MasterCard (NYSE:MA) has demonstrated itself to be an exceptional business and investment over the years. On the company side revenues grew by 10% annually from 2008 through 2015, while company-wide earnings grew by about 18% per annum. The profit margin is approaching 40% and the amount of capital required to feed the business is minimal.
Perhaps equally impressive have been the returns generated for longer-term shareholders. Earnings-per-share growth eclipsed 20% per year during that time due to share repurchases, while share price growth and dividend growth was significantly higher. All told, investors saw total returns compounding at over 30% annually during that seven-year stretch.
To be sure exceptional growth is still anticipated, with analyst estimates for intermediate-term growth easily in the double-digits. Aside from working with more prudent growth anticipations, there are two knocks against MasterCard as a potential investment.
The first relates to valuation. When you're used to an average multiple being around 15 times earnings, or you see that Wells Fargo (NYSE:WFC) is sitting in plain sight at 11 or 12 times earnings, it can be hard to react favorably to a company with an earnings multiple in the 20's. Still, an investor could still stand to benefit even with a higher P/E ratio, should above average growth formulate.
The second thing that keeps many investors at bay is the low dividend yield. Based on a $0.19 quarterly dividend and a share price near $87, MasterCard has a "current" yield of about 0.9%; not exactly the sort of passive income stream that's easy to live off.
In addressing this "issue" I like to underscore two points. First, if your goal is to generate an above average and "hands off" income stream, MasterCard may not be for you - despite how much admiration you might have for the business. That's a perfectly rational stance to take as there are tons of investment alternatives out there. Of course if you're not looking for a strong starting income component, the economics of the business and propensity for earnings and dividend growth may look more attractive.
The second thing to note is that if you're willing to take a more "hands on" approach, there is a middle ground. You can both own shares of MasterCard and generate substantially more than 1% per year. Let's explore some possibilities by looking at a few available call options:
The above table uses the September of 2017 call option bids as of the time of this writing. Note that I have no affinity for this expiration date (many prefer much shorter timeframes) but it does give you a longer-term sampling of what is out there. We think about dividends on an annual basis, so looking at cash flow in the same light is an easy comparison.
The first column details the strike price, or the price that you would be willing to sell 100 shares of MasterCard. If you never want to sell, naturally none of these arrangements would be attractive to you. Alternatively, if you're thinking about selling or would like to own the company with a higher yield, these sorts of option possibilities could be interesting.
The second column highlights the "net" premium, which uses the most recent bid less $0.20 for frictional expenses. The third column details the upfront cash flow yield that making this agreement would provide (which could be taxed differently than qualified dividends). Finally, the last column shows how the agreement potentially "caps" your upside.
With option agreements it's all about being content with either side of the arrangement. I'll go through an example to demonstrate what I mean.
Perhaps you are content to hold shares of MasterCard at today's valuation, but you'd be happier if you could collect a cash flow yield north of 2%. The dividend component might add $0.80 per share or so in the next year, leaving a little over $1 per share required to meet your target.
In looking at the table above, you could think about owning shares of MasterCard and selling the $115 call option expiring in September of 2017. Immediately you would receive proceeds of ~$105, that could then be redeployed or spent as you see fit.
With this agreement there are two basic outcomes: either the option is exercised or it is not. Let's explore both.
You start with 100 shares that have a current liquidity bid (if you wanted to sell today) of about $8,700. If the option is not exercised, you have the $105 in beginning option premium to go along with dividend payments perhaps totaling $80 or so. Your income for MasterCard would be in the $180 to $200 range, resulting in a cash flow yield north of 2%.
Some will point out that selling the option will not prevent against a loss, which is true. However, it should be evident that this scenario would be preferable to simply owning shares alone. If you're happy to hold for the long-term (regardless or a reasonably higher or lower price) the only difference if the option is not exercised is that you have an extra $100. You're always going to be ahead by the amount of the option premium in this scenario.
A second possibility is that the option is exercised. In this case you would still receive the $105 in upfront option premium to go along with $11,500 (less frictional expenses) in sale proceeds. Whether or not you also collect dividends along the way depends on the timing of the option assignment.
The risk here is that shares could go to $120 or $140 and you're stuck selling at $115. That's a real risk and something you need to be cognizant of. However, this agreement would also translate to a total gain of over 33% in just over 14 months' time. Give me that return consistently and I'll show you an exceptional place to grow wealth.
Of course you're not limited to agreeing to sell at a single strike price or expiration (or at all). If you're looking for a higher cash flow component you could agree to sell your shares of MasterCard at say $95 or $100, generating a 4% to 6% "bonus" cash flow yield for the period. It's true that your upside is further "capped" but you'd still be looking at the prospect of generating significantly higher cash flow yields or else selling with 15% to 20% gains during the timeframe.
In short, MasterCard has proven itself to be an exceptional business with strong growth prospects. It's hard for many to own because of the relative valuation and low dividend yield. In both aspects you need to be comfortable and understand the dynamics. However, depending on your appetite to potentially sell your stake along with your required returns, you can do something about the lower starting income stream. There are a plenty of agreements out there that offer both a reasonable "maximum" gain for the period to go along with a significantly higher cash flow component.
Disclosure: I am/we are long WFC.
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.