There are three characteristics that, to me at least, constitute the perfect business. The first would be consistently high profitability metrics, ideally demonstrated over a period of decades spanning multiple business cycles. The second would be a large runway for future earnings growth. The final one would be a timeless business model immune from changing technological and societal trends. I think most stocks I cover on the site do a decent job of scoring a two out of three. Obviously there is no such thing as perfection, but most would pass points number one (i.e. very high quality earnings) and three (i.e. a defensive businesses).
In that sense payment processing giant Mastercard (NYSE:MA) is somewhat similar. It also scores a two out of three, but the composition is slightly different. In Mastercard’s case we clearly have an amazing growth story. A decade ago the company was making ninety cents per share in net profit for its stockholders. Last year it made four dollars and fifty cents a share. Each year that passes sees folks use less cash and write less checks. Instead, we are using debit and credit cards to fund all manner of purchases; a trend that is set to continue for years and years to come.
The other point that Mastercard scores highly on is the first one. I mean the profitability metrics here are insane. We are talking about a business that converts around 35% of its revenue into net profit. On top of that it requires very little in the way of capital outlay, so nearly all of reported profit actually ends up as free cash for shareholders. The business pumps out over forty cents in surplus cash every single year for every dollar of invested capital sitting on the balance sheet.
The big concern is with point number three, because it is vulnerable to technological change (and litigation too). Essentially Mastercard sits in the middle of a transaction by connecting a merchant’s bank with the customer’s bank. It makes a chunk of its money by charging fees to those banks based on the volume of activity on its network. International transactions produce a higher fee as well as some additional charges (e.g. currency conversion). In addition it charges what it calls transaction processing fees. This basically means taking a cut at every stage of the payment process, from authorization to settlement. These are microscopic but, given the sheer volume of transactions involved, they add up to billions of dollars in annual revenue.
Now, is it possible that evolving technology will upend this high margin setup at some point? Sure, I mean who can predict the future after all? There are also a bunch of legal issues that crop up as a result of what is basically a monopoly tollbooth. The flip side to that argument is that folks tend to overestimate the threats to the business. I mean Mastercard is already over fifty years old and is doing better than ever. Its network is immense, with tens of thousands of financial institutions spread across the globe. Millions of consumers are aware of the brand, reinforcing the need for merchants to access the network (this is why it spends so much on advertising). It is very tough to imagine where new competition will come from.
Mastercard: Possible Returns From Here
The first time I wrote about Mastercard I finished with this claim in respect of potential technological disruption:
At the end of the day if your more “speculative” holdings end up being as high quality as the global card issuers then you should do just fine.
At the time the stock was trading at just over $100. It made annual earnings of $3.75 per share, and there were a bunch of articles telling us that blockchain technology was going to takeover the world. Since then it has basically doubled, and analysts expect Mastercard to make around $6.35 per share in net income this year.
That looks expensive but for two points. Firstly, the growth runway is still really long here. Even in the USA gross dollar volume on Mastercard branded products is growing at a 10% clip. Secondly, because of the strong business economics the company can be very shareholder friendly without crimping growth. The dividend payout ratio is kept low, so this manifests itself by way of a huge stock buyback program. Over the past five years the company has retired around 15% of outstanding shares.
Now, depending on the prevailing valuation this probably gives you a 2%-3% boost to annual earnings per share. Add to that the above mentioned growth prospects and I don’t see why this stock can’t average double digit growth for a very long time. Yes, the current P/E ratio is 31x estimated 2018 profit. But I think it has the long-term growth prospects to back it up. As I said last time: if investors make this their speculative investment then they will do just fine.