I like businesses that have some degree of unique franchise value and lack of penetrability. MasterCard has built a two-sided network for payment acceptance. The business has been successful in working with issuer partners to get payment cards in the hands of consumers. This in turn has afforded it ubiquitous acceptance across merchants globally.
MasterCard's stock price has barely budged over the last 12 months. However, this lack of share price movement belies continued good growth in the business.
In Q2 2016, MasterCard saw an increase in revenue of some 13%. This was largely driven by an increase in processed transaction volume of 14%. The result was a beat on both revenue and earnings per share expectations. Excluding a one-off of provisions for litigation charges, MasterCard saw earnings per share increase almost 14% on a currency neutral basis.
For a company with double-digit growth in its underlying transaction drivers and profitability, MasterCard trades at what I consider to be a fair valuation of 23x forward earnings. Yet, the stock price hasn't shown many signs of forward movement in the last year. I would submit that MasterCard is being held back primarily on concerns of merchant litigation activity, rather than valuation concerns or slowing growth.
Visa (NYSE:V) and MasterCard shares were hit hard on the news of the overturning of a legal settlement that was negotiated between MasterCard, Visa and over 7,000 merchants for alleged antitrust violations. Visa and MasterCard settled these allegations at a cost of almost $7.25B in 2013. Share prices of both businesses dropped some 5% on the initial news several months ago.
Separately, consumers in the UK launched a $24B lawsuit against MasterCard for improper cross-border transaction fees, alleging that MasterCard levied cross-border fees at a rate that restricted competition.
The fact of the matter is that the credit card processors and the merchants share an uneasy alliance. Merchants would love nothing better than to dispense with the credit card giants, who have a lot of transaction data on their businesses, and impose a virtual tax every time a consumer swipes one of their cards through a machine.
The reality is that merchants have tried and failed to come up with alternatives to displace Visa and MasterCard. MCX was supposed to be the answer, but constant delays and struggles have beset the business and led to layoffs and other challenges with MCX rolling out a product. The reality is that merchants have no choice but to accept the Visa and MasterCard paradigm, no matter how much they don't want to.
Litigating MasterCard and Visa out of existence is likely to hurt the merchants as much as the consumers who have become beholden to credit and debit cards from the networks to simplify the payments process. The reality is that merchants are now significantly dependent on the payment networks for frictionless commerce.
I'd argue that for merchants, the primary objective is more about seeing if they can extract a larger share of rebates from Visa and MasterCard and reduce the toll that they are paying on purchases made via the payment networks.
Part of the pressure that they can exert on MasterCard comes from the legal pressure that they can exert on the credit card networks. However, equally important is that major networks need to make Visa and MasterCard believe that they have a credible alternative to present to the networks for payment.
MCX has imploded as a result of a failure to solve any real pain point, apart from merchants' desire to have an alternative to Visa and MasterCard.
The great hope for merchants was the viability of PayPal (NASDAQ:PYPL) to transition into a mechanism to support bank account-linked payments, steering volumes away from Visa and MasterCard networks to the ACH network. With 188M users worldwide, PayPal was seen as a compelling alternative to Visa and MasterCard, with a credible, large user base to make a meaningful impact on Visa's and MasterCard's volumes.
In a blow to merchants hopes to be free of the large payment networks. PayPal struck a deal with Visa where it gets better access to leverage Visa's in-store network, in exchange for agreeing not to steer its customers to link their PayPal accounts to bank accounts.
While PayPal benefits from better in-store network access and acceptance riding on Visa's network, its ability to act as a credible alternative to the payment networks has now been crushed. It is expected that MasterCard will likely follow with a similar deal in due course.
The fact that the largest independent payments entity has now thrown its hand in with the incumbent payment networks speaks not only to the dominance of Visa and MasterCard, but also the difficulty in competing with these businesses. While alternative payment approaches may exist around the presentation layer or user experience to the customer, it appears clear that emerging innovation will continue to ride Visa's and MasterCard's payment rails.
For merchants, that means that the only compelling way they have to push back at Visa and MasterCard is to drive an increasing volume of litigation to get the payment networks to buckle. The threat of an alternate payments regime to the status quo has largely been neutered in the medium term.
For these reasons, I believe that the lull in MasterCard's stock price is likely to prove temporary. Merchant litigation will be drawn out, and in the absence of a compelling competitive alternative, the networks will be in no great hurry to strike a deal that erodes their long-term franchise dominance.
In the meantime, the drivers that have been propelling MasterCard's transaction growth, including a cash to credit shift, greater acceptance mechanisms (including mobile point of sale) and increasing growth internationally will all continue to drive MasterCard's profitability higher.
Disclosure: I am/we are long MA, V.
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.