Chit Chat Stocks - Visa (Ticker: V) Not So Deep Dive

Episode Date: June 27, 2023

Visa Inc. (V) is a global payments technology company that operates a vast electronic payments network, connecting consumers, businesses, and financial institutions across the globe and enabling seamless and secure transactions in multiple currencies and countries. At the end of the month, we will publish an Arch Capital episode that will cover the company: Airbnb. Listen closely as Brett and Ryan go through the history, financials, and future prospects of Visa. Enjoy the show! ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Mine Safety Disclosures Blog: https://minesafetydisclosures.com/ Timestamps Company Background | (4:05) Industry | (21:00) Management & Ownership | (32:38) Earnings | (34:42) Balance Sheet | (37:10) Valuation | (39:54) Our Analysis | (40:58) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome into Chit Chat Money. My name is Brett Schaefer, and I'm joined by my co-host, Ryan Henderson. Today, we are doing our Tuesday not-so-deep-dive episode where we analyze one

stock covering the basics of how the business works, who owns the stock, any sort of management government stuff or governance stuff it's industry earnings financials all the good stuff what we think about the company whether we like that or we're going to put on our watch list thinking about buying the stock whether we're going to research it further basically we're going to hopefully help you if you don't know the company well learn about it more and maybe get inspired to either do more research yourself put it on your watch list we hope to just it's not how do i I describe it. I always describe it wrong. We're not outsourcing our research. We're hopefully sharing our research in a public forum with everyone else. Today, we are covering the end

of our payments theme. Let me see if I can name the other four companies we did. PayPal, bill.com, and shift4payments. Yeah, the other one was not at the top of mind. And then today, we are covering Visa. To round this out, I think it's a perfect one to end on. We also did an interview with Matt Cochran, if you're interested in the card networks, covering MasterCard, the other side of the Visa coin of the duopoly-ish, although maybe not in the future. We'll talk about that and the competitive advantages and industry part. Anything else before we start out, Ryan, that you want to disclose, talk about before we get into the background of Visa's business? No, not really. I want to say…

Oh, charts will be on the newsletter. yeah link in the show notes we reference any charts they will be there numbers will be there yep i guess i'll go ahead and preface the fact that i'm gonna go a little long-winded on the history and the description of what visa does and i'm actually going to start with the history and the reason i'm going to do that is because i have had visa described to me probably dozens of times i've researched the business kind of vaguely and for the life of me i i like i peripherally or kind of like surface level understood what visa did but i could never i never really had a thorough grasp on it you're saying something clicked this

week something clicked we had a magic moment yes and sometimes it takes like just an absurd amount of reading before I really get the grasp on a business. I read one blog and it did it for me. It instantly clicked. The blog was called Mind Safety Disclosures. We will link to it and I'm going to reference it throughout this episode a lot. First off, if a blog is called Mind Safety Disclosures, you have to read that. That is a perfect name for anyone that doesn't know what That is read some more SEC filings and then get back to us because that is actually a, it's, it's an hilarious joke. The so I'm going to reference it a couple of times.

I want to give them just a ton of credit because this is really when it kind of clicked for me. And so, like I said, we will link to it. I don't know if it will be in the show notes, but in the newsletter, for sure. Yeah. Newsletter, it will certainly be in there. So let's start with the history. um i think it's really important to understand the history to see because the history paints visa's value today and it kind of goes back to the roots of when this was more of a manual process as opposed to a digital process but it's really kind of the same uh sort of competitive advantages

exist in the business model today so i'm going to go back and kind of lay the groundwork so So at the start of the 20th century, I believe that's accurate, 1900s, early 1900s, borrowing money was not very easy, especially for banks or borrowing money from banks, especially for little things. It was very inaccessible. there's actually even a popular quote at the time that said, a bank is the place for a poor man to put his money so that a rich man can get what he wants or get it when he wants. This is when installment credit started to be introduced. So to help more people be able to afford goods, things like cars, this was kind of the booming times of the automobile. In order to be able to afford more goods, merchants and manufacturers started letting

people buy items without putting all the money down at the time of the purchase. So it's just installment loans from the actual merchant themselves. So it's basically buy now, pay later, reinvented. But basically, you didn't have to put all the money down up front. By extending this credit, it allowed people to buy more things they otherwise wouldn't have and merchants to sell more items they otherwise wouldn't have. But this wasn't very sustainable for individual merchants. This is kind of, I'm quoting, I'm going to say MSD, which is Mind Safety Disclosures here.

It says, lending money was not without cost. Merchants had to assess each individual customer's creditworthiness, bear the risk of late or non-payment, and shoulder all of the back office headaches and expenses that came with managing thousands of individual accounts. It was not easy on the customer side of things either. uh every time someone wanted to make a purchase like something little say it's like I don't know 200 worth of uh back to school clothes that you couldn't afford right at the moment you'd have to present and kind of appeal for credit you'd have to like bring like statements of income and convince merchants to lend to you and no yeah no credit score so it's a little tougher to underwrite one as a merchant. And so a lot of banks didn't want to write these loans because they're small

and it's just not worth the effort and you got to do all the billing and there's so much back office work involved. And keep in mind, the billing at this time is not some digital invoice where they then just route money to your account. This is all physical shipping, costs money. You have to go collect all the cash as well. So it was this kind of laborious process, although there was one bank that would lend these kinds of loans, and that was Bank of America. Bank of America became the largest bank in the US, I think, by around the 1950s because they made so many of these loans.

They really appealed to middle America. However, it was coming across much of the same pain points that merchants were initially. So they were willing to do it, but it really wasn't that efficient of a process. So in order to make that process more efficient, in 1958, Bank of America introduced the Bank AmeriCard credit card. So the difference between credit card and installment loans is that instead of having to settle up at the end of your installment period, it was just revolving credit. This is how the credit system works today.

You could pay it all off when your credit is due, or you could defer it further, but pay the bank interest on those basically carried balances. And so sound concept, but the difficulty now is getting people to use it. This presents kind of the chicken or the egg problem where merchants don't want to accept it if a lot of people aren't using it and people don't want to use it if merchants don't accept it. So you got to find a way to kind of get that flywheel clicking. And so the way they did this was to hyper-localize. And they started by pre-approving everyone in Fresno, California, because they refer to this as the Fresno drop, because 45% of the residents there banked with Bank of America. And they actually had really good success early on in terms of onboarding smaller merchants. Some of those smaller merchants had three kids in the back office trying to reconcile all these accounts that were like a $4.50 order, paying for the shipping to send the bill out and all these headaches that they didn't want to really have to go through.

And so they were like, yes, this would save a lot of my problems for all the Fresno residents that order from here, and I wouldn't have to – it wouldn't take nearly as much work on our end. So it worked. It worked fairly well in Fresno, California, and some other cities in California started to adopt it. There were early issues. There was a lot of fraud. There was too many late payments. And that discouraged a lot of the other banks from trying something like this. But after about three years, it started to become profitable and they really started to figure it out and kind of had this early lead.

And so they wanted to expand this internationally, but there was laws that were put in place during the Great Depression, which basically said banks weren't allowed to have out-of-state customers. And so instead of Bank of America launching a branch to every single – basically trying to build Bank of America. Hold up. You said international. You mean interstate. Interstate. Sorry. So their solution was instead to franchise out the Bank of America program to other banks around the country. But the program quickly fell apart due to the authorization process. So authorizing a transaction is pretty easy when the merchant and consumer had the same bank. So here would be the process, right?

You would call, you go, you've got a Bank of America card, you've got the same bank as the merchant, you give them the credit card, they call the bank and say, hey, is he good for this? Yes. Boom. You're good to take that home, that item, whatever it is. However, when the merchant and the consumer did not have the same bank, it became a very difficult problem. Here's another snippet from MSD. It says, the merchant had to call his bank, who then put the merchant on hold while they

called the cardholder's bank. The cardholder's bank then put the merchant's bank on hold while they pulled out a big printout to look up the customer's balance to see if the purchase could be approved, all while the customer and merchant stood there in the store waiting for the reply. And that was when the system was operating smoothly. Sometimes the merchant got a busy signal. Other times, his calls went unanswered. Could you imagine this process? I think sometimes it takes a little too long to read my chip at the modern point of sales devices. I could not imagine sitting there for 10 minutes waiting. Yeah. And Ryan, we're going to talk about this in the US, the tap to pay revolution hasn't cuddled, but maybe we'll get you on that later. We'll talk about that market share and why that

we're actually improving that even, or Visa is improving that even further. So authorizations were the first problem. The second problem was interchange and interchange is kind of this, still, it's a really important concept today. I want to hammer down on these too, because this is where much of the value that Visa provides comes into play. So in describing a cross-state transaction prior to computers, MindSafety Disclosure says, in order to settle with one another, the merchant bank had to physically mail crates full of paper and sales receipts to customers' banks all over the country on an almost daily basis. The cardholder banks then had to manually match up the sales drafts with

their customers' accounts, reimbursed the merchant's bank, and then finally billed the cardholders. It was one thing to settle accounts with five banks or even 25. It was another thing to settle accounts with 150 banks with millions of cardholders, billions of dollars in sales. You can see how this would be pretty much impossible for an individual bank to do. There needs to be an intermediary. As you can imagine, this was an enormous issue. And in 1968, Bank of America held a meeting with all its member banks to sort out the issue. The resolution was to turn Bank AmeriCard into its own independent entity co-owned by all the member banks that were a part of the Bank AmeriCard programs. This new organization was given the order or the mandate to make the credit card system run smoothly.

And they actually, I know that's kind of a broad mandate, but it actually started working. this is also kind of at the time where digitization is coming into play computers are becoming potentially a little little more mainstream so they can use them this is when the the new the stock exchange had the thing over the many the the paper trades i can't remember exactly what happened where they would write the volume became too high that they had a whole intervention at this time as well we'll say that's for the financial history show but yeah so they i'm to deliver another quote here from mind safety disclosures he says in 1973 bank americard used computers to automate the authorization process three years later they did the same to interchange

the digitization of these processes immediately bore fruit transactions could now be processed 24 7 365 authorization times dropped from 5 minutes to 50 seconds banks cleared and settled transactions overnight instead of a week or more and postage and labor costs were reduced by 17 million in the first year alone. That's $79 million in inflation adjusted. So the automation behind this turned this into a functioning operation. And by this time, so kind of late 1970s, they'd really gotten their feet under them. The organization, the Bank of America organization was in a good place. And that is when they decided to change their name to Visa. So that is the origin story. I know that was a little long, but I hope it

paints a picture of what Visa is now. They are functionally the largest connector between banks globally. So that kind of leads into the what they do section. I'm going to quote mine safety disclosures for the last time. I'll stop referencing it after this, but I wanted to use it because it just, it really made it click for me. So I hope it makes it click for everyone else. This is an illustration of where Visa fits in. So, and it kind of encompasses the whole history section that I just laid out. Consider a small merchant bank in Thailand that wants to enable their clients, i.e. merchants, to accept credit cards from tourists. For a transaction to take place, the Thai bank must have a way of communicating with each tourist bank so that

transaction can be approved and money can be transferred that means developing software that integrates with every single one of the tourist banks and every single one of the merchant point of sale systems there has to be support for hundreds of languages and currencies all while ensuring compliance with thousands of local laws and regulations operating standards must be established so that the banks can settle merchandise returns cardholder disputes and fraudulent transactions and the entire process has to be automatic real time and operate with zero failure or downtime the truth is most banks simply don't have the resources to do this with more than a few other banks let alone thousands so visa does it for them it's so much easier to just tap into

the visa network than to try to do this from the ground floor not to mention as more banks pop up around the world as there's more different types of transactions that visa network grows even more powerful, and important. So it's kind of a self-reinforcing advantage that they have there. I've also laid out an illustration of the typical transaction and kind of where Visa fits in. But for their services, they generate revenue in three different ways. And this is more the current business model. So the first one is service fees. In order to be part of Visa's network. Banks pay a small percentage of each transaction to Visa. This is the percentage part of Visa's take rate. So sometimes you'll see that Visa gets a fixed 7 cents on every transaction

plus 0.1% or something like that. This is the percentage part. And keep in mind, this scales really well with payment volume. So it's not just about kind of... I mean, Theoretically, if you had a $0.04 transaction that you paid for via Visa, someone would be losing money in that transaction. This is just the percentage. As the cost of goods rises, Visa takes more money. That's the service fees. It's what it takes in order to be a part of Visa's network. The data processing fees is the fixed fee that Visa gets for the settlement and transfer of funds behind every transaction. Keep in mind, this used to be very costly every time due to the shipping costs required for every single bill. But today, it's all upfront costs and investments

in equipment and technology. So there are very little variable costs to each transaction. So if there's 100 million transactions and they're getting that fixed fee, it's pretty much the same cost as a billion transactions. So there's lots of operating leverage there and ability for them to raise margins. I know I've talked a long time. Brett, do you want to interrupt here? Sure. I'd just say that there's the value-added services that they might talk about. If you're someone interested here, that's just the stuff that they've layered on top of for their merchants or basically their bank, whoever their customers you describe it as, which is basically the fraud detection, security, tokenization, which I guess

is a part of security as well, FX stuff, which Ryan is going to get into, but not just the fees they earn on that the bank connection stuff and i guess consulting which all these companies seem to add on top yeah we have a consulting arm for you too which you can pay us to consult about our products but generally it's the the payment transaction fees yeah and then the last big driver of revenue is cross-border fees this is very similar to service fees they take a percentage of each transaction on cross-border purchases however when the merchant bank and the cardholder bank are in different countries visa ramps up its take rate significantly because cross-border transactions are far more complex usually there's currency conversions well most of the time there's

currency there is there is almost always currency conversion yeah but and there's also local regulations we talked about this on regulations yeah we talked about this in the episode of wise we talked about this in the episode interview we did with on ad yen you can find in our feed a lot of a lot of the complication and a lot of the there's also higher rates of fraud yeah yeah yeah exactly and this is a big development during the pandemic as the rate of transactions that were cross-border you know have gone through a huge sort of bullwhip effect all right so those are the three primary drivers they also have a tiny revenue line that says other revenue small i i didn't dig into the nitty-gritty there um but it's not it's pretty trivial to the

business basically the more dollars that flow across visas rails so the the payments that they're processing between banks um the more the the more revenue they're going to take home very simple i know a lot of people know that but i hope that gives a better illustration of what Visa actually does. Yeah. And yeah, it's easy to understand how they make money, but I think how the business works is a lot more important when you're analyzing or evaluating their competitive advantages and the competitive threats that they face, which we'll get into, I guess, probably in this section. So we're going to hit industry and competition. The industry is the global payments market. I mean, it's ginormous. They are really going after

any transaction that is transferring money from some person to a business or just some organization to another organization. Generally, though, the vast majority of their business is for consumer to business transactions, which is the ones you think of. You go to a store or you're online and you use it to take your money from your bank account and transfer it or using your credit card connected to a bank account and purchase something from a merchant. that tam globally even x china is in the tens of trillions of dollars each year visa is estimated to have 40 global market share of credit card volumes and over 60 in the united states and they did 11.6 trillion dollars in volume last year excluding their cash

uh business i would just look at that one i think it's the most important i think i saw that number And then I also saw another number in their 10K that said 14 trillion. 14, yeah, that's including these cash things that I would say this is a better definition of what their most important business that's growing. But again, you can look up the definitions of that. Either way, it's over $10 trillion. But yes, there's two numbers they give out each quarter. If you look at their total, total addressable market though, which again, who really cares?

But it's actually larger than even the tens of trillions of dollars that we're outlining here because their ambitions are getting to, you know, to get into payment processing for, or excuse me, payment transactions for business to business transactions. I would listen to the bill.com episode for an example of that. Peer to peer, government to consumer, they want to do a lot of that as well. That's what they talk about, again, in all their filings, all their conferences that they go to. they talk about adding in this on top of their consumer to business and basically layering it on top of the network they've already built. Plus, they have the value-added services that we discussed earlier. So it's huge. And it's growing because industry volumes are generally going to grow with the global economy. And as everything becomes cashless eventually,

which it still has, you look up a lot of different estimates, I actually found a wide variety of estimates of what is cashless versus the old check or any sort of paper transaction. Either way, though, it's actually still globally a lot farther than people think from becoming a full cashless society. If you are listening to this, there's a higher likelihood that you're in the middle class or above in the United States. That is one of the most cashless, especially if you skew younger which our audience does the most cashless um demographics out there there's still a lot of runway left in latin america africa asia etc now if we move to competition again we're going to have to be it's going to be a little bit long-winded here trust

me on the ownership i cut it down a bit to try to make that quicker for this episode there's a lot because really they compete with everything and they're on every sort of payments transaction out there so if we look at direct competitors these are the ones that are easy to quantify. And I'm going to separate it between US international. So in the US, their biggest competitors in order are MasterCard, American Express, and then Discover. There's really no one out there that's a direct competitor besides those four. If we look at direct competitors outside of the United States, we also have MasterCard and American Express, but we also have UPI slash Arupe, which is India government sponsored entities that are trying to, well,

kind of have disrupted them a bit. There is UnionPay, which is a China solution. I'll have some links in the newsletter about how both of these entities are growing. And then there's other state-sponsored platforms in a few other countries. And then they're competing with MasterCard as well. Now, it's hard to describe, or maybe people would agree or disagree whether these are competitors, but I call them looming competitors that some people argue will be competitors over time or actually are competing with them. And that could be Apple Pay and Google Pay or some of these e-wallets that could be included in there as well. I would say they are competitors if they try to circumvent the networks. There are the buy now, pay later

solutions. There are the cryptocurrency platforms. There are the peer-to-peer platforms like Zelle or PayPal. And then there are other government solutions that are looming like FedNow or whatever the Federal Reserve tries to come out with. Again, though, with all these solutions, what's strange is that today, they are actually the ones that are helping drive growth across Visa. But if they get too big, for example, Apple Pay, if they grow much faster than Visa and become a huge portion of their revenue, or what people talked about and worried about with PayPal, maybe 10, 15 years ago, there are worries they could break apart and form their own network which i guess maybe we can discuss what do you think ryan is the biggest threat to visa today

after researching this and then i'll give my opinion as well i think the risk that someone that is a payments layer on top of the existing networks so apple pay paypal google pay whatever you want to uh wise probably maybe um maybe they're a competitor maybe i mean why is it the big venmo sell all these cash app they're all layered on top of the card networks cash up has tried to do that a bit yeah they've actually tried it the chances that they are able to circumvent then the major card networks or maybe i should say the likelihood that they can successfully do that seem extremely low given all the friction that we laid out in the what they do section being able to manage the security and the clarion and the interchange process and

everything that goes on behind the scenes um for all the banks around the world to have as much acceptance it seems nearly impossible so yeah and here's let me try to make an anecdote here even if the solutions were equivalent from everything except for the maybe the branding or whatever it would still be very difficult for me to get convinced to switch over on my google pay account and just for anyone that's apple clothing for apple pay uh my that's basically what i have in my google pay account is i've connected my travel rewards card that i use for everything um just i use travel rewards some people use whatever card they use and it is ubiquitous across all of my

Android or Google connected devices. So anything I'm on the internet, the Google Pay is synced across my phone and basically any internet connected device I use and the card is there. It pops up. I pay my security code or use my fingerprint or however

security thing it is and I pay with the card. Why would I switch to an internal Rails when I want the card points? Because I'm giving up those card points. I think that increases their moat again. That's a specific example, but I think that applies to a lot of people.

Maybe someone could try to circumvent the rails for a particular geography, but when you're processing international payments, we're talking about being connected to all the banks globally. or a huge chunk of the banks globally, that seems very difficult for any individual player that hasn't been doing this for 60 some odd years to just start from the ground up. Yeah, and I think I've probably spent more time researching this since it's my section. And I think my conclusion is that union pay,

which again is the China solution, and the India solution, which again, I'd read up on that, have some links in there, are the biggest concerns for someone like Visa. It's not the end of the world because they're actually linked to an article that Visa and MasterCard are now getting accepted on the India solution after they were not included at first in the government-sponsored one because I'm guessing it was such a pain for the international travelers. UnionPay has grown a lot. They have a really big chunk of the market. And I think that's probably something that could impede on their growth and impede on Visa's global market share over the next few years, but I don't think it kills the business.

And these wallets or any other non-government sponsored solution, especially in markets that Visa and MasterCard are already established in, I just highly doubt one. There used to be, and again, we'll try to skip through the management and some of these other sections to get kind of going through the episode. But there was a, and again, I linked to this in the newsletter info on this, there was a merchant-sponsored network to try to evade the 3% fees that they pay. Because, yeah, as Ryan mentioned, the fee paid to Visa is very small, but the fees paid to the banks and the credit cards are quite large. It was called something like Merchant Exchange, something, something. It was a bunch of retailers. They tried to make it, and it totally flopped. and people talk about FedNow and stuff like that

or a cryptocurrency solution or whatever. But I don't think that the government can create the same sort of consumer experience as Visa, the same sort of brand. It's going to be clunky. I really don't think that competitive threats are very large, except internationally with some of these state-sponsored solutions

in places where Visa doesn't already have a large market share. for example india and obviously china is a big difference but union pay has been expanding outside of china which i think is the biggest threat in my my mind but what's interesting is that on one of the recent conferences i listened to on uh they have a lot of them on the quarter app for visa which is it's very very nice you can go listen to those they said that india is one of their fastest growing markets so yeah it feels really tough to interrupt the cycle or the kind of is it a network now

100 network effect yeah marketplace benefits i would say uh because there's no like peer-to-peer network effects it's definitely a network you have because if you have more Sure. The more consumers have it, the more valuable it is to the merchants. The more merchants use it, the more valuable it is to every consumer that joins. All right. Yeah, I don't think there's any way to interrupt it. The biggest risk to me is regulation, but we can talk about that in a little bit. So do you want to fly through kind of the ownership here? The financials, I'll try to go through pretty quickly too, because I know we've gone long winded, but I think that's the most important part is

how durable is this business? Yeah. And if you want to look up again, the charts the earnings all that good stuff will have it in the newsletter people want to get in the nitty-gritty on the financials but we'll try to speed up through this so management frankly going to keep it short really don't care who's in charge of this thing all i want to know is that they're consistently returning cash to shareholders and are not trying to move into markets through acquisitions outside of their core competency which you know for example coco on the 80s phil morris kind of did that a bit uh it would just be a big concern for a really high quality business to do that um capital returns boxes are checked off for me the return they return you know growing

amount of money to shareholders each year, mainly through share repurchases. I have a question here, but it actually is related to one that you're about to ask in the earnings section. So I'll just leave it at that. Executive compensation is extremely boilerplate. The management team is going to get overpaid on a nominal basis. Look, just deal with it. It doesn't matter for a business of this size. Executive comp is based on a bunch of metrics that make it irrelevant really for what you're actually going to look for for good incentives here you have net revenue growth earnings per share growth transaction growth and then a lot of qualitative esg type stuff again it's not great but i don't think it matters that much and i didn't really see

any creation of low bars to jump through a lot of their hurdles were in the double digit growth range but definitely something to track and see if they lower that and then overall when i read read through the proxy statement, I got to say it was so boring, which is a good thing. But also, you know, there's nothing that was going to make me say, oh, wow, I'm going to invest in this because of this ownership structure, these incentives, but there was definitely nothing to keep me away. Extremely boilerplate company. If there was no executive team next year, do you think this business would still grow? And they had all the division heads, right? Like we're talking, they have president of the company keeps running, like all the systems run fine,

but the executives are just gone uh and you're again you're talking corporate executives not like person in charge of visa direct or whatever sure yeah yeah i think they'd be fine because they do have a lot of like they mentioned that you kind of decentralize and have a lot of the each country heads like they'd still be there all right let's go through the earnings i'll make it pretty quick keep in mind this business is just sub 500 billion dollar market cap so just kind of keep that in mind when I go through some of these numbers. They have a gross revenue and a net revenue figure. The important line item here is net revenue. So that's just money from services, data processing and international transactions minus incentives for their

clients. So some of the incentives they give to financial institutions. So $31 billion in last 12-month net revenue. Their revenue since 2003 has compounded at 15% per year. It's been quite steady. It's a pretty even breakup between data processing fees, service fees, and then international fees a little lower, but still it's growing pretty quickly. 98% gross margin business. I don't think I've ever seen a gross margin figure that high. have you they are the gross profit royalty they are the ultimate gross profit royalty remember how we they are everyone else's cost of goods sold yeah exactly every single episode we talk about when we look at the cost of revenue of something when it's a high margin business we

always say yeah there's the cloud costs and then there's payment processing fees added a couple percentages there well these are the payment processing fees yeah um in the last 12 months they've done $18.2 billion in free cash flow. Free cash flow margins have really climbed over the last decade. They've unlocked a lot of that operating leverage. So in 2010, Visa had 30% free cash flow margins, and that might've been maybe a low annual figure or whatever, but it was around that area. And then in the last 12 months, they've had 59% free cash flow margins. So they've really unlocked a lot of that operating leverage. And then last thing I'll mention here, because I don't think the granularity in terms of how they

did this quarter is that important to the thesis. Over the last 10 years, Visa has generated $100 billion in free cash flow. They've spent $71 billion of that 100 on repurchasing shares. So it's been a very steady repurchase program, pretty simple capital allocation strategy. And And then over that time, shares have come down by 18%. I'll ask a question here in a second around that, but let's talk about the balance sheet first. $20 billion basically in treasuries and money market funds, no real short-term debt, but 20, basically the same amount of cash they have in debt.

So $20.6 billion in long-term debt. It's a bunch of senior notes that extend all the way out to, I think like 2050. and it's really low interest rates, extremely low, mostly between 1% and 3%. Most of it doesn't mature until after 2030. So same amount of cash as they have in debt, and they're earning more interest on that cash and they're paying out on their debt. That's fantastic. My question, however, is do you think they should be buying back stock right now at, we're about to talk about the valuation of earnings yield of 3.4% or investing that cash in treasuries that earn 5%. Yeah. And I got the EV to operating income just for the valuation.

I just used that one just since it's a mature business at 24 times and that's not including taxes. So I guess that will be a little bit higher earnings yield if you flip that around them 3.4%. I think, yeah, this is one of those where it's a really unique situation right now. And I think probably not buying back would be good, but on the other hand, it's definitely not a bad thing because the business keeps growing. I think maybe they should have some sort of, for businesses like this, I kind of think on the one hand, I think it's right to do it consistently. It's probably better to just do it consistently and have it very, very simple for your buyback strategy. But on the other hand, I kind of think it wouldn't be a terrible idea

to say, we'll buy back when the earnings multiple is below X amount, or they say, we'll buy it when you have some sort of relation to what they can earn on their cash balance. Because I would much rather have them build up the cash balance right now and then deploy it, say, when their earnings multiples below 18 times or something like that but yeah i agree it's not a thesis breaker but if you own the stock if you own shares in a company you shouldn't be against a company buying back because if you think that the stocks aren't cheap why don't you own it why do you own it so and they've actually been they've been they've still been buying back a lot of stock lately, but they've been allocating more to investment securities than they typically do.

So the split has moved a little bit more towards treasuries, but they're still pouring back a lot of money into the stock buybacks. Do you want to walk through whatever's left of the valuation? I know you already mentioned the operating income multiple. Yeah. I mean, enterprise value for anyone that cares is going to be almost the exact same as the market cap. I kind of wish they had a little bit more of a levered strategy, but You know, it's fine. Not a thesis breaker by any means. Enterprise value is $475 billion. EV to operating income again, which is the one I like to use, is 24 times. So right around the market average. And as the market has run up this year in early 2023, the multiple has come up. Not as much as some of the other stocks out there, but it has come up. and i actually i think i want to look it actually hasn't done that well this year maybe it has not comparatively to uh you know nvidia i guess is what everyone compares things

to now but year to date the stock is only up 10 so actually underperform underperform the s&p kind of interesting what a horrible business the uh let's talk anecdotal evidence yep go ahead And for me, well, I use MasterCard, but it doesn't really matter. There does seem to be kind of this perception among merchants that, and really everyone, it seems like, thinks that Visa and MasterCard take more than they deserve. Oh, yeah. It's a big indicator that people don't understand payments. yeah but yeah first of all most of that uh percentage that's taken off accrues to the issuing bank but or the cardholders the whoever issued the card their bank takes the bigger chunk but that perception might be important in terms of people trying to push regulation

so yeah yeah yeah exactly i think that's maybe a low light and that's that's kind of foreshadowing here that that was i think my only low light is that it has a bad perception which kind of invites regulation yeah and typically they've been able to sidestep regulation because again they're not the one their fees don't really get impacted and they kind of move it around a bit and it's not it's not as important as again the total fee that typically is applied to a transaction i think though the perception would change if you said hey look we can get rid of these fees for merchants but you're gonna your credit card points they're going to zero and i think people would maybe think about that a little harder yeah and let's not let's

remember the unlock that credit cards gave to really america broadly like it's so much more consumer purchasing that people couldn't afford a lot of items they they would just save up the cash until they could buy something i mean this like really credit drives the economy yeah i'm on team credit is good um uh but yeah the only other thing i'd say is it just seems impossible to disrupt yep i'd say the same thing i i basically got a note here it's not a contrarian take but i think it's one of the best modes in the world and the moat only expands as more cards in circulation grow or if cards in circulation are growing you know fast you know there's not someone out there growing much faster than them however this might be a contrarian feeling i have is that

amex is actually poised to do well over the next decade compared to their previous 20 years where they seeded some share to visa and mastercard i don't think they'll seed as much share as people think we did cover amex on our financial show ryan i'm curious if you agree or disagree here probably not a big deal for visa but i think amx is still poised to do well they've expanded pretty well internationally and are going to continue to do that i think i mean it's a good example of a brand that's been around for a really long time that a business that's been around for a long time and still has some of the issues which is you know you travel maybe there isn't as much international merchant acceptance so i know there's a lot of people out there with amx cards that also

feel like they have to get some sort of a visa mastercard oh everyone thinks that yeah 100 um so yeah i mean i i guess if amex starts to get real good international merchant acceptance kind of more they're getting better they're getting better at it yeah more so than visa then or not more than visa but kind of to try to get on parity with the mastercard and visa i think that would mean better uh yeah they're probably in a better position than visa over the next 10 years as a stock yeah instead of a duopoly it's an oligopoly how sad but uh yeah and maybe i would some feeling i have is if i really cared about visa i would enter um a research union pay more i think they have a much bigger market share than people think they have globally like 30 percent all right

future growth yeah much i think some of that is china specifically but they're expanding outside of china all right future growth opportunities ryan what did you pick for this one so i went business to business payments i think this is keep in mind throughout its history visas focus primarily on consumer to business payments but they seem eager to expand and b2b and they really called us out uh throughout their 10k and in a lot of the conference calls b2b payments are apparently a 4x or four times larger market and one where visa has less than one percent share so the chance to kind of expand market share more so than they're able to in consumer to business um the here's a quote from so one of their offerings is visa b2b connect which is a cross-border

payment solution for businesses it says visa b2b connects multilateral network delivers b2b cross-border payments that are predictable secure and cost effective um basically it's they're able to tack on all these different wrappings yeah on the same by leveraging the same network so basically it's just like a different presentation but it's really the same visa network because you're just going bank-to-bank channels. So this is them going after B2B cross-border payments. It seems like they're having a lot of success with it. The CEO, Ryan McInerney, I believe is how you pronounce it, said last quarter, while Visa Direct is growing fast, B2B is the largest component of new flows.

I think it's not guaranteed, but it's enough to say that, hey, there's still another market out there beyond consumer to business where they can expand their payment volumes yeah and i would for anyone again all these payment shows relate back to visa go listen to our bill.com one that's right we're going to be a growth driver for that i would say for example we use wise business for a lot of our international payments to any sort of advertiser any sort of relationship payment thing we have for anyone with chitchat money and i bet that is built on the visa b2b payments platform because they are a user of Visa Direct. And this reminds me, I want to say this

because I don't want to forget because I don't think I wrote it down in the highlights and lowlights. Visa is one of those businesses where I really like when a company has both the customers and their suppliers, which I guess would say in this case, the customers technically could be defined

in different ways. But let's say both the customers, which would be the individual people that have the cards and the acceptance people, they're both working extremely hard on Visa's behalf. Another example would be Google, iOS for Apple. So I guess iOS and Android, YouTube. um any other examples you have ryan where people the customers the people that are paying you money are doing the legwork for you and i think this is the ultimate example of that and i really really like those businesses yeah i just looked and wise does use visa direct i think they definitely use the b2b solution too right i probably i would assume so yep all right and that leads into my

future growth opportunity, which I wrote down everything because it seems like Visa and MasterCard, you can lump those in, are all encompassing, which I'm only half joking here. But on a specific note, I think Visa Direct looks very promising, should be a solid growth driver this decade. I will leave a link for more details, but essentially it is a service that is part of Visa's, what they call a network of network strategy that allows other financial service solutions to push and pull money to any other visa connected card which in this case i think they said it's almost six billion connections at this point and i think it actually goes beyond just the visa cards themselves it's they allow it allows them

again it's just a lot a lot of different connections to a lot of different cards and a lot of different bank accounts so an easy example of customers here again this is not a consumer-facing product. So the customers here include, say, Remitly for international remittances, and then peer-to-peer apps like Venmo. Visa Direct transactions were $5.9 billion. That's not a dollar amount. That's the total amount of transactions in fiscal year 2022, and growing 36% year over year. I think when they get their annual report out this fall, that will be another important thing to track over time. And I think it's not going to be impactful to earnings at least in the short term unless it really really takes off but it will be very

impactful as a moat expander what do you think ryan yeah i think that's right i mean even if you're trying to be i think maybe this is a good chance to lump in a quote from max levchin when he was building paypal i gotta pull it up real quick but he basically lays out that the services that are on top of visa's network like visa direct is kind of the plug-in for a lot of these services from the way i understand it it lets them do their cross-border services they apply acquired a company called cross currency to even help even more with that right that's added on you know it's included into some of the stuff for the companies that want it Yes. Let me pull up this quote. He says, and this is when he was building PayPal. He says,

PayPal is actually a more or less commodity business. It sounds very cool and innovative, emailing money around and moving money in the internet, but it's really not very difficult. The credit card interface has existed for 20 years. The AFT system existed since the 70s, which is the way you move money into bank accounts. It's really not that tough. All we really do is put a very pretty web front end on it and let people use their email address instead their account number it's without him explicitly saying it's the moat does not accrue to the layers on top maybe it does but it's a different mode the moat belongs to the card networks underneath yeah and just for example of what because i know it's hard visa direct's hard to understand i had

to read about it like five times before i kind of understood it but the way i think it expands the moat is that if someone is using visa direct for example venmo i just pulled up the venmo credit card when they launch a credit card for these fintech solutions for these financial institutions can you guess who who's the credit card is branded by visa they're not going to go to some they're not going to go to american express which again is a formidable competitor in this case but when they have the visa direct relationship already why would you choose anyone else for your credit card especially because the fees are going to be the same all right that's your point highlights and lowlights ryan we went through a lot of these so why don't we go through any

that you think are important for the listeners that we haven't hit yet? Yeah, I think we're probably going long, so I'll go quick. It's inflation protected. I wouldn't be surprised if interest, or it's not interest, if margins actually expanded from here.

There's so much operating leverage. I feel like they're proactively trying to limit their margins. Do they need to advertise guys on absurd amounts of money at the world cup yeah all the soccer games and the nfl stuff well an important one is they try to teach americans tap to pay on every football commercial for three years straight and apparently it didn't work so that my point is like they can try as much as they want this is a cash generating machine the there's also i guess one of the highlights

that I liked. It sounds like there's still a lot of verticals to expand into. I think a lot of people get caught up with, okay, this business is maybe saturated. It's too mature. There's not going to be a lot of growth. I think on top of the existing growth, which is inflation plus a couple percentage points, there's other verticals. The other thing I like, simple capital allocation philosophy now maybe they can shift more to treasuries but the buyback's been consistent it's very simple it adds it helps uh increase the per share profits so i expect that to continue and it usually is a sign that management's not going to do something stupid because they probably could have gone on and just made acquisition after acquisition of stuff that didn't make sense

maybe it wouldn't have entirely ruined their business but it wouldn't have allowed them to drive as much value to shareholders. Low lights, I think really I only have one, which is that there is not a very good perception among merchants or among society generally about the card networks. Maybe that invites litigation or regulation. And if they're ever doing 80% profit margins or something like that, I got a feeling the government's going to try to step in Yeah, there's going to be a lot of finger pointing. Hey, hey, look at that. You're not allowed to have that much. You're not allowed to make money. Yeah.

My lowlights I just add, I mentioned this earlier, is union pay and the other state-sponsored entities out there. Definitely a risk I'm watching because they do seem to be growing quickly. Highlights that we haven't talked about. I think you go on and on and on about the highlights of this business. But from one thing people worry about is, like Ryan mentioned, the TAM saturation, the market saturation. Haven't we already gone through, this is what everyone asks, haven't we already transitioned everyone to cashless products, right? But I still think there's a ton of growth left to be had for cashless payments in general. One, international, which we already talked about, is much less in a lot of places, except for East Asia and the United States, or certainly East Asian markets. first, international travel is only expected to grow, which not only increases their payment volumes, but widens their moat. Because as globalization grows, their moat only should

expand as well. Tap-to-pay in the US is much lower. It's way below global levels from market penetration and is going to only grow over time. And the reason that makes it helpful is because on average, it drives more transactions. If someone uses tap to pay versus the traditional methods of paying with a credit card, I think it was something like 7% pop or whatever on average. There's e-commerce growth. There's the digital wallets. Like we mentioned, Apple Pay and Google Pay are actually... People talk about them being risk, but in reality, they are really helpful for a lot of... For companies like Visa and MasterCard at this moment. I mean, I could go on and on and on um almost everything we've covered in payments even this month you know

paypal shift for payments bill.com and then the stuff we've covered on interviews or talked about uh in historical episodes which would be like wise remitly adyen etc etc they all drive growth back to visa so i think i'll sum it up there bull case ryan at the current you know earnings What do you think could mean some solid returns from here? What does the math look like? More of the same is what I put here. So I think in order to get good double-digit returns over the next five years, you have to assume that they continue to trade at 25 to 30 times earnings, which over their history

as a public company, they've traded at, I have it pulled up real quick, an average PE multiple of 34 times they're currently around 30 to high 20s definitely be conservative there because they were much younger as in 2010 so yeah yeah um i think basically just just have to assume that they still get the premium valuation which i think it's realistic and then they continue to grow free cash flow per share north of 15 a year it's been 25 a year i believe since inception maybe, or since they came public. So yeah, like I said, more of the same, which seems like a very realistic outcome. Yeah, I think that's a good summary. I have nothing to add really. So bear case, Ryan, as we wrap things up. Well, multiple contraction, I guess,

is kind of the big one here. If it starts to trade at 15 or 20 times, you've obviously got, that's going to be a hindrance to returns. The other thing I think is worth mentioning is that it traded at 30 times on average earnings since it's gone public, but that's when the risk-free rate was not 5%. That's when people could get a really low yielding treasury. So it's like, I don't know if it's just that attractive to me at a 3%, 4% earnings yield when you can get 5% returns on risk-free bonds. So that's kind of just the math, like the, I guess, give and take I'm going through in my head. It feels bulletproof, probably the most bulletproof business other than maybe like

Moody's or something, but even Moody's has cyclicality more so than Visa. It feels like Probably the most bulletproof business we have ever looked at. Yeah. I like them better than the rating agencies. So. Because the rating agencies are based on pricing power. I feel like that could get regulated away, but again,

another. Yeah. That's a great, but those are great businesses as well. I just don't like it as much. My bear case is going to be one we haven't talked about, which is deflation. Deflation could actually be a big headwind for them.

We don't know if that's going to occur. I know everyone's worried about inflation right now, but no one was worried about inflation five years ago. and maybe we'll be worried about deflation. Who knows? We don't know what's going to happen. And then I also think multiple compression. So yeah, I mean, the obvious one we talk about

every episode is multiple compression. In this case, I think it's a concern if it starts trading at 15 times earnings. Yeah, the returns probably don't work out too well. All right. I think we know the answer to the final question, but more or less interested, Ryan. I'm more interested.

Something makes me a little reluctant to buy any business above a $400 billion market cap at 30 times earnings just because the law of large numbers. But I think this could maybe deserve a spot in anyone's portfolio. It's so bulletproof. And the valuation was not as absurd as I was expecting going in, to be honest. I thought it was going to be like 40 times earnings. So I am certainly more interested. when we say more interested it's not like we're buying if we say less interested it's not like we would not ever buy it it's more of after doing the research and after recording this episode were we more interested in the company it's not you know it's not whether we'd buy or sell today

i mean i'd love to get it cheaper just because it feels like cash flow is guaranteed and you know they're going to buy back but that yeah because of that it makes me feel like i won't ever get it cheaper you never know you never know wait for some has it ever traded below 20 20 because of the durban stuff the dodd franks forget the exact stuff in 2010 it had a 10 free cash flow 2011 10 free cash flow um yeah i think that was one of the best buys of all time uh we don't have to get into the acri investment team basically made a big bet on them and master of heart in 2011 i believe or could have been before that but yeah same with todd combs i believe yeah and look i'm more interested as well maybe i'm being too gritty

but i am waiting for this to trade at 15 times earnings and then i would buy i think it's it could happen at some point you never know there's always some sort of threat that pops up remember when buy now pay later and that kind of caused a little sell-off at one point i mean maybe that could actually i think so i think so a small one a small one for a short period of time but maybe something like crypto pops up where they're like oh yeah yeah you know this is the big threat to the card networks i don't think people have taken that one too seriously but we didn't talk about crypto much i guess that's one way to potentially circumvent but i think it might have some user adoptions problems yeah let's uh i don't think there's much to talk

about there all right maybe some listeners don't don't uh don't appreciate that but hey if you got a take please tell us why it's kind of disruptive because i've never heard a good argument about that but let's kind of wrap things up i think we're in about an hour so not too long even though we're worried about it we hope a lot of people learned stuff from this episode and that you got some great takeaways on visa's business and the company or excuse me the stock remember to subscribe to the newsletter to get more information along with this episode. We are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may

hold securities discussed in this podcast. Thank you everyone for tuning in. We'll see you next time.