Mastercard provides a masterclass in compounding returns

Card network business Mastercard (US:MA) is seen as an inflation hedge. It takes a percentage of every transaction conducted on its network and as prices rise, so does its revenue. This, coupled with the resilient state of US consumer and cross-border spending and the continued shift to cashless transactions, has helped Mastercard’s share price steadily trend upwards over the last year. 

Between a quarter or a third of global payments go through Mastercard’s network. This makes it the second-largest such business behind Visa (US:V). Mastercard doesn't provide credit cards; it simply gives access to the payment network the cards work on.

The genius of these two businesses is, as the name implies, the network effects. Payments companies are useless without scale because they need banks and merchants signed up to transact between each other. The many digital payments businesses that have sprung up over the past decade are not seeking to disrupt these networks: they rely on them, too, and typically focus instead on improving front- or back-end services.

Mastercard's resilient moat can be seen in its substantial profit margins. In the three months to September, its adjusted operating margin was 58.8 per cent. This is near its record highs, an increase of 1.2 percentage points year on year, and compares favourably to almost every other company in the S&P 500. The latest jump was due to the global travel rebound providing a one-fifth increase in higher-margin cross-border transactions. Cross-border revenues make up around 35 per cent of total revenue at the business, compared with 25 per cent at Visa.

The most recent quarter showed the strength of its business in other ways. It doesn’t need to spend much to scale up; in other words it has a lot of operating leverage. Last quarter, revenue rose 11 per cent on a constant currency basis yet its operating expenses were flat. This combined to push up operating profit by 21 per cent year on year, with diluted earnings per share increasing 29 per cent.

Despite Mastercard being one of the most reliably profitable businesses in the world, it is still vulnerable to macroeconomic conditions. If the delayed impact of interest rate rises pushes the US and other economies into recessions, slows consumer spending and reduces travel, the company will not be immune.

Investors must also factor in the possibility that spending trends have not yet returned to normal post-pandemic. Chief financial officer Sachin Mehra admitted there had been some normalisation in spending and travel over the three months to September. The guidance is for revenue to grow by single-digit levels in the fourth quarter, but that assumes a resilient consumer.

To diversify the business away from being just a proxy for consumer spending, Mastercard has been prioritising “value-added services and solutions”. This includes fraud management, data analytics and other consulting services. Broker RBC Capital Markets describes Mastercard as “looking at itself as a strategic partner with its clients as opposed to just a vendor”.

This gives it a chance to upsell more services to banks that already use its transaction services. At the same time, when Mastercard is competing for new business, the strategy gives it a way to try to differentiate itself from the other payment providers. So far things are progressing well: last quarter value-added services revenue rose 14 per cent on a constant currency basis. And the company has been consistently growing its top line faster than rival Visa. Its superior return on invested capital also bodes well for new projects like the above. The risks are a serious regulatory threat to what is effectively an industry duopoly, or a cash-rich rival such as Apple (US:AAPL) seeking to move into the network arena. Neither appears an immediate risk to the business.

The quality of Mastercard's business is displayed in its valuation. FactSet broker consensus has it trading on 28 times its forward earnings. This is expensive, but it is much lower than the 45 times forward earnings on which it traded mid-pandemic when earnings started to rebound. It also must be considered that as a capital-light business it turns almost all its profits into cash, meaning its forward price to free cash flow ratio is also 28.

Mastercard’s growth is likely to slow next year, but it is a difficult company to ever bet against. Since 2017, revenue has doubled. Going back to 2011, it is up 338 per cent. It has been a high-margin compounder over a long period of time and its substantial economic moats limit the downside. Businesses like this are rare, and to take advantage you usually have to pay up for them.