Mastercard: Double-Digit Return Thesis Intact Despite 10% Correction (NYSE:MA)

Introduction

We review our investment case on Mastercard (NYSE:MA) after shares corrected by nearly 10% from their $367.25 peak on August 28.

Since our initial Buy rating in March 2019, MA shares have returned 41.8% (including dividends), more than double that of the S&P 500:

The move to digital payments is a strong secular trend, and we also have Buy ratings on Visa (V) and PayPal (PYPL), which have also done well; we have been Neutral on American Express (AXP), which underperformed as expected.

We last reiterated our Buy rating on MA in May. In this article, we utilise the company’s Q2 2020 results and post-Q2 volume data, as well as comments by senior executives at investor conferences.

Volumes Now in “Normalization” Phase

MA management believes that most markets are now in the “normalization” phase of the COVID-19 outbreak, but not yet resuming “growth”:

“Remember us talking about a four-stage framework … containment, stabilization, normalization and growth. We believe that we are across the world and most markets in the normalization phase. So we’re making our way back out of the valley in terms of the lowest growth rates … we see modest improvement around that. But we’re also seeing that the path is not linear.”

Michael Miebach, MA President and CEO-Elect (Deutsche Bank conference, September 14, 2020)

As of August, MA’s global switched volumes were 2-3% higher year-on-year, including U.S. volumes at 4-5% higher and non-U.S. volumes roughly flat:

MA Switched Volume Growth Y/Y (Constant Currency) (Since March 2020)

Source: MA company filings.

According to MA, “all regions outside of the U.S. have seen improvements from July to August”, while the U.S. saw a slight deceleration (from +5% to +4%). The “continued modest improvement” in August was due to re-openings in some markets, offset by the withdrawals of government support programs.

Travel & Entertainment (“T&E”) volumes remained weak in August due to COVID-19 restrictions. Excluding T&E, year-on-year growth in switched volumes has returned to the same level as Q4 2019 as of August.

Cross-border volumes remain depressed. As shown above, excluding intra-E.U. volumes, cross-border volumes were approx. 50% lower year on year in August, while intra-E.U. cross-border volumes showed a small improvement.

The weakness in cross-border volumes was mainly due to weak Card Present and Travel volumes; Card Not Present (Non-Travel) volumes have been 20% higher year on year through July and August:

Q2 2020 P&L Impact

The volume trends above translated into Q2 2020 volume declines of 8.9% in Purchase Volume and 10.0% in Gross Dollar Volume (excluding currency):

Within Q2 Purchase Volume, credit card volume was down 18.8% year on year, while debit card volume was up 8.0% (but with no adverse impact on revenues). Q2 revenues were down 17% year on year (excluding currency), primarily due to Cross-Border Volume Fees declining 52% (or by $737m):

MA Key P&L Items (2020 Q2 & H1)

Source: MA results release (Q2 2020).

In other revenue lines, Domestic Assessments was down 8% in Q2, mostly in line with volume decline; Transaction Processing was down 6%, less than the 10% decline in the number of transactions, due to a favourable mix. Other Revenues were up 14% year on year, with 4 ppt from acquisitions and the rest from value-add services (especially Cyber Intelligence and Data & Services).

Operating expenses were down 6.4% year on year in Q2, including Advertising & Marketing being down 58.7%, providing some offset to the revenue decline. However, EBIT was still down 27.9% year on year for the quarter.

Adjusted EPS fell 28.1% year on year for Q2 2020 and, including Q1’s decline of 2.4%, fell 13.0% year on year for H1 2020.

Near-Term Outlook

Management did not provide any forward guidance on revenues, due to ongoing uncertainties on COVID-19 and the economy. However, currency is expected to be a 1% headwind to revenues in both Q3 and Q4 2020.

Expenses are expected to be down low-single-digits, excluding acquisitions, in Q3; including acquisitions, they are expected to be up mid-single-digits. (Currency is not expected to have a material impact.)

If current volume trends were to continue, we believe Q3 EBIT would be down approximately 20% year on year, due to Net Revenues being down 10%, mostly driven by Cross-Border Volume Fees being down 50%, and expenses being up 5%. (We expect Domestic Assessment revenues and Rebates & Incentives costs to be flat; Transaction Processing revenues to be up 5% and Other Revenues to be up 20%.)

Other Developments

Other developments since Q2 2020 results included:

  • The $3.2bn Nets account-to-account payments platform acquisition, originally announced in August 2019, received conditional approval from the European Union in August 2020. The condition is to provide one third party with a Nets technology license, which MA does not expect will affect its ability to compete.
  • The PayPal Business Debit Mastercard was expanded to 5 more countries (France, Italy, Spain, Austria, and Ireland) in September. The card was launched in the U.S. in 2003 and has been available in the U.K. and Germany.
  • MA’s efforts in China are continuing, as confirmed by comments made by the CEO in mid-September, with MA still working with joint venture partner NUCC to build the technology needed. MA expects to seek formal approval to start operating in China from the Chinese central bank “early next year”.

Valuation

At $331.78, on 2019 financials, MA shares are trading at a 42.1x P/E and a 2.2% Free Cash Flow (“FCF”) Yield; the Dividend Yield is 0.5% ($1.60):

Mastercard Net Income, Cashflows & Valuation (2016-20H1)

Source: MA company filings.

Despite the lower Net Income, FCF was significantly higher year on year in H1 2020, due to favourable working capital cashflows.

Buybacks were restarted at end of Q2 2020, and $1.0 billion was spent to repurchase shares by July 27, with an average price of about $300.

Shares have re-rated upwards significantly since we initiated our Buy rating in March 2019, when they were trading at 36.3x P/E. However, we believe the higher multiple is justified, given the “lower for longer” interest rates outlook and MA’s unique earnings resiliency and growth.

Long-Term Earnings Potential

COVID-19 has resulted in an economic shock and will likely push the economy into a recession, but it has also accelerated the move to digital payments, which will benefit MA earnings. We believe MA will eventually return to the “high teens” EPS CAGR target it had set for 2019-21 before COVID-19:

MA has a track record of achieving a high-teens EPS CAGR. During 2011-19, EPS CAGR was 19%, on a Net Income CAGR of 16%, with most earnings returned to shareholders in dividends and buybacks:

MA Net Income & Return of Capital (2011-19)

Source: MA company filings.

Illustrative Returns Forecasts

In our illustrative return forecasts, we assume:

  • Net Income to be 20% lower year on year in Q3 2020 and 15% lower in Q4, resulting in a full-year EPS that is 14% lower year on year
  • 2021 Net Income to be 5% higher than 2019, representing some recovery in H2 and earnings growth from the continuing move to digital payments
  • Thereafter, Net Income to grow at 14.5% each year, and the share count to fall by 1% each year, which together give a mid-teens EPS CAGR, slightly below the pre-COVID-19 high-teens management target
  • Dividend to be $0.40 per quarter for 2020, and then grow with EPS on a 20% payout ratio
  • 2023 year-end P/E of 42x, roughly flat from the present level, and implying a 0.5% Dividend Yield

At $331.78, with an exit price of $467.43 and dividends, we believe shares can deliver an annualised 11.6% return and a 43% total return over 3.5 years:

Illustrative Mastercard Returns

Source: Librarian Capital estimates.

Conclusion

MA card volumes are now in a “normalization” phase in most markets, being 4-5% higher year on year in the U.S. and flat internationally in August.

However, high-margin cross-border volumes remain approx. 40% lower year on year, which means we expect Q3 EBIT to be 20% lower year on year.

Before COVID-19, MA has a target for a high-teens EPS CAGR and has a track record of achieving this. COVID-19 has accelerated the move to digital payments and will likely accelerate MA’s long-term earnings growth.

We expect EPS to more than recover by 2021 and to grow at a mid-teens CAGR thereafter.

At $331.78, the shares can deliver an annualised return of 11.6% and a total return of 43% over 3.5 years. We reiterate our Buy rating.

Note: A track record of my past recommendations can be found here.

Disclosure: I am/we are long MA,PYPL,V. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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