Still Substantial Risk in Credit Card Investments

Credit card companies are breaking down - and this may be the beginning of the next “shoe to fall.” Oh sure, I understand that Capital One Financial (COF) and American Express (AXP) are already long gone. I’m not talking about those companies. No I’m looking at the transaction processing companies - primarily Visa Inc. (V) and MasterCard (MA) who actually benefit by taking a small fee for every transaction using their networks. Now up to this point, the stocks have been hit, but not so much worse than the average blue chip company. Investors simply don’t see the risk at this point. Both companies are cash flow positive, both have an established base of clients and international opportunities. Both are forecasting earnings growth and both stocks enjoy a relatively healthy multiple.

I’m not going to tell you I think Visa or MasterCard are going to go belly up. The situation just isn’t that dire. But I do think investors will be surprised at how sharply these companies can drop in the coming quarter or two. See, the “healthy multiple” is actually a testament to the confidence that investors have in the future growth of the companies. You’ll pay 20 times earnings if you expect those earnings to grow quickly.

But credit (and debit) card transactions just aren’t going to have the same growth trajectory they have enjoyed for the last several years. And if this growth is called into question, investors could quickly re-value the stocks to multiples of 15, 10 or even 8. If Visa began trading at 8 times earnings it would be a 64% drop!

There was a very informative opinion piece in the WSJ yesterday that outlined some of the issues facing credit card lending, the companies who offer the credit, and consumers who rely on credit. As the economy continues to contract, lenders are looking at their exposure and quickly realizing that outstanding credit lines can be a big risk.

Ms. Whitney states that there is currently about $5 trillion in credit card lines outstanding, and that about $800 billion is drawn upon. The available $4.2 trillion seems like it would afford considerable liquidity, but the author expects the available lines to decrease by $2 trillion by the end of the year, and by $2.7 trillion by the end of 2010. We are already seeing lenders cut back at a much more rapid pace than expected.

Part of the issue accelerating this trend is the fact that no lender wants to be left holding the last or largest receivable when a consumer goes under. So there is a race to reduce credit lines and re-price interest rates to encourage customers to pay off balances quickly. While this may help individual lenders, it has a striking effect on consumer confidence.

Many consumers look at their credit lines as a safety net. If something drastic happens, they can draw on that $10,000 credit line until they figure out how to deal with it. But if that line is cut, a prudent consumer will build another safety net (likely by socking away savings which is the wiser thing to do in the first place). This leads to less spending for a time and could further hurt the transaction processors.

I believe the consumer spending contraction is still in place and will carry out for several quarters to come. In my opinion the analyst expectations for Visa and MasterCard earnings are inflated. The stock prices also reflect optimism which leads to a dangerous situation in a bear market.

Revisions of earnings expectations coupled with shrinking price/earnings ratios on stocks have a multiplication effect on investors. Lending stocks have already discounted the risk and are not worth shorting. But I believe profits could be made shorting the transaction processing companies in the weeks and months ahead.

Disclosure: Author has a short position in Visa.

Comments

[Echo To All:]

I understand your thesis, but your not quantifying the 'paper-to-electronic' payment change. We all know consumer spending will be down, and the market is not giving MA or V a free pass. They are currently trading at with a 2009 PE of 14-15. So I ask... if a PE of 14-15 too much of a premium for MA, that has beat (sorry... crushed) earnings expectations quarter after quarter.

They are able to do this because the social change of paper-to-electronic payment is extremely difficult to quantify.

I'm not saying MA is going to the moon, I'm just saying ur thesis needs to account for the social change. And your not doing this.

As for the charts, they are holding up very well. Get worried when MA breaks the 120 level. That is when the charts will indicate a fundamental issue not yet revealed.

Mar 11 09:31 AM

[soonerxii:]

nice piece. good job changing the creepy sig pic also.

Mar 11 09:36 AM

[ScroogeMcduck:]

This article might have some value if you mentioned the precentage ratio of trasaction fees associated with credit cards VS debit cards. Not to mention the use of debit cards expanding thoughout the world. the decrese in transations has already been predicted at v and MA witch is y they have cut cost if you look at there Q4 you would see that.

Mar 11 10:34 AM

[taperx:]

You don't seem to mention anything about the international scene what so ever. Everytime Visa or MC goes out to another country, who has not established a dominate credit card market and sells their product to them, This not only creates a potential for credit/debit card users but also pulls in the banks in THAT community. Therefore the availability of credit increases world wide. The problem with predicting a complete downside to these companies is very difficult. Visa is also approaching the option of buying out Visa Europe which may or may not happen. The trend from cash to plastic will make any investor do well. The only downside is the unknown. This is an entity that has never been seen before. Theoreticaly nothing will slow down growth until every man woman and child has a debit or credit card in their wallet. I see nothing but upside!

Mar 11 11:36 AM

[User 374347:]

why would you want to short V ahead of Visa's inclusion into the S&P 500 and maybe even the Dow 30?

Mar 11 12:02 PM

[Rohan C. Pease:]

What you fail to recognize about Visa and MA is that they have no credit risk! They make money on transactions, the bank issuer is the one taking on the default risk. As far as growth rates, Visa's debit transactions offset declines in credit transactions, not to mention debit transactions provide higher margins. This hedge is what makes V and MA so special, they can adapt to the changing economic cycle. The international growth is in debit cards, as people in emerging nations move from cash and check to electronic payments. Finally if you listened to their earnings call you would know that the cost containment is the reason for the EPS groth and Visa's CFO said they can maintain 22% EPS growth with transaction growth in the single digits. Previous estimates had transaction growth at 14-18%. If you want to play the international growth angle go with MA since approx 63% of revenue is derived from outside the US, Visa is opposite and earns 2/3 of its revenue from the US. Visa will benefit from a strong dollar and MA will benefit from a weak dollar, although this is a small item on the bottom line since most of the FX risk is hedged. Visa and MA represent a rare financial that is not posting huge losses and can maintain growth, that is worth a premium in this market.

Mar 11 12:21 PM

[Martinta:]

Very good point. Visa and MasterCard claim that there is a secular shift from cash to credit/debit cards for consumer purchases.

On Mar 11 09:31 AM Echo To All wrote:

> I understand your thesis, but your not quantifying the 'paper-to-electronic'
> payment change. We all know consumer spending will be down, and the
> market is not giving MA or V a free pass. They are currently trading
> at with a 2009 PE of 14-15. So I ask... if a PE of 14-15 too much
> of a premium for MA, that has beat (sorry... crushed) earnings expectations
> quarter after quarter.
>
> They are able to do this because the social change of paper-to-electronic
> payment is extremely difficult to quantify.
>
> I'm not saying MA is going to the moon, I'm just saying ur thesis
> needs to account for the social change. And your not doing this.
>
>
> As for the charts, they are holding up very well. Get worried when
> MA breaks the 120 level. That is when the charts will indicate a
> fundamental issue not yet revealed.

Mar 11 01:10 PM

[Zachary Sch...:]

Kewgardens - I chose Visa because it has a bit of a higher multiple, although the pattern on MA may be a bit more attractive as a short. I'm not real comfortable with a pairs trade here - I think both are vulnerable and largely indifferent between the two.

Echo - I understand the bullish argument here. I just don't agree with it. Debit card revenues may help keep both companies from totally imploding, but I don't believe the transition will fulfill future growth expectations.

Taperx - The International growth does bear mentioning. But the recession is global in nature and former expectations for huge international expansion have been toned down.

374347 - Inclusion in an index may have a short-term effect on a stock but eventually prices will be determined by fundamentals. I have found it very difficult to make money by trading ahead of expected index changes

Finally, Rohan - This is the primary bullish argument for these stocks... "They have no credit risk." You are absolutely correct. I'm not basing any short bias on the fear of default. But as BANKS experience defaults, they will issue fewer cards and constrict open lines of credit. This will certainly cause decreases in credit card purchases. As far as debit cards go, if people don't have the money to spend on credit, why do we expect them to have cash to spend out of bank accounts (using debit cards)? I think the issue is much more contraction of consumer spending and much less of an argument of HOW that spending is transacted.

Thanks everyone for the insightful comments!
Zach
zachstocks.com

Mar 11 03:03 PM

[Rohan C. Pease:]

Zachary - Thank you for the feedback, although I disagree with you short view of V and MA it's nice to hear back from the author. I will admit that I believe there isn't much upside to these names, and that there multiple is begining to turn a bit rich when looking at consumer spending. However I think there are better names to short if your theis is based on consumer spending. I understand you want to go after the last one standing since its valuation would appear to have a far drop when it breaks, but I believe going after high consumer disc. names would yield better results. I would like to short RIMM and TIF rather then V and MA.

Mar 11 05:37 PM

[Zachary Sch...:]

Sure, that makes sense. Although many popular consumer names are already beaten down. I've been vocal about my aversion to:

Capella and other education names: zachstocks.com/2008/12.../

VMWare: zachstocks.com/2008/12.../

Blue Nile: zachstocks.com/2008/12.../

Las Vegas Sands: zachstocks.com/2008/08.../

among others. There are plenty of names to be wary of as you say. Good luck with RIMM and TIF and thanks for the dialog

Zach
zachstocks.com

Mar 11 08:38 PM

[ZAIDANE:]

What happened if the stumilis works and the stock market goes north.you are betting against the economic recovery.

Mar 11 09:37 PM

[taperx:]

Zach, Just because we are in an economic downturn does not mean that V and MC will stop selling their product in the debit card world. The way is see it, the card companies upside is in the actual transition from cash to plastic. Barrowing has now become just one entity of their business. (credit cards) I beleive that the main goal of these companies is to push debit world wide. If you look at the United States alone you will find that people are paying more and more with a debit card instead of writing a check. This is where i think the card companies win. The banks love this service because it is obvious that they are saving money by having the card companies do the block of transactions instead of them. Internationally this theory should catch on. It is truly a business model that is the envy, and, is almost impossible to duplicate

Mar 12 12:57 AM

[Zachary Sch...:]

Zaidane - These are two of my short picks. If you head to my blog you will see quite a few long ideas as well. I've never found it helpful to trade explicitly from the short (or the long) side but instead look for opportunities both ways. That reduces volatility and allows you as a trader to be more flexible.

Taperx - I think the basic discussion between you and me can be summed up in this: V and MC are in the process of gaining a bigger slice (plastic) of a shrinking pie (spending - domestically and abroad). We probably both agree on this. Now the question is whether the driving force is the shrinking pie (my take) or the expanding share (your take). There are no absolute certainties on either side, but the discussion is important and beneficial even if we don't resolve our disagreement.

Best to both of you,
Zach
zachstocks.com

Mar 12 05:54 AM

[taperx:]

Zach, Not a huge disagreement, like i said in my first post the biggest downside to V/MC is the unknown. Pushing their product in other countries abroad will take time.I just think over the years they know how to do it right.

Mar 12 10:21 AM

[Julie Simms:]

This hits home, HARD. I can't get into this one, I'm too biased. I will agree that V and MA stand in better shape then AXP in terms of credit risk. I hate to say, but how bout a pais trade, short AXP long Visa.

Mar 13 07:17 PM

[ZAIDANE:]

Just curious . Did you cover? like i told you before that the tide will arise all boats.credit cards have some issues but the stock market is looking farward. Thank you

Mar 26 02:03 PM

[Zachary Sch...:]

Zaidane, yes I actually did cover - I owned short-term puts and had to get out of them before their time value depreciated...

But at the same time, I still think the thesis is valid and am looking for the proper timing to get back involved.

The difficult in trading large macro-type assumptions is timing. As they say, the market can stay irrational longer than you can stay solvent... So you have to pick your spots wisely.

Best,
Zach
zachstocks.com

Mar 27 04:18 PM

[Rohan C. Pease:]

Funny Visa didn't participate in the rally till recently. I thought you were right, however I'm glad I kept my entire position in Visa, it is my biggest stake and almost sold off a third around $55 due to many insights including yours. Now that V is up about 15% since mid march I think I hang on some more as the picture improves a bit. If I had to guess, I would get back into the puts at around $72/share. I have one question you may be able to answer Zach, how many shares are in lock up that member banks own after the IPO, and how long is the lock up period? I've seen some figures disbursed, but not the entire picture.

Apr 03 03:13 PM

[Rohan C. Pease:]

I say $72 because since the rally all the analysts say it could go to $80. Interesting how they always change their mind on a whim, I swore they were all bearish a month ago. For me I have been long Visa since the day it went public. The "movment of cash to electronic payments" is a worn out thesis, but I was there when the VP of the FED of Atlanta spoke about this conversion, he was very convincing and I believe that over the next 3-5 years it will prevail over the "impaired consumer balance sheet" thesis. You see Zach I like half of my portfolio to be positioned for 3-5 years with the other half for quarterly investments and weekly trades. With 3-5 years on my side I don't need to so worried about the timing in Macro assumptions.

Apr 03 03:23 PM

[Rohan C. Pease:]

As far as my RIMM and TIFF recommendations I'm glad I don't short much as these would have blown me out of the water with their earnings suprises!!! OUCH

Apr 03 03:26 PM