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Visa Stock: Only For Really Committed Long-Term Investors Here (NYSE:V)

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Thesis and background

Visa Inc. represents (V) An ideal always-on founder with its wide moat, size, and role as a fee bridge to the business ecosystem. In the event you follow Warren Buffett’s portfolio, he has been a large, long-term contributor to V. He’s been holding V since 2011 (with an average entry price of about $21 at the time). Currently, V is the 16th largest holding in his portfolio: ~10 million shares, with a current value of about $2.1 billion. As a result, Buffett (or Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B)) owns about 5% of the total shares outstanding. V represents the ideal type for the long run compound which Buffett loves. He had commented on the beauty of such works (and the difficulty of finding them) many times. An example is cited below:

Warren Buffett: In an inflationary world, owning a bridge (like a company) would be great because you set your costs of capital. You built it with the old dollar and you don’t have to keep exchanging it.

V has all of the above qualities – it is a toll bridge to the business ecosystem, it only needs one time capital costs to be determined in old dollar, almost no cash needed to maintain once it is put in (no more than 5% of operating income as will be detailed later) .

Its quality combined with the valuation expansion during a long bull market, the current price level has gone ahead of the fundamentals. The current PE stands close to 44x. It’s not crazy that this high quality works. However, the premise here is that it predates the basics of business a bit. Investing at this point will take some time, patience and commitment for the basics to catch up.

Business and moat

Visa Inc. It is the world’s largest retail electronic payments network. Their payment processing platforms are used all over the world. Visa credit, debit and prepaid cards are some of the most popular brand names in the world. With its leadership and size, V has superior profitability and financial strength compared to other peers in the same sector and also to the market as a whole, as shown in the following chart. Profitability is envied on every metric – both in absolute terms and in relative terms when compared to peers. The business is also in a very strong financial position. It is essentially debt-free, meaning interest expense is negligible relative to income. As of this writing, interest expense is less than 3% of EBIT.

Source: Alpha Search.

At the same time, the company generates large amounts of cash, as shown in the following chart. Operating income of about $13.3 billion this year, it has maintained double-digit growth in the past decade at a 13% compound annual growth rate (CAGR). With a very low debt level and strong profitability (and an impressive return on capital which will be detailed later), the business has enviable financial flexibility. As shown in the chart below, it only takes about 23% of operating cash flow (“OPC”) to cover dividends and maintenance capital expenditures in the last decade. With essentially no service debt, the remaining 77% of operating income is forfeitable. And, as we’ve seen, V was using most of it to buy back its stock – averaging 74% of the OPC.

As will be explained later, with its huge return on capital, it simply doesn’t need much reinvestment to support future growth. So it can afford to use almost all of the dispensable OPC in stock buybacks.

Source: Author based on data from Alpha Search.

Evaluation and short-term considerations

As mentioned earlier, the current PE stands near 44x. It’s not crazy that this high quality works. But it is in the extreme both in absolute terms as a relatively mature company and also in relative terms when compared to its historical track record.

To put things in a broader context, the following two charts examine valuation using the EV/EBITDA multiplier and dividend yield. As we’ve seen, the EV/EBITDA multiplier started around 10x at the start of the decade. Expanded to the current level of 35x – 350% expansion. As can be seen from the following chart, the dividend yield is currently at a historic low near 0.5%. Dividend yield decreased due to higher prices. The contract started with a dividend yield of around 0.75%. And despite continued dividend increases (at a staggering 28% compound annual growth rate over the past decade), the price has gone up faster and the yield is down to around 0.5% now.

Because of this significant valuation expansion, I think there are some good possibilities for near-term volatility going forward.

Source: Alpha Search.

Source: Alpha Search.

Long term return and sustainable growth rate

As mentioned earlier, given the significant expansion of the aforementioned valuation, there are some good possibilities for volatility in the near term. Here we will examine the long-term prospects.

If you’re such an author who shares the concepts of owner earning, perpetual growth rate, and an equity title, the long-term return is simpler. It is “simply” the sum of the owner’s profit return (“OEY”) and the permanent growth rate (“PGR”), i.e.

Long-term ROI = OEY + PGR

Because in the long run, all fluctuations in the rating are averaged (all the best in the end). And it doesn’t really matter how the company uses the earnings (paying as dividends, keeping them in the bank account, or buying back the shares). As long as it is used reasonably (as V did in the past), it will reflect as a return to the employer.

OEY is the owner’s profit divided by the entry price. All the intricacies in estimating the owner’s earnings – the company’s real economic gain, not the nominal accounting gain. Here as a raw and conservative estimate, I will only use free cash flow (“FCF”) as owner earnings. It is conservative in the sense that strictly speaking, the owner’s profit must be the free cash flow plus the portion of CAPEx used to fuel growth (that is, CAPEx for growth). At current price levels, OEY is ~2.2% for V (~44x price to FCF).

The next and most important component is PGR. To understand and estimate it, we will first need to estimate the return on capital employed (“ROCE”). Note that ROCE is different from ROE (which is more significant and important in my view). ROCE takes into account the return on capital already in use and thus provides insight into how much additional capital a business needs to invest in order to earn a certain additional amount of income – a key to estimating PGR. For companies like V, I consider the following items that are actually used by capital:

1. Working capital, including accounts payable, receivables and inventory. This is the capital required for the day-to-day running of their business.

2. Total property, plant and equipment. This is the capital required to do business and actually manufacture its products.

3. Intangible book value, which mainly consists of intellectual property and patents for such business.

Based on the above considerations, the ROCE for V over the past decade is shown below. As we have seen, V has been able to keep the ROCE remarkably high and stable over the long term: averaging 105% over the past decade. To put things into perspective, as detailed in my previous article for JNJ, the leading pharmaceutical company, a sector that relies heavily on technology leadership and intellectual property. JNJ is the company with the highest ROCE in the group of healthcare stocks I analyzed, JNJ has a ROCE of “only” about 50%. Now let’s move down the ladder and think about businesses that are more manufacturing-oriented and capital-intensive – but still highly dependent on technological advances. As detailed in my previous articles for Lockheed Martin (LMT) and General Dynamics (GD), the ROCEs of these defense business leaders, who have almost a monopoly moat, are “only” in the 20% to 30% range.

Source: the author and alpha search.

With 105% ROCE, this means that even if V reinvests only 5% of its profits to expand its capital employed, it can maintain 5% PGR (PGR = ROCE * portion of reinvested profits = 105% * 5% = 5%) . And a 5% reinvestment rate is really the situation here for V based on my analysis as mentioned earlier. As mentioned earlier, this is the reason why V is able to use nearly all of the OPC for dividends and share buybacks after covering maintenance capital expenditures. Of course, another reason is that companies on this scale are simply not able to find many opportunities to reinvest their profits. But after all, 5% PGR actually makes it a long-term earner with only 5% of the income reinvested!

Now we have the two puzzle pieces in place to estimate the long-term return. At current price levels, OEY is estimated to be around 2.2% for V, and PGR around 5%. So the long-term total return at the current valuation would be a single number higher by about 7.7% as shown in the chart below. As we’ve also seen, even when the ROCE fluctuates somewhat, the fluctuations won’t change the long-term return significantly.

Source: the author and alpha search.

And as a final note, for those of us who like to wait for a better entry price, the following chart shows how much longer-term return potential has changed as a function of entry price. As can be seen, the long-term yield potential does not change much within a very wide range of the entry price, as indicated by the green box. This probably confirms something you’ve already heard before – if you own a large long-term business, the entry price doesn’t matter much.

However, many investors seem to interpret this one-sidedly and I would like to do a little hair-splitting here. The above statement refers to the long-term rate of return, not the absolute dollar amount of return. When your entry price drops by 10%, yes, it is true that this will not affect your long-term rate of return as much as we have seen. But a low entry rate of 10% will give you an additional return of at least 10% in the absolute dollar amount – because you will buy 10% more shares for the same dollar amount that you have, plus any additional return caused by the higher rate of return.

Source: the author and alpha search.

Conclusion and final thoughts

Visa Inc. represents An ideal permanent fixture featuring a wide moat, scale and role as a toll bridge for the business ecosystem. The current PE stands close to 44x. It’s not crazy that this high quality works. However, the premise here is that it predates the basics of business a bit. Investing at this point will take some time, patience and commitment for the basics to catch up. At current price levels, OEY is estimated to be around 2.2% for V, and PGR is around 5%. So the total long-term return at the current valuation would be a single number higher around 8%. It’s still a solid investment when considering the safety and quality of the work – if you can stick with it and dispense with any potential valuation fluctuations in the near term.

Thanks for reading and we look forward to your comments.

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