Mastercard And Visa Will Outperform The Credit Card Industry In The Long Run

By Taylor DeStefano on March 30, 2009 More Posts By Taylor DeStefano Author's Website Despite all of the problems surrounding consumer credit, the credit card industry is in a position to benefit over the long run, as the public continues to make the transition from paper to plastic. Additionally, consumer spending, although it has hit a speed bump, will rise over time. Indeed, late payments on credit cards hit a record high in January and defaults are likely to worsen until the economy makes a turn around. Although the commercial banks, such as J.P Morgan (JPM: 26.58 0.00 0.00%) and Bank of America (BAC: 6.82 0.00 0.00%), saw net losses in their credit card divisions last quarter, credit card companies like MasterCard (MA: 167.48 0.00 0.00%) and Visa (V: 55.60 0.00 0.00%) fared better. Visa and MasterCard are unique in that they operate the electronic payments networks the cards are processed on but do not have direct credit risk due to lending. The following is a run down of companies that are part of the credit card industry and how consumer spending is going to affect the industry in the future. Visa & MasterCard Visa and MasterCard are the two companies that I believe will outperform the industry in the long run. Don’t be fooled; the next two quarters still pose risk for a their stock prices as the economy continues to contract and consumers spend less money. However, that could present a more attractive buy-in point. Many trends that these companies will be able to capitalize on are the same, as their business models are extremely similar. For example, both will want to concentrate on their debit -card businesses, as this is seen as the quickest growing electronic payment option going forward. It makes sense that debit will be more likely to beat out cash and checks than credit, especially in these economic times as consumers try to borrow less. Visa, which operates the world’s largest electronic payments network, makes money from serving, processing, and transactions fees rather than issuing credit cards, which is one reason why it is poised to excel. Payment volume and transactions are the drivers for Visa’s revenue, as it benefits every time a card is swiped, and more cards are being swiped every year. Operating in over 170 countries, Visa is also in a great place to expand abroad. Visa may seek to acquire Visa Europe in the coming years to geographically diversify their revenues. The company will rely primarily on growth in emerging markets to offset some of the slowdown in developed countries. Many investors might think expanding abroad is not smart during a global financials crisis, however, this is a great opportunity for the company to grow in countries with large populations and very low penetration of credit and debit cards. This means the relative growth rate in these nations is much better than in more mature and currently struggling economies. The company recently launched its first global marketing campaign, entitled “More people go with Visa,” which perpetuates the idea of a single global company. MasterCard generates its revenues from operations fees and assessments. Furthermore, not only does the company processes payment transactions but it also offers consulting services to customers. Similar to Visa, I expect transactions volumes to increase for MA due to a shift toward greater credit usage, despite a slowdown in consumer spending in the near term. The other positive to MA’s business model, just like Visa’s, is that it does not have the same credit risks that lenders like commercial banks have. Increasing its debit card business has been a priority for MA, and it recently launched a new debit card program with KeyBank, which is a unit of KeyCorp (KEY: 7.87 0.00 0.00%). What hurts MasterCard is that Visa has more of the U.S. market share in the debit business, with over 53 percent of its total volume in debit cards and the rest in credit. MasterCard only has about 30 percent of its transactions coming from debit cards in terms of gross dollar volume. To put it in perspective, total debit card volume last year grew 13 percent versus a 2 percent decline in credit cards in the U.S. With many Americans avoiding excessive borrowing now, debit card use is likely to increase as people stick to their budgets. MasterCard is also seeking to capture emerging markets growth in the future, particularly in China and Brazil. MA reported that emerging countries in Asia and Latin America have had double-digit growth in gross dollar volume in credit and debit transactions in the fourth quarter of 2008; they fell 5 percent in the U.S. for the same period. One way that Visa and MasterCard will boost their bottom lines is charging banks that issue cards higher fees to offset lower consumer spending. The new transaction fees planned are just under 2 cents per transaction but could mean over $600 million in added revenues for the networks. The new fees will most likely be passed on to merchants. American Express American Express (AXP: 13.63 0.00 0.00%) is a leading global payments and travel company. While Visa and MasterCard are embracing their current business models and positioning for more growth, American Express has recently decided to go back to its roots. The company ramped up its credit card business just before the financial crisis, which was bad timing to say the least. Now, it plans to return to its policy of issuing charge cards to more affluent customers with healthy credit. However, in the process of the transition the company is cutting lines of credit to long time customers which does not bode well for its reputation for customer service. If the company would not have handed out credit so freely prior to the housing bubble, it would not be experiencing this problem to this extent in the first place. Historically, AXP has performed well in prior economic recessions due to the focus on charge cards. Charge cards differ from credit cards in that the user must pay off his or her balance in full each month. One reason this downturn has hit AXP the hardest is that many of its customers come from the U.S. coasts, meaning more exposure to California and Florida. These two states are among the worst suffering in terms of the real estate market. AXP’s major transition away from its original reputation as an exclusive brand began in 2003, as the company was attempting to get a bigger piece of the credit card market. With 2003 being the first year that total annual use of cards exceeded cash and checks, it seemed like the right strategic choice at the time. The problem is that as it expanded its customer base, the company kept giving out more and more cards and increasing limits to promote spending. After all, AXP collects fees from merchants every time a card owner makes a purchase, so it wants the number of purchases to be as high as possible. Now, the company is thinking about returning to its typical affluent customer base. So, the real questions is, can American Express hold onto the loyalty of its customers after all of these strategic changes, or will the company be bought out by a competitor? Although many potential buyers for American Express are laden with their own issues, AXP would be a great target for a buyout. Lately, many analysts have been revising their earnings estimates for American Express for the next two years, even noting a significant possibility that AmEx will post a loss. Standard & Poor’s has placed the company on review for possible downgrade as its credit quality worsens at a pace that exceeds average levels for the industry. One possibility for the credit card company is to cut its dividend to help conserve capital; it currently stands at 18 cents per quarter. One thing is for sure, this is definitely a credit card company to stay away from in 2009. Discover Financial Services Discover (DFS: 6.31 0.00 0.00%) is one of the largest card issuers in the U.S. and also offers different loans and savings products to customers. DFS currently operates through two business segments: U.S. Card and Third-Party Payments. In the Third-Party Payments segment, Discover is looking to increase the number of financial institutions that issue credit and debit cards to be used on the Discover Network; the company just entered the debit card business in 2006. While the company has solid fundamentals, weakening credit quality and this type of economic environment mean industry charge-off rates will continue to increase. Increased charge-offs prompt companies to bulk up their reserves, which is what you are currently seeing at the big banks. This will definitely hurt DFS as a credit card issuer, which is why I still favor V and MA going forward. Credit, Saving, and Spending Consumer spending is extremely important as it contributes to 2/3 of the U.S. economy. However, as Meredith Whitney from Oppenheimer notes, what is under-appreciated is the role of credit card availability in that spending. She estimates that over $ 2 trillion of credit card lines will be cut this year; this is relative to the $ 5 trillion of lines outstanding now in the U.S. This could potentially be detrimental to consumer confidence and the economy. Currently, five lenders comprise 2/3 of the market. The problem is that none of them want to be the last one holding an open line of credit to a customer. As lines are cut, since people have more than one relationship with credit card providers, risk exposure shoots up for the lender with the largest remaining line outstanding. A major reversal in how credit is obtained and used in the U.S. is necessary and will result from the current crisis. It cannot be argued that savings can always be relied on, although it was the reliance on credit that got our economy into this mess in the first place. As consumers de-leverage, their savings rate will have to rise. However, a dangerous result of banks cutting lines of credit is taking credit away from people who have the ability to pay their bills. If credit is taken away from a typically able borrower, that borrower’s financial position weakens considerably, which does not bode well for consumer spending or the economy. In order to try to ease the pain on consumers, regulators have outlined new rules for card issuers that restricts them from raising interest rates on existing card balances except under certain circumstances. The banking industry has until July 2010 to comply, and this plan will cause card issuers to reconstruct their lending practices which increases costs. Naturally, the banks are looking into ways to combat the new rule or strategies for other types of fees to pass onto customers. Either way, consumers are guaranteed to see rates hiked up. As default rates continue to surge and banks pull lines of credit, consumer credit problems are going to get more serious, and it’s possible that this will have to be the government’s next big focus. Disclosure: The Fund the author is associated with is long JPM.