Payment stocks like Mastercard Inc (NYSE: MA ) have been investor favorites of late. Indeed, while Mastercard stock has risen 53% over the past year, it's not even close to the best performer in its industry. The gains in MA stock have been dwarfed by Square Inc (NYSE: SQ ), up 188%, and PayPal Holdings Inc (NASDAQ: PYPL ), which has risen 79%.
Investors are hot on the payment space - and with good reason. Secular tailwinds - notably decreasing use of cash and higher e-commerce spending - should benefit the industry for years to come. Mastercard and rival Visa Inc (NYSE: V ) have enormous competitive moats and appear to be taking share from American Express Company (NYSE: AXP ) and Discover Financial Services (NYSE: DFS ). SQ and PYPL have more specific bull cases - but enormous runways for growth.
The big runs in the space have raised some concerns about valuation. I've written that I see SQ as overvalued (though clearly the market disagrees), and PYPL has stalled out since November. Mastercard stock itself isn't cheap, or even close, trading at 29 times 2018 consensus earnings-per-share estimates.
So, the first question that arises when it comes to MA stock is if the sector, and the stock, look too overheated at the moment? The second is whether MA stock is the best pick if the industry still has enough growth potential to drive upside? I think there's still room for upside and though I wrote last week that Visa stock looked like the slightly better pick , investors can't go wrong with MA, either.
What Can Go Wrong With MA Stock?
Given a relatively full valuation, it's important to consider the potential risks to Mastercard stock. The good news is that a major collapse in MA seems exceedingly unlikely. An economic downturn, for instance, might not help MA stock. But Mastercard still grew revenue and adjusted net income nicely, even in 2009.
Market share doesn't move all that much, or that quickly (though it's worth pointing out that Mastercard has lost share to Visa , based on purchase volume, in credit cards; it has gained in debit cards).
Aside from widespread adoption of bitcoin - which I firmly believe will not happen - Mastercard's place in the payment industry seems secure. But that doesn't mean MA stock is bulletproof.
For one, that valuation could be considered a concern. Between 2012 and 2017, Mastercard's adjusted net income rose 75%. Mastercard stock, on the other hand, jumped 208%. Investors paid 23x trailing twelve-month EPS at the start of the run. Now, they are paying 38x trailing earnings.
That's an enormous multiple expansion, even with the benefit of tax reform. And it's one reason why I lean ever so slightly toward Visa, which is a touch cheaper at 28x 2018 consensus EPS. But in both cases, the concern might be already-high operating margins, which for Mastercard were 54.4% on an adjusted basis in 2017.
It's simply tough to expand those margins that much - and even seemingly major moves don't have a major effect. A 200 bps increase would add less than 4% to Mastercard's operating earnings. The double-digit revenue growth expected in 2018 (and 2019) is driving earnings higher, for now. But if that growth slows at all, investors are paying 30x EPS for a business likely to grow net income in the low double-digit range, at best, with some help from the debt on the balance sheet. That's a potentially dangerous combination.
Mastercard Stock Worth the Money
The valuation isn't perfect, admittedly. But MA stock isn't one that will ever look cheap, most likely. And with double-digit revenue likely to continue for some time, there's room to grow into the valuation. It's not as if Mastercard stock looked that cheap a year ago - and it's already returned more than 50% since then.
And there is a case that it's MA, not V, that's the better pick of the two credit card giants. MA has outperformed recently. EvercoreISI analyst David Togut argued last month that Mastercard's head start in Europe made it the better choice. Visa still is integrating its 2016 acquisition of Visa Europe and, on the continent, leans more toward more mature and, thus, lower-growth markets.
But, again, investors really can't go wrong. Both companies will get their share of the growth being driven by Square and Shopify Inc (NYSE: SHOP ) in e-commerce. A turnaround at American Express could pose a threat, and AXP stock is cheaper.
But I agree with Bret Kenwell's assessment that V and MA are better plays . Unless something dramatic changes in the financial system, Mastercard will have years, if not decades, of growth ahead of it. And that should lead to above-market returns for its shareholders.
As of this writing, Vince Martin has no positions in any securities mentioned.
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