Tuesday, December 18, 2012

Three Plays in Growing Smart Card Market

It was over in minutes.  As I exited a crowded New York City bus, I felt a push against my backpack.  I did look back to see who was behind me, but shrugged off the insult as I made my way round the corner from the bus stop to a deli.  It was there I discovered my wallet had been lifted from the backpack. Within minutes a total of $1500 in Bloomingdale’s gift certificates had been purchased on my credit and bank cards.  The efficiency in this larceny was remarkable.

Credit and bank card theft happens every day in every city and town around the world.  Card sponsors and merchants are left holding the bag.  The tools are available to address these threats.  The industry just needs to implement them.  For example, card sponsors in Europe have adopted stricter security procedures inherent in payment cards with computerized chips called “smart cards.”  As a result, global card fraud worldwide as a percentage of total volume has actually decreased. In 2010, total fraud losses equaled 4.46¢ per $100 in total volume of purchases and cash, down from 4.71¢ per $100 in 2009. Even so, since the rate of spending outpaces loss reduction, total global fraud increased to a whopping $7.6 billion in 2010. 

According to Nilson Reports, the U.S. accounts for 47% of global credit and debit card fraud even though it generates only 27% of the total volume of purchase and cash transaction.  In 2010, payment card fraud losses totaled $3.6 billion in the U.S. from all general purpose and private label, signature and PIN payment cards.   The U.S. has a disproportionate percentage of the global total losses for two reasons as U.S. banks and card sponsors have been slow to adopt newer technologies such as the computer chip-fortified cards used in Europe.  U.S. credit card issuers are able to push responsibility onto merchants in a way not possible in Europe or elsewhere.  What is more, U.S. issuers are reluctant to decline card authorization from merchants because they do not want to alienate the U.S. cardholder who normally has at least four credit cards in his wallet.


Source:  The Nilson Report

Market Opportunity; Investment Theme

Even though European card issuers have managed to reduce loss through card theft, the remaining losses are clearly very high.  There is considerable incentive to adopted additional solutions to bring losses as close to zero as possible.  What is more, as credit card use gains popularity around the world, card issuers in other jurisdictions are keenly interested in preventing credit and bank card fraud. 

In my view, the situation presents an opportunity for card suppliers and security solution providers.  Here I look at three companies which appear well positioned to capitalize on the opportunity:  a market leader, an integrated supplier, and finally a technology innovator.

First a Brief Look at Smart Cards

Originally developed in the 1970s, one of key attractions of smart card technology is versatility.  It works on multiple applications such as access control, banking, health care or transportation.  What is more it allows cross compatibility with various devices like personal computers, personal digital assistants (PDAs), mobile phones, ATM’s, digital receivers and many more devices.

Earliest bank and credit cards operated with a magnetic strip across the back of the card, but increasingly card issuers have turned to smart cards with an embedded semiconductor chip to hold identification and authentication information.  Besides allowing storage of information, smart cards with embedded microprocessors can also process information such as the authorized user’s identity or a Personal Identification Number (PIN).  Although not the only possible method, the majority of implementations of EMV cards and terminals confirm the identity of the cardholder by requiring the entry of a PIN.  Indeed, the use of chip-embedded credit and bank cards has become the norm in Europe and is one of the security measures that has helped significantly reduce fraud there.

Smart cards have been widely adopted for bank and credit cards.  This is due in part to the establishment of technology standards by international payment processors.  In 1993, MasterCard, Visa, and Europay (EMV) agreed to work together to develop the specifications for smart cards as either a debit or a credit card. The first version of the EMV system was released in 1994 and later updated in 2000 and 2004.  Twenty-two countries have already adopted the EMV standard, including most of the European Union and various Asian, African and South American countries, and both Mexico and Canada are currently migrating to the EMV standard.  Visa (V:  NYSE) and MasterCard (MA:  NYSE) recently announced plans to accelerate adoption of embedded chip technologies in the United States by 2015. This includes migrating the payment infrastructure to accept EMV compliant cards featuring PIN-based authentication.

According to market research firm, Electronics.ca Research Network, the global market for smart cards, including those intended for use as bank or credit cards, was valued at $4.7 billion in 2011.  The sector is projected to reach nearly $7.3 billion by 2017.  This represents a five-year compound annual growth rate of 7.4%, a rate not observed in many industries in the continued troubled economic environment.

Electronics.ca reports there are about 6.8 billion smart cards in use around the world today.  This very large market that can be divided by the way smart cards communicate.  The contact between the smart card and the detection system can be via direct, physical contact or through radio frequency without contact.  Contact cards represent about two-thirds of the total 6.8 billion smart cards in use around the world.  However, contactless cards are growing in popularity with highly mobile consumers and are expected to jump from about 21% of total cards in use today to about 28% of the market in the next five years.

Corroborating this forecast is another from ABI Research, which indicates there is a growing demand for secure microcontrollers for smart cards enabling high levels of security and authentication as well as increasing security within connected devices.  The group recently increased its shipment forecasts for 2012 from 261 million to 540 million units.

ABI Research also reports that growth in the contactless market is driven by continued adoption of dual-interface bank and credit cards, migration to contactless identification cards, and increasing penetration of Near Field Communication (NFC) technology into handsets. The group estimates that in 2012 contactless shipment growth was 30% for the chips and 24% for finished smart cards. The tipping point for contactless growth is expected around 2014 to 2015, which coincides with the completion of some large scale projects within the government identification and payments market.  Thus, along with the opportunity presented by growing smart card volumes, suppliers are also presented the chance to offer high value-added products with improved functionality.

The Market Leader  -  STMicroelectronics

Formed through a string of key acquisitions and previously known as SGS-Thomson, STMicroelectronics (STM:  NYSE) is one of the earliest entrants to the smart card arena.  In September 2012, in an effort to enhance security ST introduced its next generation of secure microcontrollers for smart cards used in transportation, banking and other payments.  Unlike competing chip-card products that implement software-based security, ST’s secure microcontrollers use tamper-proof hardware to execute robust security algorithms. 

In 2011, ST sold $1.2 billion in microcontrollers and memory chips, including those used in smart cards.  This represented 12.1% of the company’s total sales.  ST does not break out profit margin on particular chip groups.  However, ST did disclose that the microcontrollers and analog segment in which the smart card products are included, earned an operating profit of 20.3% in 2011, well above all other reported segments reported by ST. 

ST reported losses during the three years of the recession that gripped most economies between 2007 and 2009, but returned to profitability in 2010 and 2011.  That said, total sales have declined in each of the first three quarters of 2012 compared to the prior year and ST has reported a net loss for the year so far.  The problem has been in ST’s wireless division, which has been a losing segment for several years.  In November 2012, ST announced a decision to exit the wireless market and its interest in a joint venture with Ericsson (ERIC:  Nasdaq), called ST-Ericsson.  With this major strategic change, STMicroelectronics estimates it will face a combined market value of $14 billion, including the chance to supply its higher-margin microcontrollers for smart cards. 

Investors responded warmly to ST’s plans to focus on its most profitable opportunities and its stock has rebounded from three-year lows set in early 2012.  Still, STM is priced well below the peak three-year price, providing investors with a compelling entry point for a long position.  Additional developments in ST’s strategic ‘re-focusing’ should serve as strong catalysts for upward price movement even before earnings reports reveal a return to profitability.

The Integrated Supplier  -  Gemalto, N.V.

Gemalto, N.V. (GOTFF:  OTC/PK or GTO:  Paris) supplies contact and contactless smart cards, payment chip cards, payment terminals, and user authentication solutions for secure online banking.  According to the Nilson report, Gemalto is the number one provider of microchip-embedded cards used in banking and credit, commanding the largest market share in the segment.  The company’s customers include three hundred of the world’s banks. 

Secure transaction cards and security applications represent 25% and 17%, respectively, of Gemalto’s total revenue.  The company has forecast high single-digit growth for sales in its secure transaction segment over the next year as the U.S. market migrates to the EMV standard noted above and mobile payment adoption grows.  The real promise is in security solutions, which Gemalto predicts could grow at double-digit rates on wider usage of robust authentication in the private sector, including banking and credit applications.

Gemalto’s optimism is supported by the recent certification of the company’s new high-end SIM card by the three largest payments networks, American Express, MasterCard and Visa.  Gemalto’s UpTeqNFC card as it is called had already been certified under EMV standard.  The UpTeqNFC acts as a tamper-proof secure element for consumers’ confidential credentials and payment data and is expected to be popular for NFC transactions.

U.S. investors can take a position in Gemalto through the company’s quotation on the Over-the-Counter service.  Otherwise Gemalto trades on the Paris bourse under the symbol GTO.  Presently, Gemalto shares are quoted on the OTC at 36.1 times trailing earnings, which is a substantial premium to the 11.2 earnings multiple commanded by shares of Samsung Electronics Co. (SSNLF:  OTC/PK), the largest player in the world smart card industry.  Of course, a variety of factors not related to smart cards drive either stock.  In the case of Gemalto, the smart card market opportunity presents a more important element of its overall financial picture. 

The Innovator  -  Smart Metric

Smart Metric (SMME:  OTC/BB) is new to the smart card market and is making its entrance felt throughout the industry.  The company has applied its prodigious expertise in sub-micro engineering to building biometric sensor technology that can be embedded in a smart card and used to read fingerprints.  Smart Metric has also developed fingerprint recognition software with the ability to match up to 60 points on a fingerprint, far more than any other matching program.  Smart Metric CEO Chaya Hendrick believes its technological superiority can win the company a seat at the smart card banquet. 

The company expects to set records when it takes its new technology to the market in early 2013.  Fingerprint applications are not without precedent.  Gemalto has used the Match-on-Card fingerprint technology from Precise Biometrics for facility access cards.  SecuGen Corporation in South Africa teamed up with Net1 Applied Technology for identification cards secured by fingerprints.   However, Smart Metric’s cards will be the first bank and credit cards with the superior security capability of biometric identification.

Card holders simply swipe the Smart Metric card with their thumb when it arrives to record their fingerprint.  The fingerprint data cannot be altered or extracted from the device.  Subsequently, the card can only be activated by that person before inserting into an ATM or card reader.  The fingerprint scanning, matching process and device activation all occur on the card.  Smart Metric management believes it is the only system ready for the market that performs all functions inside the device and without connection to a central database.

Smart Metric believes its biometic smart cards represent a significant improvement over existing smart cards.  Using PINs for authentication have been proven vulnerable to security attacks such as the so-called “man in the middle attack” or can be circumvented through “card not present” frauds.  If a card or device can only be authenticated with by fingerprint matching, both threats are eliminated. 

Smart Metric recently launched its first commercial application  -  a biometric fingerprint-activated MedicalKeyring.  Patients can carry the device as a key ring attachment to provide critical medical care information in the event of an emergency.  The devices are also helpful in avoiding costly and time-wasting duplicate medical tests as results from one test can be accessed and analyzed by multiple health care professionals.
Smart Metric expects to follow along with a second commercial product in the health care sector.  The company has developed another portable medical record device with storage capacity of 128 gigabytes.  This is more than enough for an individual’s medical data accumulated over a lifetime.  Any information on the devices, including X-rays and other medical imaging, can only be accessed with authentication by fingerprint. 

The company is first targeting the U.S. market, where security of health care information has been a particular concern.  Management says it is working on an arrangement with an unnamed pharmacy chain in the U.S. that will market the device to its customers.  This represents a low-cost means to access a large retail market.

Smart Metric has already set up manufacturing capacity in Argentina.  The Argentina location offers qualified labor and attractively priced facilities.  Management concedes its biometric sensor and fingerprint recognition software pad the production cost of its devices.  Smart Metric engineers have had to develop specialized manufacturing processes for embedding fragile biometric chips into the card.  Location in a low-cost market helps, but the company expects the exceptional security benefits of its smart cards can be justified by risk of loss to fraud and identify theft.

The Argentine outpost also affords a friendly trading relationship with other South American countries.  Smart Metric management is particularly interested in the Brazil market, which is far ahead of the U.S. in smart card adoption.  By 2009, Brazil had 486 million EMV compliant bank and credit cards or roughly two smart cards for every person in the country.  Frost & Sullivan predicts that EMV migration in Brazil will be close to 100% by 2013, with even faster adoption of prepaid cards.

The company is still at a developmental stage, has yet to record revenue and has reported a total of $12.2 million in net losses since inception in 2002.   To put a finer point on the matter, investors should note that Smart Metric has used a total of $9.2 million in cash since inception in 2002 through the end of September 2012. The cash burn rate in recent months has been near $185,000 per month.  Cash on hand at the end of September 2012 totaling $610,498 gave the company a three month cushion. Smart Metric has no debt and has been capitalized exclusively with sales of common stock.

Shares of Smart Metric are quoted on the Over-the-Counter Bulletin Board.  The stock is currently price under $1.00 per share and is considered a micro-cap stock.  Micro-cap stocks are characterized by price volatility, low trading volume and wide bid-ask spreads, which makes such stocks appropriate only for risk-tolerant investors.  Investors with patience could consider the stock as an option on Smart Metrics a highly innovative technology.

Smart Metric shares could pay off in the court room as well as in the market for smart cards.  The company has filed a patent infringement suit against MasterCard and Visa related to a patent Smart Metric received in the U.S. in 2004.  Smart Metric claims its patent covers any use of contact data cards to make a data connection between a card reader and a public or private data network, such as those for retail purchases, ATM transactions using EMV cards, among other secure and authenticated data exchanges using a smart card. 

If Smart Metric prevails in the case, it could force a financial concession or some sort of settlement by MasterCard and Visa such as royalties for each contact transaction in the U.S. payments market.  While contactless transactions are growing as a percentage of the total payments market, contact cards still represent over half of cards in use.  The case is currently in the discovery stage and a court date is expected to be set in Fall 2013.

As in all early stage companies, qualified management is critical to realizing strategic goals.  Smart Metric was founded by Chaya Hendrick, a computer engineer with previous entrepreneurial successes.  Elizabeth Ryba is a director of Smart Metrics and brings to the firm sixteen years experience in the credit card industry.  Ryba has a background in marketing and has extensive experience in product launch and promotion.  The company’s chief financial officer is Jay Needelman, who has lengthy corporate experience and is a certified public accountant.

Summary:  Going for Growth

Protracted difficult economic conditions have driven companies to conserve every penny in case of even darker days around the corner.  Unfortunately, cost cutting and conservative cash management does not power earnings growth in the long term.  It takes growing sales that can only materialize in healthy addressable markets. 

Three vehicles are offered to play the important and growing market for smart cards  -  one of the leading semiconductor producers with a highly differentiated line of security chips, a dominant player in banking and credit cards and a new innovative entrant.  The first two  -  STMicroelectronics (STM) and Gemalto (GTOFF)  -  are seasoned mid-cap stocks supported by substantial sales, profits and strong balance sheets.  The third company  -  Smart Metric (SMME) is not as well fortified, but offers the remarkable growth potential that can only be generated by leading edge technology.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.



We are well on are way to becoming a cashless economy. Companies involved in credit card security credit card processing appear to have a very bright future. The three companies in the post appear to have excellent prospects.

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