This is from the AMM Dividend Letter released August 30, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
What does the rise and fall of the following human civilizations have in common: the Pitcairn Islands, Easter Island, Anaszi of the American Southwest, Mayans, and the Vikings of Greenland?
As Jared Diamond points out in his book Collapse: How Societies Choose to Fail or Succeed, these civilizations existed in extremely fragile environments but their early settlers thought they had arrived in robust ones. The early settlers successfully built up their civilizations using short-term solutions that would create terrible problems for them in the future. In their defense they had no real way of determining between a real robust environment and a fragile one merely masquerading as such. Their fall highlights the all too familiar problem of extrapolation.
We, all of us, tend to make short-term decisions based on a long-term view that extrapolates the current conditions far into the future. You can already see the financial problems extrapolation can get us into. From Jared Diamond.
All of us Moderns – house owners, investors, politicians, university administrators, and others – can get away with a lot of waste when the economy is good. We forget that conditions fluctuate, and we may not be able to anticipate when conditions will change. By that time, we may already have become attached to an expensive lifestyle, leaving an enforced diminished lifestyle or bankruptcy as the sole outs.
How can you overcome extrapolation?
To quote the cartoon G.I. Joe, “knowing is half the battle”.
Our brain has two systems for thinking. System 1 is quick and reflexive. System 2 is slow and analytical. When faced with long-term financial decisions it is best to slow down, gather all relevant information, engage your system 2, and ask if you are over extrapolating your current situation. You’ll come up with a better long-term plan. Relying on system 1 for any long-term planning will put you in the same situation as the early human settlers above.
Treat your finances like you’re running a business.
Our favorite CEOs are the ones that have a singular focus on reducing costs every minute of every day like Carlos Brito of Anheuser Busch InBev (BUD). In good times or bad they ruthlessly cut non-strategic costs so they have more money to spend on strategic costs, the necessary spending to grow their business. When it comes to your finances you too need to ruthlessly cut non-strategic costs to free up more money to spend on your strategic costs. The costs that improve your health, help you spend more meaningful time with your family and loved ones, and especially saving and investing more.
It’s not about finding the highest yielding stocks right now. It is about investing in high-quality highly-profitable industry leading companies that use their dependable cash flow to increase their dividends, your income, year-in and year-out. When you “fluctuate” into retirement the objective is to obtain a dependable rising income stream. The best dividend payers are those companies that are willing and dedicated to increasing their dividend payout every year.
Visa the subject of this month’s letter is one of our lowest yielding positions but it also offers us some of the highest potential income growth.
Sincerely,
Your Portfolio Management Team
Dividend Stock in Focus
Visa, Inc. (V): $212.52*
*price as of the close August 29, 2014
In the early 1900s retailers, department stores, and grocers started to offer lines of credit directly to their customers that had proof that they could pay off their debt quickly. The credit card didn’t exist until John Biggins, a banker at Flatbush National Bank, came along in the 1940s. John developed a far easier and more direct system of credit with his Charg-It card.
At first both the customer using the Charg-It card and the Merchant that accepted the Charg-It card had to be clients of Flatbush National Bank. Merchants would deposit their sales receipts from the Charg-It purchase and then Flatbush National would bill the customer. The Charg-It program simplified the line of credit for the customers and helped the merchants convert credit receivables into cash quicker. The first credit card was a great success. It was so successful that 68 years later in 2008 Visa had the largest IPO ever at $17.86 billion.
Visa is not a credit card company; it does not take credit risk. Visa is a payment network; it facilitates commerce between a customer and their bank with a merchant and their bank. The chart below highlights the information and money flow in a standard credit card transaction. There is Visa right in the middle of the transaction collecting fees for allowing the easy flow of capital through its payment network.
Click image to enlarge
This is the beauty of Visa’s network, once it is built the capital needed to maintain it is minimal and the more transactions that occur over the network the more money Visa makes. More on this later.
You will notice that your position in Visa is lower than a standard position size. We view Visa as a duopoly with MasterCard (MA), another position in your account and the subject of our next letter. Visa and MasterCard control over 87% of the global payment volume, 60.5% for Visa and 26.9% for MasterCard according to The Nilson Report, and because of this we are treating both positions as one focused position in global payment networks.
We are also balancing income now with higher income later. Both Visa and MasterCard’s dividend yields are under 1% which is far below our normal threshold. We don’t want to lower your current overall portfolio income by being too heavily invested both Visa and MasterCard. We also didn’t want to miss out on the opportunity to invest in these companies at both a fair price and with the potential for high future dividend growth.
Dividend History:
Within a few months after its IPO Visa started paying a quarterly dividend of $0.105 per share. Visa has raised its dividend every year since and now pays a quarterly dividend of $0.40 per share. Visa has grown its quarterly dividend at a compound annual growth rate of 24.97%.
Click to enlarge. From S&P Capital IQ.
Visa’s current payout ratio is 18% and the company has the ability to payout much more. They have no debt, very high margins, and low capital needs to maintain and grow their business. If Visa had zero earnings growth it could continue to grow its quarterly dividend at a 24% compound annual growth rate for the next 4.5 years until it reached a 50% payout ratio.
Catalysts for Dividend Growth and Price Appreciation
Network Effect
The more connections between consumers and merchants in a network, the more valuable the network. Visa has the largest and most valuable payment network. Building a valuable network requires a lot of capital up front but after it is built the capital requirements to maintain the network are low. As transaction volumes grow the network becomes more profitable. Visa’s operating margin started at 43% in 2008 and expanded to 61% at the end of the 2013 fiscal year. Lower capital maintenance requirements plus higher profitability equals higher returns on capital. Visa’s Return on Capital (ROC) has increased every year since its IPO.
Click to enlarge. From S&P Capital IQ
As long as transaction volumes continue to increase, which it should as discussed below, then Visa’s profitability should remain high and generate significant returns on capital and equity for its shareholders.
Debit and Credit Card Growth
Visa estimates that 30% of consumer spending across the globe is still carried out through cash and checks. This is about $10 trillion in gross dollar volume. In the U.S. alone this is still an $18.3 billion volume potential. Payment by debit and credit cards still has a lot of room to grow.
Click to enlarge. From 2013 Federal Reserve Payments Study.
Smart Phone Growth
The newest factor driving the use of debit and credit cards are smartphones.
Click to enlarge. From Bidness ETC.
Visa expects 50% of all transactions through their network to be made through a mobile device by 2020. Purchases made through an App with your stored payment information are already common place. The growth will come from the Mobile Wallet and the use of your phone for point of sale purchases. In 2011 mobile phone transactions accounted for just 5% of all retail sales and are expected to reach 19% by 2016. This is why Google, Amazon, Apple, and many others are extremely interested in developing the mobile wallet. Visa was interested in building its own mobile wallet too but recently canceled its development efforts and is focusing on being a partner rather than a competitor.
Visa launched its Digital Services to help financial firms, merchants, and developers build out their mobile payment solutions. The rumor is Apple will partner with Visa and enter the mobile payment market this year.
Visa has unveiled a suite of services designed to “facilitate secure payments across a broad range of internet-connected devices and wearables”. The announcement of the new Visa Digital Solutions service comes amid reports that Apple is in talks with the payments network to enter the mobile payments market this year and includes the news that Visa’s cloud-based tokenization service will go live in September 2014 — the same month that the next iPhone and the first iWatch are expected to launch.
We are almost at the point where we can leave the house with just our phone and pay for anything we want and Visa will be right there, processing your mobile payment through its network.
Visa Europe
Like Visa before its IPO, Visa Europe is owned by a consortium of banks and is technically run as a not-for-profit membership association. Visa Europe is its own entity, it was not included when Visa was combining entities and preparing its IPO. Visa Europe operates under an irrevocable license and pays royalties to Visa. Even though Visa Europe was not combined with Visa the European organization was given a Put option to sell itself to Visa at any time. The sale price is dependent on Visa’s forward P/E ratio and Visa Europe’s adjustable sustainable income, not based on Visa Europe’s current accounting to reduce profits. Visa also has a Call option to buy Visa Europe if their business deteriorates significantly.
Heightened European bank regulation and the need to maintain higher capital ratios could force the consortium of European banks to sell Visa Europe sooner than expected. Plus, it is rumored that the banks believe they could set-up and better run their own payment network. The cost of the purchase has been estimated from as low as $3 billion to as high as $11 billion. Visa has sufficient room on their balance sheet to fund the majority of the purchase with debt which could explain why Visa has not issued any during this period of low interest rates.
Integrating the two systems and transferring Visa Europe users over to Visa’s network would take time but the profits are worth it. Europe is seeing the same type of growth in the use of debit cards, credit cards, and smartphones as discussed above and payment volumes are expected to reach $3.73 trillion by 2016. Visa would greatly benefit by having this growing transaction volume over its network and not on a licensee’s. Also, Visa Europe’s operating margin is around 23% compared to Visa’s 62%. Even though European financial regulations will make it tough for an integrated Visa Europe to reach 62% operating margins there is still a lot of room for margin improvement and increased profits for Visa.
Return of Capital
Since it’s IPO at the end of fiscal year 2013 Visa has reduced its total shares outstanding by 9.25%. Visa has high credit worthiness, cash flow, and plenty of room on its balance sheet to issue debt and reduce their shares outstanding by a lot more. The only reason Visa has not leveraged is it needs the room on its balance sheet to buy Visa Europe.
Click to enlarge. From S&P Capital IQ.
Pre-Mortem:
The pre-mortem is a brief rundown of what could go wrong with our investment. In the event that any of these items gains significant traction, it could give us cause to cut or eliminate the position from the portfolio.
New Competition
The time and money it will take to build a network to compete with Visa is a high barrier to success but Dwolla is taking on the challenge. Visa’s network operates in the ACH (Automated Clearing House) system. A slow system where fund transfers from the consumer’s bank to the merchant bank’s account goes through many steps and takes several days to complete. Dwolla is building its own network where fund transfers are instantaneous and involve only 2 steps. Because Dwolla is building it’s own payment processing network it eliminates interchange fees and charges a very low processing fee, $0.25 per transaction for anything over $10 and it’s free for anything under $10. For merchants the value proposition of Dwolla is extremely attractive. If Dwolla’s network gains traction in both consumers and merchants Visa will lose market share.
Legislation
The Durbin amendment attached to the Dodd Frank Bill requires banks with more than $10 billion to end exclusive network affiliations assets and to use multiple payment processing networks for signature and PIN authorized debit card transaction. Visa had the largest share of debit card transactions in the U.S. and lost some market share because of the Durbin amendment. The amendment also put a cap on interchange fees. Further legislation could impact Visa’s business.
Mobile Wallet
We already highlighted this as a positive catalyst for Visa but it could also be a negative one. Just like Dwolla above, the rise of the mobile wallet could move payment processing off of Visa’s network as new payment networks emerge. So far this is not the case but disruption from new technologies is always a concern.
Litigation
When you are as big and profitable as Visa you will attract lawsuits. Listed below are a few of the outstanding litigations that could affect Visa’s business.
- Interchange opt-out litigation. Action against Visa for trying to monopolize the debit-card-related market. Wal-Mart recently joined in with an opt-out complaint.
- European Competition Proceedings. Another review of the interchange fees being charged.
- Target’s data breach. Visa has been named in Target’s Data Breach lawsuit for not developing chip technology soon enough.
Foreign Governments
Foreign Governments could rule that all transactions in their country need to be routed through a domestic payment network taking volume growth away from Visa’s global network. Russia recently tried to do this but reversed course.
Conclusion:
Visa is a great business in a very favorable long-term trend and the stock has traded at premium because of this. We viewed the sell-off in Visa’s stock price earlier this year as a great opportunity to pay a fair price for a high quality business. Our definition of “fair price” means we are paying a price that should still generate double digit returns. Our fair value for Visa is $220 per share. Buying Visa at or below this price should deliver strong total returns over the next several years.
Chart courtesy of Stockcharts.com.
All previous letters are archived here.
