Mastercard has the exact characteristics that we as portfolio managers truly appreciate: there are almost no competitors, the underlying growth in the industry is high, the business is stable and there are several pockets of growth that the highly competent management can exploit. A return on invested capital of more than 100 percent and a growth rate in free cash flows of more than 15 percent almost says it all.
Mastercard owns and operates one of the world’s largest payment networks. It is a very stable industry that is extraordinary due to the growth rates being high while two companies form a duopoly in the market for global payments (outside of China). Cash payments continue to make up more than half of all consumer payments – however, due to technology and ongoing expansions of the payment network, this share is reduced day by day. For Mastercard, this underlying and structural trend means that the projected growth rates for earnings and free cash flows are between 15-20 percent per year.
For citizens of a Scandinavian country, digital payments are just normal, everyday life, whether by payment cards in a store or online or using a smartphone app, and cash is becoming less and less important. Sweden and Denmark are expected to be virtually cash-free in the next 5 to 10 years. In the rest of the world things are looking quite a bit different. Here, cash continues to be used in more than 55 percent of all consumer payments, though this share is gradually decreasing by about 2 percentage points per year.
These trends are opportunities for Mastercard and Visa (which is also part of our portfolio) to grow for many more years at solid and stable rates. Today, Visa is the world’s largest payment network, but Mastercard is currently gaining small market shares, payment by payment, on the European market.
Due to the increasing number of digital payments, the number of transactions processed on Mastercard’s network are growing by approximately ten percent per year. This is driven by a higher share of transactions and a general increase in level of spending. The growth rate is also supported by a growing e-commerce sector, wherein the number of digital payments is growing approximately four times as fast as in the brick and mortar stores.
There are significant differences between countries and global regions in terms of what proportion of consumer payments are made in cash or digitally. In Europe, cash is used 70 percent of the times a consumer completes a payment, and this is in sharp contrast to Scandinavia. In Denmark and Sweden, less than one out of 10 consumer payments are by cash.
In general, digital payments are the preferred option for many stakeholders. For shops and stores, it means that they have less cash management and it also reduces the risk of theft and they have to pay less for cash transports. For consumers, it is easier to carry a card than having to keep a pile of cash at hand. And last, but not least, the authorities have an interest in increasing the proportion of digital payments. After all, it is significantly easier to trace digital payments, and if digital payments are more widespread, it makes it harder to avoid paying the proper fees and taxes.
Significant monetary reform in India
This very issue led to the government and central bank of India to undertake an extensive replacement of bank notes at the end of 2016. In less than a month, 86 percent of all bank notes in circulation were made unusable, and the people of India thus had to go to the bank and exchange any cash they had for new notes. The government in India does a lot of work towards accelerating the use of digital payments – and of course this means that the Indian market is a major focus area for Mastercard and Visa.
In the short run, the earnings in India will not be a significant part of the earnings growth in Mastercard. By increasing the number of acceptance points that accept the payment cards from the global payment processing giants, Mastercard and Visa increase the chances of them becoming important players in the emerging market. Digital payments are only used in ten percent of payments in developing countries, and there is thus a lot of room for strong and ultimately very profitable growth.
Mastercard’s success in developing countries, including the Asian countries, is something that we see as an expression of the long-term visions among the management, in which Ajay Banga is the CEO. Ajay Banga joined Mastercard as COO in 2009, and prior to that he headed the Asian business unit at Citigroup. Ajay Banga, known for his visions and long-term strategic thinking, is alongside CFO, Martina Hund-Mejean, a significant asset to Mastercard. This management team has worked to create significant shareholder value through a disciplined allocation of capital and sound strategic decisions. Martina Hund-Mejean has been CFO since 2007. We find nothing to indicate that Mastercard will not be able to continue its significant value creation.
Currently, there are 2.4 billion issued Mastercards, and this include credit and debit cards. Mastercard’s customers are not the card holders, but rather the many companies that issue the cards – such as banks. This is an important point to keep in mind, as it also means that Mastercard carries none of the credit risk for its customers, where any defaulted payments would be incurred by the business. This credit risk is carried by the individual card issuers, and this helps to add an element of stability and predictability in the development of Mastercard’s earnings and free cash flows.
Instead, Mastercard’s product is the network that handles the communication between the payer’s and the receiver’s bank. In addition to this network, Mastercard also sells a number of services such as systems that can detect potential cases of fraud or unwarranted use of the card. As e-commerce and other payment methods, where the card “is not present”, continues to grow, the risk of misuse of cards also grow. Thus, Mastercard is making ongoing investments into finding new methods to recognise and halt these payments as efficiently as possible before they are processed.
When a payment is made via a Mastercard, the company receives approximately 0.2-0.3 percent of the payment – this amounts to around 25 cents for every 100 US dollars that go through the network. Several local regulations have been passed, both in the US and Europe, that have focused on the costs to make digital payments and who are to pay the fee (i.e., the cardholder or the store).
In this context, Mastercard by itself only keeps a small part of the charged fee that may amount to around 1.5 dollars for every 100 dollars in transaction volume. The difference between Mastercard’s share and the total fee goes to the other parties involved, and we mainly find the banks as being the ones impacted if limits are implemented to cap the fee.
A scalable business
The marginal cost for each incremental transaction is practically zero for Mastercard. In effect, this means that the incremental operating margin is very attractive, and while Mastercard currently already has an operating margin of 56 percent, this is expected to increase as more and more payments are processed through the network. Visa, which as mentioned is the largest global payment network has an operating margin of more than 65 percent – and the difference between the two levels are mostly an issue of scale.
For both companies, however, the fact is that payment networks do not require significant capital investments and therefore these only amount to two percent of revenue. Due to this low need for investment and the high operating margin, the return on the invested capital are more than 100 percent at Mastercard. Thus, Mastercard is capable of creating significant annual free cash flows, and today these amount to four percent of the market value – and they are distributed to shareholders via a small dividend of around half a percent and share buy-backs amounting to around 3.5 percent of the market value. The management is expecting to grow net revenue by around 13 percent per year and the earnings per share by almost 20 percent. This is value creation on a grand scale, and we are happy to be a part of it.
In addition to the strong focus on developing countries, where India (as mentioned) is a good example, Mastercard is also focused on increasing the proportion of payments made with the issued cards that are processed on the company’s own network. While this proportion is close to 100 percent in the United States, the proportion is less than 45 percent in Europe. One of the reasons why Mastercard’s revenue is currently growing faster than Visa’s is that Mastercard, due to reduced regulations in Europe, has been able to expand its network. Large parts of Europe have regional or national payment networks. Eased European regulations have allowed the global networks to join the competition for payment processing services, just as Visa’s acquisition of Visa Europe from the member banks in Europe has opened up opportunities for Mastercard. The management at Mastercard has been very good at executing on these opportunities.
Today, consumer payments are virtually the entire business in the payment networks, but there is an increasing focus on the opportunities to grow the networks to also include business-to-business payments. Currently only around 30 out of 100 payments made by companies that are processed by the networks while the majority is usually via bank transfers, such as invoices. This is less efficient and more time consuming compared to how the networks could manage the process. Therefore, investments are made in this area as it can result in a significant expansion of the market for both Mastercard and Visa. Mastercard acquired the British company Vocalink in 2017, which is a company capable of administering account-to-account payments that do not use the networks. This expands the payment options that Mastercard has to offer.
Security, security and more security
Investing in IT security is the top priority in all management and board meetings at Mastercard. When a network processes around 85 billion transactions per year – amounting to more than 230 million each day, almost 10 million per hour or almost 2,700 per second (!) – you do not want to skimp on security. The person making a payment must feel completely confident that the right amount will be transferred to the right place, and that he will receive the money if a terminal tells him that the payment is accepted – and at the same time, people need to feel confident that no one can pay with a card that they are not entitled to use. In other words, security is the alpha and omega for these networks.
We view the business models of Mastercard and Visa as being incredibly stable and predictable. The migration from cash to card payments is helping to create a long-term growth curve, and even if consumer spending levels fall during
times of crisis, the networks should be able to maintain their level of revenue
– and thus, also maintain their level of earnings. In addition, the cash flows in these payment giants are inflation proof, as revenue is mostly based on the transaction volumes. At the same time, Mastercard has almost no debt, and this leaves a lot of financial manoeuvrability. Based on prospects of annual growth in earnings and free cash flow per share at around 20 percent, and a long period ahead where significant growth can be maintained, we remain satisfied co-owners – just as we have been for more than 7 years.