When The Bill Comes Due
Priceless. That's the theme of MasterCard Inc.'s long-running advertising campaign claiming that there are some things in life on which you just can't place a value. Little did the Purchase (N.Y.) credit-card outfit know that someday its own ad shtick could be applied to its upcoming initial public offering. Just what will investors be buying if they invest in shares of MasterCard when it goes public next year? Right now, no one can say for sure.
What we do know is this: In the first quarter of 2006, MasterCard -- which helped to pioneer the credit card nearly 40 years ago -- will convert from a private, members-only club for banks to a public enterprise. Wall Street forecasts a blockbuster IPO that will eclipse the $1.2 billion raised by search engine Google Inc. (GOOG ). Street estimates put the value of MasterCard anywhere from a conservative $2.65 billion to as much as $7 billion. In a world where plastic has trumped cash as king, MasterCard, second only to Visa USA Inc. as a payment network, seems like a good bet.
But is it? The credit-card issuer is embroiled in dozens of lawsuits that could cost millions in legal fees and tens of billions in damages -- and new investors could be stuck with the tab. MasterCard is in a bitter battle with consumers, regulators, and merchants worldwide over issues ranging from data security breaches to processing fees. In filings with the Securities & Exchange Commission, MasterCard says it plans to spend $650 million of the IPO proceeds on legal fees. It has no other reserves to fight this litigation, and although the banks will probably be on the hook for some of it, they're distancing themselves from the MasterCard network.
The most damaging cases are some 38 federal lawsuits by merchants that charge MasterCard and Visa with antitrust infractions and abuse of market power. MasterCard and Visa have already lost a similar case filed by the Justice Dept., as well as a class-action suit led by Wal-Mart Stores Inc. (WMT ) in which they had to pay $3 billion in damages. As a result of the DOJ case, American Express and Discover cards have sued the networks and big banks for damages stemming from anti-competitive behavior. "These are terrible cases for the industry," says Duncan MacDonald, former general counsel of Citibank (C ) cards. "The 'big bomb' is if they are found to have colluded in price-fixing, the dirtiest sacrilege you can commit in the commercial world." A MasterCard spokeswoman says the company is in its SEC-mandated quiet period and cannot discuss the IPO.
But what the company says in its reports to the SEC is revealing enough. In an amended registration statement filed on Nov. 14, MasterCard states that legal and regulatory risks threaten its prospects for future growth, its profits, and its business model. The company says it believes that the legal woes have been brought on by its ownership and governance structure, and it hopes that by overhauling the board, bringing in new independent directors, and cashing out the member banks who currently set prices, MasterCard can put its legal troubles behind it.
Others aren't so sure. "The liability to the banks and MasterCard is unlimited," says William McCracken, chief executive of Synergistics Research Corp., a financial-services market research outift in Atlanta. Meanwhile, few analysts think that $650 million is enough to cover legal bills and damages, and MasterCard says "it is unable to estimate the amount of potential charges." Says Craig J. Maurer, a managing director with Fulcrum Global Partners LLC.: "If the motivation to go public is to protect itself from legal problems, that's a pretty thin investing prospect."
There are plenty of good reasons, though, for MasterCard to do an IPO. It will gain cash to make acquisitions, invest in new technologies, and hire top talent at a time when the payments industry is becoming brutally competitive. New entrants such as Wal-Mart, PayPal, Google, and even mobile-phone operators are entering the fray. For example, Japan's NTT DoCoMo Inc. (DCM ) plans to launch new cell phones next year that can function like credit cards, in partnership with Sumitomo Mitsui Financial Group, the world's largest bank. MasterCard also plans to use fresh capital to become a better marketing machine, à la rival American Express Co. (AXP ), as well as to narrow the longstanding gap between its arch-nemesis, Visa USA. MasterCard processed $1.03 trillion in transactions last year, less than half of Visa's $2.27 trillion. AmEx is a distant third, at $414 billion.
Visa, too, is feeling heat from the lawsuits. On Oct. 20 its board approved a plan to change the company's governance structure by replacing bank executives with eight independent directors. Visa, however, will continue to be owned and controlled by its member banks. Elizabeth Buse, Visa USA executive vice-president in charge of product development, says the company has no plans to go public, and she is unsure whether MasterCard's reorganization "will afford it any more legal protections than Visa's ownership and governance structures will afford Visa."
Both card networks will soon find out. They and their partner banks face their nastiest legal tussle over so-called interchange fees. These are the lucrative charges that banks and the networks collect from merchants every time a credit or debit card is used to pay for a purchase. Merchants typically pass these charges, which by some estimates add up to more than $24 billion each year, on to consumers in the form of higher prices.
"A CIVIL WAR"
Visa and Mastercard have argued for years that their fees are fair. U.S. regulators have yet to weigh in. But foreign governments have so far sided with the merchants. The Reserve Bank of Australia mandated lower fees in 2001 and the European Council and Britain's Office of Fair Trading are considering regulation. Because of class-action laws that are unique to the U.S., legal and credit-card experts here anticipate an ugly battle between lawyers representing the merchants and the banks. "It's a civil war," says MacDonald, who argues that the government should step in.
Even MasterCard's best customers are making things tough. As banks and merchants each consolidate, they are negotiating lower processing rates, thereby squeezing its margins. And as they shed their member status, big banks such as Citi and JPMorgan Chase (JPM ) will finally be free to promote their own brands over the network. This is no small issue. A huge portion of MasterCard's revenue is concentrated among its five largest customers. For the first six months of 2005, these customers represented $485 million, or 34% of revenues. The loss of any one customer could hurt the business. Already, Citi and GE (GE ) Consumer Finance have announced they will issue rival American Express and Discover cards.
The timing of the IPO seems to be working against MasterCard, too. Financial companies have made up almost a fifth of IPOs in the last few years as newcomers have benefited from low interest rates. Returns for 2005 listings have been decent, up 7% vs. the S&P's 3.5% gains. But consumer credit quality is faltering and personal bankruptcies are up. The value of MasterCard going public? Hard to say.
By Mara Der Hovanesian, with Justin Hibbard in San Francisco