2022 has been a particularly difficult year for investors with few places to hide from the sharpest rise in interest rates in US history1. As a result, the main difference in performance between stocks this year can be explained by the sensitivity of each business to interest rates, in other words, the duration of their cash flows. Indeed, a company which generates its cash flows far away in the future will see the present value of its cash flows compressed by higher interest rates. But the duration of cash flows alone cannot explain all of the stock’s performance in 2022 and it is interesting to see how, even within the same sector, performance can vary significantly between different players, beyond their sensitivity to interest rates. One such example is the payments sector, where some of our highest conviction names Visa and Mastercard, have performed strongly this year in contrast with the Fintech sector and other competing technologies.
The great recovery
The impact of the pandemic on different industries has varied dramatically. Sectors such as tourism, hospitality and retail were particularly hard hit as people stayed home and avoided non-essential travel. Other sectors, such as e-commerce and technology saw an increase in demand as people turned to these platforms to buy goods and services. It was no surprise, then, to see Fintech doing so well during the pandemic as locked-down consumers shifted their spending online, accelerating demand for digital payments around the globe. On the other hand, global payment companies like Visa and Mastercard suffered from the temporary loss of their international payment business as cross-border travel suddenly came to a halt. This largely explains why, in 2020, the S&P Kensho Future Payments Index, comprised largely of financial technology companies like Paypal, Mercadolibre or Shopify, rose more than 57 per cent compared to Visa and Mastercard’s performances of 17 per cent and 20 per cent respectively for the year.
Fast forward to 2022 and the picture looks very different. As most economies decided to ease restrictions in February and March 2022, e-commerce began to normalize, consumers returned to physical stores and spent more on travel and hospitality. In a reversal of fortune, Fintechs saw a great deceleration and sometimes even a contraction in the demand for their services, leading the S&P Kensho Future Payments Index to fall 34 per cent in 2022. Conversely, Visa and Mastercard benefitted from the strong recovery of international travel, helping both companies beat expectations and raise guidance for revenues and margins every single quarter in 2022, despite their withdrawal from Russia earlier this year. Visa has managed to grow its earnings 27 per cent in 2022, and these are now 38 per cent above pre-pandemic 2019 levels. Mastercard is expected to report similar earnings growth when it reports in February 2023. The recovery in international travel has therefore been a strong driver for the stocks in 2022, we saw them decline only 3 per cent and 4 per cent respectively compared to the S&P 500’s fall of 19 per cent.
A stable competitive environment
While the recovery of international travel has been a great tailwind for Visa and Mastercard, the shares have also benefitted from easing competitive pressure. Indeed, during the pandemic, a number of Fintechs with ambitions to compete with Visa and Mastercard experienced strong growth, fuelling fears that the payments networks would lose share to new players favoured by younger consumers. One such example was Buy Now Pay Later (BNPL). BNPL firms offer consumers the ability to purchase goods and services online and pay for them over time, typically with no upfront costs or interest. This is appealing to consumers who don’t have access to credit or who want to avoid taking on traditional forms of debt. BNPL leaders such as Affirm, Afterpay or Klarna experienced a boom in business during the pandemic and analysts began to predict exponential growth from there. With inflation steadily increasing throughout 2022, analysts are now worrying about the ability of consumers to continue to spend on discretionary items. It is now widely believed that sustained interest rate hikes in the US and in Europe will lead to recessions which will shrink consumer spending and potentially increase bad debts for BNPL providers. Higher interest rates also mean higher servicing costs for BNPL players who tend to have large amounts of debt on their balance sheets. This led to the share prices of the leading BNPL players to decline significantly in 2022 with Affirm’s stock price down 90 per cent and Block’s share price (formerly known as Square, which merged with Afterpay in February 2022) down 61 per cent.
Another financial innovation long hailed as a potential competitor of the payments network is the controversial asset class of cryptocurrencies. We have written in the past about the limitations of Bitcoin which made it a slow and expensive payment system unlikely to ever rival Visa and Mastercard (TOO BIG TO SCALE). Nevertheless, at its peak in November 2021, many crypto enthusiasts expected decentralised finance to be the future of payments. Since then, the market capitalisation of cryptocurrencies has shed more than two trillion dollars and is currently valued at around $800 billion. The crash of TerraUSD, the world’s third-largest stablecoin and the recent bankruptcy of the leading crypto exchange FTX have led many investors to demand more regulation in the sector. While blockchain remains an interesting technology, we think payments are unlikely to be its best use case.
As these technologies each face their own challenges, Visa and Mastercard continue to gain share from cash and cheque payments and are partnering with Fintechs around the globe to further entrench their networks.
A resilient business model
The last tailwind to Visa and Mastercard in 2022 has to do with the resilience of their business models in the face of persistent inflation and a slowing economy. Indeed, as we have continually highlighted in our inflation newsletter series2, we believe that companies with strong pricing power, high operating margins and low capital intensity are best positioned to protect the value of their cash flows in inflationary periods. Visa and Mastercard pass all of these tests with flying colours. Capital expenditures as a percentage of net revenues have averaged 3 per cent and 4 per cent respectively over the last five years. Visa’s reported operating margin of 64 per cent is currently the highest in the S&P 500, while Mastercard’s margin of 53 per cent puts it comfortably amongst the 10 highest. Finally, two-thirds of their revenues are variable and tied to the prices paid by consumers, meaning that inflation directly benefits Visa and Mastercard’s revenues. This, coupled with the recovery in cross-border payments, has helped the two companies report record operating margins in 2022, above their 2019 peaks.
The picture might be less clear when it comes to how the global payment networks might fare in a recession. Indeed, with revenues tied to Personal Consumption Expenditures (PCE), an economic contraction would surely hurt Visa and Mastercard’s top line. If we look at the companies’ historical growth rates, over the last decade both have grown net revenues at an 11 per cent CAGR. Over the same period, PCE has grown at a CAGR of roughly 4 per cent, while the growing penetration of cards is estimated to have added 4 to 5 percentage points to growth3. For Mastercard, the remainder of growth has come from growing its ancillary services business, gaining share from rival networks and exposure to fast growing countries in Europe and Asia. For Visa, the growth delta has largely come from acquiring Visa Europe in 2015 as well as building a data business to rival that of Mastercard’s.
Looking forward, we expect PCE growth to contribute roughly half of Visa’s growth and around 40 per cent of Mastercard’s growth over the next five years. This enables us to model a few scenarios. First, in the event of a “soft landing”, PCE would slow or even stagnate. In this scenario, we would expect Visa and Mastercard to be able to continue to grow at 5-7 per cent helped by the strength of their underlying structural growth driver – the continued penetration of cards as well as the growth in ancillary services and new B2B channels. In the event of a deeper recession, PCE could contract like it did in 2009 when it fell 4 per cent between 2007 and 2009, before recovering fully by 20124. In this scenario, we would expect PCE to be a headwind in the low-single-digit range which would still allow Visa and Mastercard to grow anywhere between 2 per cent and 4 per cent annually, helped by the same drivers mentioned above. Finally, in the worst-case scenario of a protracted period of stagflation, like the one experienced in the US in the 1970’s, Visa and Mastercard would actually benefit from the nominal PCE growth which would help offset the contraction of PCE in real terms.
Visa and Mastercard have been publicly listed for 14 years and in the Seilern Universe for almost the same length of time. Throughout that period there have been a number of threats which have often worried investors, like the Durbin amendment in 2011, big tech’s entry into payments in 2015, government nationalism in 2017, the rise of Fintech in 2019 and of course the latest BNPL and crypto threats in 2020 and 2021. These risks have often led to periods of underperformance and while we took each of these threats seriously, our research suggested the networks could navigate these disruptive events and turn some of these foes into friends. Visa and Mastercard remind us of the importance of doing your own research, cautiously ignoring the noise and letting earnings drive share prices over the long-term.
30th December, 2022
Any forecasts, opinions, goals, strategies, outlooks and or estimates and expectations or other non-historical commentary contained herein or expressed in this document are based on current forecasts, opinions and or estimates and expectations only, and are considered “forward looking statements”. Forward-looking statements are subject to risks and uncertainties that may cause actual future results to be different from expectations. The views, forecasts, opinions and or estimates and expectations expressed in this document are a reflection of Seilern Investment Management Ltd’s best judgment as of the date of this communication’s publication, and are subject to change. No responsibility or liability shall be accepted for amending, correcting, or updating any information or forecasts, opinions and or estimates and expectations contained herein.
Please be aware that past performance should not be seen as an indication of future performance. Any financial instrument included in this website could be considered high risk and investors may not get back all of their original investment. The value of any investments and or financial instruments included in this website and the income derived from them may fluctuate and you may not receive back the amount originally invested. In addition stock market fluctuations and currency movements may also affect the value of investments.
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