Visa: A wonderful business with a strong moat

Visa is basically a technology company in the payments processing industry.  Network effects and economies of scale contribute to the duopoly enjoyed by Visa and Mastercard.  Both companies should grow earnings as they are toll bridges on the secular trend towards electronic payments.

Unfortunately, the valuation remains a little high so this is not one of my best ideas.

Adjusted TTM P/E: 23.47 (source: Yahoo Finance / Capital IQ)
Forecasted earnings growth: “Mid to high teens” (source: Q3 investor presentation)

*Disclosure:  Long Visa.

Company and industry overview

According to Visa’s website:

Visa is a global payments technology company that connects consumers, businesses, banks and governments in more than 200 countries and territories, enabling them to use digital currency instead of cash and checks.

Visa has built one of the world’s most advanced processing networks, capable of handling more than 24,000 transactions per second, with reliability, convenience and security.

Visa does not issue cards, extend credit or set rates and fees for consumers. Visa’s innovations, however, enable its bank customers to offer consumers choices: Pay now with debit, ahead of time with prepaid or later with credit products. In fact, 70 percent of Visa payment transactions in the United States are not credit, but debit and prepaid.

From the world’s major cities to remote areas without banks, people are increasingly relying on digital currency along with mobile technology to use their money any time, make purchases online, transfer funds and access basic financial services. All of which makes their lives easier and helps grow economies.

Generally speaking, electronic payments can often create value for merchants and consumers compared to cash.

  1. It reduces the amount of fraud from counterfeit currency, theft, etc.
  2. Many business have costs associated with handling cash.  They have to regularly count it to detect theft (e.g. from employees and short change scams).  They need to hire security guards to protect the cash and to transport it safely.  The overall level of theft and fraud can be lower with electronic payments.
  3. Electronic payment options allow consumers to make a purchase if they forgot to carry enough cash.
  4. Credit cards allow/encourage consumers to make expensive impulse purchases.
  5. In some cases, electronic payments can reduce labour costs due to a faster checkout process or an automated checkout they doesn’t require a human employee.
  6. Electronic payments facilitate online shopping.  The trend towards more online shopping will increase the market share for electronic payments.

Merchants are allowed to give consumers a discount for using cash (or other non-electronic forms of payments).  Currently, this practice is not very popular among merchants.  To me, this suggests that electronic payments are very valuable to the vast majority of merchants.

Payment processing ecosystem

Acquirers / processors / merchant account provider – These companies process the sale for merchants.  They are responsible for soliciting and screening merchants.

Resellers / payment gateways – They resell the services of the acquirers.  Some resellers are banks (of all sizes).  Generally speaking, the financial industry often charges high prices because their customers are not aware of competing solutions or have difficulty comparing prices due to a lack of price transparency.  Due to numerous hidden charges, many small merchants have a hard time figuring out their costs will be before they sign up.  Often, they calculate their costs by looking at their monthly bills.  I think the industry will see more price competition as the Internet has made it a lot easier for merchants to find low-cost alternatives.

As more commerce moves online, there will be a focus on providing technology services.  Online merchants want payments to integrate into their web stores, want to track the performance of advertising campaigns, digital rights management, features to detect and mitigate fraud, etc. etc.  Software features will be the area where value is added and where these companies will compete.  Visa has entered this line of business through its acquisition of CyberSource.

Issuer – These companies issue the cards.  They try to sign up new customers, take credit risk for their customers, and pay for their cardholders’ purchases.  They are responsible for innovations in rewards programs and (usurious) lending practices.  American Express issues cards while Visa and Mastercard do not.

Card associations / credit card networks – These are the companies (e.g. Visa, Mastercard) that make up the rules and collect the interchange fees.  Visa and Mastercard do not issue cards or take on credit risk.

Card associations have historically enjoyed a close relationship with their issuers.  Many payment processing networks like Visa were started by groups of issuing banks.  Issuing banks can use their existing relationships with consumers to entice them top sign them up for credit and debit cards.  Card associations need issuers so that there is a critical mass of consumers with cards for a particular payment network.  Conversely, the issuers need the card associations to handle issues regarding technology, fraud, regulatory compliance, rules regarding the payment network, etc. etc.  Issuers and payment networks will work together to maximize their profits.  It is in the issuers’ interest to entice consumers to use products with high interchange fees as this generally maximizes their profit.  They may implement rewards programs to encourage consumers to use credit or debit cards over cash.  In general, merchants will grudgingly pay high interchange fees because they do not want to alienate their customers or to inconvenience them.  I believe that this dynamic is beneficial for Visa.

Payment networks are difficult to duplicate

Some of the challenges faced by competing payments networks are as follows:

  1. The “chicken and egg” problem.  A payments network needs to achieve a large number of consumers and merchants on the network.  Consumers are less likely to go through the inconvenience of signing up for an account unless there are many merchants who will accept that particular payment method.  Similarly, merchants won’t bother with a new payments network unless there are enough consumers using it.
  2. Fraud and convenience.  There are tradeoffs between fraud and convenience.  A payments network needs to offer high convenience for consumers without excessive losses from fraud.  There is room here for talented management teams to create value.  A large part of Paypal’s success has to do with its ability to detect and prevent fraud and to provide cost-effective customer service for false positives generated by anti-fraud business practices.
  3. Scale.  A payment network needs enough size to overcome its fixed costs such as regulatory compliance.  I believe that increasing government regulations will present some barriers to entry.

Historically, there have been many companies that have tried to compete against dominant payment networks.  Virtually all of these companies exit the business within a few years.  This occurs even when large banking institutions and venture capital firms support a venture.  Many companies paid large amounts of money to acquire new customers and still did not succeed.  Competition is intense as new entrants are willing to operate at a loss for years.  Citigroup’s c2it (now defunct) used to offer free transfers to compete against Paypal.  The continual failure of competing companies suggest that Visa, Mastercard, and Paypal have very strong moats.  Unlike other industries, payment network companies usually die within a few to several years.  Whereas a second-rate textiles manufacturer such as Berkshire Hathaway might continue operations for decades, upstart payment networks tend to have massive losses and exit the business within a few years.

In the reseller / payment gateway space, competition is also intense.  Many new startups have been able to gain market share and this has been an easier industry to break into.  I think that the reason why startups have succeeded in this area is because the incumbent companies do not enjoy network effects like the card associations do.  Even weaker competitors such as Digital River (see my previous blog post which explains why Digital River is hated by its customers) have been in business for over a decade.  It seems that moats are much stronger in the payment network space than they are in the payment gateway space.

Is Paypal a threat to Visa?

In my opinion, Paypal is not a significant threat to Visa.  In some cases Paypal is one of Visa’s valued partners and it other cases it is a direct competitor.  The area where Paypal competes against Visa is in its system of funding payments through ACH/EFT transfers.  For most non-eBay purchases, these ACH-based payments compete with traditional credit card payments.  However, Paypal’s system is more prone to fraud.  I believe this is why many items such as gift cards and digital downloads cannot by paid for via Paypal’s ACH system and require a credit card to complete the purchase.  It is also a regular practice for Paypal to preemptively freeze the accounts of (honest) merchants and consumers as part of its anti-fraud practices.  Its anti-fraud algorithms aren’t perfect and have often come up with false positives.

Amazon, another company that has experimented with payments through ACH, is currently pushing a Visa-branded credit card instead of its own ACH payment option.  Like Paypal, Amazon seems to have issues with fraud that prevent customers from using ACH for unusually large purchases, gift cards, digital downloads, etc.

My prediction is that Paypal will continue to grow its revenues and market share.  However, it will remain a smaller (though highly profitable) player in the payment processing industry.

Legal settlements and anticompetitive behaviour

Visa has faced many lawsuits due to its dominance in the payments industry.  What I’m interested in is:

  1. What will the cost of these lawsuits be in the future?
  2. Did it behave unethically?

I’ll tackle the second question first.  Some of the criticism directed towards Visa is that merchants pay “excessive” fees.  Many of Visa’s critics make this point even though it is legal to charge high prices.  (In my opinion, it is not unethical to charge high prices or to raise them.)  Legally, Visa’s “anti-steering” and “no surcharge” rules have been attacked for being anticompetitive.  Merchants are not allowed to add a surcharge to purchases funded by a Visa credit or debit card.  However, they are allowed to offer discounts to those paying by cash.  I don’t believe that this practice is clearly anticompetitive or unethical.  This rule protects consumers from hidden charges.  Visa is actually creating value for consumers.  In jurisdictions where surcharges are allowed (e.g Australia), consumers have been abused by excessively high hidden fees when paying with a credit card.  Many states in the US disallow such surcharges to prevent such abuses.  Currently, most merchants do not provide favorable treatment for cash over credit cards even though they are allowed to steer consumers towards cash or other payment options.

The other issue is whether or not Visa has behaved unethically against American Express and Discover.  From Visa’s 10-K:

The complaint alleged, among other things, that the implementation and enforcement of Visa’s bylaw 2.10(e) and MasterCard’s Competitive Programs Policy, or CPP, which prohibited their respective members from issuing American Express or Discover cards violated Sections 1 and 2 of the Sherman Act and California’s Unfair Competition Law, and sought money damages (subject to trebling) and attorneys’ fees and costs.

On October 13, 2008, Visa, MasterCard and Discover reached an agreement in principle to settle the litigation. The parties executed a final settlement agreement on October 27, 2008 that became effective on November 4, 2008 upon approval by holders of Visa’s class B common stock. Visa’s net share of the settlement totaled $1.8 billion, of which $1.74 billion was paid over four quarters from the escrow account established by the retrospective responsibility plan.

Let’s suppose for a second that these tactics were 100% effective in stifling competition.  The end result would be very similar to a regulated monopoly.  Is it unethical to have a regulated monopoly?  I would lean towards saying no.  There should not be a double standard between governments and private businesses.  As far as the issuers are concerned, they have a vested interest in keeping their costs down.  I think that they should be allowed to discourage competition between their “suppliers” (the card associations) if they believe that it will lead to lower costs or other benefits.  In any case, it should be in the issuers’ interests to encourage competition between their suppliers.  I don’t see exclusive deals as being unethical.

As far as the cost of future lawsuits go, I’m not a lawyer.  However, I would simply extrapolate from the past and expect to see Visa face headwinds from regulators due to its dominant market position (much like Microsoft).

Reading the 10-K and other filings

Initial public offering structure

In my opinion, Visa’s structure during the IPO was well though-out as it provided safeguards for IPO investors.  An A/B/C class structure was created.  IPO investors bought class A shares.  Banks/issuers and other parties owned B and C shares.  The class structure has certain elements designed to deal with the conflicts of interest between the IPO investors and the banks.  Firstly, class A shareholders are protected against the cost of settling past litigation.  Class B shareholders will cover all of the litigation costs for cases prior to Visa’s IPO.  When class B shares are converted to A shares, the exchange ratio will be adjusted so that the B shareholders effectively pay for past litigation.

Secondly, class A shareholders are given more voting power than the other classes.  This protects them because the banks’ interests aren’t always aligned with the class A shareholders.  As the banks are also issuers, they want Visa to lower its fees since they own 100% of their issuing business and less than 100% of Visa.

Is management ethical?

I don’t see any red flags.  Insider compensation has actually gone down in the past few years, despite the growth in profits and market cap (which can always be used as excuses to increase insider compensation).

Management is returning cash to shareholders via dividends and share repurchases instead of trying to build an empire.

Adjusted earnings

In its earnings press releases, Visa provides adjusted non-GAAP earnings to help investors understand the performance of the company.  In my opinion, these figures are helpful and aren’t inflated for promotional purposes. Visa does not add stock-based compensation or add “one-time” expenses every year.  The biggest adjustment to Visa’s non-GAAP earnings is the litigation provision for its legal settlement.  Because these legal costs will be covered by class B shareholders, it is not an expense that class A shareholders will have to pay for.  This is the reason why Visa’s non-adjusted P/E ratio is higher than it should be.

Minor tail risks

Firstly, Visa has an indemnity agreement with Visa Europe that could expose it to significant liabilities.  (The IPO consisted of all parts of Visa except Visa Europe.)

Under our framework agreement with Visa Europe, we are required to indemnify Visa Europe for losses resulting from any claims in the United States or anywhere else outside of Visa Europe’s region arising from our or their activities that relate to our payments business or the payments business of Visa Europe. This obligation applies whether or not we or any of our related parties or agents participated in the actions that gave rise to such claims. Such an obligation could expose us to significant liabilities for activities over which we have little or no control. These liabilities would not be covered by our retrospective responsibility plan.

Secondly, Visa faces some settlement risk if the global financial system were to collapse.  If you own many highly-leveraged investment banks then this is a risk that may be worth worrying about because all of these financial companies may lose money at the same time.

The Company’s settlement exposure is limited to the amount of unsettled Visa payment transactions at any point in time. The Company’s estimated maximum settlement exposure was approximately $49.3 billion at September 30, 2012, compared to $47.5 billion at September 30, 2011.

Overall, I do not believe that these risks are that significant.  Every company has some tail risk anyways because the CEO or employees may commit fraud.

Repatriation taxes (aggressive)

Companies have a choice of either assuming that earnings will be repatriated immediately (conservative) or never repatriated (aggressive).  Visa chose the latter.

Cumulative undistributed earnings of the Company’s international subsidiaries that are intended to be reinvested indefinitely outside the U.S. amounted to $2.6 billion at September 30, 2012. The amount of income taxes that would have resulted had such earnings been repatriated is not practicably determinable.

The real expense will likely be somewhere in between.

Visa’s foreign earnings have been increasing.  In YE2009:

Cumulative undistributed earnings of the Company’s international subsidiaries amounted to $276 million at September 30, 2009, all of which are intended to be reinvested indefinitely outside the U.S. The amount of income taxes that would have resulted had such earnings been repatriated is not practically determinable.

In YE2012:

Cumulative undistributed earnings of the Company’s international subsidiaries that are intended to be reinvested indefinitely outside the U.S. amounted to $2.6 billion at September 30, 2012. The amount of income taxes that would have resulted had such earnings been repatriated is not practicably determinable.

The present value of the future tax expense may be a few hundred million dollars a year.  For a company that generates around five billion a year in profit, I do not believe that this accounting distortion is that significant.

Acquisitions accounting (conservative)

One can make the argument that companies earnings can be distorted when accounting rules force them to amortize the cost of intangibles acquired in acquisitions.  In Visa’s case:

Amortization expense related to finite-lived intangible assets was $68 million, $63 million and $10 million for fiscal 2012, 2011 and 2010, respectively.

I do not believe that this accounting distortion is significant.  An amortization expense of 0 would increase earnings by $68M, which is negligible.

Options accounting (overly conservative)

The YE2012 10-K states:

As the Company’s publicly traded stock history is relatively short, historical volatility relies in part on the historical volatility of a group of peer companies that management believes is generally comparable to Visa. The expected volatilities ranged from 31% to 35% in fiscal 2012.

The expected volatility should really be around 27% or less.  Using the historical volatility of peer companies inflates the reported stock-based compensation expense as peer stocks are presumably more volatile than Visa stock.

As share-based compensation was $147M in YE2012, I don’t believe that this accounting distortion is significant.

Bottom Line

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
– Warren Buffett, 1989 letter to shareholders

This is a wonderful company at an ok price.  At an adjusted P/E of around 23, the valuation could be better.  Comparing Visa to Altisource at a P/E of 30, I would rather own Altisource due to Altisource’s much higher growth rate.  Still, I think that Visa is a reasonable investment.  If the multiple stays the same and Visa grows earnings at 15%/year after buybacks (plus some dividends on top of that), returns should be satisfactory.  Management had guided to “mid to high teens” earnings growth so future growth may be a little higher than 15%/year.

5 thoughts on “Visa: A wonderful business with a strong moat

  1. “As far as the issuers are concerned, they have a vested interest in keeping their costs down. I think that they should be allowed to discourage competition between their “suppliers” (the card associations) if they believe that it will lead to lower costs or other benefits. In any case, it should be in the issuers’ interests to encourage competition between their suppliers. I don’t see exclusive deals as being unethical.”

    I’m confused as to what you mean by this. The lawsuit isn’t alleging that the issuers were discouraging competition between the suppliers (Visa, Mastercard, Discover, etc.), it alleges that the suppliers were restricting the issuers from doing business with other suppliers.

    Is your argument that because the card associations (suppliers) were owned by the issuers, any actions on the part of the associations were implicitly supported by the issuers? That may be true, but was every issuer through Visa an owner of Visa? If not, then this is still an issue, since not every issuer would have a stake in Visa’s monopoly, but all of them would bear the costs of that monopoly.

    • In general, I don’t think that the government should interfere. It is unlikely that an oppressive monopoly would form. Ultimately, the issuers could band together again and form a new payments network/card association (this is how Visa’s predecessor was formed). The threat of this would keep Visa in check. Currently, the issuers can simply play Visa and Mastercard against each other. The current market is competitive as all of the card associations are fighting each other. The competition is pushing the card associations to create value, e.g. in making online purchases easier through digital wallets. Maybe society doesn’t need more payment networks. We should let the private market work these issues out.

      Compare and contrast this with the dialysis industry. Government intervention is clearly needed to curb the abuses in the industry. When the suppliers (the kidney doctors and the DaVitas of the world) band together, competition goes down and patients suffer. In payments, cash is always a competitor. And cash never behaves in cartel-like behaviour.

      • I understand your argument–I’m just confused why you said that the issuers were discouraging competition between the credit card associations. Weren’t the associations the ones who were discouraging competition?

  2. Do you think a faster, less costly system of transferring money (something similar to Bitcoin) may eventually be a significant threat to the moats of companies such as Visa and Mastercard?

    • Nope. The technology is the easiest part of their business. Paypal had something like 30-40 competitors. The hard part is figuring out how to fight fraud… I think the only way to learn that is the hard way. Conversely, they have to get good at attracting customers and vendors who won’t commit fraud, so that the legitimate business makes enough to cover the cost of fraud. Compliance is something else that they have to deal with.

      The Canadian debit market is an example of a very low cost system. It won’t get lower due to the cost of fraud and compliance. Visa is trying to slowly turn the Canadian debit market into a high cost system. The banks may be incentivized to encourage this because they will get a piece of the action.

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