Charge Up Your Stock Holdings With These Card Companies

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Jim Sinegal, who is a senior equity analyst on our financial-services team, and we're going to talk about the payments industry.

Jim, thanks for joining me.

Jim Sinegal: Thanks for having me.

Coffina: Maybe for our viewers who are less familiar with the payments industry, if you could just start us off by talking about the major players. Let's start with issuers. What's the role of issuers in the payments industry, and do we think they have economic moats?

Sinegal: The issuers are responsible for issuing cards to cardholders and in a lot of cases, lending. The biggest issuers are the big banks, J.P. Morgan, Citibank, Bank of America, Capital One, all enormous issuers of credit cards. They are not the strongest moats in the industry, but they do have some competitive advantages, especially as the industry has consolidated. There are a lot of advantages to scale and card issuing, and so we see those companies getting pretty good returns.

Coffina: The weakest link in the chain we usually think of as acquirers. What is the acquirer's role?

Sinegal: The acquirers, although maybe the weakest in the value chain, it's still a pretty good business. The acquirers are the companies that deal with merchants. Just as issuers provide cards to cardholders, the acquirers are the companies that are going out and signing up merchants. It's a little weaker for a couple of reasons: Number one, the acquirers are dealing with big merchants like Wal-Mart, whereas the issuers are dealing with individual cardholders. Number two, the industry is a little more fragmented. And number three, the barriers to entry are a little lower. We've seen over the past decade, new companies like PayPal Online and Square with small merchants, getting into the acquiring space, but overall it's still a decent business.

Coffina: So the widest moats in this industry belong to the payment networks. To start us off, there is a big difference between an open-loop card network and a closed-loop network. Can you explain what the difference is?

Sinegal: Basically, a closed-loop network provides all of the functions. They issue cards to cardholders, they deal with merchants, and they do all of the intermediary work. That's a company like American Express or Discover. Open-loop networks like Visa or MasterCard are dealing with merchant banks and issuing banks. So they basically only provide the connections between financial institutions, between acquirers and issuers, and they are not dealing with the cardholders and the merchants at the end points.

Coffina: Why do we think that networks have the strongest competitive position?

Sinegal: I like to think of the networks as a toll booth on spending. For every transaction, the networks are going to get their $0.10 or $0.15. I think one of the reasons they have the strongest competitive position is because they have the biggest network. The Visas and MasterCards of the world are touching almost every merchant and basically every cardholder as well. As you know, with the network effect, the more number of connections, the stronger the competitive advantage, and that's exactly what Visa and MasterCard have established.

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Coffina: Last, you recently took a fresh look at these companies, and I'm thinking of Visa and MasterCard in particular, and you significantly raised our fair value estimates. What are the important factors to consider when valuing these companies?

Sinegal: Yes, there are a couple of really important factors. Number one is growth. They are very fast-growing companies. Not only do they grow along with consumer spending, but as consumers around the world shift from cash to electronic methods, that's all the more growth for the payment network. So that's number one. After looking at the potential market size in 10 years, we boosted our long-term growth assumptions.

Second is margin. These companies really cut back on their spending during the financial crisis. At one point we thought that would rebound a bit, but what we've seen is, spending has not rebounded, but yet growth has resumed. So I think there is a little more margin than we'd previously thought.

Third, as the "mobile wallet" threat has evolved, it looks like the Googles and the Apples of the world are going to be looking to partner with the networks in order to gather data, improve their advertising and marketing efforts, rather than disintermediate the networks. So as that's developed, we became a little more bullish on the network and that was a third factor that led to an increase in our fair value estimates.

Coffina: Would you buy any of these stocks today?

Sinegal: They are all very pricey, at 20 or 30 times earnings in a lot of cases. You're really paying a lot for the growth prospects at this point. On the other hand, when you look at the market overall, there aren't that many bargains around, so putting your money into a high-quality stock like this isn't the worst decision you can make.

I think there are some that are interesting even at a reasonable value. A company like Discover has a lot of potential upside. They are doing some interesting things, actually, on the lending side, rather than the payment side and they have a lot of potential upside if they manage to steal any share from Visa or MasterCard. We don't think that's a sure thing, but it is a bonus if you buy the company at a reasonable value.

Coffina: Thanks for joining me, Jim.

Sinegal: Thanks for having me.

Coffina: For Morningstar StockInvestor, I'm Matt Coffina.

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