion, the above response does little to address the concerns, which I have highlighted in this section. I believe that further clarification from management is needed on this matter.
Large and Mysterious Other Receivables Bucket Is Another Concern
Perhaps even more concerning than the increase in prepayment receivables has been the large and consistent growth in UEPS's other receivables. I have provided below a table, which shows the rapid increase in other receivables over the past five years:
As shown above, since FY 2010, other receivables have grown at an accelerated rate year after year. From FY 2010 to FY 2015, other receivables have increased by $36.5mm or 369.7% from $9.9mm to $46.4mm. This growth in other receivables is alarming for a few reasons. First, in its filings, the Company has not provided a definition of other receivables. Thus, I have no indication as to what the nature of this receivable is. This is highly concerning given the large growth in other receivables over the years. The lack of transparency by the Company in regards to such a large and growing item should be concerning for an investor.
In addition to concerns over a lack of transparency, the fact that UEPS has such a large amount of other receivables is, by itself, highly peculiar. As mentioned earlier in this article, the Company breaks out its trade receivables separately from prepayment receivables and other receivables. Thus, it is reasonable to conclude that other receivables is a non-trade receivable. According to the website AccountingTools.com (here), non-trade receivables are defined as follows:
"Non trade receivables are amounts due for payment to an entity other than its normal customer invoices for merchandise shipped or services performed."
"Examples of non trade receivables are amounts owed to a company by its employees for loans or wage advances, tax refunds owed to it by taxing authorities, or insurance claims owed to it by an insurance company."
Based on the above excerpts, as a non-trade receivable, the Company's other receivables should be related to items due from entities outside of their normal customer base. In other words, other receivables should relate to amounts due from miscellaneous entities rather than customers. These amounts due from miscellaneous entities could be loans to employees, tax refunds, insurance claims, etc.
Based on this definition, it would be reasonable to assume that other receivables should be a fairly small item on UEPS's balance sheet. A business typically should generate more receivables from its customers than from miscellaneous entities. However, as of the end of FY 2015, the amount of UEPS's other receivables ($46.3mm) was almost the same as their trade receivables ($49.0mm).
The fact that UEPS has committed such a large amount of working capital to what typically is a minor account is alarming. It is especially concerning considering the lack of transparency from the Company regarding the nature of its other receivables account. I believe that management needs to provide a detailed definition of other receivables in order to erase any questions as to the nature and validity of this account.
My final concern regarding UEPS's other receivables is the large amount of incremental cash that this account consumes every year. As mentioned previously, as of the end of FY 2015, other receivables amounted to $46.3mm. This represents almost $1 per share of incremental cash that is consumed/tied up in other receivables. Given the consistently large increases in other receivables over the past five years, it is likely that this cash drain will continue to grow.
This is troublesome for investors given the upcoming SASSA contract expiration. The Company will likely need all the cash it can to sustain itself as it transitions the business through this challenging period. Of course, this does not even take into account the large increase in prepayment receivables over the past four years. On a combined basis, from FY 2011 to FY 2015, prepayment receivables and other receivables have increased by a total of $59.4mm.
As of today, the Company has net cash of $42.8mm on the balance sheet. Thus, if the current trend continues, the entire amount of UEPS's net cash could be consumed by increases in non-trade receivables within a couple of years.
In my email to UEPS's investor relations earlier this week, I asked the Company to provide a detailed definition of its other receivables. I also asked the Company to provide an explanation as to why this line item has increased so much over the past few years. In response to my questions, the head of IR sent me the following response:
"(other receivables is) transaction related given there is a lag between when a transaction is authorized and when it is settled."
Unfortunately, this response from IR is fairly generic and provides little insight as to what other receivables actually is. I asked IR to further clarify the nature of this expense in a follow-up email, but I have yet to hear back from them. If I receive a meaningful response on this matter, I will provide an update in the comments section.
Increase In Receivables Has Accelerated In FY 2016
Over the past six months, the increase in the Company's receivables has only accelerated. Provided below is a breakdown of UEPS's cash flow from operations for the first six months of FY 2016:
As shown above, the Company's total receivables (trade receivables + prepayment receivables + other receivables) increased by $31.1mm during the first six months. A breakout between UEPS's three receivable buckets was not provided in the 10-Q. That being said, given the large overall increase in total receivables, I believe it is reasonable to assume that the Company's non-trade receivables contributed to this increase.
Thus, it appears that the large growth in UEPS's non-trade receivables has continued and may have even accelerated through the first six months of this fiscal year. As a result of this large increase in receivables, the Company only generated $11.5mm of free cash flow during the first six months of the year. This poor free cash flow generation in comparison to net income provides a good illustration for why UEPS's rapidly increasing receivables should have investors concerned.
A Few Thoughts On KSNET
Another item that I would like to quickly touch upon is the overall performance of the KSNET/International Transaction Processing business. Based on some of the issues discussed in this article, it appears that the performance of this business has been deteriorating over the past few years. From a revenue growth perspective, the Company's prepayments to sales agents have increased over 3x from FY 2011 to FY 2015.
Despite this large increase in marketing, annual revenue growth has decelerated from 15% a couple of years ago (FY 2013 vs. FY 2012) to just 8% today (FY 2015 vs. FY 2014). From an earnings perspective, as I discussed at length, it appears that KSNET margins may be inflated due to potentially aggressive capitalization of prepayment receivables. Additionally, from a cash flow perspective, KSNET requires an unusually large amount of cash to sustain its business.
In FY 2015, the Company spent $28.2mm in capex on its KSNET business. At the same time, the Company had also funded $53.4mm of prepayment receivables for its KSNET sales agents. Given the large and increasing capex and working capital requirements of this business, I believe it will be hard for KSNET to generate significant cash flow.
Finally, in addition to all this, Korean regulators have recently instituted new regulations which limit the fees that KSNET can charge its customers (based on UEPS management commentary in the most recent 10-Q). Thus, things are looking rather challenging for KSNET going forward. Overall, given this segment's declining revenue growth, potentially inflated profitability and increasing cash consumption, I think that the KSNET business may be worth far less than what investors believe.
The rapid increase in UEPS's prepayment receivables and other receivables should be a point of great concern for investors. I believe that the issues raised in this article call into question the quality of the Company's earnings and financial reporting. I also believe that the deterioration in the Company's working capital position is an indication that their business (particularly KSNET) is not performing as strongly as investors may believe. Overall, given the additional issues highlighted in this article, I continue to believe UEPS shares represent an attractive short opportunity at the current share price level.
Disclosure: I am/we are short UEPS.
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.