A Slowing Global Economy Can't Stop Mastercard

|
 |  About: MasterCard Incorporated (MA), Includes: EPAY, FISV, V, WU
by: Valuentum

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Mastercard's (MA) case, we think the firm is fairly valued at $429, about in line to where it is currently trading.

For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Mastercard posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. We compare Mastercard to peers Bottimline Tech (EPAY), Fiserv (FISV), Western Union (WU), and Visa (V). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

Our Report on Mastercard

Click to enlarge

Investment Considerations

Investment Highlights

• Mastercard earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 85.5% during the past three years.

• Mastercard has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 38.5% in coming years, and the firm had no debt as of last quarter.

• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.

• The firm experienced a revenue CAGR of about 10.4% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.

Business Quality

Most Recent Quarterly Results

Payment processor Mastercard reported a strong second quarter Wednesday. The firm earned $5.65 per share, up nearly 17% from the same period a year ago (and $0.07 higher than the Street expected). Revenue grew just 9% to $1.8 billion, though that was negatively impacted by currency, causing the number to fall about $90 million short of consensus expectations. Operating margins grew 130 basis points to 54.6%, but that figure still lags Visa's.

Payment growth volume roughly tracked revenue growth, with total payment dollars increasing 9.4% year-over-year, to $890 billion. Even more telling, payment transactions increased 29% to 8.5 billion, as users are becoming more and more comfortable with paying for everything with plastic. The movement towards a "cash-less" society continues, and innovations such as Square will only increase point-of-sale acceptance. As a result of the class action merchant lawsuit against the payment network duopoly, Mastercard had to take a $13 million after-tax charge in the second quarter.

Much like competitor Visa, we love Mastercard's cash rich business model and powerful network effect. The firm has generated over $1 billion in operating cash flow year-to-date. Thus, it was no surprise that the firm was able to repurchase $671 million in stock during the second quarter, and still has $1.4 billion available to repurchase shares under its current authorization.

However, we prefer Visa to Mastercard, though investors often see the two as interchangeable. Visa has a more powerful brand name, in our view, better operating margins and a favorable valuation. Of course, if Mastercard were able to bring its operating margins to parity with Visa's, the firm would experience some tremendous earnings expansion. Regardless, Mastercard registers only a 6 on our VBI (our stock-selection methodology), so we'd have to see a significant pull-back in the shares before getting excited about its return profile.

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Mastercard 's 3-year historical return on invested capital (without goodwill) is 85.5%, 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 to the right, 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.

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. Mastercard 's free cash flow margin has averaged about 29.8% 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. For more information on the differences between these two measures, please visit our website at www.valuentum.com. At Mastercard , cash flow from operations increased about 95% from levels registered two years ago, while capital expenditures expanded about 27% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Mastercard 's shares are worth between $322.00 - $536.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $429 per share represents a price-to-earnings (P/E) ratio of about 28.8 times last year's earnings and an implied EV/EBITDA multiple of about 17 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 10.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 10.4%. Our model reflects a 5-year projected average operating margin of 55%, which is above Mastercard 's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.1% for the next 15 years and 3% in perpetuity. For Mastercard , we use a 10.8% weighted average cost of capital to discount future free cash flows.

Click to enlarge

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 $429 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 was 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 Mastercard . We think the firm is attractive below $322 per share (the green line), but quite expensive above $536 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 Mastercard 's fair value at this point in time to be about $429 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of Mastercard '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 $579 per share in Year 3 represents our existing fair value per share of $429 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.

Pro Forma Financial Statements

Click to enlarge

Click to enlarge

Click to enlarge

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

Additional disclosure: Some of the firms mentioned in this article may be included in our actively-managed portfolios.