Investors who held Mastercard for the past 10 years, have been rewarded handsomely with a 27.4% returns compounded annually. A $10,000 investment would have returned approximately $113,000 over this period. In this article, we will discuss why Mastercard’s wide moat has allowed it to reinvest its earnings at high returns.

In this post we will discuss Mastercard’s business model, reasons for their high margin, and why Mastercard will likely continue to grow and compound returns for its shareholders.

How Mastercard makes money

Mastercard does not see itself as a credit card company. Rather it sees itself as a technology company in the payment industry.

Mastercard & Visa are commonly known as a tollbooth business. Before we begin, it is important to know who are the players in this space:

• Account holder (That’s you and me)
• Issuer’s Bank (Our bank)
• Core Network (This is where Mastercard & Visa comes in)
• Merchant (The store you buy your product from)
• Acquirer’s Bank (The merchant’s bank)

Simply put, the role of Mastercard is to be the bridge between our bank and the merchant’s bank. While doing that, they collect a small fee of approximately 0.25% on the transaction. For example, when you buy your iPhone for $2,000, Mastercard will make $5 from the transaction.

The beauty of Mastercard business model is that it does not assume credit risk nor does it have to deal with end-users like us. It merely sits as a connecting network for the banks and collects a small fee.

The company makes the bulk of its revenue by mainly charging a small percentage of the transaction and a fixed fee per transaction.

Some of the key metrics investors should track to measure if Mastercard’s business performance and moat would be:

• Gross Dollar Volume (GDV) – How much we as consumers spend using a Mastercard in total.
• Cross-border volume growth – The increase in consumers spending overseas.
• Switched transactions – Number of transactions processed.
• Number of cards issued
• (Rebates + incentives)/Revenue – This is the amount Mastercard spends to attract financial institutions to carry its brand. An increasing ratio may mean the industry is getting competitive.

Rational competition

Industries that are dominated by a few key players (duopolies or oligopolies) often act like monopolies. Tacit collusion is normal and competition is rational, as industry players raise prices in tandem and compete for the share of the market. This “cooperative behaviour” allows companies to generate sustained high returns on capital.

“A basic industry with few players, rational management, barriers to entry, a lack of exit barriers and noncomplex rules of engagement is the perfect setting for companies to engage in cooperative behavior…and it is for this reason that the really juicy investment returns are to be found in industries which are evolving to this state.”

Marathon Asset Management

As a connecting network, Mastercard is effectively a duopoly with Visa. We can see that Mastercard has been able to hold their fees steady over the years as we can see from the crude take-rate (obtained by Revenue/GDV).

And this has translated into fantastic margins for Mastercard. Their gross margins are 100% as there are no variable costs associated with every transaction. With GDV and revenue growing at a fast clip as shown in the table above, Mastercard is able to spend its gross profits on marketing, R&D and the likes to expand its moat.

Their operating margins have consistently been above ~50% for the past decade. Except for its closest competitor Visa, there probably isn’t another company that is able to consistently generate such high operating margins.

Network effect

When it comes to an economic moat, there may be none stronger than a network effect once it has been set in motion. The idea is simple, as more customers carry a Mastercard, more merchants would accept Mastercard, which would then drive even more customers to own a Mastercard.

Over the years, we have seen this played out beautiful as the number of cards issued and merchants on-boarding grow. At of 2019, there’s approximately 2.2 billion Mastercard issued around the world.

Compounding machine

The characteristics of a compounding machine are: (1) Ability to generate high returns on capital in cash; and a (2) Long runway for growth. Let’s see how Mastercard fare in this aspect.

(1) Ability to generate High ROIC in cash

Over the past 5 years, Mastercard’s Return On Invested Capital (ROIC) has an average of approximately 60%. To put this in perspective, the average ROIC of the S&P500 companies hovers between 9% to 13%. As a quick rule of thumb, we typically want to look for at least a sustainable 20% ROIC.

Having a ROIC of 60% means that every dollar of retained earnings will generate an additional $0.60 of earnings.

Over a 5 year period, the company’s cash conversion is also above 100%. This means that every dollar in earnings translates to more than a dollar in cash.

Over the last 3 years, the company generated $20.1 billion of operating cash flow. And returned $18.4 billion to shareholders through share buybacks and dividends.

Mastercard is able to do so because it is a capital-light business that doesn’t require huge investments; freeing up plenty of cash for shareholders’ benefit.

(2) Long Runway for Growth due to Cashless trend

Without room to grow, a high return on invested capital alone would not generate wealth for investors. So let’s take a look at what makes Mastercard a compelling investment.

The company processed a gross dollar volume of $6.5 trillion in 2019, which seems already immense. However, the Total Addressable Market (TAM) size for payments is $235 trillion! And cash payment still accounts for 85% of transactions. The trend of moving towards a cashless society remains a powerful propeller for Mastercard’s growth.

This is especially so when an estimated $68 trillion of total payment (~30%) is still made in cash & check. In light of COVID-19, it will likely accelerate the trend of declining cash usage and hasten the change in consumer behavior towards cashless transactions.

In Mastercard’s latest research, contactless payment grew twice as fast as cash payment as consumers are concern about the spread of germs. Likewise, with social distancing in place, many are turning towards e-commerce for their shopping needs. This could potentially be a long-term consumer behavioral change in Mastercard’s favor.

Risk: Fast-changing landscape

The payment industry is a fast-changing one. In recent years with online transactions accelerating, we have seen the growth of payment aggregators such as Adyen and Stripe. And even more recently, we have seen Square threatening to take over the offline transactions. These payment aggregators threaten to take over the acquirers slice of the pie.

However, they are still reliant on payment networks and their technology is built on top of Visa’s and Mastercard’s technology. The real threat would come if Stripe venture into personal banking solutions and achieve huge success. Imagine using Stripe to store your savings and to process your online transactions, skipping the card network altogether.

That would be similar to what Alipay and Wechat Pay has achieved in China, with so many users on their network they are able to bypass the card networks altogether.

This still seems quite far-fetch for the players outside of China. And would likely trigger anti-trust lawsuits if a player becomes as dominant as Alipay or WeChat Pay. To achieve this dominance and bypass the card networks, everyone must be using Stripe’s credit card and bank account.

All-in-all, Mastercard is a company with a fantastic moat and a capital-light business. Though the fintech and payment industry is a fast-evolving one, understanding the dynamics would allow us to observe that these card networks are likely to retain its dominance for years to come.

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