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In 2012, various players in the payment processing industry witnessed gross fraud losses of $11.27 billion, up 14% year over year. Out of this $11.27 billion, 65%, or $7.1 billion, was attributed to card issuers. The losses due to fraud are more significant for premium credit card players such as Visa (V), the major service provider in the industry. However, Visa has taken some initiatives to counter the growing problem of fraud losses.

On its way to enhance the VAA model

In its efforts to reduce card payment fraud, Visa recently made improvements in Visa Advanced Authorization, or VAA, which is its risk-management tool. The VAA technology is used to track, accept and deny payments from cards. The enhancements in the VAA will assist financial institutions to determine which transactions to decline in real time. It will also allow them to confidently accept transactions and cut out friction from payments for merchants and consumers. This will help reduce fraud by billions of dollars for financial institutions.

Moreover, this effort will be very effective, especially for gas stations, which accept card payments at a larger scale. The enhancement in the VAA model includes indicators specific to automatic fuel dispensers, or AFD, transactions. The VAA model uses account velocity for AFDs, which better determines the account's normal behavior. With this, the suspicious activities at gas stations can be detected very easily. This model also has the potential to enhance the efficacy of fraud detection by 266% in debit transactions, and 163% in credit transactions for this segment.

Improvements in the VAA will reduce fraud not only on transactions where the physical card is present, but also when the physical card is not present, like with online shopping. Visa is hopeful that these improvements in the VAA model will benefit the detection of fraud by 130% for debit transactions and by 175% for credit transactions.

Such efforts were required since the gross fraud losses have reached $0.05 per $100 in total volume. Fraud as percentage of total volume has been increasing over the last two years. With respect to global brand cards such as Visa, MasterCard (MA) and American Express (AXP), the situation is worse; fraud losses averaged $0.06 for $100 in total volume.

Visa witnessed total volume of $6.7 trillion on its payment products over the last four quarters ended June 30, 2013. Visa can cut out a major portion of its loss with the improvement in its VAA model, which in turn will enhance its profits.

Peers also taking steps to prevent fraudulent activities in online and mobile payments

Visa, along with MasterCard and American Express, announced a proposed framework promoting a new global standard to improve the security of digital payments and facilitate a better purchasing experience while shopping on handhelds, personal computers or other electronic devices.

According to the proposal, account numbers will be replaced with digital payment tokens for online and mobile transactions. Tokens will be the digital representation of a consumer's credit card, so the proposed standard will not require merchants and digital wallet operators to store account numbers. Theoretically hackers can't access the data since the token system doesn't require numbers to be entered. The new token system will also provide better information about the transactions, which will improve fraud detection and expedite the approval process. This will facilitate better card-less transactions for merchants.

Apart from making a global standard for online and mobile payments, MasterCard is taking steps to enhance security in online payments. It has also joined the Fast Identity Online, or FIDO, alliance to replace passwords with biometrics. The new biometrics based options will require fingerprints, iris scanning, USB security tokens, smartcards, or NFC as security to access online payments.

MasterCard believes that with this alliance it will be able to deliver strong security for consumers without affecting the consumer buying experience. We believe that the initiatives taken by Visa's nearest rival, MasterCard, will enhance its profitability by eliminating a significant portion of the fraud losses.

Valuation

Company

TTM Price/Sales

TTM Price/Book in the most recent quarter

TTM Operating Margin

Visa

10.94

4.67

60.8%

MasterCard

10.73

11.98

55.0%

American Express

2.78

4.37

20.8%

From the above table, we infer that American Express looks attractive with respect to valuation, with the lowest trailing twelve month, or TTM, price/sales and lowest price/book value in the most recent quarter. However, Visa's price to book/value also seems attractive since American Express' price to book value isn't lower than Visa's value by a considerable margin. Moreover, Visa's operating margin is also the highest among its peers, which gives a positive outlook on its profitability since it doesn't have long-term debt.

Conclusion

We believe that Visa has the ability to give consistent returns to investors since its valuation multiples are attractive compared to MasterCard.

Its constant innovation to enhance security in the payment system will lead to a decrease in fraud losses, which will further enhance profitability for the company.

Visa needs to continue development in the payment system since it will enhance the customer experience while making cashless payments.

Source: Visa: Enhanced Security Leads To Better Returns

Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Shweta Dubey, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.