Please refer to our disclaimers, which can be found in the footnote of this page and here.

Contents

• Contents
• Performance
• Annualised Returns Summary and Portfolio Statistics
• Portfolio Discussion: Visa
• Visa Business Overview
• Value-Added Services
• New Flows
• Business Quality & Cost of Capital
• Why do we like the business?
• Key Risks
• Valuation
• Experts Consulted in our Diligence
• Business Update
• Footnotes

Performance

3Q 2024 performance was +6.1% net (vs. the MSCI ACWI at +6.6%). Since inception (1 Jan 2019), the portfolio has compounded at +18.2% gross / +15.4% net (vs. the MSCI ACWI at +13.4%), representing +4.8% gross (+1.9% net) annualised outperformance. Year-to-date, the top contributors were Salesforce, Alphabet, and Meta Platforms, while the top detractor was Charter Communications.

As mentioned in our prior letter, we increased our Charter Communications position during 2Q 2024 following the share price decline. The stock price rallied almost 50% into the third quarter, and we sold half of the position as it had grown too large in the portfolio relative to the quality of the business, despite the forward return remaining attractive. As outlined in our 1Q 2024 letter, we penalise the quality of the business due to its capital upgrade requirements, and because its moat relies on participants remaining economically rational.

We discussed Pinduoduo in our 2Q 2024 letter, noting that we had not acquired stock at that time. During the third quarter, a significant price correction occurred following the earnings call. Management highlighted increased competition (as discussed in our Alibaba update in our 1Q 2024 letter) and reduced long-term margins due to re-investment. They also ruled out short-to-medium term capital returns. Our conservative underwriting already accounted for these factors (particularly regarding the take-rate), so we used the price drop to build a full position. The stock has since rallied significantly due to China's stimulus announcements.

Pinduoduo is the only new position year-to-date. The cadence of investments we expect is about one new name per year, with a handful of adjustment trades each quarter where price movements, relative to value, are extreme. We are on track this year.

Annualised Returns Summary and Portfolio Statistics

Portfolio Discussion: Visa

We’ve followed the global payments ecosystem for a long time. We are attracted to the secular tailwinds driving digital payments including the continued share-gain of cards over cash/check and the growing share of online commerce, where there is greater economic capture. We first began our work with an industry study where we sought to understand the duration of the secular tailwinds and how the power in the value chain was evolving. We may share this study in a future letter.

Our work led to two investments, Visa and Block. We think the card networks (Visa and Mastercard) will continue to maintain their dominance. While there has been some increasing power in other parts of the value-chain, and a modularisation of some of their services[1], these networks remain irreplaceable assets. We follow both Visa and Mastercard but prefer Visa on valuation grounds.

We observed increasing integration between point-of-sale (“POS”) services, gateways, payment facilitators, and merchant acquirers to provide superior software and data-driven value-added services such as fraud detection, lending, inventory management, payroll etc. Within this segment we have preferred those focused on small-to-medium sized businesses (“SMEs”) like Block. SMEs are more likely to seek a one-stop-shop payment solution leading to higher yields for the provider, with price less likely to be most important variable. In contrast, enterprise customers prioritise pricing, with large customers often appointing multiple providers to avoid lock-in and enable real-time payments routing to optimise cost. We looked closely at Adyen[2], for example, but did not get there on business quality for this reason (it’s unclear to us whether the business will commoditise). We landed with Block because it had a dual ecosystem of merchants in its integrated POS / payment facilitator business (Square) and consumers in its banking business (Cash App). We saw merit in the potential synergies between these two ecosystems and without this, Block would not have met our quality criteria. We discuss Visa in this letter and will save Block for a future discussion.

We first invested in Visa in November 2021 (see chart below). As the market declined, we used Visa as a source of capital to invest in stocks with higher forward returns. We reinvested in Visa in November 2023, due in part to worsening forward returns in other names.

Crash Course in Payments for those Unfamiliar

Payment networks are built on a four-party model that includes the consumer, the consumer’s bank that issued the card (issuing bank), the merchant, and the merchant’s bank (merchant acquirer). When a card purchase is made, the card network routes the payment request to the issuing bank. Once the issuing bank authorises the transaction, the transaction is posted to the consumer’s account and the issuing bank pays the merchant acquirer less an interchange fee (the issuing bank’s charge). The merchant acquirer then pays the merchant less an amount called the merchant discount (i.e. the fees to all the facilitating participants including the interchange fee). Typical merchant discounts rates are around 2% for credit (closer to 3% online, or if involving payment-related software services on top, and cheaper for debit). The issuing bank takes the lion’s share given it assumes the credit risk in most transactions (unless the merchant isn’t using certain security measures). The other participants each take a small share. The card networks also coordinate the clearing and settlement information for the banks and offer various value-added services in the process, including real-time fraud analysis to assist issuing banks in the authorisation decision. The card networks also set the rules regarding payment disputes and will manage the dispute process as an added service if required. When payments are made online, card details are collected by a gateway (akin to the physical card terminal), which can be an independent company or integrated with either the merchant acquirer / payment facilitator or the card network.

Visa Business Overview

Visa is a global payments network that facilitates the switching (authorisation, clearing and settlement) of card-based payment transactions between consumers, merchants, and their associated financial institutions (card issuer banks / merchant banks), while also providing associated value-added services. The network spans more than 200 countries/territories and involves more than 4.5b card credentials, 15k financial institutions, and 100m merchant locations. Its large scale means that Visa, in effect, earns a toll on global consumption.

All network participants adhere to Visa’s payment protocols, including payment dispute processes. The network's value to each participant grows as it expands, demonstrating strong network effects. Although Visa also operates a physical infrastructure network, the primary strength lies in its protocol network. Replicating the physical infrastructure would not easily persuade participants to switch to a different framework. This has resulted in a concentrated market structure, with Visa and Mastercard together accounting for approximately 75% of global card volume outside China, with Visa holding just under 50%. They are the only truly global payment networks.

Historically, competition between Visa and Mastercard has been directed towards issuing banks because merchants were incentivized to accept both forms of payment due to their scale. However, regulatory changes have required debit cards to allow routing over competing networks at merchants’ discretion, meaning a merchant may accept a Visa debit card but then choose not to route the payment through Visa’s network. Consequently, competition now also orientates towards larger merchant acquirers and merchants, as the networks encourage merchants to select their routing network (it is no longer a shared monopoly in acceptance).

Visa takes a small piece of every Visa-related transaction. This includes volume-based revenue (~12 basis points of card volume / $15b revenue), transaction-based revenue for switching services (~5.3 cents per transaction / $11b), transaction-based revenue for the provision of value-added services such issuer processing, gateways, and risk-based solutions (~2.2 cents / $5b), cross-border processing revenue and currency conversion (1%-1.5% / $12b)[3]. They also earn non-transaction-based value-added services and other revenue from things like consulting ($4b). These revenues are offset by a contra-revenue item called Client Incentives (~10 basis points / $12b), which are contractual discounts to various parties to win their business[4]. Issuers historically received most of the incentive payments but since the introduction of debit routing choice regulation, these incentives also flow to the large merchants and merchant acquirers (in fact, in debit, they now receive a greater share than the issuing banks[5]). Management doesn’t think about incentives as something distinct and manages the business for growth on a net basis. Visa’s share of the economics in the value-chain is a minority (7%-15% depending on offline/online, debit/credit, and what value-added services are used, representing 12-40bps of the payment volume). Despite taking a minority share, the limited capital required to operate the network, relative to its scale, means Visa earns very high returns on invested capital.

What infrastructure underpins a payments network?

A card network is physical communications network, for example, VisaNet is made up of state-of-the-art data centres connected through 1,600 secure network endpoints linked by 1.2 million miles of fibre-optic lines. Hence the use of the phrase "card rails" when referring to how payment communications occur. Like any communications network, card networks require speed and capacity to function with real-time services. The network connects all the parties involved in a transaction but also connects other networks to facilitate non-network and non-card-based payments.

Value-Added Services

Visa’s core network creates a privileged position to offer value-added services on top. Much of these are intrinsically linked to the core payments network (could not exist standalone), while others are more modular in nature and work across different card networks. Value-added services totalled $7.1b in FY2023, and they are growing around 20%. Roughly 2/3 is generated on a per transaction basis (included as part of Data Processing revenue), while the remainder is a mix of volume-based and consulting-based revenues. Over half of Visa’s clients use 5 or more services and about a third use 10 or more. Disappointingly, Visa does not provide great transparency here. The key areas include:

Acceptance Solutions

CyberSource is a major component and functions as a modular payment gateway with various additional merchant services, of which many overlap with other Visa offerings including risk analysis and token management. Click to Pay is another key acceptance solution and is essentially a wallet embedded into the checkout process that prevents the need for consumers to enter card details, creating a more secure and smoother checkout experience. It also allows things like biometric identification. Like CyberSource, it is modularised and works across networks.

Our channel checks on CyberSource suggest it is valued for its global capabilities with solid integrations and security offerings. Customers, however, commented on its cost and complexity. Further, there has been a rise in competition here from companies like Adyen who have strong relationships with merchants and alternative data security options.

Overall, we rate Visa’s acceptance solutions higher than Mastercard’s.

Risk and Identity Solutions

These solutions aim to reduce fraud and boost authorisation rates. Some solutions integrate closely with the payment network, like 3D Secure, adding extra authorisation steps for cardholders. Others use real-time data analysis with machine learning to inform payment authorisation (e.g. analysing location and spending patterns against past fraud).

Visa’s extensive global scale affords it a privileged data set here and as a result, these are some of the more defensible value-added services. That said, Visa’s data also has weaknesses. Visa does not see the itemised receipt, only the total amount. We also learned that Visa does not get visibility across issuing banks so cannot tell if the person using a card from one issuing bank is the same person using another card from a different issuing bank. Although Visa serves end consumers, it really is a B2B business since it only interfaces with financial institutions, which are protective of their customer relationships and data. We also learned that Visa wants to avoid data privacy obligations that would apply if they were in receipt of such data.

Another key offering, the Visa Token Service, creates unique digital tokens linked to card numbers for electronic wallets like Apple Pay and online payments. It also enables Visa Click to Pay. Token management services help payment facilitators manage token approval, storage, and deletion. Tokens, now exceeding 10b (compared to 4.5b card credentials), have grown rapidly since their introduction.

Visa has significant leverage in requiring merchants to utilise these yield-enhancing tools due to their control over network rules. For instance, if merchants do not implement card chips for card-present transactions or 3D Secure for card-not-present transactions, the liability for fraud shifts from the issuer to the merchant. Considering these risks, merchants are compelled to adopt these services. Such practices approach the threshold of anti-trust regulations.

Issuer Processing

Some issuing banks may find it challenging to handle their own processing and might choose to outsource these services to Visa, including dispute management and buy-now-pay-later options. In our conversations with a former lead executive from Visa's strategic initiatives team, it was noted that this area is not a major focus for the business and is seldom discussed in top management meetings.

Other

In addition, Visa also offers open banking and consulting/advisory services. Mastercard has historically had a much stronger consulting practice than Visa, though Visa has largely closed the gap.

New Flows

Visa's core business is consumer-to-merchant payments, a $50 trillion market by payment volume[6]. With this market maturing, Visa now targets $185 trillion of other payment types (“New Flows”), through Visa Direct, Visa Commercial Solutions, and Visa Cross-Border Solutions. However, their “right to win” is limited to certain areas, mostly where the existing business can be easily expanded. The strongest potential lies in the lower-value, higher-velocity payments (addressed by Visa Direct) and the expansion of commercial card payments (part of Commercial Solutions). Transparency on these New Flows is limited, but we estimate $4 billion in revenue for FY2023.

Visa Direct

Visa Direct repurposes the existing VisaNet debit network to push real-time payments to accounts linked with debit cards, like processing card refunds. It enables account-to-account transfers and business-to-consumer payments (e.g. insurance payouts), targeting $65 trillion in lower value, higher velocity payments. Visa has a “right to win” here as it is an extension of the existing network. Only Visa and Mastercard can do this on a global basis, and Visa Direct currently has a strong lead over Mastercard Send. Economically this is highly attractive as it is mostly incremental profit given the infrastructure is already in place with ample capacity. Visa Direct has grown significantly, achieving an annual run rate of 7.5 billion transactions (3.5% of total) and growing at 40%. Current economics match typical carded debit data processing yields, estimating a revenue of over $500m, which is minor now but could be significant in the future. Cross-border payments are a small part of Visa Direct today, but they have much greater economic potential, estimated to be 20-50 times higher than domestic transactions.

Visa Commercial Solutions

Visa Commercial Solutions includes commercial card payments (like single-use virtual cards), B2B Connect for high-value non-card cross-border payments, and AR/AP[7] related payments. While commercial cards are well-established (we estimate $3.5b in revenue for FY2023), single-use virtual cards are a newer and impactful addition. These virtual cards enhance control and tracking of payments, such as for employee travel expenses, and simplify reconciliation. This innovation is expected to drive further growth in commercial card usage.

We are less optimistic about Visa's role in non-carded commercial payments (in terms of including them in our base case underwriting). Visa lacks a competitive edge, especially in high-value domestic payments already well-served by real-time ACH networks, but it is also true for high-value cross border payments. B2B Connect is a direct end-to-end network that aims to remove the need for intermediary correspondent banks. As the B2B Connect network is still being built out, it currently does not serve all international payment corridors, even when supplementing its network with correspondent banks, which creates an adoption hurdle and slows the network expansion. AR/AP has some additional challenges as each geography (and even each industry) has different requirements. Evidence of progress is limited; our channels checks showed that B2B Connect and AR/AP solutions aren't gaining the expected traction. Bother Visa and Mastercard have progressively reduced their emphasis during earnings calls.

Visa's challenge in business payments is that it requires a different go-to-market approach. For instance, virtual cards cost more than ACH payments, requiring customer education to highlight operational savings despite higher costs. When selling to financial institutions, these products target the treasury function, or for B2B Connect the head of correspondent banking, distinct from Visa’s card-side relationships. B2B Connect is to be more integrated with Visa Direct, which should help from a cross-selling perspective as solutions can be bundled.

Mastercard has a stronger business at present in pure account-to-account. It has diverged from Visa in strategy with ownership of domestic real-time account-to-account payment infrastructure.

Visa Cross-Border Solutions

Visa Cross-Border Solutions offers treasury management services for global payments. A core element is Visa’s acquisition of Currencycloud, a cloud-based FX payments management system. It enables financial institutions to offer their clients FX solutions while taking care of the switching as well as the regulatory items such as opening foreign banks accounts, licensing, and KYC/AML requirements. It also provides real-time FX pricing (unlike traditional card or Swift payments), which reduces settlement risk and allows these institutions to offer tighter FX spreads. While a modular solution (i.e. Currencycloud can still utilise Swift or domestic payment networks), it provides a natural funnel for cross-border Visa Direct payments. Visa faces the same go-to-market challenges here as mentioned above – it is a different selling motion than their core business.

We have some concerns on cross-border payments in general because the economics on currency conversion are very steep. As solutions like Currencycloud makes it easier for financial institutions to offer a better cross-border experience, competition among these same institutions should drive these lucrative yields down, which potentially impacts Visa’s own FX-related revenues (i.e. its core International Transaction revenue as well as Visa Direct Cross border). This doesn’t mean it’s wrong for Visa to push this solution as if they don’t, someone else will. We simply question the long-term sustainability of FX transaction yields. However, these are unlikely to come under pressure in the medium-term and the growth potential in this area outweighs this risk for now.

Business Quality & Cost of Capital

Why do we like the business?

Clear superior value proposition, rivalled only by Mastercard

Visa has the largest global payment network. Relative to its only rival (Mastercard), it still has circa 30% more card credentials and 3x the number of financial institutions (similar country breadth, merchants, merchant locations, and pricing). The size of the network is a key part of the value proposition. Merchants want the most consumers and a cheap price, consumers want a payment method that will be accepted anywhere, issuing banks want a product that is easy to sell to consumers.

Other networks don't compare. For example, American Express is costly and lacks the same consumer scale, so it is not a “must have” for merchants. Domestic ACH networks are cheaper but inefficient for cross-border transactions and lack consumer safeguards. The value proposition isn’t just about money transfer; the protocol element of the network is also a key.

The strength of the value proposition extends to Visa Direct and those value-added services that are intrinsically linked to the payment network. While the value proposition is solid in other areas (e.g. acceptance solutions), they rank lower on our scale given higher competition.

Deep competitive moat rooted in 3-sided protocol network and enhanced by a strong brand

As explained above, the key power in Visa’s business is a global-scale 3-sided (consumers, merchants, financial institutions) protocol network. That is, the common framework that all parties have agreed to operate under. This is very difficult to replicate and has led to a global duopoly in carded payments. This is underpinned by a well-recognised and trusted global brand. Visa’s fortified position in consumer-to-merchant card payments affords it a strong competitive advantage to grow into other payment areas such as Visa Direct and commercial cards, as well as those value-added services that are intrinsically linked to these networks. While other areas of Visa’s value-added services have been modularising with narrower moats, the power of the core network is very likely to endure.

Long-duration growth runway with high returns on invested capital

Our base case has Visa’s revenue growing at high single-digits with a long duration. Visa’s core baseline volume growth is driven by cardable personal consumption expenditure, which we assume is ~5% on a nominal basis over the long-term. Cash/check transactions still represent about 25% globally (ex-China). Most studies we have seen include ATM transactions (leading to higher current cash levels and therefore more opportunity), however, we exclude them because it double counts the cash transaction (once withdrawing the money and once spending the money). Visa and Mastercard have just over 75% combined market share of carded transactions. If cash/check declines to ~15% share, and the combined Visa-Mastercard share rises to ~80%, then the implied Visa-Mastercard volume growth is high-single digits. We think this is very reasonable.

There are a few tailwinds and headwinds for how this translates into revenue growth, though quantifying the impact is difficult:

• Transaction Size: Most of the remaining cash opportunity is in smaller transaction sizes. Electronic wallets and contactless payments are helping accelerate the use of cards for smaller payments (though COVID brought a lot of this forward already). As such, growth in Visa-processed transactions and revenue should marginally outpace volume growth.
• eCommerce: For online transactions, Visa can earn yields up to 3x offline. This is a combination of higher merchant discount rates (more to share between participants) and the additional value-added services, particularly relating to fraud detection. Online should outpace offline as eCommerce continues to take share over the long-term.
• Cross-Border: While not present in the data yet, in the longer-term we would not be surprised to see compression in cross-border economics for the reasons already discussed above.

Value-added services have been growing consistently at levels close to 20%. Given the strength of these offerings (discussed above) and Visa’s ability to force adoption in certain areas, we think this success will continue. This has a positive impact on data processing yields/pricing. Non-transaction-based value-added services are also a meaningful growth driver.  Overall, value-added services add 200-300bps to growth.

Success in addressing New Flows can create upside to both the level and duration of growth. Our base case assumes continued success in Visa Direct and commercial cards, but no contribution from other areas like B2B Connect or Visa Cross Border Solutions. This adds just over 50-100bps annually to the growth in Visa-processed transactions, with the contribution growing as scale is achieved.

Operating income growth is slightly higher than revenue given modest margin expansion. Visa has a good record of controlling expense growth and aims for it to lag net revenue growth. We think this is very achievable given the capacity available in the network and with Visa Direct adding minimal marginal costs. Said differently, economies of scale remain.

Key Risks

Execution in new growth areas

Continued success in value-added services and New Flows is critical to Visa’s growth runway. Our base case only underwrites the areas where we think Visa has a “right to win” stemming from the advantages afforded by the core business (i.e. those areas built on the core network or directly tied to the core network).

The key residual risk is execution. The organisation structure was altered to promote these two areas with their own leads reporting into the CEO (Antony Cahill in valued-added services and Chris Newkirk in New Flows), each with their own management teams. However, this separation also presents some challenges for cross-sell motions, where the teams must work together (e.g. bundling value-added services into Visa Direct). In addition, the modularisation of solutions can also create organizational and execution challenges. We mentioned above that CyberSource overlaps with other Visa risk solutions — this can create a confused and/or competing selling motion not necessarily aligned to the whole.

Another key execution challenge is that B2B payments requires different disbursement and acceptance endpoints than the core network. For example, to expand virtual cards, acceptance by businesses in their finance functions is required. For B2B Connect it involves selling to a banks head of correspondent banking. For AR/AP and Currencycloud it involves selling to the treasury function. This all requires a different go-to-market motion than the consumer-to-merchant business. Visa recognises this and you can see this in their hiring and in management commentary.

Regulation

Visa’s dominant position makes it vulnerable to regulation. There have been various iterations of regulation over the years including interchange fee caps, debit routing choice, potential credit routing choice, open banking etc. Visa also faces a new DoJ lawsuit regarding its practices in the US debit market. Interchange fee caps regulate the maximum fee that can be paid to issuing banks. These have had little impact on card network fees in most jurisdictions where they have been implemented. The networks continued to push net yields higher either through price hikes or the introduction of value-added services, some of which are forced on the ecosystem. Debit routing choice regulations ensure merchants can route payments over alternative networks. Similar credit routing regulation may come into effect[8]. In practice, this too has had little impact. Given volume-based pricing, there is little incentive for merchants to route payments over alternative networks. Visa/Mastercard cemented this with some potentially anti-competitive practices that further incentivised the ecosystem to route payments over their own networks[9]. This is part of the current DoJ lawsuit. The other component of the lawsuit alleges that Visa illegally uses its monopoly position to disincentivise companies like Apple and PayPal from building their own alternative networks and creates incentives for them to not promote alternatives like ACH. We think this is a stretch by the DoJ. We don’t think Apple is interested in building their own network while PayPal has been trying despite any incentives.

The problem with all the regulation to date is that the market is a natural duopoly, perhaps even a natural monopoly[10]. A larger network is good for all network participants…bigger is better. Most importantly, this is true for the consumer, whom anti-trust regulation seeks to protect most. As such, the regulator can (and should) promote competition and stop the networks using their dominance to foreclose other markets (through contracts, payments, or the like), but the core card payments market will still gravitate towards a concentrated duopoly, with market power maintained. Because bigger is better here, the regulator should not be focused on making the networks smaller or forcing inferior networks on consumer. The only real way to prevent consumer harm is to also directly regulate network pricing and render them public utilities. However, this is not possible under US anti-trust doctrine. We don’t dismiss the latest DoJ lawsuit as trivial, but we don’t see a large long-term impact given this and because some elements of the lawsuit, like volume-based pricing, do not appear anti-competitive to us. There is potential for some debit share loss in the US, but the networks can push pricing whether directly or through linked value-added services. For example, Visa currently doesn’t charge alternative networks for some of the services it provides in their own transactions (e.g. de-tokenising credentials for them), but this could change.

Wallets

As contactless payments have grown, so too have payments with phone or watch wallets with Apple Pay or Google Pay (and also PayPal online). While the networks still earn network fees on such transactions, after all they are still routed over their networks in most cases, the large consumer aggregation and power of these companies mean they also take a piece of the merchant discount rate. At present, we believe this comes out of the interchange fee, but it still represents an overall shift in power, albeit a manageable one.

Compression in FX margins

We discussed above the potential compression in long-term FX margins as more innovation occurs in that area. However, we don’t see this has happening in the next 5-7 years. There is also more potential for volume growth here than the risk of price compression.

Domestic real-time payment networks

Government-backed domestic real-time payments networks are being built around the world. For example, the US launched FedNow in 2023. This is an improvement over the ACH network but also comes at a higher cost. The problem with such networks is that they fail to address one of Visa/Mastercard’s core value propositions, which is to set the rules for dispute processes in transactions thereby creating trust in the process. These networks also do not solve the cross-border element required in a global system. As such, we think these make it harder for Visa or Mastercard to attack various domestic payment opportunities like AR/AP but they are unlikely to supplant their core businesses.

Crypto

Crypto currency has a strong value proposition, but, as for RTP networks, it does not solve the requirement for trust in the process with consumer protection mechanisms. There are also challenges for governments who want to maintain control of their currencies for monetary policy and legal reasons. That said, the space is evolving and interest in central bank controlled digital currency is increasing. This remains a known unknown.

Valuation

Our valuation summary is shown below. As of 11 October 2024 ($278), our IRRs going forward in our downside, base, and upside case are 1%, +10.5%, and +17% respectively[11]. We compare this range to our cost of capital for a business of this quality[12] and assign a valuation score of 1 out of 3. On a base case, Visa trades around fair value currently. However, relative to other positions, we see Visa as having very strong downside protection.

We discussed many of our assumptions above so won’t repeat them here. In brief, we think there is a continued opportunity for cards to take share from cash/check, though this has limited duration given the already high penetration. Visa and Mastercard should do slightly better as they continue to take marginal share from smaller networks (albeit with some headwinds from regulatory actions). Continued success in value-added services helps add to the growth level and duration, particularly those directly tied to the payment transaction. These help to win volume and to expand net yields as more value-added services are adopted. Without them, pricing growth would be limited and may even face negative pressure. New Flows in Visa Direct and virtual commercial cards create both higher volume and transaction growth. Given the economies of scale and capacity available in the network, expenses should grow slower than net revenue leading to modest margin expansion. Our downside, base, and upside cases look at different scenarios in each.

Our 5-year exit multiple is a 4.5% forward free cash flow yield in the base case (22x FCF), which represents an expansion in the yield (multiple compression) from current levels of 3.5%. This is based on the quality and growth potential (level and duration) at exit[13]. The higher exit yield is warranted given the maturing core business.

Experts Consulted in our Diligence

We often get asked how we find the right experts for our diligence. We thought we would answer this using Visa as an example. Our broader research process is detailed here.

First, we identify profiles of experts who can answer the critical questions. It is important to not simply rely on who is available. We source experts through personal networks as well as expert network firms with strict screening criteria. Experts come from various segments such as customers, employees, suppliers, competitors, and consultants. We are pleased with the calibre of experts we access. For Visa, examples include the Head of Visa Direct in Europe, the Head of Global Solutions, the co-founder of Currencycloud, the Head of Strategic Initiatives in Europe, and the B2B Connect Implementation lead. We adhere to strict compliance protocols to avoid any material non-public information.

Business Update

Although the strategy has been running for almost 6 years, Kalakau Avenue the business had its first birthday in September. It has been a blast!

Matthew Brown

Founder & Chief Investment Officer

Footnotes

[1] The networks talk a lot about their services modularising, but the reality isn’t so. Much of the services are one and the same with the payment network/transaction. They are modular in the sense that clients can choose whether to buy them as an added service but much of these could not exist as a standalone business. If you are unfamiliar with what modularisation means, see here.

[2] Probably the best example of a next-gen, enterprise-focused, integrated merchant-acquirer / point-of-sale solution

[3] We adjust reported numbers to separate out Value-Added Services

[4] Some would argue that these should be called Client Disincentives as they often represent the removal of punitive fees if the issuers/merchants route over their own networks in debit, the topic of the recent DoJ lawsuit. That is, they disincentivise competition.

[5] According to the Fed, “Issuers received 39.4 percent of [debit incentives] in 2021; acquirers/merchants received the rest. After Regulation II took effect, the share received by issuers progressively decreased from its peak of 74.5 percent in 2011 to its 2021 value. By contrast, the share received by acquirers/merchants correspondingly increased, and they have received the majority of [debit incentives] since 2019.”

[6] Including cash, check, and potentially cardable ACH payments

[7] Accounts receivable, accounts payable

[8] A bill has been proposed in the US but so far has not gotten traction

[9] Alleged examples include having contractual exclusivity for certain authorisation mechanisms (e.g. signature vs PIN), liability shifting from issuer to merchant if network owned (and therefore routed) security measures are not used, volume assessment fees, controlling what merchants can send to an issuer for authorisation of payment (i.e. making payments routed over competing networks less likely to be authorised), hurdles to de-tokenize credentials for alternative networks, tying credit card contracts to the level of debit volume etc.

[10] A natural monopoly is one where the market is best served by a single player. In contrast, most monopolies are inefficient for society.

[11] Refer to our disclaimers, we make no guarantees of future performance, and our projections should not be relied upon

[12] Our cost of capital is the Longer-Term Cash Rate + 8% for a business quality score of 3. This gives us a cost of capital of 11%.

[13] We sometimes get asked why we don’t use a DCF method. Our method is mathematically equivalent…an exit FCF yield is the inverse of (1+g)/(r-g).