What Earned Visa Its Spot on the Dow in 2013?

If the economic crisis that began in 2007 was largely the story of financial stocks leading the market lower, the rebound that began in 2009 might well be the story of financial stocks leading the market higher. That remained true this year, as credit card issuers were among the market's best large-cap performers in 2013:

V Total Return Price Chart

V Total Return Price data by YCharts.

One of the big financial stories in a year lacking much real drama was a rather unexpected shift in the Dow Jones Industrial Average (DJINDICES: ^DJI  ) that gave it a decidedly more financial bent. American Express (NYSE: AXP  ) , which had been the Dow's lone credit card issuer for three decades, finally got some company when Visa (NYSE: V  ) joined the index this fall. However, as you can see in the graph above, Visa's share price growth was a bit less impressive than its premium-branded peer. We've already examined AmEx's impact on the Dow in 2013, but let's take a look at Visa's fundamental performance now to see whether its underperformance was justified relative to a soaring AmEx:

Metric

Fiscal 2013* Result

Fiscal 2012* Result

Change

Revenue

$11.8 billion

$10.4 billion

13.5%

Net income

$5 billion

$2.1 billion

138.1%

Earnings per share

$7.59

$3.16

140.2%

Free cash flow

$2.6 billion

$4.6 billion

(43.5%)

Dividends paid

$864 million

$595 million

45.2%

Source: Morningstar. *Visa's fiscal year ends in September.

We immediately notice that there's a big discrepancy between Visa's soaring earnings and its cratering free cash flow, and a quick glance at both last year's news and Visa's most recent 10-K should help explain why. Visa and MasterCard (NYSE: MA  ) , along with card-issuing banks, originally reached a combined $7.3 billion settlement in a wide-ranging class-action lawsuit against "swipe fees" in the summer of 2012, during the tail end of Visa's 2012 fiscal year.

That explains the net income difference -- Visa wrote off the settlement on 2012's income statement. However, the ongoing nature of Visa and MasterCard's legal appeals (Visa's 2013 10-K includes more than 200 uses of the word "litigation") meant that Visa did not wind up drawing on its resources to pay off this settlement until the 2013 fiscal year -- the 2013 cash flow statement includes a $4.4 billion hit for "accrued litigation." Let's see what Visa's financials would look like in 2012 and 2013 without the impact of these huge one-time charges:

Metric

Adjusted 2013 Result

Adjusted 2012 Result

Change

Income before taxes

$7.2 billion

$6.2 billion

16.1%

Free cash flow

$6.9 billion

$4.8 billion

43.8%

Source: Visa 2013 10-K. Adjusted to remove impact of litigation settlement only.

In this case, we have to use pretax income rather than net income, as Visa used its 2012 settlement write-off to obtain a much more favorable tax position for that fiscal year. While that figure grew far less than Visa's share price, we can see that adjusted free cash flow actually improved right in line with Visa's 46% year-to-date stock gains. That's much better than any fundamental improvement recorded by AmEx over its trailing 12 months, and it also happens to handily best MasterCard's results, which do not appear to have been affected anywhere near as heavily as Visa's by litigation losses.

Visa's key credit-use numbers also showed strong growth in 2013. Payment volume rose 13% in the fourth quarter, and for the full fiscal year, Visa recorded a 10% rise in service revenue, 17% greater data-processing revenue, and 12% greater international transaction volume over 2012. Because total transactions (58 billion) only grew by 10% over the prior year's result, these results largely show a Visa that's finding more ways to get more money out of each card member.

These results are more noteworthy in light of a continued American deleveraging -- revolving debt declined by more than $50 billion between early 2010 and the end of 2012, and average credit card debt per household fell by more than $2,500 over that time frame. Visa's global payment-card dominance is not quite as overwhelming as it once was, either, at least not in terms of its availability:

Issuer

U.S. Card Members

International Card Members

Total Card Members

Visa

278 million

522 million

800 million

MasterCard

180 million

551 million

731 million

American Express

53 million

52 million

105 million

Source: Daniel P. Ray and Yasmin Ghahremani, creditcards.com. Data current as of June 2013.

However, despite MasterCard's growing card network, Visa remains far in the lead over its rivals in terms of purchase volume. Last year, the new Dow addition processed $981 billion in transactions, nearly double MasterCard's second-place total of $534 billion. When you add all these numbers up -- Visa processes more transactions worth more money from more cardmembers than anyone else, and it's growing at a faster clip than fellow Dow component AmEx -- it seems fairly obvious why the Dow brought it into the fold this year.

Investors' major concern at this point might boil down to valuation, as Visa's current P/E of 29 is higher than it's been at any point (excepting the adjusted period of its litigation writedowns) since the beginning of the post-crash economic recovery. That doesn't mean that Visa wasn't a great choice for a forward-looking Dow, or that it won't remain a strong investment for long-term investors. It simply may point to weaker returns in 2014 than shareholders have enjoyed this year.

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