No Plastic in MasterCard’s Profits

The processor's strong earnings disappointed momentum investors who wanted a larger surprise

If there’s a case to be made for subprime lending fears getting blown out of proportion, the market’s hammering of MasterCard Inc. (MA) after an impressive earnings report on Aug. 1 would be Exhibit A.

The Purchase (N.Y.) processor of credit and debit payments swung to a profit of $252 million, or $1.85 a share, in the second quarter (including special items), from a net loss of $310.5 million, or $2.30 a share a year ago. Excluding special items, MasterCard earned $195 million, or $1.43 a share in the latest quarter on a 17.8% jump in revenue to $997 million.

The results easily exceeded the $1.33 consensus estimate among Wall Street analysts, but that wasn’t good enough for some investors whose expectations were based on the 35% margin by which the first-quarter earnings beat analysts’ forecast.

Shares finished the day down 6.7% at $150.00, but had been pounded down as much as 13.6% in earlier trading.

Driving the revenue gains were a 13.3% rise in gross dollar volume on a local currency basis to $555 billion, a 15.2% hike in the number of transactions processed to 4.6 billion, and 17.3% growth in cross-border transaction volume.

On a conference call to discuss the results, Chief Financial Officer Chris McWilton said, “The travel market remains healthy” and “when people travel, they put big-ticket items on their cards,” like plane tickets and hotel bills.

Standard & Poor’s raised its 2007 earnings per share outlook by 13 cents to $4.93 and boosted its 2008 forecast by 15 cents to $5.85. S&P also reaffirmed its 12-month target price of $149, which is 25.5 times its 2008 estimate and a higher multiple than it has on MasterCard’s peers. (S&P, like BusinessWeek, is owned by McGraw-Hill.)

The sell-off likely stemmed from profit-taking after the huge gain the shares have enjoyed since the start of the year, said Moshe Katri, an equities analyst at Cowen & Co. As with a similar sell-off in January, he said the lower price would be recognized as a buying opportunity. At the close of trading on July 31, the shares were up 66.8% from Jan. 3. (Cowen has done investment banking with MasterCard and was involved with its IPO.)

The stock was also hammered in sympathy with other financial names, which continued to stumble under the weight of growing subprime contagion fears, even though MasterCard isn’t a bank and doesn’t share the banks’ and brokerages’ exposure to credit-related issues, he said.

Consumers tend to think of MasterCard as credit-card company because its logo appears on credit cards, but in fact it’s a network of payment processors that collects a fee on every credit, debit and other related transaction by consumers but doesn’t benefit from interest and monthly charges on account balances. Unlike the banks and other financial institutions that actually issue the cards, MasterCard isn’t vulnerable to defaults on credit-card balances.

The momentum investors who believe that a 10-cent margin above Wall Street estimates wasn’t sufficient were unrealistic to expect the company to continue to beat Wall Street earnings forecasts by 35% every quarter, said Anurag Rana, an analyst at Keybanc Capital Markets.

“This is not Google,” he said, adding that expectations of a bigger margin were all the more outlandish in light of the fact that analysts’ estimates for MasterCard’s profits kept climbing every two weeks during the quarter. “I’m not sure why that wasn’t enough for some people.”

And any investors who sold the stock because of worries about credit risks don’t understand what the company actually does, he said. “They are a processor. There is zero credit risk in these [credit-card] companies.”

MasterCard’s stable business model makes it a good bet when there’s nervousness about the overall market, he added.

While the company has done a good job of reducing selling, general and administrative (SG&A) expenses as a percentage of revenue to 70% from 80% when the company went public in May 2006, Cowen’s Katri said the SG&A expense ratio remains artificially inflated. Though the company won’t say it, that’s due to litigation-related reserves that he believes are being socked away in preparation for potential settlements of two major lawsuits that are still pending. Eventually, SG&A will be brought down to between 30% and 40%, he predicted.

Meanwhile, the operating margin widened to 27.3% this quarter from 17% a year ago, much of which he said can be attributed to the declining SG&A expense ratio. “For every 1000 basis-points move in the SG&A expense ratio, you’ll get $240 million n net income, which translates to $1.70 in earnings per share,” Katri said.

The fact that 2008 earnings estimates have doubled since MasterCard went public shows that a lot of momentum players have been buying the stock over the past several months. It’s only natural that when the company beats analysts’ estimates by just 10 cents a share that those investors will be disappointed and could sell, he said.

Rana at KeyBanc doesn’t agree that the SG&A expense ratio is much higher that it should be and doesn’t believe MasterCard is setting aside a lot of cash for possible litigation costs. The company hasn’t hesitated to spend money to build its business, even when the offering price after its IPO wasn’t very good, he said.

With $2.8 billion in cash and cash equivalents, its balance sheet is strong enough to respond to any litigation expenses down the road. Even after subtracting $229 million in short- and long-term debt and roughly $500 million in legal obligations for settlements of previous lawsuits, it still has $2.1 billion in cash on its balance sheet, which is very healthy, Rana said.

MasterCard’s prospects for long-term profits certainly appear to be robust. Even if consumer spending flattens or declines slightly, the conversion from paper to plastic forms of payment indicate that the company will still be able to grow in the U.S., while 53% of its gross dollar volume came from overseas in the first quarter of 2007, Calyon Securities said in a research note.

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