Tom A's Stock Picks

MA - attracive but risky at today's price

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Mastercard is a well known brand. Their operation is essentially data-processing and not exposed to the actual risk of lending money. Revenue and EPS growth have been outstanding. For their last quarter, revenue increased 17.8% over the same period in 2006, while total operating expenses increased 3.2%, excluding special items. The cashless society is a reality - you can swipe your card at the grocery store, the gas station, or the hamburger stand, paying next month or next year for a hamburger today. As this trend goes global, Mastercard stands to process an ever larger number of transactions without proportionate expense increases. This is an attractive scenario. If revenue growth continues to outpace expenses, not unlikely in what is essentially a data-processing business, an exponential increase in earnings will follow.

The shares have increased from 46.00 when MA went public in May 2006 to a high of 174.60 on 7/13/2007. At a current price of 147.97, it is tempting to look for a rebound after a temporary setback during the past few weeks. I would avoid doing so, because I have significant reservations about the sustainability of their recent growth and margins, as well as the possibility of adverse developments on pending litigation. MA is attractive but overpriced compared to the risks involved.

My analysis starts with 5 year average EPS - in this case, 1.32/share. MA, at 147.97, is trading at 110 times its 5 year average EPS. That kind of a number gives me pause. In reviewing the past five years results, grounds for concern emerge. During the years before they went public, their results include substantial charges for legal settlements arising from restraint of competition, as well as a 400 million charitable donation made when they went public. Even looking past those items, their historical margins are much less than they have achieved recently. For the most recent quarter, net income as a percent of revenue is 25.2%, which I regard as unsustainable, based on past history and the realities of competition.

I went to the SEC website and read their most recent 10-K and 10-Q reports, with attention to the legal proceedings. There are a number of restraint of competition issues pending for which they have not recorded any reserves. That is possible under GAAP, given the contention that they can't predict the outcome: but, in view of the previous substantial settlements, which created a loss in 2002, I would be concerned about the risk of adverse legal developments.

The most recent 10-K is also informative on the nature of competition in the US and global payments business. Competitors include: Visa, American Express, Discover, and JCB. Visa has a significantly greater volume in the global general purpose card industry than Mastercard. American Express and Discover do not utilize formal interchange fees and as such have generally avoided the regulatory scrutiny and litigation challenges Mastercard has encountered. JCB is dominant in Japan. China Union Pay has been established as the predominant domestic card acceptance brand in the People's Republic of China. I don't believe this kind of competition will permit the current high margins MA has achieved to continue indefinitely.

Case in point - On 9/25/2007, America Online Co-founder Steve Case announced the launch of an internet-based payment system that claims to reduce merchants' cost for accepting cards by 75%, from 1.9% to .5%. Those 25% profit margins will draw a thundering horde of competitors. Any kind of global slowdown would make retailers pay very close attention to a 1% or more reduction in the cost of processing payments.

Selecting a proper P/E multiple is tricky here - Discover (DFS) and American Express (AXP) are publicly traded and have P/Es of 14.3 and 18.1 respectively, compared to MA at 28.7. However, they are not directly comparable as they have the credit risk of holding customer balances on their books, at least while awaiting securitization, while MA is a data-processor and not a lender. Visa has plans to go public, but that has not yet occurred and so they are not available as a comparable. S&P places MA in the Data Processing and Outsourced Service sub-industry, checking the peer companies listed, I noted several P/Es comparable to MA's.

Revenues can fluctuate due to circumstances beyond MA's control: historical examples would include the SARS epidemic, the Iraq War, and the aftermath of 9/11.

Taking all of this together, my impression is that MA is priced at a multiple that reflects annual revenue growth of 15% for a substantial period of time, with margins holding steady or increasing from today's high levels. In today's market, small shortfalls from optimistic projections are punished severely. Given the risks inherent in regulation and litigation, together with the prospect of insurgent competition, I would not be interested in owning the stock at current prices - my maximum buy point would be 125 and I wouldn't get aggressive at prices above 100.