A Masterclass on Visa

History

During the 1950s, the lack of a standardized financial credit system caused inconvenience for consumers who had to maintain separate revolving credit accounts with each merchant they dealt with. To solve this problem, Bank of America founded Visa in 1958 as a credit card program called BankAmericard, which aimed to unify the entire payment system. The program was initially tested in Fresno, California, where Bank of America had a significant market share. By 1959, Bank of America had distributed the new credit card to over 2 million people in California.

In 1966, Master Charge (now Mastercard) was created by several banks to compete with BankAmericard, but legal restrictions limited its expansion to other states. BankAmericard then signed agreements with other banks in different states to avoid being displaced by this new competitor. In 1970, Bank of America relinquished control of the program to a consortium of banks, which formed National BankAmericard Inc.

By 1972, National BankAmericard Inc. had licenses to operate in more than 15 countries. It launched the first electronic authorization system in 1973, followed by an electronic clearing and settlement system. This initiative laid the groundwork for VisaNet, which powers all Visa transactions today.

In 1974, the International Bankcard Company (IBANCO) was founded to manage BankAmericard's international expansion. By 1976, the program united under the name Visa, and the different banks and program names merged into a single entity.

The Visa Network was designed to address the problem of consumers having to use multiple methods to make transactions. VisaNet offers a single connection point for facilitating payment transactions to multiple endpoints, thereby streamlining the process for consumers.

Anticipating Demand Surges

Since the 70s, Visa has spent hundreds/billions of dollars for the network to continue being improved and remain athe head of competition. At the beginning of the 2000s, management detected a trend that was pushing transaction demand higher and higher: electronic payments. Until that moment, Visa’s Network processed all transactions through first-generation datacenters, but in 2005, they completed a multiyear initiative to expand the reach and capacity of the Network datacenter which had a completely renovated design, up to the most modern technology. It was capable of handling more than $1 trillion in annual transaction volume and was designed to meet the growing volume of credit, debit and prepaid transactions for the foreseeable future. For some perspective, the network had around 1/2 trillion in transaction volume at that point in time.

The first transactions were processed at OCC (Operation Center Central) in March 2005, and the migration of transactions volume to OCC continued through 2006. For the first time since launching the electronic authorization in the 70s, Visa now had the ability to house multiple authorization systems under one single roof, with better security and back-up technology as well. The transition made the network be always available and with abundant processing power ready to meet new demand.?

The second datacenter of this kind was built on 2009. The importance of renewing the technological infrastructure is clear once you get to know the outputs. This is an extract from an article of 2009, stating in words the impact of the improved security:

“Still, despite the rising tide of breaches, the credit card company insists the amount of money that people are actually losing through fraud is decreasing. In the early 1990s, before the rise of e-commerce, Visa lost 18 cents out of every $100. Fraud was much more primitive then, usually resulting from lost or stolen cards.”

Today (in 2008), with global criminal enterprises actively trying to steal customers' financial information, fraud is a much more sophisticated business. Yet despite that, Visa says its loss has declined to 5 cents for every $100.”

In 2018, once again expecting a continued abrupt growth in transaction volume, Visa built two new datacenters that would process transactions in a completely renewed manner, again up to the most modern technology. On this occasion, the company saw the mobile market and the internet of things as potential major fuelers of digital transactions. At the same time, expanding datacenters footprint allowed Visa to cover more ground, helping it to offer a better service to customers worldwide by reducing both the cost and time needed for each transaction.

As of today, these four datacenters make up for the VisaNet, which supports:

• 3+ billion cards distributed among the global population
• 16.6k financial institutions
• Over 46M merchants
• 200bn transactions per year

Business Overview

Visa is one of the leading companies in the digital payments industry. The company facilitates global commerce and money transfers across almost the whole planet through their global network, VisaNet. Thereafter, Visa created a suite of products around their built infrastructure.

To get a bit deeper into the business offerings, we first must define where VisaNet is actually located in this ecosystem.

How do electronic payments work?

In every transaction, there are multiple parties involved and there are different steps needed to complete a transaction.

• Consumers?are issued debit or credit cards, which allows them to access their money or credit lines and make purchases to merchants that accept such form of payment.
• Issuers?are the banks that issue these cards to consumers. They are the ones who authorize transactions and guarantee payment on behalf of the consumer.
• Merchants?are sellers who decide to participate in the network by accepting these payment methods.
• An?acquirer?is the merchants’ bank, who provide merchants access to the network by authorizing their transactions and ensuring they receive their payment.
• VisaNet?is the network that connects all parties involved, enabling the flow of transactions, through which money payments/transfers are done.

The electronic payment process consists of three steps: authorization, clearing, and settlement. Authorization is when a card is used for payment and the transaction details are sent to VisaNet for fraud prevention and to ensure there are enough funds available. If the transaction is approved, the funds are put on hold and the approval is sent back to the merchant. Clearing involves the transaction details being sorted and sent to each issuer for the funds to be debited from the consumer's account. Settlement is when VisaNet sends consolidated settlements to participating issuers and acquirers for funds to be transferred between institutions.

Visa is the owner of the Network that processes these transactions and connects all participants involved in money transfers. However, it is not a financial institution and does not issue cards, extend credit, set rates or fees, or bear credit risk. Visa offers transaction processing services, Visa branded payment products, APIs for digital payments, and solutions such as advisory services, open banking, risk detection, and identity solutions to clients.

VisaNet has the unique ability to be used as a "Network of Networks," allowing it to process transactions regardless of the initial or endpoint network used. Visa provides clients with solutions for issuing, risk detection, open banking, advisory services, and identity solutions.

To fuel for growth, the company runs a quite heavy client incentive program. Through it, it pays financial institutions, merchants and strategic partners to grow payments volume, increase Visa’s acceptance and win clients. In 2022, slightly more than a fourth of the total net revenues were employed on client incentives.

Thesis

In the previous section, we kind of went through Visa’s thesis, but for further clarification, we’ll synthesize it here. VisaNet is the most important player in digital payments and it got immensely adopted, making a potential displacement very unlikely. The predominant position the network has, should allow VisaNet to be one of the main factors causing this economic growth Moody’s Analytics and McKinsey wrote about. But it doesn’t end there.

Economic growth brings with it higher aggregated income, which, down the road, increases the demand for transactions and cards. In parallel, digital finance brings with it the inclusion of millions and billions of people to the system. Each of these ‘new’ members will demand cards and transactions, as every human being that has to pay for stuff. Here’s what Visa’s CEO had to say in this respect:

“There are still hundreds and hundreds of millions of people to bring into the financial mainstream. There are still trillions of dollars spent on cash and check.” Q1 2023

In parallel, a strong workforce playing in payments’ favor is the Money Supply. One of the main tasks central banks have in the modern world is to continue fueling each country’s GDP by printing money, roughly speaking. When nations grow, if the money supply stayed flat, there would be a continuously smaller money supply for the goods and services produced, making forward growth slow down due to money’s scarcity. Therefore, to avoid such natural slowdown, central banks issue money to fill in this gap. Economics are much more complex, but I wanted to transmit the essence here.

Visa got itself to be in a place of acting in favor of the economy and people’s inclusion, which in turn fuels Visa’s business. I’d expect Visa to continue benefiting in the foreseeable future from such flywheel and, its leading position should allow the company to capture a major part of the markets it creates and from overall economic growth as well.

At the same time, the sole factor of countries issuing money to not let economies slow down their growth, benefit the payments industry as a whole. Being electronic payments the ‘easiest’ method in which people can make payments, they should continue to attract most of the extra demand generated by future ‘extra’ money.

Management

Alfred Kelly is the man leading Visa. He worked as the President and Head of Global Consumer Group at American Express for 23 years, from 1987 to 2010. After leaving the company, he performed as the CEO of NY Super Bowl Host Committee for a few years and as the CEO of Intersection Co in 2016. In parallel to these activities, Kelly joined Visa’s board in 2014 as an independent director. In late 2016, Alfred was named Visa’s CEO and continues in that role.

Glassdoor offers some insights as to how is Alfred’s image indoors. There are over 6 thousand reviews and, as usual, the larger the number, the more ‘truthful’ the rating becomes. His approval is quite high given how large the company is, though not spectacular.

The image above illustrates the amount of stock each of the top managers have. The sum of all owned stocks plus the obtainable within 60 days accounts for 3.5M, equating for 830M dollars at Visa’s price of $230 per share. Less than 1%. Not much skin in the game in relative terms, but in absolute terms, that’s a big number.

MOAT

As stated, Visa is the facilitator of VisaNet and all services provided are built around that. In consequence, to analyze the main long-durable competitive advantage Visa has, we have to look at VisaNet.

The most developed and mature MOAT the company has is its Network Effects. They began acquiring clients and platform users since the 70s, turning VisaNet into the most demanded infrastructure for processing digital payments. In consequence, merchants and banks, almost without a choice, have to implement payment solutions leveraging the Visa Network because, if not, they would basically lose clients. As of today, VisaNet has got extremely intricated on 80% of the world’s economy. I reiterate, it is not an option to not utilize it if you are a merchant or a bank. This MOAT seems to be one of the widest out there.

Visa has been around for over 60 years now and it has made a complete name of itself. Perhaps not at the level of Microsoft Office or Google, but Visa must be at the top 10 most known technological tools at a worldwide basis. I’m talking the name here, not the offerings. Many people see their debit/credit cards with the name ‘Visa’ on them, but not all of them now it’s not Visa who issues the card. Nevertheless, the brand awareness it has created cannot be ignored, and I’d assume they have a quite heavy Brand Value mark.

Additionally, this can be seen through consumers’ lenses or through other participants. There may be not a single merchant or bank who actually distrust the service Visa provides, further strengthening the company’s Brand Value.

I’ve read people claiming Visa benefits from high switching costs and a low-cost producer advantage given the infrastructure it has developed. However, this is my view on both regards:

1. Given the number of players and technologies that have arisen and that get rapid and wide adoption, I wouldn’t say Visa benefits from high switching costs.
2. I agree at some point because the developed network allows Visa to process payments faster and more efficiently than competition, as well as covering more territory. However, there is not an immense gap in costs, and technologies like Bitcoin’s Lightning Network are presenting competition in all fronts.

Lastly, the long-durable competitive advantage Visa has been able to build over the past half a century is further strengthened by a very tall barrier:

“If you wanted to build your own payments network to compete with Visa, you’d need to win over the issuing banks. Of course, you won’t get the issuers if you don’t have merchants to accept your card and you won’t get the merchants unless you have the issuers’ card customers, who want to know that the card is accepted nearly everywhere...and, critically, you won’t get anyone unless you can ensure security, which itself depends on the insights garnered from the 100bn+ of transactions these two networks process every year. Every time you swipe your card, Visa evaluates over 500 different data points to determine fraud risk, calculates a risk score, and sends that score to the issuer to approve the transaction.all in a fraction of a second. Clearly, this is a tough chicken/egg nut to crack.” Expanding the Rails, Part 2

Competitive Positioning

The competitive landscape in the digital payments space is quite inclined to the two biggest players, up to the point this market could be categorized as a Duopoly (nothing new). The reason for this is because the sum of both companies controls over 80% (roughly speaking, hard to find Asia numbers) of the total volume processed, but that doesn’t mean there are no other significant players. American Express did over 1.5 trillion dollars in 2022, which is an immense number, in absolute terms, though a 10% of Visa’s volume.

The following chart displays total volume growth for each of the 3 main players the sector has; Visa, Mastercard and American Express. Over this period, Visa outgrew its competition by a wide margin:

1. It achieved a 9.1% CAGR vs the 8.9% by Mastercard and the 6% by American Express.
2. Visa captured 10.3 extra trillion dollars in total volume, while Mastercard increased theirs by 5.9tn and American Express 904bn.

The three aforementioned competitors make up for over 80% of the digital payments industry. The following chart is based upon the controlled market by these 3, but keep in mind there’s a total 10-20% that’s not theirs.

Since 2007, market share did not change that much. The main difference is American Express lost market share to Visa and Mastercard, being Visa the one able to benefit more from this. For the past 15 years, the space has been almost completely dominated by Visa.

The second variable from which we could analyze competition is the total transactions performed by each network. The following image displays such variable for the previously selected timeframe (starting in 2007, when Visa went public).

Even though the chart looks very similar to the one presented in total volume, there’s a difference. On this occasion, Mastercard slightly outgrew Visa, exhibiting a 12.2% CAGR while Visa achieved 11.6%. It is worth mentioning Visa began the period from double the base of MA, but still. In nominal terms, Visa was able to process an additional 208bn transactions than it had in 2007, while Mastercard an extra 124bn.

The last front we’ll be looking at is the total cards each company has in circulation and how has it grown over the last decade and a half.

Similarly to the last comparison, Mastercard also outgrew Visa when it comes to total cards. MA grew its total cards in circulation from 916M in 2007 to 2,731M in 2022, at a 7.6% CAGR. On the other hand, Visa’s total cards went from 1,592M to 4,100, growing at a 6.5% CAGR. Again, Visa was able to make financial institutions issue more of their cards in nominal terms than Mastercard, but the bigger base at which it began made it quite difficult to compete in the percentage growth realm.

The Difference

There are two things we must cover here. Firstly, a distinction with Apple Pay and Google Pay, which are commonly mistaken as competitors. Same though not that clear with Paypal.

1. Paypal. While Paypal is an online service that secures virtual payments using end-to-end encryption, Visa is a card network that facilitates transactions by connecting consumers, banks and merchants.
2. Apple Pay. Apple Pay is a mobile payment and digital wallet service that allows users to make purchases with their Apple devices. In other words, Visa is the network that facilitates transactions, while Apple Pay is a specific service that utilizes Visa’s or other network to enable mobile payments.
3. Google Pay. Same as Apple Pay. It’s a technology made to purchase things. It outsources payments processing to networks such as VisaNet.

These are easier to distinguish than the differences with companies like Mastercard or American Express, both of which belong to the more closer circle in terms of offerings.

1. Mastercard. Visa and Mastercard basically serve the same purpose, but there are some differences in acceptance, geographical revenue sources and the processing fees structure.
2. American Express. Similarly as with Mastercard, the differences are, beyond the overall size, at a more narrow level, such as the processing fee structure.

Financial Soundness

Since going public, Visa has been consistently increasing its revenue at quite a fast pace, accompanied with a higher margin efficiency. During the 15yr period:

• Revenue grew at a 15% CAGR from 3,590M to 29,310M in 2022 (keep in mind Visa reports its Net Revenues, which means its their revenues after client incentives)
• Gross profit increased from 3,590M to 28,567M, growing at a 14.8% CAGR
• Net income at the beginning of the period was -1,076M and at the end, 14,957M. Since 2008, it has grown at a 28% CAGR
• FCF has gone from 345M in 2007 to 17,879M in 2022, exhibiting a 30.1% CAGR. FCF/Share currently stands at 8.65 and it has grown at a 21.8% CAGR since 2007 or at 46.8% since 2008

Given the higher performance net income, free cash flow and operating income have had, it’s easy to conclude that margins have expanded by at least a fair amount. The following chart computes Visa’s margins at the different income statement levels.

It seems like a bug, but Visa’s gross profit margin is literally almost 100% and has consistently stayed close to that number for the past decades. Going down through the income statements, margins have only improved for Visa since going public. More specifically

• Operating margin has increased 2.430bps since 2008, going from 43.1% to 67.4%.
• Net margin has gone from 12.8% in 2008 to 51% in 2022, expanding 3.820bps.
• FCF margin has increased a total of 5.910bps since 2008, now standing at 61%.

The logical requirement for bottom line margins to improve is for revenue to increase at a faster pace than costs, which is what happened across this timespan. Visa actually reports its operating costs in a very well fragmented way. However, it is broken so much down to the point that if I include all variables, the chart turns unintelligible. With the purpose of clarity, I selected what I considered to be the most relevant expenses. For reference, here’s what Visa reports:

From the operating expenses, I chose to go with Personnel, Marketing and Network. On different fronts, I also decided to include the cost gross revenues have, Client Incentives (CI in the chart); and, lastly, Capital Expenditure. Keep in mind the operating expenses and CapEx are in terms of Net Revenues, while Client Incentives are in terms of total revenue.

The trend for operating expenses is extremely clear, also explaining the rise in operating margin:

• Expenses in Personnel have declined 400bps as a % of net revenues
• Marketing expenses as a % of net revenues have declined 11.7pp over the last 15 years
• Network and Processing expenses have declined 290bps since 2008

In the same line as operating, CapEx has gone from 6.6% of net revenues in 2008 to 3.3% in 2022. The only expense, which is taken out of the equation by Visa very up on the income statement, that has trended upwards is Client Incentives. During the last 14 years, CI has increased from being 15.6% of total revenue to 26% in 2022, perhaps raising some concerns on competition.

One fabulous thing Visa has is it does not spend a single dollar in R&D, which is absolutely impressive given their continued leading position in this market.

Capital Allocation Skills

A case could be made where some of the charts illustrated above speak of the discipline in which management allocates capital at an operating level. For further breakdown of their actual skill, we’ll recur to the usual standards for measurement.

The three financial metrics upon capital allocations skills can be examined have been trending upwards, with no signal of peaking yet. In the period 2008-2022:

• Return on Assets has gone from 8.58% to 14.67%, with an average of 11.5%.
• Return on Equity has climbed from 7.78% in 2008 to 40.88% in 2022, averaging 21.6% per year.
• Return on Invested Capital has increased from 11.03% to 29.1%, showing an average of 20.5%.

In absolute terms, all three returns on capital are very high. However, they are not as high as they could be given the industry Visa is in. Here’s a comparison for the last decade between Visa and Mastercard (average). Worth keeping it in mind.

Value Return to Shareholders

Almost since going public, Visa has continuously returned value to its shareholders, mainly in the form of stock repurchases. The following chart computes the 3 principal activities in which companies can do this task.

• Until 2016, the company had almost no issued debt. After issuing, Visa repaid a total of 5.75bn of debt
• Stock repurchases have been consistent during this decade and a half while SBC kept low, making Visa’s total shares outstanding decline by more than 30%
• Dividends paid have been yearly increasing as well with now the company paying over 3bn in dividends to shareholders.

Finally, as of the last reported results, 1Q FY’23, Visa held a total of 20.4bn in debt while having 16.1bn in cash and equivalents, making the overall business have a net debt position of 4.3bn. Definitely not a splendid balance sheet though the incredibly high profitability levels Visa has makes it extremely anti fragile. A single quarter’s FCF can almost cover the whole gap between debt and cash.

Risks

• Competition. The digital payments industry is highly disruptible, as we’ve seen with blockchain and tech-enabled companies. At the same time, Mastercard continues to be a heavy weight in the space.
• Regulations that could affect the payments industry as a whole
• Cyber attacks have been rising very rapidly over the past years and Visa is surely in the spot of attracting them.

Conclusion

Visa's future prospects are promising given its leading position in the electronic payments industry and its ability to adapt to changing market dynamics. As the world continues to shift towards digital payments, Visa's network infrastructure and API capabilities put it in a strong position to continue to serve as a key facilitator of transactions across various platforms and networks.

Additionally, its focus on innovation and providing value-added services to clients through its issuing solutions, advisory services, and risk detection and identity solutions will be critical for continued growth and success. Overall, Visa's continued investment in technology and strategic partnerships will be key to maintaining its dominant position in the industry and achieving future success.

DISCLAIMER

The information in this article is?for information and discussion purposes only. It?does not constitute a recommendation to purchase or sell any financial instruments or other products.?Investment decisions should not be made with this article and one should take?into account the investment objectives or financial situation of any particular person or institution.

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