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Are Credit Card Companies Getting Too Rosy?

Sunday - 6/16/2013, 1:30pm  ET

Credit cards have become a standard part of American life, and their expansion into emerging markets has made them popular growth plays. Given the tough competition in the industry and the number of legal challenges, many firms in the credit card industry are trading at very high valuations. With increasing valuations but steady growth rates, it may be time to take a step back. 

V Revenue Quarterly YoY Growth data by YCharts

Visa and MasterCard are similar companies. Both firms are middlemen and neither carries customer debt on their balance sheets. These firms have been successfully sued for anti-competitive behavior, due to high fees and onerous terms of service. The results of ongoing litigation are still up in the air. If major retailers win the ability to negotiate their own settlements, then credit card companies will face very expensive negotiations. 

With a major legal battle looming in the distance and lack of expanding growth, it is imprudent that Visa and MasterCard are trading at richer forward price to earnings (P/E) ratios. From 2011 until 2013 their forward P/E ratios have significantly increased from around 15 to above 22. At the same time, Visa's revenue growth rate has stayed the same while MasterCard's revenue growth rate has fallen significantly. 

Visa benefits from growth in the emerging markets, but its overall revenue growth rate isn't moving. Its second quarter 2013, year-over-year constant payment volume increased 13% in Asia Pacific and 21% in Latin America and the Caribbean. The company is profitable with a profit margin of 21.5%, a return on investments (ROI) of 8.9% and it is trading at a P/E ratio around 50. If its revenue was growing a quicker pace, then its increasing valuation would be easier to justify. 

With no debt and well-known brand name, MasterCard is very similar to Visa. Even though MasterCard has suffered some highly visible fraud, the company is very profitable. Its profit margin of 37.7% and a ROI of 42.1% are significantly higher than Visa's. Still, MasterCard's revenue growth rate has fallen below Visa's and its current P/E ratio around 25 looks very expensive. The pending legal cases pertaining to its monopoly behavior only gives more cause for concern. 

American Express  is slightly different from Visa and MasterCard. American Express focuses on the higher end of the market and has fallowed a vertically integrated model. The company retains customer debt on its balance sheet like a bank.

American Express' focus on the higher end of the market helps to remove itself from main street's woes. In Q1 2013, its net write off rate of 1.9% was significantly lower than many major banks. Bank of America net write off rate was 4.2% and Capital One's rate was 4.5%. This focus on the upper end of the market is a wise decision and will help American Express to grow even as America's middle class suffers from low wage growth.  

The company's revenue growth has been falling, and it deserves its valuation discount relative to Visa and MasterCard. American Express' profit margin of 13.2% and earnings before interest rate and taxes margin of 25.7% are good enough, and it recently boosted its dividend to $0.23 per quarter. 

Conclusion

Visa and MasterCard are facing a number of challenges. Some of the world's best funded retailers are trying to craft their own increased settlements related to credit card companies' earlier monopolistic behavior. Visa and MasterCard continue to grow in the emerging markets, but over all their growth is steady or falling. Against this backdrop their increasing forward P/E ratios above 22 are unnerving.

American Express isn't growing as quickly as Visa or MasterCard, but it is growing and comes at a much more reasonable valuation. Also, American Express' focus on the higher end of the market will help to insulate it from the middle class' challenges. At current prices following Warren Buffet into this company is very attractive. 

This article was originally published as Are Credit Card Companies Getting Too Rosy?on Fool.com

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