Model Portfolio rmcduff:RMG1

Editors Note: This analysis was presented by mFOLIO Master, Randolph McDuff at a gathering of the m100 on October 6, 2007 when MA was trading at $153. In Q2, 2008 MA reported a loss due to a settlement with American Express. Excluding this charge, revenue grew 25% and earnings 9%. The stock is now trading at $230 and is still RMG1's largest holding.

MasterCard (nyse: MA)

MasterCard manages and licenses out the MasterCard, Maestro and Cirrus payment systems to third party users. Revenue is a combination of transaction processing income through the MasterCard interchange systems, assessments on gross dollar value (GDV) run through their systems, gateway fees and licensing fees. Revenue is earned globally, with roughly 52% of total income earned from the United States.

MasterCard is my preferred play for growth in global commerce

As one of the two major global credit card processors, MasterCard is uniquely positioned to earn revenues which should at least match worldwide growth. MasterCard reports 750 million active accounts globally.

MasterCard also should participate from a global shift towards "non-cash" payments.

Growth rates for MasterCard are impressive

Statutory filings report growth rates 2x - 3x higher than each regions' GDP, for all markets that MasterCard competes in.

3 month growth (in local currencies) for the six major markets that MasterCard operates in, for Q2 ending June 30, 2007 were as follows:

In addition to growth in transactions, cash volumes also grew sharply in each region. The exception was in the United States, where cash transactions were essentially flat in the second quarter of 2007.

MasterCard should generate more than 1/2 of total revenues from outside the U.S. as soon as Q1, 2008

MasterCard is now accepted in more European locations than the U.S. Asia should also have a higher acceptance rate than the U.S. By the end of 2007. At that time, MA may be considered a truly global company.

There is NO representative peer group

The only company that appeared close to being a peer, First Data, was recently taken private by KKR. EBITDA margins of 22% for FD greatly lagged that of MA. The takeover was priced at an effective rate of 16.8x EV/EBITDA.

First Data differed somewhat from MA, inasmuch as FD paid for access to the MasterCard and Visa interchange networks. In short, First Data was as much a "client" of MasterCard as any other credit card firm.

Investors occasionally place MA into a group with American Express and Discover

This is wholly incorrect. While AXP and DFS participate in interchange networks, MA DOES NOT issue credit cards, extend credit, determine interest rates & other fees, or establish merchant discounts. AXP and DFS also lack the international penetration of MA.

DFS ($21.77): 87.7% U.S. Revenue. 98% of operating income is tied to the U.S. Economy. Loan losses were 17.1% of total revenues in the 2nd quarter of 2007. Discover loses money from international operations and lacks a comprehensive international interchange network. Consequently, DFS pays MA and VISA for international access, just like any other client.

According to most recent GAAP balance sheet, it appears that DFS is selling for 13.2x my 2007 estimated EV/EBITDA. I would note that the balance sheet is virtually impossible to work through on a representative basis. The firm does not segment securitization revenues, but I estimate that they are at least 2x higher than AMEX.

Discover produces 2 balance sheets in each quarter; one assumes the sold portfolio is retained (which appears better than GAAP results). One complies with the basics of GAAP, but is very light on detail. DFS emphasizes the results of the retained portfolio, which is not GAAP compliant.

My impression: a bad read. In my experience, opaque balance sheets are generally hiding something from the public. I believe that Morgan Stanley spun off DFS at the high, with a clear understanding that business was turning for the worse.

AXP ($60.63): Sells for roughly 11.4x my estimated 2007 EV/EBITDA. 72% of revenues are U.S. 54.7% of operating income derived from the U.S. Securitization income accounts for 9.8% of total revenues. Loan losses were 15.4% of total revenue (1st half of 2007). Interestingly international loan losses were just 10.2% of foreign revenues. EBITDA margins were 17.8% of revenues in the first half of 2007. AXP also produces 2 balance sheets, but places more emphasis on GAAP results.

The firm still does not fully segment travel related operations and private banking from credit card operations. These are a larger component of AMEX than one would think, and may obscure loan losses as a percentage of total revenues.

My impression: I have followed AXP on and off for the better part of 20 years. Financial reporting has vastly improved over that time. A better read than in years past.

MA ($153): sells for roughly 14.5x my estimated 2007 EV/EBITDA. EBITDA margins were 36.8% of first half 2007 revenues. I removed a sizeable non-recurring payment in the second quarter to arrive at my EBITDA margin. 73% of revenues were based upon transaction processing, and 27% of revenues were earned from various assessments based upon the GDV (gross dollar value) of charges run through the interchange networks as well as licensing and "gateway" fees.

U.S. Dollar revenues were 51.8% of total revenues in the last quarter. Revenues were roughly .0024% of purchase volumes. 42.5% of MasterCard accounts are U.S.

My impression: The balance sheet is a top notch read.

The lack of peers means that MasterCard coverage is problematic for a largely "reactive" Wall Street

17 analysts (according to Yahoo) remain nicely scattered with recommendations. There is an 11% difference in the analyst mean recommendation for 2007. The mean difference grows to almost 15% for 2008, suggesting some analysts are actually doing homework, and some aren't. Price targets range from a low of $88 to a high of $190.

Competing technologies will have a difficult time eroding the MasterCard's franchise

Recently, some discussion has revolved around the potential for displacement of traditional credit card processors (such as MasterCard and Visa); by "alternative" suppliers, such as Paypal, Amazon, and "Revolution Money." In point of fact, some of these "competing" technologies represent new clients for the MasterCard system.

My review of the industry suggests that structural barriers should limit alternative supplier penetration in the general market. The alternative suppliers go after the merchant to generate revenues, but make limited efforts to attract banking systems that represent "gatekeepers" of the interchange.

Without full partnership of banks (i.e. Revenue splits at least as lucrative as the banks presently have with credit card processors), the business model will have a hard time scaling to the mass consumer, mass business level. Alternative payment system operators are not new, and have come and gone in the past.

Due to economies of scale enjoyed by the Visa-MasterCard duopoly, it is virtually impossible for new competitors to compete on price

While small merchants often complain about charges, the formula to determine fees is complex. Most of the "charge fees" are earned by merchant banks and suppliers. MasterCard earns a modest tolling fee of just .0024% of purchase volumes. New firms such as Revolution Money intend to charge gross fees of 0.5% to merchants. However, the lack control over "push fees" (among other charges) which move money to bank accounts from business.

Paypal fees (across the board) are equivalent or higher than MasterCard and Visa. Small merchants (less than $3,000 per month) pay 2.9% + $0.30 per transaction. The lowest fee ($1,000,000 per month of sales) is 1.9% + $0.30 per transaction. According to data supplied by Ebay, overall Paypal net transaction charges as a percentage of total payment volume was 3.7% in the first half of 2007. As this fee is virtually unchanged from 2006, one can assume that 3.7% represents the aggregate cost of using Paypal.

Finally, since many consumer Paypal accounts are funded with credit cards, companies such as Visa and MasterCard remain fully in the loop, earning their interchange fees.

VISA's public aspirations for 2008 should be good for comparative analysis

Intuitively, I think that VISA will increase investor interest for MasterCard. Evaluations to an incorrect peer group should finally be put to rest.

MasterCard has been considered a "first mover" in many fronts, primarily in Europe and Asia. Comparisons with Visa will likely be favorable.
As a private company, VISA does not break down financial figures. However, industry sources suggest that MA has been gaining market share on a global basis, and has absolute dominance in European debit cards.

MasterCard has a strategic investment

MA owns 4% of the stock of Redecard SA. Redecard is a publicly traded MasterCard equipment provider and service provider to financial institutions in Brazil. This holding has a market value of $450 million U.S. And is recorded on MA's books at the historic cost of $12.9 million.

Harmonization of the European debit card systems should be a major plus by 2011

French residents cannot pay for a purchase in Belgium with a debit card. This is because uniform standards for payment processing at the bank level do not exist. The European Union has mandated that a national system be implemented by 2010. The "Single Euro Payments Area" or SEPA will adopt one system for clearing both debit and credit charges and payments in a uniform and timely fashion.

The Maestro systems now in place at MasterCard have been designed expressly for this purpose. Visa does not have a competing system capable of meeting SEPA standards in place, and appears several years away from doing so.

The credit crunch may have produced unintended benefits for MasterCard; that being a reduction of potential competition

A small group of individual banks had discussed setting up their SEPA standardized debit system in Europe, so as to try and compete with Maestro. However, recent credit turmoil and apparent mutual distrust on counterparty obligations have left banks wary of one another. The capital cost to develop a competing system could be significant. Such a system may never to market. As a result, I suspect that upfront costs for a competing debit card system won't get past capital allocation departments at major banks.

Conclusion

Investors interested in MasterCard should be willing to accept that misperceptions will persist until/if Visa goes public. As part of a global duopoly, a public peer for comparison will then truly exist.

I own MasterCard, for duopoly profit margins and an outstanding business model. High EBITDA margins earned at MasterCard do not come at the expense of merchants or consumers. They are earned via an efficient business with global economies of scale.

Member banks earn the overwhelming majority of profit from MasterCard relationships, but also take on most of the business risk. This provides both MasterCard and merchant banks with mutual incentives to vigorously expand the franchise. As a result, I do not consider competing technologies to be a credible threat for the business model.

MA appears to be at the forefront of a European SEPA payment program. If SEPA is enacted using the Maestro system, future growth would accelerate.

MasterCard represents the largest investment position of RMG1. I endeavor to purchase world-class companies for less than 10x forward EV/EBITDA. This suggests that a new entry point for MA would be $127 U.S. Or better. Macro developments in Europe and Asia suggest that EBITDA may surprise on the upside, and I prefer to overweight Europe.