This Small IPO Stock Could Jump as Much as 70%

With each passing month, the challenges seem to build for major banks. Their commercial customers are not looking to take out big loans and their consumer business isn't looking so hot either. Regulators have started to curtail certain fees, limiting debit-card transaction charges, for example.

In response, banks are doing what they always do in such times, raising fees elsewhere. That free checking account? Get ready to start paying up for the privilege as more banks toss in monthly charges of up to $5 per month. You use a debit card? Some banks are starting to charge a $3 to $6 monthly fee if you use it at least once a month. This is great news for NetSpend Holdings (Nasdaq: NTSP ) , a once-broken initial public offering (IPO) that appears to have hit bottom and may soon rise up as it benefits from the changing banking landscape.

Prepaid: from wireless to debit

As the wireless phone business started to mature, the industry was able to squeeze out more revenue by attracting lower-income consumers with prepaid calling plans. There's no need to worry about the risk of an unpaid bill with these customers, because they have to pay in advance. NetSpend is doing the same thing for the banking business: providing prepaid debit cards that consumers can use at an ATM, at the checkout counter or for online transactions. Customers can access all of their account information on a website online, just as traditional banking customers can.

It's a huge market opportunity. The Federal Deposit Insurance Corp. ( FDIC ) calculates roughly 60 million Americans are "underbanked," meaning they lack the creditworthiness to obtain traditional banking services. NetSpend, along with rivals such as Green Dot (Nasdaq; GDOT) and others, are tackling this niche, which is still mostly unpenetrated. NetSpend is a bit smaller than Green Dot, but no small fry itself, with $300 million in annual revenue. This is the result of a network of 750 retail distributors operating 39,000 domestic locations where customers can buy a card.

NetSpend makes its money by charging service account fees. It's still a great deal for customers. The average checking account costs $279 a year, while the use of prepaid debit cards cost $158, according to Barrington Research. This may explain why checking accounts are slowly losing favor. According to the Nilson Report, the number of card transactions is growing 10% annually while the number of paper transactions is declining 3% annually. D.A. Davidson adds that "the U.S. Government is soon to eliminate paper check payments, and merchants are increasingly likely to favor debit over credit-card transactions."

The road to deeper industry penetration has gotten bumpy, though. NetSpend saw sales rise at least 40% every year through 2008, but growth cooled to around 20% in 2009 and 2010. When the company went public in October 2010, analysts were anticipating a similar growth rate for 2011 and 2012, but the loss of a pair of sales channel partners led the company to lower guidance, so investors should anticipate sales growth in the low teens in 2011 and 2012. NetSpend is said to be in talks with new channel partners and, if successful, then it could see an uptick in its projected growth rate.

The recent slowdown in growth isn't a sign the market is quickly maturing, it's just that NetSpend will need to find ways to further boost awareness of the prepaid debit cards, which many low-income consumers still know little about. A recent deal with television network BET could be a huge boost. The two firms will start working together this winter to target BET's 90 million strong viewership base (of which 11 million are "underbanked," according to D.A. Davidson). Preparing for the launch has led to increased spending this year, which is why analysts expect per-share profits to rise only about 15% this year to roughly $0.45.

-- David Sterman

The dampened near-term outlook has pushed this stock down from the 52-week high of $16 to a recent $6. Curiously, the falling stock price comes at a time when NetSpend should finally start to see a solid profit increase in 2012 and beyond. The charm of thisbusiness model is its low fixed costs , which could enable profit margins to rise at fast pace. In 2010, "incremental revenue converted to incremental EBITDA at a 50% rate," according to Barrington Research. Operating margins are expected to rise from 15% in 2010 to 18% in 2011 and 22% in 2012, according to Sterne Agee.

The other big concern for NetSpend has been revenue consistency. Signing up new customers doesn'tmean much if they only stick around for a few months. So NetSpend is pushing customers to link their prepaid debit cards to direct deposit payrolls, which reduces customer churn. Roughly 23% of customers did so in 2008, 34% did in 2010, and 37% used direct deposit to replenish balances in the most recent quarter. The company is courting Human Resource departments at companies in a bid to get the number above 40% in 2012. As this figure rises, investors can be better assured that sales growth won't cool off from the current level.

Risks to consider: Netspend's success has attracted interest from traditional banks looking to offer their own prepaid debit cards. Rising competition could lead to price wars, pushing the company's margins back down.

Action to Take --> This is a business either being built for higher profits or to find a home at a larger financial institution. Sterne Agee thinks NetSpend "could be a strategic fit for other card companies, money transfer providers, a direct competitor or even private equity companies." They add shares , trading for less than six times EBITDA, look like they could easily move up from here. Analysts have target prices n the $7 to $10 range, implying upside between 20% and 70%.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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