This Dividend Growth Stock’s Recent Pullback is a Compelling Buying Opportunity

Credit card companies like Visa (V), Mastercard (MA), and American Express (AXP) continue to benefit from a transition away from cash toward digital payments. Visa is now the third most-valuable company in the financial sector, with a market value of about $550 billion, behind only Berkshire Hathaway and JPMorgan Chase.

Visa has fallen almost 6% during the past two months and is little changed on the year, drastically underperforming the 18% gain in the S&P 500. Here’s why this Dow Jones Industrial Average component is an incredible long-term investment opportunity worth considering now.

A simple yet effective business model
Visa mainly makes money from consumer and commercial debit and credit card transactions. And if you look at its financial statements, it splits up that revenue into two major categories: service and data processing.

The dollar amount of total transactions drives service revenue, whereas the number of processed transactions drives data processing revenue. In other words, there’s a baseline fee that merchants must pay Visa regardless of the size of the transaction, but the larger the transaction size, the higher the total fee.

In Visa’s recent quarter, it booked $4.03 billion in service revenue and $4.26 billion in data processing revenue. In total, it had $8.78 billion in revenue, $5.13 billion of which was international and $3.64 billion from the U.S.

Visa makes money when consumers buy more goods and services with credit cards. Most of its business is international, and it makes money from transactions regardless of size. These characteristics help protect it from pullbacks in U.S. consumer spending and recessions.

A decade ago, it would have been unheard of for a business not to accept cash. And it was common to convert U.S. dollars into foreign currency when traveling. Now, many businesses are cashless, and credit card companies have simplified foreign transactions by handling currency conversions.

The Visa investment thesis is beautifully simple. It centers on a sustained global switch away from cash toward digital payments, which will increase the number of processed transactions, and the growth of global commerce, which will boost total transaction volume.

A high-margin cash cow
When thinking of recession-resistant stocks, popular consumer staples like Coca-Cola and Procter & Gamble come to mind. And while both of these companies are rock-solid Dividend Kings, Visa has an unrivaled track record for consistency.

During the past 20 years, the company’s revenue and operating income have increased in a near-perfectly straight line up and to the right. Even during 2020, revenue and operating income only fell about 15% despite the pandemic.

Visa’s 67% operating margin means that it is converting roughly two-thirds of every dollar in sales into operating income. As you can see in the chart, it is then converting the bulk of that operating income into net income. Over the last 12 months, the company has converted 54% of sales into net income — which is a sky-high level of profitability. And that’s not surprising.

Visa operates in an oligopoly of the credit card industry — mainly with Mastercard and American Express. The industry is large enough for all three companies to grow, but also has high-enough barriers to entry to make it difficult for a competitor to achieve the same levels of scale and security.

Processing fees vary slightly by payment network and whether the transaction is in person or online and manually keyed. But in general, merchants have to accept Visa or risk losing a substantial amount of business.

Returning capital to shareholders
Visa only yields 0.8%, which isn’t what most would consider a worthwhile dividend. But the low yield results from its outperforming stock price, not a lack of dividend increases.

In fact, Visa’s dividend has increased more than fivefold during the past decade, and it has also bought back nearly a fifth of its share outstanding during that time.

If Visa’s stock price had kept pace with the S&P 500 during the past decade, the yield would be over 2%. But investors would surely take the capital gains in exchange for a lower yield.

It’s also worth noting that the company has just a 22% payout ratio, meaning just 22 cents of every dollar in net income is going to the dividend. For context, a payout ratio of 50% is generally considered to be a healthy level. Part of the reason for Visa’s low payout ratio is that the company spends substantially more on buybacks than dividend payments.

During the past 12 months, Visa earned $18.4 billion in net income, bought back $13.1 billion in stock, and paid $4 billion in dividends. So it is returning nearly all of its net income to shareholders through dividends and buybacks.

If it didn’t buy back any stock and just paid dividends, the yield would be about 4%. However, buying back stock is a better use of capital than dividends over the long term since buybacks reduce the share count and increase earnings per share, making the stock a better value. Investors also must pay income tax on dividends.

A reasonable valuation
Despite vastly outperforming the S&P 500 during the past decade, Visa is only up 10.3% in the past three years, but it has continued to increase its top and bottom lines. The slowdown in stock price appreciation has brought the price-to-earnings (P/E) ratio down to 29.4 — which is lower than its median P/E over the last three, five, seven, and 10-year time frames.

The forward P/E is 26.4, implying 12% expected growth in earnings per share. That’s not a breakneck growth rate, but it isn’t bad for a high-margin, stable, dividend-paying business. All told, Visa is at a reasonable valuation.

A blue chip stock you can count on
Visa is a rare example of a company that checks all the boxes. The business model is reliable and effective, there’s a path toward long-term growth, and the company rewards its shareholders with dividend raises and buybacks.

Best of all, the stock trades at a discount to its historical average P/E even though the investment thesis is arguably stronger today than in the past.

Visa is at the top of its game, and the recent pullback in the stock price is a compelling buying opportunity.

— Daniel Foelber

Source: The Motley Fool