I'm Still Waiting For A Fat Pitch From Visa

| About: Visa Inc. (V)

Summary

Visa is a superior, high quality business capable of delivering long term outperformance.

Visa's share price has fallen almost 11% since the start of 2016.

While still not in my strike zone, stock buyers at current levels should expect low double-digit returns.

Visa (NYSE:V) is a high-quality business that I currently have a substantial position in. In spite of my current ownership, I'm always looking to add more of the business at attractive prices.

With the compression in the P/E ratios of growth names and the general market turmoil, Visa has declined to a low point of just over $69, representing a decline of almost 12% since the beginning of the year. At this level, Visa is trading at a PE of 27x earnings. This is a great business, with the valuation now getting to levels that are beginning to peak my interest.

The widest of moats

Moats are an attractive proposition in assessing any investment. They help ensure the basis for long-term returns by keeping competition at bay.

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. The emergence of digital currencies like Bitcoin have helped to reinforce just how difficult it is to unseat Visa and MasterCard (NYSE:MA). Open source payment frameworks suffer from the lack of an ecosystem driver to orchestrate merchants, win over consumers and provide the needed funds for ongoing technology investment and security. It's the reason that I believe Visa and MasterCard will be successful long term in the payments ecosystem.

Profitable, high return business

Visa's financials are the envy of most businesses. In fact, the financials are so good that they give rise to Visa's biggest business threat, which is the risk of regulatory intervention and caps on interchange by regulators.

Visa's gross margin is an impressive 82%, and this has been steadily on the rise, increasing from 75% in 2008. However, it is Visa's operating margins that are really eye catching. Visa has an operating margin north of 65%. There are very few businesses that retain such a high level of revenue from their business.

Even better, Visa has a business that requires a rather nominal level of ongoing capex, at less than 10% of operating cash flow. Unsurprisingly, the cumulative effect of these strong economics is a business that throws off a huge amount of free cash flow, at almost 50% of revenues. That's conversion of revenue to free cash flow better than Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Apple (NASDAQ:AAPL) and Facebook (NASDAQ:FB).

Growth Drivers

Best of all, Visa and MasterCard have a number of inbuilt growth drivers that will propel the growth of these businesses forward for the better part of a decade or more.

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 have been rapidly increasing. As disposable income increases, the average spend per user will also increase, contributing to additional credit card purchase volume.

Visa and MasterCard are both the beneficiaries of China's decision to open up its credit markets to external competition. UnionPay's stranglehold on the local market for credit card issuance looks set to be steadily lifted. Meaningful traction in the Chinese market will likely take some time.

Valuation

It's clear that Visa is a great business. In fact, it's a great business with a strong set of growth drivers that should propel growth for quite some time. Visa has been growing earnings in the mid-to-high teens on an organic basis over the last several years.

While continued US dollar appreciation may lead to headwinds on an FX adjusted basis, organic growth should be fairly stable and predictable. Visa should be able to enjoy EPS growth in the high teens for at least the next 5 years. As much as I am an admirer of this business, I don't believe that Visa will be able to materially exceed mid-to-high teens EPS growth going forward.

I'm striving to get returns on capital invested of close to 15% for any new capital that I deploy. With Visa trading on a PE ratio of close to 27x earnings today, and an expectation of 18% annual growth for the next few years (analysts suggest a long run growth rate of just under 17% over the next 5 years), I believe Visa should produce a capital return of at least 11% annually over the next 5 years. This is based on the assumption that Visa's PE will eventually align to a level reflective of its long-term earnings growth.

I realize it's entirely possible that Visa will still carry a PE premium that reflects the high quality of its business, but given I already have a large holding of Visa, I'm keen to add to Visa when (and if ) its P/E comes down to a minimum level of 22x earnings, or close to $60 a share. The business was, in fact, trading at below these valuations in 2010 and 2011.

If market volatility continues, it's possible that we may get to these levels, but till then, I continue to wait for a fat pitch from Visa. Nonetheless, holders buying Visa at current prices should see low double-digit returns from this business for at least the next 5 years. Given otherwise bearish predictions for future S&P 500 returns over the next decade, that is still not a bad return on investment.

Disclosure: I am/we are long V, MA.

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.