By The Valuentum Team
Visa Inc (NYSE:V) offers investors tremendous capital appreciation upside. At the top end of our fair value estimate range, we value shares of Visa's Class A common stock at $271 per share, and we will cover in detail how we obtained that figure in this article. The company has ample pricing power, especially on the credit card processing side of things, and its growth runway is supported by powerful secular tailwinds (such as the proliferation of e-commerce and the global shift away from cash to card). Its dividend growth potential offers incremental upside to its capital appreciation upside, and shares of V yield a modest ~0.8% as of this writing.
Visa is the largest retail electronic payments network based on payments volume, total volume, and number of transactions. The company 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.
Please note that Visa is not a bank and does not issue credit cards. Visa takes on no credit risk - unlike American Express Company (AXP) and Discover Financial Services (DFS) - yet it is an integral part of the growing cashless society. Sales are primarily generated from payments volume on Visa-branded cards, though Visa offers an expansive slate of payment processing and solutions services as well.
Visa acquired Visa Europe through a transaction valued at $23+ billion back in June 2016 which unified the brand globally. Visa was compelled to drop its potential acquisition of Plaid due to antitrust concerns, though we still view the company's growth outlook quite favorably as international travel activities are steadily resuming.
The firm is well-positioned to capitalize on the ongoing shift towards a cashless society. Surging e-commerce demand represents a major growth opportunity for Visa. Please note our enterprise cash flow model, which we will cover in detail in this article, assumes Visa significantly grows its revenues over the coming fiscal years, aided by the aforementioned secular growth tailwinds along with a recovery in global travelling activities.
Visa is a stellar company with a rock-solid cash flow profile, ample liquidity on hand, impressive operating margins, a promising growth outlook, and numerous competitive advantages. This company is one of the best operators in one of the strongest industries. Please note that Visa has a multiple share class structure, and the publicly traded shares we are referencing here are its Class A common stock. The company also has outstanding Class B common stock and Class C common stock.
When Visa reported third quarter earnings for fiscal 2022 (period ended June 30, 2022), the company beat both consensus top- and bottom-line estimates. The company benefited from strong payment volumes growth at its credit card payment processing business, which tends to be more lucrative than its debit card payment processing business. On a constant currency basis, Visa's credit card payment volumes were up 20% year-over-year last fiscal quarter while its debit card payment volumes were up 5%. Strong performance on both fronts, though we appreciate the favorable business mix shift as that supports Visa's profitability metrics.
Visa reported that its payment volumes were up 12%, its cross-border volume was up 40% (up 48% when excluding intra-Europe volumes), and that its processed transactions were up 16% year-over-year in the fiscal third quarter. This powered its GAAP revenues higher by 21% year-over-year last fiscal quarter to $7.3 billion. A $0.7 billion litigation provision recorded last fiscal quarter saw Visa's GAAP operating income rise by just 2% year-over-year to $4.1 billion, though when removing that special item, its operating income would have grown by 19%. Visa's core operating expenses have also grown meaningfully of late as the firm is bulking up its marketing efforts and back office activities to prepare its business for a post-COVID world.
On a GAAP basis, Visa's Class A common stock posted $1.60 in diluted EPS last fiscal quarter (up 36% year-over-year) due to substantial net income growth and a reduction in its outstanding diluted share count. Its adjusted non-GAAP EPS rose by 33% year-over-year to reach $1.98 in the fiscal third quarter. We appreciate that Visa's business is on a powerful upswing.
During the first three quarters of fiscal 2022, Visa generated $12.3 billion in free cash flow (defined as net operating cash flow less capital expenditures) while spending $2.4 billion covering its dividend obligations and another $9.5 billion buying back its Class A common stock. The company's cash flow generating abilities are simply stellar, aided by its asset-light business model and relatively modest capital expenditure requirements to maintain a given level of revenues (Visa spent $0.7 billion on its capital expenditures during the first three quarters of fiscal 2022). We view Visa's share repurchases favorably given that its stock has been trading below its intrinsic value for some time and continues to do so.
Visa exited June 2022 with a net debt load of $6.4 billion (inclusive of short-term debt, exclusive of restricted cash and noncurrent investment securities), a burden we view as manageable given its impressive cash flow profile. Additionally, Visa had $2.2 billion in noncurrent investment securities on hand at the end of the fiscal third quarter, some of which was represented by cash-like assets (namely US Treasuries). The company had $17.4 billion in cash, cash equivalents, and current investment securities on the books at the end of June 2022 (that is on top of its noncurrent investment securities holdings), providing it with ample liquidity to meet its near term funding needs.
The best measure of a company's ability to create value for shareholders is expressed by comparing its return on invested capital ['ROIC'] with its weighted average cost of capital ['WACC']. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Visa's 3-year historical return on invested capital (without goodwill) is 53.9%, which is above the estimate of its cost of capital of 8.9%.
In the chart down 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. Visa has historically been a stellar generator of shareholder value, and we forecast that will continue being the case going forward.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows, net of balance sheet considerations. We think Visa is worth $226 per share with a fair value range of $181-$271 per share. As Visa has been firing on all cylinders of late, there is room for Visa to test the top end of our fair value estimate range going forward.
The near-term operating forecasts used in our enterprise cash flow models, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 13% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 5.4%.
Our valuation model reflects a 5-year projected average operating margin of 66.1%, which is above Visa's trailing 3-year average. Beyond Year 5, we assume free cash flow will grow at an annual rate of 5.3% for the next 15 years and 3% in perpetuity. For Visa, we use an 8.9% weighted average cost of capital to discount future free cash flows.
Although we estimate Visa's fair value at about $226 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.
In the graph up above, we show this probable range of fair values for Visa. We think the firm is attractive below $181 per share (the green line), but quite expensive above $271 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.
The Dividend Cushion Ratio Deconstruction for Visa, shown in the image above, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Visa's numerator is larger than its denominator suggesting strong dividend coverage in the future.
The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information. Though the near-term economic environment looks challenging, Visa's dividend health remains rock solid.
Visa's rock-solid fundamentals provide the ultimate base for its capital appreciation upside and dividend growth potential. We think the firm's business model is one of the best in one of the strongest industries. The fact that the company does not issue credit cards keeps it from taking on credit risk that would otherwise harm its financial standing, dividend potential, and share buyback capacity.
Visa's per-share dividend has grown significantly in recent fiscal years, and its robust free cash flow generation gives it significant capacity for years of increases moving forward. Secular growth tailwinds such as the rising e-commerce demand supports Visa's longer term outlook. We like Visa's capital appreciation upside and view its dividend growth potential as an incremental source of upside to our thesis.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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: Callum Turcan owns shares of DIS, META, GOOG, VRTX, and XLE and is long call options VRTX. Visa Inc (V) is included as an idea in Valuentum's simulated Best Ideas Newsletter portfolio. This article is for information purposes only and should not be considered a solicitation to buy or sell any security. Neither Valuentum nor any of its affiliates own any securities mentioned in this article. Contact Valuentum for more information about its editorial policies.