Why I Own Mastercard Shares

Mastercard (NYSE: MA) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Mastercard shares for the portfolio in December 2014 at a price of US$89 and subsequently made three more purchases (in February 2015 at US$85, in March 2017 at US$111, and in June 2019 at US$267). I’ve not sold any of the shares I’ve bought.

The purchases have worked out very well for my family’s portfolio, with Mastercard’s share price being around US$303 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Mastercard shares.

Company description

The US-headquartered Mastercard should be a familiar company to many of you who are reading this. Chances are, you have a Mastercard credit card in your wallet. But what’s interesting is that Mastercard is not in the business of issuing credit cards – it’s also not in the business of providing credit to us as consumers.

What Mastercard does is to provide the network on which payment transactions can happen. Here’s a graphical representation of Mastercard’s business:

Let’s imagine you have a Mastercard credit card and you’re buying an item in a NTUC supermarket. The transaction will involve five parties: Mastercard; the cardholder (you); the merchant (NTUC); an issuer (your bank that issued you the credit card); and an acquirer (NTUC’s bank). The transaction process will then take place in six steps:

1. Paying with your Mastercard credit card: You (cardholder) purchase your item from NTUC (the merchant) with your credit card.
2. Payment authentication: NTUC’s point-of-sale system captures your account information and sends it to NTUC’s bank (the acquirer) in a secure manner.
3. Submission of transaction: NTUC’s bank gets Mastercard to request an authorisation from your bank (the issuer).
4. Authorisation request: Mastercard sends information of your transaction to your bank for authorisation.
5. Authorisation response: Your bank authorises your transaction and pings the go-ahead to NTUC.
6. Payment to merchant: Your bank sends the payment for your transaction to NTUC’s bank, which then deposits the money into NTUC’s bank account.

Mastercard’s revenue comes from the fees it earns when it connects acquirers and issuers. In 2019, Mastercard earned US$16.9 billion in net revenue, which can be grouped into five segments:

• Domestic assessments (US$6.8 billion): Fees charged to issuers and acquirers, based on dollar volume of activity, when the issuer and the merchant are in the same country.
• Cross-border volume fees (US$5.6 billion): Charged to issuers and acquirers, based on dollar volume activity, when the issuer and merchant are in different countries.
• Transaction processing (US$8.5 billion): Revenue that is earned for processing domestic and cross-border transactions and it is based on the number of transactions that take place.
• Other services (US$4.1 billion): Includes services such as data analytics; consulting; fraud prevention, detection, and response; loyalty and rewards solutions; and more.
• Rebates and incentives (-US$8.1 billion): These are payments that Mastercard pays to its customers. Revenues from domestic assessments, cross-border volume fees, transaction processing, and other services collectively make up Mastercard’s gross revenue. We arrive at Mastercard’s net revenue when we subtract rebates and incentives from gross revenue.

With the ability to handle transactions in more than 150 currencies in over 210 countries, it should not surprise you to find that Mastercard has a strong international presence. In 2019, the US accounted for just 32% of the company’s total revenue; no other individual country took up a revenue-share of more than 10%.

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Mastercard.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

On the surface, Mastercard’s business already looks huge. The company processed 87.3 billion switched transactions in 2019, with a gross dollar volume of US$6.5 trillion; these helped to bring in US$16.9 billion in net revenue.

But the total market opportunity for Mastercard is immense. According to a September 2019 investor presentation by the company, the size of the payments market is US$235 trillion. From this perspective, Mastercard has barely scratched the surface.

It’s worth noting too that around 80% of transactions in the world today are still settled with cash. So there are still plenty of cash-based transactions available for Mastercard to divert to its network.

Mastercard formed a JV with NetsUnion Clearing Corporation last year to conduct business in China. Earlier this month, the JV received in-principle approval from China’s central bank to operate in the country. Prior to this, Mastercard had no operations in China, so the regulatory approval could pave the way for a huge new geographical market for the company. NetsUnion Clearing Corporation’s stakeholders include China’s central bank, the People’s Bank of China. The JV will be able to apply for formal approval within a year.    

2. A strong balance sheet with minimal or a reasonable amount of debt

At the end of 2019, Mastercard had US$7.7 billion in cash and investments on its balance sheet, against US$8.5 billion in debt. This gives rise to US$0.8 billion in net debt.

I generally prefer a balance sheet that has more cash than debt. But I’m not troubled at all in the case of Mastercard. That’s because the company has an excellent track record in generating free cash flow. The average annual free cash flow generated by Mastercard in 2017, 2018, and 2019 was US$5.0 billion, which compares well with the amount of net-debt the company has.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Ajay Banga, 60, is Mastercard’s President and CEO. He has been CEO since July 2010, and I appreciate his long tenure. In 2018, Banga’s total compensation was a princely sum of US$20.4 million. But that is reasonable when compared with the scale of Mastercard’s business – the company’s profit and free cash flow in the same year were US$8.1 billion and US$5.5 billion, respectively. More importantly, his compensation structure looks sensible to me as a shareholder of the company. Here are the important points:

• In 2018, 66% of Banga’s total compensation was from stock awards and stock options that vest over multi-year periods (three years and four years, respectively).
• The stock awards are based on Mastercard’s revenue and earnings per share growth over a three-year period. I emphasised “per share” because Mastercard shareholders can only benefit from the company’s growth if there is per-share growth. 
• The value of the stock awards and stock options are nearly the same.

The lion’s share of the compensation of most of Mastercard’s other key leaders in 2018 also came from stock awards and stock options. This is illustrated in the table below.

It’s worth noting too that Mastercard’s management each have many years of experience with the company. Current CFO Sachin Mehra replaced Martina Hund-Mejean when the latter retired in April 2019; Mehra first joined Mastercard in 2010. The fact that Mastercard promotes from within is also a positive sign for me on the company’s culture.

There’s also a point I want to make on the alignment of interests between Banga and Mastercard’s shareholders: As of 26 April 2019, he controlled 1.859 million Mastercard shares which have a value of around US$563 million at the current share price. That’s a sizeable stake which likely places him in the same boat as other shareholders of the company.  

On capability and innovation

Mastercard is a digital payment services provider. Some of the key business metrics that showcase the health of its network are: (1) Gross dollar volume, or GDV, of payments that flow through the network; (2) cross-border volume growth; (3) the number of processed transactions; and (4) the number of the company’s cards that are in circulation. The table below shows how the four metrics have grown in each year since 2007. I picked 2007 as the start so that we can understand how Mastercard’s business fared during the 2008-09 Great Financial Crisis.

It turns out that Mastercard’s management has done a great job in growing the key business metrics over time. 2009 was a relatively rough year for the company, but growth picked up again quickly afterwards. As mentioned earlier, current CEO Ajay Banga had been leading the company since 2010, so the increases in the business metrics from 2007 to 2019 had happened mostly under his watch.

As another positive sign on Mastercard’s culture (I talked about the promotion from within earlier), we can look at Glassdoor, a website that allows a company’s employees to rate it anonymously. 96% of Mastercard’s employees who have submitted a review approve of Banga’s leadership, while 81% will recommend a job in the company to a friend. I credit Mastercard’s management, and Banga in particular, for building a strong culture.

Coming to innovation, Mastercard’s management has, for many years, been improving the payments-related solutions that it provides to consumers and organisations. This is aptly illustrated by the graphic below, which shows the changes in Mastercard’s business from 2012 to 2018:

Here are some interesting recent developments by Mastercard:

• Launched Mastercard Track in 2019; Mastercard Track is a B2B (business-to-business) payment ecosystem which helps to automate payments between suppliers and buyers.
• Drove blockchain initiatives in 2019, in the areas of cross-border B2B payments and improving provenance-knowledge in companies’ supply chains.
• Implemented AI-powered solutions to prevent fraudulent transactions and improve fraud detection. 

In particular, the B2B opportunity is huge and worth tackling, because companies do encounter many pain-points that are related to payment issues. This is shown in the graphic below.

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

I think Mastercard is a great example of a company with recurring revenue from customer-behaviour. Each time we make a purchase and we pay with our Mastercard credit card, the company takes a small cut of the payment.

I showed earlier that the company handled trillions in dollars worth of payments in 2019, and processed billions in transactions. These numbers, together with the fact that no individual customer accounted for more than 10% of Mastercard’s revenues in 2019, 2018, and 2017, lend further weight to my view that the company’s revenue streams are largely recurring in nature.     

5. A proven ability to grow

The table below shows Mastercard’s important financials from 2007 to 2019:

A few key points about Mastercard’s financials:

• Net revenue compounded decently at 12.6% per year from 2007 to 2019; over the last five years from 2014 to 2019, the company’s annual topline growth was similar at 12.3%. 
• The company also managed to produce net revenue growth in 2008 (22.7%) and 2009 (2.1%); those were the years when the global economy was rocked by the Great Financial Crisis.
• Net profit surged by 18.2% per year from 2007 to 2019. Mastercard’s net profit growth from 2014 to 2019 was similarly healthy at 17.5%. Net profit was negative in 2008 because of large legal settlement expenses of US$2.5 billion incurred during the year, but it is not a cause for grave concern for me. 
• Operating cash flow grew in most years for the entire time frame I studied; increased markedly with annual growth of 21.8%; and had been consistently positive. The growth rate from 2014 to 2019 was still impressive at 19.2% per year.
• Free cash flow, net of acquisitions, was consistently positive too and had stepped up from 2007 to 2019 at a rapid clip of 20.1% per year. The annual growth in free cash flow from 2014 to 2019 was 16.8% – not too shabby. It’s worth noting that Mastercard’s capital expenditure of US$2.6 billion in 2019 is significantly higher compared to the past primarily because of large acquisitions totalling US$1.4 billion. Without the acquisitions, Mastercard’s free cash flow in 2019 would be much higher at US$7.0 billion.  
• The net-cash position on Mastercard’s balance sheet was positive from 2007 to 2018 and had dipped into negative territory only in 2019. I mentioned earlier that I’m not troubled by Mastercard currently having more debt than cash, since the company has been adept at producing free cash flow and the amount of net-debt is manageable. 
• Mastercard’s diluted share count declined by 24% in total from 2007 to 2019, and also fell in nearly every year over the same period. This is positive for the company’s shareholders, since it boosts the company’s per-share earnings and free cash flow. For perspective, Mastercard’s free cash flow per share compounded at 20.0% per year from 2014 to 2019, which is higher than the annual growth rate of 16.8% over the same period for just free cash flow. Mastercard’s share price has also increased by a stunning amount of nearly 3,000% in total since the start of 2007. This means that the share buybacks conducted over the years by Mastercard’s management to reduce the share count have been excellent uses of capital. 

In Mastercard’s 2019 fourth-quarter earnings conference call, management guided towards net revenue growth in the low-teens range for 2020. Growth in the first quarter of 2020 was expected to be around two percentage points lower than the whole year. But in late February, Mastercard updated its forecast for net revenue growth. The ongoing outbreak of COVID-19 has negatively impacted cross-border travel and cross-border e-commerce growth. As a result, Mastercard now expects its 2020 first-quarter net revenue growth to be “approximately 2-3 percentage points lower than discussed [during the earnings conference call].” Mastercard added:

“There are many unknowns as to the duration and severity of the situation and we are closely monitoring it. If the impact is limited to the first quarter only, we expect that our 2020 annual year-over-year net revenue growth rate would be at the low end of the low-teens range, on a currency-neutral basis, excluding acquisitions. We anticipate giving further updates on our first-quarter earnings call.”

No one knows what kind of impact COVID-19 will eventually have on the global economy. But I’m not worried about the long-term health of Mastercard’s business even though COVID-19 has already made its mark. My stance towards COVID-19 is that this too, shall pass.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

There are two reasons why I think Mastercard excels in this criterion.

First, the company has a long track record of producing strong free cash flow from its business. Moreover, its average free cash flow margin (free cash flow as a percentage of revenue) in the past five years from 2014 to 2019 was strong at 33.5%. In 2019, the free cash flow margin was 32.9%.

Two, there’s still tremendous room to grow for Mastercard in the entire payments space. The company has a strong network (the number of currencies it can handle; the number of countries it operates in; the sheer payment and transaction volumes it is processing; the billions in its self-branded credit cards that are circulating) as well as a capable and innovative management team that has integrity. These traits should lead to higher revenue for Mastercard over time. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t – that will mean even more free cash flow for Mastercard in the future.

Valuation

I like to keep things simple in the valuation process. In Mastercard’s case, I think the price-to-earnings (P/E) ratio and price-to-free cash flow (P/FCF) ratio are suitable gauges for the company’s value. That’s because the company has been adept at producing positive and growing profit as well as free cash flow for a long period of time.

Right now, Mastercard carries trailing P/E and P/FCF ratios of around 38 and 56 at the current share price of US$303. These ratios look expensive, and are also clearly on the high-end (see chart below) when compared to their own histories over the past five years.

(Note: The chart above is from Ycharts and the P/FCF ratio excludes the impact of acquisitions. Using my own numbers for Mastercard, the company’s P/FCF ratio falls to 44 if I remove acquisition-related effects. My P/FCF ratio and that from YCharts are not the same, but they are similar enough. Moreover, I’m only relying on the P/FCF chart for general guidance.)

But I’m happy to pay up, since Mastercard excels under my investment framework. I also want to point out that Mastercard not only has a large market opportunity – the chance that it can win in its market is also very high, in my view. Put another way, Mastercard scores well in both the magnitude of growth and the probability of growth. For companies like this, I’m more than willing to accept a premium valuation. But the current high P/E and P/FCF ratios do mean that Mastercard’s share price could be volatile going forward. This is something I have to be – and I am – comfortable with.

The risks involved

There are a few key risks that I see in Mastercard.

First is a leadership transition. Mastercard announced earlier this month that long-time CEO Ajay Banga will become Executive Chairman on 1 January 2021. Current Chief Product Officer, Michael Miebach, will succeed Banga as CEO on the same date. Given the timeline involved, the transition seems planned. Miebach, who’s relatively young at 52 this year, joined Mastercard in June 2010. Again, this promotion from within is a positive thing in my view. Banga has high-praise for Miebach, commenting in the announcement:

“As the company moves into this next phase of growth, we have a deep leadership bench–with Michael at the helm–to take us to the next level. He has a proven track record of building products and running businesses globally.

Over his career, Michael has held leadership positions in Europe, the Middle East and Africa and in the U.S. across payments, data, banking services and technology. During the course of Michael’s 10 years at Mastercard, he has been a key architect of our multi-rail strategy–including leading the acquisition of Vocalink and the pending transaction with Nets–to address a broader set of payment flows. He’s also a visionary who kickstarted much of the work behind our financial inclusion journey.

I am excited to continue working closely with Michael and supporting Mastercard’s success when I become Executive Chairman.”

Miebach looks like a safe pair of hands and Banga will still continue to have a heavy say on Mastercard’s future given his upcoming role as Executive Chairman. But I will be keeping an eye on this leadership transition.

Competition is the second risk I’m watching. I mentioned in my investment thesis for PayPal (a digital payments services provider) that the payments space is highly competitive. There are larger payment networks such as that operated by Mastercard’s competitor, Visa (which processed US$11.6 trillion on its platforms in the 12 months ended 30 September 2019). In my PayPal thesis, I also said:

“Then there are technology companies with fintech arms that focus on payments, such as China’s Tencent and Alibaba. In November 2019, Bloomberg reported that Tencent and Alibaba plans to open up their payment services (WeChat Pay and Alipay, respectively) to foreigners who visit China. Let’s not forget that there’s blockchain technology (the backbone of cryptocurrencies) jostling for room too. There’s no guarantee that PayPal will continue being victorious. But the payments market is so huge that I think there will be multiple winners – and my bet is that PayPal will be among them.”

Just like PayPal, there are no guarantees that Mastercard will continue winning. But I do think the odds are in Mastercard’s favour.

Regulations are the third risk I’m watching. Payments is a highly regulated market, and Mastercard could fall prey to heavy-handed regulation. Lawmakers could impose hefty fines or tough limits on Mastercard’s business activities. In general, I expect Mastercard to be able to manage any new legal/regulatory cases if and when they come. But I’m watching for any changes to the regulatory landscape that could impair the health of Mastercard’s business permanently or for a prolonged period of time.

Lastly, there is the risk of recessions. Mastercard did grow its net revenue in 2009, but the growth rate was low. I don’t know when a recession in the US or around the world will hit. But when it does, payment activity on Mastercard’s network could be lowered. As I mentioned earlier, COVID-19 has already caused a softening in Mastercard’s business activity. 

The Good Investors’ conclusion

To wrap up, Mastercard excels under my investment framework:

1. The payments market is worth a staggering US$235 trillion and Mastercard has barely scratched the surface.
2. The company currently has more debt than cash, but the net-debt level is manageable and the company has a strong history of producing free cash flow.
3. Mastercard’s management team has proved itself to be innovative and capable, but that’s not all – the company’s leaders also have sensible compensation structures that align their interests with shareholders.
4. Mastercard’s revenue streams are highly likely to be recurring in nature (each time we make a payment with a Mastercard service or product, the company gets a cut of the transaction).
5. The company has a long history of growing its net revenue, profit, and free cash flow, while keeping its balance sheet strong and reducing its share count.
6. There is a high likelihood that Mastercard will continue to be a free cash flow machine.

The company does have a high valuation – both in absolute terms and in relation to history. But I have no qualms with accepting a premium valuation for a high-quality business.

I’m also aware of the risks with Mastercard. I’m watching the leadership transition and also keeping an eye on risks that are related to competition, the regulatory landscape, and recessions.

But after weighing the pros and cons, I’m happy to allow Mastercard to continue to be in my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.