MasterCard Is Tier 1

"And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. ... And most of the other people who've made a lot of money have done so in high-quality businesses." -- Charlie Munger 

At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I seek out and invest in elite businesses. These include companies with the strongest competitive advantages, greatest growth opportunities, and best management. I call these businesses Tier 1 enterprises, and MasterCard (NYSE: MA  ) fits that description perfectly.

A wide moat
MasterCard operates the second-largest credit card payment network across 150 currencies and more than 200 countries, placing the company in an excellent position to profit from the massive global shift toward electronic payments and away from cash transactions.

As a financial services company, having a respected and trusted brand is of paramount importance. MasterCard has been able to build such a brand thanks in part to the fantastic success of its nearly two-decade-old "Priceless" advertising campaign, and has strengthened its brand image by earning a reputation for the reliability and security of its payment processing platform.

MasterCard also enjoys powerful network effects, as each new merchant that accepts MasterCard makes the network more valuable to consumers, and each new consumer who carries MasterCard increases the potential pool of customers for participating merchants (thanks to an easier means of purchase and therefore likelihood of sale).

MasterCard earns a small fee from every transaction that passes through its payment network, and its tollbooth business model produces steady, fast-growing cash flow. It also helps MasterCard earn extremely impressive operating margins (53.5% in 2012) and returns on capital (38.5%). Those are some of the highest I've seen among all the companies I follow, and they are strong signs of competitive advantage.

The numbers tell the story
MasterCard's powerful brand and network have helped the company build massive scale. Three numbers in particular stand out:

  • 2 billion: How many cards displayed MasterCard's logo over the past year.
  • 34 billion: The number of transactions the company processed in 2012.
  • 3.6 trillion. The dollar amount of the transactions that flowed through MasterCard's network.  

From these numbers you can get a sense of the tremendous scale that this business already enjoys. But the most important number, and what's most exciting to me, is the number 85. That's the percentage of global transactions that are still made via cash or check. Thus, MasterCard is an already dominant business, but it still has tremendous room for growth as the world continues to move away from cash and toward electronic payments. And few companies are as well positioned to benefit from this trend as MasterCard.

Excellent management
Leading MasterCard toward this exceptional profit opportunity is CEO Ajay Banga. He joined MasterCard in 2009 and brings valuable international experience from prior leadership positions at firms such as Citigroup. Much of MasterCard's growth lies overseas, and Banga's global skillset wills serve the company well. MasterCard's employees seem to agree; 87% approve of the CEO, according to Glassdoor.com.

Risks
MasterCard, despite its strengths, is not invulnerable to competition. eBay's PayPal poses the greatest threat, as its electronic payments network has been experiencing strong growth, particularly in the mobile space. Even titans such as Google, Amazon.com, and Apple have either entered or are rumored to be entering the payments space. While these threats are not to be taken lightly, it also should not be forgotten that MasterCard serves as a partner for many of these services, helping to process transactions or serve as a funding source. So while these rivals may challenge MasterCard's growth in some respects, their success could also benefit MasterCard.

MasterCard is also not immune to global economic slowdowns. A pullback in consumer spending would hurt the company's transaction revenue. But markets operate in cycles, and a downturn of this nature would ordinarily be followed by an economic recovery. So I will likely view these types of pullbacks as opportunities to add to Tier 1's position in MasterCard, rather than a reason to sell.

Finally, and possibly most importantly, onerous regulation is an ever-present risk facing MasterCard. U.S. legislators have made it clear that they're willing to step in and actually cap MasterCard's and other credit card companies' debit fees when they feel that it's in the best interest of merchants and consumers -- as demonstrated by The Dodd-Frank Act -- and it's possible that regulators in other countries will take similar action in the future. In addition to the threat of increased regulation is the threat of litigation, as MasterCard is facing multiple lawsuits with the potential for billion-dollar settlements. Unfavorable rulings could have serious negative effects on MasterCard's stock price, but the fear associated with these non-certain outcomes is also a likely reason we can buy MasterCard's shares at such an attractive price today.

Valuation
Within Tier 1, I'm willing to pay a bit of a premium for a quality business -- and MasterCard certainly fits the bill. But with the company trading at 19 times analysts' earnings estimates for 2014, and with Wall Street expecting nearly 18% annualized growth over the next five years, I don't think we're paying that much of a premium for MasterCard. In fact, I estimate that shares could return more than 12% per year over the next half-decade if Banga and his team can reach those growth targets, and I believe they will. Those would be solid returns for a Tier 1 business that I consider to be moderate- to low-risk.

The Foolish bottom line
MasterCard is a dominant Tier 1 business with many years of strong growth ahead. It will benefit from the long-term secular trend of cash to plastic as well as the growth of the global economy -- two trends in which I'm eager to invest. And so, at least 24 hours after this article is published -- standard operating procedure for The Motley Fool's Real-Money Stock Picks program that's designed to give Fools the opportunity to buy ahead of us should they so choose -- I will be buying shares of MasterCard in the Tier 1 Portfolio.

More expert advice from The Motley Fool
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  • Report this Comment On August 07, 2013, at 12:04 PM, oceaqua wrote:

    I seldom see a comparison of Mastercard with Visa. Care to give one here?

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