1 Misunderstood Risk to Visa and MasterCard

If you merely read the news headlines, Visa and MasterCard are in a world of hurt. Higher incentive spending is hurting revenue and profits. See these two recent examples.

In June, one headline read that "MasterCard's Revenue Misses Estimates on Higher Incentives."

In October, another read "MasterCard Revenue Dented by Rebates."

Two quarters in a row and Wall Street collectively hits the panic button. You shouldn't.

What are incentives?You can think of incentives as a bounty that Visa and MasterCard pay to banks to issue cards to their members. It's effectively the price Visa and MasterCard pay to "buy" transaction volume on their networks.

If banks can demand a greater share of the card network's revenue, card network profit margins will shrink. Profit growth will slow. Visa and MasterCard would no longer justify their above-average valuations.

Yet despite all the worries, recent growth in incentive spending barely appears on a longer-term horizon. If you chart incentive spending as a percentage of gross revenue over the last six fiscal years, you'll find the trend toward higher incentive spending to be...well, relatively benign.

I'll concede that looking backwards doesn't provide a perfect view. Contracts between banks and card networks are lengthy, often spanning several years. What we see on the income statement today is a reflection of deals that were signed years ago. This is important to consider as we think about what the income statement can tell us about Visa and MasterCard's place on the plastic card totem pole.

However, the tunnel vision on incentive expenses completely ignores developments elsewhere in the financials. As a whole, Visa and MasterCard are becoming much more efficient at acquiring transaction volume, not less efficient.

Incentive spending is just half the puzzle. It's the price the networks pay to "buy" a bank's customers. The alternative is traditional marketing expense, which is recorded in a completely different line item on the income statement.

If our sole goal is to measure Visa and MasterCard's efficiency in gathering transaction volume, the best measure is "incentive" expenses plus "marketing" expenses. When combined and divided by gross revenue, you'll see a trend of generally lower spending to acquire transaction volume as a percentage of revenue.

This chart not only captures more of Visa and MasterCard's spending to acquire customers, but it shows that total marketing spending as a percentage of gross revenue is falling. While incentives expenses are growing marginally, the impact is more than offset by declining marketing spend elsewhere.

It is important that banks are taking a greater part of the networks' revenue. It stands as evidence that Visa and MasterCard may not have as much pricing power through this channel as they had in the past. But it's hardly a death knell.

The story isn't as simple as "incentives are rising, and that's bad news." For now, incentives are rising, but it's offset by savings in general marketing spending.

The article 1 Misunderstood Risk to Visa and MasterCard originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends MasterCard and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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