ELECTRONIC PAYMENT SYSTEMS INVESTMENT THESIS
VISA INC. (V) AND MASTERCARD INC. (MA)
March 26, 2014
Sector: Financials
Industry: Credit Services
Current Price/Share:
 Visa: $218.40
 MasterCard: $75.28
Estimated Intrinsic Value/Share:
 Visa: ~$142 to ~$197 (Base Case Scenario: ~$171)
 MasterCard: ~$52 to ~$72 (Base Case Scenario: ~$59)
Current Premium to Intrinsic Value:
 Visa: ~11% to ~54% (Base Case Scenario: ~28%)
 MasterCard: ~5% to ~45% (Base Case Scenario: ~27%)
EXECUTIVE SUMMARY / TWO-MINUTE DRILL
The business: Visa and MasterCard share one of the most wonderful business models that I
have encountered thus far. They operate global, open-loop electronic payments networks that
connect all constituents of the financial system: consumers, businesses and merchants, and
financial institutions. Through these networks, Visa and MasterCard provide fast, secure, and
reliable electronic payments and facilitate the authorization, clearing, and settlement of payment
transactions. Unlike closed-loop networks (such as those of American Express or Discover),
Visa and MasterCard do not issue cards, extend credit or set rates and fees for account holders.
While they cannot make money on interest, they also do not bear the same level of credit risk as
card issuers. Their businesses are effectively toll booths in the payments value chain; they
provide the rails on which an increasing amount of commerce rides.
Visa’s and MasterCard’s strong competitive advantage stems from a network effect. The
number of users of both networks has reached a critical mass such that replicating their
respective infrastructures would be a near-insurmountable, extremely costly task for potential
competitors. Given the size of these networks, the incremental costs (in terms of personnel,
technology, and capital) of adding a user are relatively small compared to the additional revenue
each new user generates. This combination drives robust operating margins (~60% for Visa,
mid-50% range for MasterCard), extraordinary free cash flow generation – the vast majority of
which is returned to shareholders via buybacks and, to a lesser extent, dividends – and
sustainable returns on invested capital well above each company’s respective cost of capital.
In addition to being high return businesses, Visa and MasterCard possess long runways for
growth. Cash and checks are used to complete ~85% of consumer transactions worldwide.
Although data breaches of cardholders’ information (such as at Target and Neiman Marcus)
have been the subject of recent media scrutiny, electronic payments are generally safer, more
Electronic Payments Investment Thesis
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reliable, and more convenient than their paper counterparts. Due to these factors – as well as
other advantages, such as convenience for consumers – electronic payments will approximate
100% of all transactions over time and make paper methods of payment effectively obsolete.
This shift is due in part to the explosive growth in online and mobile commerce, for which
electronic payments are the sole option. Another avenue of growth – one that both Visa and
MasterCard have only scratched the surface of – is offering electronic payment systems for
commercial enterprises and governments. Employee payrolls, social service disbursements,
and other related transactions are still mainly handled using checks, but are increasingly being
shifted to other forms such as prepaid cards. Though the size of this opportunity is only a
fraction of their core consumer-oriented businesses, it provides an ancillary, untapped source of
growth for Visa and MasterCard.
The risks: The main risks to Visa’s and MasterCard’s businesses are litigation, regulation, and
legislation. Since the credit crisis and subsequent recession of 2008-2009, financial institutions’
activities and practices have been much more heavily scrutinized and regulated. Most of this
scrutiny, as it relates to electronic payment companies, has focused on interchange or “swipe”
fees – the transfer fees exchanged between a merchant’s and cardholder’s financial institutions
each time a card is used, to help pay for the costs of maintaining the payment network. While
Visa and MasterCard do not directly collect these fees, they indirectly influence their revenues.
Swipe fees determine the volume of transactions each company processes; higher fees incent
issuers to provide customers with more Visa- or MasterCard-branded cards, which in turn drives
a higher percentage of transactions processed with cards. In essence, interchange fees are one
of the driving factors in affecting the speed of the transition from cash and checks to electronic
forms of payment.
Merchants have contended – and continue to contend – that interchange fees are unreasonably
high. They note that the overall costs of operating payment networks have trended down over
time – which they have, as a glimpse at Visa’s and MasterCard’s operating margins will show –
while swipe fees have increased as a proportion of the gross dollar volume per transaction.
Lawmakers argue that consumers bear the burden of high swipe fees as merchants pass them
through to the public via higher prices on products and services. Regulation of interchange fees
has therefore been squarely in the crosshairs of various governments across the globe – for
example, the Durbin Amendment in the U.S., which places a cap on maximum interchange fee
rates. Swipe fees are also frequently subject to litigious activity; in December 2013 a federal
judge had approved a ~$5.7 billion dollar settlement between merchants and Visa and
MasterCard in a merchant class action lawsuit related to excessive swipe fees. The debate
about swipe fees will undoubtedly persist and remains one of the most critical risk to Visa’s and
MasterCard’s businesses going forward.
A lesser, though still significant, risk is technological disruption. A slew of competitors have
emerged in recent years with the aim of disintermediating Visa’s and MasterCard’s positions in
the payments value chain. Many of these emerging players are non-traditional (non-financial
institution) in nature and are focused on the fast-growing online and mobile payments space.
PayPal, Amazon, and Google are a few such competitors that have developed “digital wallets.”
While Visa’s and MasterCard’s core businesses are well-defended, online and mobile payments
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represent one of their key growth drivers going forward, particularly in emerging economies
where banking infrastructure is minimal and citizens rely on these methods for their financial
needs.
The price: Visa and MasterCard are wonderful businesses, but I do not recommend a purchase
of shares in either company at current prices. Both companies have grown free cash flow at
tremendous rates with seven-year CAGRs of ~30% for Visa and ~50% for MasterCard. Based
on the current prices of both companies, a two-stage, reverse discounted cash flow analysis
indicates the investment community expects Visa and MasterCard to sustain ~11-14% FCF
growth rates for each of the next ten years (and, for the following five years, at half of those
rates). Although I believe these expectations are reasonable (if slightly bullish), current
valuations leave investors with little margin of safety if they fall short of these goals – whether
due to internal operating factors or external ones (such as a global economic downturn).
My projections for Visa and MasterCard fall at the lower end of the market’s expectations, with
free cash growing at annual rates of ~12% and ~11%, respectively, over the next decade.
Based on these projections – and using a conservative 13% discount rate, in part to account for
the projections being over a longer time frame (and therefore more prone to error) – prices of
shares of Visa and MasterCard are both nearly 30% above my estimated intrinsic values. I
believe current investors of either company can feel comfortable holding their shares at these
levels – and let the magic of compounding continue to do its work – but I preach patience to
those looking to establish new positions.
With that being said, I believe it is worthwhile to track the performance of both companies going
forward. Visa and MasterCard possess extraordinary business models with well-defined
pathways for growth, and are worth paying up for – but only to a certain extent. Rare is the
opportunity to purchase a wonderful business at a fair price, let alone a cheap one. I prefer to
purchase businesses at a discount of at least 20-25% to my estimates of their intrinsic values. I
would be willing to forgo such a discount for either Visa or MasterCard, as I have a high degree
of confidence they will both continue to produce stellar financial results going forward. They are
wonderful businesses, and a purchase of either at a fair price should reap rich rewards.
If history is any indication, the vicissitudes of the stock market will eventually offer an entry point
for either Visa or MasterCard (or, ideally, both) with a more attractive risk-to-reward proposition.
Based on each company’s current financial performance, I am a buyer of Visa at ~$170/share
and MasterCard at ~$60/share, assuming there is no significant change in either company’s
fundamentals.
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COMPANY AND INDUSTRY OVERVIEW
VISA: Visa is an electronic payments network company. It traces its roots back to 1958 when
Bank of America launched BankAmericard in Fresno, CA. The company mailed 60,000 credit
cards (unsolicited) to town residents – about a quarter of Fresno’s population – to test the
acceptance by both consumers and merchants of an all-purpose credit card1. This strategy was
not new: there had been dozens of attempts to launch a similar product by other small banks, all
of which met with failure as these institutions lacked the resources to create an effective
payments network. BankAmericard was a success – by October of the following year, the
program had expanded to more than two million cards throughout the state of CA. By the mid1960s, Bank of America was signing licensing agreements with a group of banks outside the
state, blanketing the country with >100 million cards. International agreements followed a few
years later in Canada, the U.K., and France.
In 1970 Bank of America relinquished control of the BankAmericard program to the consortium
of issuer banks, which in turn created National BankAmericard Inc. (NBI) to manage and
develop the system within the U.S. INBANCO was then formed in 1974 to manage the
international program, which had expanded to fifteen countries by that time. The licensees
belonging to the U.S. and various international networks united under a new name – Visa – with
NBI being branded as Visa U.S.A. and INBANCO as Visa International. It was at this time that
Visa launched VisaNet, the world’s first electronic authorization, clearing, and settlement system
that enabled transactions to be completed in seconds. This combination allowed the
consolidated entity to quickly scale its business while also ensuring its customers a secure and
reliable payment network.
By the 2000s, Visa operated as four separately incorporated non-stock companies: Visa
International, Visa U.S.A., Visa Canada, and Visa Europe. The first three entities merged in
2007 to become a single company, which was taken public in March 20082. Visa Europe still
operates as a separate company owned by its licensee banks3. As a result of this
reorganization, Visa’s financial results prior to 2007 do not provide a meaningful comparison
with the combined entity’s present-day operations.
Today, Visa is the leading electronic payments network in the world, operating in >200 countries
and with ~1.9BB account holders. Visa transactions totaled 87.5BB in FY 2013, accounting for
nearly $7 trillion of gross dollar volume.
MASTERCARD: MasterCard’s origins are, unsurprisingly, similar to Visa’s. A group of
California-based banks, including Wells Fargo, formed the Interbank Card Association (ICA) in
1966. These banks, in conjunction with New York’s Marine Midland Bank, created an interbank
1
There existed revolving credit accounts that worked with specific merchants, the most successful
programs being those of Sears and Mobil Oil. BankAmericard represented the first all-purpose card.
2 The IPO raised ~$19BB, including the underwriters’ overallotment option of ~$1BB; shares were priced
at $44/share.
3 Visa Europe can sell itself to Visa Inc. under specified terms of a put option that the company holds. The
details of this put option are included in the appendix.
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card named Master Charge. The ICA expanded into Mexico, Japan, and Europe in 1968.
Master Charge was rebranded as MasterCard in 1979, and the company continued to expand
its business all over the world.
MasterCard went public in May 2006, with the IPO representing 46% of the company’s equity.
Priced at $39/share and raising $2.4BB, the IPO valued the company at ~$5.2BB.
In comparison with Visa, MasterCard is a slightly smaller company. During its FY 2013, the
company had nearly 1.2BB account holders, and transactions totaled ~45BB with gross dollar
volume of $4.1 trillion. One of the primary differences between the two companies is that
MasterCard has a stronger presence in Europe – due in part to Visa Europe being a separate
entity from Visa Inc. – while Visa has a larger market share in the U.S. as well as in emerging
countries.
THE BUSINESS MODEL AND ECONOMICS OF THE ELECTRONIC PAYMENTS INDUSTRY
Visa and MasterCard operate two of the largest electronic payments networks in the world. A
common misconception about these companies is that they are credit card issuers and,
therefore, bear a measure of credit risk in the form of customers defaulting on payments. But
Visa and MasterCard do not issue cards, extend credit, or set rates and fees for account holders
of branded cards and payment products; they merely facilitate electronic payment transactions
between the financial institutions of merchants (“acquirers”) and those of customers (“issuers”).
Source: MasterCard 2013 10-K
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The diagram above depicts the flow of money in a typical payment transaction. A description of
each step of the transaction will illuminate Visa’s and MasterCard’s role in the payment process.




A customer (a Visa or MasterCard account holder, who may be using either a physical
card or other type of payment device depending on the type of transaction) selects
goods or services to purchase and presents the card/payment device to the merchant as
payment.
The transaction information is then transmitted electronically to the acquirer and routed
through Visa’s or MasterCard’s payment network to the issuer for authorization.
Following authorization, a clearing file with the final transaction data is submitted from
the acquirer and processed for final settlement between the issuer and the acquirer.
The issuer pays the acquirer an amount equal to the value of the transaction, minus the
interchange fee, and posts the transaction to the customer’s account. The acquirer then
pays the amount of the purchase, less a merchant discount, to the merchant.
o The interchange fee represents a sharing of a portion of payment system costs
between the issuer and the acquirer. It is a means of reimbursement to issuers
for a portion of the costs they incur in providing services that benefit acquirers
and merchants. Some of those benefits include security, fraud protection,
guaranteed payment, and speed of service. While Visa and MasterCard set
default interchange rates, they do not earn revenues from these fees4.
o The merchant discount rate is established by the acquirer to cover its costs in
participating in the open-looped payment system and providing services
rendered to merchants. The interchange fee, described above, typically
comprises a majority of the merchant discount rate.
Put another way, Visa and MasterCard are toll booth businesses. As the intermediaries
between issuers and acquirers, they own the rails over which electronic payments can be
made among the millions of merchants worldwide where their cards are accepted. Visa
and MasterCard earn revenues by providing the network, resources, and data to complete
transactions between customers, merchants, and their respective financial institutions, collecting
fees based on both the gross dollar value of transactions and the number of transactions that
they process. The different revenue streams are described in more detail below.

Service or assessment revenues are earned for providing financial institutions with
support for the delivery of Visa- or MasterCard-branded products and solutions – for
providing issuers’ customers with the convenience of a non-cash payment solution that
bears the Visa or MasterCard brand. These revenues are generated from gross dollar
volumes on branded cards and payment products for purchased goods and services (i.e.
how much a customer spends using a card/payment product); thus, they are highly
correlated with both economic conditions and consumer confidence. Service revenues
are the largest portion of Visa’s and MasterCard’s gross revenues at 38% and 34%,
respectively, for FY 2013.
4
The interchange fee is discussed in much greater detail later in this report, as it is a point of great
contention between merchants and payment processors such as Visa and MasterCard, and bears
significant scrutiny from regulators and legislators.
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


Data or transaction processing fees are earned for providing authorization, clearing,
settlement, network access, and other maintenance and support services that facilitate
transaction and information processing between issuers and acquirers. Visa and
MasterCard earn these “swipe fees” anytime a branded card or payment product is
used. Processing fees are a more stable source of growth compared to service revenues
since they are contingent upon a secular factor – the ever-growing number of
transactions processed – and not economic factors. Processing fees are the next largest
component of each company’s top line after service revenues, at 33% and 30% of FY
2013 gross revenues for Visa and MasterCard, respectively.
International or cross-border transaction revenues are earned on transactions where
the country of origin of the issuer and the merchant differ, requiring a currency
conversion for the transaction to be processed. In addition to citizens visiting other
countries and making purchases while abroad, cross-border transactions are
increasingly being driven by the global nature of e-commerce, which has grown at an
astonishing pace in recent years. These revenues are driven by the gross dollar volume
of such transactions and represented 24% and 25% of Visa’s and MasterCard’s
respective FY 2013 gross revenues.
Other revenues consist of fees charged for certain services and differ between Visa and
MasterCard. Other revenues account for a larger proportion of total gross revenues for
MasterCard (12% in FY 2013) compared to Visa; this difference mainly reflects the fact
that MasterCard accounts for consulting and research fees as a source of revenue
whereas Visa accounts for them as an offset to client incentives, as described below.
o For Visa, other revenues are primarily license fees for use of the Visa brand
(including revenues earned from Visa Europe); fees from account holder
services, licensing, and certification; and other activities, including optional
service or product enhancements (such as concierge services and extended
account holder protection).
o For MasterCard, other revenues include consulting and research fees generated
by its professional advisory services group, MasterCard Advisors, and loyalty &
rewards solution fees charged to issuers for benefits provided to account holders
(insurance, assistance for lost cards, locating ATMs, etc.). These fees are in
addition to account enhancement services and program management services.
These four sources of revenue are offset by client incentives, which consist of long-term
contracts with financial institution clients and other business partners for various programs
designed to build payments volume, increase branded card and product acceptance, and win
merchant routing transactions over each company’s respective network. For FY 2013, client
incentives accounted for ~16.5% of Visa’s gross revenues and ~26% of MasterCard’s gross
revenues. As shown in the following chart, Visa has consistently paid its clients a lower level of
incentives as a % of its gross revenues compared to MasterCard.
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$2,000
17.1%
25.0%
16.5%
20.0%
$8,346
17.0%
$6,714
$8,065
16.2%
$5,539
$5,099
$4,000
15.2%
$6,911
$6,000
15.6%
$4,992
$8,000
$9,188
$10,000
30.0%
26.1%
$11,778
24.1%
26.1%
$7,391
24.9%
$10,421
22.7%
$6,263
Net Revenues ($, MM)
$12,000
26.7%
15.0%
10.0%
5.0%
$0
Incentives as % of Gross Revenues
Visa and MasterCard - Net Revenues and Incentives
$14,000
0.0%
2008
2009
Visa - Net Revenues
Visa - Incentives as % of Gross
2010
2011
2012
2013
MasterCard - Net Revenues
MasterCard - Incentives as % of Gross
Much of this difference reflects how each company offers incentives to issuers. MasterCard
pays issuers more upfront incentives, whereas Visa’s are tiled more towards issuers hitting
certain goals (in terms of gross dollar volumes processed, transactions processed, etc.)5. I view
Visa’s model for client incentives – being more performance-based – as a small
competitive advantage. If incentives are going up, then it means Visa is bringing in more gross
revenue; in MasterCard’s scheme, this may not necessarily be the case. To a lesser extent,
MasterCard also shows a higher proportion of client incentives due to the fact that its European
operation is consolidated within its corporate structure (Visa Europe remains separate from Visa
Inc.).
More broadly, however, the key competitive advantage in the electronic payments industry
is the network effect. There were a combined three billion Visa and MasterCard account
holders as of the end of 2013, or slightly more than 40% of the world population6. This current
user base, combined with merchants’ broad acceptance of Visa and MasterCard payment
products and the payment networks that both companies have created, make it exceedingly
difficult for potential industry entrants to unseat either company’s dominant position as an
electronic payments provider.
Beyond having wide moats around their businesses, Visa and MasterCard also benefit from the
scalability of electronic payments networks. Given the large size of each company’s network,
the incremental costs of adding another account are minimal in terms of both recurring
expenses (related to personnel, data processing, etc.) and capital investments. As a result, both
Visa and MasterCard have steadily expanded their operating margins over the last nine years,
even through the doldrums of the subprime-fueled financial crisis – a true testament to the
strength of their business models. Current operating margins, adjusted for litigation expenses, at
both companies are extraordinarily high, ranging from ~45% to >60% over the last five years,
relative to the average mid-teens margins of an S&P 500 constituent7.
From a conversation with Victoria Hyde-Dunn, Visa’s investor relations representative.
Assumes a current world population of ~7.1 billion people, based on data from the U.S. Census Bureau.
7 Per data from Reuters, the average trailing five-year operating margin of an S&P 500 company is ~17%.
5
6
Electronic Payments Investment Thesis
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Underlying Operating Margins
70.0%
Excludes the Impact of Litigation Charges
56.3%
60.0%
59.5%
59.9%
61.5%
51.9%
53.5%
55.1%
51.2%
50.0%
43.1%
38.4%
40.0%
30.0%
28.3%
30.9%
44.5%
39.0%
27.3%
20.0%
10.0%
49.7%
Visa
MasterCard
13.4%
6.9%
0.0%
2005
2006
2007
2008
2009
2010
2011
2012
2013
The combination of high returns, low incremental costs to grow the business, and a long
runway for growth make Visa and MasterCard two of the most attractive and wonderful
businesses today. However, a wonderful business does not necessarily make for a wonderful
investment if the price paid does not justify the expected return. A more thorough analysis of the
risks facing Visa and MasterCard is necessary to better understand the challenges these
companies face and why an investment at current prices may not be wise.
THE RISKS
The primary risks facing Visa’s and MasterCard’s businesses are litigation and regulation
with respect to interchange fees (“swipe” fees), and technological disruption from new
competitors, particularly in the fast-growing areas of online and mobile payments.
LITIGATION & REGULATION OF INTERCHANGE (SWIPE) FEES
Visa and MasterCard have frequently come under fire by merchants for charging
excessive interchange fees, more colloquially referred to as “swipe” fees. Recall that in a
typical transaction or purchase, the acquirer – the merchant’s financial institution – pays the
interchange fee to the issuer as a means of balancing the costs and benefits among the
different constituents of payments transactions8. For cardholders, these benefits include
convenience, security, acceptance at millions of locations worldwide, and rewards programs.
Merchants’ benefits include increased sales, faster transaction times (compared to cash or
checks), and security and fraud protection.
In turn, the acquirer charges the merchant a fee – the merchant discount – for services
rendered, with the interchange fee portion comprising the majority of this fee. On the surface,
8
There are certain circumstances when an issuer pays the interchange fee to the acquirer; for example,
when an account holder uses a card to withdraw cash from an ATM, the issuer pays the interchange fee
to the acquirer for maintenance costs associated with the ATM.
Electronic Payments Investment Thesis
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merchants typically bear the bulk of the economic burden of the interchange fee; but
regulators and consumer advocacy groups suggest merchants pass on a significant
portion of these costs directly to the consumer.
Although Visa and MasterCard do not collect the interchange fee, they set default interchange
rates for financial institutions in the absence of an already-existing agreement between an
acquirer and an issuer. Interchange fees vary according to a number of factors: the type of
transaction (credit, debit, or prepaid), the size of the merchant (larger merchants such as
Walmart can negotiate proportionally lower swipe fees compared to a mom-and-pop shop), and
the proximity of the cardholder (swipe fees for online transactions are higher than face-to-face
transactions, where the cardholder is present, due to a greater risk of fraud). In some countries
such as Australia, interchange fees are regulated with the intent of ensuring merchants do not
pass on these costs to customers, although the ultimate effect of these price controls is
questionable9.
Swipe fees approximate 1% to 3% of the total cost of the average transaction in the
U.S.10,11 Although these fees appear to be nominal on the surface, they can deeply cut into the
profits of merchants that operate high-volume, low-margin businesses, such as grocery stores
and discount retailers. As cash and check transactions continue to diminish over time, swipe
fees will generate additional scrutiny as these types of merchants will push for lower fees to
protect their own business interests.
The Durbin Amendment of the Dodd-Frank Act – the provisions of which became law in
October 2011 – set a cap on the maximum U.S. debit interchange fee assessed for debit
products issued by large financial institutions12. An initially proposed cap of $0.12 per debit
card transaction was increased to $0.21 per transaction, plus five basis points of the gross
dollar volume of the transaction13. This cap effectively cut swipe fees by ~50% and, as a result,
regulation has reduced revenues for both Visa and MasterCard. These companies do not collect
swipe fees, but they are an important factor on which they compete with other payments
providers: lower swipe fees increase the attractiveness of closed-loop payments systems, such
as those operated by American Express and Discover, to issuers, and they directly influence the
number of transactions each company processes. Simply put: the lower swipe fees are, the less
incented financial institutions are to offer Visa and MasterCard products to their customers.
In addition, the Amendment (1) requires issuers must make at least two unaffiliated payments
networks available for processing each debit transaction and (2) prohibits issuers (as well as
Visa and MasterCard) from restricting a merchant’s ability to direct the routing of debit
transactions over a preferred network. These requirements also diminish the companies’
revenues due to the adverse impact on pricing (issuers can negotiate lower service fees from
U.S. Government Accountability Office: “Rising Interchange Fees Have Increased Costs for Merchants,
but Options for Reducing Fees Pose Challenges,” November ’09
10 Visa U.S.A. Interchange Reimbursement Fees, April ‘13
11 MasterCard 2013-2014 U.S. Region Interchange Rates, March ‘13
12 Large financial institutions are defined as those with more than $10BB of assets.
13 Issuers could earn an additional $0.01 per transaction if they develop and implement fraud-prevention
policies and procedures in alignment with the standards set out by Dodd-Frank.
9
Electronic Payments Investment Thesis
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either Visa or MasterCard due to the lack of network exclusivity and the resulting increased
competition between the two companies) and the reductions in the number of transactions
processed. As shown in the accompanying exhibit, this part of the amendment
disproportionately impacts Visa’s business, as the company is by far the largest debit
processor14.
Similar legislation and regulation has been proposed in other areas of the world,
suggesting Visa and MasterCard face these challenges in all of their major markets. In
July 2013, the European Commission put forth legislation that includes a cap on credit and debit
interchange fees of 30 and 20 basis points, respectively, per transaction15; a prohibition on
merchants increasing prices on products that are subject to regulated interchange rates; and the
prohibition of rules preventing an issuer from “co-badging” (putting a competing brand on its
credit or debit cards)16. In Poland and Hungary, legislation capping domestic interchange fees
became effective in January 2014, while similar legislation is being considered in Portugal and
Israel17.
For FY 2013, Visa processed 40.4BB debit payment transactions, or nearly double MasterCard’s
20.9BB.
15 Initially for intra-EEA cross-border consumer transactions and subsequently for all domestic consumer
transactions within the EEA.
16 European Commission: “Proposal for a Regulation of the European Parliament and of the Council on
interchange fees for card-based payment transactions,” July ’13
17 MasterCard 2013 annual report, February ‘14
14
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While the looming threat of increased regulation affects Visa’s and MasterCard’s
businesses on an ongoing basis, litigation periodically results in significant cash
outflows for these companies. The most prominent example was the Interchange Multidistrict
Litigation (MDL) case. Beginning in 2005, ~55 complaints (all but thirteen of which were class
action suits) were filed by merchants against Visa and MasterCard, alleging the companies
unlawfully set interchange reimbursement fees and tied and bundled transaction fees in
violation of federal antitrust laws. The plaintiffs sought monetary damages totaling in the tens of
billions of dollars in addition to attorneys’ fees and injunctive relief. In early 2011 Visa and
MasterCard entered into an agreement relating to the Interchange MDL, under which the
monetary settlement would be split between Visa and MasterCard at two-thirds and one-third,
respectively, of the total amount owed. Terms of the settlement were completed in December
2013 with payments totaling $5.7BB18.
This sizeable settlement did not signal the end of the swipe fee-related litigation. Certain
individual merchants that were part of the class action suit objected to the proposed settlement
and have chosen to opt out of the monetary damages portion. While the opt-out provision
entitles Visa and MasterCard to claw back 25% of the settlement payment, approximately 22
opt-out cases had filed by hundreds of merchants pursuing damages claims on allegations
similar to those raised in the MDL. On March 21, 2014, the appeals court upheld the original
swipe fee provision in the Durbin Amendment19; the retailers are now considering pursuing an
appeal to the Supreme Court. While this latest decision represents a victory for Visa and
MasterCard, historical precedent suggests retailers will continue to press payments providers
and financial institutions on the swipe fee issue. To the extent they are successful in pursuing
this litigation, Visa’s and MasterCard’s results will continue to be weighed down by litigation and
settlement fees going forward.
Although litigation expenses are lumpy by nature, I believe it is foolish to dismiss them
as “extraordinary” or one-time items. They must be included in run-rate earnings and
free cash flow projections as their presence, or lack thereof, has an enormous impact on
the resulting valuation of each company. Some analysts – and even MasterCard itself –
adjust results for litigation expenses, but given their magnitude it is impossible to cast them
aside so readily. If one were to exclude litigation expenses, cumulative operating income over
the last ten years for Visa and MasterCard would be higher by 37% and 20%, respectively20.
Estimating the timing and magnitude of such litigation expense is difficult, but given the various
legal actions taken against both companies over their operating histories, a litigation provision
must be included in their go-forward results to reflect the true economics of running their
businesses. I assume annual litigation expense of ~1% of net revenue for each company
going forward; while this figure falls below the average of the last several years, I believe the
worst of the expenses related to litigation and legal settlements are behind Visa and
MasterCard.
Washington Post: “Judge approves Visa, MasterCard $5.7 billion settlement with retailers,” Dec. ‘13
Bloomberg: “Fed Upheld on Debit Card Swipe-Fee Cap by Appeals Court,” March ‘14
20 Operating income on a pre-tax basis. For Visa, results are over the past nine years given the
company’s more recent IPO and the consequent dearth of detailed financial information on years prior to
FY 2005.
18
19
Electronic Payments Investment Thesis
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As the relative costs of maintaining their payments networks continue to decline and
their margins widen, swipe fees set by Visa and MasterCard will remain under close
scrutiny from merchants and governments alike. These fees are intended to balance the
costs and benefits of electronic payments networks among financial institutions, merchants, and
customers. Fraud and payment security are two critical risks that help to justify swipe fees, but
advances in technology have steadily reduced the number of such security breaches. As these
risks become increasingly remote, merchants, customers, and governments will undoubtedly
continue to put pressure on Visa and MasterCard to reduce swipe fees.
For example, in the U.S., Visa and MasterCard are transitioning all of their branded cards from
magnetic-stripe cards to cards equipped with EMV technology. The companies have imposed
various liability deadlines for merchants and ATMs beginning in October 2015 and continuing
through October 201721. EMV cards are chip-based and require inputting a PIN number to
complete a transaction, as opposed to magnetic-stripe cards that require a signature. EMV
technology has been proven to be more reliable and more secure compared to traditional cards.
MasterCard has noted that counterfeit fraud has decreased substantially – between 60% and
80% – in markets where it has been implemented22. Despite the amount of press about credit
card fraud, instances of fraudulent transactions are rare. Visa CEO Charlie Scharf commented
that fraud rates are at historic lows with less than $0.06 of every $100 transacted lost to fraud23.
Lower swipe fees do not have a direct impact on Visa’s and MasterCard’s revenue, but
rather an indirect one. Reductions in these fees will slow the penetration of each
company’s products and thus the number of transactions they process. There are a
number of factors that influence how quickly this migration will occur, which are discussed in
greater depth in the market opportunity section. But the incentives offered to financial institution
issuers, in the form of swipe fees, are one of the most critical drivers in speeding the
electronification of commerce.
TECHNOLOGY AND ELECTRONIC & MOBILE PAYMENTS
Aside from stealing share from cash and checks, electronic and mobile payments are the
biggest growth opportunities for Visa and MasterCard. E-commerce is growing at a much
faster pace than retail sales in traditional brick-and-mortar stores, with various market research
organizations forecasting growth rates ranging from the high single-digits to upwards of nearly
20% over the next several years. Growth in mobile payments is even more explosive, driven in
large part by emerging economies where less-developed banking infrastructure necessitates the
use of alternative forms of payment. Since credit and debit cards are the dominant payment
methods in these channels, growth in these areas accrues almost exclusively to
electronic payment systems.
21
Under normal circumstances the card issuer is liable for fraudulent transactions. However, after a
liability shift has been implemented and the deadline has passed, merchants and ATMs are liable for any
fraudulent transactions if they do not support the new technology.
22 Barbara Gasper, Executive Vice President – MasterCard Q4 2013 conference call, January ‘14
23 Charlie Scharf, Visa CEO – Visa Q4 2013 conference call, October ’13.
Electronic Payments Investment Thesis
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New technologies have been developed that have the potential to disintermediate Visa’s
and MasterCard’s roles in the electronic payments value chain. The most notable of
these technologies is the digital wallet. Digital wallets are electronic devices with associated
software that allow individuals to complete a number of different payment transactions. They
store all of a user’s pertinent information, such as account numbers for credit and debit cards
and bank accounts, shipping and billing addresses, and other personal credentials. With a
digital wallet, consumers can purchase goods and services online with a computer or in brickand-mortar stores with a smart device equipped with near-field communications (NFC)
technology24. The purported advantages to the consumer of paying with a digital wallet are:


Convenience: they eliminate the tedious task of filling out forms with their card numbers
and/or addresses; a user must simply provide a piece of information such as an email
address and/or password/PIN number; and
Security: digital wallets providers have redundant integrated protection systems
embedded in their software. They rely on digital certificates for both online and physical
purchases, encrypting payment and personal information with associated transactions
and verifying the identity of the person completing the transaction.
Like Visa and MasterCard, digital wallet providers earn a small percentage (the “take rate”) of
each transaction’s gross dollar volume.
Several non-traditional (that is, not associated with financial institutions) providers have
emerged as leaders in the fragmented digital wallet space – among them: eBay’s PayPal,
Google, Amazon, Square, and Isis (a joint venture between the major American mobile phone
carriers: AT&T, Verizon, and T-Mobile). More companies – most notably Apple and Facebook –
have their eyes on expanding into mobile payments.
While the advantages of digital wallets to the consumer – convenience and security – are
readily apparent, the important question remains: what are the advantages to
merchants? On the surface, digital wallet providers simply add another link to the payments
value chain, with their take rates cutting further into merchants’ profit margins. To justify their
existence, they must offer some value to merchants in excess of their take rates. Those
companies that are the forefront of mobile payments can offer merchants unique insights into
consumer behavior – for example, Google and Amazon through their core businesses of
search/advertising and retail, respectively. With this information – which can be easily integrated
into each digital wallet provider’s service – merchants can more effectively tailor the consumer
experience, through targeted discounts and rewards programs, and in turn drive increased
customer loyalty and higher revenues.
With increased adoption of digital wallets, Visa and MasterCard risk losing their control
and influence of the customer’s purchase experience. Both companies spend hundreds of
millions of marketing dollars annually to earn the highest share of consumers’ spending. With
24
NFC, combined with a digital wallet, effectively transforms a smart phone into a card like those offered
by traditional financial institutions; payments can be completed with the simple tap of the phone with a
merchant’s NFC-compliant point-of-sale terminal.
Electronic Payments Investment Thesis
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these advertising campaigns, Visa and MasterCard attempt to push for more frequent use of
their products at the point of sale – to drive deeper engagement and greater attachment with
their respective brands over their competitors. With digital wallets, the consumer’s decision to
use those products will not be at the point of sale, but rather when he or she decides which
payment methods to link to the wallet. Consumers could just as easily link their savings or
checking accounts to the digital wallet, removing Visa and MasterCard from the payments value
chain altogether. For this reason, increased adoption of digital wallets could drastically cut into
both companies’ market share.
To combat their competition, Visa and MasterCard have begun offering their own digital
wallet services in V.me and MasterPass, respectively. They have also sought partnerships
with some of their competitors in the mobile payments space. For example, MasterCard
established a partnership with Google’s digital wallet in which a customer may use the Google
wallet wherever MasterCard is accepted.
Digital wallets are still in the early innings, and given the fragmented market, it remains
unclear which service will emerge as the leader. The threat to Visa’s and MasterCard’s core
businesses may only be minimal – these companies possess a first mover advantage, as the
security of their networks has earned the trust of millions of customers and merchants
worldwide – but competitors’ digital wallets may cut into their share of growth in the areas of ecommerce and mobile payments.
THE CHINESE MARKET AND CHINA UNIONPAY
The dynamics of the Chinese market deserve some attention given the size of the country’s
economy and its impact on global commerce.
China UnionPay is currently the sole payments processor of domestic transactions and
operates the sole domestic acceptance mark in China. Although Visa and MasterCard can
transact business in China via cross-border transactions (i.e. foreign consumers visiting the
country, or online shoppers, can use a Visa- or MasterCard-branded product to purchase goods
at a domestic Chinese merchant), all domestic electronic payments are required, per the
People’s Bank of China (PBOC), to be processed over China UnionPay’s network. This
regulation deprives Visa and MasterCard of a significant growth driver for its processing
revenues. For example, in 2011 total non-cash payment transactions in China numbered
~10BB25; while this figure is only a fraction of the number in the U.S. (~115BB transactions), it is
growing at, by far, the fastest pace of any country in the world (32.7% in 2011, with Russia
being second at 18.1%; the U.S. and Europe grew at 6.6% and 3.2%, respectively). MasterCard
noted that it expects China will overtake the U.S. as the world’s largest card market by 202026.
In July 2012 the World Trade Organization ruled that China has discriminated against
foreign electronic payment brands in favor of China UnionPay27. However, the WTO panel
Capgemini and RBS: “World Payments Report 2013,” September ’13; the figure cited excludes ATM
(cash withdrawal) transactions.
26 Wall Street Journal: “MasterCard Sees Surge In China Credit-Card Use,” September ’10
27 World Trade Organization: “China – Electronic Payment Services” (DS413), July ‘12
25
Electronic Payments Investment Thesis
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dismissed claims that China UnionPay operates a monopoly in the country. As China UnionPay
is backed by, and effectively controlled by, the PBOC, domestic financial institutions have been
reticent to partner up with Visa or MasterCard directly. Both companies have established
partnerships with China UnionPay to offer co-branded products, but Visa’s Charlie Scharf
characterized the progress that the company has made as “some very small incremental
things,”28 and domestic transactions continue to be processed solely on China UnionPay’s
network. At a recent industry conference, Scharf noted that Visa’s opportunity is not imminent,
viewing it as a five- to fifteen-year opportunity: “It’s going to take a long time for the market to
actually open up in a way that we actually do have that level playing field”29. Even when Visa
and MasterCard are able to effectively compete in the country, China UnionPay has a first
mover advantage that will likely limit the two companies’ growth opportunity.
Beyond its home country, China UnionPay has ambitions to compete with Visa and
MasterCard on a global scale. In just twelve years since its conception, China UnionPay has
grown into the world’s largest card brand (>3.5BB cards in circulation) and the second largest
by transaction volume (~$2.5 trillion in the first half of ’13, compared to Visa’s ~$4.6 trillion).
Overseas revenue grew 30% in 2012 and now accounts for ~5% of the company’s total
revenue, with the brand being accepted in >140 countries worldwide. UnionPay has been
aggressive in expanding outside of China, waiving fees that its competitors charge and offering
the lowest fees in the market overseas30. China UnionPay is unlikely to steal significant share
from Visa and MasterCard in those companies established markets (North America and
Europe). But to the extent it can be a more formidable competitor in emerging economies such
as Russia and India, a large chunk of Visa’s and MasterCard’s expected growth may not
materialize31.
MARKET OPPORTUNITY
The fundamental value driver for the electronic payment industry is gross dollar volume
– the total amount of money spent using cards32 – which is a function of both growth in
the number of cards/transactions and average spend per card. Average spend per card is
largely driven by global GDP growth and is thus mainly tied to worldwide economic conditions.
In the near term, growth in consumer GDP will be the primary driver of average spend. As
commercial enterprises and governments increasingly adopt electronic payment methods and –
over time – we progress towards a 100% cashless society, growth in average spend should
approximate global GDP growth. Due to the network effect of Visa’s and MasterCard’s
businesses, the incremental investments required to support growth are relatively low, helping
to sustain these companies’ returns on invested capital and free cash flow growth.
Charlie Scharf, Visa CEO, Q3 2013 conference call, July ‘13
Bloomberg: “Visa CEO Says China Delays Opening Card-Payments Market,” February ‘14
30 Reuters: “Coming to a store near you: UnionPay, the world’s biggest bankcard,” March ‘14
31 Unfortunately, since China UnionPay is not a publicly-owned company, detailed information on the
company’s operations, both domestic and foreign, is largely unavailable.
32 For the sake of simplicity, I will refer to “cards” as all payment products offered by electronic payment
providers, including physical credit & debit cards, prepaid cards, digital wallets, etc.
28
29
Electronic Payments Investment Thesis
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Growth in the number of cards and card transactions provides the most significant
opportunity for electronic payment providers going forward. The key question, then, is to
determine (1) the market penetration of electronic payments (the proportion of
transactions completed with cards vs. cash & checks); and (2) the incremental rate of
market penetration going forward (the rate at which cards are displacing cash & checks).
Electronic payment penetration is a tale of two markets – developed and emerging
economies. For 2012, data from Visa indicates that the global split of electronic payments vs.
cash & check as a % personal consumption expenditures (PCE, totaling ~$23 trillion) was
roughly 50%/50%. In developed markets, electronic payments have a ~60% share of PCE
(totaling ~$13 trillion) while that share was only ~40% in emerging markets (totaling ~$10
trillion)33. According to MasterCard, approximately 85% of worldwide retail payment
transactions, representing 60% of retail transaction value, are completed with cash34. The 2013
World Payments Report indicates the volume of global non-cash payments transactions grew
nearly 9% in 2011 to 307BB transactions with expected growth of 8.5% to 333BB transactions in
201235. Developed and emerging economies contributed equally to non-cash payments growth
in 2011, although emerging economies are growing at a faster pace given that North America
and Europe account for about two-thirds of global non-cash transaction volumes. Based on
these figures, there remains a long runway for growth in non-cash payments. A relatively
larger opportunity exists in payments processing given the lower proportion of
transactions completed with cards compared to the dollar volume spent using cards.
Before attempting to estimate the penetration of electronic payments going forward, should we
accept at face value that the transition to a cashless society is an inevitability? There is
strong evidence to support migration to an all-electronic payments system and the eventual
phasing out of cash & checks.
All constituents of the financial system have an economic incentive in moving to a
cashless system, though it should be noted that such a system is not without its
disadvantages. A study by the Institute for Business in the Global Context suggests the annual
cost of using cash is ~$200BB in the U.S.36 As shown in the following chart, the majority of this
cost is borne by the government in the form of lost taxes; the other half is borne by consumers
(for time spent procuring cash; in this case, time truly is money) and businesses (for retail theft).
According to MasterCard37, cash costs society as much as 1.5% of GDP; this estimate
translates to ~$1.1 trillion lost in 2013, assuming gross world product of $73.87 trillion38 – for
perspective, this figure is roughly equivalent to the country with the 15th largest GDP in the
world, approximating the output of Mexico or South Korea.
Visa 2013 Investor Day Presentation, slide 12, June ‘13
MasterCard Advisors: “Cashless Journey: The Global Journey From Cash to Cashless,” September ‘13
35 Capgemini and Royal Bank of Scotland: World Payments Report 2013, September ‘13
36 The Institute for Business in the Global Context: “The Cost of Cash in the United States,” September ‘13
37 MasterCard Advisors: “Cashless Journey: The Global Journey From Cash to Cashless,” September ‘13
38 GWP is taken from the CIA’s World Fact Book.
33
34
Electronic Payments Investment Thesis
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If we assume that the breakdown of the costs of cash is similar in other countries around
the world, then governments have the largest incentive to push for a cashless society.
Beyond taxes lost from unreported transactions, governments would be able to much more
easily execute fiscal policy and control the money supply, as well as identify black market
transactions, which should help to reduce crime. The disadvantages of a completely cashless
system for governments are minimal.
Adoption of cashless methods of payment also depends on the willingness of
consumers and businesses. For consumers, the most important issues regarding electronic
payments are related to convenience and security. In developing economies, the physical
banking infrastructure is so underdeveloped that tools like online banking and mobile payments
– which are much more readily accessible due to the proliferation of mobile phones and devices
– are significantly more convenient and have largely displaced traditional banking measures.
For this reason consumers’ adoption of electronic payment methods in developing economies
will move at a much faster pace compared to developed economies’ adoption over the last 4050 years. Security, or the “Big Brother” issue, is an important matter, particularly in light of
recent credit & debit card breaches at major U.S. retailers as well as the NSA tracking scandal.
Privacy is another critical factor. Many people may not be willing to forgo the anonymity granted
by cash and/or want a “data trail” of all of their payments, which is a reason why the world may
never be a pure cashless society or – at the very least – why adoption may be slower than
anticipated.
Electronic Payments Investment Thesis
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For businesses, accepting electronic payments is a necessary consequence of a worldwide
economy that is becoming increasingly interconnected and reliant on electronic commerce. The
2013 World Payments Report estimates that e-commerce transactions will grow at a compound
annual rate of ~18% between 2010 and 2014, or nearly doubling from 17.9BB to 34.8BB39. The
entirety of the benefit of e-commerce will accrue to electronic payment providers as cash &
checks are unacceptable forms of payment through this medium. Conversely, ongoing issues
related to swipe fees, as discussed in the previous section, will slow the adoption of electronic
payment methods. As non-cash payment methods continue to take share from cash & checks,
governments, merchant groups, and consumers will all put pressure on financial institutions and
payment providers to lower these fees, which will indirectly slow some of Visa’s and
MasterCard’s revenue growth.
For some of the reasons stated above, the transition to a 100% cashless society appears
to be at least 15-25 years away. Electronic payments offer many advantages over traditional
cash & checks, such as convenience for consumers and easier tracking of payments for
merchants (for the purposes of data mining and improving the customer experience) and
governments (for tax collection purposes and identifying black market transactions). However,
all constituents must be completely comfortable with such a system before it can be
implemented on a wide scale. For consumers, those concerns relate to security and privacy.
Advances in technology, such as using biometric scanning to complete a payment transaction,
may help to alleviate security concerns, but the widespread use of such technologies is still
likely years away. For merchants, concerns include the cost of electronic payments – namely,
the purchase of point-of-sale terminals to accept electronic payments, and .
Admittedly, estimating the trajectory towards a cashless society is difficult as there are many
factors involved, including technological advancements related to security of electronic
payments as well as the “human” factor related to consumers’ willingness to wholly adopt noncash payments. But I believe this range provides a conservative estimate based on current
penetration of non-cash payments (as a % of the total value of consumer payments) for each
nation, depicted on chart below and to the left; and the trajectory (measured according to an
index) of how non-cash share has shifted over a five-year period (2006-2011) on the right. Major
developed economies such as Japan, and fast-growing emerging economies such as India and
Russia, score relatively low on both of these measures.
39
Capgemini and Royal Bank of Scotland: World Payments Report 2013, September ‘13
Electronic Payments Investment Thesis
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Source: MasterCard Advisors, “Cashless Journey: The Global Journey from Cash to Cashless,”
September ‘13
The following calculations and assumptions were used in estimating the 15-25 year time
frame of a cashless society.

To derive worldwide consumer expenditures, I used data from the World Bank for (1)
GDP by country for the last six years (2007-2012; 2013 data is not yet available) and (2)
consumer expenditures as a % of GDP. While there exists a significant cardable
opportunity for non-consumer (government & commercial) expenditures, my focus is on
consumer expenditures because they comprise the majority of processed transactions.
Non-consumer expenditures are very large in terms of gross dollars, but transactions are
infrequent relative to transactions for consumer expenditures.
o I exclude China from the world consumer expenditure data, as China UnionPay
has an effective monopoly in the country and all transactions continue to be
processed over its network. While Visa and MasterCard likely earn some
Electronic Payments Investment Thesis
Page 20
revenues from cross-border transactions with China, I feel the volume is small
enough that excluding China from the data would provide a more accurate
estimate of the percentage of consumer expenditures transacted using cards.

Visa and MasterCard each provide detailed data on gross dollar volumes (GDV) that are
processed on their respective payments networks. The sum of these two figures
represents the majority of electronic payments made; to derive the total gross dollar
volume of all carded (electronic payment) transactions, an adjustment must be made for
the direct credit card providers (such as American Express and Discover). According to
The Nilson Report, Visa and MasterCard combined accounted for ~84% of global credit
card transactions and ~96% of global debit card transactions in 201140. Unfortunately,
this data is for transactions and not GDV. Visa and MasterCard likely have a lower share
of GDV relative to their share of transactions as:
o debit cards are typically used for small-ticket purchases, so debit transactions
have a lower average GDV; and
o American Express attracts more affluent customers, who tend to have higher
average billings per transaction. For example, American Express’ billed business
per card was ~$8,880 in 2013 ($952BB billed on ~107MM cards outstanding).
This compares to average GDV per card of ~$3,100 and ~$3,200 for Visa and
MasterCard, respectively, in 2013.

Therefore, I make the simplifying assumption that the sum of Visa’s and MasterCard’s
GDV account for ~75% of total GDV for electronic payment transactions.
$, BB
2007
2008
2009
Total Visa Payment Volume
$3,634.0 $4,344.0
$4,262.0
Total MasterCard Payment Volume
$2,273.0 $2,540.0
$2,460.0
Visa + MasterCard Payment Volume
$5,907.0 $6,884.0
$6,722.0
Adjustment for Other Cards
$1,969.0 $2,294.7
$2,240.7
Total Electronic Payment Volume
$7,876.0 $9,178.7
$8,962.7
Worldwide Consumer Expenditures (Ex. China)
$32,089.3 $35,232.4 $33,717.5
Total Payment Volume as % of Consumer Expenditures
24.5%
26.1%
26.6%
YOY Change
1.5%
0.5%
2010
2011
2012
$5,004.0 $5,866.0 $6,320.0
$2,723.0 $3,251.0 $3,650.0
$7,727.0 $9,117.0 $9,970.0
$2,575.7 $3,039.0 $3,323.3
$10,302.7 $12,156.0 $13,293.3
$36,380.5 $40,265.6 $40,969.5
28.3%
30.2%
32.4%
1.7%
1.9%
2.3%
Between 2007 and 2012, the share of worldwide electronic payment GDV rose from
~24.5% to ~32.5%. If this rate of improvement were extrapolated on a straight-line basis going
forward, then electronic payments would account for 100% of GDV in about twenty years.
However, note that the YOY improvement has accelerated each year in the exhibit above, with
the exception of 2009, so it is possible that a cashless society becomes a reality in fewer than
twenty years. Therefore, I believe a range of 15-25 years appears to be a prudent estimate.
How is this estimated timeline of a cashless society helpful? It provides a rough guide as to
the length of time that Visa and MasterCard can grow free cash flows at above average rates
(for perspective, the seven-year CAGRs on free cash flows for Visa and MasterCard are ~31%
and ~51%, respectively). Intuitively, once electronic payments reach the (near) 100% threshold,
Visa and MasterCard will settle in as mature businesses – revenue growth will be primarily
40
The Nilson Report: Chart of the Month, April ‘12
Electronic Payments Investment Thesis
Page 21
anchored to average spend per card, which is unlikely to outpace world GDP growth by a
significant margin. This timeline will inform my discounted cash flow analysis later in the report,
where a reasonable range of FCF growth rates over a fifteen-year period – using a two-stage
model – will be used to determine intrinsic values for the equity of Visa and MasterCard.
FINANCIAL OVERVIEW
1) Consistent, high returns on invested capital that reflect a durable competitive
advantage. On a purely quantitative basis, MasterCard’s ROIC is vastly superior to that of
Visa’s, having averaged 62% over the past five years. However, this wide gap between the two
companies does not make much sense given that the economics of their businesses are
virtually identical; in fact, an analysis of these companies’ operating margins indicates that
Visa’s larger size/market share enables it to consistently achieve a higher level of operating
profitability compared to MasterCard.
Return on Invested Capital
120.0%
Visa
MasterCard
111.8%
115.3%
105.1%
100.0%
90.1%
91.0%
23.2%
22.8%
2014E
2015E
82.1%
80.0%
67.5%
66.8%
60.0%
52.1%
41.5%
40.0%
19.9%
20.0%
8.0%
11.1%
13.2%
2010
2011
25.9%
29.1%
32.3%
6.5%
0.0%
2009
2012
2013
2016E
2017E
2018E
The difference in ROICs derives from balance sheet accounting. Visa has significantly greater
goodwill and intangible assets compared to MasterCard, accounting for ~86% of shareholders’
equity at the end of FY 2013 vs. ~24% for MasterCard. In particular, Visa values its customer
relationships at $6.8BB and its tradename (brand) at $2.6BB, or 25% and 10%, respectively, of
equity. MasterCard values these respective items at $153MM (2% of equity) and $11MM (0.1%).
Much of this difference reflects an accounting anomaly that occurred when Visa Inc. was formed
in 2007 from the numerous stand-alone Visa entities (Visa U.S.A., Visa Canada, Visa Latin
America, etc.); the combination of the entities resulted in Visa taking on significant goodwill &
Electronic Payments Investment Thesis
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intangible assets due to purchase accounting41. The discrepancy in ROICs is a non-issue as
the economics underlying these companies’ businesses is virtually identical.
However – just to provide some perspective – in the following exhibit, I have adjusted
MasterCard’s intangible assets and goodwill to reflect these values if they were proportional to
those of Visa’s. The purpose of this adjustment is to obtain a better sense of the relative returns
between these two companies assuming there are no significant differences in how they
account for these items. Even with this adjustment, MasterCard generates higher returns
on invested capital compared to Visa. MasterCard runs a much leaner organization than
Visa. While its revenues are ~70% of Visa’s, MasterCard employs far less physical plant &
equipment (less than a third than Visa does) and is more efficient at managing its net operating
assets (working capital).
Return on Invested Capital
Adjusted for Differences in Intangibles & Goodwill
60.0%
Visa
56.1%
MasterCard
53.2%
49.5%
50.0%
43.2%
43.2%
43.4%
38.4%
40.0%
35.3%
32.3%
29.1%
28.1%
30.0%
25.9%
23.3%
23.2%
22.8%
2014E
2015E
19.9%
20.0%
11.1%
10.0%
13.2%
8.0%
6.5%
0.0%
2009
2010
2011
2012
2013
2016E
2017E
2018E
I expect Visa and MasterCard will produce returns on invested capital above their
respective costs of capital going forward. As the electronification of commerce accelerates,
both companies’ operating margins will steadily expand with revenue growth outpacing the
incremental expenses and capital costs required to support that growth. High barriers to entry in
the electronic payments business – dominated by these two companies and China UnionPay –
will keep competition to a minimum and help to preserve Visa’s and MasterCard’s margins and
returns.
2) “Intelligent” growth – the ability to reinvest free cash flows at high rates of return.
The pathway for growth in electronic payments is very clear and very long. Electronification of
commerce is well underway, but there still remains a long distance between where we are today
and a 100% (or nearly 100%) cashless society. As discussed in the preceding section,
customers, merchants, governments, and financial institutions all have viable reasons for
moving away from cash & checks given their associated economic costs.
41
From a conversation with Victoria Hyde-Dunn, Visa’s investor relations representative.
Electronic Payments Investment Thesis
Page 23
The already-large payments networks of Visa and MasterCard have reached a critical mass
such that the costs of adding incremental users are far lower than what they stand to gain
in terms of revenue growth. By the same token, the value users receive from the convenience,
reliability, and security afforded by these payment networks outweighs the costs – which, if
regulators are correct, are the swipe fees that merchants pass onto customers through higher
prices of goods and services. The greater value relative to cost for both payments providers
and users drives the “virtuous cycle” of the beneficial network effect. As more users join
these networks, the incremental costs for Visa and MasterCard, as well as the users, become
cheaper and cheaper, allowing these companies to generate increasing economic value.
The following chart depicts the economic value added (EVA) as well as the EVA momentum for
both Visa and MasterCard, for historical and projected periods. To refresh: EVA is economic
value added – net operating profit after tax less the cost of all sources of capital. It aims to
measure the true economic profit of an enterprise after accounting for the full opportunity costs
of all invested capital. EVA momentum takes this concept a step further, taking the change in
EVA between two time periods and dividing it by the prior period’s revenue; it measures the
EVA growth rate scaled to the size of the business in terms of revenue. The advantage of EVA
momentum is that it links the income statement and balance sheet together, and quantifies
whether or not top-line growth in fact created economic value – that is, if the additional cost of
capital required justifies the expansion of the business.
Visa - EVA
MasterCard - EVA
50%
$5,000
Visa - EVA Momentum
MasterCard - EVA Momentum
40%
$4,000
30%
$3,000
20%
$2,000
10%
$1,000
EVA Momentum
Economic Value Added ($, MM)
EVA and EVA Momentum
$6,000
0%
$0
-10%
($1,000)
($2,000)
-20%
2009
2010
2011
2012
2013
2014E
2015E
2016E
2017E
2018E
MasterCard has historically produced more economic value than Visa, and at a more
consistent pace. There are a few caveats to this assertion. In 2012 Visa expensed $4.1BB in
litigation charges to cover the company’s portion of the MDL settlement, which adversely
impacted its ROIC and economic value added for that year (MasterCard expensed a portion of
the MDL litigation charge in 2011, and the impact on its results was more blunted). Furthermore,
as was highlighted in the ROIC section, Visa carries a higher cost of capital (on a $ basis) than
MasterCard due to a much heavier burden from intangible assets and goodwill, which has the
effect of reducing its reported EVA. The differences in EVA are minor if one were to adjust
Electronic Payments Investment Thesis
Page 24
MasterCard’s balance sheet to account for intangibles and goodwill on levels similar to Visa’s.
The exception is for FY 2013 and the projected period; if one were to exclude litigation
expenses, Visa has shown a greater magnitude in the improvement in EVA over the last several
years. All else equal, I expect that trend will continue going forward; given Visa’s larger market
share – particularly in the faster-growing area of debit – the company should generate
incrementally greater EVA than MasterCard.
EVA and EVA Momentum
Adjusted for Differences in Intangibles & Goodwill
Visa - EVA
MasterCard - EVA
Visa - EVA Momentum
MasterCard - EVA Momentum
40%
$5,000
30%
$4,000
20%
$3,000
$2,000
10%
$1,000
0%
EVA Momentum
Economic Value Added ($, MM)
$6,000
$0
-10%
($1,000)
($2,000)
-20%
2009
2010
2011
2012
2013
2014E
2015E
2016E
2017E
2018E
With respect to EVA momentum, both companies have produced positive values in every
one of the last few years (excepting Visa’s FY 2012, due to the litigation expense). Visa’s
progress has been more uneven compared to MasterCard’s, but I expect both companies to
produce similar EVA momentum going forward. Regardless of the differences between the two
companies, EVA momentum highlights the attractiveness of the economics of the
electronic payments business. For the historical periods shown, EVA momentum for Visa and
MasterCard has averaged ~9% and ~12%, respectively, while projected EVA momentum is
estimated to average ~4% to ~4.5% annually for each company. Recall that over the last 20
years, average EVA momentum for component companies of the Russell 3000 is 0.3%, with
firms in the 75th percentile averaging EVA momentum of 1% to 1.5% annually.
The low capital requirements of Visa’s and MasterCard’s core businesses coupled with
the excess returns they generate presents these firms with a “good” problem: how to
allocate all of those free cash flows. Both companies have been aggressively returning
capital to shareholders, mainly through repurchasing equity: FY 2013 buybacks totaled $5.4BB
for Visa and $2.4BB for MasterCard, representing 19% and 35%, respectively, of beginning
shareholders’ equity. Dividend payments are still quite low in terms of both yield (0.7% for Visa,
0.6% for MasterCard) and the payout ratio (17% of FY 2013 net income for Visa, 8% for
MasterCard). My expectation is that equity repurchased (in dollars) will increase at low doubledigit rates for Visa and MasterCard going forward. For dividend payments, Visa targets a payout
ratio of 20% of trailing twelve-month net income (which results in an annual growth rate of ~12%
in total dividend payments going forward), while I expect MasterCard will be somewhat more
aggressive in raising their dividend (19% CAGR).
Electronic Payments Investment Thesis
Page 25
The other primary use of excess free cash – expansion through acquisition – would likely
represent an intelligent use of capital to the extent it expands the capabilities of either
company beyond their core businesses. But the dearth of competitors in the electronic
payments industry is a double-edged sword. While limited competition helps to preserve Visa’s
and MasterCard’s margins, it also leaves few opportunities to grow via acquisition.
Acquisitions in either the e-commerce space or the mobile payments space make the
most sense for Visa and MasterCard given how quickly these areas are growing.
Unfortunately, the companies branching out into this space are mainly large conglomerates that
have no interest in selling their payments initiatives; in many cases they were created with the
explicit intent of competing head-to-head with Visa and MasterCard. These initiatives include
those of Google, Amazon, and eBay’s PayPal. There have been rumors of eBay possibly
spinning off or selling PayPal, spurred on by a series of letters that Carl Icahn has written to
eBay’s board and CEO John Donahoe. However, eBay has been adamant about keeping
PayPal as a component of its online auction business, arguing that the combination produces
more value for shareholders than if the enterprises were separate. Therefore, I view a potential
acquisition of PayPal as a low probability scenario.
Another viable acquisition target could be Square, Inc. Square is a mobile payments
company that was founded in 2009, whose initial mission was to allow individuals and small
merchants to accept debit and credit cards using iOS-/Android-powered smart devices. Use of
Square requires no start-up costs for merchants; there are no sign-up fees, activation fees,
cancellation fees, bank routing fees, etc. The software and physical card reader are both free.
However, the “swipe” fees associated with using Square are much heftier relative to other
payment processors, at 2.75% per swiped transaction and 3.5% (plus $0.15) per manuallyentered transaction. Square argues that its value proposition is more attractive than traditional
processors due to hidden costs associated with its competitors’ business models. Square is
functional in the U.S., Canada, and Japan, and accepts the four major cards (Visa, MasterCard,
American Express, and Discover).
According to an article in the Wall Street Journal, Square’s 2013 net sales were $110MM to
$165MM (gross sales were ~$550MM, of which 70-80% accrues to financial institutions in the
form of interchange fees) on gross dollar volume of ~$20BB. The company expects to reach
$1BB in gross sales on ~$30BB of gross dollar volume in 2014, which represent growth rates of
~82% and ~50%, respectively. While the company is not yet turning a profit, private investors
have valued Square at ~$5BB as of January 2014 and CEO Jack Dorsey is considering an
initial public offering42,43.
But I don’t believe a buyout of Square would represent an intelligent use of capital for
either Visa or MasterCard. While Square is growing at a rapid pace, it is questionable whether
or not the price that a large payment processor would have to pay for this business would be
justified. Even if private investors did not demand a premium to the ~$5BB valuation, Visa or
42
43
The Wall Street Journal: “Square Exploring 2014 IPO With Banks,” November ‘13
The Information: “Employee Stock Sales Boom, As Square Considers One at $5 Billion,” December ‘13
Electronic Payments Investment Thesis
Page 26
MasterCard would be paying ~17-25x forward net sales (assuming 70-80% of the $1BB gross
sales estimate is reduced by interchange fees) for a company earning zero profits (and is likely
incurring losses). On the other hand, an acquisition of Square has a degree of strategic value. It
would provide a payment processor with a stronger presence in mobile payments and rob its
competitors of a growing revenue stream. If an acquisition were to take place, the most
natural partner would be Visa. Visa invested in Square in 2011 –as of 2013, owns a ~1%
stake in the company – and has a company executive on Square’s advisory board44,45.
3) Capable and honest management teams. Visa CEO Charlie Scharf is still relatively new in
his role, having taken over from Joe Saunders in November 2012. However, he is not new to
the company – he was a director of Visa for nearly eight years (Visa U.S.A. from February 2003
to October 2007; Visa Inc. from October 2007 to January 2011). Scharf has extensive
experience in the credit card and retail finance business, serving as CEO of JPMorgan Chase’s
Retail Finance business for nine years and as CFO of Citigroup’s global corporate and
investment bank for thirteen years. I believe Scharf is an excellent choice to lead Visa for a few
reasons: he possesses a unique combination of financial, consumer, and operating experience,
and he is well-known and trusted by some of the largest bank issuers.
On this second point, his experience working for (and presumably his contacts at) these
financial institutions has already paid dividends for Visa. First, Visa converted Chase’s
consumer credit portfolio from rival MasterCard in 2012. Chase had the fifth largest U.S. credit
card portfolio in 2013 with market share of ~13%46; in its last conference call, MasterCard noted,
While we expected some attrition would occur in 2013 [from the Chase portfolio],
that did not happen. We don't have any specifics on how these cards will migrate,
but we are now assuming an impact in 2014. Given the size of this portfolio, we
can offset some, but not all, of this attrition with our [new business] wins and, as
we expect, net revenue growth for 2014 to come in at the lower end of our 3-year
range [of 11% to 14%]. (emphasis is my own)
Second, Scharf helped to bring on Ryan McInerney, his protégé at JPMorgan Chase who was
CEO of Consumer Banking, to Visa in May 2013. While Scharf is relatively young at 48 years of
age, the addition of McInerney (who is 38 and serving as President) provides the company with
additional depth on its executive bench. McInerney reports directly to Scharf in his role, and his
duties – as outlined in the most recent proxy statement – are closely aligned with those of the
CEO, suggesting that a long-range succession plan may already be in place.
Ajay Banja has been with MasterCard for over four years, first serving as President and COO
from August 2009 to July 2010, at which point he took over as CEO. Before joining MasterCard,
he was with Citigroup for approximately thirteen years in a variety of roles, including CEO of the
The New York Times: “Visa Invests in Square for Mobile Payments,” April ‘11
Business Insider: “Here’s Who Will Become Filthy Rich If Square Is Really Worth $3.25 Billion,”
February ‘13
46 The Nilson Report: Chart of the Month, February ‘14
44
45
Electronic Payments Investment Thesis
Page 27
International Global Consumer Group, EVP of the Global Consumer Group, President of Retail
Banking North America. Banja’s experience on the issuer side of the electronic payments
industry is on par with Charlie Scharf’s. He also has a background in building brands from
previous experience with PepsiCo and Nestle in sales, marketing, and management positions
(as part of PepsiCo, he helped to introduce the KFC and Pizza Hut brands to India). One edge
that I believe Banja possesses that Scharf does not is his international experience, which will
come in handy in helping to develop faster-growing markets in Asia Pacific, Latin America, and
Africa.
Both Scharf and Banja appear to be able operators based on each CEO’s experience and
the exceptional results of each company under their tenures thus far. Going forward, I
believe the differentiating factor between the two companies’ leadership teams will be how each
one:
 Addresses the technological shift within electronic payments, with there being greater
emphasis on growth areas such as e-commerce and mobile payment solutions – will
either company be able to offer a value proposition to consumers, merchants, and
financial institutions that separates themselves from the competition?

Handles the competition from both traditional (China UnionPay) and alternative (PayPal,
Google, Amazon, Square) providers. In the latter case, my sense is that these
companies will ultimately be partners rather than competitors of Visa and MasterCard;
customers, merchants, and financial institutions have cultivated trust in the Visa and
MasterCard networks and brands over many years, which will be extraordinarily difficult
for the alternative providers to displace or replace.
However, China UnionPay is a different case altogether. It has grown rapidly in its twelve
years of existence, and it possesses an important first mover advantage in one of the
largest and fastest growing economies in the world. The extent to which Visa and
MasterCard can grow their business in China over the next decade or so, as well as
compete internationally with UnionPay, will be important factors in determining the
ultimate growth opportunity for each company.
I will now turn to executive compensation to assess whether or not each company’s leaders are
properly incented in terms of having compensation that is tied directly to having long-term
shareholders’ best interests at the forefront.
The majority of Visa management’s compensation is tied to performance – 88% for the CEO
and 83% for other named executives. Approximately three-fifths of total compensation derives
from the company’s long-term incentive plan; of this amount, roughly half is tied to certain
performance goals, with the other half split equally between stock options (which generate value
for executives only if the stock price appreciates) and restricted stock (to retain key officers).
Long-term performance goals are primarily related to an earnings per share target that is set at
the beginning of each fiscal year, with performance shares being award in equal increments
over rolling three-year performance periods. At the end of each of these periods, the total
Electronic Payments Investment Thesis
Page 28
amount of performance shares awarded is adjusted by a total shareholder return (TSR)
modifier, determined by how Visa ranks in comparison with the TSR of other S&P 500
companies. In addition to long-term performance compensation, annual cash bonuses are
awarded to management based on net revenue growth (40% weighting for both FY ’13 and ‘14)
and net income (60%). I rate Visa’s compensation scheme as only mediocre because the
majority of long-term awards are tied to EPS.
I prefer MasterCard’s compensation scheme to Visa’s. The mix of performance-based vs.
base compensation is similar at ~90% for the CEO and ~80% for other executives. But in terms
of long-term incentives, MasterCard awards performance share units based on a return on
equity goal over a rolling three-year period, which is modified by the compensation committee at
the end of each period according to qualitative and quantitative factors (primarily goals for net
income and net revenue). Annual cash bonuses are based on net income (two-thirds weighting)
and net revenue (one-third) goals. As MasterCard carries no debt, ROE is a close enough proxy
to ROIC that it satisfies the type of incentives that I like to see management compensation tied
to. Using an ROE goal instead of an ROIC goal may incent management to take on debt to fund
an ill-advised acquisition, but I view this scenario as remote given management’s history of
managing assets (the company has been debt-free for four years) and the company’s strong
free cash flow generation, which can be used to finance any growth initiatives.
4) Strong balance sheets: conservatively financed companies that employ little to no
debt leverage. Only a few words need to be said here: neither Visa nor MasterCard currently
has any long-term debt. Both companies have historically been judicious in taking on debt, with
Visa being debt-free the last three years and MasterCard for the last four. Barring a significant
(transformative) acquisition – such as PayPal – I do not expect either company to add leverage
to its balance sheet going forward given the strong free cash generating characteristics of
electronic payments providers (free cash flows as a % of net revenue have ranged in the high30% to low-40% range in recent years).
5) A reasonable price (though a cheap one is better) relative to intrinsic value. I have
judged Visa’s and MasterCard’s businesses to be of exceptional quality, but valuation discipline
is a necessary and critical component of the investment decision process. I typically seek a
discount of at least 20-25% to intrinsic value in potential investment prospects to provide myself
with a margin of safety – against both unforeseen calamities (such as an economic downturn)
and my own projections of a business’ earning power. Given my confidence in Visa’s and
MasterCard’s business models, as well as the clear pathway to growth that each company is
pursuing, I would be comfortable paying slightly higher prices – closer to their intrinsic values.
But regardless of how fantastic the business is, I would never entertain paying a rich or
unreasonable price for it.
Truly exceptional businesses – the top 1% – by definition do not come along often, and being
able to purchase an interest in them at cheap prices is rarer still. If my assessment of Visa and
Electronic Payments Investment Thesis
Page 29
MasterCard as truly exceptional businesses is correct, then the long-term returns should take
care of themselves, and I am less apt to quibble over a 5% price differential47.
VALUATION
Before running a discounted cash flow (DCF) analysis of Visa and MasterCard based on my
financial projections, I first run the analysis in reverse using its current share price to determine
investors’ expectations for the companies going forward. I then compare these expectations
with my own estimates to discern if there is a large gap in value. A few assumptions must be
made for this exercise.
Assumptions:



A forecast period of fifteen years before Visa and MasterCard settle into mature states
as businesses. Fifteen years reflects the lower bound of my expectation that the financial
system will be completely cashless (or nearly so). Over this time period, I expect Visa
and MasterCard will steadily capture market share from cash & checks, which should
drive strong free cash generation. As electronic payments become the de facto choice of
payment, these companies’ growth should correspondingly decelerate.
A two-stage DCF model, in which free cash flow growth for the last five years slows to
half of the rate assumed for the first ten years. Visa and MasterCard have experienced
tremendous growth in their free cash flows in recent years. I believe that growth will slow
over the next several years due in part to both (1) the strong growth of the last few years
reflecting an abnormal period of time, when the world came out of one of the worst
economic downturns in history; and (2) the law of large numbers. Going forward most of
Visa’s and MasterCard’s growth will derive from developing economies, which I expect
will adopt electronic payments faster than developed economies have (a process that
has taken several decades). This expectation is due in part to the relatively poor banking
infrastructure in these countries, as well as the abundance of mobile & smart devices
that will make mobile payments and e-banking more easily accessible. Once the majority
of this growth is captured (which I am assuming is after ~10 years), FCF growth will
correspondingly slow, eventually reaching a steady state approximating global GDP
growth.
A discount rate range of 11% to 13%. The resulting valuation of a DCF analysis greatly
relies on the discount rate used. Both Visa and MasterCard have stated that their
weighted average cost of capital runs at ~10%, but I believe a more conservative
discount rate is necessary in this DCF analysis to account for the longer forecast period
being used. Estimating a company’s financial results more than a few years out runs a
higher risk of being inaccurate.
I invoke Charlie Munger’s words to better express this sentiment: “Over the long term, it’s hard for a
stock to earn a much better return than the business which underlies it earns. If the business earns 6% on
capital over forty years and you hold it for that forty years, you’re not going to make much different than a
six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18%
on capital over twenty or thirty years, even if you pay an expensive-looking price, you’ll end up with one
hell of a result.”
47
Electronic Payments Investment Thesis
Page 30
Based on these assumptions, the following sensitivity tables provides a range of valuations
encompassing different initial (ten-year) FCF growth rates and discount rates for both Visa and
MasterCard.
Visa:
Initial
Free
Cash
Flow
Growth
Rate
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
21%
22%
23%
24%
25%
26%
27%
28%
9.5%
10.0%
$197.08
$182.45
$214.50
$198.19
$233.64
$215.47
$254.67
$234.43
$277.78
$255.25
$303.15
$278.09
$331.00
$303.14
$361.57
$330.61
$395.10
$360.72
$431.86
$393.72
$472.17
$429.86
$516.34
$469.44
$564.72
$512.77
$617.69
$560.18
$675.66
$612.04
$739.09
$668.75
$808.45
$730.72
$884.26
$798.43
$967.10
$872.38
$1,057.57
$953.09
$1,156.34 $1,041.17
10.5%
$169.82
$184.12
$199.80
$217.00
$235.85
$256.53
$279.18
$304.01
$331.20
$360.98
$393.57
$429.24
$468.27
$510.94
$557.59
$608.57
$664.26
$725.06
$791.43
$863.85
$942.82
11.0%
$158.81
$171.86
$186.16
$201.83
$219.00
$237.80
$258.40
$280.94
$305.62
$332.62
$362.16
$394.47
$429.78
$468.38
$510.55
$556.61
$606.89
$661.76
$721.63
$786.91
$858.08
Discount Rate
11.5%
12.0%
$149.13
$140.55
$161.09
$151.56
$174.19
$163.61
$188.53
$176.79
$204.23
$191.19
$221.41
$206.95
$240.21
$224.18
$260.77
$243.01
$283.26
$263.59
$307.86
$286.08
$334.75
$310.65
$364.13
$337.48
$396.23
$366.77
$431.30
$398.75
$469.58
$433.65
$511.37
$471.71
$556.97
$513.23
$606.71
$558.48
$660.94
$607.81
$720.05
$661.54
$784.46
$720.06
12.5%
$132.91
$143.08
$154.20
$166.34
$179.62
$194.12
$209.96
$227.26
$246.16
$266.80
$289.33
$313.91
$340.74
$370.01
$401.93
$436.72
$474.65
$515.98
$561.00
$610.01
$663.37
13.0%
$126.06
$135.48
$145.77
$157.01
$169.27
$182.66
$197.28
$213.23
$230.64
$249.64
$270.36
$292.96
$317.61
$344.48
$373.77
$405.68
$440.44
$478.30
$519.52
$564.38
$613.18
13.5%
$119.88
$128.64
$138.19
$148.61
$159.98
$172.38
$185.90
$200.65
$216.74
$234.27
$253.39
$274.23
$296.94
$321.69
$348.64
$377.99
$409.95
$444.73
$482.58
$523.75
$568.53
14.0%
$114.29
$122.45
$131.34
$141.03
$151.59
$163.11
$175.65
$189.33
$204.23
$220.46
$238.15
$257.42
$278.40
$301.25
$326.12
$353.19
$382.64
$414.68
$449.53
$487.42
$528.61
14.5%
$109.20
$116.82
$125.12
$134.16
$144.00
$154.71
$166.38
$179.09
$192.93
$208.00
$224.40
$242.25
$261.69
$282.83
$305.84
$330.87
$358.09
$387.68
$419.84
$454.80
$492.78
14.0%
$42.62
$45.55
$48.75
$52.23
$56.02
$60.16
$64.66
$69.57
$74.93
$80.76
$87.11
$94.03
$101.57
$109.77
$118.70
$128.43
$139.01
$150.52
$163.03
$176.64
$191.43
14.5%
$40.80
$43.53
$46.51
$49.76
$53.29
$57.14
$61.33
$65.90
$70.87
$76.28
$82.17
$88.58
$95.56
$103.16
$111.42
$120.41
$130.19
$140.81
$152.37
$164.92
$178.56
MasterCard:
Initial
Free
Cash
Flow
Growth
Rate
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
21%
22%
23%
24%
25%
26%
27%
28%
9.5%
$72.36
$78.61
$85.49
$93.04
$101.34
$110.46
$120.46
$131.44
$143.48
$156.69
$171.16
$187.03
$204.40
$223.43
$244.25
$267.03
$291.94
$319.17
$348.93
$381.42
$416.90
10.0%
$67.10
$72.76
$78.96
$85.77
$93.25
$101.45
$110.45
$120.32
$131.13
$142.98
$155.97
$170.18
$185.74
$202.77
$221.40
$241.77
$264.03
$288.35
$314.90
$343.89
$375.53
10.5%
$62.57
$67.70
$73.33
$79.51
$86.28
$93.71
$101.85
$110.76
$120.53
$131.23
$142.93
$155.74
$169.76
$185.09
$201.84
$220.15
$240.15
$261.99
$285.83
$311.84
$340.21
11.0%
$58.61
$63.30
$68.44
$74.06
$80.23
$86.98
$94.38
$102.48
$111.34
$121.04
$131.65
$143.25
$155.94
$169.80
$184.95
$201.49
$219.55
$239.26
$260.76
$284.21
$309.77
Electronic Payments Investment Thesis
Discount Rate
11.5%
12.0%
12.5%
$55.13
$52.05
$49.31
$59.43
$56.01
$52.96
$64.14
$60.34
$56.96
$69.29
$65.07
$61.32
$74.93
$70.24
$66.09
$81.10
$75.90
$71.29
$87.85
$82.09
$76.98
$95.23
$88.85
$83.20
$103.31
$96.25
$89.99
$112.15 $104.32
$97.40
$121.80 $113.15
$105.49
$132.36 $122.78
$114.32
$143.89 $133.31
$123.96
$156.48 $144.79
$134.47
$170.23 $157.33
$145.93
$185.24 $171.00
$158.43
$201.62 $185.91
$172.05
$219.48 $202.16
$186.90
$238.96 $219.88
$203.07
$260.19 $239.18
$220.67
$283.33 $260.20
$239.84
13.0%
$46.85
$50.23
$53.93
$57.96
$62.37
$67.18
$72.43
$78.16
$84.41
$91.23
$98.68
$106.80
$115.65
$125.30
$135.82
$147.28
$159.77
$173.36
$188.17
$204.28
$221.81
13.5%
$44.63
$47.78
$51.21
$54.95
$59.03
$63.49
$68.34
$73.64
$79.42
$85.72
$92.58
$100.07
$108.23
$117.11
$126.79
$137.34
$148.81
$161.31
$174.90
$189.69
$205.77
Page 31
Assuming a discount rate of 11% to 13%, investors expect Visa’s and MasterCard’s free
cash flows to grow at a low double-digit to mid-teen rate for the next ten years and a midsingle digit rate for the subsequent five years. I believe these are reasonable, though
somewhat optimistic, expectations for these companies. I project Visa and MasterCard to grow
free cash flows at rates of ~12% and ~11%, respectively, each year for the next several years;
for perspective, over the last three years, both companies have grown free cash at annual rates
of ~18%.
Key figures and drivers for my estimates of free cash flow growth going forward are outlined
below.
Revenue Growth: I expect both Visa and MasterCard will grow net revenues at low double-digit
rates for the next few years, with Visa’s growth slightly outpacing MasterCard’s. This difference
reflects a few factors:


MasterCard’s business has more exposure to Europe whereas Visa’s is more
concentrated in the U.S. Over the last five years, Visa has grown faster than MasterCard
due in part to the faster pace of the economic recovery in the U.S. While conditions are
improving in Europe, the U.S. economy is still projected to grow at a higher rate than
Europe over the next few years, per projections from the IMF48.
The transition of Chase’s consumer credit portfolio from MasterCard to Visa. While
neither company has quantified the size (revenue) of this piece of business, MasterCard
suggested all of its new business wins in the coming fiscal year would not be able to
make up for the loss of this portfolio.
For both companies, overall top-line growth will be underpinned by low double-digit to mid-teen
growth in processing revenues as electronic payments – more so in the form of debit cards than
credit cards – continue to take share from cash & checks. Service/assessment revenues are
projected to grow a little faster at Visa than MasterCard due to higher growth in payments
volume at Visa to reflect the differences in the two companies’ geographic mix of business (as
stated above). Somewhat offsetting gross revenue growth will be a higher percentage of client
incentives for both Visa and MasterCard, reflecting increased competition for issuers’ business.
Operating Expenses: With net revenues growing at low double-digit rates, Visa and
MasterCard will benefit from operating leverage as the costs of maintaining their payments
networks are disproportionately low compared to incremental revenues taken in. Most of this
leverage will impact the personnel and marketing expense lines (and to a lesser extent, the
general & administrative line), each of which has steadily declined as a % of net revenues over
both companies’ operating histories. The lone exception is for Visa’s FY 2014 marketing
expenses, which will see a modest increase due to advertising spend on the Winter Olympics
and the World Cup. Consequently, I expect Visa’s operating margin will increase ~2pts to 63.7%
over the next five years, while MasterCard’s will increase ~3pts to 57.2%.
International Monetary Fund: “World Economic Outlook Update,” January ’14. The U.S. is expected to
grow at 2.8% and 3.0% in ’14 and ’15, respectively, compared to 1.0% and 1.4% growth in Europe.
48
Electronic Payments Investment Thesis
Page 32
According to my base case scenarios, the intrinsic values per share for Visa and
MasterCard are $171 and $59, respectively. Current share prices for these companies are
nearly 30% higher than my intrinsic value estimates and are therefore not suitable
investment prospects.
With that being said, I believe a range of outcomes must be considered in addition to the base
case scenarios laid out above. Annual FCF growth rates of 9.5% to 14% seem both reasonable
and conservative relative to Visa’s and MasterCard’s operating histories (or at least relative to
their last few years as public companies, for which detailed financial information is readily
available). A bear case of 9.5% could arise from a combination of adverse factors: a slowdown
in the global economic recovery; slower penetration of electronic payments, perhaps due to
consumer concerns about security or merchants/governments putting additional pressure on
payment providers to lower swipe fees further; continued difficulties with accessing the Chinese
market; and increased global competition from other players in this space, particularly China
UnionPay. A bull case of 14% would suggest Visa and MasterCard are fairly valued at today’s
prices, and could reflect faster than expected market penetration of electronic payments or
generally better than anticipated economic conditions.
Using my standard 13% discount rate, these FCF growth ranges would imply intrinsic
values per share for Visa and MasterCard of $141 to $197 and $52 to $72, respectively. My
preference for a 13% discount rate reflects (1) my required rate of return on investments (low
teens) and (2) incorporating a margin of safety into my investment selections. In this particular
case, I believe a somewhat higher discount rate (compared to these companies’ ~10% cost of
capital) is appropriate given the 15-year time frame used in the DCF analysis. At current
prices, MasterCard’s stock is more modestly priced than Visa, but I still would not
consider a purchase unless both stocks declined 20%+ in value (assuming there is no
significant change in their fundamentals).
Turning to traditional relative value metrics, the following charts depict the historical P/E (using
underlying earnings per share, which exclude litigation expenses) and P/FCF ratios for both
Visa and MasterCard. The P/E ratios for both companies have recently converged after several
years in which the investment community had assigned a higher multiple to Visa, as Visa has
grown revenues and underlying earnings per share at a faster rate over the last five years
(CAGRs of 13% and 28%, respectively, for Visa, compared to 11% and 20%, respectively, for
MasterCard). Both companies are currently near the high end of their historical P/E range. I
believe these relatively high multiples provide further justification for waiting for a more ideal
entry point for investing in either company.
When looking at free cash flow multiples, both companies have traded at similar valuations over
the last several years. If one were to exclude the 2009 multiple – which is skewed by the
(relatively) poor results of the 2008 fiscal year – from analysis, Visa and MasterCard are also
valued near the high end of their historical P/FCF ratios.
Electronic Payments Investment Thesis
Page 33
Historical Price-to-Earnings Ratio
Historical Price-to-FCF Ratio
Trailing Twelve Months
Trailing Twelve Months
44.0
29.0
Visa
MasterCard
39.0
27.0
25.0
34.0
23.0
29.0
21.0
Visa
MasterCard
19.0
17.0
24.0
19.0
2009
2010
2011
2012
2013
Current
2009
2010
2011
2012
2013
Current
Lastly, I compare the enterprise value to FCF ratios of Visa and MasterCard with related
companies in the electronic/card payments sector: American Express and Discover. AXP and
DFS carry lower multiples than Visa and MasterCard as the former two companies bear a
degree of credit risk in their business operations, whereas the latter two companies are purely
payment processors. Strictly comparing Visa and MasterCard, the latter is a better value at
current prices according to all relative value metrics, but only slightly so.
$, BB
V
MA
AXP
DFS
Enterprise Value
$137.4 $83.9 $138.0 $41.2
Free Cash Flow
$5.1
$3.4
$7.5
$3.3
EV/FCF Multiple
26.7
24.6
18.4
12.5
Note: data for AXP and DFS was taken from Capital IQ.
CONCLUSION
Visa and MasterCard are both wonderful businesses that possess a tremendous growth
opportunity over the next 15+ years. However, they are fully-priced at current valuations, and I
would not advise establishing a new position in either company unless their share prices fell
20% or more (assuming no significant change in fundamentals).
Ideally, I would like to own both of these businesses. They produce stellar returns on invested
capital; have a well-defined runway for growth, which primarily reflects a secular shift in how
commerce is transacted and is therefore partially insulated from adverse economic conditions;
and have extraordinarily clean capital structures. If hard-pressed to choose one, I prefer Visa.
Visa is the dominant player in the electronic payments space (and debit cards specifically) and –
according to my analysis – is projected to grow at a slightly higher pace than MasterCard (due
in part to having a small advantage over MasterCard in terms of the level of client incentives it
pays to issuers). But I would not hesitate to purchase MasterCard if its share price were to
approach my base case intrinsic value estimate of ~$59/share.
Electronic Payments Investment Thesis
Page 34
APPENDIX: THE VISA EUROPE PUT OPTION
Visa Inc. has granted Visa Europe a perpetual put option which, if exercised, will require
the company to purchase all of the outstanding shares of capital stock of Visa Europe
from its members. Visa Europe may exercise the put option at any time.
The put option provides a formula for determining the purchase price of the Visa Europe shares,
which subject to certain adjustments, applies Visa Inc.‘s forward P/E multiple at the time the
option is exercised to Visa Europe’s adjusted sustainable income for the forward 12-month
period. The calculation of Visa Europe’s adjusted sustainable income under the terms of the put
option agreement includes potentially material adjustments for cost synergies and other
negotiated items. Upon exercise, the key inputs to this formula, including Visa Europe’s
adjusted sustainable income, will be the result of negotiation between Visa Inc. and Visa
Europe. The put option provides an arbitration mechanism in the event that the two parties are
unable to agree on the ultimate purchase price.
The fair value of the put option represents the value of Visa Europe’s option, which, under
certain conditions, could obligate Visa Inc. to purchase its member equity interest for an amount
above fair value. At year-end 2013, the fair value of the put option liability was ~$145MM.
While this amount represents the fair value of the put option at year-end 2013, it does not
represent the actual purchase price that Visa Inc. may be required to pay if the option is
exercised. The purchase price Visa Inc. could be obligated to pay 285 days after exercise
will represent a substantial financial obligation, which could be several billion dollars or
more. Visa may need to obtain third-party financing, either by borrowing funds or undertaking a
subsequent equity offering in order to fund this payment. The amount of that potential obligation
could vary dramatically based on, among other things, Visa Europe’s adjusted sustainable
income and Visa’s P/E ratio, in each case, as negotiated at the time the put option is exercised.
The following table calculates Visa’s total obligation assuming, for illustrative purposes only, a
range of P/E ratios for Visa Inc. and assuming that Visa Europe demonstrates $100MM of
adjusted sustainable income at the date of exercise. Note that the $100MM of assumed
adjusted sustainable income provided in the table is for illustrative purposes only. This
does not represent an estimate of the amount of adjusted sustainable income Visa Europe
would have been able to demonstrate at year-end 2013, or will be able to demonstrate at any
point in time in the future. Should Visa Europe elect to exercise its option, Visa believes it is
likely that it will implement changes in its business operations to move to a for-profit model in
order to maximize its adjusted sustainable income and, as a result, to increase the purchase
price. The table also provides the amount of increase or decrease in the payout, assuming the
same range of estimated P/E ratios, for each $25MM of adjusted sustainable income above or
below the assumed $100MM demonstrated at the time of exercise. At December 31, 2013 , the
Visa's spot P/E was 21.5x , and there was a differential of (1.3x) between this ratio and the
estimated spot ratio applicable to Visa Europe. These ratios are for reference only and are not
necessarily indicative of the ratio or differential that could be applicable if the put option were
exercised at any point in the future.
Electronic Payments Investment Thesis
Page 35
Visa's
Forward
P/E
25
20
15
Payout at
$100MM Adj.
Sust. Income
($, MM)
$2,500
$2,000
$1,500
Electronic Payments Investment Thesis
Increase in Payout
for Each $25MM
Adj. Sust. Income
Above $100MM
($, MM)
$625
$500
$375
Page 36