Visa: Money For Nothing

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About: Visa Inc. (V), Includes: AXP, MA
by: Jieming See
Summary

Global payments are becoming increasingly cashless and convenient. As a market leader, Visa is well placed to benefit due to its transaction-driven business model.

Unlike closed loop operators, open network operators like Visa do not bear credit risk and have better potential for growth as they work in partnerships (not competition) with the banks.

Among the open network operators, Visa has much better operating cash flows and an even stronger share buyback program than Mastercard.

Applying mid-cycle price earnings multiple of 32 and forecasting 2019 earnings per share of $5.17, I estimate Visa’s fair value to be $165.47 a share.

That's the way to do it. (Source: Pixabay)

If there is one ubiquitous topic dominating the discussion boards on investment websites nowadays, it is the growing topic of Fintech. From cryptocurrencies to QR codes, the rise of Fintech has come in various forms and has put the spotlight on what has been until now an underappreciated area of finance, namely that of the payments processing businesses. Nowadays companies from various industries (e.g., e-commerce retailer like Alibaba (NYSE:BABA) and consumer electronics maker Apple (NASDAQ:AAPL)) are all starting their own proprietary payments platforms to tap into this lucrative market. As the global trend towards cashless processing continues, companies are starting to see the opportunities in the lucrative cashless or electronic payments business.

While new technologies are emerging in the space of cashless payments, the payments processing business itself is not new. In the current form of credit and debit cards, payments technology companies like Visa (V) and Mastercard (MA) have been dominating this business for years now with their electronic networks and partnerships with merchants and banks globally. In fact, you can even call them the first truly global "Fintech" pioneers. In my view, a company like Visa offers an even better investment opportunity than other payment companies for three main reasons. Firstly, its open network business model allows for much faster growth, and secondly, its fee-based model is transaction-driven and does not expose Visa to any credit risk. Lastly it has a strong track record of positive operating cash flows, and this has funded a share buyback program that had almost doubled in size over the last three years.

Overview of the payments industry

While Visa is known by many consumers as a "credit/debit card company," this phrase could not be more of an understatement of how the company conducts its business as it hints at credit exposure when there is actually none. To understand what Visa actually does, one had to actually understand how a credit or debit card system operates via its network of cardholders, retailers, merchants, and card issuing banks. When a consumer makes a Visa card purchase at a retailer, funds actually move from the cardholder's banks to the retailer's bank accounts via Visa's electronic payments network. The key players here are:

The Retailer or Merchant provides goods or services to the cardholder and assumes some default risk of a non-paying customer.

The Merchant Bank maintains the retailer's bank accounts and provides cash management services. In return, it receives a service charge from the retailer (known as the merchant discount rate)

The Issuing Bank is a financial institution that issues the card to the consumer and hence bears the credit risk in the process. They also earn the most revenue in the process to compensate the risk

The Payment Network Company operates the payment network and charges both the merchant and issuing bank a fee. It assumes no credit risk at all. This is where Visa fits in with its VisaNet network system.

Figure 1. Unlike issuing or acquiring banks, payment companies are not exposed to credit risk at all (Source: ValueWalk with diagrams by author)

Figure 2. According to McKinsey, global payments revenue is expected to reach $2.2 trillion in 2018 (Source: ValueWalk)

Being a network operator, Visa's business model is entirely transaction driven. The good thing about such a business model is that Visa assumes no credit risk at all and is entirely focused on either growing the network of merchants or promoting the increasing use of its cards to drive more transactions and more fees. As payments become increasingly cashless and more convenient across the world, McKinsey forecasts global payment revenues to grow 5% per year annually from 2015 to 2020. Cards can be expected to become an increasing share of these payments going forward. According to the Bank of International Settlements (BIS), there has been a trend of increasing card payments as a percentage of GDP across both advanced and emerging market economies during the 10-year period between 2007 and 2016. Looking forward, more global payments revenue and more card usage are opportunities for Visa's transaction-driven business model.

Figure 3. According to BIS, card payments have generally increased since 2007. (Source: BIS)

Open vs. Closed Networks and Visa's competitive advantage

Within the payments industry, there are two competing business models that benefit the payment operators in different ways. In an open loop network, the merchant banks differ from the issuing banks, and this allows open network operators like Visa and Mastercard to grow their networks in partnerships with various banks and financial companies. In contrast, a closed loop network requires the network operator to also be the issuing and merchant bank and therefore makes the network less flexible for growth. Companies like American Express (AXP) and Discover Financial Services (DFS) are examples of closed network payments companies. While closed loop network operators are able to capture more revenue per transaction because they are involved in every step of the transaction, they also take on more credit risk as they are also the card issuing bank and the merchant bank.

Figure 4. The open network has numerous advantages over closed networks. (Source: ValueWalk with diagrams by author)

Figure 5. In terms of transaction volume, Visa card was the overall market leader in 2017. (Source: Nilson Report)

Because open network operators are able to grow transaction revenue in partnership with banks rather than against them, transaction volume for Visa and Mastercard is much higher compared to their closed loop competitors like American Express and DFS. According to Nilson report, Visa and Mastercard generated 147.9 billion and 75.8 billion purchase transactions globally in 2017, dwarfing the 7.5 billion purchase transactions by American Express.

Figure 6. Open network operators like Visa and Mastercard enjoy much higher margins than closed network payment companies like American Express. (Source: DBS Vickers, Reuters with analysis by author)

While closed loop operators can capture more revenue per transaction, translating that to profitability is quite another thing. The process of serving every single step in a transaction also incurs significantly more costs, and this is the reason why American Express has much lower operating and net income margins than Visa and Mastercard, even though it has a higher revenue. For the quarter ending 30th September 2018, American Express generated $10.4 billion in revenue, but could only earn a net income of $1.6 billion. This translates to a margin of only 15.8%. Visa and Mastercard had much lower revenue of $5.4 billion and $3.8 billion for the same quarter, but earned much higher net income of $2.8 billion and $1.8 billion, respectively. This enabled both open network operators to enjoy net income margins close to 50% each.

In short, I view the open network business model more favorably than the closed loop model, as it has a much higher potential for growth without any of the credit exposure and operating costs that come with servicing the other aspects of the transaction process. For a market leader like Visa, this is quite a strong competitive advantage.

Visa's share buyback program

Visa's business model effectively generates money for nothing when consumers swipe for fees. This has created strong operating cash flows, which also fund its growing share repurchase program over the years. From 2015 to 2017, Visa has grown its annual operating cash flows from $6.5 billion annually to $9.2 billion.

Figure 7. Supported by strong operating cash flows, Visa has been increasing the size of its share buyback program faster than rival payment company Mastercard. (Source: DBS Vickers, Reuters with analysis by author)

Unsurprisingly, such a strong growth in operating cash flows has enabled Visa to more than double its share buybacks from $2.8 billion in 2015 to $6.7 billion in 2017 while Mastercard has maintained its share buyback at between $3.4 billion to $3.7 billion. At $312 billion, Visa's market cap is about 50% more than Mastercard's market cap of $208 billion, but its share buyback is 80% larger. In my opinion, this makes Visa a more attractive candidate than Mastercard among the open network payment operators as investors are better rewarded in terms of capital returns.

Valuing Visa - a Price/Earnings Ratio approach

For 2019, Visa guides for a low-double-digit growth in annual revenue. Using its 3% quarterly growth rate for 2018, I estimate the company to grow about 13% in terms of revenue for 2019. This is close to Visa's forecast of a "low-double-digit growth". Assuming Visa maintains an average 60% operating margin and 50% net income margin for 2019, I estimate it to earn about $5.17 a share for 2019.

Figure 8. Visa forecasts low double digits growth for the 2019 (Source: Visa)

Figure 9. Historically Visa's P/E ratio has ranged between 24 and 48; we apply a mid-cycle P/E of 32 to estimate its mid-cycle valuation. (Source: YCharts)

Figure 10. Applying a P/E ratio of 36 to forecasted earnings of $5.17 a share, I determine the fair value of Visa to be $165.47. (Source: DBS Vickers, Reuters with analysis by author)

In order to estimate the one-year fair value of Visa's share, I applied a mid-cycle price earnings ratio of 32 to its 2019 earnings per share estimate. For the last five years, Visa has traded at a P/E ratio of between 25 and 48, so 32 is a fair mid-cycle estimate. The fair value of Visa's shares is estimated to be about $165.47, which implies a 10% upside from the current level. Given its strong business model and solid financials, the company represents a very attractive opportunity for investors.

Conclusion

As payments become increasingly cashless globally, purchasing will become more convenient and global payments volume can be expected to increase. Business models that are more transaction driven would be a better way of capturing the growth in this market. This is why I think open networks are better than closed loop networks, because it is much easier for such networks to grow and add cardholders and merchants through partnerships with the banks. VisaNet is one good example of such a network, and the beauty of such a payment ecosystem is that Visa is able to earn fees without taking the risk of poor credit. This also means its business model requires less capital, and as a market leader, it is able to translate that dominance into high margins. As a result, Visa is able to use strong operating cash flows to increase its share purchase program and benefit investors. Visa currently trades at 10% below my one-year target price, and I will put this on my watch list for potential buying opportunities in 2019.

Figure 11. Visa's money-making machine is the best way to please investors too (Source: Meme Center)

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in V over 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.