Wednesday, June 25, 2008

Master of Cards

This morning when I read Mastercard (MA) had made a $1.8 billion settlement with American Express (AXP), I assumed that such a big hit would surprise the shortsighted folks who have been looking at MA's quarterly numbers and expecting a trajectory to continue to the moon. (When investors come to expect surprises, there's something seriously amiss. Their behavior stops seeming the rational activity of investors and begins to mirror the folks in line to buy lottery tickets.) The settlement is payable in twelve quarterly installments of $250m each, beginning later this year (the third quarter). Mastercard is taking a current $1b accounting charge.

Both assets and earnings will take a nasty hit, starting soon. Yet, Mastercard as I write is up something like $14 per share in the wake of the settlement announcement. Why?

Let me back up to my original thinking on Mastercard. Mastercard, like Visa (V), does not issue cards. These guys license brands. The organizations -- MA and V -- were not created as publicly-traded corporations. Rather, they were organized by banks to facilitate a bank-run card-issuing scheme that would (a) create a small number of standards adoptable by a large number of banks, so that (b) the banks -- who actually controlled the cooperatives -- would be able to lower costs and increase card issuance and elevate acceptance of their credit products. Remember, banks make their money by lending deposits at higher interest than they pay depositors. Credit cards are a way to help make sure folks are borrowing, and the rates offered on credit cards -- because the loans are unsecured -- are some of the most oppressive rates a person can lawfully be charged. (Talk to me about "payday loan" firms and pawnbrokers, if you like; they play some legal games to seem not to violate laws against illegally high interest, and they make crazy returns doing it.)

The upshot? Banks banded together into cooperatives -- Mastercard and Visa -- to make iteasier to market credit card products, and they did it so that as credit cards became an increasingly significant part of worldwide commerce, the banks would be receiving rather than paying the middleman fees these card networks would support. Not until many years later, after folks had seen what a cash cow American Express' card business was, did folks think about demutualizing a card syndicate (combining under one tradeable entity's roof the brand, the contracts, the processing infrastructure, the personnel with the relevant expertise, and the expected flow of fees from the various licensing and processing operations), and getting the public to bid the value of the resulting assets toward the moon. Rising share prices would lead to benefit to banks who formerly ran the cooperatives: they could sell out and take the cash, or they could show a fattening asset on the books. Without the public offering, the asset would be illiquid, hard to value, and sure to be criticized if touted as a major balance-sheet booster. With folks excited about the valuations found in American Express, there's no question why banks wanted to show the true value of their card brands and processing networks by creating a liquid market for their ownership.[1]

In MA, though, the business isn't credit card debt. When American Express issues a card, it extends credit as it sends out the branded card -- and American Express benefits from interest payments or suffers from defaults. By contrast, MA's business depends only on the cards being issued (ka-ching: issuance fees) and used (ka-ching, ka-ching, and maybe also another ka-ching: per-transaction fees, percentage-of-charge fees, and maybe even fees for acting as the transaction's processor). MA is not a bank. MA was designed not to compete with or control the bank member-owners and thus has no say at all in credit limits, credit decisions, payment terms, etc. MA leaves all that up to banks, who pay MA fees. MA is thus not limited by its lending power or its risk tolerance in its power to issue cards. Personal bankruptcies and slow payment and the like isn't MA's problem -- it's the problem of the bank that issued the card.

If you fear consumer credit problems just don't invest in banks that make consumer loans like credit cards. That's still no reason to avoid MA.

When MA went public and quickly sailed into the high 40s, I had some quick thinking to do. I was, after all, about to leave for a month on business and would have crummy Internet access. First, I thought, the planet only has a few really enormous credit card brands -- cards consumers and merchants will easily recognize, trust, and use. Second, American Express may have superior average credit risks, but (a) growth is limited to American Express' power to find and seduce more good credit risks to its brand, and (b) the network benefit of the Visa/MA credit processing systems worldwide ubiquity makes it easier to sell consumers on a Mastercard than on AmEx. (Eat your heart out, Discover.) Third, you couldn't yet buy Visa so nobody but MA was a pure card play: they were mixes that involve credit risk and the like, and suffered from a smaller base of supporting merchants. (If you can't use the card where you are shopping, you can't use the card.) Fourth -- and this one was the clincher -- the planet is getting more electronically connected, the availability of banking services is increasing worldwide, more commerce is being conducted at distances and at speeds that make cash and checks impractical, and the standard of living for the world is increasing ... which all lead to a major global trend toward electronic payments, the primary beneficiary of which will be established players with the most-available processing networks.

So I bought at 47 early June following Mastercard's public offering.

One of the overhanging risks when I did that was ongoing litigation with American Express. American Express said that Visa and Mastercard colluded with member banks and with each other to exclude American Express from offering cards through the member banks, and damaged American Express' business. Folks were wary of the huge money flowing through Mastercard becoming a potential input in a damages calculation. I had some personal doubt that (a) the US would really hand a big award to an antitrust plaintiff after essentially giving Microsoft a free pass despite obviously violating the law on purpose for essentially the whole of its presence in the operating system market and for sure its whole participation in the browser market, and (b) that American Express, which keeps the whole profit from every transaction by dealing directly with each merchant and each customer, could really articulate a damages model anyone would believe that depended on Visa or Mastercard preventing third-party banks from issuing American Express cards. The only thing I could imagine was that if Visa or Mastercard managed to make merchants not accept American Express, AmEx could successfully describe that the value of its merchant network had been impaired in ways that caused more demand for Mastercard products. However, I never heard a merchant say "I don't take AmEx because Mastercard threatened to pull out" -- I only ever heard them say "I don't take it for orders less than $750 because AmEx charges merchants too damned much." I hadn't been a fan of the bank cartels' handling of the merchants or of small banks or the like, and I sure liked American Express, but I didn't think American Express was really in a position to clobber Mastercard on the damages theory in the news.

Uncertainty, however, is a killer. Folks didn't know how the antitrust litigation with AXP was going to work out, and folks worried about MA's exposure to a whopping verdict. As MA approached its public offering, folks expressed worry that MA's accounting reserves for pending litigation might be inadequate.

The upshot: the lifting of the cloud of antitrust litigation risk from Mastercard, though it is going to eat $1.8 billion in future cash flow, is so reassuring that the public is willing to pay more for the shares knowing the size of Mastercard's loss than it was willing to pay while it could still speculate that the loss might turn out to be trivially small.

My big regret: I oughta have bought more MA at 47!

[1] To understand the importance to financial companies of having not just revenues or accounting profits but demonstrable liquid assets, let me compare the banks after the Mastercard IPO to Amercan Capital Strategies (ACAS). ACAS' valuation of illiquid assets continues to attract derision and scorn even though the company has proven repeatedly, through sales of whole portfolio companies and through fractional shares of its entire portfolio, that its valuations really stand up to scrutiny by third parties negotiating in an arm's-length transaction. The fact that ACAS pulls in significant operating revenues from its illiquid and hard-to-separate business operations hasn't helped the shares resist getting clobbered with the collapse of the financial stocks in the last year -- a collapse from which ACAS, unlike Mastercard, seems to be struggling to shrug off. Not that ACAS is having trouble getting credit (its credit is great), and not that ACAS isn't getting payments from those who own it money (ACAS seems to be great at picking risks, as they're paying like champs), and not that ACAS isn't able to continue its fat dividend (the dividend is rising, and ACAS is making so much money it's still having to accumulate undistributed profits and will probably end up rolling those profits forward in a way that will force ACAS to pay larger dividends down the road in order to maintain its tax status) ... ACAS just has a balance sheet full of illiquid securities and observers just don't believe anything ACAS says about them even when ACAS demonstrates folks pay what ACAS says the stuff is worth by actually making a sale.

No comments: