MasterCard Stock: Is the Competitive Advantage Sustainable?

Identifying moats by looking at MasterCard.

Jul 27, 2014 at 11:39PM

I spend most of my waking hours studying businesses and the industries they operate in, and trying to identify those businesses that have a long-lasting competitive advantage.

Businesses that consistently generate strong free cash flow, or FCF, relative to their sales and net income, and above-average returns on equity, or ROE, may have a competitive advantage (or "moat" as it is sometimes referred to by Warren Buffett) that protects their profits from the competition.

This advantage can take different forms such as a strong brand (think Coca-Cola, Tiffany, or Starbucks), cost leadership (think Wal-Mart and Costco), or network effects, meaning that the service becomes more valuable to users as the number of users increases (think eBay's PayPal).

In the latter case, an increasing number of people with PayPal accounts will encourage more vendors to accept PayPal as a payment option; with more vendors offering PayPal, more consumers will be enticed to sign up for the ease and security of paying with PayPal. The network effect strengthens the brand and provides organic growth, growing free cash flow and returns on capital, and barriers to entry by potential rivals.

When trying to identify these companies, please keep in mind five key principles:

  1. Identifying a company with a moat is hard.

  2. Identifying a company with a sustainable moat is very hard.

  3. Most companies don't have anything resembling a moat.

  4. Stocks of companies that have a sustainable competitive advantage outperform over a long period of time. To drive home this point, I will turn to Buffett. In his 1987 letter to shareholders, he wrote, "Only 25 of the 1,000 companies [in a Fortune magazine study] met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade 24 of the 25 outperformed the S&P 500."

  5. You may disagree with my assessment of a company's competitive position or the longevity of that position (like I said, this is hard work), and I welcome any and all feedback.

Today, I will discuss MasterCard (NYSE:MA). MasterCard is a payment processing company that earns fees for processing credit and debit card transactions on its super-fast network.

Unlike traditional credit card companies, MasterCard does not provide credit and therefore faces no default risk.

MasterCard has two reinforcing competitive advantages: It is a trusted, globally recognized brand and it benefits from network effects. In other words, the company's strong brand encourages consumers to obtain a MasterCard, and as more and more consumers open a card, more stores will accept MasterCard as a form of payment. The network works in the reverse direction as well. As more stores accept MasterCard, more consumers will choose to carry a MasterCard in their wallet.

MasterCard's business model is not capital intensive so it can operate with very little (or even zero) debt, and its steady stream of fees provides a strong and growing free cash flow and almost obscene returns on equity.

According to Morningstar Key Ratios, over the past five years, MasterCard has generated average returns on equity of 43%, an average FCF margin (FCF/revenue) of 34%, and an average free cash flow-to-net income ratio of 1 times (indicating the high quality of its earnings).

Every industry and company is different, but in general, I get excited when I find companies that have historically generated ROE of at least 20%, FCF margins of at least 10%, and a FCF/net income ratio of at least 1 times. MasterCard is especially appealing to me because its high returns on equity are driven primarily by high net income margins (37% in 2013, according to Morningstar Key Ratios), and not by leveraging the balance sheet with debt.

Furthermore, MasterCard is positioned to profit from three long-term secular growth trends: the shift away from paying with paper, the growth of online shopping, and the continued increase of the middle class in emerging markets.

MasterCard does face considerable risks, including a fiercely competitive payments industry (especially in mobile payments), heightened government regulation of interchange fees, and legal fines and costs associated with defending its business model from additional class action lawsuits (it has already agreed to pay billions in fines).

MasterCard currently trades at 29 times trailing 12-month earnings, 22 times forward earnings, and 26 times free cash flow. I can't argue that the stock is cheap at these multiples, but I will point out that 26 times FCF starts to look more reasonable when you compare it to MasterCard's five-year average ROE of 43%. In the very least, I encourage you to read more about MasterCard and the industry and to put MasterCard on your watchlist.

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John Rotonti has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Costco Wholesale, eBay, and MasterCard. The Motley Fool owns shares of Costco Wholesale, eBay, and MasterCard and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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