By Shawn Allen, Contributing Editor
The gains that investors have made by owning shares in either Visa Inc. or Mastercard Incorporated are truly staggering.
Mastercard Incorporated began trading as a public company on May 25, 2006 via its initial public offering at $39 or $3.90 after adjusting for its subsequent 10 for 1 split. On Thursday it closed at $268.63. That’s a gain of 6,788%! That’s 37.1% compounded annually for the past 13.4 years. An investment of $10,000 at the IPO would now be worth $689,000. And, that’s not counting the substantial dividends received.
Visa Inc. began trading as a public company on March 19, 2008 with an IPO price of $44, or $11 adjusted for its subsequent 4 for 1 split. It closed Thursday at $176.34 for a capital gain of 1,503% or 27.0% compounded annually for the past 11.6 years.
In contrast, American Express Company investors have experienced positive but unexceptional results over a similar time period. On the date that Mastercard debuted in 2006, American Express closed at $54.09. On Tuesday it closed at $116.97 for a gain of 116% or a compounded average capital gain of 5.9% per year.
What explains the enormous gains and profits of Visa and Mastercard? It basically comes down to one word: “Monopoly”.
To understand the extent of their monopoly power, let’s take a look at the credit card industry structure.
It’s important to understand that neither Visa nor Mastercard actually issue credit cards directly. Instead, they each run the enormous computer systems that connect millions of merchants with hundreds of millions of card holders world-wide. They also each run extensive marketing campaigns at all times to encourage consumers to hold and use their cards.
Numerous financial institutions issue their card brands under license. No matter which institution issues their respective cards, Visa and Mastercard indirectly receive various fees for every transaction as well as various fixed fees. And given their profits, it is clear that those fees are extremely lucrative.
In some respects, Visa and Mastercard are a duopoly. Today it would be difficult for any consumer to participate in the economy without holding at least one of these card brands. But they don’t need both. And many financial institutions choose to issue one brand or the other but not both.
Together, these two companies account for a staggering 95% of the credit cards issued world-wide, excluding China where they are mostly blocked from competing. This degree of market dominance by just two companies has led to monopolistic profit levels and a lack of competition in the fees that they collect.
And, I would go further and argue that from the perspective of most merchants the Visa and MasterCard brands are effectively two separate monopolies. Most retailers, restaurants, hotels, and other product and service providers have no real choice but to accept both of these card brands. And they have no real choice but to accept all the various terms and conditions imposed on them by each. That includes things like accepting “Gold” cards that impose a higher fee on them than regular cards and refraining from offering discounts to those who pay by cash, cheque, or debit card.
Only the very strongest and most powerful retailers such as Costco are in a realistic position to accept only one of these two card brands and to therefore negotiate far better terms.
The users of credit cards can be divided into two main groups. The first consists of those who do not pay off their bills monthly and who therefore incur substantial interest costs. These customers use the cards basically out of necessity and/or because they are not financially disciplined. They are unlikely to stop using credit cards in the foreseeable future.
Then there are those that pay their bills off monthly and rarely, if ever, incur interest charges. Given the rise of debit cards in the past few decades, these consumers and businesses could easily switch to them. Debit cards typically impose a far lower fee on merchants.
The credit card companies keep these customers loyal by providing various rewards and incentives. Those rewards and incentives are effectively paid for by the merchants. Higher discount fees charged to merchants fund higher rewards, leading consumers to favor credit cards over debit cards despite the higher costs imposed on merchants. So far, the merchants have been effectively powerless to change this.
American Express operates differently. Amex directly issues credit cards which account 86% of its billed business volume. This means that Amex takes credit risk and earns interest. Co-branded cards issued by partners in a manner similar to Visa and Mastercard account for only 14% of its billed business. While Amex is large, it is far smaller than Visa and Mastercard, accounting for just 2% of total cards outstanding. But, because it caters to a higher-spending clientele, it accounts for 8% of total payments volume.
The credit card industry was probably always destined to be dominated by just one or at most a few companies. Here’s why: Merchants only want to accept a few cards and of course they want to accept the ones that the most people carry. Consumers want to carry only one or two cards and they want/need to carry the ones that are most widely accepted. In this scenario the first one or two card brands that got out to a big head start had a big advantage to stay ahead. Warren Buffett describes this phenomenon as “survival of the fattest”.
The bottom line is that Visa and Mastercard operate with considerable monopoly power. Their dominant market share is evidence of this, as is their enormous profitability. American Express does not have monopoly power but still benefits from its established brand position and by the fact that its two main competitors do not compete aggressively on their fees.
It is certainly possible that credit card company profitability levels will be driven down by new competing technologies and/or by government action to regulate fees or outlaw onerous terms and conditions that prevent merchants from encouraging customers to use lower-fee options, including debit cards. But so far, the continued movement towards electronic payments and away from cash and cheques, as well as the mostly hands-off approach of governments, has meant that these three credit card companies have continued to steadily grow their profits. For investors, they certainly merit consideration.
We have two of these companies on the IWB Recommended List. Updates are included in IWB21938.
This article originally appeared in the Internet Wealth Builder #21938, on October 28, 2019.