Mastercard is in a sweet spot, where the demand for the company’s services is growing significantly. Thus, the underlying growth is excellent for one of the world’s leading payment networks, and so is the marginon the core business. It is so high, in fact, that many other highly profitable industries can only look at with envy. Exciting potential awaits in India.
Electronic payments are becoming an increasing part of everyday life all over the world, whether it be paying with cards in stores, online shopping or through smartphone apps. Mastercard is one of the world’s leading payment networks, and only Visa (which is also one of our companies) has a larger share of payments and processes more payments globally. These global networks can handle more transactions in multiple countries and across national borders than their competitors, who are typically national or regional networks, such as China Union Pay in China or American Express whose main business is in the United States.
Large parts of the future value creation are to come from this increased usage of electronic payment options. Payments with cash and cheques still account for around 58 percent of all payments globally outside of China. This share is expected to decrease by around two percentage points per year, and this will result in around ten percent annual market growth in the number of processed transactions.
Of course, the share of electronic payments and card payments vary a lot from region to region. While the countries of Northern Europe are at the forefront of this development, and Sweden is expected to go cashless within the foreseeable future, the number of cash payments in Europe still account for more than 70 percent. It is not just in the networks’ interests to reduce the share of cash payments, it is also an advantage for store managers and governments. Handling cash is both burdensome and costly for the stores, and the absence of cash naturally also reduces the incentives for potential robbers to break in.
States around the world need electronic payments
States around the world have a keen interest in promoting electronic payments, since doing so will make it harder to perform tax evasion, as their income are registered from numerous sources via the electronic payments. A good example of this is India, where the National Bank at the end of 2016 in a short period of time made around 86 percent of cash notes invalid and forced the residents to go to the banks and exchange these notes for new and different ones. This was part of a strategy to clean up the country’s black economy, and it allowed the banks to register how many cash notes were distributed to each individual. Electronic payments will make it easier for tax authorities to administer this.
Mastercard has been focused on expanding payment acceptance, including India despite being aware that the short-term profit in the country is not overwhelming. However, making it easier to use cards or other electronic payment are assessed to be attractive in the long run. The CEO of Mastercard is Indian-born Ajay Banga the head of the Asian business unit at the American bank, Citi Group, prior to joining Mastercard. We view this as a strong asset for the company, as Ajay Banga can make use of his previous experience in the region. Senior management includes Martina Hund-Mejean, who has been CFO since 2007. This senior management team has created significant shareholder value, and it is expected to continue to create growing cash flows – something which is bound to please the co-owners.
Even though Mastercard has its name on 2.4 billion cards, the company is not itself at risk in the payments. The customers are not the ultimate cardholders, but the banks and institutions who issue the cards to people around the world. Along with the processing power, Mastercard also sells a number of services, including systems used to identify potential credit card fraud or misuse.
The expectations for growth have been dialled up
As more and more commerce take place online, the risk of misuse will also increase. This is one of the reasons why the payment to Mastercard is higher for transactions where the card is not necessarily physically present, e.g. payments made in an online store. Mastercard’s average yield per transaction amount to 0.2-0.3 percent of the purchase amount. The regulation of card fees in the last few years thus primarily impact the banks, who charge up to one and a half to two percent of the transaction amount.
The costs per transaction for Mastercard, however, are very nearly zero, and the incremental margin is thus very high. This has resulted in Mastercard today having margins around 55 percent – a number that is significantly higher for Visa, but this can be attributed to these same economies of scale advantages. It is estimated that the profit margin on the core business – processing payments – amounts to 85-90 percent.
In the fall of 2017, senior management increased its projections for growth for the next three years. The expectations thus now state that net revenues is to grow by approximately 13 percent, the operating margin continue to be more than 50 percent, and finally, the earnings per share should grow by 20 percent annually. These are high growth rates, but they are highly plausible. However, it is critical that this growth can be achieved without significant capital expenditures, as the annual investments amount to approximately two percent of net revenue and are mainly directed towards investments in the IT systems that process payments and guarantee security. This means that the returns on the invested capital are more than 100 percent.
The free cash flow yield is around four percent, and of these, the majority are distributed to shareholders through ongoing dividend payments just below one percent, and the rest through value-creating share buybacks. The buybacks result in the non-selling shareholders getting a larger share of the value in the future.
IT security is high on the agenda
In 2017, Mastercard acquired the British company, Vocalink. This is part of the expansion of Mastercard’s addressable market, where there will be an increased focus on increasing the share of electronic payments between companies. The proportion of business-to-business payments made electronically is lower than it is for consumer payments, and therefore, there are more revenue opportunities. The development of new payment methods such as payments via apps, e.g. ApplePay, is just another day at the office for Mastercard and Visa, since their global payment network makes them extremely attractive business partners.
This also means that IT security is a primary risk, and fortunately, the management is keenly aware of this. In 2017, more than 75 billion transactions were made on Mastercard’s network (equivalent to more than 2,300 per second), and over the last year, the focus has increased on anonymising this data so that there will be no useful information in the numbering of transactions or the like for outsiders. In a modern world where more and more objects are connected to the internet – whether this be smartphones, tablets, cars, TVs, etc. – this leads to more potential access points of information. Network security is thus on the agenda of all senior management meetings at Mastercard, and it is also on the agenda every time we communicate with the company’s competent senior management team.
Mastercard significantly beats Bitcoin when it comes to speed
When developing solutions, there is a balancing act between making it increasingly easy to make the payments, while at the same time reducing the risk of unwarranted use of the cards. This might lead to using finger touch IDfor ApplePay. However, Mastercard has also developed the technology for Selfiepay, where a sensor can recognise your appearance and approve payment if there is a positive match. Through 2017, the so-called cryptocurrencies, including Bitcoin, have been frequently spoken of. Mastercard and Visa have also worked with the underlying technology, blockchain, since this may have future applications in certain types of payment situations. In that context, it is interesting, however, that the speed of a Bitcoin transfer can in no way match the speed with which Mastercard can process a payment – and therefore, while blockchain technology might be applicable, it is somewhat doubtful that it could be used to pay for your Starbucks coffee or your supermarket groceries.
The cash flows in Mastercard and Visa are delightfully inflation-proofed, since the revenue is based on the transaction amounts from the issued cards. Due to the high profitability and the low need for investments, all of the earnings convert to free cash flows, and this is why the cash flows are expected to grow at the same pace as the 20 percent earnings growth. With this in mind, we find the current pricing attractive, and we therefore look forward to many more years of significant value creation that will certainly benefit long-term co-owners.