I finally made my way through the monster known as the Visa IPO document. The VISA SEC filing to register the initial public offering can be found here. I consider the Visa IPO financial pornography- most of us will not be able to participate in the initial offering, other than buying after the market opens at, most likely, more than the initial price. Most, if not all, of the shares are spoken for by institutions, hedge fund, pension funds etc. The Visa IPO is expected to open sometime mid-month (March 20 is the date being cited by several sources) on NYSE with the proposed ticker symbol of “V.”

I have attempted to do a Q & A on the highlights of the Visa IPO with some of my own commentary. As usual, please do your own due diligence. This is a long post so bear with me (it is also from the February 25 filing so there may be some amendments to the IPO by Visa).

WHAT IS VISA?

This sounds like a stupid question but Visa is not a card credit company. The credit cards and debit cards with Visa on it are issued by financial institutions. To quote the IPO: “Visa operates the world’s largest retail electronic payment network and mangers the world’s most recognized global financial services brand.” In other words, Visa operates the electronic transfer of funds- it is the clearing house for all the credit card and debit card transactions for the banks that issue the cards (non-payment of credit cards are the banks responsibilities and not Visa) and merchants that have accounts.

It makes its money from two major sources: “data processing fees” and service fees- the fees charged to banks and merchants. Essentially, it is the middle person between the merchant and the banks. Every time you and I use the card, it makes money.

Visa, before the IPO, was “owned” (I use the term loosely) by financial institutions that license the cards around the world and manage the system in various territories (this becomes important as described below). Thus, Visa U.S.A. had a series of financial institutions that administered and managed the network in the U.S.

By total transaction (44.4 billion in 2006), it is almost twice as large as its closet competitor (Mastercard).

HOW MUCH MONEY IS IT RAISING AND AT WHAT PRICE?

406,000,000 shares are being offered with an over-allotment of 40,600,000 of class A common stock (the underwriter is allowed to issue these in the event the shares are full subscribed). There are 277,035,213 Class B shares outstanding which are held by the financial institutions that are members of Visa U.S.A. There are 203,885689 Class C shares outstanding owned by financial institutions outside the U.S. (keep the Class B and C shares in mind). These are non-voting.

The maximum offering price is $42. Only the Class A shares are being offered meaning that the Visa IPO should raise over $17 billion. Most observers indicate that the price will be somewhere in the range of $37-$42.

IS THIS AN EXPENSIVE STOCK TO OWN?

YES. THE STREET GOT GREEDY. At a maximum share price of $42, the price to earnings (p/e) ratio will be approximately 27 or, in other words, you are expecting Visa to grow at 20% plus per year to make it a reasonably priced.

A key metric to measure the performance of any credit card companies is transaction growth- after all, it gets paid every time someone uses a credit card. The IPO states that credit card transactions will grow at a rate between 11% between 2006-2012 which is a decrease from annual compound growth rates of 14% from 2000-2006. THE CREDIT CARD INDUSTRY IS PROJECTED TO SLOW DOWN. Even in emerging markets, the projected growth rates will be between 17-20%- well below the p/e of 27. The problematic statistic is North American projected transaction growth for this period is 8% (a 4% decline in the U.S. from its 2002-2006 transaction growth rate)- good but not great and certainly not worth a p/e of over 20 even at the lower offering price of $37/share.

The bottom line: the proposed p/e is above Visa’s current growth rate and the industry’s growth forecast meaning the underwriters added a significant premium to the price. By comparison, Mastercard’s p/e is approximately 24 and American Express p/e is approximately 13.

WILL A DIVIDEND BE PAID?

It is anticipated that a dividend of $0.42 per share/year will be paid commencing June 30, 2008. This represents a 1% dividend yield on an offering price of $42.

WHY WOULD I BUY?

(a) Good financials: Operating revenue of $15.9 billion in 2007. Removing allowances for a litigation fund (see below) and expenses are only $2.23 billion. There is $4 billion cash on hand which suggests an ability to increase dividends in the future. The company is massively profitable once you strip out short-term litigation concerns (see below).

(b) Cash-Flow Rich Business: Visa gets paid first in any transaction. It makes money even if card holders default on their debt. Good cash flow + limited risk = great business model.

(b) Dominant market share and brand: Visa is the world’s largest retail electronic payment network by any financial measure- by miles (total volume of business as of 2006 was $3.23 billion vs. Mastercard (no. 2) at $1.9 billion). But did Visa gain this position through uncompetitive practices and deception (see below)? Now that its hand have been caught in the cookie jar by regulators (several of the lawsuits are not settled and there is no admission of liability by either side), will an even playing field erode its market position?

WHAT ARE THE PROBLEMS?

(a) Poor use of IPO funds. It is anticipated that Visa will use $10.2 billion of the initial offering to redeem the Class B and Class C shares. In other words, the financial institutions will be cashed out using our money. I am sure that many of the financial institutions will keep their shares but there may not be the same incentive to manage and expand the Visa brand now that the original “owners” are cashing out (some of the banks booked this revenue already).

(b) Litigation. The VISA IPO lists a wide variety of lawsuits and government actions underway over uncompetitive conduct (Visa use to bar its merchants from using other credit cards as a condition of supply), to deception (unclear currency conversion policies) and competitors suing over the same issues (there is a lawsuit with Discovery that, based on the information provided about the trial so far, does not look good for Visa). The lawyer in me say “uh oh” reading the status of some on-going actions. Thus, $3.0 billion of the initial raise is being used to create a fund to pay out various litigation and/or penalties to be paid pursuant to regulatory settlements.

These are short-term problems and a good chunk of change was used in the Mastercard IPO to pay on-going lawsuits. These are not structural issues which will slow its future growth.

But that’s $13 billion dollars NOT used to expand the business. $13 billion to make banks and lawyers richer.

(c) Its biggest customers are in trouble and may not necessarily be loyal after being cashed out: Visa makes 22% of its operating revenue from 5 customers (7% from JP Morgan alone). All of these customers are not bound by exclusivity agreements to Visa; they can walk away at any time. Banks, to say the least, are in trouble. Banks may have to consolidate to get themselves out of these problems. Larger customers have more bargaining power which means it can cut a better deal and Visa’s historical pricing power could be cut (remember since the banks don’t own Visa exclusively anymore, it has no real loyalty to it).

(d) The industry is slowing down: As stated above, credit card transactions are projected to slow down to a healthy pace but nowhere near the valuation proposed in the Visa IPO. Growth in emerging markets cannot keep pace with the frenzy of spending Americans did from 2002-2006 and the American consumer is spent. Many emerging markets have cultures which have real aversion to debt; one wonders whether projected growth in these markets takes these cultural factors into account?

CONCLUSIONS?

Good business with some short-term problems but is the VISA IPO priced too high for you and I to make money? (assuming pricing is towards the $42 range) Don’t use the Mastercard IPO as a precedent: different context/better timing, a no. 2 in the industry with clear room to grow and the banks did not have issues at that point in time.

I love the business but the longer term play may be to let Visa settle down at some more realistic valuation after the IPO and monitor the situation then. Given that the VISA IPO may be the only major offering this year, Wall Street has a natural incentive to be greedy and I would want to avoid the hype being created to feed the greed. Just my 2 cents.

Do your own due diligence and, if you are happy, beg someone to sell you some shares.

Here are some other blogs which address the Visa IPO

Million Dollar Journey

Chris Perruna

Investing Blog