The credit card processors, Visa (V) and MasterCard (MA), have been 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?
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 $130B business, earning close to $10.5B in revenue with 80% gross margins.
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. While the merchant is paying more per transaction, Visa has to pass on some of this to the bank that issues the Visa card, as well as to the bank that the merchant banks with.
It's a fairly complex ecosystem, but the important thing to remember is that Visa takes 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 Visa doesn't take any credit risk. So the person defaulting on its 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 to 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 are one of my favorite businesses.
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 that's being put on credit cards is increasing. Checks and cash are decreasing in use with check usage globally declining from 22% in 2005 to 16% in 2009.
Increasing acceptance - Credit cards are being accepted by merchants who previously hadn't accepted them. This is thanks to the lower costs of Point of Sale terminals such as those distributed by Square. The result is that accepting credit card payments is now cheaper for many smaller merchants, all of which will contribute additional purchase volume 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. This was in the single digits in the early 2000s. As disposable income increases, the average spend per user will also increase, contributing to additional credit card purchase volume
What do the financials indicate?
I am using numbers sourced from morningstar.com for this analysis.
Visa's 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's operating cashflow growth over the 2008-2012 period has been an eye-popping 77% p.a. I believe that the initial couple of years in the measurement period, were artificially depressed with extraordinary items, but nonetheless 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 from $0.42 to $0.88. A review of Visa's payout ratio suggests Visa has plenty of scope to increase its dividend further.
Visa has maintained a payout ratio of around 20% since it first introduced its dividend. Even with the significant increase in its dividend toward the end of 2012, I estimate Visa's payout ratio to have increased to no more than 25% (some special charges artificially depressed Visa's net income in 2012).
I believe Visa has plenty of scope to raise its dividend quite substantially, possibly 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 $370M in capex for Visa). I believe once Visa has additional traction with its overseas expansion program, it will significantly ramp its dividend (likely within 2-3 years), potentially putting it on a yield closer to 2%.
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 take significant growth in dividends and a long-term horizon for dividend income to be comparable with dividend stocks offering a higher current yield of 3% 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 significantly 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 close to $160 and has had a significant run over 2012 (increasing almost 60%). A decline in price may present a more compelling opportunity to enter the stock for a dividend investor.