Tuesday, July 8, 2008

Cream of the Cards

I've posted on the markets' mispricing of ACAS, and I thought it might be worth looking at a few other companies whose prospects I think are solid and asking whether they may have become bargains during the apparent panic underway in the markets. So here we address Mastercard (MA).

The Payment Industry
Mastercard is in an interesting industry. Financial services are reaching into more countries and are accessible to people on continents where they traditionally have been unavailable. With increases in access to banking will come increased access to payment card products (debit or credit), so there will be enormous growth in non-US cardholders (and users). As cardholding grows, the value of being a participating merchant grows. As users and merchants increase the demand on the card system, the value of having a big fast processing network improves, and the number of transactions one can tax in exchange for the use of the big, fast data centers that make this all work grow. Growth need not all come from abroad, though: trends in the developed world toward online transactions put pressure on vendors to accept convenient payment, and lots of folks have payment cards.

And since revenue is growing faster than expenses, profits will grow faster than revenues.  Nice, eh?

Risks Are Opportunities
  • Suppose inflation devalues money? Transaction sizes promise to swell, and with them size-based fees. Mastercard is a global inflation hedge.
  • Suppose a worldwide recession crushes consumers? Transaction size declines in this event, but frequency promises to grow, driving per-transaction charges.
  • Suppose the US dollar collapses? The US-dollar value of non-US transaction fees paid to Mastercard in local currencies soars. Mastercard's growing foreign business offers protection against US currency risk.
  • Suppose people can't pay their fat card bills? Ahh, that's the beauty of Mastercard -- who cares?

Mastercard attracted me for several reasons, not the least of which was the simplicity with which its operations can be analyzed. One might look at American Express (AXP) and wonder whether its desire to be a widely-held brand (i.e., pressure for acceptance by vendors) might lead it to unacceptable credit risks, and before the Ameriprise spinoff, L scoffed at investment in AXP under a Peter Lynch thesis.[1] Mastercard is so simple that one need only examine one kind of transaction to understand its business, and one never need worry whether different parts of the business might lead the company off a cliff. (Recent examples of this are easy to think of: Countrywide preferring deals to due diligence, Merrill Lynch preferring investment banking fees to even slight thought to home value risk exposure magnification, and so on.)

So, what's the story with Mastercard?

Mastercard: A Pure Play in Cashless Payment
Mastercard just wants people to swipe cards. (OK, they are branching out: you can now put your card near a non-swipe reader -- oooOOOooo!) Mastercard may acquire transaction processors, but it's just part of the game to increase the portion of per-transaction card fees actually captured by Mastercard. It's silly to say it, but all these things you see Mastercard doing that don't seem to involve pushing cards into your pocket (buying processors, buying technology integrators, etc.) are all designed to achieve performance in a single business: making money off card use. Card use is thus all you need to think about to evaluate Mastercard's business.

If you are a fan of Collins' Good to Great, you will recognize this focused area of specialization as Mastercard's hedgehog concept. Mastercard gets paid by making payment easy. Understanding this is understanding Mastercard.

(You might think about whether Mastercard is in a position to be squeezed out of the market, but since Mastercard is settling antitrust claims with plaintiffs as big as AXP, you are probably safe to conclude Mastercard isn't on the very brink of being crushed. On this topic, though, this article wins "best headline".)

Mastercard isn't a creditor. Mastercard licenses creditors (and folks who want to let you carry gift cards, and folks who want you to debit existing accounts, and whomever else wants a license) the use of the Mastercard logo and, with it, the promise that where the logo appears their customers can make payments hassle-free. If you can't pay your bill, Mastercard doesn't care particularly. The next creditor issuing you a card will pay Mastercard a fee to do so, and if your interest rate is high (or too low) Mastercard knows nothing about it and can't be helped or hurt by it.

Developing Countries?
What's Mastercard doing in China? In China, banking hasn't got the history it enjoys in Korea or Japan -- after all, China was technically communist until the country's constitution was amended in 2004 to recognize a right to private property -- so folks can't, for example, expect a check to be processed, and therefore have no realistic alternative to pay by check. And neither Mastercard nor anyone else sees a stack of greenbacks waiting for the person who makes check processing easy in China. Mastercard is working to make it easy for banks to issue Mastercard products, easy for merchants to accept and get paid through Mastercard products, and easy for users to handle Mastercard products. As financial services reach more and more Chinese, and as Chinese increase their income as the country industrializes, the demand for payment systems and the utility of offering cashless payment will make payment cards an explosive hit.

Explosive? Why?
Mastercard is often cast as an antagonist of merchants trying to get paid -- as are Visa and AmEx and other payment card vendors. To the extent the parties argue how much Mastercard should be paid for processing payments, this is true. But the big picture is exactly the opposite. Card companies want people paying with cards in merchants' stores because they get fees. Merchants want people paying with cards because people who pay with cards are willing to spend more (though there is an argument this isn't generalizeable and that its appearance may be more a "definite maybe" than a fact).

Vendors may grumble about interchange fees, but they want customers and they even more like customers whose ability and willingness to spend money has been enhanced beyond the cash in their pockets. Folks who take off for an ATM don't always come back, and willingness to pay is impacted by the effort to make the payment. Making payment easy is very good for merchants. One easily imagines a reinforcing feedback loop involving increased merchant acceptance and increased customer expectation that cards will be accepted. Since Mastercard's infrastructure costs don't escalate with anything like linearity with card use, an explosion in card use in the developing world can be expected to yield a hurricane of money at Mastercard's headquarters in Purchase, NY.

With built-in inflation protection and currency-protection, and the entirety of China into which to grow,[2] Mastercard is set to make money almost regardless what happens, merely because it's riding a trend -- cashless payments -- that is heading to the moon. It's Mastercard's game to lose. Of course, as AmEx has proved, you can be #3 and still make good, solid money. This isn't a winner-take-all game. In fact, Mastercard-owned transaction processors probably handle quite a bit of non-Mastercard payment processing volume, and definitely keep some processing fees from those transactions. Nice, eh?

Worldwide transaction growth will drive Mastercard results regardless what happens to the US currency, the rise of foreign powers, credit dislocations, or the like. Developing countries, improved communications, online commerce, and the like will all drive payment card use. Mastercard trades at about $240 after previously reaching past $320 in June of 2007. I've bought January 2009 calls with a strike price of 250, and 350. The 350s are a trade idea -- a whim -- but the 250s recently became long-term gains, and as summer spending's effect on Mastercard becomes evident in future quarterly reports I will begin making an orderly exit from both the call positions.

So, is Mastercard underpriced? Mastercard seems to be gaining share and improving its return on its infrastructure while building its brand and gaining plum cardholders ... the likelihood that Mastercard's profit potential is fully appreciated by the markets in this time of apparent panic seems about zilch. The P/E ratio -- that is, the price paid for the earnings delivered -- has tightened from 35 to 25 while Mastercard's business has only improved. The outlook for the future makes one's face screw up trying to estimate forward P/E (that is, the price paid now for the earnings MA will deliver over the next year, as opposed to the earnings you know MA delivered over the last four quarters). Given the growth I expect in Mastercard, and the strong reasons for the growth and the absence of credible threats to that growth, I think investing at a trailing P/E of 25 is a good deal.

I expect to sit on my Mastercard shares ... forever.


[1] Peter Lynch's "invest what you have seen works" theory articulated in One Up On Wall Street is a pretty good way to weed out investments you don't understand. It does lead to funny results, though, like mine with Microsoft. AmEx is another example: American Express Bank had to L's knowledge mis-processed so many different checks -- into the wrong account, lost, sent to the wrong AmEx subsidiary, you name it ... some of them six-figure retirement checks L had AmEx process for relatives looking to control their own retirements, and the loss of those checks at the very time they were willing to make investment decisions was a terribly confidence-undermining failure in a financial institution -- that the whole of AmEx was subject to the suspicion it was rife with incompetence and about to rot from within, leading to a customer rebellion. L concluded the only people who'd invest in AXP were those who avoided its services enough to be unaware of their quality. Now that AMP has been spun off, presumably L might consider AXP safe hunting grounds again.

[2] Banking in China is in such condition that one can't expect checks to be processed at all in many places, and I've seen stories about online sales consummated by runners coming to buyers' doors, though virtual currency has also hit the news as a factor in some Chinese commerce. Will travelers trust virtual currency in lieu of trusted payment brands? Who will help Chinese banks connect to vendors who want to accept payment cards? Mastercard's expertise in transactions processing and facilitating card issuance should make card issuance much easier than home-grown solutions likely to be incompatible with the expectations of world travelers.

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