New digital payments technology The death of the credit card has been greatly exaggerated. There have been numerous digital payments technologies (like digital wallets, PayPal, Google Wallet, etc.) that have been introduced over the last several years. However, most of these new solutions have not been runaway successes as predicted, mainly because they are trying to solve a problem that doesn’t exist. Credit cards are here to stay for three compelling reasons: Credit cards are incredibly easy to use, fairly easy to carry and very secure for the most part. They have only become easier to use over the last 5-10 years, as signatures are no longer required for most purchases and nearly every card provides fraud protection. So consumers will continue to use credit cards for a long time to come Many digital payments solutions still use credit cards on the backend. In other words, many digital payments link back to credit cards or debit cards to actually facilitate the payments and merely provide a user-friendly front-end experience. In this case, V and MA still make their cut. As I expected, we have seen this most recently with Apple's new payment solution - Apple Pay. Both V and MA (and American Express) make still make their cut from this platform. There are some solutions like PayPal that have a bifurcated approach - they link to credit/debit cards but also directly to bank accounts. In the latter case, V and MA don’t make a cut. However, I am not convinced that PayPal or similar solutions will be taking significant share away from card-based payments in the near term. Issuers have done a great job at creating strong incentives to continue to use credit cards – i.e. airline mileage cards and rewards cards. So while consumers may make some purchases through PayPal here and there, the majority of their purchases (and especially the larger ones) will be relegated to a card.

Lawsuits As with many companies, there is litigation risk with V and MA. However, V and MA have been the target of more litigation than most other companies. In the past, they have been sued for anticompetitive behavior by the likes of American Express and Discover with both of the latter receiving large settlements. More recently, they also settled a lawsuit with retailers nationwide over interchange (swipe fees). They were several large retailers (30 in total like Amazon, Walmart, Target) that bowed out of that settlement so there is more litigation and/or settlements that are coming. Given that there are several large retailers that are litigating, V and MA could be on the hook for several billion dollars. While these payments do impact cash flow and valuation as a result, I believe that the quick settlement/resolution will also lift a cloud of uncertainty from hanging over both companies.

Focus on share repurchases rather than dividend payments Both V and MA have generated a tremendous amount of cash flow over the last several years. However, they both sport very low dividend yields. In my opinion, the dividend yields are far too low for companies that have high operating cash flow and very low capex requirements. Both companies have used their cash primarily to fund share repurchases. While I like all shareholder friendly activities, I have a strong preference for dividends and consistent dividend policy. Management is generally not good at evaluating when their shares are cheap and often buy the stock when it is overpriced. Furthermore, share repurchases are often used to mask overly generous equity awards to management. As I have made clear in my investment philosophy, dividends keep management disciplined (not wasting money on foolish low return ventures) and I like to see continuously increasing dividends. V and MA have consistently increased dividend payments in the last few years, but not to the levels that I would expect and not to the levels that their FCF will comfortably allow. I would like to see management increase dividend payments significantly to at least a 35% FCF payout ratio. MA is currently paying out about 22% of FCF. An increase to a 35% FCF payout ratio would increase their payout to 18 cents per share per quarter from 11 cents per share per quarter currently. This would amount to a dividend yield of about 1% versus 0.6% today. This payout is still conservative and would still provide MA with ample operating flexibility to make acquisitions, fund share repurchases and potential litigation. Visa currently pays out about 15% of FCF. An increase to a 35% FCF payout would increase their payout from 41 cents per share currently to 96 cents per share. (a 135% increase). It would result in a dividend yield of 1.8% versus 0.8% today. There is no guarantee that V and MA will drastically increase their dividend payments in the near term but I am generally optimistic that the management teams will realize that dividends need to be increased consistently and significantly.



Management

Both V and MA generally have good, capable management teams that have for the most part acted in the best interest of shareholders. Each company needs to be evaluated separately in this regard.

Visa Management

A former JPM exec, Charles Scharf, has been at the helm at Visa since late 2012. Scharf is no stranger to the banking world having been one of Jamie Dimon’s right hand men at JPMorgan previously. Scharf has had meaningful impact in a short time at Visa. I would guess that Scharf was one of the chief architects behind the recent transition from nearly all of JPMorgan Chase Bank’s credit cards from MasterCard branded cards to Visa branded cards. Previously Chase issued both MasterCard and Visa cards to its customers. I would imagine that Scharf (given his relationships at JPM) was able to strike some type of sweetheart deal that assures exclusive Visa issuance or at least very high volumes of Visa cards for lower interchange fees. Anecdotally, my Chase MasterCard was recently automatically switched over to a Visa card. Given that Chase is the largest card issuer in the country, this is a big deal for Visa, even though it’s difficult to determine exactly what the financial impact will be. Scharf was quick to bring over his colleague from JPM, Ryan McInerney, to serve as president. McInerney was previously CEO of consumer banking for JPMorgan Chase so he has the experience and relationships to serve him well in this new role. Scharf is supported by a solid supporting cast, but I wouldn’t be surprised to see some C-suite turnover in the near term as many of the folks (CFO, CMO) are of the old-guard pre Scharf.

Visa has treated shareholders pretty well during Scharf’s term. They increased the dividend 21% (from 33c/share to 40c/share) and also repurchased 33 million shares for $5.4bn. The company also put in place a new repurchase program of $5.0bn in October 2013 through which 16mm shares (for $3.4bn) have been repurchased through June 30th, 2014. Some of these repurchases have offset dilution caused by stock options and other stock based rewards, but the total diluted share count has decreased considerably from 2011 through June 2014, which is good for shareholders. Generally, I would say that management has acted in the best interest of shareholders, but I would like to see more of the cash dedicated to dividends going forward as it signals confidence in the business from the management team as I have articulated previously.

From a corporate governance perspective I also appreciate that Visa maintains an independent chair of the board (Robert Matschullat) that is separate from the CEO position. While it is important that the CEO and Chair of the Board work together collaboratively, it is also important to maintain a separation of powers.

MasterCard Management

Ajay Banga, a former Citigroup and Nestle executive, has served at the helm of MasterCard since 2010 (joined MA in 2009 as COO). He has a diversity of experience working in financial services and also consumer packaged goods, which I think is very well suited to a company like MasterCard that depends heavily on both brand marketing and its financial institution partnerships. Banga has been credited with driving a new focus on innovation at MA and repositioning the company to think of itself as a technology company rather than just a payments processor. He has also launched an internal innovation lab called MasterCard Labs in 2010.

Like Visa, MasterCard demonstrates good corporate governance practices by separating the role of CEO and Chairman.

Banga has generally acted in the best interest of shareholders. During his tenure as CEO, dividends have increased at a CAGR of 65% (2010-2014). This is a tremendous feat. More importantly, Banga has drastically improved the dividend policy versus his predecessor. Before his arrival, dividends were held flat since early 2007, likely due to the recession, but I would argue unnecessarily so. Banga also initiated MA’s first ever share repurchase program in September 2010. Since then, the company has repurchased nearly $8.3bn of shares through July 24, 2014, which is significant given a current market cap of $88bn. $728mm is remaining under the current repurchase program, but I expect management to authorize a new program fairly soon. My primary gripe with MA is the same as V. I would like to see a meaningful increase in its dividend. I expect management to partly deliver on this next year.

Valuation

V and MA are both great companies. They both generate robust operating margins due to high operating leverage and a natural index to inflation. They will both also continue to experience strong growth as they benefit from the continuing secular shift to card-based payments. Generally they both also benefit from a durable competitive advantage and defensible moat in the form of embedded ecosystem integration, coupled with universal acceptance, strong issuer relationships and strong consumer brand recognition.

As with all great companies, the question comes down to valuation and if the current prices provide a reasonable return to prospective shareholders.

Based on a simple DCF, using reasonable assumptions for discount rate and growth, I arrived at a value of ~$87 per share for MA, which provides about 15% upside from today’s price of $75. For Visa, similar discount rate and growth assumptions were utilized to arrive at a value of $223, which would make it more or less fairly valued (~4% upside) versus today’s share price of ~$215.

What does all this mean? Valuation is an imperfect science with many inputs so these derived values are not exact. Generally, I believe there is a low margin of safety (lower than the 25% I would generally require) built into MA at current prices. Visa is fairly valued and has no margin of safety. However, as Warren Buffett has said on many occasions, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price” and both V and MA are wonderful companies where the expected margin of safety will typically be less than can be found on other less wonderful businesses. However, even buying at fair value would provide a return of 7-8% annually (with low risk) for an investor. And I believe that management can and will drive more value over time by increasing dividend payments, thereby instilling more discipline and signaling more confidence in the future business (which lowers risk and in tandem, the discount rate).

Based on the valuation analysis, I am a buyer of MA at current levels and would look to buy on short-term dips to provide further upside. For V, I will withhold buying until short-term dips present a more attractive entry point.

DISCLOSURE: I am currently long MA stock. I am not an investment advisor and this article presents my personal views. While I have conducted a fair bit of research to write this, you should also do your own research and come to your own conclusions.