AMM Dividend Letter Issue 12: MasterCard’s Dividend Growth… Priceless
This is from the AMM Dividend Letter released October 4, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
Berkshire-Hathaway, the company that Warren Buffett built in to one of the largest and most successful companies on the planet, recently hit a new all-time high price of more than $200,000 per share.
Like most successful long-term investments, it has not always been a smooth and steady climb higher for shares of Berkshire. Since 1980 the company’s stock has declined in price by more than 19% five different times. In the last 15 years the company twice experienced declines of around 50%.
Buffett, arguably the greatest investor of our time, suffers stock market losses just like the rest of us. Part of his success is focusing on the long-term and riding out the downward swings. We can see from Buffett’s experience and hindsight, that it is impossible to earn outsized returns over the long run without experiencing some short-term declines.
This is not to say that if you just buy and hold any and all stocks that you too will become the next Warren Buffett. The great myth is that Buffett got rich just through investing. Warren is a very talented and extremely sophisticated investor and business man; he became wealthy by leveraging his talents through one of the earliest hedge funds, which he called The Buffett Partnership Ltd. Later on, he took over one of the Partnership’s failed investments; a textile company called Berkshire-Hathaway, and used Berkshire’s free cash flow for investment opportunities.
We can not go back in time and duplicate Warren Buffett’s way to wealth for you. However, we can utilize one of his more successful and famous investing strategies, buying high quality dividend growth companies.
One of Warren’s most famous stock purchases was his investment of ~ $1 billion in Coca-Cola (KO) stock (roughly 6% of the company) in late 1988/early 1989. At the time, the investment represented 35% of Berkshire-Hathaway’s entire equity portfolio. Coca-Cola wasn’t considered a “value” stock at the time; it was trading at a premium of 30% to other soft drink company’s shares. Coca-Cola’s stock had also experienced several years of gains, and wasn’t considered “cheap”.
Why did Warren Buffett buy Coca-Cola?
Coke was then, and is now a high-quality company with a large defensible market position and an easy to understand business. Coca-Cola generated above average returns on capital and excess free cash flow. Coke used its cash flow to grow the dividend paid out to shareholders every year. The outgoing CEO had spent the last several years using a lot of Coca-Cola’s excess cash to buy unrelated and under performing companies. When the new CEO took over, he pledged to sell these assets, return more capital to shareholders, and focus on what Coca-Cola did best.
Over the years, Coke has split its stock many times. Now Warren Buffett’s original purchase price is around $3.25 per share (split adjusted). In 1988, Coke paid a dividend of $0.075 per share (split adjusted too). Coca-Cola now pays $1.22 per share, which represents a 38% current annual yield on Buffett’s original investment. By staying in Coca-Cola’s common stock, a high-quality dividend growth company, Berkshire-Hathaway receives a 38% cash return every year on its original investment just in dividends!
It took 26 years to reach a 38% current yield on the original price paid in 1988. Companies don’t have to worry about retirement but individual investors do. 26 years may be too long for most people to stay invested. During those 26 years Coca-Cola grew its dividend at a compound annual rate of 11%.
At an 11% compounded annual growth rate, Coca-Cola’s dividend doubled in 6.6 years, tripled in 10.5 years, and quadrupled in 13.3 years. This is not even factoring in dividend reinvestment. You may not have 26 years but if you can stay invested in high quality dividend growth companies for 10-15 years, you should see some large income gains over time.
Dividend Stock in Focus
MasterCard, Inc. (MA): $74.33*
*price as of the close October 3, 2014
You may recall from the last issue of the AMM Dividend Letter that John Biggins invented the credit card with the creation of the “Charg-It” card for customers of the Flatbush National Bank. The next key development in the history of credit cards was the creation of the Diner’s Club Card.
Frank McNamara was out at an important dinner and when the bill came he realized he left his wallet at home. Frank found a way to pay for the dinner but the experience led Frank to imagine a new way to pay for dinner and other things without the need for cash. With his partner Ralph Schneider, Frank created the Diner’s Club. The card was not a true credit card but a charge card; the balance had to be paid off at the end of each month. After two years of existence, the Diner’s Club card had over 20,000 people using the card to pay for eating and entertainment expenses.
The Diner’s Club Card was a “closed-loop” payment network. The card issuer both authorizes and handles all aspects of the transaction and settlement between the merchant and the consumer. The increased acceptance and use of the Diner’s Club Card paved the way for the Bank Card Associations and their “open-loop” system, which connects two different financial institutions, and more importantly increases the use of plastic cards over cash.
In 1966 the interbank Card Association, a national credit card “open-loop” system, formed. We now know it as MasterCard. How MasterCard’s “open-loop” payment network works is outlined below.
MasterCard and Visa represent our investments in the electronic network payment duopoly. Even though both positions represent small relative portfolio weightings, they should be viewed as one large combined position in electronic payments.
MasterCard has the second largest global payment network behind Visa and controls about 26.9% of global payment volume according to The Nilson Report. Owning both Visa and MasterCard means owning around 87% of the total global payment volume.
Another reason to treat Visa and MasterCard as one position is their low current dividend yields of around 1%. We don’t want to lower your current overall portfolio income by being too heavily invested in both Visa and MasterCard; however we also didn’t want to miss out on the opportunity to buy both great companies at a fair price with the potential for high dividend income growth in the future.
MasterCard’s IPO was on May 25, 2006 and the company paid its first quarterly dividend of $0.009 (split adjusted) later that year. The following year MasterCard increased its quarterly dividend to $0.015 per share and kept it at this rate for the next 4 years. It is only recently that MasterCard started to really grow its dividend. The 8 year compound annual growth rate (CAGR) for MasterCard’s quarterly dividend is over 36% but as you can see in the chart below most of this growth has come in the last few years.
MasterCard’s payout ratio is only 12%. Just like Visa, even without earnings growth MasterCard could grow its dividend at a CAGR of 20% for the next 6 years to reach a 50% payout ratio. We think MasterCard should be able to grow its dividend at a high rate for even longer.
Catalysts for Dividend Growth and Price Appreciation:
The more connections between consumers and merchants in a payment network the more valuable the network. MasterCard owns one of the most valuable payment networks. Building such a valuable network requires a lot of capital up front but after it is built the capital requirements to maintain the network are much lower. Plus, the incremental costs to add another user declines as the network becomes larger. Lower costs with higher transaction volumes make the network extremely profitable.
MasterCard’s operating margin started at 20% in 2006 and expanded to 55% at the end of the 2013 fiscal year. MasterCard’s net margin has gone from 10% right before its IPO to 37% at the end of the 2013 fiscal year.
Increased profitability combined with lower capital maintenance requirements for MasterCard’s network has increased its return on capital from 20% in 2006 to 39% by the end of its 2013 fiscal year.
Growth of Debit and Credit Cards
The majority of consumer spending around the world is still done through cash and checks. Visa estimates this amount to be around $10 trillion in gross dollar volume. In the U.S. cash and checks still account for $18.3 billion.
Smart Phone Growth, Mobile Wallet, & Apple Pay
In 2011 mobile phone transactions accounted for $101 Billion or 5% of all global consumer spending. By 2017 this number is expected to reach $721 Billion to represent about 20% of consumer spending.
Apple’s entry into the mobile wallet, Apple Pay, should help increase the adoption rate of mobile transactions and speed up the growth in payment transaction volume. Mobile Wallets have been around for a few years. So far each new mobile wallet has had limited success pushing consumers to ditch their physical credit cards and pay through their smartphone. Apple has the reach and the caché to drive the global adoption of mobile wallets. The growth of mobile wallets like Apple Pay should drive further transaction volume over MasterCard’s payment network as more people leave their wallets and cash at home.
Return of Capital
Since its IPO MasterCard has reduced its total shares outstanding by more than 11%. MasterCard has the cash flow and the room on its balance sheet to take on additional low interest rate debt to reduce shares outstanding further and lower its overall cost of capital.
The pre-mortem is a brief rundown of what could go wrong with our investment. In the event that any of these items gains significant traction, it could give us cause to cut or eliminate the position from the portfolio.
The time and money it will take to build a network to compete with MasterCard is a high barrier for competitors to overcome but Dwolla is taking on the challenge. MasterCard’s network operates in the ACH (Automated Clearing House) system. A slow system where fund transfers from the consumer’s bank to the merchant bank’s account goes through many steps and takes several days to complete. Dwolla is building its own network where fund transfers are instantaneous and involve only 2 steps. Because Dwolla is building its own payment processing network it eliminates interchange fees and charges a very low processing fee, $0.25 per transaction for anything over $10 and it’s free for anything under $10. For merchants the value proposition of Dwolla is extremely attractive. If Dwolla’s network gains traction in both consumers and merchants MasterCard will lose market share.
The Durbin amendment attached to the Dodd Frank Bill put a cap on interchange fees. Further legislation on interchange fees could impact MasterCard’s business.
We already highlighted this as a positive catalyst for MasterCard but it could also be a negative one. Just like Dwolla above, the rise of the mobile wallet could move payment processing off of MasterCard’s network as new payment networks emerge. So far this is not the case but disruption from new technologies is always a concern.
When you are as big and profitable as MasterCardyou will attract lawsuits. Listed below are a few of the outstanding litigations that could affect Mastercard’s business.
- Interchange opt-out litigation. Action against MasterCard and Visa for trying to monopolize the debit-card-related market. Wal-Mart recently joined in with an opt-out complaint.
- European Competition Proceedings. Another review of the interchange fees being charged.
- Target’s data breach. MasterCard has been named in Target’s Data Breach lawsuit for not developing chip technology soon enough.
Foreign Governments could rule that all transactions in their country need to be routed through a domestic payment network taking volume growth away from MasterCard’s global network. Russia recently tried to do this but reversed course.
MasterCard is a great business in the middle of a strong secular trend. The sell-off earlier this year offered an opportunity to buy a great business at a fair price. Again, a fair price is our estimate of the price we are willing to pay for at least double digit annualized long-term total returns. This doesn’t mean MasterCard can’t get cheaper in the short-run. We would love to buy more MasterCard if it did get cheaper because our long-term return expectations would increase. We have a per share value of $85 for MasterCard and buying below this price should provide strong long-term total returns.