The credit card processors, Visa and MasterCard, have been my core holdings of mine for years (more so MasterCard). I am a big fan of their business models. Can they also be good dividend growth stocks?
Core Business
Visa is one of the major credit card networks in the world, along with MasterCard, Amex and Discover. Highly likely that somewhere in your wallet, you may have your own branded visa card that has been issued to you by your bank. Visa is an almost $100B business, with $10.5B revenue and 80% gross margin.
How does Visa make money? Each time a credit card or debit card transaction is processed on the Visa network, Visa charges the merchants who put through that transaction an assessment fee. This is basically a small percentage of the total transaction value.
On average, Visa keeps something like 0.2% of the average transaction value for a credit card transation. While the merchant is paying more per transaction (something in the order of 2%), Visa has to pass on some of this to the bank who issues the visa card and the bank that the merchant banks with.
It’s a fairly complex ecosystem, but the important thing to remember is that VIsa take a small piece of every transaction that takes place on its network. Unlike American express, Visa doesn’t do any consumer lending.
What this means is that it doesn’t take any credit risk, this all sits with the bank that issues the card. So that person defaulting on their credit card payment doesn’t really affect Visa at all, as Visa makes money each time from processing the transaction and not on the lending.
Credit card networks have huge moats. It’s not an easy task to set up a network, what with needing to have banks issue the cards, consumers use the cards, and merchants to accept the cards. The network effects are significant and not easy to replicate. It’s the reason that credit cards networks are one of my favorite businesses along with the Chicago Mercantile Exchange.
Where is the growth?
Increasing spend – we are moving more and more to a cashless society. While penetration of credit cards is fairly high in western economies, the amount of spend thats being put on credit cards is increasing. Cheques and cash are decreasing in use . Check usage globally has decline from 22% in 2005 to 16% in 2009.
Increasing acceptance – Credit cards are being accepted by merchants who previously hadn’t accepted them thanks to lower costs of Point of Sale terminals. The emergence of mobile Point of Sale terminals such as Square and Paypal have led to the credit card acceptance by greater number of merchants who previously hadn’t accepted them before, all of which will contribute additional purchase for Visa
International – Credit card penetration amongst some of the rapidly growing BRIC countries has been rapidly increasing. Russia and China have seen increases in credit card penetration to 24% and 65% respectively from single digits in early 2000′s. As disposable income increases, the average spend per user will also increase, contributing to additional credit card volume.
What do the numbers say?
Visa doesn’t have publicly available information for a 10 year period so this analysis will be done on a 5 year view
5yr revenue
Visa compound revenue growth over the 5 year period (2008-2012) has been a very respectable 14% p.a .
5 year operating cash flow growth
Visa operating cashflow over the year period has also been an eye popping 77% p,a in the 5 years from 2008-20012. I believe that the initial couple of years in the measurement period was probably artificially depressed with extraordinary charges. Cashflow growth from 2011- 2012 was an impressive 32%
Dividend Growth Rates
Visa has had a dividend in place since 2009 and this dividend has increased by 28% p.a over the 2009-2012 period. A review of its payout ratio suggests Visa has plenty of scope to increase its dividend further.
Visa has maintained a payout ratio that has been consistent under 20%. Even with the significant increase in its dividend in 2012, I estimate Visa’s payout ratio to have still been no more than 25% (some special charges artificially depressed Visa’s income in 2012).
I believe Visa has plenty of scope to raise its dividend quite substantially, at least doubling it from where it is today. This is a business that doesn’t require a lot of capital spending (a review of capital spending for the last couple of years reveals a mere $350M in capex for Visa).
Whether it will do so is a another question, but once its overseas expansion program is further advanced then I think it will significantly ramp its dividend within 2-3 years, potentially putting it on a yield of about 2%.
Wrap Up
Visa is in my view the poster child of a wide moat business. It currently generates strong revenue growth, and tremendous free cash flow growth. As a dividend growth stock, it does leave a little to be desired. With a very small current yield, it will likely take extraordinary growth in dividends and a long term view for dividend income to be comparable to other higher income yielders that offer 3.5% plus.
Having said that, I sometimes look to hold businesses just because they are great businesses, irrespective of the fact that the initial dividend may be small. I believe that Visa can and will increase its dividend and provide strong dividend growth over a lengthy period of time. Its a stock that I’m happy to hold onto indefinitely, pending periodic reviews of business performance.
Visa is currently trading at premium in my view at $160/shr (I was able to pick it up in early 2012 at just over $100). A decline in price with a bump in the yield may present a more compelling opportunity to enter the stock.
Visa is a great company, but right now it’s not an attractive investment to me. It has a low yield, sub 1%, a PE ratio near 50, and is trading close to its 52 week high. I’m wondering if there’s going to be a pullback on this company like there currently seems to be on Apple. But I would love to own Visa one day and will keep watching it.
I agree with you My FI. At these prices, its certainly on the high side as far as valuation, and I wouldn’t be interested in initiating a new position at these prices.
You bring up an interesting point as far as valuation os concerned. I think that Visa is likely about 20-30% overvalued at this point. I sometimes wonder though, if my holding period is 20 years, would buying at say, 10% premium over fair value make that much difference over the long haul if the stock has a strong business model, and I’ll likely see many years of dividend growth?
I think a 20-30% overvaluation is probably too much, but I’ve become more comfortable over the years buying wide moat stocks at fair value or slightly above fair value than waiting for bargain basement prices (though if I can get them at bargain basement prices, even better!).
Visa is one of those stocks with such a strong business model and high barriers to entry that I’m comfortable sticking it in the bottom drawer and periodically monitoring through to my “dividend retirement”, whenever that may be!
Visa is a great company to own long term. I went to the company reports to figure out earnings and p/e (this is a good idea to make sure you get accurate valuation). it’s not as expensive as you think. At the end of 2011, it was trading at a p/e of 20. The current trailing p/e for last year (which has not been reported yet) implies a p/e of 25. So there was some multiple expansion here.
With a 5year growth rate of 18%, it is not overly expensive. Of course it remains to be seen how much more multiple expansion the market will support.
Thanks for stopping by Six Figure Investor,
I agree with you on Visa being a great long term company to hold. Not only does it have a large moat business in my view, but its also riding some favorable tail winds (cash to credit, international exposure) that make it a great company to hold for an extended period of time.
On the valuation point, i typically tend to look at forward earnings and PEG. On 2013 estimates, Visa looks to be trading at about 18x forward earnings, and an indicative 5 yr PEG of about 1.2. I typically prefer to pick up companies at PEG of 1 or less, hence my comment that I think its about 20% above what I’d like to pay for it.
18x for forward earnings isn’t too bad for a company of Visa’s growth potential. To your point there has been slight multiple expansion thats pushed up its valuation about 20% beyond where it has been historically priced (ie, 20x trailing in 2011 to 25x trailing in 2012) but the earnings power of the business is such that it may actually support this higher valuation.
I wanted to buy some Visa and Mastercard during the financial collapse but invested in other stocks. I love their business models and believe that as we grow more and more into a digital society their revenues will continue to increase. My only concern is the competition from other vendors such as paypal, Bluebird, etc.
Hi Marvin,
You raise a good point about what the longer term threat is from alternative payment solutions. In my view, the challenge that these vendors face in displacing Visa or Mastercard is significant (not insurmountable).
Today many of the alternate vendors actually use Visa and Mastercards payment rails (ie they don’t have a rail of their own). In fact Paypal is actually one of the major sources of Visa and Mastercard payment volume (ie much of their volume goes over the credit card network payment rails). Paypal is able to push payments over the ACH network (ie the cash transfers). This is where Paypal really drives its margins today. Paypals greatest source of revenue is on microtransactions, where it picks up 5% commission plus $0.5 per transaction, plus transactions it can drive over ACH networks. The problem is that Paypal hasn’t been able to incentivise people to load their accounts with cash rather than their cards. If they can do this and do it in a big way, then I’d be more worried about their competitive threat.
The other significant issue that any competitor faces if they want to launch a truly competitive payment system is merchant acceptance and consumer acceptance. The merchant acceptance problem is easier to solve. Merchants are sick of paying the interchange (particularly the retailers whose margins are tight). So the retailers would be game if someone can lower their interchange rate. The consumer problem is harder to solve. You need to incent consumers to use an alternate product, be able to distribute this in large numbers, provide adequate customer support, and give them a reason to put volume on the card.
Is it impossible? Absolutely not. But its a pretty big ask and would need someone with deep pockets willing to make a substantial investment and bear some significant upfront losses to give this a shake. It’s why I dont believe any start up companies will take major share from Visa and Mastercard. The investment they would have to make would probably exhaust their financial resources, unless they got acquired by someone better resourced.
I looked at V around $90 and decided to pass because of the low yield (around 1% or so at the time) and the P/E was a little out of my comfort zone. I regret not picking it up at that level. I think V (and probably MA) will be a long-term winner.
While there is innovation in the POS devices currently (Square, etc.), which can affect companies like VeriFone, the credit card companies enjoy a large moat through high barriers to entry as you outlined above.
Best wishes!
DM,
You raise an interesting point about what’s perceived as fair value and what kind of a premium you should be willing to pay. I don’t believe Visa or Mastercard have really ever been significantly under fair value (Mastercard probably initially when it floated, and maybe both during mid 2011 when there were all the issues with Durbin and debit interchange and what that would mean for the credit card networks). I’ve learnt over time to get more comfortable paying a slight premium over fair value for companies that I think have strong barriers to entry, significant cashflow and have the widest of wide moats. I think Visa falls into that category.
On the low dividend yield, my thought here is that if Visa’s moat is enduring enough over 30+ years (and I think there’s every chance it could be) and its growth continues like it has been, I’ll still be getting something like 30-40% yield on cost, which in my books, is not at all a bad return on investment!