Thu, 31 Jul 2014
Recent decelerating revenue growth has disappointed investors but is a temporary phenomenon, says Morningstar StockInvestor editor Matt Coffina.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We are about halfway through earnings season now, and most earnings have come in either at or above expectations, but one firm that disappointed was Visa.
I'm here today with Matt Coffina. He is editor of the Morningstar StockInvestor newsletter and also owns Visa in his Tortoise portfolio. We are going to take a look at the quarter and get his take on the long-term outlook for Visa.
Matt, thanks for joining me today.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Let's start by looking at the quarter in the short term. What was the market so disappointed by?
Coffina: I think the market is seeing that Visa's growth is decelerating. They grew constant currency revenue 7% in the quarter, only 5% in dollar terms when you take out the adverse currency movements. And then they grew earnings per share 15%. Both of these are meaningful slowdowns from the prior quarter, which in turn was a slowdown from the quarter before that.
Visa has always been seen as a growth stock since it came public, and that growth does seem to be slowing a bit, which is one of the reasons I allocated the stock to our Tortoise portfolio instead of our faster-growing Hare portfolio.
Glaser: What's causing the slowdown? Is it short-term geopolitical issues or is it a longer-term structural issue?
Coffina: I think it's mostly short term in nature. Visa and MasterCard both have very long runways for growth. According to the companies, about 85% of retail transactions still occur using cash and checks. There is still a very long way to go in this secular shift from paper-based forms of payment to electronic forms of payment.
Not to mention that these companies also benefit from growing personal consumption expenditures globally. They are almost guaranteed to grow revenue faster than overall GDP growth as long as they don't get disrupted by some kind of new payment technology.
I definitely don't think that's the case currently. It's not some new payment technology that's causing the trouble. Rather, it's slower-than-anticipated overall economic growth. And in particular, Visa is seeing slower cross-border transactions. They generate extra fees when people from one country use their debit and credit cards in a different country, and those have slowed down very considerably this quarter and in recent quarters. I would attribute that, as you mentioned, mostly to geopolitical tension. They are seeing that, for example, in Argentina, Venezuela, the Middle East, Ukraine, and Russia--pretty much exactly where you would expect fewer people to be travelling internationally, and that's what is weighing on them this quarter.
Glaser: What impact is currency having on the results?
Coffina: There are actually two effects from currency. The most obvious one is on the top line where, as I mentioned, currency was a 2-percentage-point headwind to revenue growth this quarter. This is a trend we are seeing across all global businesses for companies that report in dollars but earn a lot of their revenue in international markets, especially emerging markets. For example, there has been a very severe headwind for companies like Philip Morris International or Unilever that derive a very significant share of their sales from emerging markets. Visa is somewhat less exposed than those kinds of companies, but still faces a fairly severe headwind from foreign currency on the top line.
The other impact in this quarter is that their cross-border fees are actually directly related to the volatility between currencies. Visa will help its financial institution customers convert payments from one currency to another, and they earn a fee for that, and that fee is greater when currencies are more volatile. Surprisingly enough, currency volatility has actually slowed down a lot in the last quarter. Visa said it was the lowest currency volatility they have seen in almost 15 years. I think that's especially surprising in light of these geopolitical tensions, and I would be very surprised if that persists. I think it's likely that currencies will continue to be volatile going forward, or return to volatility going forward.
Glaser: You talked a little bit about the issues on the top line, but how about profitability? Is management doing a good job keeping expenses under control?
Coffina: This is definitely a bright spot for Visa. Their operating margin expanded to 64% in the latest quarter. Far and away, this is one of the most profitable businesses you'll ever find. They actually managed to cut operating cost this quarter about 3% versus, again, that 7% constant-currency revenue growth, and this is one of the great features of this business model: It has a very highly fixed-cost structure, and they are able to achieve a lot of operating leverage, even with modest levels of revenue growth.
I would expect to see more of that going forward. I think management is hesitant to promise a lot of operating leverage. I think they want to have the flexibility to reinvest in the business wherever they see opportunities for growth. But the cost structure is so fixed, that they almost can't help but experience operating margin expansion in most periods.
In general I would expect these companies to sustain high single-digit or even low double-digit revenue growth over the long run. It's been a little slower than that here. But I do expect that to reaccelerate over the long run, and then have faster operating income growth, maybe a couple of percentage points faster than revenue growth. And then on top of that, these companies generate a tremendous amount of free cash flow, which they're able to use for share repurchases. Visa repurchased more than 3% of the float year-over-year.
I think the basic growth algorithm still works, where Visa can grow earnings per share at a mid-teens level. It was 15% in the latest quarter, with only 5% dollar revenue growth. I think mid-teens earnings per share growth or probably even high teens in the short run remains a very realistic expectation for these companies. Mid-teens I think is sustainable for five or 10 years at least into the future, again, as they take advantage of these secular growth tailwinds.
Glaser: Even though the shares sold off a bit after these earnings, does this present a buying opportunity?
Coffina: Visa is trading pretty close to our fair value estimate. It was when I bought the company earlier in July, and it's still trading at less than a 5% discount to our fair value estimate. Especially in the current, fully valued market, where there are so few deeply discounted companies out there, so few opportunities, I think that it still makes a lot of sense to own a very, very high-quality, fast-growing business like Visa at what I consider a fair price. It's only trading for a bit over 20 times forward earnings, and again, growing earnings per share at a mid-teens rate for the foreseeable future.
Visa's valuation is maybe not super-cheap, but I think it's very, very reasonable for such a high-quality company. I think this is a fine time to own or to buy Visa shares, and I would say the same for MasterCard. If anything, I think MasterCard looks marginally more attractive than Visa at present.
Glaser: Matt, I appreciate the updates today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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