Mastercard: 'Overvaluation' Masks Opportunity

Mastercard is a business of exceptional quality, worthy of a long-term holding in any investor\'s portfolio.

The business historically trades at a premium to the S&P 500, and is now at a premium valuation to even where it has historically traded over the last 5 years.

What\'s often lost in the valuation analysis is that Mastercard is putting in place the seeds to grow some fairly substantial new revenue streams which may transform the business.

Mastercard (MA) is a very high quality business, possibly the highest quality business in the small universe of companies that I invest in. It is one of the 5 great businesses that I’ll never sell. The company has consistently increased both its revenues and earnings since listing, even through the severe downturn of 2009. Best of all, Mastercard has managed to achieve this with a great deal of financial discipline. Mastercard has net margins of almost 40%, and returns on invested capital of greater than 50%. Being able to invest capital at such high rates of return for extended periods of time where there are opportunities due to the secular shift from cash to digital payments and dramatic increases in per capita incomes in developing economies gives rise to exceptional long-term profitability and returns to shareholders. In fact, Mastercard returns almost the entirety of its free cash flow to shareholders in the form of dividends and share buybacks.

However, accessing such a high-quality franchise very rarely comes cheap for investors. Mastercard typically trades on a premium valuation to the market and typically at a significant premium to the S&P 500’s average valuation. At this time, Mastercard now trades at a premium valuation to even its own elevated historical standards. The business currently carries a price to forward earnings ratio of over 30, the highest that it has traded at any point in the last five years.

While this premium valuation may be causing investors pause, Mastercard is slowly transforming into a very different business, and the premium valuation that it carries maybe masking some fairly substantial opportunities that are hidden beneath the surface.

Mastercard's recently reported results continue to show a core business in consumer digital payments that is firing on all cylinders. The company reported revenue growth of almost 16% (in constant currency), consistent with growth in recent years. Payment volume growth was up 14% year on year. Operating margins once again came in at just under 60%, indicating that the business still retains considerable pricing power and operating leverage as it scales with volume on a limited fixed cost base. Cross-border volumes, which tend to be a very lucrative part of the business for Mastercard, were also up approximately 17% year-over-year, excluding currency impacts. These results are extremely high quality given the economic malaise that affect various parts of the global economy in which Mastercard operates, including depressed growth in Europe as well as strong instability in Latin America.

With the secular tailwind of an ongoing global shift from cash to digital-based payments and the acceleration towards electronic-commerce only gathering steam, Mastercard is extremely well positioned to benefit from both of these trends and therefore experience continued growth in its core business just from personal consumer expenditures alone.

However, beyond Mastercard's core business, the company has set the stage to move into two fairly large adjacent markets which have the potential to increase its addressable market by 4x its current market.

Mastercard has been significantly bulking up its business to business payment initiatives, and has been putting in place the elements of delivering an enhanced B2B payments solution. ACH, which is the current standard in direct account to account transfers for business, often has delays in receipt of payments of at least several days. Part of Mastercard’s push here has been the development of a more efficient, real time payments infrastructure for B2B payments. This initiative received a real boost from the company’s acquisition of Vocalink in 2017, which itself was a set of existing ACH rails. By being able to innovate on top of these rails for enhanced payment delivery, Mastercard likely has a better chance of success to commercialize a B2B product, and have banks use and deploy this.

Mastercard aims to streamline the payments reconciliation process, which is plagued with delays due to inconsistent file formats and a lack of standardization, causing the delays in receipt of funds. Mastercard’s push into this space has been complemented with the $3B acquisition of Nets in August 2019. Nets is an electronic payments platform that allows for payment clearing and instant payment services, and will facilitate Mastercard’s ambition of being able to introduce additional efficiency and speed into the execution of B2B payments.

To put the size of this opportunity in context, B2B payments is close to 3x the size of Mastercard’s addressable personal consumer expenditure opportunity at almost $120T.

As part of this push into B2B payments, Mastercard announced just over a month ago that it would be bringing all of its current and future B2B payments under the Mastercard Track brand.

Another very large space that Mastercard has recently been pushing into is the consumer money transfer space, which the business estimates to be a $60 trillion market, larger than the consumer personal expenditure market that Mastercard currently serves. Mastercard Send is a service that Mastercard has developed to facilitate disbursements to consumers, whether these are peer to peer or business to consumer transfers, both domestically or internationally.

While Mastercard Send initially focused on P2P payments, and was adopted by Google Pay to help facilitate transfers between consumers, Mastercard has arguably stumbled on a far bigger market, which is the use of Mastercard Send to facilitate payments from businesses to consumers, such as in the context of emergency insurance claims (Allstate) as well as making payroll for independent agents in the gig economy, facilitating direct payments for Uber drivers. Mastercard acquired Transfast earlier this year to further extend the reach and application of Mastercard Send, particularly for cross border transfers.

While Mastercard hasn’t made significant revenue traction in either consumer payments nor in real time business to business payments, the company has the brand, infrastructure, systems and relationships to create significant new revenue streams in both these large markets. Companies with such significant wide moats typically have the ability to fairly easily cross into a new market areas where they can leverage their brand and existing infrastructure to do so. It is not a significant stretch to believe that Mastercard can make meaningful traction in both new markets, especially since they have acquired technology that is currently used to service both of these areas, which can in turn be scaled via Mastercard's assets.

Mastercard may look overvalued and certainly is trading more expensively than it has been in its recent past; however, much of the potential growth from the new businesses that the company is pursing is not priced into the stock at current levels. Investors considering a position in this business have the opportunity to come and invest for the strong continuing growth in the core consumer expenditure payments business and stay for the likely considerable growth that will follow in business to business payments and consumer payments.

I am/we are long MA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.