The Visa Franchise

My Objectives for an Investment in Visa Stock

I’m conducting a deep dive into Visa’s (V) business through a review of a vast amount of information from various sources. The purpose of my research is to answer two key questions: (1) Is Visa ready for The Prime Portfolio? and (2) What is the degree of my conviction and, therefore, the amount I should allocate toward the investment? I’ve already partly answered these questions, but I’d like to hear the perspectives from the TVC community to fine tune my understanding and expectations for this investment.

How I Think About Visa

Before making an addition to The Prime Portfolio, I ask four questions, which are inspired by Warren Buffett but that I expect to apply according to my own unique investing style:

1. Is the business simple and understandable?

2. Is the business a franchise?

3. What are the business’ prospects 10 to 20 years into the future?

4. Are its profits regulated?

I'll explore the first three of these questions in this post.

In determining the long-term viability of my investment in Visa, I’m laser-focused on long-term strategic developments that could strengthen or weaken the quality of its business. With that in mind, let’s begin the analysis.

The Business of Visa – Is it Simple and Understandable?

In a nutshell, Visa collects a small portion of each credit card and electronic payment that is authorized on its network. It has been likened to a tollbooth-type business on world commerce. The company processes a much higher percentage of digital versus physical location-based payments, and is expected to benefit a great deal from the continuing emergence of online retail and a global shift from cash and checks to electronic payments.

The company operates what is effectively a global duopoly with MasterCard (MA) in what’s sometimes referred to as the four-party payments model. The way the system works is that issuers (consumer banks) provide credit cards to consumers who then use them to make purchases from merchants.

Upon presenting a card for payment, the transaction data from a customer’s purchase is transmitted by the merchant to the merchant acquirer (payment processing company), and the information is then routed to Visa or MasterCard to authorize, clear, and settle the transaction.  The issuer releases the funds to the merchant, while a merchant service charge is withheld and shared among the issuer, acquirer, and payment network. The lion’s share of the fee goes to the issuer (largely to reflect their credit risk and responsibility for fraud protection), with the next largest amount to the acquirer, then the small remaining amount to the network (usually Visa or MasterCard). The entire process is facilitated by the payment networks, and is depicted graphically in the illustration below. 

Source: MasterCard SEC 10-K Annual Report

Source: MasterCard SEC 10-K Annual Report

The basics are relatively simple if one will devote some effort to understanding it but, as we will soon see, there are major technological shifts under way in the industry. The outcome of this rapid innovation remains uncertain and difficult to accurately predict.

For now, though, it’s important to note that for each stakeholder within the four-party model, there are a large number of participants: issuers, consumers, and acquirers. But there’s one exception: the payments networks. Visa’s network dominates the global market, and they have spent decades organizing the system by gaining acceptance with a vast number of financial institutions (issuers), distributing billions of cards to consumers, and ensuring a secure and reliable network capable of processing several times in excess of its current processing volume of approximately 3,000 transactions per second.

The large scale and coordination of the disparate parties into a cohesive unit in a network system that works on time, every time is a big part of what makes the payment networks’ business model so strong. The next question to investigate is how strong this business model is and whether it represents a long-term, entrenched, and reliably profitable business franchise.

The Visa Franchise

A franchise business is one that is needed or desired and that has no close substitute. In the business world of today, Visa is one of just a few providing their critical service. Their payments network connects all the parties on each side of credit card and digital payments transactions: consumers, merchants, payments processors, and card issuing banks.

The Visa network encompasses approximately 17,000 financial institutions and 44 million merchants. While there are thousands of financial institutions and millions of merchants, there are just a handful of payment networks of any significant scale: Visa, MasterCard, American Express (AXP), Discover (DFS), and China UnionPay. No one will challenge the assertion that the payment networks hold the power in the current payments value chain. Visa has 58% global market share according to the Nilson Report as reported by Morningstar, and together with Mastercard the two handle 80% of all purchase card transactions worldwide.

At a time when rapid technological innovation is diminishing the power of many long-time players within the four-party payments ecosystem, the networks have been largely unaffected. The source of Visa’s power in the industry comes from its ability to coordinate a network of worldwide acceptance among the vast number of industry participants described above. Consider the words of industry expert Karen Webster, from her article on PYMNTS.com:

"All of the innovation that has been unleashed as a result of the new technologies and ways of interacting at merchants still rides the existing network rails. Why? They have built universal acceptance at all physical merchant locations now on an international scale, and that is a very, very difficult capability to replicate without great expense and over a very long time frame."

Morningstar Analyst Jim Sinegal chimes in with his own take on Visa’s entrenched competitive position:

"Its effective network of 16,800 financial institutions, 44 million merchants, and billions of cards. . .creates a formidable barrier to entry. While many potential competitors have close connections to consumers, the global financial institutions that rely on Visa are much harder to penetrate. Indeed, firms like Apple and Alphabet have chosen to use existing networks to process payments in the digital environment. . ."

Add to that the fact that the Visa network processes nearly 100 billion transactions per year, with merchants, customers, and banks confident that each one will be safe, secure, and authorized within seconds. And Visa management claims to have capacity many times in excess of its current volume.

Matt Coffina of Morningstar’s superb StockInvestor service notes that Visa’s moat is among the widest around and that the company possesses elements of all five sources of competitive advantage: intangible assets, a network effect, switching costs, cost advantages, and efficient scale.

And the company’s fundamentals bear out its dominance and franchise quality: operating margins ranging from 52% to 65% in the past four years, net margins of 40% to 45%, conservatively financed with minimal debt first added in 2016, robust cash flow, and a total shareholder yield (combined dividend and share repurchases) of 2.5% to 5.0% over the past six years. A six-year financial analysis of some key financial data for Visa is displayed in the image below:

While merchants complain about high credit card fees eating away at their profits, the vast majority of those fees are collected by issuers and processors, leaving only a small fraction to Visa. In fact, out of the trillions of dollars of payments volume moving across its network, Visa recorded revenue of just $15 billion.

So, while merchants may not like high card fees, only a small fraction of those are collected by the networks, with the remainder going mostly to banks to cover the costs of information security, default risk, and any associated profit margin necessary to facilitate the extension of credit to consumers which leads to a higher volume of revenue for merchants. Like it or not, in the current industry environment, Visa is deeply entrenched and turns remarkably high profits by taking a tiny cut of each payment that’s authorized and settled on its network. For now, Visa’s franchise is as strong as ever.

What Are Visa’s Prospects 10 to 20 Years into the Future?

There are a few companies with an established, dominant competitive position similar to that of Visa, but many of them have no clear path to future growth. From what we can see today, Visa has no such challenges. The company is positioning itself to be a primary beneficiary of expanding e-commerce, emerging payments technologies, and the secular shift from cash and checks to digital spending.

As more and more digital payments proliferate, Visa stands to gain even greater share of worldwide payments. As the slide below demonstrates, 43% of digital payments ride Visa’s network rails versus just 15% of physical retail spending, tripling its share for each dollar moving from physical retail to digital.

This massive advantage of Visa in digital spending means that the importance of the cashless revolution can’t be understated. And the opportunity is vast. Barron’s points out that even in the advanced economy of Germany 70% of transactions are still made in cash. Management explains that cards’ share of worldwide transactions have grown from 31% in 2012 to 36% in 2016. The opportunity is immense and this evolution is in its early innings, making for a long runway for future growth.

We already discussed how the shift to e-commerce is affecting this growing trend, but even in the physical world new payments technologies are becoming more widespread. Consumer behavior is gradually evolving with the ubiquity of smartphones and shift to mobile payments. And the trend is just beginning. With the internet of things, internet-connected devices could easily total 21 billion within a few short years.

In order to accomplish its strategic initiative to expand access to capture the upcoming growth opportunity, Visa management is researching methods to embed Visa in these connected devices to enable easy and convenient payment methods. Management’s vision is for a transition from 3 billion payment cards today to 30 billion connected payment devices in the future.  

As if the previous statistics weren’t convincing enough, Visa has some additional untapped global growth opportunities. China is opening up its country to foreign payments companies, and Visa is partnering with UnionPay, the largest network in China. The Chinese market is estimated at $8.4 trillion of payments volume. And Visa is looking to gain a foothold in another massive market: business-to-business payments. The vast majority of accounts payable payments are made by check. Shifting these transactions to electronic form would open up an estimated $13 trillion of new payments volume. Transitioning other B2B transactions to electronic form holds promise for Visa as well, as summarized in the image below.

So, to answer the question posed, what does the future look like for Visa? The opportunities presented make it appear quite promising, with the market potential measured in the billions (of revenue) and tens of trillions (in payments volume). But let’s also hear some other professionals’ perspectives:

1. In an article published on Sum Zero in September 2016, Talguard Investments Fund Manager Dan Chen summed up his thesis by stating that, “Visa has decades-long catalysts, the likes of which the market doesn’t care much about.” That's because the intense focus on short-term performance obscures the larger long-term opportunity.

2. In an interview with the Motley Fool, CEO Jason Oxman of the payments industry group Electronic Transactions Association said that:

"One of the things that’s most important about a payments system or network is security and reliability.  So, there’s a reason that. . .Visa invests hundreds of millions of dollars. . .in the network. . .  So, if I’m thinking 10 years from now, will there still be payments networks that are interoperable, that are interactive?  Absolutely, there will be, because that’s where the utility comes from."

So, if Visa can maintain the most reliable and secure network and prevent competitors from creating similar capabilities, their future could be very bright, despite all of the disruption expected to affect various parts of the payments ecosystem.

3. Referencing Morningstar’s Jim Sinegal again, he believes that “Visa is winning the payment wars,” and that, “if competitors fail to take share during the transition from cards to mobile payments, Visa could be entrenched for decades to come.”

All of these analyses, if proven correct, provide evidence that Visa is exactly the type of company that fits the criteria I want to build out The Prime Portfolio.

All told, a dominant business model, growth in e-commerce, a potential shift in business-to-business payments, the internet of things, an expected entrance into China, and the overall global opportunity of the rapid transition to electronic payments in our increasingly digital world mean that Visa’s long-term prospects are highly promising and that world commerce could be riding its rails in increasing volume for a very long time into the future.

Disclosure: Jason Rowland owns shares of Visa (V) and all stocks in both The Prime Portfolio and The Action Portfolio.

Disclaimer: I am not a registered investment advisor. I receive no compensation from any of the companies of which I own shares and of which I write about. The strategies discussed are designed to suit my own investment objectives, not those of any other individual. They are for illustrative and educational purposes, and they are not guaranteed to be effective. It is possible that not all material information will be discussed about each security highlighted on the site.

All investments involve risks. All information on The Virtuous Cycle website is general analysis and my own interpretations of available information. It is neither financial nor investment advice, nor is it a recommendation to buy or sell any security based on an individual's specific investment goals or financial situation. Individuals must do their own due diligence and determine how each investment fits into their own investment and financial plans prior to making their own investment decisions.