Visa's Network Effect Cannot Be Denied

| About: Visa Inc. (V)

Summary

Visa benefits from one of the strongest competitive advantages out there – the network effect. As more consumers use credit/debit cards, more merchants accept them, thereby creating a virtuous cycle.

Visa is not a bank and does not issue credit cards. The firm takes on no credit risk but remains an integral part of the trend toward a cashless society.

Visa has agreed to acquire to acquire Visa Europe in a deal valued north of 21 billion euros ($23+ billion), unifying the brand globally after eight years as separate companies.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Visa's Investment Considerations

Investment Highlights

  • Visa (NYSE:V) is the largest retail electronic payments network based on payments volume, total volume and number of transactions. The company benefits from one of the strongest competitive advantages out there - the network effect. As more consumers use credit/debit cards, more merchants accept them, thereby creating a virtuous cycle.
  • Visa is not a bank and does not issue credit cards. The firm takes on no credit risk--unlike American Express (NYSE:AXP) and Discover Financial (NYSE:DFS)--but remains an integral part of the trend toward a cashless society. Sales are primarily generated from payments volume on Visa-branded cards.
  • Visa has agreed to acquire to acquire Visa Europe in a deal valued north of 21 billion euros ($23+ billion). The deal will unify the brand globally after eight years as separate companies. The transaction includes a payment of 16.5 billion euros upfront and another of as much as 4.7 billion euros after the fourth anniversary of the deal's completion. Visa plans to issue $15+ billion debt to finance the deal.
  • Visa reported a strong first quarter to its fiscal year 2016. Total operating revenue advanced more than 5% from the year-ago period, driven by payments volume growth, increased 12% on a constant dollar basis. Bottom-line performance was even stronger, as net income jumped nearly 24% from the first quarter of fiscal 2015. Free cash flow growth was strong as well, growing nearly 12% on a year-over-year basis.
  • In fiscal 2016, Visa is expecting constant dollar revenue growth in the high single-digit to low double-digit range. Foreign currency is anticipated to have a negative 3% impact, and client incentives are projected to be 17.5%-18.5% of gross revenues. Constant dollar EPS growth is expected to be in the low-end of the mid-teens.
  • Visa is included in the Best Ideas Newsletter portfolio, and we think the company is one of the best ideas in one of the strongest industries, the Financial Tech Services industry. The company's fundamentals are rock-solid, in our view.

Business Quality

Economic Profit Analysis

In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Visa's 3-year historical return on invested capital (without goodwill) is 81.5%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Visa's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is an impressive 6.3 (anything above 1 is considered strong). Click here to learn more about the Dividend Cushion ratio.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Visa's free cash flow margin has averaged about 39.5% during the past 3 years. As such, we think the firm's cash flow generation
is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Visa, cash flow from operations increased about 44% from levels registered two years ago, while capital expenditures expanded about 47% over the same time period.

Through the first quarter of fiscal 2016, Visa reported cash from operations of nearly $2 billion and capital expenditures of ~$126 million, resulting in free cash flow generation of ~$1.9 billion. This represents an increase of nearly 12% from the first quarter of fiscal 2015.

Valuation Analysis

This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.

We think Visa is worth $75 per share with a fair value range of $60-$90. Shares are currently trading at ~$76, near our fair value estimate. This indicates that we feel there is similar upside potential and downside risk associated with shares at this time.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.

Our model reflects a compound annual revenue growth rate of 10.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 11.4%. Our model reflects a 5-year projected average operating margin of 67.1%, which is above Visa's trailing 3-year average.

Beyond year 5, we assume free cash flow will grow at an annual rate of 6.4% for the next 15 years and 3% in perpetuity. For Visa, we use a 10.8% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $75 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Visa. We think the firm is attractive below $60 per share (the green line), but quite expensive above $90 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Visa's fair value at this point in time to be about $75 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Visa's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $100 per share in Year 3 represents our existing fair value per share of $75 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Wrapping Things Up

We think the firm's business model is one of the best in one of the strongest industries, and its Dividend Cushion ratio is among the highest in our coverage universe. The fact that the company does not take on credit risk like Discover or American Express keeps it from bad loan exposure that would otherwise harm the health of its business, particularly in an economic downturn, and its dividend potential. We may like this attribute the most.

Based on its Dividend Cushion ratio, Visa clearly has tremendous dividend growth potential. However, management continues to choose to allocate its capital towards investments into its business and share repurchases, something that we like. Management's willingness to increase the magnitude of its payout seems to be the largest obstacle preventing dividend growth, from our point of view. The company recently agreed to acquire Visa Europe, and expects to issue more than $15 billion in debt to finance the transaction, which could have an impact on the trajectory of dividend expansion moving forward, but we're not worried.

Visa's business remains on solid ground and is full of growth potential, as was evident in the first quarter of fiscal 2016. The company is included in our Best Ideas Newsletter portfolio, and it currently registers a 6 on the Valuentum Buying Index.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: V is included in the Best Ideas Newsletter portfolio.