September 14, 2010 - 10:53pm EST by
2010 2011
Price: 200.00 EPS $13.54 $16.27
Shares Out. (in M): 131 P/E 14.8x 12.3x
Market Cap (in $M): 26,200 P/FCF 0.0x 0.0x
Net Debt (in $M): -2,872 EBIT 0 0
TEV ($): 23,328 TEV/EBIT 0.0x 0.0x

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Mastercard is a great business in which partial ownership can be acquired from Mr. Market for only 12.3X 2011 EPS (10X EPS after excluding anticipated net cash).

What is Mastercard worth? One could argue 20X EPS, which would still provide an investor with a 15% return from a 5% earnings yield plus 10% long-term earnings growth. In the near-term, 10% growth is absurdly low and in the long-term no company can grow at 10%, so my target is 15X. I am using consensus estimates; they seem reasonable +/- $1.

FY2010 Consensus EPS: $13.54
FY2011 Consensus EPS: $16.27
FY2012 Consensus EPS: $19.31 (these are a couple days old, may be a bit off)

My 18 month outlook is $330 per share or +65% upside from $200. This assumes a 15X forward EPS of $19 plus $30-40 per share in cash at 12/31/11.

Mastercard's business generates terrific economics. As is well known, Mastercard operates a global electronics payment network, providing services such as authorization (approve/deny payment), clearing (exchange transaction information) and settlement (reconcile transactions and exchange funds). The business generates transactional revenue, but it is more of the recurring variety; the fees are basically a royalty on global economic activity and consumption. The financial metrics are terrific: a Q2 EBIT margin of 52.6% and ROIC of 80% (360% after excluding net cash).

Mastercard is a wide-moat business. The moat is created by the network effects of having a base of 944M card members which can be used in 30.6M merchant locations in 210 countries and 150 currencies. Card issuing banks basically have two network options to ensure global acceptance of their debit or credit cards: Mastercard and Visa. While American Express and Discover are doing a good job improving their own networks, they are still dramatically smaller than the big two. Mastercard and Visa have scale and know-how based advantages. For example, in 2009 Mastercard securely processed 42,637 transactions per minute over their global network for a cost of about 2 cents per transaction (12 cents for total costs, the majority of which are people, consultants and advertising); incremental transaction costs are effectively zero. The network has the capacity to accept 140M transactions per hour with a 140 millisecond response time on a 24x7 basis and historic network availability is 99.9%.

Coke and Pepsi, Visa and Mastercard. Visa's moat is clearly wider than Mastercard's because they have 70-80% more unit and dollar volume than Mastercard and their unit costs are less than 9 cents vs. less than 12. However, I would argue Mastercard is to Visa what Pepsi is to Coke - a strong, entrenched number two (it's also cheaper with less exposure to US debit, which is a risk factor discussed below). The companies have two core customers - card issuing banks and merchants. For the merchants, the two behemoths are more like dual monopolies than competing oligopolies and both are likely to maintain strong acceptance levels. For the card issuing banks, the competitive situation is a more competitive duopoly/oligopoly and this is where Visa is advantaged; American Express and Discover are players here, but only at the margin. Issuers have a incentives to keep a strong number two in business or face monopolistic pricing from a vendor providing a critical business function.

Mastercard's revenue should grow nicely. The growth runway for electronic payments is significant in both developed and emerging markets. Secular growth drivers include increased discretionary spending (EM), market share gains for credit, debit and prepaid vs. cash and checks, inflation and pricing power for the networks. During Mastercard's May 2009 investor community meeting the following macro data was presented: Global personal consumption expenditures grew from $22T to $33T from 2003 to 2008 (+5.5% US, +10.5% ROW, +8.8% WW CAGR) and electronic payments share of the pie grew from 35% to 45% at the expense of cash (47% to 44%) and checks (18% to 11%). By 2013, PCE is expected to grow from $33T to $38T (2.7% 5 year CAGR). Visa's 2010 investor day presentation indicates that cash and check represented just 30% of US PCE in 2009. So the TAM in 2013 is about $26.6T vs. $14.9T in 2008 (+79%). Also, I believe Mastercard and Visa still have good pricing power relative to the utility of their service and as a result of a duopoly industry structure.

Implementation of a common payment system called SEPA creates a near-term growth opportunity for Mastercard in Europe, where they have about 63% debit market share but do not processes transactions. The TAM is about 21B debit transactions, which is huge in comparison to the 22.4B transactions the company processed in 2009 (accounting for 40% of revenue). JPM pegs the opportunity as up to $1.76B in revenue and $7.49 in EPS assuming 100% penetration at 8.5 cents per transaction. A 5 cent transaction fee and 50% penetration rate would add $520M to revenue or $2.21 in EPS.

Why is the stock cheap? Mastercard lost a few high profile accounts to Visa recently; WaMu in the US (JP Morgan consolidated with Visa) and HSBC and RBS in the UK. WaMu is self explanatory. Management asserts that as a result of a debit platform acquisition in the UK they were prohibited from setting debit interchange rates for an interim period; HSBC and RBS were attracted to Visa because of more attractive interchange rates.

Oh, and then there is the Dubin Amendment. Snuck into Fin Reg was a provision for price controls on debit interchange and rules which outlaw network exclusivity for pin-based debit. It is important to understand that Mastercard and Visa do not earn interchange fees. Interchange is a fee earned by the card-issuing banks. Mastercard and Visa fees are generated from assessment fees and transaction processing fees charged to the issuing banks. These fees average about 21 cents per $100 transaction on average. Many analysts assert that lower interchange will pressure the fees charged by V and MA. This is certainly possible, but there are counterpoints.
*Where else are the card issuers going to go? Your choices are Visa and Mastercard, unless you want to restrict your card holders' ability to transact globally.
*Jamie Dimon outlined how his bank would make up for lost debit interchange and overdraft this afternoon at the Barclay's conference: new fees. JD also pointed out that debit interchange of about 75bps is more than fair compared to the hidden costs of cash (theft, security, transport, etc) and check (slow settlement, extra fees for guaranteed payment, check handling costs, online purchases, etc) which can run from 50bps to over 100bps.
*Visa made 2 interesting points at Barclays today. First, prices are already set by competitive bid situations. Second, many valuable features are bundled together with their service, including guaranteed payment and resolution dispute policies. If fees were restricted, Visa will unbundle pricing. Also, if merchants sought to use alternative networks Visa would not offer resolution dispute, etc. It would be problematic for a consumer to buy a product with their Visa card and learn that they have no ability to dispute charges or return a product because of how the merchant routed their transaction.
*US debit revenue accounts for approximately 10% of Mastercard revenue and a lower % of profit. Is this really a big deal for earnings?

Suggested follow up work:
Catch the webcast of Mastercard's analyst day tomorrow (9/14/10).

There are three sell-side research reports I recommend reading:
9/8/10 Merrill Lynch downgrade of Visa
9/13/10 Bernstein downgrade of Visa and Mastercard
6/7/10 JP Morgan report "Could Debit Network Fee Regulation Actually Unlock Value for V/MA?"
The first two highlight the risks, the second highlights the recent capitulation (note the author repeatedly states risks may hurt sentiment, but not earnings) and the last illustrates why the fees charged by Mastercard are actually quite reasonable.

Long-term risks:
Continued government interference and regulation
Disintermediation by existing or new closed-loop networks
Competition from China Union Pay (recent MOU may mitigate?)
Litigation (MA likely settles the Brooklyn merchant litigation within 3 years for $1-2b paid out over several years)

Near-term risks:
Consensus long (although that is not evident by the stock price)
Macro concerns


Execution on the $1b stock buyback announced today
Earnings growth
April 2011 Federal Reserve guidance on debit interchange
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