Visa is set to benefit from the growth in electronic payments.

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
Visa is a global card Goliath that operates an open-loop card network and owns one of the most recognized and respected brands in the world. The firm's clients are thousands of financial institutions around the world that issue its cards. When a cardholder swipes a Visa card, the card information and the transaction details are received by Visa, which facilitates the authorization, clearing, and settlement of the transaction. The firm then charges its clients different fees based on the dollar volume and the number of transactions.We think Visa enjoys one of the widest economic moats that a company can desire--a network that connects thousands of financial institutions. It is very hard to build any network, but duplicating Visa's is almost impossible. Visa has contracts with thousands of issuers around the world that push Visa cards to their customers. Switching from one card network to another is a costly process, and we think issuers don't have a lot of incentives to do so. On the other side of the network, acquirers have interest in acquiring as many transactions as possible and have no incentives whatsoever to stop acquiring Visa-branded cards. As a result, merchants can keep accepting Visa.Even with an army of banks on its side, Visa has to ensure that cardholders actually use their Visa cards and that merchants accept them. To make this happen, the company has invested and keeps investing in its brand, which we view as another competitive advantage. The Visa brand stands for trust, reliability, and convenience. Cardholders all over the world know that they can use Visa anywhere and shop without the need to carry any cash or checks.Merchants, in general, have love-hate relationships with Visa, as well as with other card networks. Although they like the benefits, merchants usually end up footing the lion's share of the bill when customers pay with cards. The bill comes in the form of a discount fee that each merchant pays to its acquisitor. The bulk of this fee--the interchange fee--is set by Visa and is transferred to the card issuer. Despite these costs, the power of the Visa brand leaves merchants with no choice but to accept the card. The alternative is to risk sales, which most aren't willing to do.Visa is one of the best-positioned firms to benefit from the growth in paper-free payment methods. The Nilson Report projects that the share of such payments will reach 65% of total payments by 2014, and the share of card sales will expand to 50% from the current level in the mid-40s. While Visa isn't immune to tepid consumer spending, in the long run, the secular trend of moving away from cash and checks and toward electronic forms of payment is likely to remain intact, despite any hiccups on the economic front. Aside from these positive tailwinds, the level of competition in the payment market is on the rise as American Express AXP and Discover Financial DFS try to steal share from Visa and MasterCard MA. In addition, we pay attention to new technology, such as mobile payments, which over the long run could fundamentally change the competitive dynamics in the payment market.
Valuation
Our fair value estimate is $105 per share. We expect revenue growth to average 14% during the next two years. We think this growth will come from credit and debit card purchase volume and the number of transactions processed by Visa. We model total purchase volume to increase 13% in 2012, despite the new limits on interchange fees in the U.S. We model higher operating expenses over the next few years but we expect the firm to maintain positive operating leverage through 2013. We project Visa will be able to keep its operating margin above 60%.
Risk
Several lawsuits allege that Visa engaged in anticompetitiveand anticonsumer practices. It's very hard to estimate the costs ofthese lawsuits, but the bill could mount to several billiondollars. Regulation is another risk that could derail this businessmodel. If governments interfere in the way the network operates,the downside can be substantial. We also think that competitivepressures are mounting. MasterCard's initial public offering, Discover's spin-off,and a court ruling from a few years ago in favor of AmericanExpress might change the competitive dynamics of the card networks. Anotherrisk is pressure from five top clients (that contribute more than20% of revenue) to lower prices.
Management & Stewardship
We think management's performance clock began ticking afterthe IPO. The top brass have to prove to shareholders that they canwork together, respond to Visa's challenges, and deliver theresults expected from them as leaders of a public company. Themanagement team was assembled during the process of reorganizingthe predecessor entities of Visa, the regional associations, andmerging them into one entity to sell shares to the public.Some of the senior managers never worked in the card industrybefore and have little experience running a services company likeVisa. In addition, top managers are strangers to one another, andtheir ability to work together in harmony was never seriously tested.The good news is that CEO Joseph Saunders is a card industryveteran who successfully led the card issuer Providian until it wassold to Washington Mutual. We think that his experience atProvidian and Washington Mutual's credit card unit will serve himwell in running Visa.
Overview

Financial Health: Visa's balance sheet looks pristine, and the firm's cash flows are stable, recurring, and growing. Given its financial strengths, the firm is returning capital to shareholders though share buybacks and dividends.
Profile: Visa manages a group of global payment card brands, which itlicenses to financial institutions that issue cards to theircustomers. The firm acts as the payment processor by facilitatingthe authorization, clearing, and settlement of transactions on itsproprietary networks. Visa maintains the largest card scheme in theworld.