Visa's Still a Force to Be Reckoned With

Wide-moat

Excluding the effects of the merger with Visa Europe, management now expects net revenue growth of only 7%-8% for fiscal 2016 on a constant-dollar basis, further reduced by 3 percentage points because of the strength of the U.S. dollar against foreign currencies. Nominal payment volume increased 5% in the December quarter (12% in constant-dollar terms) and 7% in the March quarter (also 12% in constant-dollar terms). Processed transactions increased 9% over the past 12 months. We think these results--high-single-digit growth in transactions and low-double-digit growth in underlying payment volume--are more than acceptable in a tough quarter and representative of the long-term growth runway available to Visa. The relative strength of the U.S. economy is likely to ebb and flow, but the overall growth of electronic payments will continue. In fact, it seems likely that cross-border commerce could increase dramatically over a longer time frame.

Management addressed several issues related to the upcoming acquisition of Visa Europe. Originally, the transaction contained a provision for an earn-out based on the performance of the combined company. However, the European Commission apparently frowned on that arrangement, and Visa will now pay an additional EUR 750 million upon closing and EUR 1 billion plus 4% annual interest for the following three years. We believe that switching costs for Visa Europe's issuing customers do exist, and that the combined corporation will be in a strong position to maintain relationships with European banks after the close of the deal.

Finally, Visa appears to be managing expenses well, given the somewhat weak revenue environment. Reported operating margin was steady at 67%, with operating expenses increasing 6% during the year. Visa slightly cut back on marketing costs and managed to reduce professional fees 15% in order to come in below its initial goal of high-single-digit growth through the first half of fiscal 2016. We believe that, with continued expense discipline, the firm is capable of moderating a weaker second-half outlook.

King of the Hill in Digital Payments Visa dominates the global market for electronic payments, accounting for about half of all credit card transactions and roughly three fourths of debit card transactions in recent years, according to the Nilson Report. The company primarily earns fees based on the volume of payments made under the Visa brand and the number of transactions processed through the Visa network. In a world in which the number of digital payment transactions is constantly growing, this wide-moat company should flourish.

The next five years are likely to see rapid changes in the nature of the payment business as cards are slowly replaced by electronic payment methods. This presents an opportunity for Visa in the form of volume growth tailwinds, but also a threat as new competitors attempt to manage the payment process and develop new ways to authenticate payments. We think Visa is on track to ensure that its connections in the virtual world are as plentiful and secure as they are in the physical, and competitors will have a tough time replicating the network's offering.

Like many dominant businesses, Visa faces the threat of increased regulation. The company's ability to set interchange fees at an optimal rate is slowly being reduced as countries around the world lower maximum interchange limits. Thus, issuers' incentives (and cardholders', due to a resulting decline in rewards) to choose Visa have fallen considerably. That said, few competitors can match the investments in technology, security, and marketing that Visa makes, limiting possible alternatives in the payment space. Furthermore, although the networks maintain the largest number of connections within the payment ecosystem--and therefore the widest moat--the fees they receive make up only a small portion of the value chain.

We've long believed that new payment methods would incorporate, rather that disrupt, Visa's business. We think Apple Pay's early success supports this thesis. Complex international regulatory regimes create a significant barrier to entry, and we still see the successful coordination of financial institutions and merchants around the world as a herculean task.

Moat Comes From Network Effect, While Risk Comes From Regulation A powerful network effect is responsible for Visa's wide economic moat. A payment method widely accepted by merchants is attractive to cardholders, while a payment method used by many cardholders is attractive to merchants. Thus, each additional user of the Visa brand increases its value to others.

The company also benefits from other moat sources. A trusted brand is important to users of payment systems, and Visa has spent billions of dollars over decades on this intangible asset.

Although a number of competitive threats are visible on the horizon, we don't foresee a substantial change in the company's near-term competitive position. In recent years, issuer and merchant consolidation and cooperation have strengthened the bargaining power of customers, yet Visa maintains a strong position relative to its customers, as evidenced by the relatively small recent increases in rebates and incentive payments to customers. We believe the potential effects of mobile applications are balanced. It may be marginally easier for cardholders to switch among payment methods using mobile technology, but these applications could also raise switching costs for cardholders and merchants by applying spending data to optimize rewards, discounts, and other offers.

The largest risk to Visa, in our view, is related to regulation and litigation. As an extremely profitable participant in an oligopoly, Visa is often the target of lawyers and politicians. For example, the Dodd-Frank Act limited debit interchange fees in the United States in 2010, and the European Union has taken the first steps toward new regulations covering interchange and other aspects of the payment system. Merchants in the United States have also taken issue with the company's fee-setting practices. Additionally, Visa could be vulnerable to disruption via new technologies or innovative agreements between issuers and acquirers.