Seeking Alpha

Mastercard: Valuation Risk Continues To Rise

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About: Mastercard Incorporated (MA)
by: Passive Income Pursuit
Passive Income Pursuit
Long only, value, dividend growth investing, long-term horizon
Summary

Mastercard is a Dividend Challenger with 9 consecutive years of dividend growth.  Shares currently yield 0.47%.

Using Mastercard's cash flow and balance sheet to analyze the quality of the business.

Valuing Mastercard using a MARR analysis and dividend yield theory.

At current levels, Mastercard is a hold or a dollar cost average approach, not bulk buys.

Mastercard (NYSE:<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Dividend Stock Analysis Passive Income Pursuit

Payments processing, i.e., credit card networks, might be young in their public history, but they are rich in generating wealth for owners. Since its IPO in 2006, a $10,000 investment in Mastercard (MA) would be worth over $600k and that doesn't include the dividends that have been paid out.

ChartData by YCharts

Mastercard has ridden the wave of the transition from a society that largely uses cash and checks for transactions to one where most purchases are done with a swipe. Mastercard's existing network would take years for an upstart to build out which protects the business and keeps it earning high margins.

Dividend History

The bulk of my investments are in businesses that qualify as dividend growth investments, primarily with companies that could be quantified at medium yield-medium growth or high yield-low growth. However, as a relatively young investor, I also recognize the power, and profit potential, of owning shares in the low yield-high growth category. Companies such as Visa (V), Ecolab (ECL), Automatic Data Processing (ADP), and the like, might not provide much in the form of current dividend income, but the growth potential is enormous.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Dividend HistoryImage by author; data source: Mastercard Investor Relations

*An interactive version of this data is available here.

Mastercard is a Dividend Challenger with 8 consecutive years of dividend growth. Mastercard has paid a dividend every year since their IPO in 2006 without any decreases. Although, the dividend was frozen at $0.015 for 20 consecutive quarters from February 2007 through December 2011.

The 1-, 3-, 5- and 10-year rolling dividend growth rates since 2006 are shown in the following table.

Year Annual Dividend 1 Year 3 Year 5 Year 10 Year
2006 $0.009
2007 $0.054 500.00%
2008 $0.060 11.11%
2009 $0.060 0.00% 88.21%
2010 $0.060 0.00% 3.57%
2011 $0.060 0.00% 0.00% 46.14%
2012 $0.105 75.00% 20.51% 14.22%
2013 $0.210 100.00% 51.83% 28.47%
2014 $0.440 109.52% 94.28% 48.96%
2015 $0.640 45.45% 82.67% 60.55%
2016 $0.760 18.75% 53.53% 66.16% 55.83%
2017 $0.880 15.79% 25.99% 52.99% 32.19%
2018 $1.000 13.64% 16.04% 36.63% 32.49%
2019 $1.320 32.00% 20.20% 24.57% 36.22%

Table and calculations by author; data source Mastercard Investor Relations

*Dividends and growth rates are based off calendar year payments based on the dividend pay date.

As I mentioned above, Mastercard had 15 consecutive quarters of paying out $0.015 per share in dividends. That was centered around and coming out of the Great Recession which is excusable in my book. Despite the nearly 4 years with zero dividend growth, the worst 5-year period has still seen 14.2% annualized dividend growth.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Dividend Payout RatioImage by author; data source Mastercard SEC filings

Mastercard's payout ratio has climbed over the last decade as dividend growth has outpaced growth in free cash flow and net income. That being said, the dividend is still well covered by net income and free cash flow with ample room for further increases.

Quantitative Quality

With a goal of buying into a business and holding forever, determining the quality of a business is an important part of my investment strategy. The strength of the business will show itself through the financials.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Revenue Operating and Free Cash FlowImage by author; data source Mastercard SEC filings

Riding the wave of the push to less use of cash, Mastercard has seen its revenues grow from $5.10B in FY 2009 to $14.95B in FY 2018 with growth every single year. In total, Mastercard's top line has grown 193% or 12.7% annualized.

The increase in transaction volume and high operating income speaks to the negligible marginal cost to process additional transactions. Operating income grew from $2.27B to $8.37B from FY 2009 to FY 2018. That's 269% total growth or 15.6% annualized.

Similarly, cash flow from operations has grown from $1.38B to $6.22B which is 352% growth in total or 18.2% annualized.

Free cash flow has outpaced all of them, growing from $1.24B to $5.89B from FY 2009 to FY 2018. Growing 376% in total or a whopping 18.9% annualized.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Cash Flow Margins Image by author; data source Mastercard SEC filings

Since Mastercard's cash flow generation outpaced growth in revenues, it should come as no surprise that margins have improved. Although, they have leveled out since FY 2015.

Mastercard's free cash flow margin is incredibly strong with a 10-year average of 36.8%. Over the last 5 years, the average comes to 39.0%. I want to see FCF margins >10% as a sign of a strong cash generating enterprise and Mastercard is well above that mark.

My preferred profitability metric is the free cash flow return on invested capital, FCF ROIC. The FCF ROIC represents the annual cash return that a business generates based on the capital invested. Successful buy-and-hold investing is built on finding businesses that earn, and can re-invest, capital at high rates of return. I want to see a FCF ROIC >10%.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Free Cash Flow Return on Invested CapitalImage by author; data source Mastercard SEC filings

Mastercard's FCF ROIC has been well above my 10% threshold. The high, and climbing, FCF ROIC speaks to the strength of the business and its ability to see massive FCF generation with little additional capital investment. Over the last decade, FCF ROIC has averaged 41.6%, and over the most recent 5 years, the average comes to 43.7%.

I want to find businesses with capital allocation plans that align with how I believe I would do so as an owner. That means with the cash the business generates, first and foremost, we take care of and grow the business via capital expenditures. Secondly, with any remaining cash, I would return some to shareholders in the form of a growing dividend. Any remaining cash would then be used to shore up the balance sheet, pay down debt or repurchase shares.

To understand how Mastercard has used its free cash flow, I calculate 3 variations of the metric, defined below:

  1. Free Cash Flow, FCF - Operating cash flow less capital expenditures
  2. Free Cash Flow after Dividend, FCFaD - FCF less total cash dividend payments
  3. Free Cash Flow after Dividend and Buybacks, FCFaDB - FCFaD less cash spent on share repurchases

Ideally, a business will have positive or negligibly negative FCFaDB more often than not. I'm not concerned about the FCFaDB in any given year, rather it's the trend over the longer term that gives a glimpse into how management is behaving.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Free Cash Flows Image by author; data source Mastercard SEC filings

As we saw earlier, Mastercard has generated positive FCF every year over the last decade which has allowed management to move to dividends as a way to enhance shareholder returns. In total, Mastercard has produced $34.37B in FCF over the last decade.

Mastercard has also maintained a positive FCFaD every year despite a rapidly growing dividend. In total, $4.69B has been sent to shareholders via dividend payments which puts the cumulative FCFaD at $29.69B for the last 10 years.

The positive FCFaD has allowed management to grow the dividend as well as move to share repurchases to return additional cash to shareholders. In total, Mastercard has spent $24.45B on buybacks, putting the FCFaDB at $5.24B.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Shares Outstanding Image by author; data source Mastercard SEC filings

The $24.45B Mastercard has spent on share repurchases have decreased the share count from 1,304M in FY 2009 to 1,026M in FY 2018. That's a total reduction of 21.3% or ~2.6% annualized.

The following chart shows the breakdown of the cash used for shareholders via capital expenditures, cash funded dividends and share repurchases, and extra dividends and buybacks that were not supported by cash generated by the business. The extra dividends and buybacks had to be funded by either debt, cash on the balance sheet or asset sales.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Cash For Shareholders Image by author; data source Mastercard SEC filings

As you can see, Mastercard has spent more cash than was generated through operations in 4 of the last 10 years. They do still have a net positive FCFaDB for the entire period. The bulk of cash used for shareholders has been generated through the business which is a positive sign as the extra buybacks can always be scaled back if need be.

Until FY 2014, Mastercard carried essentially no debt on their books. Since then, debt has ramped up significantly with long-term debt at $5.83B at the end of FY 2018. The debt-to-capitalization ratio has subsequently climbed up to 54%.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Debt to Capitalization Image by author; data source Mastercard SEC filings

The rapid increase in debt would be a big red flag for some companies; however, in Mastercard's case, there's nothing to be concerned about. The free cash flow interest coverage sits at a very healthy 28.5x for FY 2018. Meanwhile, the entire debt load at the end of FY 2018 could be paid off with 1.1 years of FY 2018's FCF and 1.3 years of FY 2018's FCFaD.

Valuation

The minimum acceptable rate of return, MARR, analysis is one method to determine whether an investment is attractive or not. The MARR analysis entails estimating the future earnings and dividends that a business will generate, applying a valuation on those earnings and then comparing the expected return with your threshold return.

Analysts expect Mastercard to report FY 2019 EPS of $7.69 and FY 2020 EPS of $9.05. They also expect Mastercard to manage 17.1% annual earnings growth over the next 5 years in total. I then assumed that Mastercard would see 8.0% annual earnings growth for the following 5 years. Dividends are assumed to target a 22.5% payout ratio.

Historically, Mastercard has traded at a premium multiple to the market within a range of 17x-35x. According to Morningstar, Mastercard's 5-year average TTM P/E is 34.8x. For the MARR analysis, I'll examine P/E ratios ranging from 15x-35x.

ChartData by YCharts

The following table shows the potential internal rates of return that an investment in Mastercard could provide if the assumptions laid out above come to fruition. Returns include dividends taken in cash following Mastercard's historical payment schedule and are calculated assuming a purchase price of $279, Friday's closing price. Returns run through the end of calendar year 2024, "5 Year", and calendar year 2029, "10 Year".

Alternatively, I want to determine what prices levels would provide the returns that I desire assuming the forecasts for earnings growth pan out. The target returns that I will use are 10%, my typical minimum threshold for investment, 14% and 16%. The 14% is derived from the ~13% annualized earnings growth plus the starting dividend yield with the 16% including 25% undervalued normalizing over 10 years, or ~2.3% annualized.

Another valuation method that I use is dividend yield theory. Dividend yield theory is best suited for well-established businesses with a history of paying dividends. Dividend yield theory is based on mean reversion, with the 5-year average dividend yield being a good proxy for the fair price for the business in question.

Mastercard (<a href='https://seekingalpha.com/symbol/MA' title='Mastercard Incorporated'>MA</a>) Dividend Yield TheoryImage by author; data source Yahoo Finance & Mastercard Investor Relations

Mastercard shares currently offer a 0.47% dividend yield which is well below the 5-year average yield of 0.66%. Dividend yield theory suggests a fair price of $200 for Mastercard shares.

Conclusion

Mastercard, the business, is in rare territory on the quality spectrum. Not only is the business growing by leaps and bounds as the continued transition from cash payments to card and electronic payments continues to ramp higher, but Mastercard's marginal cost to process additional transactions is essentially nil.

That's what has allowed Mastercard's margins to continue to expand over the last decade with operating cash flow margins >40% and free cash flow conversion around ~94%. Its strong free cash flow generation and minimal need for additional capital expenditures has seen the free cash flow return on invested capital expand 50.2% for FY 2018.

And of course, Mastercard has a built-in inflation hedge in the way the business is constructed. Since Mastercard takes a cut of the transactions they process if inflation rises, Mastercard's cut rises along with it.

There's no doubt that Mastercard is deserving of a premium multiple compared the market. In the case of Mastercard, the valuation seems quite rich at the moment with a TTM P/E of 41.4x, 36.3x 2019's estimates and even 30.8x 2020's estimates. The expected, and likely, growth that Mastercard will enjoy over the next decade will make up for overvaluation if the growth is sustained.

However, the question right now is how long do you expect the tremendous growth to continue and how much of the growth in the business are you willing to forego due to the eventual valuation compression.

"Bidding more for something is the same as saying you’ll take less for your money." - Howard Marks, The Most Important Thing

That doesn't mean that an investment in Mastercard won't generate adequate results for buyers at current levels. That being said, investors at the current lofty valuation are banking on growth to bail out them out. There's a very high likelihood of investors losing out on upwards of 40% of the growth of the underlying growth of the business should valuations contract to a ~25x P/E in the future.

Dividend yield theory suggests a fair value range between $180 and $224 based on the current annual dividend of $1.32. Since Mastercard is likely to announce a sizable increase in December, it makes sense to look at how the fair value range would shift due to the raise. Assuming an increase to $0.40 per share per quarter, a 21% increase, the fair value range based on dividend yield theory would increase to $242-$271.

My fair value range based on the MARR analysis is $214-$253.

Mastercard resoundingly qualifies as a business that I want to own for the long haul; however, I can't bring myself to add shares at current levels. If the share price declines into the $250s, I would begin to get interested in adding shares to my portfolio.

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

Additional disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PAYX 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.