October 29, 2012 - Small Fees Can Add Up To Big Profits for Visa
While out shopping over the weekend I noticed something. You have probably seen it, too. Just take a look around your local department store or even the corner grocery store. What do they all have in common? This time of year they will almost all have some sort display of red, green, silver and gold prompting us all to get ready for the fast-approaching year-end holidays. I know, Halloween is still two days away, but the commercialism of Christmas has been reaching back into October. But, before I go off on too much of a rant, the early holiday decorations were not what I was talking about.
Before you get to the displays, what do you see on the doors? A little sticker telling you which credit and debit cards can be used in the store. How long has it been since you have been in a store and could not use plastic of some kind? More and more consumers are moving away from cash and using plastic to pay for purchases. The proliferation of these cards has made cash nearly obsolete in many households. Even roadside produce stands will take a MasterCard (MA) or Visa (V) these days.
Every swipe of one of those cards adds up to big profits for the companies which process the transactions. MasterCard (MA) and Visa (V) are expected to post higher earnings this week as they continue to benefit from a shift away from cash and checks while navigating growing concerns about the slowing global economy and increased regulatory scrutiny. Of the major credit card companies, these two only process payments. Both Discover (DFS) and American Express (AXP) loan money to their clients and, therefore, have additional costs associated with lending, debt collections, bad debt and the regulations associated with holding consumer debt.
Discover Financial Services reported earnings last month. The company said credit card use increased and more customers paid off their card balances on time in its fiscal third quarter. The news overshadowed a slight earnings decline for the period, mostly due to the setting aside of more money to cover bad loans and for fees and penalties from a settlement with regulators. In the quarter, Discover reported a 13 percent increase in transaction volume through its payment services business.
A couple of weeks later American Express said its net income rose slightly in the third quarter, aided by lower expenses and increased spending by the credit card issuer's customers. Spending by the company's cardholders rose during the quarter versus the previous year. The increased spending helped boost revenue but the company also benefited from lower operating costs. Even so, the company's provisions for loan losses jumped over 90 percent to $479 million from $249 million a year earlier, when write-offs and delinquencies were declining at a faster rate and American Express released a far bigger portion of its reserves set aside to cover bad loans.
Since neither Visa nor MasterCard have consumer loans, they are immune to the risks associated with delinquencies and provisions for loan losses. They operate the networks over which card issuing banks and merchant banks process card transactions and, as such, growing their transaction volumes is crucial. They may only make a tiny amount from each transaction, but think about how many times you see cards get swiped in just one day. The increase in transaction volume reported by Discover was encouraging news for Visa and MasterCard.
In September, MasterCard warned that revenue growth in the second half of the year would be lower than the 13% growth it saw in the second quarter, due partly to tougher comparisons and economic uncertainty. However, it's been gaining debit transaction shares at Visa's expense due to the Durbin amendment as banks add MasterCard's network to their cards to comply with the new rules. The Durbin amendment requires there be more than one transaction network available for debit card transactions.
Visa's transaction volume growth has waned in recent quarters, though much of the pressure it has been under has been due to reduced fees and additional costs associated with provisions of 2010's Dodd-Frank Act. Last month, however, the company said debit declines slowed in August, leading some to speculate the trend will continue for the full quarter.
Both companies will be reporting earnings on Wednesday, with MasterCard reporting before the open and Visa stepping up after the market close. Both companies have been expanding in the area of mobile payments technology, and investors will be looking for clues about whether those investments are helping drive additional volume over their networks. Mobile payment will be an area of tremendous growth in the coming years as consumers shift away from cash and checks for even small, one-time purchases like Girl Scout cookies or that rocking chair at the county fair.
Of the two companies, Visa appears to have the better potential, at least in the intermediate term. The company remains focused on innovation for both consumers and merchants. The effects of the Dodd-Frank Act have largely been incorporated and volume increases are expected in both credit and debit networks over the coming quarters. The company is working on initiations for not only mobile payments but a number of deals and partnerships designed to add security to new payment solutions for customers and merchants alike.
Investors considering Visa may want to look at the January 120/115 bull-put credit spread. In this trade you will sell the January 120 put while buying the same number of January 115 puts for a 45 cent credit or better. As long as the stock does not fall more than 12.5% you will realize your full return of 9.9% return (44.0% annualized, for comparison purposes only). To get that return holding the stock it would need to shoot above $150. With the spread trade we get that return as long as Visa does not fall below $120. Visa has not closed below $120 since late June and has not been below its 200-day average, which currently sits above $120, in more than a year.
Be certain you fully understand the risk and reward profile of any trade before you put your hard-earned cash to work. If you have comments, concerns, praises or criticisms, please e-mail me at bfrey@InvestorsObserver.com.