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.

Well, I figure it’s time to post a follow up to my previous post. To recap, here is the chart I posted on October 5, 2009. This is a three-year weekly chart which I typically use to determine the intermediate/long term market trend driving the stock.

In this chart, ISIS’ stock has breached its 50-week moving average. Remember that breaching the 50-week moving average necessarily means that the stock has also fallen through its 200-day moving average (not displayed). To me, this means that, on a short term basis, market participants have lost conviction in ISIS’ stock. More worrisome to me than the interim breach of the 50-week moving average was the negative divergence in RSI during the stock’s previous uptrend as well as the lack of any clear areas of support before the $12 range. Coincidentally, the $12 support level defined by several previous lows as well as the prior interim high seen on the far left of the chart also coincides with the $12.12 defined by the 200-week moving average. As such, I made the call that “a retest of the 200-week moving average is not out of the question” and that there was “a potential 15-20% additional value at risk” on October 5, 2009.

Okay, now let’s look at how the stock has traded since my call.

In the month following my call, ISIS hit a daily closing low of $12.31/share, basically right at the 200-week moving average (which averaged upwards slightly since October 5, 2009).

Am I clairvoyant!?
No, of course not. In fact, I don’t even consider myself primarily a technical investor. I merely use it to guide my short term decisions. For those that write off technical analysis, however, I think this is a great example of just how it can be used to improve your investing. I wasn’t analyzing ISIS in hopes of timing my trades. I was merely trying to establish a disciplined stop-loss for a position that I hold. In the end, I did not buy back into ISIS, but instead allocated capital to BX on November 5, 2009. In the interim, I saved myself from holding ISIS and losing an additional 12% on my position.

The key to remember with technical analysis is that it does not stand in place of or in contrast with fundamental analysis. But, absent a market moving press release, it is a method of understanding how “Mr. Market’s” voting machine will vote during a discrete period of time. I know this seems like very carefully chosen wording, but there is no such thing as one strategy which works in all situations in investing. The key is to stick with what you know and have the tools necessary to analyze different opportunities. In the case of determining emotionless stop losses and profit maximizing entry points, I am a believer in technical analysis.

Full disclosure: Author is long shares of BX at the time of writing. No position in any other stock mentioned.

What is arbitrage?
Rigorously speaking, arbitrage is the practice of taking advantage of a price differential between two markets which allows the arbitrageur, or person taking advantage of the arbitrage, to obtain a risk-less profit.

Technically speaking, an arbitrage refers to a situation where the same asset sells for a different price in two markets. For example, a textbook in the UK selling for $20 and a textbook in the USA selling for $100. The arbitrageur would buy the UK textbook and simultaneously sell the USA textbook and pocket the $80 difference. The simultaneous stipulation is sort of a idealized hypothetical case. This act would imply a completely riskless arbitrage since there’s no risk of being able to execute one transaction or another or risk of pricing changing at any instance in time.

Merger Arbitrage
There’s no such thing as a true riskless opportunity in real life is there? In fact, in today’s world of increasing information parity and quickening execution times, can arbitrage opportunities exist? Well, there’s one regular kind of transaction structure which creates potential arbitrage opportunities all the time – merger transactions!

When an acquiring company chooses to purchase a target, the stocks of the two businesses will continue to trade independently for a period of time as the deal works out regulatory and other issues before closing. During this period of time, there remains risk that the transaction will not close or any number of other events could prevent the transaction from closing. Provided the transaction does close, however, the merger transaction establishes an accepted price for the stocks in question and gives an investor the opportunity to extract value from variations to the closing price.

Five Opportunities if you’re interested
Here are five pending merger transactions right now.

The classic merger arbitrage opportunity is the all stock merger. In the above chart, you can see it with Black & Decker and Stanley Works. Here, the proposal is that Black and Decker shareholders will receive 1.27 SWK shares per Black & Decker share. Here, we know that at closing day, there is an established exchange rate for the two stocks. Yet, at closing prices, SWK’s closing price of $50.17, today, the exchange of 1.27 shares would yield an implied value of $63.72/share to Black and Decker shareholders versus Black and Decker’s closing price of $62.27 today. This is the arbitrage opportunity. As time passes, we know that the valuation gap must close since the stocks of each company technically represent the same combined entity (assuming the merger closes). As we don’t know how exactly the gap will shrink, we can buy the BDK at $62.27 and short SWK at $50.17 to lock in the spread that we have identified.

The second kind of merger transaction is the all cash deal. This is simple enough. For example, Oracle offers Sun Microsystems $8.50/share in cash. In this case, there isn’t really an “arbitrage” opportunity as you won’t be buying and selling the shares on each side of the transaction. The $8.50 simply sets the exchange value and purchasing the target’s shares (JAVA in this case) allows you to profit from any spread.

Finally, there’s the Pepsi and PepsiAmericas deal where you see that consideration is given in 50% stock and 50% cash. This is simple enough. Calculate the spread as though the transaction were 100% stock. Then, average that with the value of the cash exchange. And, voila, the implied price!

Full disclosure: No position in the stocks mentioned in this post.

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.