Before MasterCard's (NYSE:MA) IPO last week, Bill Simpson wrote a detailed analysis of the company and offering. MA shares priced at $39--below its $40-43 range-- on May 24th. The text of Mr. Simpson's original writeup follows:
MasterCard plans on offering 61.5 million shares at a range of $40- $43. Goldman Sachs is lead managing the offering with Citigroup, HSBC, and JP Morgan joint bookrunning. Post-offering MA will have 135 million shares outstanding for a market cap at $41.5 of $5.6 billion. 3/4 of IPO proceeds will be used to redeem Class B shares from holders, 1/4 to increase capital/ defend against litigation and general corporate purposes.
Post-offering J.P. Morgan, Citigroup, Bank of America, and HSBC will all own between 5%-10% of MA outstanding shares.
Note that concurrent with this offering MA will donate 13.5 million shares to The MasterCard Foundation, a private charitable foundation. This donation is not tax deductible and will be expensed in the second quarter of 2006. The result of this donation is that MA will post a large bottom line loss in 2nd quarter 2006, and an overall loss for full year 2006. This is not an operational loss, but something holders of MA need to be aware of. Also MA will contribute approximately $40 million in cash to the foundation over the next 4 years.
From the S-1:
MasterCard is a leading global payment solutions company that provides a variety of services in support of the credit, debit and related payment programs of nearly 25,000 financial institutions. We manage a family of well-known, widely accepted payment card brands, including MasterCard®, MasterCard Electronic™, Maestro® and Cirrus®, which we license to these financial institutions.
MasterCard has a world-wide scalable branded payment system that links issuers and acquirers around the globe for transaction processing services and permits cardholders to utilize their cards at millions of merchants worldwide. MA generates revenues from the fees charged to customers for providing transaction processing and other payment-related services (operations fees) and by assessing customers based on the dollar volume of activity on the cards that carry the MasterCard brands (assessments). Approximately 2/3 of revenue is derived from operations fees, 1/3 from assessments.
Actual fee determination for MA is extraordinarily complicated and probably worthy of a dissertation. We're looking into MA here to determine if and at what price it is investable, so as is usual I'm not going to delve into the complicated fee structure. It is enough for our purposes to know how MA derives fees.
Customers include 25,000 financial institutions in 210 countries and territories. Cards carrying the MasterCard brand are accepted at over 25 million places worldwide. MA processes over 13 billion transactions annually. Yeah that is 13 billion. Top 5 customers accounted for 33% of 2005 revenue, JP Morgan Chase accounted for 11%.
Total transactions increased 16% in first quarter 2006, fueled by a 25% growth in online transactions, and a 14% growth in offline transactions. Online transactions while growing swiftly accounted for 19% of total transaction in 2005. Compound 3 year growth rate for online transactions through MasterCard have been 55%. Online transaction will continue to be a major growth driver for MA into 2006, 2007 and beyond.
A typical MasterCard transaction involves MasterCard and four other parties: the cardholder, the merchant, the issuer (the cardholder’s bank) and the acquirer (the merchant’s bank). MA's customers are the banks involved in each transaction, the issuer and the acquirer. MA's processing services facilitate efficient, secure, processing of each transaction, while guaranteeing settlement. This is not a groundbreaking revelation of course, nearly all of us use this type of payment processing in our everyday lives. Of note MasterCard does not issue or manage cards, set interest rates or extend credit to cardholders.
MA has experienced a solid growth trend the past 5+ years due to the increased usage of credit/ debit cards in place of cash money and checks. Going forward online/ offline credit/ debit transactions are expected to continue to increase in volume and as a % of total payment method. Most likely as important, the barrier to entry here is rather high. MasterCard, Visa, and American Express are the 3 giant global payment solutions systems, anyone new entering the space would have to sell-in to banks/ financial institutions that have been customers of the three behemoths for decades. Note that American Express differs from MasterCard and Visa in that they do issue their own branded cards. Discover has made some inroads into the business of the three, but relatively small overall. MasterCard is branded very very well.
A key concern with the MA offering, is that they appear to have thus far fallen well behind Visa in debit card usage in the US. This is significant as much of the organic growth in this space going forward will be derived from the continued shift of consumers using debit cards as opposed to cash/checks. Visa has attempted to 'shut out' MasterCard in the US debit card arena. They've instituted a policy with their 100 largest debit card issuers stating those issuers must pay a substantial penalty if use of Visa debit cards drop 10%. This effectively shuts out MasterCard from doing significant debit card business with these 100 Visa debit customers. MasterCard is challenging this policy in court. MasterCard does have a leading position in offline/online debit transactions in Europe however.
MA will have approximately $8 a share in cash/ securities (minus debt) post-offering. The large cash/ securities on hand is a cash horde for legal litigation/ settlement purposes. 2 1/2 X's book value post-offering. MA will pay an annual dividend equaling 36 cents. Dividend will be paid quarterly and at $41 1/2 the yield would be a little under 1%. Fueled by the worldwide shift to credit/ debit payments and away from cash and checks, MA has experienced solid consistent revenue growth this decade. Revenues grew 16% in 2004 and another 13% to $2.94 billion in '05. Operating margins have been in the 13% range. Something to note: MA spends a large amount on advertising & market development for the purpose of ongoing branding. In 2005 this expense line was 33% of overall revenue. This seems a little high to me for such a large, thin margin business but was consistent with prior years advertising/ marketing spending. Operating expenses have grown on par with revenues the past few years, taking away any economies of scale MA might enjoy with increased revenue. Net margins the past few years have been in the 9% range. In 2005 MA earned $1.98 per share. At a $41.5 pricing, MA would be trading 21 X's trailing earnings.
Going forward MA states in 2006 they've given substantial rebates/ incentives to customers in support of the conversion of a large payment card program to MasterCard. The incentives/rebates take the form of a reduction in revenue. MA feels these incentives will largely offset their assessment revenue growth in first 1/2 of 2006. From the prospectus, “As a result, we do not expect the same level of revenue growth in 2006 as we experienced in 2005.” Also for 2nd quarter advertising/ marketing expenses are expected to increase due to MA's sponsorship of the World Cup.
So taking this into account, lets look at MA's potential revenue and earnings for 2006. First of all MA will book a bottom line loss in 2006 due to the donation of shares concurrent with IPO to the MasterCard Foundation. This is pre- IPO non-operational or material and I'm wiping it off completely. MA will release non- GAAP numbers for 2nd Q and that is what should be looked at. The donation is akin to pre- IPO charges many companies take in order to get their business in line going forward as a public company. Now the contributions going forward that MA will make to the Foundation will be operational to the extent they are not tax deductible. Those however will be just a 2-5 cent drag on earnings annually. I'm not concerned in the least about the effect on operations or earnings of this donation. Not one bit.
In the first Q '06 revenues rose 12%, even with the rebates/ incentives coming off assessment fees. I think it reasonable to assume MA can continue to grow revenues in this range throughout 2006. In preparation for the World Cup sponsorship MA cut back advertising/ marketing growth in Q1 2006. The result was a stronger then historical net margin of 17%. I don't think that is sustainable. I would expect lower then historical net margins in the 2nd Q as MA spends heavily on World Cup sponsorship.
So by year end I would anticipate 12% revenue growth with 10% net margins. I think MA can earn somewhere in the $2.50 ballpark in 2006. Again that is with the donation folded out. At a $41 1/2 pricing MA would be trading at 17 X's 2006 earnings.
Let us look at MasterCard in comparison to American Express (NYSE:AXP). The two are not identical operations, but AXP is MA's closest comparable:
AXP, $64 billion market cap, $4 per share in cash. Currently trading 6 X's book value and currently trading 18 X's 2006 earnings estimates with a 5- 10% expected revenue growth rate. MA, $5.6 billion cap at $41.5, $8 per share in cash. At $41 1/2 trading 2 1/2X's book value and 17 X's my 2006 earnings estimates with a 10- 15% expected revenue growth rate.
The big risk here is litigation risk. MA has been on the receiving end of number of lawsuits, including one currently brought by Discover and American Express. This lawsuit is an offshoot of a previous antitrust suit filed against MasterCard and Visa by the US government. The suit focused on MasterCard and Visa's policy of having bank customers agree not to issue competing cards to MasterCard and/ or Visa, thus shutting out competition in the customer base of each from the likes of American Express, Discover and others. Thus far Visa and Discover have been unsuccessful in their suits, having been denied.
The kicker here though is that the latest ruling has allowed for Visa/ Discover to refile in an attempt to seek damages. If they are eventually successful in receiving damages, then MA's stock could very well take a quick hit. MA has built up nearly a billion dollar reserve for this and other potential negative legal outcomes. MA also has various lawsuits around the world in which they are the defendant or plaintiff. Par for the course for large multi- national operations these days.
In 2003 MA expensed a little under $800 million as part of a settlement from a lawsuit from merchants.
In a related risk, going forward MA will no longer be permitted to extract special assessments from customers for extraordinary expenses such as legal damages and settlements. In the past, MA would 'lay off' a portion of their litigation costs to their banking customers. Directly as a result of this, upon completion of the IPO, Standard & Poor’s Rating Services expects to lower MA's credit ratings from A-/ A-2 with negative outlook to BBB+/ A-2 with stable outlook and subordinated debt rating from BBB+ with negative outlook to BBB with stable outlook. MA does not have significant credit risk as debt loads are tiny, so this operationally should not effect MA. However Standard & Poors is essentially saying MA has a lot more risk to legal damages/ settlements going forward due to the elimination of these 'special assessments.'
Large offering, but a solid one. MasterCard is branded globally about as well as a company can be branded. Factor in (outside of a legal settlement in 2003) they've shown significant positive cash flows annually and they're positioned well in a business that stands to see solid organic growth over the next 5+ years. Cash/ checks are becoming a thing of the past in most transactions, with MasterCard, we've a solid money making operator positioned extremely well to take advantage of this trend. I like this deal and think even with the large amount of shares it works in range nicely.