Long/Short Investments
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Long/Short Investments in L/S Equity: Valuation and Ideas,

​VISA (V): $84 Price Target

Visa (V) is a well-known financial services brand that facilitates electronic payments between businesses, merchants, consumers, and governments organizations. The company operates the largest electronic payments network worldwide.

I believe there are many things to like about the business:

  • Market leader with a strong brand name
  • The ubiquity of electronic payment and personal credit
  • The relatively high commission the company makes from facilitating transactions through its service
  • The company is service-based only and has no cost of good sold expenses and therefore reaps a gross margin of 100%. The company basically collects a royalty on worldwide economic activity.

I believe Visa is a strong candidate for long-term earnings growth. FY2017 revenue is expected to grow by 10% year-over-year. Even if we assume this decreases by 10% each year (e.g., 9.0% Y/Y growth in 2018, 8.1% in 2019, 7.3% in 2020), with EBITDA margins of 84% throughout (the company is currently achieving above that level), EPS will be expected to double in ten years’ time, or grow by about 7% annually.

Visa’s depreciation and amortization has hovered over 20% of revenue for years due to an aggressive incentive amortization plan. With capital spending at 3.7% of sales long-term, we should expect D&A expense to converge closer to that figure over time. Based on these assumptions, we should expect profit margin to come in at 53%-54% over the projection period. Over time, especially with the recurring nature of the company’s cash flow, this will build a large cash balance over time. I expect annual cash flow to also double to $16.8 billion by 2026, which should help Visa provide a better dividend yield over time (it currently stands at just 0.72%).

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Capital Structure

Visa is lightly leveraged, with just 8% of its capital coming from debt. I believe its optimal capital structure is comprised of 15%-20% debt, with the potential to go beyond that in the future.

The company’s earnings before interest and tax (EBIT) is artificially low due to the high level of amortization currently in place, which will normalize long-term. Depreciation and amortization expense is currently 23%-24% of sales, which is extremely high, particularly for a company that spends less than 4% of total revenue on capital expenditures. Over time, this normalization in the amortization expense will raise its coverage ratios (i.e., EBIT/interest expense) and make debt more financially feasible. Even now, the company is operating at a projected EBIT coverage ratio of 17x for EY16. With projected sales growth and amortization expense normalization, this coverage ratio should continually grow, allowing for accretive debt issuance opportunities.

Even now, the company’s cost of capital would be minimized at approximately an 80%-85% equity/15%-20% debt structure.

At its current WACC, I have the company valued at $197.4 billion and its stock at approximately $84 per share.

Visa is in a unique position where a steady issuance of debt could serve to lower its cost of capital long-term, obviously contingent on the future interest rate and capital markets environments, and future operational/financial performance.

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Valuation

Based on the financial assumptions mentioned above, I have the stock valued within a range running from $76-$95 per share.

The market values the overall company at $181 billion. I place the value somewhere between $178B-$222B.

A 20% discount from median share price valuation would set the buying price at $67.48 per share. A 15% discount would place the purchase price at $71.70. I was also strict with the cost of equity figure, discounting at 10% (i.e., expected annual return), or an overall WACC of 9.37% inclusive of the cost of debt.

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Conclusion

At its current $77 value, Visa seems less than 10% off from a being a pretty solid value pick even under fairly conservative modeling assumptions and a discount rate demanding above-market average return. (For the FY2016, I conservatively have its EPS at 2.57. Consensus sits at 2.78.)

Pair this with the quality of the business model (essentially a royalty on global economic activity, as mentioned earlier) and Visa provides something positive among a sea of overvalued assets in the current equities market. On the basis of profitability, cash flow, earnings growth, and capital structure, Visa is a great company to own. Its market growth also looks okay, albeit probably not stellar, going forward. Visa doesn’t look cheap on the basis of some traditional value metrics such as P/B and P/S, especially in the case of the former where 43% of its assets are of the intangible form (e.g., customer relationships). For the sake of safety, I would like to see Visa dip down into the low-70’s to initiate a position.

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Potential Catalysts

  • Earnings growth
  • Accretive debt offering once amortization of volume, support, and client incentives begin normalizing, increasing EBIT margins and bettering the company’s financial ability to tolerate debt

Risks

  • Government intervention/regulation
  • Competition from alternative electronic payment vendors, esp. alternative payment methods that reduce the need for intermediation networks