Early Friday evening, Visa (V), Mastercard (MA), and a cohort of banks including JP Morgan Chase (JPM), Wells Fargo (WFC) and Bank of America (BAC) reached an agreement with a group of approximately 7 million merchants for a total settlement of about $7.25 billion over a 2005 lawsuit that alleged price-fixing by the payment processing networks. Though exact payments from each firm have yet to be released, the cash component of the deal will be approximately $6.05 billion for past damages and will include $1.2 billion in interchange reductions.
Visa and Mastercard have been easy targets for legal action thanks to both firm’s healthy gross margins and robust cash-flow generating abilities. In 2010, the Durbin amendment was attached to the Dodd-Frank financial reform bill to essentially create a price ceiling because Senator Dick Durbin thought these firms were making too much money and gauging retailers. However, we think both firms provide card users and merchants with spending analytics, security, and fraud prevention safety—which is why we’re fans of both Visa’s and Mastercard’s business models.
Though this deal has been stirring for some time, we do not think the bill will have far reaching implications for the industry. Since credit and debit cards provide users with security, fraud safety and convenience, we think payments will continue to shift from cash to plastic and mobile payments, especially with technologies like Square making it easier for merchants to accept cards anywhere. Further, consumers tend to spend more when using cards, thus it makes sense for merchants to take the fee for higher revenue and profits.
However, the agreement allows merchants to tack on surcharges related to users paying with credit or debit cards. This isn’t an entirely new notion, as several states allow gas stations to sell gas paid with cash at a discount to gas paid with credit cards. Several merchants already have minimum charge policies to eliminate small transactions where network fees may eat into gross margins. The settlement may have a larger impact on banks that may no longer be able to receive similar fees.
Regardless, we think clarity on this issue is a positive for the payment processing industry. Though we do not think it will lead to significantly lower card acceptance costs and reduced prices for consumers, as some have suggested, we do think it will eliminate legal overhang on both stocks. The deal gives merchants the ability to collectively bargain with Visa and Mastercard, but we do not think this will have a material effect on industry pricing. Visa and Mastercard will still operate a virtual duopoly, with neither firm engaging in aggressive price tactics to gain market share (as both are happy splitting the pie). Considering there are 7 million merchants included in this settlement, we think it’s more likely that the merchants will undercut each other rather than the payment processing networks.
Though we like both Visa and Mastercard, both firms are trading within our fair value range at this time. Visa and Mastercard generate enormous amounts of free cash flow and have very strong networks that will be very hard to replicate, even as mobile payments and PayPal (EBAY) grow. We like Visa more because our point estimate of its fair value still suggests valuation upside and it has more to gain as uncertainty is lifted (it underperformed drastically while the Durbin amendment was in limbo). Visa remains a holding in our Best Ideas Newsletter portfolio.