In a world regulatory framework designed to maximize competition among firms, it is a wonder that any company earns outsized profits. However, some industries are suited to allow a handful of companies to dominate without fear of new entrants breaking up the party.
Global card payment processing companies, like Visa Inc (NYSE:V), Mastercard Inc (NYSE:MA), and Discover Financial Services (NYSE:DFS), are one group that enjoys this advantage.
Barriers to entry
Each of the three companies has a global network that would be expensive and time-consuming to replicate. The networks are composed of countless financial institutions, merchants, and cardholders. Visa Inc (NYSE:V)’s logo appears on 63% of all credit cards in the world, while Mastercard Inc (NYSE:MA)’s share is 31%. Discover Financial Services (NYSE:DFS) is quite a bit smaller than the other two.
Each of the three benefits from the tendency of consumers and merchants to use trusted names with large user bases. Trusted brands are important for emerging economies, where fraud is more rampant than in developed economies.
But the real barrier to entry is in the Catch-22 where merchants want a wide customer base and customers want wide merchant acceptance. Visa Inc (NYSE:V), Mastercard Inc (NYSE:MA), and Discover Financial Services (NYSE:DFS) have each made it past the invisible tipping point where the merchant networks are large enough to attract customers and the customer networks are large enough to attract merchants. The difficulty of overcoming this paradox is why Visa Inc (NYSE:V), Mastercard Inc (NYSE:MA), and Discover Financial Services (NYSE:DFS) will be able to earn high and stable profits for years to come.
Differences among the three
Despite enjoying the benefits of oligopoly, each of the three companies is different in important ways. For instance, Visa does not lend to cardholders; it is simply a fee-based business model. This shields the company from the deterioration of consumer credit profiles that occurs with every major economic slowdown.
Mastercard Inc (NYSE:MA) is similar to Visa Inc (NYSE:V), except that its market share is significantly smaller by comparison. In addition, MasterCard and Visa’s enormous lead in the market opens them up to periodic antitrust lawsuits that pose billions in potential liabilities. However, it is unlikely that any governmental action will break up the cabal any time soon.
Of the three, Discover Financial Services (NYSE:DFS) is the odd one out. The company is primarily a credit card issuer — and is a distant second to American Express Company (NYSE:AXP) in this market. But the company also operates a global payment processing division that includes its Pulse network.
Although Discover Financial Services (NYSE:DFS) is far behind MasterCard and Visa Inc (NYSE:V), its merchant acceptance level is starting to increase as its brand becomes better-known among consumers. In addition, the company acquired Diners Club International — which operates a global network — as parts of an international expansion plan. The acquisition enabled the company to overcome the catch-22 that makes market entry nearly impossible.
As a result of its small but growing presence, Discover may be a good acquisition target for MasterCard — which is desperate to gain ground on Visa.
Bottom line
Visa Inc (NYSE:V), Mastercard Inc (NYSE:MA), and Discover enjoy the advantages of barriers to entry. The paradox of organic growth — that a large number of merchants is required to attract consumers, and vice versa — makes it nearly impossible for a latecomer to build a global network from the ground up. The only practical way to enter the market is to acquire an existing network, as Discover did in its acquisition of Diners Club.
As a result, each of the three companies will likely earn outsized profits for years to come. Any company that has structurally-protected profits is likely a good long-term investment, even if the price seems a little high today. Over the long run, the value creation will be so much greater than the average company that paying a small premium to the market will hardly make a difference.
The article An Industry in Which All Companies Make Huge Profits originally appeared on Fool.com and is written by Ted Cooper.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends MasterCard and Visa. The Motley Fool owns shares of MasterCard. Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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