Visa 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." -- Charles 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 and greatest growth opportunities. I call these businesses Tier 1 enterprises, and Visa (NYSE: V  ) has earned its place among the elite.

A wide moat
Visa operates the largest credit card payment network across more than 200 countries and territories, 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. Visa has been able to build such a brand thanks in part to successful advertising campaigns such as "It's everywhere you want to be" and "More people go with Visa." Visa then bolstered its brand image by earning a reputation for the reliability and security of its payment processing platform.

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

Visa 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 Visa earn extremely impressive operating and net income margins (59.9% and 20.6%, respectively, in 2012). 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
Visa's powerful brand and network have helped the company build massive scale. Three numbers in particular help demonstrate this:

  • 2.1 billion: How many cards displayed Visa's logo as of December 31, 2012.
  • 82 billion: The number of transactions (payments and cash) the company processed over the last year.
  • 6.5 trillion. The dollar amount of the total transactions that flowed through Visa's network.  

From these numbers, you can get a sense of the tremendous scale 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, Visa is an already dominant business, but it still has tremendous room for growth as the world continues to move away from cash payments and toward electronic payments. And few companies are as well-positioned to benefit from this trend as Visa.

A new leader at the helm
Leading Visa toward this exceptional profit opportunity is newly minted CEO Charles Scharf, who took the reins in November 2012. While I typically like to see a longer track record of success when it comes to the CEOs of the companies I invest in for Tier 1, Scharf does have considerable leadership experience from prior roles such as head of JPMorgan Chase's retail banking and mortgage operations. And Scharf is already quite familiar with Visa's operations; he served on Visa's board from 2003 to 2011. I will be watching Scharf closely to see that he's executing on Visa's growth strategy, and I believe he has the skills necessary to be successful in the role. But what gives me even more confidence is that, as my colleague Joe Magyer has said, an investment in Visa is not "a jockey bet. We're betting on the horse." And by that I'm referring to Visa's trusted brand, powerful network effects, and massive scale advantages.

Risks
Visa, 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, 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 Visa 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 Visa's growth in some respects, their success could also benefit Visa.

Visa 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 Visa, rather than a reason to sell.

Finally, and possibly most importantly, onerous regulation is an ever-present risk facing Visa. U.S. legislators have made it clear that they're willing to step in and actually cap Visa's and other credit card companies' debit fees when they feel 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 Visa is facing multiple lawsuits with the potential for billion-dollar settlements. Unfavorable rulings could have serious negative effects on Visa's stock price, but the fear associated with these non-certain outcomes is also a likely reason we can buy Visa'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 Visa certainly fits the bill. But with the company trading at 21 times analysts' earnings estimates for 2014, and with Wall Street expecting nearly 19% annualized growth over the next five years, I don't think we're paying that much of a premium for Visa. In fact, I estimate shares could return more than 11% per year over the next half-decade if Visa can reach those growth targets, and I believe it will. Those would be solid returns for a Tier 1 business that I consider to be moderate-to-low risk.

The Foolish bottom line
Visa 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 Visa in the Tier 1 Portfolio.


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