Visa Inc. (NYSE:V) is a wonderful company that few can argue about its quality as a company. The business model is excellent. Just charge merchants a percentage of every transaction with no liability for the customers' ability to pay. It's essentially a financial toll road that has excellent growth prospects moving forward.
I initiated a position in the company in August 2013 and have been more than pleased with the results as they are the 5th best performer in my portfolio as judged by internal rate of return. In that time I've received a dividend return of 1.60% and share price appreciation of 48.05%. That's good for a total return of 49.65% with an internal rate of return of 22.49%. As a dividend growth investor the even better news is that the dividend has been increased by 69.70% since I initiated the position.
Visa is a Dividend Challenger with 8 consecutive years of dividend growth. At a price of $71.56 the current yield is 0.78%.
However, that's what it's done for me in the past and has no bearing on the future. Is there any value in the shares at the current prices?
Business Overview
I want to start off looking at Visa's moat because that's a big factor in determining its financial metrics. Visa's moat is based on its network strength. They are the largest payment processor and credit card network in the world and building out a network to rival Visa's would require a huge undertaking of capital. You would have to convince just about every major bank to use cards with your brand, convince retailers to accept your network, and consumers to use your cards.
With Visa's network already built out they sit in a dominant position. In the first quarter of Fiscal Year 2016 Visa processed 19.0 billion transactions with total payment volume of $1.3 trillion. Those were 8% and 11% increases, respectively, from the year ago period.
Profitability
Visa's margins are truly amazing. Gross margins have risen from already lofty levels to 81.8% over the trailing twelve months. Operating margin has been expanding as well and sits at 65.6% for the last twelve months. Of course what's really amazing is that net profit margin is sitting at 47.6% over the last year.
Cash Conversion
Visa is a cash conversion monster. Over the last 5 years and the TTM period, Visa has turned an average of 44.7% of revenue into operating cash flow. Visa also requires very little in the form of ongoing capital expenditures to maintain and grow their business. Over the same time period capital expenditures have averaged just 8.8% of operating cash flow.
High conversion of revenue into operating cash flow plus low capital expenditure requirements leads to a huge free cash flow margin. Over the same time period as above Visa has managed to convert 41.1% of revenue into free cash flow.
Visa's cash flow margins are impressive and so is their cash flow. When analyzing the cash flow of a company I like to look at several iterations of free cash flow.
- Free Cash Flow (FCF) - The traditional free cash flow calculation of operating cash flow minus capital expenditures.
- Free Cash Flow after paying the dividend (FCFaD) - Free cash flow as calculated above minus the total cash dividend payment.
- Free Cash Flow after paying the dividend and share buybacks (FCFaDB) - The FCFaD value minus net cash spent on share buybacks.
The following chart shows Visa's cash flow for the last 5 years and the TTM periods.
Shareholder Friendliness
All of that cash flowing through the business leads us to how Visa decides to reward shareholders. Companies have 2 ways to directly reward shareholders through buybacks and dividends, and of course reinvesting cash to grow the business rewards shareholders as well. Let's focus on share buybacks first.
Since fiscal year 2011 Visa has managed to reduce the share count by 13.5%.
Share buybacks have two big advantages. One, they reduce the share count which helps to inflate all per share values such as earnings and cash flow and in turn should lead to a higher share price over time. The second is that a constant cash payment of a dividend now goes further.
For example, Visa made $0.15 per share in dividend payments in Fiscal Year 2011 on 2,828 M shares. That works out to a total of $423 M in cash in shareholders pockets. In Fiscal Year 2012 the share count was reduced to 2,712 M so without accounting for an increase in the per share dividend payment that same $423 M in cash could have paid out a $0.156 dividend payment without Visa spending any more cash than the previous year.
Of course this wasn't the case as Visa increased their dividend during Fiscal Year 2012 and every year since then too. The total annual cash payment of dividends has increased by 29.2% per year between the end of Fiscal Year 2011 and the end of Fiscal Year 2015. Over that same time the per share dividend payment has increased by 33.8% per year. The difference is explained by the share buyback which has reduced the share count by 3.5% per year. That stretches the same cash that was available for dividend payments an additional 4.6%.
Visa has historically been priced at a premium, deservedly so, which we'll examine in further detail later. Given the current TTM P/E ratio of 25.7 and the 2016 Forward P/E Ratio of 25.5, I would prefer to see the ratio of buybacks to dividends skew more towards dividend payments.
The above graph shows the ratio of cash spent on dividends and share buybacks. Dividends have averaged 24.6% of cash returned to shareholders over that time.
Clearly Visa makes it a priority to return much of their excess cash to shareholders. Between Fiscal Years 2011 and 2015, inclusive, management returned 81.5% of free cash flow to owners.
Growth Prospects
Visa still has plenty of opportunities to continue growing their businesses for years to come.
- Continuation of trend towards using credit/debt cards instead of cash/check leading to more payments processed on the Visa network.
- Increases in amount spent each year per card holder.
- China recently opened its markets to external competition. While it will take a lot of work to penetrate UnionPay's leading position Visa has the cash and ability to take market share.
- A rising global middle class means there is more disposable income available to be spent each year.
- Continued rollout of their network to merchants around the globe.
Combined these growth trends should allow Visa to grow earnings at a double digit rate annually over the next five years.
Risks
The biggest risk to Visa's business model comes from the government. If the government decides it needs to protect consumers by limiting the fees they can charge that could significantly impair their profitability. However, as I mentioned earlier the growth both in number of transactions processed and total dollar volume will continue to climb which would offset any reduction of processing fees over time.
The other big risk is an already established competitor, Mastercard (MA) or Paypal (PYPL), taking away market share. However, Visa has a huge advantage in their current scale and the global payment processing business is large enough for multiple parties to thrive.
Valuation
The problem with Visa isn't the company or its operations. It's the fact that investors have bid the share price up to expensive levels. On a TTM basis the P/E ratio sits at 25.7. The 2016 Forward P/E ratio is 25.5 and the 2017 Forward P/E ratio is 22.0.
Return Expectations
So the question becomes can Visa's growth outperform its lofty valuation. Before adding shares to my portfolio I like to look at a few return scenarios. If the returns look adequate even in a bearish assumption then the shares could make for an attractive investment.
Assumptions for return calculations:
- Purchase price of $71.56, closing price from Friday, February 5th.
- Purchase date of Monday, February 8th.
- Analyst estimate of 5 year earnings growth rate of 16.6% which seems reasonable based on their past history and future growth potential.
- Starting annual dividend of $0.56 is grown at the same rate as earnings per share therefore maintaining the payout ratio.
- The first dividend payment for Fiscal Year 2016 has been paid so only 3 dividend payments will be received this year.
The following chart shows the current price, the earnings per share estimate for fiscal years 2016 through 2020 and the corresponding price with varying P/E ratios. It's important to note that these are future estimates of both earnings growth and share price trajectory.
The following table shows the compound annual growth rate of an investment in Visa from the current price across a range of ending P/E ratios. Ending prices have been adjusted for cumulative dividends received and are reflected in the return calculations.
Despite what many would consider to be excellent growth of the business, there's not many return scenarios that look that appealing. Only 10 of the possible 30 return scenarios depicted offer 10% or greater annualized returns.
Granted a P/E ratio of 15 or 17.5 is not likely to happen over the next 5 years barring a major collapse in the markets as a whole or some other financial calamity. Visa's long term growth should still justify at least a 20x TTM P/E ratio, if not higher, so I would consider the PE20-PE27.5 scenarios the likely outcomes assuming normal market and economic conditions. That pushes the ratio of 10%+ returns to 10 out 20.
Conclusion
Before investing in Visa at the current price you have to ask yourself if you're willing to take on the possibility of your own returns lagging behind the true business performance of the company.
The valuation has come down over the last week as the share price has fallen. That's helped to bring the TTM P/E ratio down from above 27 to around 25. The growth prospects for Visa haven't changed so this has opened up an opportunity for investors to add shares at a decent valuation.
There's been opportunities to add shares of Visa at a 20x P/E ratio in the past and I expect other opportunities will arrive in the future when the markets are going haywire. However, I consider the shares to be on the high end of fair value right now but it's attractive enough to initiate a position for those looking to add this wonderful company to their portfolio. Personally I'll be waiting for a better opportunity to add shares when the markets are a bit more crazy.
Visa is a wonderful company and one that I'm glad to own already. Visa's growth potential and shareholder friendliness makes them one of the few Challengers that I think is a "no doubter" Champion in the making. It's been one of the best performers in my portfolio. The current valuation isn't undervalued yet; however, it still represents a possible entry point in one of the more stable, high growth companies for ones portfolio.
