MasterCard has an impressive global brand.

by Michael Kon, CFA

On Friday, Visa V and MasterCard MA announced that they have reached a settlement with U.S. retailers in two separate legal battles over credit and debit interchange fees. Visa agreed to pay $4.4 billion to the plaintiffs while MasterCard's share will stand at $790 million. MasterCard will have to add $20 million to an allowance the firm set earlier this year to cover the costs of the settlement while Visa will have to book $4.1 billion charge in the quarter.

In addition to the monetary compensation, the card companies agree to give a 10-basis-point reduction in credit interchange rates for eight months, allow merchants to impose surcharge for card transactions, and to negotiate with merchant buying groups future interchange rates collectively.

Despite the lofty price tag of this settlement, we think the economic implications it will have on Visa and MasterCard in the short term aren't material. Although both companies will report lower earnings in the coming quarter, Visa will recoup the lost earnings by diluting the holdings of its bank owners. MasterCard will have to foot the bill to this settlement but the amount it will pay to retailers won't impact our projections for the payments firm.

In the long run, we think the settlement opens the door for retailers to have a seat at the table when bank interchange fees are being determined. Although merchants' influence on rates could initially hurt issuers more than networks, in the long run, this dynamic could further create a more competitive environment in the network space. We accounted for a more intense competitive landscape in our projections and at this point we are keeping our fair value estimates for both firms unchanged.

Thesis 05/15/12

MasterCard operates the second-largest, open-loop card network in the world. Its clients are financial institutions that issue MasterCard cards to their clients and process card transactions. When a cardholder swipes a MasterCard card, the merchant transfers the card information with the transaction details to an acquisitor--a transaction processor such as First Data, which services merchants by connecting them to the card network. MasterCard then facilitates the authorization, clearing, and settlement of the transaction and charges different fees for each processed transaction. In addition, MasterCard charges card issuers assessments for the right to issue its cards.

We think that connecting thousands of financial institutions through a card network garners MasterCard a wide economic moat. MasterCard has contracts with thousands of issuers around the world that offer its cards to their customers. For issuers, switching from one card network to another is costly, and the incentives aren't that high. On the merchant's side, merchant acquisitors have an interest in acquiring as many transactions as possible and have no incentives to stop acquiring MasterCard's cards. Merchants cannot afford to reject MasterCard because of the potential loss of sales.

MasterCard invests heavily in its brand to ensure that spending on its cards continues. With its "Priceless" marketing campaign, the brand is now better recognized globally and cardholders all over the world know they can shop with it anywhere.

With all these competitive advantages, we think MasterCard is one of the few companies set to benefit from the global trend of moving away from cash and checks toward electronic forms of payment, including cards. We believe this shift, along with increased acceptance of cards for almost any type of payment, is a very fertile field of long-term growth for MasterCard. MasterCard isn't immune to economic headwinds, but in the long run the secular trend of moving away from cash and checks toward electronic forms of payment is likely to remain intact despite any economic challenges. That said, we are carefully watching the actions of competitors as the rivalry in payments is on the rise. In addition, we're paying close attention to new technology such as mobile payments, which could over the long run fundamentally change the competitive dynamics in the payment industry.

Valuation

Our fair value estimate is $394 per share to account for higher growth rates and wider operating margins during the next five years. MasterCard benefits from global growth in the use of credit and debit cards. Despite the tough economic conditions in many markets, MasterCard benefits from strong secular trend of moving toward electronic payments. We model revenue to grow 15% in 2012 and 2013, and to average 10% through 2019. We expect the firm to keep expenses in check, but we doubt that the current operating margin is sustainable. We model operating margins around 47% in the long run, mainly due to higher marketing expenses.

Risk

MasterCard's biggest risk is regulation. New rules on interchange might derail the firm's business model. If governments interfere with the way the network operates, the downside can be substantial. We also think that competitive pressures are mounting and the changing market might bode poorly for MasterCard's future. Several lawsuits allege that MasterCard engaged in anti-competitive and anti-consumer practices. It's very hard to estimate the costs of these lawsuits, but the bill could mount to several billion dollars.

Management & Stewardship

Before joining MasterCard, CEO Ajay Banga served as CEO of Citigroup's C Asia-Pacific businesses and was a member of the bank's senior management team. Banga, despite his limited experience in the card business, has all the qualifications to head MasterCard. Nevertheless, we doubt that his appointment will materially change MasterCard's already attractive growth prospects in foreign markets. What concerns us the most is that management, old and new, has been very willing to open shareholders' wallets when it comes to acquisitions. Although MasterCard's deal-making record isn't that long, management paid lofty prices for all of its recent acquisition targets, which we think could become detrimental to shareholders' returns if these deals grow in size.

Overview

Financial Health: 

The balance sheet looks pristine, although in the future there could be large liabilities related to litigation. MasterCard is flush with cash and has almost no long-term debt.

Profile: 

MasterCard manages a group of global payment card brands, including MasterCard, Maestro, and Cirrus, which it licenses to financial institutions that issue cards to their customers. The firm acts as the payment processor by facilitating the authorization, clearing, and settlement of transactions on its proprietary networks.