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Related topics: stocks, investing strategy, MasterCard, Visa, Michael Brush

It took a financial meltdown and years of consumer complaints for politicians in Washington to finally take up banking reform. We could argue about how well they did.

But innovators have been on the case for a while -- helping fed-up customers like Clearwater, Fla., nurse Edna Jackson dump traditional bank accounts, and aiding many consumers simply spurned by banks.

Jackson got frustrated years ago with a constant barrage of large bank overdraft charges for overspending by just a few dollars.

So three years ago, she opted for what's now one of the hottest alternatives -- a reloadable prepaid card that lets her manage her money without ever dealing with a bank. "I really enjoy my card. I use it for everything," says Jackson. She likes the card so much she tells her friends to get one, too.

In fact, use of prepaid cards has been soaring, a trend that should continue for years both in the U.S. and abroad. The Mercator Advisory Group, a research firm, estimates that the $8.7 billion loaded onto reloadable prepaid cards in the U.S. in 2008 will grow to $118.5 billion in 2012, or 92% a year

image: Michael Brush

Michael Brush

"We think the market opportunity in the U.S. and globally is tremendous," agrees Stewart Stockdale, who leads the prepaid card division at Western Union (WU, news). "It is still in the early stages."

That's exactly the kind of multiyear trend in which it often pays to invest. And just as the credit card world has Visa (V, news) and MasterCard (MA, news), this one also has two leaders: Green Dot (GDOT, news), whose stock you can buy now, and NetSpend, a private company preparing to go public.

How they work

With reloadable prepaid cards, users typically go to stores to put cash onto a piece of plastic that works like a debit card. Usually bearing a Visa or MasterCard logo, these cards can be used at most retailers. They also allow users to withdraw money from ATMs, pay bills and do transactions online.

While formally issued by banks, they are managed and marketed by other companies, and consumers never interface with the banks themselves.

You might think Visa and MasterCard would feel threatened by reloadable cards. Instead, they see them as a growth driver. These two credit card giants make money by licensing their brands and taking a little piece of every transaction. That's why both companies are also potential ways to buy this trend, along with Western Union.

The two newer names are the ones that show the strongest growth, though. Customers put $5.8 billion on Green Dot cards and $7.3 billion on NetSpend cards last year, and that will rise sharply by many estimates.

Operating revenue at Green Dot, which practically invented this space, more than tripled from 2006 to last year, to $234.8 million. Green Dot reported $15.5 million, or 29 cents a share, in earnings on $92.8 million in revenue for the second quarter. NetSpend revenue almost tripled from 2006 to last year, to hit $225 million. NetSpend expects to report $5 million to $7 million in net income on $65 million to $68 million in revenue in the third quarter, about flat from the first two quarters of the year.

No fee-free lunch

Why are prepaid cards so popular? Simply put, a lot of people are fed up with banks, and they're not taking it anymore. "The fees are what really pushed me away from the banks," says Jackson. "The fees can be outrageous. With the prepaid card, I don't have that worry."

Mind you, reloadable cards do charge fees. It's just that they can be lower, with fewer surprises. Prepaid card issuers charge anywhere from $3 to $5 for a card. Monthly fees run around $6, and it can cost up to $5 each time you put money on a card, though direct deposit of paychecks is typically free.

JPMorgan Chase analyst Tien-tsin Huang estimates bank customers don't find prepaid cards attractive until they are getting hit with about five insufficient-funds charges per year, since prepaid cards cost about $150-$300 a year.

So who uses them? "Most of our customers make $30,000 to $50,000 a year," says Green Dot CEO and founder Steven Streit. "They are folks who are living paycheck to paycheck. They are very cash-flow sensitive and fee sensitive."

Prepaid card users may not be able to get credit cards because of low credit scores, or they may have a hard time keeping minimum balances in traditional accounts. But they need plastic for things like booking airfare or hotel rooms, and paying bills. "We are living increasingly in a cashless society," says Streit. "If you don't have MasterCard- or Visa-branded debit card, you are going to have a rough day."

Another factor boosting demand for prepaid cards is the increasing use of direct deposit to pay workers. Jackson has her paycheck deposited directly onto her NetSpend card; she estimates that half the employees on her floor at the hospital where she works have their pay deposited to a prepaid card.

The potential customer base is big. According to government studies, more than 70 million people in the U.S. are unbanked or under-banked, which means they have accounts but pay bills in other ways, such as with money orders or cash. "A large number of consumers today are living outside the financial mainstream," says Hyung Choi, head of U.S. prepaid products at Visa. Less than 20% of this group has ever used a prepaid card, says Choi. "So clearly it is early days."

Here's a closer look at the main players in this space.

Green Dot

Green Dot is clearly the leader in reloadable prepaid cards, with about 3.2 million active accounts. Its cards are available in about 50,000 stores across the nation. Most of these outlets -- Wal-Mart Stores (WMT, news), Walgreen (WAG, news), CVS Caremark (CVS, news), Rite Aid (RAD, news) and Sears (SHLD, news) -- are locked up in exclusive, multiyear agreements.

This is one of Green Dot's big advantages because it creates "a powerful network effect which should attract more retailers and cardholders," believes Huang at JPMorgan Chase, who has a 12-month price target of $60 on the stock. It recently traded for $47. Green Dot also has partnerships with TurboTax for tax services and with PayPal.

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Green Dot
Graphical chart for GDOT

Besides card fees, Green Dot also gets a piece of the "interchange" fee, the part of a purchase price that merchants share with card issuers. Deutsche Bank analyst Christopher Mammone expects Green Dot revenues and earnings to grow by 30% to 35% a year over the next three years.

One problem with the stock is that a lot of investors like it, which means it is pretty fully valued; you're not getting a bargain. That's one reason JPMorgan's Huang suggests buying on dips. "It is definitely pricing in a lot of growth," agrees Nick Einhorn, an analyst with Renaissance Capital, which invests in initial public offerings. "The assumptions underlying the valuation are not unreasonable, but they have to execute. The stock is at a price where, if they disappoint, it could really take a big hit."

Critics also lament the high turnover in Green Dot's customer base. Only 38% of its customers have had cards for more than a year, which suggests it has to keep finding lots of new customers to maintain growth. Green Dot CEO Streit responds that the high turnover shouldn't be a surprise, since many customers use cards for one-time expenses. Streit says many customers who let cards lapse later use Green Dot cards again, suggesting that turnover isn't as high as it seems.

Einhorn says the short-term nature of the prepaid card can actually be one of its appeals. Using a prepaid card means you don't have to lock into a long-term bank or checking account to get a debit card. "You pay and use it for a month, and that is it," says Einhorn.

Another risk to watch for is that early investors and Streit, who founded the company, still own about 59% of the stock. They will be free to sell when lock-ups expire around mid- December, which could put downward pressure on the price.


NetSpend is the second-largest player in the reloadable prepaid space, with about 2.1 million active cards. It's in about 38,000 retail locations, but it has more of a presence at payday lenders and check-cashing outlets. One challenge for NetSpend is that Green Dot has locked it out of many of the most important retailers. But a plus for NetSpend is that it has more direct payroll deposit relationships -- with about 800 employers. People who put their paychecks on prepaid cards tend to keep the cards longer and use them more often.

NetSpend is a private company, but it is pricing shares next week for an IPO in the near future. Given the hot growth rates for this sector, and the sharp rise in Green Dot shares after its IPO, even if the stock has pulled back lately, demand for NetSpend stock in the IPO should be robust.

For retail investors, pre-IPO shares will be hard to get, unless they have large brokerage accounts at one of the underwriters, which include Goldman Sachs Group (GS, news), Bank of America (BAC, news) and William Blair. Be wary about chasing shares if they shoot up immediately after the IPO.

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Graphical chart for V

Visa and MasterCard

These two credit card networks like reloadable prepaid cards because they offer three ways to make money. Visa and MasterCard collect licensing fees for use of their brands, and they each offer networks that prepaid card issuers can use when customers reload cards.

Finally, the more consumers use plastic, the more card-related fees they can collect on retail transactions.

Prepaid cards have been the fastest-growing form of payment at Visa for several years, but from a small base. Its brand is on more than 135 million prepaid cards in about 10,000 card programs in 110 countries.

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Graphical chart for MA

MasterCard is in six of the world's largest prepaid programs, and it is about to launch a new one with Univision, the TV channel that caters to Hispanics. Currently, reloadable prepaid cards are "a small part of revenue, but a big part of growth," says Laura Kelly, the head of prepaid cards at MasterCard.

Morningstar analyst Michael Kon has a four-star rating on Visa, the second-highest Morningstar rating. He has a three-star rating on MasterCard. But using these giants to invest in this trend is tough, since prepaid cards are such a small part of the companies' total business.

Western Union

Customers who already use Western Union instead of banks to handle cash and checks are exactly the kind of people who might use prepaid debit cards. Prepaid cards are "very much in our sweet spot," says Western Union's Stockdale. "Our money transfer business and bill paying business is very much the same customer."

Western Union has only 650,000 prepaid cards in circulation, but it is trying to win over customers by offering cards with no upfront costs or monthly fees.

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Western Union
Graphical chart for WU

Another advantage for Western Union is that it has 430,000 offices in 200 countries and territories. The "un-banked" population is huge in many emerging countries where Western Union has a strong presence, including Mexico and Brazil. Barclays analyst Darrin Peller has an overweight rating on the stock in part because he thinks Western Union will be able to take advantage of this network to sell a lot of prepaid cards to all those people without bank accounts. Unlike Jackson, in Florida, they've never had bank fees to gripe about. So they just might give Western Union an earful about its fees, instead.

At the time of publication, Michael Brush did not own or control shares of any company or fund mentioned in this column.

Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.