These two large payment networks are undoubtedly some of the most dominant businesses in the world. Both stocks have crushed the broader market over the years, thanks to rising revenues and expanding bottom lines. And in their most recent fiscal years, Visa (V 0.33%) posted a net profit margin of 51%, while Mastercard's (MA -0.07%) was 45%. So it's not much of a surprise that Warren Buffett's Berkshire Hathaway has sizable positions in these businesses.
Although a valid argument can be made that these thriving enterprises have unassailable economic moats, based on their outstanding historical financial performances, there is one risk that shareholders should be mindful of. Let's take a look at what might be the biggest threat to these two Buffett stocks.
A powerful competitive position
It's worth taking the time first to understand what makes Visa and Mastercard such wonderful companies. While traditional banks like JPMorgan Chase and Bank of America approve customers for credit cards and take on default risk, Visa and Mastercard simply control the communications platforms that connect the various parties of a typical transaction. These parties include consumers, merchants, and their respective financial institutions. Visa and Mastercard collect a tiny fee any time data flow across their networks.
As I noted earlier, this business model has proven to be incredibly lucrative. Each additional transaction these companies process carries virtually no cost, so they generate lots of free cash flow. Even more importantly, it's almost impossible for anyone to compete with their dominance.
Imagine if a new start-up wanted to create its own card payments network from scratch. It would not only need to get partner banks to want to approve credit cards to consumers, but it would also need to incentivize merchants to want to accept them. It's a classic chicken-and-egg problem. People won't want cards that aren't accepted anywhere, and merchants don't want to take cards that no one has.
This favorable situation is why Visa and Mastercard have near-impenetrable economic moats. As the world continues moving away from cash and checks to digital transactions, especially in less developed countries, these two businesses are set to continue flourishing.
A possible threat
But capitalism creates competition, and even these two most prosperous enterprises aren't without the possibility of disruption. This isn't disruption in the sense that something besides cards will be used. It's disruption in the sense that large merchants, who are the ones footing the bill to accept cards, set up their own payment systems that bypass Visa and Mastercard altogether.
A perfect example of this already happening is Target and its RedCard debit card, which pulls customer funds directly from their checking accounts when they make purchases at any of the retailer's 1,948 nationwide stores. This means that the transaction doesn't run through Visa's and Mastercard's networks. In the fiscal 2022 third quarter (ended Oct. 29, 2022), 10.8% of Target's $26.5 billion in revenue came from these RedCard debit cards. That's meaningful penetration, to be clear.
There's a caveat, though: The fact that Target offers a 5% discount to these customers, all to avoid paying roughly 2.5% in payment processing fees if it simply accepted only Visa- and Mastercard-branded cards. Maybe that calculation is worth it in order to drive customer loyalty and greater repeat shopping behavior.
This could also apply to other merchants where people spend on a recurring basis, such as Netflix for streaming entertainment, Amazon's Whole Foods for groceries, or Planet Fitness for a gym membership. The hypothetical end result could be direct payments from checking accounts to every merchant a person shops at.
But Visa and Mastercard shareholders don't have much of a reason to worry right now. People love their general-purpose rewards credit cards a lot. Combined, these companies processed $22 trillion of payment volume in fiscal 2022. These figures will continue marching much higher over time.
