Keep Tabs on This Subprime Leader

 | Jul 17, 2012 | 11:30 AM EDT  | Comments
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Remember the subprime credit industry and all the mischief it caused global markets during the housing bust? Well, it's back, though it has a whole new name -- and it promises it absolutely won't hurt a fly this time (unless the fly really deserves it).

One of the leaders of the new wave of subprime lenders is NetSpend (NTSP). More broadly, the company is a provider of reloadable prepaid debit cards and related financial services in the U.S. The firm currently serves a market of 60 million consumers that it delicately calls "under-banked." Those are people who don't have a traditional bank account, or who rely on alternative financial services.

Based in Austin, Texas, the company has served more than seven million clients in the past decade with solutions for purchases, bill-paying and money management, all without requiring the need for a checking account or credit history. It was founded by Rojelio and Bertrand Sosa, immigrants from Mexico who saw an opportunity to service both legal and illegal immigrants who were not being serviced by traditional banks.

Chief executive Daniel Henry has run the company since 2008, when he came over from Euronet Worldwide (EEFT), an electronic-payment and transaction-processing firm he cofounded.

Here's the skinny on how the process typically works: Customers provide the company with their name and address, either online or at one of the partner retail sites, and receive their card in 10 business days. Consumers then have access to an extensive distribution network of more than 100,000 locations, such as retailers, check cashers and grocers, where they can purchase and reload NetSpend's debit cards.

These are FDIC-insured cards from Visa (V) and MasterCard (MA), issued by a number of state- and federally regulated financial institutions. The prepaid cards come with direct deposit options, online access, bill pay and many of the other services you would receive from a traditional bank account. Additionally, NetSpend offers an optional interest-bearing savings account that can be tied to the card. Because Visa and MasterCard only partner with member financial institutions, the firm has to work with banks such as MetaBank (CASH), U.S. Bank (USB), Bancorp (TBBK), SunTrust (STI) and others to issue the cards.

In addition to the prepaid card solutions, NetSpend also offers corporate payroll cards. The sales staff typically works with the treasury departments of partner banks to offer employers a payroll card solution for employees. The firm acquired Skylight Financial in 2008 to become the second-largest U.S. payroll card provider behind First Data.

So now that we know what's in it for the consumer, exactly how des NetSpend generate revenue? Well, this primarily comes from à la carte charges, ranging from $1 to $2, for purchase transactions or PIN purchases. Additionally, there are options for monthly fee plans, ranging from $5 to $9.95, that include most typical transactions for free. This has led to year-end 2011 revenue in excess of $300 million on 2.1 million active cards and 865,000 direct-deposit accounts.

NetSpend has an interesting revenue-sharing model with its merchant distributors that helps lead to strong partner loyalty. The firm shares its card post-activation revenue on a residual basis with its distributors -- revenue generated from the various fees associated with each account. This means many of its distribution agreements call for a forfeiture of all residual revenue, should the merchant cancel or fail to renew the contracts. As a result, NetSpend's partners are more inclined to continue the relationship, instead of looking at alternative options that would result in starting from scratch with another firm.

According to analysts at research firm Jefferies, prepaid card suppliers like NetSpend will benefit sharply from recent government regulation that has capped interchange and overdraft fee income -- though it could result in more competition as well. For instance, corporations like Western Union (WU) and American Express (AXP) have recently entered the market. With banks losing out on some of the fee revenue as a result of the new regulations, many of them are experimenting with prepaids as a way to recoup lost revenue and the nearly 20% of consumers that are not eligible to open a bank account.

Direct deposit accounts have grown by more than 60% annually the past five years, while the gross dollar volume of transactions have climbed at a 43% clip during that same time frame. Sustaining this type of growth makes for the biggest question mark moving forward, and NetSpend shares are down about 15% from their $11 initial public offering price in late 2010.

NetSpend (NTSP)

Most of that drop, however, occurred alongside the entire peer group last year, and for 2012 shares are actually up more than 16%. Keep this emerging growth stock on your radar.

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