November 24, 2020

Mastercard: Double-Digit Growth For Over A Decade – Priceless (NYSE:MA)

Investment Thesis

Mastercard’s (MA) network is a critical part of the payments infrastructure across the globe, providing support for various types of digital and mobile payments, both of which are expected to grow rapidly in the coming years. But Mastercard is also helping to shape the future of real-time payments – another space that is expect to grow quickly. Mastercard’s essential role in these markets, combined with its exceptionally profitable business model, makes this stock a compelling long-term investment.

Mastercard’s Business Model

Mastercard is one of the largest payment networks in the world, behind Visa (V) and China-based UnionPay. It has over 2.2 billion payment cards in circulation, which are accepted in over 210 countries (and territories) by over 37 million merchants.

Mastercard, like Visa, is an open network – it processes payments, but does not issue cards. Instead, it works with other financial institutions that issue cards branded with its logo. This differs from American Express (AXP) and Discover (DFS), both of which process payments and issue cards, and therefore, assume the role of the acquirer.

The company’s role in a payment transaction is depicted in the graphic below:

How do credit and debit cards work?

(Source: Created by the author using graphics from Mastercard)

Mastercard’s network connects thousands of financial institutions and millions of merchants across the globe. But its partnerships extend beyond traditional banks and credit unions. The company also partners with several popular tech and fintech firms to provide debit cards and other products. For example, the Square Card (SQ) allows merchants to instantly access their Square balance without waiting for a bank transfer. Likewise, MercadoPago – MercadoLibre’s (MELI) payment platform – offers Latin American consumers a prepaid card linked to their mobile wallet balance. Even the Apple (AAPL) Card is backed by Mastercard.

The graphic below shows a few different Mastercards, each representing a partnership with a fintech firm:

Mastercard Square PayPal MercadoLibre

(Source: Created by the author using graphics from Mastercard)

Mastercard generates revenue in a few different ways. First, it collects assessment fees on both domestic and cross-border transactions. These fees are taken as a percentage of gross spend, and are shown in the chart below:

Assessment Fees (Mastercard and Visa)

(Source: Created by the author using information from Wells Fargo)

The company also earns revenue through transaction processing fees, which include connectivity fees and transaction switching fees. Connectivity fees are charged to issuing and acquiring banks for access to the Mastercard network. Transaction switching fees are charged each time an issuer receives an approval for authorization, each time transaction information clears between the customer’s (issuing) and merchant’s (acquiring) banks, and every time funds settle. These fees are charged on a per transaction basis (not a percentage of spend), and range from $0.01 to $0.05 per transaction.

Mastercard’s Market Opportunity

Mastercard has an enormous and expanding total addressable market. In the coming years, this opportunity will be driven by two catalysts: (1) increasing consumer spend and (2) increasing digital payments, both online and in stores.

1. Consumer Spending

Over the last 20 years, consumer spending has grown by 2.8% per year, according to data from The World Bank. This consistent growth in consumer spending is one of the driving forces behind economic growth in general.

Global Consumer Spending

(Source: Created by the author using data from MacroTrends)

Of course, consumer spending has decreased substantially this year, but that happens from time to time – notice the dips in 2008 and 2014. In general, though, consumer spending tends to rise over time. And that tends to act as a baseline for Mastercard’s growth. In other words, even in the absence of all other catalysts, Mastercard should still be able to grow ~2.8% per year.

2. Digital Payments

On a global scale, digital payments are expect to grow from $4.9 trillion (2020) to $8.2 trillion (2024), representing 13.4% annualized growth.

The 2020 Global Payments Report by WorldPay provides a growth forecast through 2023 for both e-commerce and POS (in-store) payments. This is shown in the graphic below. Percentages indicate a percentage of total spend in each category.

Types of digital payments

(Source: WorldPay Global Payments Report (2020))

As indicated above, digital/mobile wallet payments are expected to increase both online and in stores. Additionally, credit/debit card payments are also expected to increase in stores. These trends will directly benefit Mastercard.

You may also notice that credit/debit cards are expected to decrease as a percentage of spend online. But this is misleading, as it indicates outright usage (i.e., not through a digital wallet)

But digital wallets work with payment cards. Yes, they can be funded by bank transfer, too (i.e., Automated Clearing House). But these platforms were also built on top of card networks rather than in place of them. So, Mastercard still benefits. In fact, the effect is two-fold, as they benefit both from continued outright usage of payment cards and from increasing use of digital/mobile wallets – like Apple Pay (AAPL), Google Pay (GOOG), PayPal (PYPL), Square – when these wallets are used in conjunction with a credit/debit card.

But what’s driving the shift toward digital payments?

Mobile wallets offer increased convenience and security. Smartphones make it easy to organize and use a variety of payment cards, not to mention providing extra security in the form of password protection. So, the shift towards digital payments will be partially driven by increased adoption of mobile wallets. But the other half of the equation is increasing e-commerce penetration.

Accordingly, eMarketer’s 2019 report forecasts that global e-commerce sales are expected to grow from $4.2 trillion (2020) to $6.5 trillion (2023), representing ~16% growth per year.

Global ecommerce growth

(Source: eMarketer)

Over this time period, e-commerce sales will increase from 16% of total retail sales to 22%. This shift towards e-commerce will correlate with an increase in digital payments, and given Mastercard’s competitive position, they should capture value from this shift.

But even after 2023, there is still significant room for growth in e-commerce. Likewise, mobile wallets will continue to become more ubiquitous, and consumer spending in general should continue to rise (as it has in the past). For these reasons, I would expect Mastercard’s market opportunity to continue expanding well into the future.

Financial Metrics

Mastercard’s business model is exceptional for many reasons. First, the company’s global network has created an effective duopoly (with Visa) in many regions of the world, making it all but impossible for competitors to upset the status quo. This advantage is further reinforced by strong network effects – each new cardholder adds value for every existing merchant, and each new merchant adds value for every existing cardholder. Additionally, Mastercard’s business model is operationally efficient, as revenue growth has significantly outpaced growth in operating costs over the past decade. As a result, operating margins have trended upwards over time, from the high-40%’s to the mid-50%’s range. And this has translated into expanding profit margins. Finally, due to the asset-light nature of the business, capital expenditures have also been low, which has allowed the company to grow free cash flow exceptionally quickly over a long period of time.

As I mentioned earlier, Mastercard card generates revenue through (1) assessment fees on both domestic and cross-border transactions, and (2) transaction processing fees. Before diving deeper into the financials, let’s examine both of these metrics over the last decade.

The chart below shows gross dollar volume (GDV), which represents the total amount of currency moving through Mastercard’s network. This is important, as assessment fees are taken as a percentage of gross spend.

Mastercard Gross Dollar Volume

(Source: Created by the author using data from Mastercard Investor Relations)

As indicated above, GDV has increased at 9% annually since 2010.

The chart below shows switched transactions over the last decade. This figure directly impacts the amount of revenue generated from transaction processing fees.

Mastercard Switched Transactions

(Source: Created by the author using data from Mastercard Investor Relations)

As indicated above, the number of switched transactions has grown even more quickly than GDV, at 15% annually since 2010.

Given the metrics above, it’s not surprising that Mastercard has been able to grow revenue consistently and quickly over the last decade. This is shown in the chart below.

Mastercard revenue growth

(Source: Created by the author using data from Mastercard Investor Relations.)

Mastercard has grown revenue at 12% per year since 2010. While 12% growth in any given year is nothing extraordinary, to consistently grow at that pace for a decade is quite impressive. Even more impressive, that number includes the impact of the most recent quarter, in which revenue dropped 19%. However, investors shouldn’t be worried about this. Q2’20 coincided with the height of the COVID-19 pandemic, and the associated business closures and social distancing precautions significantly reduced consumer spending during this time. As the situation improves, revenue growth will resume and potentially accelerate.

I would also like to note that operating margins have trended upward over the last decade, reaching 57.5% in FY’19. While margins have dropped a bit in 2020, they still remain above 50%. As a result of this increasing efficiency, Mastercard has grown earnings at 19% annually since 2010. Once again, that number is exceptional.

Finally, Mastercard has kept capital expenditures relatively low over the past decade. Accordingly, free cash flow has grown at 19% per year since 2010. This is shown in the chart below.

Mastercard free cash flow growth

(Source: Created by the author using data from Mastercard Investor Relations)

Again, this type of growth over the course of a decade is very impressive. Few businesses will ever achieve that level of financial success.

Valuation

Mastercard currently trades at 47.7x earnings and 21.5x sales, both of which represent a slight premium compared to Visa. These metrics are shown in the chart below:

ChartData by YCharts

While Mastercard stock isn’t cheap, I believe the company warrants this valuation. It has executed consistently for over a decade, growing revenue, profits, and free cash flow at a double-digit pace.

Additionally, as the chart below indicates, Mastercard’s revenue and earnings growth have slightly outpaced Visa’s since 2010.

ChartData by YCharts

Whereas Mastercard has grown revenue 193%, Visa has grown slightly more slowly, at 174%. Likewise, Mastercard’s profits have grown 415% compared to Visa’s 399%. This justifies the slight premium in Mastercard’s valuation.

Risks

China’s payments infrastructure is perhaps the largest risk to Mastercard and Visa, as it would represent a complete overhaul of the current payments system in the US and Europe.

In order to discuss this risk, I will provide an overview of the payments infrastructure in the United States.

Payments Infrastructure In The United States

There are essentially three payment rails in the US: (1) Automated Clearing House (ACH), (2) Card Networks, and (3) The Clearing House Real-Time Payments (RTP) Network. And all of these involve banks to some degree.

  1. Automated Clearing House: This system facilitates bank-to-bank transfers. This includes payroll direct deposits, monthly bills, and P2P payment apps like Venmo, Square Cash, and Zelle. This would also include any movement of money between digital/mobile wallets and banks.
  2. Card Networks: This system facilitates payments between four parties: cardholders, issuing banks, acquiring banks, and merchants. Card networks simplify the payment process for merchants. Instead of every merchant needing to connect to every bank, card networks act as an intermediary – they connect to thousands of financial institutions, then connect those institutions to merchants.
  3. The Clearing House Real-Time Payments (RTP) Network: This system was introduced in 2017, making the first new type of rail in over 40 years. Unlike traditional ACH payments, which take one to three days to process, The Clearing House RTP Network provides instant payment functionality. This system is accessible to all federally insured US depository institutions. Currently, the system reaches 56% of US demand deposit accounts.

Payments Infrastructure In China

Rather than being primarily bank-based, like the US and Europe, a huge portion of payments in China flow through two big tech companies: Alibaba (BABA) and Tencent (OTCPK:TCEHY).

How did this happen?

For years, Mastercard and Visa were kept out of China. In fact, Mastercard only recently received approval to enter the Chinese market. Likewise, China’s card-based network, UnionPay, was met with some resistance from merchants – due primarily to merchants taking issue with the fees. This left a gap in the Chinese payments infrastructure.

So, in 2004, Alibaba introduced AliPay, providing consumers with a means to shop on its e-commerce marketplace. Then, Tencent’s competing product, WeChat Pay, was released in 2005. In the intervening years, these digital wallets have taken root and are unlikely to be displaced. Just to provide some context, AliPay reportedly had 1.3 billion users as of March 2020. At the same time, WeChat reported 1.2 billion users. In other words, AliPay and WeChat Pay’s combined user base is almost twice the population of China.

According to a Bloomberg report, use of these digital wallets effectively cuts banks (and payment cards) out of the equation. Most Chinese consumers transfer their paychecks from their banks to their AliPay or WeChat Pay wallets, then use these wallets to fund most purchases. This means banks don’t earn interest on account balances, nor do they earn interchange revenue from card-based spending. It also means card networks don’t take a cut either.

For this reason, if China’s payments system expanded into the US and Europe, it could certainly threaten Mastercard’s competitive position. This would be analogous to US consumers transferring paychecks into their Apple Pay or Google Pay (or PayPal) wallets, then using those wallets to fund most or all of their daily purchases.

However, this doesn’t seem like an imminent problem. Companies like Apple and Google are already being investigated for alleged monopolistic practices. Further consolidation of power in their hands is unlikely. Imagine how the Justice Department would respond if Apple and Google replaced banks and payment cards as a lynchpin of the US payments infrastructure.

Furthermore, given the tension between the US and China, and the dominance of Mastercard and Visa outside of the Asia-Pacific region (i.e., Mastercard and Visa handle a combined 90% of payments outside of China), I doubt AliPay or WeChat Pay will meaningfully enter the US or European markets anytime soon.

Mastercard and The Future Of Payments

As I mentioned earlier, The Clearing House’s RTP Network represents a new type of payment rail. Real-time payments will play an important role in the future, not only because they help meet the demands of an increasingly digitized world, but because they allow for better security and data transfer alongside payments. This may sound trivial, but quality data helps reduce fraud, money-laundering, and other financial crimes.

How does this relate to Mastercard?

The Clearing House RTP Network is powered by Vocalink technology, and Vocalink is owned by Mastercard. But the impact extends beyond The Clearing House in the United States. Vocalink’s technology has also been used to develop real-time systems in the UK, Singapore, and Thailand. And while adoption is still in the early stages, it is important to recognize that Mastercard is literally helping to shape the future of payments around the globe.

Mastercard has also created a real-time payments system using the card payment rails. This system is called Mastercard Send. And it leverages Vocalink’s technology to enable three types of real-time payments:

  • Disbursement – Payments from governments or businesses to consumers
  • Domestic P2P – Payments between consumers in the same country
  • Cross-Border P2P – Payments between consumers in different countries

Mastercard Send can reach more than 3 billion accounts in 80+ countries. For example, PayPal and Venmo users can instantly transfer funds to a bank account using Mastercard Send if the account is linked to a Mastercard debit card. And numerous other platforms use Mastercard Send to provide the same functionality: Stripe, Square, Uber (UBER), Google Pay, and Allstate (ALL).

But Visa is also innovating around real-time payments. Its system is called Visa Direct. Like Mastercard Send, it uses the card payment rails to instantly transfer funds. The only difference is that the bank accounts must be linked to a Visa debit card.

Also noteworthy, Mastercard recently announced that it would be working with ACI Worldwide (a provider of real-time payment software) to offer real-time payment services on a global scale.

Conclusion

Mastercard is a critical part of the global payments infrastructure. It owns ~25% of the payments card market, with over 2.2 billion credit/debit cards in circulation, which connect thousands of financial institutions and millions merchants.

The company benefits from a textbook network effect, as each new cardholder benefits all existing merchants, and each new merchant benefits all existing cardholders. This further solidifies its dominant position, making it all but impossible for a competitor to upset Mastercard and Visa’s “duoply” in most regions of the world.

Additionally, Mastercard’s total addressable market is enormous and expanding. In the coming years, two major catalysts will drive growth: (1) increasing consumer spend and (2) the shift towards digital payments.

Beyond this, Mastercard’s business is the picture of financial health. Revenue has grown at 12% annually since 2010. Over this time, operating efficiencies have allowed earnings to grow even faster, at 19% annually. And Mastercard’s asset-light business has kept capital expenditures low, meaning free cash flow has also grown quickly, at 19% per year over the last decade.

Finally, rather than fading from relevance in the increasingly crowded payments space, Mastercard continues to innovate and adapt to the changing world. It has partnered with several fintech firms, including PayPal, Square, and MercadoLibre, to offer branded debit cards and other services. The company is also helping to shape the future of real-time payments, which has the potential to dramatically change the industry going forward. In other words, Mastercard is just as relevant today as it was a decade ago, if not more so.

For all these reasons, Mastercard is a solid long-term investment.

Disclosure: I am/we are long MA, V, PYPL, SQ, MELI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source Article