MasterCard (MA) – Current Price: $94.35 (06/20/16)
MasterCard is a technology company in the global payments industry that connects consumers, financial institutions, merchants, governments and businesses worldwide, enabling them to use electronic forms of payment instead of cash and checks. MA facilitates the processing of payment transactions, including authorization, clearing and settlement, and delivers related products and services. MasterCard has three ubiquitous brands that include MasterCard®, Maestro® and Cirrus®. MA also provides value-added offerings such as loyalty and reward programs, information services and consulting.
A typical transaction on MasterCard’s network involves four participants in addition to MA: cardholder (an individual who holds a card or uses another device enabled for payment), merchant, issuer (the cardholder’s financial institution) and acquirer (the merchant’s financial institution). MasterCard does not actually issue cards, extend credit, receive revenue from interest rates or other fees charged to cardholders by issuers, or establish the rates charged by acquirers in connection with merchants’ acceptance of its branded cards. In most cases, cardholder relationships belong to, and are managed by, MA’s financial institution customers.
MasterCard Network from 2015 10-K
MA generates revenue by charging fees to issuers and acquirers for providing transaction processing and other payment-related products and services, as well as by assessing these customers based primarily on the dollar volume of activity, or gross dollar volume (“GDV”), on the cards and other devices that carry its brands.
MA operates the MasterCard Network, a global payments network that links issuers and acquirers to facilitate the processing of transactions, allowing MasterCard cardholders to use their cards and other payment devices at millions of merchants worldwide. MA processes transactions through its network for its issuer customers in more than 150 currencies in more than 210 countries and territories.
Earnings Consistency and Growth
Since MasterCard became a public company in 2006, it has shown consistent earnings growth, except for 2008, when income went negative. MasterCard showed a net loss that year of $535 million, which included a provision for litigation settlement of almost $2.5 billion. While net income was negative in 2008, free cash flow was still positive. Antitrust litigation has been a large issue for MasterCard, which I will discuss later.
Visa does a great job of providing a table each year in its 10-K that shows the total dollar volume, number of cards outstanding, and total transaction volume for Visa, MasterCard, Disover, American Express and JCB. I feel comfortable using Visa’s statistics for MasterCard’s growth, because they should have no reason to inflate MasterCard’s results.
See the 3 tables below showing MasterCard’s historical gross dollar volume, number of cards outstanding, and total transaction volume.
For each chart above, growth and market share are in percentages on the right vertical axis and the variable is on the left vertical axis.
Cash Flow Conversion
MasterCard does a great job of converting its net income into cash. Over the past 7 years, free cash flow has been anywhere from 84% to 132% of net income. I did not include 2008 because net income was negative. MasterCard operates in a business with low capital expenditures, so it was to be expected that they would do an adequate job converting net income into cash flow.
For most of MasterCard’s existence as a public company, it has been virtually debt free. Recently, the company has started to take on some debt. MA ended 2015 with approximately $3.3 billion in debt and approximately $6 billion in equity. MasterCard ended 2015 with an Asset/Equity ratio of 2.7, partially due to $1.75 billion liability listed under accrued expenses on the balance sheet. Liabilities like that are interest free financing, allowing MasterCard to leverage its equity while taking on relatively low levels of debt.
Interest Coverage Ratio
The most recent interest coverage ratio was 83x in 2015, which includes interest on the much higher debt level than previous years.I have very little concern with MasterCard being able to service its debt. In fact, free cash flow for 2015 was higher than the total debt level, which would allow MasterCard to pay off all of its debt with less than one year of free cash flow.
MasterCard has many competitive advantages stemming from its interactive network. This type of network has positive feedback loops embedded within. As more merchants accept MasterCard’s brands, the more consumers want the cards. The more consumers that get cards, the more merchants want to accept MasterCard. As MasterCard grows and is accepted in more places, the network effects get stronger and the moat for the business grows.
However, Visa is one competitor that makes things difficult for MasterCard. Between Visa, MasterCard, American Express, Discover and JCB, MasterCard processes approximately 35% of the transactions processed by all five businesses. This is quite a large portion of the market, but not even close to Visa’s portion. Visa has almost 58% of the market, which doesn’t leave much for the remaining three businesses.
While Visa’s larger network is most likely stronger because of its size and provides Visa with an ostensibly stronger moat, I believe that this market can continue to sustain two payment networks, as it has for multiple decades so far. Both businesses have reached the scale they need to have a sustainable competitive advantage. While I do appreciate Visa’s size in comparison to MasterCard, it doesn’t seem that Visa’s bigger size has provided it any sort of financial advantage over MasterCard that may have been expected.
MasterCard makes the following statement in its 2015 10-K, “Cash and check continue to represent the most widely used forms of payment, constituting approximately 85% of the world’s retail payment transactions.” This piece of information is one of the most important that I’ve come across in my research of the business. Whether the actual number is 75%, 65%, 85% or 95% doesn’t matter so much. What does matter is that cash and checks are still an overwhelmingly large portion of all payments made in a world that is headed in the direction of electronic payments.
While there are other types of technology trying to enter the payments industry, I’m not so sure they’re fighting for the same chunk of the industry that MasterCard is fighting for. Everyone is fighting to steal market share from the cash and check portion and no one is there intentionally defending the cash and check market share. I find this to be one of the most important qualitative aspects of MasterCard’s business.
The network effect that MasterCard has severely limits competition in the portion of the transaction that Visa and MasterCard handle. While technology in the payments space continues to evolve, most of it still involves Visa or MasterCard. PayPal, for instance, provides MasterCard-branded debit and credit cards, meaning that MasterCard is making money when you use your PayPal debit or credit card.
Visa and MasterCard are ubiquitous throughout a significant portion of the world. While new technologies are great, it’s extremely hard to match the size and scale that both companies have achieved. When you go out shopping, you can almost guarantee that the store you walk in to accepts Visa or MasterCard. You don’t get the same feeling for other technologies or brands, such as American Express or Discover.
From a consumer’s standpoint, Visa and MasterCard have provided me just about everything I need. Almost anywhere I go, I am able to use my card. The transactions are fairly quick, at least quick enough that I don’t feel inconvenienced. Although there have been some security issues with their cards, they have mainly stemmed from data breaches at various merchants. The bottom line is that consumers don’t have a reason to embrace a new brand or technology, when that new technology will be less available and less convenient for some time while the technology reaches the right scale.
MasterCard and Visa do not seem to have a bitter rivalry between the two. It seems to be an industry where there is some degree of implicit cooperation between the virtual duopoly. An industry such as this, with high returns and little competition is ripe for new entrants and large lawsuits. As you’ll see below, the litigation has been an issue for MasterCard over the years since it has become a publicly-traded company.
MasterCard has been sued numerous times over the years for very large sums of money and has settled on a number of occasions. In 2008, MasterCard settled an antitrust lawsuit with American Express. That year, a line item on MA’s income statement popped up called “Provision for litigation settlement” for almost $2.5 billion. This all stems from a 2004 Supreme Court ruling that Visa and MasterCard violated antitrust rules by prohibiting member banks from offering credit cards from rival payment networks .
In 2012, MasterCard and Visa settled an antitrust lawsuit filed by the merchants they serve. The merchants claimed that MasterCard and Visa, as well as some of their member banks, unlawfully fixed swipe fees for merchants . This suit was originally settled for $7.2 billion dollars among Visa, MasterCard and various banks, but some of the merchants, representing approximately 25% of the settlement, opted out and are now suing MasterCard and Visa separately.
While the litigation issue is extremely important, MasterCard has been able to not only survive, but thrive. This is something that I will continue to keep a close eye on.
Companies are creating new technology everyday to unseat MasterCard and its rival Visa. However, it seems to be difficult to unseat either of the two companies because of the advantages created by the size of their networks. Even companies like PayPal have a significant quantity of its transactions that use the MasterCard or Visa networks. This is again something to keep a close eye.
Regulation of the fees charged for transactions seems to be an ongoing thing in many countries. A big one is the regulation of debit interchange fees. Interestingly enough, MasterCard does not actually collect the interchange fees, but the regulation could provide disincentives to the banks that collect those fees to partner with MasterCard.
MasterCard historically applied what they call “no-surcharge rules” that prohibited merchants from charging higher prices to consumers who pay using MasterCard products instead of other means . MasterCard’s ability to apply “no-surcharge rules” is becoming much more difficult due to litigation against the company.
While the payments industry is already highly regulated, it may become more so over time because of the strong positions that Visa and MasterCard have in the space.The lack of competition because of the inherent network effects of the industry may draw more attention and regulation in the industry, especially since Visa and MasterCard are publicly traded companies.
MasterCard is currently priced at $94.35 per share, with a resulting market cap of $101.4 billion. In the most recent fiscal year, MA had $3.7 billion in free cash cash flow, resulting in a P/FCF ratio of 27.4x. MasterCard seems to be quite expensive at this time, but there could be justification for this price. I believe MA has one of the strongest moats out there and consistently shows higher returns on invested capital than Visa.
MasterCard’s interactive network provides the company a distinct competitive advantage at it’s current scale, which limits competition in the part of a payment transaction that MasterCard handles. While new competitors seem to enter the payments industry on a relatively consistent basis, most do not seem to compete with MasterCard directly. Companies such as PayPal directly compete with MasterCard in some transactions, but also have a significant number of transactions that still use the MasterCard network. According to MasterCard, 85% of payments worldwide are still executed using cash or check, so there is a long runway for growth.
I do have concerns over the litigation that MasterCard has to deal with, but I’m still unsure as to whether it’s a good thing or bad thing. MA gets sued because it has such a strong business and competitors have a tough time competing. If competitors struggle to compete with you, they’ll sue. My concern is the large settlements that MasterCard has agreed to. 2008 was a terrible year for MasterCard not because of its operations, but because it had a provision for litigation that was $2.5 billion.
The bottom line is that MasterCard has a strong business that I would love to own. I believe the price right now is on the high side of fair and I may wait to pull the trigger until I see better prices.
Disclosure: I/We have no investment in MasterCard at this time. I/We may initiate an investment in MasterCard within the next three months.
 MA 2015 10-k