Visa - It's Not Everywhere I Want to Be
(See original version of this article at Seeking Alpha.)
There has been no shortage of market commentators talking about an impending credit crunch that will hit the credit card companies severely at some point. Noted investor Peter Schiff even issued a wholesale condemnation of credit cards in the past month. While I agree that America has overdependence on credit and that the credit card companies will all suffer during the next year, the prognosticators that believe this is the end of credit cards are going overboard. The question is not whether the credit card companies will suffer; it’s how much they will suffer and how much of that is already reflected in the current prices.
There’s no question that the market does not like Capital One (COF) or American Express (AXP) right now. The market has also soured on Discover Financial Services (DFS) and to a much lesser extent, Master Card (MA). Strangely, however, Visa (V) has been spared much of the carnage. While Visa has dropped from its highs in the upper $80 range from late spring ‘08, it is only down marginally for the past year during a timeframe when the rest of the market has been completely obliterated.
Seeking Alpha contributor Ryan Pollack made a very well argued case in favor of Visa last week and before I go any further, I’d like to thank him for that analysis. I always enjoy reading well thought out cases for or against a particular stock whether I agree or disagree with the author’s conclusions. In this case, I find myself in disagreement with Mr. Pollack on Visa.
The Consumer Spending Crunch
Color me baffled as to why the market despises Discover right now, but has not turned on Visa. Perhaps this is because, as Mr. Pollack astutely points out, Visa does not take on the credit risks of its customers. While true, this seems to ignore the fact that someone does take on the credit risk of Visa’s customers and those companies that do are undoubtedly in the mood to tighten standards at the moment. With credit being contracted, that means less credit card usage. Since Visa makes its money off of service fees, data processing fees, and transaction fees; that means that Visa should not totally be spared, either.
Visa has benefitted from the increasing use of debit cards by consumers as credit has been tightened. Certainly this can bode well for Visa, but I’m simply not convinced that consumer spending is going to reach the levels that it did earlier this decade any time soon. People will certainly continue to utilize their credit cards and debit cards as a preferred method of payment, but they will be paying for things less often.
In its latest earnings call, Visa’s executives have admitted that the economic slump has impacted them unfavorably as they lowered guidance on revenue growth. CEO Joseph Saunders stated that fiscal 2009 revenue growth now appears to be in the high single digits, which is below their long-term guidance in the 11% - 15% range. He also remarked on a pronounced decline in US payment volume growth and global cross border volumes.
The Shift To Plastic
On the other hand, there are some signs for optimism with Visa and I’m not oblivious to the bullish case. Despite prophecies of doom for plastic, consumers and business owners alike seem to prefer the relative ease and security of credit cards and debit cards. Quite frankly, it’s a lot easier to pull out a card and swipe it than it is to write a check or carry around wads of cash at all times. Credit card usage is still growing in the US if Visa’s financial results are any indication. During the current crisis, an increase in debit cards seems even more profound as Visa has 14% growth in its last quarter. While, it is probable that growth in the US market will probably slow up some in the coming years, there is strong growth in international markets where credit cards are becoming increasingly popular.
Mr. Pollack also makes another spectacular point in his article about Visa Europe. If you’re ignoring the international picture, you’re ignoring what makes Visa so attractive right now. Growth in Europe and Asia should be the driving force behind this machine in the future.
The other important thing to consider with Visa is the proverbial moat. In fact, calling it “a moat” seems to be an understatement. Visa has a well fortified castle, thousands of archers standing atop of the castle walls, and a thick swamp filled with alligators surrounding their business.
All this is to say, I don’t really disagree with Mr. Pollack’s bullish case on Visa’s growth prospects. Visa will continue to grow and plastic will continue to be the trend. However, in the end, everything comes down to valuation and I am not enamored with Visa’s balance sheet or cash flows relative to its price.
Goodwill and Intangibles
In his article, Mr. Pollack remarks on Visa’s “cleaner balance sheet” and favorable ratios. I find myself in disagreement on this issue. Certainly, Visa’s leverage ratios look very healthy if you take everything at face value. Their liability/value ratio is only 32%. Cash-to-liabilities is strong at 0.46 and if you include “restricted cash”, current ratio is 1.75, and their quick ratio is 1.30. However, looks can be deceiving sometimes.
My major qualm with Visa’s balance sheet is how much of it appears inflated due to the presence of, what I would term, “non-real assets.” In particular, I cannot help but to notice the colossal-sized amount of goodwill – a whopping $10.2 billion! For those not familiar with “goodwill”, it’s strictly an accounting concept meant to measure the premium a company paid over market value for acquisitions.
Having a large chunk of goodwill on the balance sheet is not necessarily a bad thing for a company; there might be legitimate reasons that it paid more than market value for an acquisition. However, it can be a deceiving since it is classified as an “asset.” If the price of an acquisition was justified, that should be reflected in future cash flows. There’s no real guarantee that the acquisition was truly worth the amount paid for it and “goodwill” is a very distortive measure in this regard.
Visa also has an extremely sizable amount attributed to intangible assets (IAs). Intangibles are a trickier issue than goodwill since some “intangibles” could be sold off to other companies. In this sense, you could say they are “real” in one sense. But given the fact that Visa has a $10.9 billion balance in that account and this constitutes over one-third of their total stated assets, it is important to analyze these items in detail.
From their latest 10-K statement, the breakdown for Visa’s intangibles is as follows:
Intangible Assets - FY 2008
Customer Relationships --- $6,799
Tradename --- $2,564
Visa Europe franchise right --- $1,520
TOTAL INTANGIBLE ASSETS --- $10,883
All amounts in millions
Certainly, I have to believe that the Visa Europe franchise right is a commodity that could be sold on the market for a significant return. While customer relationships and Visa’s tradename most certainly have value, I would be skeptical of treating them as full assets since their values are largely dependent on the success of Visa’s operations. Also, as I stated with goodwill, if these assets have such high stated values, that should be reflected in cash flows so counting them for valuation purposes is arguably duplicative.
A Modified Balance Sheet
Once you discount goodwill and intangible assets from Visa’s balance sheet, it does not look nearly as favorable. While Visa’s book value including the two accounts is $21.70 per share, their net tangible assets only add up to 55 cents per share:
[Visit Seeking Alpha version of article to see chart]
To give a little more perspective, here’s a chart that shows tangible assets versus goodwill and IAs:
[Visit Seeking Alpha version of article to see chart]
Visa’s liability/value ratio jumps up to 47.1% if you discount goodwill and 94.9% if you discount all intangibles. While this does not mean that Visa is navigating dire straits by any stretch of the imagination, it does suggest that the strength of their balance sheet might be deceiving. In fact, what makes them healthy is the strength of their cash flows; not their balance sheet.
It Comes Down To Valuation
What it really comes down to is valuation and looking at Visa’s balance sheet and cash flows, I’m unable to reach the same conclusions as Mr. Pollack or the overall market. I decided to run a few sample quick DCF valuation scenarios. However, this is somewhat complicated by Visa’s convoluted and baffling share structure. They have three classes of stock and four different series within the “Class C” stocks. They record different earnings for all of these shares. For our purposes, we’ll assume “Class A” ownership.
In their most recent fiscal year, Visa had earnings of 96 cents per share. Operating cash flows were around 53 cents per share. Strangely, operating cash flows also seem to be more consistent than earnings, as they brought in $531 million for FY ’08, $505 million for ’07, and $450 million for ’06.
For my analysis, I will assume a cost of capital at 10% (which might be low, particularly if inflation hits any time soon) and will set up the template with an initial free cash flow (FCFs) figure for year 1 (Y1) that increases by a set growth rate (g) for the first twenty years; after the first twenty years, I lowered the growth rate to 3% in all scenarios. I will use an adjusted book value of $10, which completely discounts goodwill and creates a minor discount for other intangible assets. Here are my scenarios:
Scenario #1: Y1 FCFs = $2, g=5%
Scenario #2: Y1 FCFs = $2.50, g=5%
Scenario #3: Y1 FCFs = $3, g=5%
Scenario #4: Y1 FCFs = $2, g=8%
Scenario #5: Y1 FCFs = $3, g=8%
And here are the results:
Scenario #1: $44.48
Scenario #2: $53.10
Scenario #3: $61.72
Scenario #4: $58.24
Scenario #5: $82.35
These are by no means meant to be accurate representations of Visa’s value. Rather, I run these scenarios simply to display the high level of expectations priced into Visa’s stock. Trading in the $55 - $60 range, it becomes clear that expectations are through the roof. Certainly, Visa will have significant growth over the years as consumers continue to switch to plastic and the world follows America’s lead.
However, Scenario #3 and Scenario #4 both show an extremely aggressive amount of growth factored in already. Keep in mind that Scenario #3’s opening FCF figure is slightly less than six times Visa’s FY ‘08’s operating cash flows! Also, for Scenario #4, an 8% growth rate might not seem that unrealistic given Visa’s current and past performance; however, keep in mind that I used that growth rate for the next twenty years! That’s a long time for a company to produce abnormal earnings growth.
In trying to come up with a value-neutral valuation, I would peg Visa at around $40 given the risks and uncertainty coupled with the current market environment. However, for a more personal valuation, I would further discount the stock price due to my unease with Visa’s overly complicated financial statements, a balance sheet lacking the characteristics I like to see, and a belief that even the thickest of moats can be deceiving. Even software titan Microsoft (MSFT) is starting to see its moat chipped away more and more by open source competitors and Apple (AAPL). Visa is similar to Microsoft in that its position is very strong, but is potentially vulnerable in select areas in the future.
My personal valuation for Visa would be closer $30 based on the factors outlined above. Whether I’m using my personal valuation (which I only tend to do for purposes of analyzing a long position) or my more neutral valuation, Visa looks overpriced to me. It might not even be all that bad of a short target; though, I’ve always believed shorting quality companies comes with significant risks.
As Mr. Pollack’s article concluded, “not all credit card companies are created equal” and I agree. However, from an investment standpoint, I believe the one of Visa’s peers offers a greater risk-reward proposition: Discover Financial Services (DFS) has a very strong balance sheet and appears to be priced for catastrophe right now. Visa, on the other hand, is not “everywhere I want to be” at the current price.
Disclosure: Author holds no position on any companies mentioned in this article.