09/20/2017

Mastercard – Focus Intrinsic Value Buy Idea

AFG Mastercard Analysis

Intrinsic Value: $123.35

MasterCard (MA) is one of the largest payment technology company in the world.  The company’s technology connects consumers, financial institutions, merchants, governments and businesses worldwide, enabling them to use electronic forms of payment instead of cash and checks. MA processes transactions in more than 210 countries & territories and more than 150 currencies.  MA does not issue credit or determine interest charges/ fees charged to cardholders.  The relationship of the cardholder is with the financial institution.

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The company generates revenue by offering various services as depicted above to various entities such as financial institutions, governments, corporations, etc.  It classifies its revenues in 4 main components:

Domestic Assessments – fees charged to issuers and acquirers based primarily on the dollar volume of activity on cards and other devices that carry [MA’s] brands where the merchant country and the issuer country are the same. It also includes items such as card assessments, which are fees charged on the number of cards issued.

Cross-border – fees charged to issuers and acquirers based on the dollar volume of activity on cards and other devices that carry our brands where the merchant country and the issuer country are different. In general, a cross-border transaction generates higher revenue than a domestic transaction since cross-border fees are higher than domestic fees, and in most cases also include fees for currency conversion.

Transaction Processing – fees are charged for both domestic and cross-border transactions and are primarily based on the number of transactions.  The segment includes fees for services such as authorization, clearing, settlement, payment gateways, mobile gateways, network connectivity.

Other Revenues – revenue related to value added services such as safety & security, loyalty & rewards solutions, program management, consulting & data analytics through its professional advisory group – MasterCard Advisors.

Rebates and incentives are accounted for as a contra-revenue (negative revenue) which entails rebates/incentives provided to certain MasterCard customers based on the customers reaching certain volume targets.

The company generated over $9.6 Billion in net revenue in 2015, 2% growth over 2014.  The growth was negatively impacted by 6% due to the stronger dollar as 61% of its revenue is generated from outside the US.  MA’s revenue was also negatively impacted by the 20% increase in rebates due to new and renewed agreements.  In 2015, 30% of MA revenue came from Domestic Assessments, 24% from Cross Border, 32% from Transaction Processing and 15% from Other Revenues – primarily data analytics.

The company announced recently that it has agreed to acquire VocaLink, a company based in the UK for 700 Million Pounds (with a potential 169 Million in additional earn-out based on performance targets reached.  The company reported revenues of £182 million as it processed more than 11 billion transactions, primarily in the UK.  The company allows MasterCard to play a bigger role in the UK payment ecosystem and MA gains technology & software that VocaLink has developed for fast ACH (Automated Clearing House – enables direct credit and direct debit payments between bank accounts).  The technology is used in the UK and has also been used in ACH activities in Sweden, Singapore, Thailand and the US.  The acquisition will provide MA the ability to participate in all forms of electronic payments.  ACH represents 50% of all payment flows in the world’s top 50 countries so the addition to expand VocaLink’s offering to other countries will give it a good growth vehicle for the future.  The addition of ACH data also enhances the analytics that it can provide to its partners.

Secular Growth

The big secular trend going in MA’s favor is that as the world becomes more digitized, more transactions are becoming cashless.  Although the US and certain developed markets has seen the share of cash usage decline to less than 50%, many parts of the developing world still has over 80% of transaction done in cash.  Companies such as MasterCard will benefit as they provide the technology and infrastructure to facilitate these transactions quickly, securely, and efficiently.

At its last analyst meeting in September 2015, MA stated that its long-term 2016-2018 performance objectives (stated in 2015) are for revenue annual growth of “low double-digits”, EPS % growing “midteens” annually and operating margin % “minimum 50% annually”.  It should achieve low double digit growth this year as transactions and volumes have shown good growth through Q2 2016.

As of June 30, 2016 – the company has over 1.6 Billion Cards (Credit, Debit & Prepaid), an increase of 3.8% from December 31, 2015.  For Q2 ending June 30, 2016, over $1.2 Trillion gross dollar volume of transactions were conducted and over $4.7 Trillion was conducted in the 4 quarters ending June 30, 2016.  The most number of cards are in APMEA (Asia Pacific, Middle East & Africa), Europe second and US third.  In terms of dollar transactions, US is the highest, APMEA second and Europe thirds, though that will change as the local currency growth in the other regions have been higher than US.

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Digital Offerings

MasterCard has been proactive in the switch to digital payments, by partnering with various digital wallet providers such as PayPal, Apple Pay, Google, Samsung, Microsoft wallet, its own online and mobile payments solution called Masterpass.  The company has created innovative products such as biometric identity check that will use a combination of fingerprint and facial recognition in lieu of passwords.

Potential Risks

As the company has a heavy international presence, the company is impacted by currency movement – in FY 2015, its revenue growth was reduced by 6% due to the stronger dollar.

While MasterCard does not deal with consumer credit risk directly, as a provider of settlement and clearing services, the company does take some risk that a financial institution in its network does not

fulfill its settlement obligations.  If that did occur, MasterCard would most likely step in to make the counterparty whole and try to collect from the defaulting party.  According to MasterCard – its gross settlement exposure was $40 Billion as of December 31, 2015.   Litigation and regulatory risk – As one of the big payment network providers, the company has been in litigation with various merchants regarding the fees charged for the use of its network.  The company has set aside $541 million related to U.S. merchant class litigation settlement.  It lost a $107 million lawsuit in Q2 2016 to Sainsbury in UK in regards to those fees. Some regulators are trying to cap the fees charged to merchants.  The fear for MasterCard is that if fees that issuer banks can charge to merchants get too low, the issuer banks might pass additional fees to consumers that would curtail growth.

The company has also seen its growth curtailed as some countries promote an home grown payment processing network such as in China with UnionPay, Russia now requiring the use of its domestic processing network after the US sanctions halted much of the digital transaction processing.    The company is still able to issue cards but their processing costs to MA will be higher and/or restricted to certain segment of the market.

China has announced that would open it domestic market to foreign card networks however it still is in very early stages of the process.  Companies interested would have to meet a not clearly defined national security and cyber-security standards and then proceed to additional licensing steps.

Financial Model

We modeled in 10% sales growth for the next 5 years due to the near term outlook from the company and the belief that as world transactions increasing become cashless, companies such as MasterCard will benefit as they have the brand recognition, trust, secure and efficient networks, and global presence.  We declined the EBITDA margins from 55% to 53% to account for regulatory pressures and the increased investment in personnel for their advisory business.

MasterCard generated over $4 Billion in cash flow from operations in FY2015 and Free Cash Flow of $3.1 Billion.  The company paid dividends of $727 Million (paid $0.16 per share in each of the 4 quarters) and repurchased $3.5 Billion in stock in FY 2015.

As the default valuation growth rate is relatively high due to its low fixed capital base and much higher than what the company has grown historically, we reduced the valuation growth rate to 16% based on the sustainable growth rate shown on the growth page (derived by multiplying ROIC by the dividend payout ratio).

AFG Intrinsic Value Matrix Research ApplicationSource(AFG Intrinsic Value Matrix Research Application)

About Dhaval Sanghavi, CFA 1 Article

Partner at The Applied Finance Group
Focus areas: Global Equity Analysis, Quantitative Research.
Joined AFG in 2003

About Dhaval Sanghavi, CFA 1 Article

Partner at The Applied Finance Group
Focus areas: Global Equity Analysis, Quantitative Research.
Joined AFG in 2003