Episode 22 | Mastering Mastercard: A Deep Dive into Its Financial Strength and Future

In Episode 22 of "Market News with Rodney Lake," Rodney Lake, Director of the GW Investment Institute, analyzes Mastercard's financial health, focusing on its balance sheet, margins, and management. Professor Lake discusses Mastercard's impressive interest coverage ratio and its use of leverage to boost return on equity. He also discusses regulatory risks, competition from PayPal and Apple Pay, and potential growth concerns. Lake rates the business highly, though he remains cautious about potential regulatory challenges. Tune in for an in-depth look at Mastercard’s performance and outlook!

Transcript

Thank you for joining Market News with Rodney Lake. This is a regular program for the GW Investment Institute where we talk about timely market topics. I'm Rodney Lake, the director of the GW Investment Institute. Let's get started. Welcome back to Market News with Rodney Lake. I'm your host, Rodney Lake. Today we're in the Duquès studio here, right here in Duquès Hall at the George Washington University School of Business.

Thanks for coming back. For those who tune in on a regular basis. And welcome to any new viewers or listeners. Today we're going to have a topic discussion on Mastercard. So this is a portfolio holding for the GW Investment Institute. So this is not a massive holding for us. We've been talking about larger positions in the portfolio, but this is a position that's been in the portfolio.

It's similar to another company we've talked about already, which is visa. Many of you probably have both Mastercard and visa, possibly American Express, discover and, you know, maybe some others. Those are the big cards, in the system right now in the financial system around the world and Mastercard and let's say visa kind of have this duopoly, let's say for a majority of the market or a vast, portion of the market.

But we're going to talk about Mastercard and maybe what, you know, we can do some compare and contrast here, but it's very similar to visa. So why is it different than American Express, for example? We'll talk about that when we talk about the business. So for today's discussion we're going to do business management price valuation and balance sheet.

Just as we've done in the past. We're going to be talking about how this all works together. So that's the GW Investment Institute framework. And again business management price valuation and balance sheet. So we're going to use those four components to talk about Mastercard today. And again disclosure we own this company in the GW Investment Institute portfolio.

This is for educational purposes only not investment advice. So let's dive into this. And this is what our analyst will be doing. And our stock pitch is actually coming up pretty soon. We'll see if somebody pitches to increase our position of Mastercard. If somebody tries to sell a portion of our Mastercard position, time will tell. We'll we'll get back to that.

So let's let's get into the business. So what is Mastercard. So Mastercard does financial transactions right. And processing that's what it does. And so when you swipe that card, you know, you've heard about possibly this four party system. So what is the four party system. So that's the card holder. The person has the actual card to make the purchase.

The merchant the businesses accepting that card. You walk into a store and swipe your card. They say we take Mastercard, the issuer. That's the financial institution that you you see on that card. And the acquiring bank is the institution that's going to process that for you. And so that's what's called the four party system. Visa uses that. Mastercard uses that, as as an example.

And so that was pioneered long ago now. But that's, that's the setup. And so that's the business that they're in and they get fees for this. And so like visa and as I mentioned, you know, differentiating them from American Express, they do not take credit risk. So really it's all about the number of transactions and the people's willingness to spend.

Now Visa and Mastercard get a percentage on these transactions. So it's actually a pretty good inflation hedge. So if you think prices are going to be rising and you talk about companies that have pricing power, well visa and Mastercard effectively get their pricing power as a pass through. Because if price is increasing they get a percentage of that.

They get to participate on that. So when you talk about a good business, pricing power would be one of those elements that we would talk about as an example of, well, this could define a good business. So let let's now dive in a little bit further. So that's the business they're entering the business of transactions. They're in the business of people going out consumers and spending money.

And making those swipes. We talked about the four party system. So let's now dive in some descriptive characteristics here. So the market cap is 477 billion. So this is a very large company. That's as of, you know, sort of deep into November here, when we're recording this. And so it's a fairly big market cap. The company has grown significantly since its founding.

And again, Visa and Mastercard are really kind of this duopoly for these large transaction companies that are different again, then an American Express taking, credit risk, at American Express and not taking credit risk at visa and Mastercard. So Mastercard does pay a small dividend. We can talk about that a 0.5%. So not people are probably not owning this with a dividend.

But you could see when we get to management that's a good discipline. That management has had. So that that's really, you know, to talk about the business. So now let's get into some of the other, characteristics, about the business. And so when we talk about what's the revenue for this business, so we're talking $27 billion, for the revenue for this business so significant.

And it has been growing at a pretty steady clip. And so if you look at the compounded annual growth rate over the last few years, you know, he had some, you know, bigger numbers, in the more recent past, in 21, when everybody was at home, probably spending a lot, from Covid, but now it looks a little bit more like it's closer to 10%, you know, compounding over time.

Or around there, when you look at what's sort of, the profit margins for this business, you have net income margins that are 47%, not quite as high as visa, but high. So for an overall business, you're talking about fantastic, gross margins and EBITDA margins, you know, could be in the 60%. And so if you look at that, again, not quite as good as visa, but very good relative to other companies.

And so this is a fantastic business. Your index basically to growth. And the business, by the way, is headquartered in Purchas, New York, which is kind of fun. In any case, this is an excellent business. These have excellent margins. You have this pricing power built in because you have this indexation for the growth in prices.

So if prices rise, you kind of get that pass through, you get to participate. So if inflation becomes an issue, which it has more recently has not been a problem for 40 years. The fed is trying to tamp that down, which is seem like they have had some success. And it's going the other way. But this is a way that Mastercard gets to participate.

If in fact, inflation comes into the system so built into their business model. And when you talk about free cash flow, 13 billion of free cash flow. So you know on on revenue of 27 billion. So that's a lot of free cash flow, from, from that revenue. So really good, free cash flow in the business.

So you can see that this company doesn't require a lot of cash. It doesn't use a lot of cash. It actually puts out a lot of cash. Now that this network is built, now that they can run more transactions on this network again, very similar to visa. So that's the business. So excellent business. Now let's get into management.

So management is a little bit newer a little bit less than let's say four years Michael my bok has been in charge of this business. And over time, so and I think time will tell. We don't have a ton really to talk about here on the management. They seem to be trying to invest in and new things, just like visa.

What is the next set, you know, value add services to their client, the analytics that what can we offer to our clients that they can get, you know, better visibility on what. You know something very in particular that they want given that they have all this, you know, data that that they can help process and create different types of views for their clients.

And so but really, again, it's the transaction game that's the bedrock of that. What are they doing to help protect that. So investing in that business is critical. And again Michael my back has been there a little less than four years. So I think time will tell. I don't necessarily have a lot to talk about here. On the management.

I think they've been doing a good job over time. And I think it's a little bit early. Let's say, in the tenure of this management team to see how they, put their imprint on Mastercard. And again, it's really kind of a duopoly, with visa. So we won't spend a ton of time on that. So let's move on to, the valuation.

So when we look at the valuation for Mastercard, you're talking, you know, the this is a high quality company with good margins. So you would expect that the valuation is likely going to be a bit higher. So when we dive in and say, okay, for this company, it's a proper company with revenues and earnings. So we can use the P as a guide for us for that.

So the forward PE right now again we're deep into November here. Is 36 times. Well is that cheap. Is that expensive. How should we really think about that. Well one way to think about that is how does it look over time just against itself. Right. So if you look at Mastercard against itself over time, you're talking about that kind of a median for the last ten years.

So the last ten years has been about 36 times. So it's kind of right on top where it's been. So you wouldn't say that's really cheap or really expensive. You would kind of say, well, in the last ten years, the market has essentially valued Mastercard, right where it is. And the S&P is below that, let's say a 25 times.

But, you know, this is not a typical this is not an average company. So you would expect that it would trade above. And it has. So the median, you know, it has moved around a lot. During that period it's gone from 62 down to you know, the teens here. And so, you know, it's been all over the place.

And when you know, you have peaks and troughs in the market. Sorry, it's been to 1625. My apologies. So it's been a 60 in 25 and now it's trading at 36. And so again, that's right on sort of par with where the median is for the last ten years. So you wouldn't call that cheap again. You wouldn't call that expensive.

So that's not necessarily super descriptive and saying okay let's make a decision on the valuation. That's a it's an opportune time to buy in because of this event happen. And people are really against the company and it's really depressed. The valuation that has not really happened here. And so you could probably call this a fair valuation. So then you have to look to other elements of the business to really think about this or other elements of the framework, to really think about why should we own this company.

Let's look further now. So again, the valuation, I think we're kind of right on top. The long term median here for the forward earnings. You know, not you know doesn't really help us too much. And we'll come back to the scores, as we wrap up. But let's now dive in, to the balance sheet. So when we thinking about the element of the balance sheet here.

So where where are we on the balance sheet? So if we look at cash and cash equivalents, last 12 months at, September 30th, 2024, you're talking 11, billion and then 18 billion in debt. So you're you're still at a net debt position? Not a huge number. 7 billion. When a company generates $13 billion in free cash flow.

So you're not necessarily concerned. And if we look at what's the interest coverage ratio. Also again you're not going to be super concerned about this company. Interest coverage is 24 times. And so you have net debt 7 billion, but you're generating 13 billion in cash and you're 24 times for the interest coverage ratio for the balance sheet.

And we're going to sleep at night. The preference would be for a lot of these companies is to have net cash. Now what about a reason, that they could be using net debt is to, you know, increase the return on equity. So the return on equity adds that leverage in the business. And so when you talk about return on assets, what's the difference between return on assets and return on equity is sort of the debt in the business.

If you use the DuPont formula as a guide there. And if you look at right now the net, or the return on assets at 28 times and return on equity at almost 180 times, they're really using that leverage to help really drive the business, forward as far as like return to equity for shareholders. And so, you know, you can make an argument that they're being responsible and they have been responsible over time with that leverage.

And again, it's not so out of character or outside of the bounds of something that they can manage, with what they have in their net cash on the balance sheet, or rather the, the cash on the balance sheet, plus the free cash flow. So it's not such a big number where you're like, well, where we really worried about this.

If earnings drop, the interest coverage ratio is 24 times. So earnings would really have to deteriorate for us to be really concerned about Mastercard on the balance sheet side. So let's now go back to the business. So for the for the balance sheet maybe before we move on rather the balance sheet is something is I would say is a source of strength.

And we'll come back to scores here in a moment. But the balance sheet is not something that we're necessarily concerned about. And in fact, excuse me. In fact, this would be something that would be a source of strength. And again, probably not a ten because not net cash. And we'll score here in a moment. But it is a source of strength nonetheless.

So let's, let's get back to, to Mastercard the business and let's get back to these margins. Think about, you know what, how should we consider this? Well, when you think about okay, what are the threats to the business. And so it's a high margin business. It's going to attract others. What are some of the other risks to the business before we score it here.

Another risk would be on the regulation side, you know, Visa and Mastercard have gotten criticism that, you know, they're really a duopoly in in this market. And they, you know, charge unfair prices to merchants. However, it doesn't seem like there's enough momentum right now. At least this is opinion, by the way, that something's really going to happen here.

And now when you're going to have a transition from the Biden to the Trump administration. And it looks like there's going to be more on the deregulation side versus the regulation side. You saw a rally in the financials, and that would probably include something like, Mastercard and visa, where they might benefit from that. Now, maybe not.

Time will tell. We'll have to see how, you know, there are some pain points in here that, this administration could think, well, consumers are not necessarily benefiting as much as they absolutely could. So that that could be a source of concern for us, as shareholders in Mastercard and visa. But in this case, thinking about Mastercard, that could be a concern for us.

So it's something that we really need to think about. But the the way that the wind is blowing, let's say, to use an analogy, it doesn't look like the Trump administration is going to come in hard on visa and Mastercard in particular. So this could be a positive for us, even if they just sort of leave those companies alone.

And, you know, again, but there is a piece here for the consumer that they could be, concerned about. So again, you're talking about net margins of almost 50%. You're at 48%. So it's a good business. So I would probably rate the business. Not as good as visa. But you're an 8 or 9, for Mastercard.

Very close. Not as dominant as visa, but still very good. Making a lot of progress. And sort of or rather keeping its dominance in this market. So 8 or 9 there. Now we move on, to the management, the math, the management has done a good job. This management team has been pretty solid over time. So I would rate them also maybe as a seven.

I think they're still a little bit early, but not as you know, one rated as high as is visa in this case either. But also good using visa as a reference point here. And so then we move on to the valuation. The valuation is probably a six right 36 times. That's right on top of the market. Not something stellar outstanding but not terrible based on the ten year number.

And so maybe a six, or, you know, it's something 5 or 6. And then we talk about the balance sheet. That's probably an eight, seven or an eight. So overall, you're probably talking about a seven and eight depending on, you know, if you get really aggressive on some of these and others. And so you put those together, you wait them 25% each.

You're really talking about, 7 or 8 here. Now, the question is, in your portfolio, shall we own visa and Mastercard? Well, we own both and a couple of different portfolios. So, you know, is there something that distinguishes the one from another? Do you actually get diversification? These are other discussions that we can have in the future.

Right now we own both of these companies. I think they're both doing well. Again, on the business side, you're getting this flow through for the price, you know, protection, the pricing power that it has against inflation. So that's super helpful. On the management side, responsible management, not something where I feel like, well, let's really highlight this management team and all these great things that they're doing.

The valuation is pretty fair. Over the last, you know, ten years, we're essentially right on top of that valuation at 36 times, higher than the market. As we mentioned before, if you're looking at a company that has really good business, that has really high margins, has a great brand name, Mastercard has a great brand name that people, know and recognize, you're going to have to pay up.

So again, not we're not excited to pay 36 times, to be super clear. But when you have a good business, you have to know that other people are going to know that too. And then on the balance sheet, not concerned at all. 25 times, EBITDA, over interest. And so the interest coverage ratio, super comfortable with that.

Ideally would have, you know, cat net cash on the balance sheet as equity holders, but they're using it. It seems like to drive return on equity. Again. We've used the DuPont formula. The equity multiplier in there is what's happening. The return on assets. Plus or times the equity multiplier is going to be a return on equity.

And so they're driving up the return on equity. So if you're an equity shareholder it looks like they're using the leverage on a balance sheet to the advantage of shareholders. And that has been returned in an increased stock price over time. And so if you've been a long term shareholder you've benefited from that. But being a little bit more conservative, is sort of our point of view here at the investment in suit.

So we could drive that number down a little bit. Overall solid company. Some questions to ask is on what's the future growth of this company. What are some of those regulatory concerns. So we need to think about are they going to remain out there. Is this new administration really going to focus on the consumer part of this and say we really got to understand this, and we really want to make sure that these fees are not borne by these customers.

And in fact, they go down over time. So those are points of consideration on the competition side. Who's coming in. Is PayPal going to be making a difference? Apple Pay, Google pay, you know, is this going to really matter. And if so, how, you know, blockchain and everything else is is something to consider as well.

But then on the management, are they going to be driving innovation. So we got to really think about that. The valuation seems pretty consistent over time. If it goes up or down too much, that's something to monitor. And again, we will need to monitor what's happening on the balance sheet. So not something that to be concerned about but absolutely something to monitor to think about over time.

Again, a 7 or 8 for this company should we have in our portfolio is another consideration. We'll continue to think about that. In other companies. That's it for today, though. If you have anything that you want to hear about, please let us know. Put it in the comments. Is there a company, that you want us to cover?

Please let us know. We're driving towards the end of the semester for the GW investment and suits. We'll have a whole new set of stock pitches from our students. We're excited to hear about that. Maybe one of those will be about Mastercard to add or take out of the portfolio. Wait time will tell. We'll see. Thanks for tuning in.

See you on the next episode.

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