MasterCard: The Prize of Owning the “Priceless” Brand

Summary:

MasterCard is an exceptional franchise that is recognized by consumers globally through its “Priceless®” campaign.

MasterCard is in the business of processing payments and licensing its brand. It does not issue cards or extend credit. Basically it collects royalty on worldwide consumption. The economics of the business are very attractive. It’s in a duopoly position in most markets with its only competitor, Visa. MasterCard’s revenue has grown by 1.6x from $3.3 billion to $5.4 billion in the last 5 years since its IPO in 2006. Revenue is expected to continue to grow at low-to-mid-teen rates as electronic payments take its share from traditional forms such as cash and checks globally. Furthermore, the business requires very limited capital and almost all of it is fixed in nature – in its data centers and for marketing & advertising. These expenditures are growing at a much slower rate than revenues, hence there’s massive operating leverage. Operating margins have expanded from 20% in 2006 to 50% today. EPS has grown faster than revenues and by 3.7x from $3.52 in 2006 to $13.08 today. Amazingly, Mr. Market is offering this “wide moat” business at two-thirds its conservatively assessed intrinsic value because of valid but potentially overblown concerns over the impact of a recently passed regulation called Durbin Amendment.

Business Model: 

MasterCard operates a ‘Four-Party Payment System’ that processes information and routes transactions between the cardholders’ and merchants’ financial institutions in fractions of a second. It is so called because the network links together the four parties involved in each transaction:

• The cardholder’s issuing bank, also known as the issuer, that markets and issues payment cards to the cardholder.
• The cardholder who can use his payment card almost everywhere in place of traditional forms of payment such as cash or check.
• The merchant who accepts the payment card in exchange for goods or services and receives guaranteed payment.
• The acquirer that contracts with the merchants and provides them with payment card acceptance and processing services.

Flow of transaction information begins with the purchase, when the cardholder provides the payment card information to the merchant. The merchant sends the card information to the acquirer, such as First Data,  through its point-of-sale terminal, which in-turn passes the information along to the issuer, such as Bank of America. Card networks, such as MasterCard, typically provide the link between acquirers and issuers over which this information flows. The network routes information first to authorize and then to settle the payment. To settle, the issuer obtains funds from the cardholder  - $100 in this example – which it can pay the acquirer. However, the issuer retains a portion of the funds an an “interchange” fee. In this example, the fee is $1.50 and the issuer send $98.50 to the acquirer. The acquirer charges the merchant a processing fee, “merchant discount fee”, of $0.50 and deposits $98 in the merchant’s account. The merchant service charge is the total cost of processing the payment and in this example is $2. The card networks do not get compensated from the interchange fee or the merchant discount fee. They usually charge the issuer and the acquirer various network usage fees based on many factors that are not clearly disclosed, but whose key drivers are the gross dollar volume and the number of transactions flowing through their network. In general, the network fees amount to tiny fractions of the interchange fees and the merchant discount fees.

Like MasterCard, Visa also uses a ‘Four-Party Payment System’. Transactions on the other two major card networks – American Express and Discover – generally involve only three parties: the cardholder, the merchant, and one company that acts as both the issuing and the acquiring entity. Merchants that choose to accept these two types of cards typically negotiate directly with American Express and Discover over the merchant discount fees that will be assessed on their transactions.

In a ‘Four-Party Payment System’, the interchange fees generally account for the largest cost of acceptance of the payment cards. Even though these fees are earned by the issuer, they are set by the card networks. This may sound surprising to those who are not familiar to the payment card market, but economists have noted that the payment card market is an example of a “two-sided” market. In such a market two different groups – merchants and consumers – pay different prices for goods offered by a producer.

Other two-sided markets include newspapers, which charges different prices to consumers who purchase the publications and advertisers that purchase space in the publications. Typically, newspapers offer low subscription rate or per copy price to attract readers, while funding most of their costs from revenue received from advertisers. Charging low prices to encourage large numbers of consumers to purchase the newspaper increases the paper’s attractiveness to advertisers as a place to reach large number of consumers, and thus allow publishers to charge such advertisers more.

Similarly, the card networks use interchange fee as a way to balance demand from both consumers (who want to use cards to pay for goods) and merchants (who accept cards as payment for goods). As with newspapers, the cost to both sides is not borne equally. To attract a sufficient number of customers to use their cards, card networks compete to attract financial institutions to issue them (by compensating them through the interchange fee). Just as readers have a variety of sources from which they can receive their news, consumers also have a number of different methods (such as cash, checks, or cards offered by various issuers) by which they can pay for goods and services. The financial institutions compete to attract consumers to use the card issued by them by charging them a low fee or often offering them a negative cost through rewards. This price structure is critical to encourage the consumers to carry the  network’s cards in place of cash and checks. Once the circulation of cards for a particular network goes up, network effects kick-in, leaving merchants with limited choice but to accept the network’s payment cards. Like the case of advertisers in the newspaper market, the revenue for funding the costs of this system is mostly provided by the merchants. Unlike the advertiser’s case, the benefits that the merchants receive for participating in this system may not be obvious to you. Here is a list:

• Less vulnerable to theft and can provide safer workplace to employees.
• Faster and guaranteed payment for transactions (unlike checks).
• Faster checkout.
• Benefit of increased sales as more people are attracted to stores that accept their card.
• Is more cost-effective than merchants issuing their own cards or some other form of credit.
• Easy record keeping

As merchants acceptance for a network’s card goes up, issuers’ preference for the network also goes up. This is evident from the fact that Visa and MasterCard have dominated the credit card purchase volume for years, and it has been very difficult for Discover to gain a higher market share. The above attributes of the business model makes both, Visa and MasterCard, a “wide moat” business.

Business Overview:

The card-based forms of payments licensed by MasterCard fall in the following categories:

• "Pay Later” Cards that allow the cardholder to access a credit account (Credit)
• “Pay Now” Cards that allow the cardholder to access a demand deposit or current account (Debit)
  • Signature based debit card – primary means of validation is signature at point-of-sale
  • PIN based based debit card – primary means of validation is a PIN at point-of-sale
  • Cash access ATM card – access cash at ATMs by entering a PIN
• “Pay Before” Cards that allow the cardholder to access a pool of value previously funded (Prepaid).

In general, credit cards carry the highest interchange fees, PIN debit the lowest, and signature debit and prepaid cards in between. As a corollary, credit cards usually carry the highest rewards for the consumers and the PIN debit cards the lowest.

MasterCard generates revenues by charging its customers (issuers and acquirers) fees for providing transaction processing and other payment-related activities and assessing its customers based on the dollar volume of activity on the cards that carry their brands. Their net revenue is categorized in five categories:

• Domestic assessments: Based primarily on the volume of activity on the cards where the merchant country and the cardholder country are the same.
• Cross-Border volume fees: Based primarily on the volume of activity on the cards where the merchant country and the cardholder country are different.
• Transaction processing fees: Charged for both domestic and cross-border transactions and are primarily based on the number of transactions.
• Other revenues: Examples of other revenues are fees associated with fraud products and services, consulting and research fees etc.
• Rebates and incentives: Varies based on type of rebate and incentive – hurdles for volumes, transactions or issuance of new cards etc.

MasterCard’s pricing is very complex and is undisclosed, but it depends on the following factors:

• Domestic or Cross-Border.
• Signature-based or PIN-based. Signature-based generates higher revenue.
• Tiered-pricing with rates decreasing as customers meet incremental volume/transaction hurdles.
• Geographic region or country.
• Retail purchase or cash withdrawal.

Financials: 

Net Revenue has compounded at an average quarterly rate of 4.5% in the last 15 quarters since Q1 ‘06. Note that revenue from international transactions (Cross-border volume fees) is becoming a bigger percentage of the overall revenue as seen in the revenue breakdown chart below.

Revenue growth can be attributed to two key drivers (i) gross dollar volume flowing through the network and (ii) number of transactions processed. GDV attributed to credit in the US is slowing whereas debit in US as well as rest of the world (ROW) has been growing rapidly. Also, GDV flowing from rest of the world is a much higher percentage today than in 2006. GDV grew quarterly at an average compounded rate of 3.2% and transactions at an average compounded rate of 3.4%. The faster revenue growth can be attributed to higher cross-border volume transactions and/or pricing changes.

MasterCard is among the most profitable businesses in the world. Because of the predominantly fixed cost nature of its business, it has massive operating leverage that is evident in the chart below. Operating expenses have come down from 75% of net revenue to 46%. In the long-run, MasterCard should be able to maintain operating margin in the range of  40-50%.

These numbers are based on adjustments made to income statement. To make these adjustments, we ignore one-time events (gains as well as losses) and litigation costs. Even though we ignore litigation costs, it is expected to be an on-going cost and cannot be ignored in our future outlook or valuation of the business. It helps to do so here only to highlight the operating nature of the business.

MasterCard has a pristine balance sheet with no debt and $3.7 billion of cash and securities ($29 per share). It has reserves for pending obligation settlements and for off-balance commitments for leases and sponsorships. Adjusting for these ‘debt-like’ liabilities, it has excess cash & securities of $20 per share.

Valuation:

Mr. Market has offered this wealth compounding machine at low valuations as today only a few times before in its trading history – (i) during the great recession in 2008 and (ii) in Q2-Q3 ‘10 when a law to regulate the interchange fees and the payment card business was passed (also known as the Durbin Amendment – more on this later).

P/E ratio of 17.20x in the chart above in the 'today' column does not take into account the excess cash on MasterCard’s balance sheet. Taking out the $20 excess cash from the price for MasterCard share of $225 today gives a lower P/E ratio of 15.6x. For a business with growth prospects and profitability like MasterCard’s, it ought to trade at least at a P/E ratio of 18-20x + excess cash on balance sheet.  We believe this will require patience though. Once the regulatory clouds clear and MasterCard can prove that it can manage through Mr. Market's current concerns, Mr. Market will award MasterCard’s shareholders by expanding its P/E ratio to this range (or even higher depending on its mood). This is very similar to Mr. Market’s response from Q4 ‘08 at the peak of the recession through Q1 ‘10. The matrix below shows the skewed risk-reward profile for investing in MasterCard today. We agree that it was cheaper in Q2 ‘10 when it hit a low of $191, but I believe that today's price offer a good enough margin-of-safety. Timing the market is not a value investor’s forte. We would rather take Mr. Market’s offer today to build a position and be ready to average down our purchase price in case of further volatility.

Durbin Amendment:

Why is Mr. Market unenthusiastic about MasterCard today? The reason - a particular amendment, “Durbin Amendment”, to the Dodd-Frank Act Wall Street Reform and Consumer Protection Act that was passed by the Congress in the summer of 2010. For those not familiar with the Dodd-Frank Act, its main provisions are aimed squarely at large banks and other systemically important financial institutions in response to the recent financial crisis. The Durbin Amendment has provisions that aim to regulate the credit and debit business in the US. Interchange fees and related payment card network rules have been the subject of intense regulatory scrutiny and litigation globally for the past decade. The Durbin Amendment marks the first time these fees will be regulated in the US.

This section of the article is broken into the following sub-sections: (I) Why regulation (ii) What is Durbin Amendment (iii) Fed’s proposal (iv) Possible Impact of the Proposal.

(i) Why regulate the interchange fees?

Why regulate the interchange fees? US interchange fees are the highest in the world. The total amount of interchange revenue from credit and debit transactions is unknown but it is estimated to be about $48 billion. As per one estimate we have read, roughly $31 billion is from credit interchange and $17 billion from debit interchange. The chart below shows the breakdown further:

As per the GAO report on the interchange fees, one of the reasons for the rise in the interchange fees is increased competition among card networks for financial institutions to issue their cards. Although increased competition generally produces lower costs for goods and services, such is not the case for this market. Before 2001, Visa and MasterCard had exclusionary rules prohibiting their members institutions (they were an association then, not a private or a publicly-owned enterprise and their members were also the issuers) from issuing cards of the competing networks. In 1998, DOJ initiated a lawsuit charging, among other things, that Visa and MasterCard had conspired to restrain trade by enacting and enforcing these exclusionary rules. The trial court held that Visa and MasterCard had violated section 1 of the Shearman Antitrust Act by enforcing their respective versions of the exclusionary rule. As a result of the court’s decision, an issuer of one of these network’s cards has the option to issue cards of any other network (a Visa issuer could now issue MasterCard, American Express, and Discover cards). Network officials from Visa told the authors of the GAO report that they actively compete to retain the issuers on their network and interchange fees play an active role. Government intervention in this market led to an unintended side effect of increased interchange fees, and raising the cost of accepting the cards even further rather than lowering it. According to the GAO report analysis of Visa and MasterCard’s interchange fee schedules, several of the networks highest interchange fees were introduced after this decision.

Furthermore, payment card networks maintain a number of rules related to the terms on which merchants accept cards. The rules, which vary between the networks, generally require the merchants to accept all of the payment card networks’ cards in all of their locations on all of their transactions (no minimum and maximum purchase amounts) and to route the clearance of all transactions made using the network’s cards through their network. The rules also forbid merchants to discriminate among the networks’ cards (including surcharging or differentiating between their basic cards and reward cards), or against the payment card network in favor of other card networks. Merchants argue that payment card network rules forbid them from passing along interchange fees to card users, a large portion of the fees are ultimately passed to all consumers in the form of higher prices. Merchants and consumer advocate groups also content that interchange fees are competitively high because merchants can neither bargain over the fees nor pass them along to the card users.

Thus, many merchants find that the cost of accepting payment cards is one of the fastest growing costs of doing business and one that they can do little to control. While merchants receive many benefits for accepting payment cards as we discussed in the business overview section, there is a threshold to merchants’ price elasticity. Accordingly, US merchants have brought litigation and have pushed hard for a legislative solution to what they perceive as an unfair interchange system that enriches the financial institutions at their expense and their consumers’. The Durbin Amendment is the most substantial reply to their campaign to-date.

(ii) What is Durbin Amendment ?

The Durbin Amendment aims to improve competition among payment card networks by reducing the interchange fees on debit cards and allowing merchants greater ability to steer transactions towards lower-cost payment systems.

The legislation contains two operative sections. One section only addresses debit cards. The other section addresses all payment cards, credit and debit.

(i) The first part of the amendment requires that the interchange fees on debit card transactions be “reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” The amendment instructs the Federal Reserve to promulgate regulations for assessing whether interchange fees are indeed reasonable and proportional to the cost incurred by the issuer with respect to the transaction. In determining what fees would be “reasonable and proportional” the amendment directs the Fed to consider the similarity between debit and check transactions that it requires to clear at par. The amendment also provides in its rule making, the Fed shall only take into account issuers’ incremental costs for debit transactions; thereby excluding fixed costs like distribution and other overhead. The Fed is permitted, however, to adjust for issuers’ net fraud prevention costs. The Fed is also permitted to regulate the network fees to ensure that they are not used to reimburse issuers directly or indirectly. Small issuers with less than $10 billion in consolidated assets are exempt from the “reasonable and proportional to cost” requirement, as are government-administered payment cards, and prepaid reloadable debit cards that are not gift cards or gift certificates. The $10 billion exemption is not inflation indexed.

(ii) The second operative part of the amendment prohibits certain payment card network rules that restricts merchants’ ability to steer consumers towards particular payment systems. The small issuer exemption does not apply to this part of the amendment.

(a) First, the amendment prohibits exclusive arrangements for processing debit card transactions. The provision requires that every electronic card transaction be capable of being processed on at least two unaffiliated networks, enabling what is known as “multi-homing (meaning every transaction can find its way “home” over multiple network routings). The requirement that at least two unaffiliated debit networks be able to process each transaction opens the door among networks for transaction processing.

(b) Second, the amendment prohibits the networks from restricting merchants’ ability to decide on the routing of debit transactions. Combined with the multi-homing requirement, this permits merchants to route payments to the networks to the debit network offering them the lowest cost, rather than the current system. This means that card networks will have to compete with one another for merchant routing, presumably resulting in lower interchange fees.

(c) Third, the amendment prohibits payment card networks from preventing merchants from offering discounts or in-kind incentives for using cash, check, debit, or credit so long as the incentives do not differentiate by issuer or networks. The provision specifically does not authorize surcharging, which most card networks prohibit.

(d) Finally, the amendment prohibits payment card network rules that forbids merchants from imposing minimum and maximum transaction amounts for credit cards. Henceforth, merchants will not be violating network rules by refusing to accept credit card transactions below $10, and federal agencies and higher learning institutions may impose maximum amounts. The amendment does not affect payment card network rules’ forbidding minimum transaction amounts for debit cards. There is no exemption from the second part of the amendment for small issuers.

The Fed is required to prescribe the regulations implementing “reasonable and proportional to cost” provision of the Durbin Amendment by April 2011. The Fed is also required to prescribe regulations regarding the multi-homing requirement by July 2011. These provisions of the Durbin Amendment are not self-executing without the Fed’s rule-making. The discounting and authorization of minimum and maximum amounts of credit transactions were effective as of the signing date of the Dodd-Frank Act, on Jul 21, 2010.

(iii) The Fed’s proposal:

On Dec 16 2010, the Fed put the proposed rule-making out for comment and notice before it's Board can  vote on the proposed rule. Comments are due by Feb 22, 2011.

During the period from Dec 13 to Dec 23, MasterCard’s stock dropped by 17% from a high of $260 to $216.

"Reasonable and Proportional to Cost" Requirement: The Fed, in its proposal, is requesting comments: one based on issuer’s costs, with a safe harbor (initially set at 7 cents per transaction) and a cap (initially set at 12 cents per transaction); and other a stand-alone cap (initially set at 12 cents per transaction). The Fed did not propose any adjustment to the interchange fee for fraud prevention costs. In order to prevent circumvention or evasion of the limits on the interchange fee that issuers receive from the acquirers, the Fed’s proposed rule prohibits an issuer from receiving net compensation from the networks. If the Fed  adopts either of the proposed standards in the final rule, the maximum allowed interchange fee received by the covered issuers for debit card transactions would be more than 70% lower than the 2009 average, once the new rules take effect on Jul 21 2011.

"Multi-Homing" Requirement: The Fed, in its proposal, is requesting comments on two alternate approaches: one alternate would require at least two unaffiliated networks per debit card. For example, a MasterCard signature debit card cannot have a MasterCard branded PIN on the back of the card, but it can have Visa 's Internlink or Discover's PULSE branded PIN). The other alternate would require at least two unaffiliated networks per debit card for each type of cardholder authorization method. For example, each card has two unaffiliated brands for signature debit transaction and two unaffiliated brands for PIN debit transaction. Under both alternatives, the issuers and the networks would be prohibited from inhibiting a merchant’s ability to direct the routing of debit card transactions over any network that the issuer enabled on the debit card.

(iv) Possible Impact of Durbin Amendment

I hope to impress upon you that the impact of the Amendment on MasterCard will be manageable, and that the analysis in the valuation section continues to be valid.

As part of the Fed’s proposal, the Fed required financial institutions to submit data that would help them comply with the Amendments “reasonable and proportional to cost” provision. Examining this data shows that the fees that the networks make on a per transaction basis is fractions of the total of interchange fee and merchant discount fee. For signature debit, the average interchange fee is 56 cents and net (accounting for per-transaction fees, non-transaction fees, and rebates and incentives) network fee per transaction is 5.9 cents for issuers and 4.5 cents for acquirers. For PIN debit networks, the average interchange fee is 23 cents and net network fee per transaction is 1.9 cents for issuers and 3.2 cents for acquirers. However, these numbers are even lower for the large issues because of the rebates and incentives they receive from the networks. Even though, it seems that the Fed’s proposed rule to cap the interchange fee will put pressure on network’s fee charged to the issuer, it seems quite unlikely that this will have a large impact on the networks. Network fees as an overall percentage of the issuer’s total gross interchange revenue today is quite small. Given the statistics from the Fed’s survey, network fees only account for 10% on average but smaller than 5% for the large issuers, who control 70% or more of the debit market. Thus, if these issuers are able to replace their lost interchange revenues from other areas and continue to be interested in maintaining the debit product, network fees will be relatively inelastic to the reduction in interchange fee.

The question then is whether banks will continue to issue debit cards and maintaining a debit card portfolio. Listening to payment card experts, I have learnt that the debit card is not yet another product in the bank’s portfolio. The debit card is an interface to the checking account. In fact, checking account is a misnomer. It should really be called a debit account. The banks aka the issuers have an incentive beyond the interchange fee to maintain the debit card product. It is an important relationship management tool required to attract cheap funding through deposits. In light of the reduced interchange fee, the banks will figure a way out to replace the lost revenue through other sources.

“If you can’t charge for the soda, you’re going to charge more for the burger” –Jamie Dimon, CEO, JP Morgan Chase.

“We’ll go back to where we were 20 years ago where there will be kind of a certain number $5, $8, $9 stated charge for having a checking account every month.” –Kelley King, CEO, BB&T.

“Our goal in the thing is to at least make the thing revenue neutral” –William Cooper, CEO, TCF Financial.

Also,  banks will look to alternate products to replace lost revenue like prepaid cards whose interchange fee is unregulated. The economics of higher interchange fees could cause its circulation to go up. Up until now, the banks weren’t too interested in the prepaid product. It was left to merchants like Walmart and H&R block. But the Durbin Amendment may change this situation going forward. Banks could steer its small customers to the prepaid product by levying a hefty charge if checking account dips below a threshold amount and showering awards for using a prepaid card. In such a scenario, MasterCard is positioned better than the other networks to take advantage of the possibility.

Next, let’s understand the impact of the two multi-homing alternates. If the first alternate is chosen, then the cost of processing a transaction (interchange fee + merchant discount fee) on a signature debit will not compete with that of the unaffiliated PIN debit. Off the 8 million merchant locations, only 2 million accept PIN debit. Also, E-commerce merchants and merchants like hotels and car rentals usually only accept signature debit cards. So, in these locations, the merchant has no choice but to accept the signature debit. The first alternate will have virtually no impact on these transactions. At the other 2 million locations that accept signature as well as PIN, the cost of processing a transaction will compete to a certain extent with the PIN transactions but only if the differential between the two is large enough. However, with the interchange fee being capped and acquirer market being competitive, the differential between the total cost of processing a signature transaction and a PIN transaction will be compressed. Even if the networks chose to pass the network fee revenue that they lost on the issuer-side to the acquirers (who in turn will pass them on to the merchants), the total processing cost of signature and PIN would be very close. Merchant's would lose the motivation to provide incentives to steer customers from signature to PIN. PIN simply will start to lose its attractiveness among the remaining 2 million merchants that use it. In the next cycle of upgrades, we think that many merchants will skip upgrading their PIN pads. As this occurs, the mix between signature and PIN should tilt further towards signature benefitting MasterCard (and Visa and Discover). Hence,  I believe that the networks will be well protected in the big picture.

The second alternate to multi-homing seems very unlikely. Even the Fed officials  (as expressed in the proposed rule-making) think that this alternate is impractical. Implementing this alternate requires significant investment and time required to educate all the parties of the payment card system. Further, it could arguably cause fraud occurrences to go up and weaken its appeal as a product harming the consumers, which is not the intent of the rule-making.

The first alternate, the one that is likely, impacts PIN routing on the signature debit cards. As an example, vast majority of Visa’s debit issuers have exclusive PIN routing contracts with Visa’s PIN brand – Interlink. The first alternate to the multi-homing provision requiring each card to have two unaffiliated networks on the card, opens up the exclusive PIN network contracts on the signature card for competition. Luckily for MasterCard, this is one of those instances where not being a market leader is a good thing. Visa is the market leader in PIN debit, whereas MasterCard is not even in the top four. Thus, MasterCard has a more to gain than to lose due to this aspect of the provision. It could help MasterCard gain market share in this area, but it is a low yielding business so it probably does not matter in the big picture.

Lastly, the provision that merchants can discount any payment card transaction may have negative impact on MasterCard’s US credit card business. It seems like a possibility, but the fact that merchants cannot surcharge dims the likelihood. Mathematically speaking they are the same, but discounting causes a consumer behavior that is a lot less pronounced than surcharging. Besides, merchants have thinner margins and may not be able or want to provide cash discounts. The possible incentives could be a dedicated debit line or coupons. The minimum and maximum limits may reduce the number of transactions but its hard to quantify the impact it may have on MasterCard’s US credit business.

The important conclusion from the above discussion is that the concerns about Durbin Amendment as it applies to MasterCard seem overblown. The losers in this case seem to be the community banks and the consumers. You may ask why community banks if they are exempt from interchange fee cap, but I will leave that discussion to some later time.

Risks: MasterCard is facing litigation in many countries globally. Management thinks that pending litigation that can have meaningful impact have already been reserved on the balance sheet (and we excluded them in our calculation of excess cash & securities). However, if any of the litigations had an unexpectedly large negative outcome, MasterCard’s equity could get wiped out. Also, regulation like one in the US in the debit card business or in its international activities could negatively impact its business and earnings power.

Disclosure: Long MA. This is not a recommendation to buy or sell any security. Please do your own research before taking any action regarding any security mentioned in this article. The author takes no responsibility for any errors in this article.

Resources:

• MasterCard, 10Ks and 10Q 2006-2010
• MasterCard, Credit Suisse Group Technology Conference, Phoenix AZ
• MasterCard, 2010 Investment Community Meeting
• MasterCard, Q3 2010 Conference Call
• MasterCard, Interchange Backgrounder
• Sequoia Fund, 2007 Investor Day Transcript
• Tweedy Browne Fund, 2010 Semi-Annual Report
• GAO, Rising Interchange Fees Have Increased Costs for Merchants, but Options for Reducing Fees Pose Challenges
• Interchange Regulations: Impact on Credit Unions, AJ Levitin
• Federal Reserve Bank of Kansas City, A Guide to ATM and Debit Card Industry
• Federal Reserve Bank of Kansas City, A Guide to ATM and Debit Card Industry 2006 Update
• Federal Reserve, Press Release, Dec 16 2010
• We will all Have to Pay for Financial Reform, Tim Chen, Huffington Post
• Is the PIN Mightier than the Pen, Ellen Richey
• Webinar on Fed’s Draft Debit Card Regulations Part I, Pymnts.com
• Webinar on Fed’s Draft Debit Card Regulations Part II, Pymnts.com
• Federal Reserve 2005 Payments Conference Proceedings
• The Antitrust Economics of Two-Sided Markets, David Evans
• Why the Market should Set Credit Card Interchange Fees, Brian Smith

What Todd Combs and I have in Common: Leucadia National Corp.

Recently, Todd Combs, a 39 year old hedge fund manager, was named by Berkshire Hathaway to manage a "significant portion" of the company's investment portfolio. Mr. Combs has been managing Castle Point Capital, a Greenwich based hedge fund for the past five years. Today, not much is known about him or his hedge fund, but we can look at Castle Point Capital 13-F SEC reports and learn of his investments. Between March 31, 2010 and June 30, 2010, Mr. Combs purchased 4 new names and added to a few of his existing positions. One of the 4 new positions is in a company called Leucadia National Corp. (NYSE:LUK). He purchased 255,000 shares at an average cost of $23.36. Coincidently, I too purchased Leucadia for my portfolio around the same time at an average cost of $19.97. 

Leucadia, under the leadership of the Chairman Ian Cumming and the President Joseph Steinberg, went from a failing company to a huge success today. Over the last 30 years (1979-2009), it's book value has compounded at 18.5% and its stock price has compounded at 21.4%.

What does Leucadia do? Here is what their 1988 letter to shareholders says:

"We tend to be buyers of companies that are troubled or out of favor and as a result are selling substantially below the value which we believe are there. We then work at improving the acquired operations with a view to increasing cash flow and profitability. From time to time we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long-term track record. We are not income statement driven and do not run your company with an undue emphasis on quarterly or annual earnings. We believe that we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated."

Leucadia has no quarterly calls, no earnings guidance, and no Wall Street analysts that follow it. One of the main reason is that Leucadia has very few operating companies. It is really a hodge-podge of assets that are usually a work in progress. In this article, I would like to highlight a few of the transactions they have done over the years. The main source for this information is their Buffett-like letters to shareholders. Mr. Cumming and Mr. Steinberg are a great example of control investors that have a value investing approach.

Insurance

In their 1991 letter to shareholders, Leucadia reported that they acquired Colonial Penn Insurance companies, a property & casualty insurer, for $127.9 million in cash. This was a great bargain purchase, since Colonial Penn had $391 million in book value. These companies had been for sale a long time and the selling price had come down to an attractive level. The problem was a portfolio of casualty insurance risks in niche markets that appeared very scary. Leucadia did an exhaustive due diligence and determined that this portfolio was properly reserved and made the purchase. Here is an excerpt about their core operation from Leucadia's 1992 and 1993 letter to shareholders:

"The direct marketing operations of Colonial Penn, prior to our acquisition, were too expensive. During 1992, we adopted a new, lower cost marketing strategy. Although this resulted in lower volume for 1992, we are pleased with the new structure cost structure and with the increasingly profitable premium volume that we hope will result. Our objective on an ongoing basis is a combined ratio of 100%." 

"A combined ratio of 100% means that premiums equal the sum of claims, related expenses, and underwriting expenses. Thus, if the combined ratio is 100% or less the shareholders keep the after tax earnings on the invested reserves and equity, which can be quite substantial."

This is my kind of insurance company - one that strives for profitability not market share or volume. In 1993, they list their guiding principles for managing the insurance companies.

1. We are driven by a search for profitability, not for volume or market share and, as a result, sometimes the best strategy is to retreat.
2. We would rather reserve conservatively and be required to release reserves than to under reserve and be required belatedly to report loss.
3. We search for niches, not dominance, on the theory that the world can tolerate many mice but few elephants.
4. We invest the portfolios conservatively. We are willing to give up marginal yield for predictability, safety, and a good night's sleep. This general conservatism helped us survive the '80s. There is no such thing as a free lunch - either it isn't lunch or it isn't free.
5. We face the responsibility of managing so much of other people's money with constant vigilance and trepidation. The insurance reserves do not belong to the shareholders, only the capital does. 
6. We invest in shorter maturity bonds. In the long run, stocks do better but over shorter periods of time they are not predictable. The obligations to our insureds are predictable. We best fulfill our obligations by investing in bonds.
7. We are afraid of long-term bonds.
8. We do not invest the insurance portfolios in uninsured real-estate, junk bonds or exotic securities.
9. We do not reinsure other insurers risks. Our plate is full with our own risks.
10. We increase our shareholder's wealth by buying businesses at the right price - not by speculating in portfolio securities.

In 1996, Leucadia reported that they sold Colonial Penn, after successfully turning it around. Their comments in the 1996 letter to shareholders gives an insight into their sell discipline:

"Since we bought Colonial Penn companies in 1991 for $127.9 million, they have been ably managed by ... Together, we have worked hard to make these entities more profitable. The companies have paid to Leucadia tax-sharing payments, management fees, interest and dividends totaling $300 million. This, plus the proceeds from the sales, adds up to approximately $1.77 billion pre-tax. This is a remarkable result and a significant return on investment, approximately, 75% per annum.

In the venture capital business, where we began our careers, we developed the belief that the science is in investing and the art is in selling. Art in the sense of the ineffable human ability to collect and integrate vast amounts of unrelated information and in some mysterious way arrive at an opinion as to whether to hold or sell. Over the years, we have learned to depend upon this process.

In deciding whether or not to sell Colonial Penn companies, we availed ourselves to both science and art. Our personal thinking went something like this. Colonial Penn Property & Casualty sells auto insurance direct to the consumer. Current conventional wisdom is that direct marketing of insurance is the wave of the future. Direct marketing companies are much in demand and lots of money is pouring into the business. GEICO, General Electric, Progressive, and others will become ferocious competitors. When the giants start to rumble, price pressure cannot be far behind. Large marketing expenses in the hope of establishing large market share and profitability is not our forte. Too much capital flowing into market niches makes for a miserable, frustrating experience.

Since auto insurance is not a particularly growing market, the only place to get new customers is from a competitor. We are afraid that in the future making money in the auto insurance business will be like picking pennies in front of a steamroller - dangerous and not significantly rewarding. For a total of over one billion dollars, 2.6 times GAAP book, 3.2 times statutory book, and 24.1 times after-tax earnings, a sale was the better part of valor."

Lending

Leucadia conducted its banking and lending activities through its national bank subsidiary, American Investment Bank (AIB). Here is an excerpt about this operation from their 1995 and 1996 letter to shareholders:

"AIB primarily offers auto loans to people with bad credit reports. We have done quite well with the program over the years and offer this service in 14 states throughout the country. In the last couple of years, significant competition began to enter the market. Several large, well financed institutions began to enter the market or bought competitors (at very large premiums) and several initial public offerings were funded. The competition has become increasingly intense, rates have fallen in the market and loan losses are up. From the borrowers point-of-view the choice is simple, go with the lower rate. We have decided not to lower rates but to let business shrink. As a result, our volumes have fallen significantly. We have seen the arrival of inexperienced money before. This is a difficult business. Higher rates are required to make money. Over the next few years we hope that the competition will dwindle and our volumes will slowly return. If not, we will go onto something else. We have no desire to be a slender lender, a lender at inadequate rates."

"[1996] One depressing tangible illustration of the current state of consumer banking is the number of mailers each of us receives offering credit cards, home equity loans, and unsecured lines of credit. In our view, the consumer banking business has become very competitive and the returns do not warrant the risk. Lenders are in a bidding war to convince customers at virtually every income level to borrow more and more. The easy access to credit allows borrowers to control their debt ratios to an unprecedented degree. Not surprisingly, we now read of skyrocketing delinquencies and bankruptcies.

These trends have hit our auto program especially hard. In keeping with the plan we announced last year, we are shrinking our portfolio rather than chase after business with inadequate rates ans excessive losses. Most of our competition securitizes their loans. As capital markets respond to the poor performance of the loans backing these securities, we expect funds available in the market to dwindle and rates to rise. Until then, we intend to approve loans cautiously, make prudent program changes, increase our loan reserves, closely monitor the debt ratios of our borrowers, and pay even more attention to servicing and collecting our existing portfolio. This will reduce earnings in the short run but will position our lending operations to take advantage of opportunities arising from the eventual shakeout in the industry. We don't expect improvement in the auto loan business in 1997. Three large auto competitors have gone out of business, but there is still no shortage of silly money about. Wall Street has yet to feel the pain; when it does, the business will improve. We maintain the perhaps naive hope that this Alice in Wonderland substandard lending market will return to rationality."

By 1998, rationality begins to return to the sub-prime market. In their 1999 letter to shareholders, they report:

"Several players who thought they could defy financial gravity ended up in bankruptcy. The acquisition in late 1998 of a $36.9 million portfolio of sub-prime auto loans, purchased at a discount, jump started AIB's return to the market.

AIB is actively back in the sub-prime business and generating $300 million in loans per annum from 29 states with an anticipated average life of 22 months. While these loans are not as profitable as in the pre-1995 era, the risk/reward relationship makes sense. We will continue to keep in mind the lessons of the past, and should events warrant, AIB will go back into its cave."

By 2001, the dot com bubble had burst and the economy had turned south. In response, AIB exited sub-prime auto lending. It was the right decision given that the potential reward did not justify the high level of risk.

During the Great Recession of 2007-2008, Leucadia got another opportunity to come back to this business through AmeriCredit Corp. Here is an excerpt about their reentry in this business from their 2007 and 2008 letter to shareholders:

"[2008] We have acquired 25% of AmeriCredit Corp ("ACF") for $405.3 million. [2007] We have known of this excellent opportunity for many years, having been in the sub-prime auto business ourselves. ACF has made and financed over $53 billion of these loans and none of its lenders has lost a penny. In this environment, financing for ACF is going to be very difficult and management is taking appropriate actions to downsize the company. We are guardedly optimistic that the financial market will climb out of its bunker next year. People need auto financing to get to work."

[2008] Years ago we owned a similar business and as a result carefully followed ACF. We observed that their large volume and efficient processing and underwriting abilities made them a fierce competitor. We also observed that when a recession hit ACF when through a period of poor results, but when a recovery began they were able to make large profits by being able to select more credit worthy customers and to charge more for loans.

Much of the above remains true; however, we began to buy the stock too soon and paid too much. The recession has been much harder and much deeper than we anticipated, though ACF is succeeding in acquiring credit worthy customers and is able to charge them higher rates. The fly in the ointment has been that is has been almost impossible to secure additional funding to make loans. Securitizations, which were the lifeblood of their funding, has been in rigor mortis. The Federal Reserve has announced a program to restart consumer funding called TALF, but as yet TALF has not been able to access it. Perhaps that will change. ACF has enough funding to operate at a much reduced volume and is committed to preserve its net worth of $15.03 per share. We have a high regard for its management."

In 2009, Leucadia reported its status on the ACF investment:

"In spite of the financial disaster, these investments [ACF and others] performed as expected - beautifully. As in much of life, ACF's secret to success is discipline. Currently, competition has lessoned and ACF can earn a fair return for its risk. Eventually banks and other folks will come rushing back into the market, margins will fall as evaluation of risk becomes, yet again, ignored and volume will become the sole focus of competitors as a means to impress the Stock Market. When that day comes, we hope that ACF will eschew volume, efficiently harvest its portfolio and watch the lemmings as the launch off a cliff. Then the cycle will begin anew. We have a great relationship with, and respect for, the management team. We believe they are the best in the industry."

In July 2010, GM announced its acquisition of ACF for $3.5 billion. Leucadia's share will be $875 million - close to 30% return per annum. Pretty sweet, given that Leucadia thought that they acquired ACF too early and paid too high a price. At one point, Leucadia's investment in ACF was down to $180 million from its investment of $405 million. Value investors don't need to time the market to do well !

Shareholder-Friendly Management
The Chairman and the President together own about 25% of the outstanding shares. Their actions in the past clearly indicate that their interests are aligned with those of the shareholders.

When asset prices were rising in the late nineties, they wrote the following in their 1997 letter to shareholders:

"Higher prices inevitably mean lower returns. The consequence of miscalculation or mistake become more deadly as prices increase. Extreme caution is in order. There is a vast amount of money sloshing around the world. As hard as we run [around the world], the hot money has beat us there. One of us predicts a very unhappy ending to this exuberance; the other doesn't know what to think. This is a conundrum. Several alternatives are available:

1. Do nothing. Keep our cash short and safe and wait until the old world returns. In the meantime, low returns are guaranteed.
2. Do the above, but give shareholders back a significant portion of their money. Perhaps individually you can do better than we think we can. At least we will worry less.
3. Stop the merry-go-round and give all the money back on the theory that a 20 year run is a good one; the old world is unlikely to return soon, but for certain it will not be in the same form. These dogs may be too old for new tricks.
4. Some combination of the above." 

Finally, in 1998, when they had more money than ideas, Leucadia returned $812 million, or $13.48, to shareholders in the form of a special dividend. The compounding of 18.5% in book value does not include this special dividend. 

In April 2008, Leucadia's stock was north of $50. It was trading at a large premium to its book value. Mr. Cumming and Mr. Steinberg took advantage of this situation and sold 10 million shares at $49.83 to an investment bank Jefferies & Company. In return, Leucadia received 26 million shares of Jefferies and $100 million in cash. Jefferies sold the 10 million shares of Leucadia and fortified its balance sheet. Wow! Not satisfied, Leucadia used $396 million to further increase its position in Jefferies to 48.5 million shares through open market purchases. At the end of it all, Leucadia owned 30% of Jefferies. Here is an excerpt about Jefferies from their 2008 letter to shareholders:

"Jefferies is not in trouble, not a ward of the U.S. Government, not burdened by toxic assets and not over-leveraged. Its employees own a substantial interest in the firm and their pay interests are being managed with the best interests of the firm in mind. Jefferies has successfully hired talented individuals from troubled or failing institutions and recently acquired a muni and underwriting business. Trading volumes have been good, their restructuring business is busy, but their capital markets and acquisition businesses remain lethargic. This will inevitably improve, but timing is uncertain. We have known Jefferies for a long time and are particularly fond of and hold in high regard its long time CEO, Richard B. Handler. We believe that over the long haul Jefferies will survive and grow to enrich our shareholders !"

As of December 2009, the fair market value of their position in Jefferies was worth $1.2 billion dollars.  Taking into account the $100 million cash it received from Jefferies, Leucadia effectively used $296 million in cash  to yield an unrealized gain of $900 million. But remember, in the process, it also diluted its shareholders. The question is whether dilution created value for its shareholders ? Here is a quick back-of-the-envelope calculation. Prior to the dilution, shareholders had a book value of $24. Dilution reduced book value per share by $1.60, but a gain of $900 million equates to $3.77 per share. Its very rare to see management dilute its shareholders but also create value. One way (maybe this is the only way) it can happen is when management uses its overvalued stock as currency to buy an undervalued asset. That is exactly what Leucadia did.

In addition to these transactions, Leucadia has partnered with Berkshire Hathaway on multiple occasions. Also, recently their investment in an iron-ore operation in Australia has also been very successful. Lastly, I will say that Leucadia has not had to pay a single dollar, or hardly any amount of significance, of tax to the U.S. Government ever. An account of these can be very interesting, but I don't intend to make this article a comprehensive coverage of all the interesting deals Leucadia has done over its 30 year history.

References:
1. Todd Comb's Portfolio, June 30, 2010.
2. Rishi Gosalia's Portfolio, Aug 31, 2010.
3. Letter to Shareholders, Leucadia, 1988.
4. Letter to Shareholders, Leucadia, 1991.
5. Letter to Shareholders, Leucadia, 1992.
6. Letter to Shareholders, Leucadia, 1993.
7. Letter to Shareholders, Leucadia, 1995.
8. Letter to Shareholders, Leucadia, 1996.
9. Letter to Shareholders, Leucadia, 1998.
10. Letter to Shareholders, Leucadia, 1999.
11. Letter to Shareholders, Leucadia, 2001.
12. Letter to Shareholders, Leucadia, 2008.
13. Letter to Shareholders, Leucadia, 2009.

The Wit and Wisdom of Charlie Munger

Charlie Munger is the 86 year old partner of Warren Buffett at Berkshire Hathaway. He is the lesser known of the dynamic duo, but Munger has had a significant, almost unquantifiable impact on the way Warren Buffett thinks and on the fortunes of the Berkshire shareholders. The reason for this impact is that, In addition to being a great investor, he is an extraordinary thinker.

Peter Kaufman has put together all his talks, lectures, and public commentary over the years into one of my favorite book: “Poor Charlie’s Almanack: The Wit and Wisdom of Charlie Munger.” If I had to name a book that has changed the way I think, it has to be this book. Even though every chapter in this book is worth its weight in gold, in this post, I will quote excerpts from one talk that I really like  – the USC Gould School of Law Commencement Address at University of Southern California on May 13, 2007.

“I’ve scratched out a few notes, and I’m going to try and give an account of certain ideas and attitudes that have worked well for me. I don’t claim that they’re perfect for everybody. But I think many of them contain certain universal values and that many of them are ‘can’t fail’ ideas.

What are the core ideas that helped me? Well, luckily I had the idea at a very early age that the safest way to try to get what you want is to try to deserve what you want. It’s such a simple idea. It’s the golden rule. You want to deliver to the world what you would buy if you were on the other end. By and large, the people who’ve had this ethos win in life, and they don’t just win money and honors. They win the respect, the deserved trust of the people they deal with. And there is huge pleasure in life to be obtained from getting deserved trust.

Another idea, and this may remind you of Confucius, is that the acquisition of wisdom is a moral duty. It’s not something you do just to advance in life. And there’s a corollary to that idea that is very important. It requires that you’re hooked on lifetime learning. Without lifetime learning, you people are not going to do very well. You are not going to get very far in life based on what you already know. You’re going to advance in life by what you learn after you leave here. I constantly see people rise in life who are not the smartest, sometimes not even the most diligent. But they are learning machines. They go to bed every night a little wiser than they were that morning. And boy, does that help, particularly when you have a long run ahead of you. Consider Warren Buffett. If you watched him with a time clock, you’d find that about half of his waking time is spent reading. Viewed up close, Warren looks quite academic as he achieves worldly success.

Another idea that was hugely useful to me was one of learning all the big ideas in all the big disciplines. And because the really big ideas carry about 95% of the freight, it wasn’t at al hard for me to pick up about 95% of what I needed from all the disciplines and to include use of this knowledge as a standard part of my mental routines. Once you have the ideas, of course, you must continuously practice their use. Like a concert pianist, if you don’t practice you can’t perform well. So I went through life constantly practicing a multi-disciplinary approach. It doesn’t help you much just to know something well enough so that on one occasion you can prattle your way to an A in an exam. You have to learn many things in such a way that they’re in a mental latticework in your head and you automatically use them the rest of your life. If many of you try that, I solemnly promise that one day most will correctly come to think, ‘Somehow I’ve become one of the most effective people in my whole age cohort.’ And, in contrast, if no effort is made toward such a multi-disciplinarity, many of the brightest of you who choose this course will live in the middle ranks, or the shallows.

Another idea that I discovered is encapsulated by the story about the rustic who ‘wanted to know where he was going to die, so he wouldn’t go there.’ The rustic who had that ridiculous sounding idea had a profound truth in his possession. The way complex adaptive systems work, and the way mental constructs work, problems frequently become easier to solve through ‘inversion.’ If you turn problems around into reverse, you often think better. Those who have mastered algebra know that inversion will often and easily solve problems that otherwise resist solutions. And in life, just as in algebra, inversion will help you solve problems that you can’t otherwise handle.

Let me use a little inversion now. What will really fail you in life? What do we want to avoid? Some answers are easy. For example, sloth and unreliability will fail. If you’re unreliable it doesn’t matter what your virtues are, you’re going to crater immediately. So, faithfully doing what you’re engaged to do should be an automatic part of your conduct. Of course, you should avoid sloth and unreliability.

Another thing  to avoid is extreme intense ideology, because it cabbages up one’s mind. If you’re young, it’s particularly easy to drift into intense and foolish political ideology and never get out. When you announce that you’re loyal member of some cult-like group and you start shouting out the ideology, what you’re doing is pounding it in, pounding it in, pounding it in. You’re ruining your mind, sometimes with startling speed. So you want to be very careful with intense ideology. It presents a big danger for the only mind you’re ever going to have. I have what I called the ‘iron prescription’ that helps me keep sane when I drift toward preferring one intense ideology over another. I feel that I’m not entitled to have an opinion unless I can state arguments against my position better than the people who are in opposition. I think I am qualified to speak only when I’ve reached that state. That probably is too rough for most people, although I hope it won’t ever become too tough for me. This business of not drifting into extreme ideology is very, very important in life. If you want to end up wise, heavy ideology is very likely to prevent that outcome.

Another thing that often causes folly and ruin is the ‘self-serving bias,’ often subconscious, to which we’re all subject. You think that ‘the true little me’ is entitled to do what it wants to do. For instance, why shouldn’t the true little me get what it wants by overspending its income? Even though, you have to get self-serving bias out of your mental routines, you have to allow for the self-serving bias of everybody else, because most people are not going to be very successful at removing such bias, the human condition being what it is. If you don’t allow self-serving bias in the conduct of others, you are, again, a fool.

I watched the brilliant and worthy Harvard Law Review-trained general counsel of Solomon Brothers lose his career there. When the able CEO was told that an underlying had done something wrong, the general counsel said, “Gee, we don’t have any legal duty to report this, but I think it’s what we should do. It’s our moral duty.” The general counsel was technically and morally correct. But his approach did not persuade. He recommended a very unpleasant thing for the busy CEO to do and the CEO, quite understandably, put the issue off, and put it off, and not with any intent to do wrong. In due course, when powerful regulators resented not having been promptly informed, down went the CEO and the general counsel with him. The correct persuasive technique in situation like that was given by Ben Franklin.

He said, “If you persuade, appeal to interest, not to reason.” The self-serving bias of man is extreme and should have been used in attaining the correct outcome. So the general counsel should have said, “Look, this is likely to erupt into something that will destroy you, take away your money, take away your status, grossly impair your reputation. My recommendation will prevent a likely disaster from which you can’t recover.” That approach would have worked. You should often appeal to interest, not to reason, even when your motives are lofty.

Perverse associations are also to be avoided. You particularly want to avoid directly working under somebody you don’t admire and don’t want to be like. It’s dangerous. We’re all subject to control to some extent by authority figures, particularly authority figures who are rewarding us. Dealing properly with this danger requires both some talent and will. I coped in my time by identifying people I admired and by maneuvering, mostly, without criticizing anybody, so that I was usually working under the right sort of people. Generally, your outcome in life will be more satisfactory, if you work under people you correctly admire.

Engaging in routines that allow you to maintain objectivity are, of course, very helpful to cognition. We all remember that Darwin paid special attention to disconfirming evidence, particularly when it disconfirmed something he believed and loved. Routines like that are required if a life is to maximize correct thinking.

I frequently tell the apocryphal story about how Max Planck, after he won the Noble Prize, went around Germany giving a same standard lecture on the new quantum mechanics. Over time, his chauffeur memorized the lecture and said, “Would you mind, Professor Planck, because it’s so boring to stay in our routine, if I gave the lecture in Munich and you just sat in front wearing my chauffer’s hat?” Planck said, “Why not?” Ant the chauffeur got up and gave this long lecture on quantum mechanics. After which a physics professor stood up and asked a perfectly ghastly question. The speaker said, “Well, I’m surprised that in an advanced city like Munich I get such an elementary question. I’m going to ask my chauffeur to reply.” Well, the reason I tell that story is not celebrate the quick wittedness of the protagonist. In this world I think we have two kinds of knowledge. One in Planck knowledge, that of the people who really know. They’ve paid the dues, they have the aptitude. Then we’ve got the chauffeur knowledge. They have learned to prattle the talk. They may have a big head of hair. They often have a fine timbre in their voices. They make a big impression. But in the end what they’ve got is chauffeur knowledge masquerading real knowledge. You’re going to have the problem in your life of getting as much responsibility as you can into the people with the Planck knowledge and away from the people who have the chauffeur knowledge. And there are huge forces working against you.

Another thing that I have found is that intense interest in any subject is indispensable if you’re really going to excel in it. I could force myself to be fairly good in a lot of things, but I couldn’t excel in anything in which I don’t have an intense interest. So to some extent you’re going to have to do as I did. If at all feasible, you want to maneuver yourself into doing something in which you have an intense interest.

The last thing that I want to give to you, as you go out into a profession that frequently puts a lot of procedure and some mumbo jumbo into what it does, is that complex bureaucratic procedure does not represent the highest form civilization  can reach. One higher form is a seamless, non-bureaucratic web of deserved trust. Not much fancy procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic. If lawyers would there introduce a lot of lawyer-like process, more patients would die. In your own life what you want to maximize is a seamless web of deserved trust. And if your proposed marriage contract has 47 pages, my suggestion is that you not enter.”

Noble Corporation: Business Analysis & Valuation

Business Overview:
Noble Corporation is a contract oil and natural gas drilling company. Its fleet consists of 62 mobile offshore drilling units (excluding additions from the recent Frontier Drilling acquisition). Shown below is the latest status of its fleet: Noble Corp has a long history of navigating well through difficult industry conditions and delivering good returns on capital and operating margins.  Also, compared to its competitors, Transocean (RIG), Ensco (ESV), Diamond Offshore (DO), Rowan Companies (RDC), Pride International (PDE), and Atwood Oceanics (ATW), Noble is among the top performers based on the metrics below:

Business Analysis:
Operating revenue for Noble and other contract drilling companies depends on drilling activity by exploration and production (E&P) companies which in turn depends on the outlook for oil prices. In the last three years, crude oil prices have gone through a wild ride causing drilling activity to peak and then to fall off very rapidly. The industry uses two metrics to evaluate the key drivers for revenue:
(i) Average Day Rates:

(ii) Average Utilization:

Jackups Segment:
Day rates have been coming down as drilling activity has slowed. Also, during the peak of the cycle, contract drillers around the world ordered a record number of new Jackups. These are also known in the industry as “being built on speculation”. These newbuilds are expected to flood the market starting 2010. Most of these newbuilds are uncontracted and thus are expected to put tremendous pressure on day rates for the resetting Jackup contracts for Noble Corp as well as its competitors. Shown below is the data for Jackup Market (Data from RigZone’s 2010 Jackup Market Outlook):

Jackup day rates for Noble Corp were lower in 2010 H1 than for the industry going into 2010. This trend wasn’t specific to Noble Corp, but was evident for all other competitors too – mostly because of the oversupply conditions in this market.

There are factors other than supply/demand that determine “day rate” for a specific rig in a contract. To name a few, factors such as age of the specific rig, high spec capabilities, the contractor’s track record, operator needs and relationships, and specific rig’s maintenance and performance records also play some role in the pricing equation. Although the average age of Noble’s fleet is 27 years old, it has “rebuilt” (made substantial improvements to) a majority of them. The average age of its Jackup fleet taking this into consideration is 13 years. Ensco has the youngest Jackup fleet (in the same sense) in the industry with an average age of 9 years. We can compare metrics for Ensco’s Jackup fleet to that of Noble to get a sense of the difference (there isn’t much):

The other factor that helps demand a premium in day rates in normal market conditions (roughly balanced demand/supply) is high spec capability.

With the overhang in supply in the current market conditions, it might be an exaggeration to say that the older and lower spec rigs in the industry will be completely marginalized, but it is likely that these units will face more day rate pressure than the high spec, newer units. Amidst fierce competition for work, owners of higher spec units have the option to step down and compete for contracts with the lower spec rigs, potentially forcing some lower spec rigs to keep day rates repressed to stay active. A potentially mitigating factor to note here is that newly built rig owners, especially unestablished rig owners building rigs on speculative basis, have higher day rate hurdles due to financing costs in order to earn acceptable margins.Later in the valuation section, I will use the economics described above to roughly measure its impact on Noble’s Jackup fleet. 

Before we move on to examining the other segment for Noble, let’s look at the current contract status for its Jackup fleet

As you can see, most of the contracts expiring in 2010 are in the Mexico region. In fact, all the rigs in the Mexico region are currently contracted to Pemex, Mexico’s state owned petroleum company. In a difficult market like today, it is concerning that these rigs could be out of work for some time. Also, to add to these difficulties, Pemex originally submitted a tender with age restrictions that would have ruled out Noble Corp’s Jackup fleet. However, very few bidders showed up, causing Pemex to lift this restriction. Subsequently, Pemex also submitted its proposal to the finance ministry to up its budget by 54%. As per Noble, in its Q2 call, Pemex may be in the market for another 21 rigs in Feb 2011 because of this budget increase. This news improves prospects for Noble’s expiring contracts in this region lifting some of the near-term concerns relating its expiring contracts.

Semisubmersible segment:
Day rates for the semisubmersible segment have gone up, despite the fall of oil price from its peak. Also, its utilization has stayed in the 90% + range. This trend is not specific to Noble Corp, but is evident industry wide indicating tighter supply. However, since the Deepwater Horizon accident, not only is the short-run outlook for deepwater drilling in the Gulf of Mexico is grim, but the long-term global impact is yet to be fully understood. This uncertainty in my opinion is what creates the opportunity to invest in Noble Corp. Let’s examine Noble Corp semisubmersible fleet:

As you can see from above, only one operator (Anadarko) has terminated contract so far based on force majeure. This termination is currently in dispute, and revenue recognition is being deferred in the current financial reports. Also, as part of the Frontier acquisition, Shell agreed to support Noble during the Gulf moratorium.  The agreement let Shell suspend the rig contracts of any rig operating or anticipate to operate in the Gulf during the moratorium, if needed. In exchange, Noble will continue to earn a reduced day rate that will cover its operating costs and allow the rig to be quickly returned to duty. The term of the contract will be extended at original contract day rate to reflect any suspension period. This reduces to a large extent the uncertainty of force majeure for its rigs operating in the Gulf.

Now that BP has capped its oil well, the possibility of extending the moratorium beyond Nov 2010 is much smaller. One of the most likely outcomes is stricter regulations. As an example, drilling contractors may be required to upgrade their fleet to meet with new minimum standards for blowout preventers. The older rigs may need to be redesigned to make space for such blowout preventers rendering them to undergo costly upgrades or possibly make them obsolete. Such a requirement would be a boon to contractors that have a younger fleet, thus creating a competitive advantage for them. In the last quarterly call, the CEO of Noble Corp commented that the cost of upgrading its fleet to meet these requirements are very manageable – “on a per rig basis, we are talking millions not tens of millions of dollars”.

The other possible outcome is a permanent shutdown of deepwater drilling in the Gulf. In such a case, Noble and other contractors in the US GOM would be looking for work elsewhere for its semisubmersibles. Such a scenario will cause the economics of day rates for the Semisubmersibles to be very similar to those in the Jackup segment.  Note that offshore US GOM accounts for 30% of US produced crude oil (Source: EIA special report US GOM fact sheet). As per 2006 MMS Estimated Oil and Gas Reserves in US GOM report, most of the remaining proven reserves are in water depth >1500' (considered as deepwater). Also, offshore drilling activity provides major employment for the surrounding states. Given all the above factors and that the BP oil well is now capped, this draconian outcome seems unlikely. Although difficult to quantify, it seems less than 10% probability for such an outcome.

Frontier Acquisition:
Noble recently bought Frontier Drilling. It was a cash transaction for $2.16B. Noble financed the transaction with a combination of cash on hand, and new long-term debt. Noble estimates total debt to go up to $3 billion (currently at $751 million) and the debt/capital ratio to go up to 28% (currently at 10%). Management thinks it can pay off debt in 3 years if it wants to, and the increase in leverage is very manageable. Earnings and cash flow are expected to be accretive starting 2011.

As per analyst estimates at Morningstar®, the acquisition was done at Frontier’s fleet replacement cost and 5x EBITDA. Frontier was facing debt covenant violations in light of potential loss of earnings from the US GOM force majeure termination of one of its rigs. Noble took advantage of Frontier's distress, by using its strong balance sheet to make this acquisition.

As part of the transaction, Noble has added three dynamically positioned drillships, two conventionally moored drillships, one deepwater semisubmersible rig, and one dynamically position FPSO vessel. All of these are already under contract. Also, Noble netted $2 billion in backlog (which is great given that it only paid $2.16 billion). Since Frontier’s 95% of this backlog is with Shell, it agreed to various agreements for Noble’s existing fleet. In addition to the agreements related to its contracts in US GOM described in an earlier section, Noble signed a 10 year contract with Shell for the Globetrotter, which is due to be delivered in the second half of 2011. As per the contract, day rate for the first five years will be $410,000. During the later five years, day rates will adjust based on market rates for such rigs every six months. Shell also agreed to similar terms for a second ultra-semisubmersible rig to be delivered in 2013.

The combined impact of the Frontier acquisition and the agreements with Shell increases Noble’s backlog to $12.9 billion from $6.9 billion previously, second only to Transocean's backlog. While much of the backlog is scheduled in the second half of the decade, the increase is substantial. Another point to note is that Shell prefers to form a relationship with an established player like Noble at higher day rates rather than a marginalized player with newer rigs and lower day rates. Also, it shows that Shell was willing to commit to deepwater for another decade even as the oil spill accident was playing out.

Valuation:
 

We estimate the earnings power of Noble Corp (excluding accretion to earnings due to the Frontier acquisition) using a worst-case (10% chance), mid-cycle (80%), and peak-cycle (10%) scenario. The details of this estimation are shown in appendix.

Noble traded at a PE ratio of 12-14x in 2006-07. Then, with the onset of the global recession, PE ratio was compressed to 4x. Oil prices recovered but uncertainty remained due to the BP Deepwater Horizon accident, Noble traded at 6x. In the longer-run, Noble ought to trade at 8-12x to reflect the growth characteristics of  deepwater drilling. Shown below is a sensitivity matrix for Noble’s stock price.

In the worst case, the downside risk is 36% from the current price (32.6$ on Aug 13, 2010). In the most likely outcome, the upside is 70% (mid-cycle scenario with a PE ratio of 10x). Note that the above is estimated without taking into account the Frontier acquisition.

Appendix: Noble Corp’s Earnings Power Estimate 

Assumptions used for the estimate:
 

Given the above assumptions, we can estimate the average day rates and utilization for the four segments:

The above give us revenue estimate for each segment under the various scenarios. To estimate earnings power, we need to estimate operating margin for the three scenarios. For peak-cycle, use the highest margin that Noble has achieved in 2007-2009. For mid-cycle, use the average of 2006-2009. For worst-case, use the average of last 10 years. The operating margin in this case is much lower than the mid-cycle scenario, but it models Noble’s costs going up dramatically.

Disclosure: The author has a long position in NE. This is not a recommendation to buy or sell any security. This article is for information purposes only.