Customer Concentration Risk

Express Scripts just recently announced the loss of Anthem as a customer when the contract between the two ends in 2019. Anthem is Express Scripts largest customer representing 17% of Express Scripts revenues and an even higher portion of earnings. This loss is a great example of the risk associated with customer concentration.

Express Scripts Faces Tough Test – WSJ


MasterCard (MA)

MasterCard (MA) – Current Price: $94.35 (06/20/16)

Business Description

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 Diagram

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.

Balance Sheet

Financial Leverage

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.


The Good

Network Effects

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.

Long Runway

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.

The Bad


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 [1].

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 [2]. 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.

New Technology

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.

Regulated Industry

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 [3]. 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.

Final Thoughts

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.



[3] MA 2015 10-k

Boeing (BA)

One of my goals with this blog is to publish a short investment thesis for various companies that I’m interested in. I’m writing them for a number of reasons; the first is to provide myself clarity in my thesis, the second is to get feedback from readers, and the third is to provide readers with a starting point for their own research. I would like to be clear that I am not making a recommendation for investing in any of the businesses I write about. I am only providing my thoughts on why I may or may not purchase shares of a business. There is no substitute for performing your own research on businesses. It’s important to note that there could be mistakes and errors throughout this research and I do not guarantee the accuracy of the information. This does not mean I do not try to be thorough and accurate in my research; it just means that I don’t want you to hold it against me if there is an error.

In the interest of full disclosure, I will tell you at the end of each post about a specific company whether I own shares in the company that I’m researching or possibly plan to purchase shares in the next three months. Most of the above information will eventually get added to a general disclosure page, but for now, this will suffice.

On to the good stuff. The first business I’m going to analyze is Boeing. Each investment analysis will be broken up as follows: 1. Business Description, 2. Quantitative, 3. Qualitative, 4. Price, and 5. Final Thoughts.

Boeing (BA) – Current Price: $134.85 (04/29/16)

Business Description

Boeing (BA) is an aerospace company that designs and manufactures commercial airplanes, military aircraft, and network & space systems. The company also has a global services and support segment, along with Boeing Capital. The company has five principal segments:

  1. Commercial Airplanes
  2. Boeing Military Aircraft
  3. Network & Space Systems
  4. Global Services & Support
  5. Boeing Capital

The Commercial Aircraft segment includes the 737 narrow-body model, as well as the 747, 767, 777 and 787 wide-body models. BA continues the development programs for the 787-10, 737 MAX and the 777X programs.

Major programs in the Military Aircraft Segment include the EA-18G Growler Airborne Electronic Attack, F/A-18E/F Super Hornet, F-15 Strike Eagle, Joint Direction Attack Munition, CH-47 Chinook, AH-64 Apache, V-22 Osprey, ScanEagle, Integrator, C-17 Globemaster III, P-8, and the KC-46A Tanker. Production on the C-17 Globemaster III ended in 2015.

Major programs in the Network & Space Systems Segment include the Ground-based Midcourse Defense and the Space Launch System.

The Global Services & Support Segment provides military customers with mission readiness through total support solutions. Products and services include integrated logistics, supply chain management, engineering  support, maintenance, modifications and updates, training systems, and government services.

Boeing Capital supplies various customers with financing to be able to purchase Boeing’s products. The portfolia consists of equipment under operating leases, finance leases, notes and other receivables, assets held for sale or re-lease and investments.

Throughout this analysis, I’m going to refer to Boeing as having two segments for ease of discussion; Commercial and Defense. The Defense portion includes the Boeing Military Aircraft, Network & Space Systems and Global Services & Support, which Boeing aggregates in its financial statements as well.


Earnings Consistency and Growth

Boeing has reported positive earnings since at least 2000. In most years BA has shown earnings-per-share (EPS) growth. Boeing stuggled through the first half of the 2000s but started growing again in 2006. Absent the large drop in earnings during the financial crisis, Boeing has been growing EPS. I am using EPS as a proxy for cash flow in this section because Boeing does an outstanding job of converting earnings into free cash flow. When looking at past growth rates, which are by no means a good indicator of future growth rates, you must be careful with where you start and end. Boeing operates in a cyclical industry, so earnings growth will not be steady and consistent as you may see with other companies and industries.

For instance, if you look at previous growth rates for Boeing starting with 2003, your growth rates will be much higher than if you start with 2000. 2003 was a large dip in earnings, as EPS in 2000 was almost 3x what it was in 2003. To get a rough EPS growth number, I averaged the five years ending with 2004 and the five years ending with 2015 to come up with an approximate compounded EPS growth rate; 10% per year compounded.

Cash Flow Conversion

It’s important that a company can turn reported earnings into free cash flow. A high growth business may have capital expenditures (CapEx) in excess of depreciation and amortization and therefore convert less than 100% of its earnings into cash. Boeing does a great job of converting reported earnings into free cash flow, with a typical ratio above 100%. I have excluded any working capital adjustments from my free cash flow calculations and assumed for conservatism that all capital expenditures are maintenance CapEx and should be subtracted.

Table 1

Year Ending 12/31/2015 12/31/2014 12/31/2013 12/31/2012 12/31/2011
Net Earnings $5,176 $5,446 $4,585 $3,900 $4,018
Free Cash Flow $5,118 $5,725 $5,003 $4,925 $4,445
FCF Conversion 99% 105% 109% 126% 111%
ROIC (FCF Basis) 30.1% 27.1% 24.5% 30.6% 28.6%

Over the past 9 years, FCF conversion averages 115% and ROIC averages 28.1% over the last 7 years. Both items must be looked at positively, showing a robustness of earnings while identifying the possible presence of an economic moat. I’ll discuss economic moats in the qualitative analysis section.

Balance Sheet

Financial Leverage

Boeing uses a significant amount of financial leverage (assets/equity) to fund itself. The average over the past 7 years is 17.7x, while the most recent ratio is 14.9x at the end of 2015. While this could be concerning, I find it important to dig through the balance sheet to see where the financial leverage comes from.

During the most recent year, almost 26% of assets were funded through advances from customers and billings in excess of related costs. Although this is a real liability, it is interest-free financing and an important way for Boeing to earn high returns on its invested capital. Another 26% of assets are funded through accounts payable and accrued liabilities, which are two more sources of interest-free financing. Healthcare and pension liabilities cover another 26% of funding. Deferred income taxes and other liabilities cover 5% of assets, leaving approximately 18% of assets funded by debt and equity. Long-term and short-term debt fund 10.6% of assets, while equity funds only 6.8% of assets. Boeing does an outstanding job of funding itself through the use of interest-free liabilities, allowing its returns on invested capital to be well in excess of the norm. Advances from customers and billings in excess of related costs can be similar to insurance float. As long as Boeing keeps building planes, it can continue to fund itself through these means.

Interest Coverage Ratio

Boeing does have a relatively high debt/equity ratio of over 1.5x. It is critical to make sure that Boeing can cover it’s interest charges. In conjunction with that, I also want to make sure BA doesn’t have any significant amounts of debt due in the near future that could cause issues.

Table 2

Year Ending 12/31/2015 12/31/2014 12/31/2013 12/31/2012 12/31/2011
Earnings from Operations $7,443 $7,473 $6,562 $6,290 $5,823
Interest and debt expense $275 $333 $386 $442 $477
Interest coverage ratio 27.1 22.4 17.0 14.2 12.2

Boeing seems to be more than able to cover its interest charges. It should be noted that BAs interest coverage ratio dropped to 6.2x in 2009, continuing to provide adequate coverage during a deep recession.

According to BA’s 2015 10-k, there are no significant principal payments due over the next five years. Most of the company’s debt is due from 2043 to 2045.


The Good


In the Commercial Aircraft segment, Boeing’s main competitor is Airbus for wide-body aircraft. Embraer and Bombardier are also competitors, but do not make the larger-size aircraft that Boeing and Airbus make. BA also mentions “other entrants from Russia, China and Japan” in its 2015 10-k.

In the defense side of Boeing’s business, they face competition from Lockheed Martin, Northrop Grumman, Raytheon and General Dynamics. Non-U.S. companies, such as BAE Systems and Airbus are also competing in this space.

Competition is limited in Boeing’s industry because of a number of barriers to entry that I will discuss below.

Switching Costs

Once a customer, either commercial or military, chooses a Boeing aircraft, it’s prohibitively expensive to change aircraft. Switching costs include procurement of new aircraft, pilot and mechanic training, facility modifications, etc. This keeps customers coming back to Boeing.


All of Boeing’s aircraft are unique to Boeing. Customers will choose aircraft based on the customer’s specific needs. These needs may include passenger count and fuel economy to name a few examples.


The costs and time associated with getting a plane approved for commercial flight and sale to customers are prohibitively long and expensive for new entrants. This creates a large barrier to entry in the aircraft manufacturing business. It is nearly impossible for a small scale airplane manufacturer to enter this market and probably one of the largest barriers to entry in the industry, keeping competition low for Boeing.

Regulated Industry

Boeing operates in a highly regulated industry, which is another barrier to entry for outside competition. On the government side of things, the U.S. government, which spends massive amounts of money on defense, wants to buy its military aircraft from a U.S. company. The U.S. government buying from a U.S. company keeps future R&D investments and technological advancement inside the U.S. border. Regulation goes hand-in-hand with the scale required to operate in the industry. Heavy regulation in the industry makes it expensive and slow to get approval for a new airplane, keeping new entrants from entering this market.

The Bad


The commercial airline business is a terrible business. Since the turn of the century, American Airlines, U.S. Airways, Delta, Northwest and United Airlines have all filed for bankruptcy. U.S. Airways actually filed for bankruptcy twice since 2000. CNN Money has an interesting graphic showing that there were 10 major U.S. airlines at the turn of the century. This is now down to just 4 major airlines because of mergers and bankruptcies. Not only have Boeing’s customers experienced major financial difficulties, the commercial airline industry has experienced major consolidations.

Directly from Boeing’s 2015 10-k, “Traditionally, the airline industry has been cyclical and very competitive and has experienced significant profit swings and constant challenges to be more competitive.”

It should also be noted that Boeing relies on its non-U.S. customers being able to access financing through the Export-Import Bank of the United States.

Airplanes are Major Capital Expenditures

It probably goes without saying, but the purchase of airplanes is a major capital expenditure for airlines and governments. If an airline is struggling financially, it may reduce its budget for new airplanes. Similarly, government budget cuts could result in lower defense spending.

New Technology

Airplane manufacturers continually need to come up with lighter, faster, cheaper, more fuel-efficient airplanes. In order to stay ahead of the competition, Boeing must continually spend money on research and development. Although Boeing has a long history of being a leader in the aerospace industry, it must continue to innovate to stay ahead of the competition.


At the end of 2015, 36% of BA’s 161,400 employees were covered under collective bargaining agreements, including 13% of which are professional aerospace engineers. In 2013 and 2014, Boeing was in contentious negotiations with the machinists’ union in the Seattle area over the location of the production of the 777X jet. Boeing was ultimately successful in the negotiations without a strike from the union, but future negotiations could result in production disruptions.

Regulated Industry

You’ll notice I’ve put this in both the good and the bad qualitative categories. The U.S. government must approve Boeing to sell any military aircraft to any foreign governments. While I agree with this policy for what I believe are fairly obvious reasons, it should be noted that the government has the ability to stop Boeing from selling to certain countries, even if we freely trade with them.


When analyzing an investment, price is one of the most important factors, but it’s not price alone. Price must be compared to the value you’re getting. You want to try to pay less than what the company is worth. Of course, the price you pay may fluctuate, but it’s readily available and knowable. On the flip side, the intrinsic value of a company does not fluctuate very much, but is difficult to obtain and at best, only an estimate.

With all of that said, the intrinsic value of Boeing should be estimated based on the future cash flows of the business discounted back to present value. To get a feel for what Boeing may earn in the future, it’s good to look at past earnings. The last five years of Boeing’s free cash flow (excluding working capital adjustments) are shown in Table 1 above. The average free cash flow per diluted share over the last 5 years is $6.81, with a most recent year of $7.36 per share.

Boeing’s current price is $134.85, which is 19.8x the five-year average free cash flow and 18.3x last year’s free cash flow. At these ranges, it doesn’t seem to me that Boeing is significantly over-priced or under-priced. I don’t intend to provide a recommendation for the business I’m analyzing, at least not an actionable recommendation. I will tell you whether I think the price of the business is near the range of what I believe to be the intrinsic value of the business, but that is only a starting point. Again, performing your own research and estimation of intrinsic value is crucial to the investment process.

Final Thoughts

Quantitatively, Boeing has consistently high returns on invested capital on a free cash flow basis and does a great job of converting reported earnings into cash. Although BA has a higher debt/equity ratio, it covers its interest payments well in excess of what would be concerning to me. Advances and costs in excesses of billings is a great way for Boeing to fund its operations with a liability that is perpetual in nature and interest free.

Qualitatively, Boeing has some significant competitive advantages, which include high barriers to entry due to scale and regulation. Competition in the aircraft manufacturing business is limited, with Boeing being one of the largest. On the flip side, Boeing’s customer base, specifically commercial airlines, are in a terrible business. Having struggling customers that are forced to file for bankruptcy on what seems like a relatively regular basis can be detrimental to a business. Airplanes are also a major capital expenditure for Boeing’s customers. In this cyclical industry, Boeing’s commercial sales can fluctuate based on investments made by commercial airlines. On the defense side of the company, Boeing is also subject to the swings in the U.S. Department of Defense budget. A few other qualitative issues I see with Boeing are the constant need to innovate and stay ahead of the competition, as well as the large quantity of union workers Boeing has to hire.

Quantitatively, I like Boeing as an investment. Qualitatively, I’m not sure that the good outweigh the bad, but I do believe that the competitive advantages that Boeing has show up in the numbers. From a price standpoint, I don’t believe that Boeing is either significantly over-priced or under-priced at current levels. As always, there is no substitute for performing your own research, but I hope this provides you with a good starting point.

Disclosure: I/We have no investment in Boeing at this time. I/We may initiate an investment in Boeing within the next three months.