Payment services company Mastercard, Inc. (MA) has been on a tear over the past 10 years. The stock has appreciated 1,240% over that time frame, easily besting the indexes. This has been thanks to a combination of sparkling fundamentals and growth that has seen both the top and bottom lines grow at a double-digit CAGR over this time frame. While these high-growth, blue-chip stocks have a tendency to burn off premiums, investors should be careful with Mastercard. The stock is well above its historical valuation levels, and management recently projected that earnings growth (although robust) will slow down some over the next few years. Buying at this level puts investors at a high risk for suppressed returns when Mastercard's overvaluation eventually catches up to shares.
Over the past 10 years, Mastercard has traded at a median earnings multiple of 27.55X earnings. While this is a high valuation to pay for most stocks, Mastercard has had the fundamentals to justify such a high multiple.
The company has roughly tripled its top line to almost $15 billion over the past decade, and the company has almost doubled its EBITDA since the recession. Revenue has grown at a 10-year CAGR of 11.88%, while earnings per share have paced at 16.39% per annum.
While growth is the foundation of a business's forward momentum, these results are amplified when a company runs an efficient business model. Mastercard is extremely profitable, running at an operating margin of more than 56%. As a result, the business is able to convert more than $0.38 of every revenue dollar into cash flow. This is more than triple the rate we look for as a benchmark (10%). The company's profitability and lean, non-capital-intensive structure results in high rates of return on the capital that Mastercard puts to work. The company generates cash returns at a 62.38% rate on invested capital.
When your business is growing and cash efficient, the cash trickles down to the balance sheet and shareholders. Mastercard is able to operate at a very strong financial position. The balance sheet is cash positive on a net basis. Cash assets of $6.68 billion against total debt of $6.33 billion result in a positive difference of $350 million.
With well north of $5 billion in free cash flow and no real need to spend it anywhere, it tends to find its way in the pockets of shareholders. Mastercard is very aggressive with share buybacks, spending almost $5 billion over the past 12 months alone. Over time, the share count has been reduced from 1.3 billion to 1.05 billion. This drastic share reduction helps supercharge the EPS growth rate.
Meanwhile, Mastercard is working its way up the ranks of dividend growth stocks. While some investors may shy away from a yield of just 0.61%, the dividend has been raised each of the past eight years. Over the past five years, the dividend has grown at a CAGR of 36.6%. This blistering pace results in surging yield on cost for those who hold over the long term. The dividend yield is low because of capital gains, not because of a lacking payout.
Mastercard "checks all of the boxes" that we look at for a long-term investment, so why do we hesitate to recommend shares? Even the best companies can disappoint investors if the valuation is out of sorts.
Mastercard closed out its FY 2018 on January 31st. During the call, management walked through the company's past three years of performance. Over the past three years, Mastercard has grown earnings per share at a CAGR of 28%. Given the full year's earnings of $6.49 per share, the stock's current PE ratio is just north of 33.1X earnings. This puts the stock at a 20% premium to Mastercard's 10-year median earnings multiple (27.55X as mentioned in the introduction). With a three-year growth rate that has outpaced its 10-year average, we can see how the stock could "get hot" and outpace its historical valuation.
However, this trend can also go the other way. Management also laid out its three-year forecast for upcoming years 2019-2021. Partially due to expected softening in consumer spending (management detailed this in prepared remarks, and again in analyst questioning), the expected EPS CAGR has been lowered to the high-teens.
Source: Mastercard, Inc.
A reversion back to historical growth rates could easily result in a similar move with the stock's PE ratio. If we extrapolate Mastercard's EPS using a CAGR of 16-19%, we would see FY2021 earnings between $10.13 and $10.93 per share. If the stock were to revert to its 10-year median valuation, the resulting share price would range between $279 and $301. While this sequence of events would result in total capital gains between 30% and 40% (not a bad three-year return by most standards), the rate of return would greatly lag historical performance because of PE compression that had taken place.
But what if Mastercard falls short of expectations? What if there is a global recession that drags the market into a full-on bearish environment? The current valuation doesn't allot a margin of safety for investors. If Mastercard were to see EPS growth of even 14% and a PE ratio of 25X three years out, the numbers change quite a bit. FY2021 earnings per share become $9.61, and the share price at that time becomes $240. This means capital gains of just 11% over a three-year time period (a mediocre return on investment by most standards). When you have no margin of safety, even a slight "tweak" to the numbers can drastically impact the bottom-line result.
We are bullish on Mastercard over the long term (5+ years), where barring an unlikely event, the company's stellar fundamentals will win out in most cases. But just because a company is strong doesn't mean that investors should write a blank check to own the name. Mastercard's projected slowdown in earnings growth warrants a margin of safety, which isn't provided at more than 33X earnings.
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Author Disclaimer: Wealth Insights is an investor and investment author. His content is not geared to anyone's specific investment goals, time horizons, or risk tolerance. Content is for illustrative purposes only and is not intended to displace advice from a fee-based financial adviser. Accuracy of data is not guaranteed.
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.