The past few weeks had been very good for network processors Visa (click ticker for report: ) and MasterCard (click ticker for report: ). Visa kicked things off with strong revenue and even stronger earnings growth for its third quarter. MasterCard followed suit, easily beating consensus expectations on 15% revenue growth and a 23% surge in earnings per share.
Then another bullet was fired in the war the US is fighting to regulate the amount of profit these firms can make. A US District Judge Richard Leon ruled that the Federal Reserve didn’t have the authority to cap debit card transactions at $0.21 based on the notion that the limit diverged from the original intent of Dodd-Frank’s Durbin amendment.
For whatever reason, politicians across the globe have taken issue with Visa and MasterCard becoming highly profitable, eschewing all of the benefits of a secure network and payment processing service. Whether Senator Durbin actually believes debit card caps would lead businesses to lower prices, or the act was simply a way to help big business increase profitability—retailers like Wal-Mart (click ticker for report: ) and Target (click ticker for report: ) come to mind—is a large political issue. However, we must deal with reality, and that means another bout of regulatory uncertainty.
There are multiple ways the situation could end up playing out. The Federal Reserve could alter its pricing regulation to keep $0.21 caps on large transactions, but perhaps move small transactions to a percentage of total value method. This may slightly harm revenue, but we doubt MasterCard or Visa would lose much sleep over this decision.
On the other hand, we could see substantially stricter debit interchange price caps. A move in this direction doesn’t really solve the issue of small transactions absorbing profits at retailers, but it would significantly reduce debit card revenue. In such a scenario, we think the card issuing partners (mostly banks) would continue to de-incentivize debit card transactions to an even greater extent. Remember, the average consumer already lost free checking thanks to the first iteration of the Durbin amendment, and Visa’s largest partner, Chase (click ticker for report: ), does everything in its power to make the unregulated credit transaction more attractive to consumers.
The previous time the transaction processors came under regulatory scrutiny, MasterCard, but particularly Visa, received irrationally low valuations, eventually proving to be an exceptionally attractive entry point in the portfolio of our Best Ideas Newsletter. Without question, Visa is slightly more exposed to this regulation than MasterCard, as it derives a larger portion of its revenue from debit transactions (which explains the recent divergent share price performance). About 23% of Visa’s transaction volumes come from the US debit market, but we think debit revenue as a percentage of total revenue is likely somewhere around 15-20%. A potential loss of revenue hurts, but it isn’t tragic to the firm’s future by any means.
Valuentum’s Take
Regulatory uncertainty is one of the material risks to what is otherwise a wonderful business model at MasterCard and Visa. Though it is too early to know for sure how the regulatory situation will play out, we tend to believe the new iteration of debit interchange caps will again have unintended consequences. More importantly, however, we doubt the new caps will negatively impact Visa or MasterCard as much as the Street anticipates. We’re sticking with our position in Visa in the portfolio of our Best Ideas Newsletter.