By The Valuentum Team
Mastercard's Investment Considerations
- MasterCard (NYSE:MA) is a payments industry leader. Every day, the firm's network makes payments happen. It doesn't issue cards, set interest rates or establish annual fees. MasterCard generates revenue by charging fees to issuers and acquirers for providing transaction processing and other payment-related services based on the gross dollar volume of activity.
- Though uncertainty persists in the global economy in 2016, the fundamentals of MasterCard's business and its approach remain unchanged. The firm's digital wallet MasterPass will continue to be a focus of the firm as it moves into an increasingly digital world.
- Investors should expect MasterCard's revenue to grow at a low-to-mid teens annual pace through 2016. The biggest drivers behind that expectation rest in 5 percentage points of personal consumption expenditure expansion, 5 percentage points of secular electronic payment penetration, and a few points from strategic investments.
- Mastercard benefits from one of the strongest competitive advantages out there - the network effect. As more consumers use credit/debit cards, more merchants accept them, thereby creating a virtuous cycle. Amazingly, 85% of the world's transactions are still completed by cash and check. This provides a long runway for future growth.
- In our opinion, there's no reason Mastercard can't double or triple its dividend from current levels. The firm's cash-rich business model drives its outstanding Dividend Cushion ratio of 4, which is one of the best in our coverage universe. The company will continue to return excess cash to shareholders, but existing plans are considerably biased toward share repurchases. Management's willingness may be the biggest obstacle for future dividend growth.
- When it comes to the credit-card processing space, we generally prefer Visa (NYSE:V) and MasterCard, which do not take on credit risk like Discover (NYSE:DFS) or American Express (NYSE:AXP). This shields it from credit quality concerns.
Economic Profit Analysis
In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
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 129.8%, which is above the estimate of its cost of capital of 10.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, 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.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Mastercard's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is an impressive 4 (anything above 1 is considered strong).
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 40.1% 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. At Mastercard, cash flow from operations increased about 16% from levels registered two years ago, while capital expenditures expanded about 82% over the same time period.
In 2015, Mastercard reported cash from operations of just over $4 billion and capital expenditures of ~$175 million, resulting in free cash flow of ~$3.9 billion. This represents a nearly 20% increase from 2014.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Mastercard is worth $91 per share with a fair value range of $73-$109. Shares are currently trading at ~$92, just above our fair value estimate. This indicate that we feel there is a similar amount of downside risk and upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our model reflects a compound annual revenue growth rate of 8.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 12.2%. Our model reflects a 5-year projected average operating margin of 58.7%, which is above Mastercard's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 6.2% for the next 15 years and 3% in perpetuity. For Mastercard, we use a 10.7% weighted average cost of capital to discount future free cash flows.
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 $91 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 were 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 $73 per share (the green line), but quite expensive above $109 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 $91 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $121 per share in Year 3 represents our existing fair value per share of $91 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.
Wrapping Things Up
Perhaps the most compelling aspect of Mastercard's business is the network effect from which it benefits. As more customers continue to use credit and debit cards, more merchants accept them, and a virtuous cycle is created. Despite the level of uncertainty surrounding the global economy, the fundamentals of Mastercard's business and its approach remain unchanged. It will continue to innovate as the world becomes increasingly more digital, a recent example being its digital wallet MasterPass.
Mastercard's cash-rich business model drives its outstanding Dividend Cushion ratio, which is one of the best in our coverage universe. The fact that it does not take on credit risk like Discover or American Express shields it from credit quality concerns. We like Mastercard's solid capital planning priorities of maintaining a strong balance sheet, liquidity, and credit ratings as these lead to stronger dividend potential. Its current payout has an extremely long runway of strong growth potential ahead of it, should management choose to ramp up its dividend policy.
All things considered, however, we're waiting patiently for a better entry point in Mastercard. We would like to see improvements in its technical indicators and relative valuation, as well as see shares trading at a discount to our fair value estimate before considering a position in the company. The firm currently registers a 3 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: V is included in the Best Ideas Newsletter portfolio.