Why The New Rules Won't Actually Demolish Visa

Investors are now becoming familiar with the story of Master Card (NYSE: MA) and Visa (NYSE: V) being pummelled by the Fed’s proposal to cut interchange rate drastically for debit cards.

To recap, Federal Reserve on December 16 announced the proposal to place a cap on the interchange fees banks allowed to charge merchants to 12 cents per transaction, a limit that could cut up to 90% of the current revenue of such transactions.

In addition, the proposal would require merchants having the choice of unrelated networks to process transactions, i.e. networks besides VISA and MasterCard.

Banks were the primary losers in this case, but the payment network giants, VISA and MasterCard, also fell into casualties. Prior to the announcement date, they already started to drop: VISA dropped ~5%, and MasterCard dropped ~2%. On the announcement date, VISA dropped additional ~15% while MasterCard dropped ~10%. Fearing the gun is going to turn to credit card processing as well, American Express also dropped ~10% since the announcement.

While the cap on interchange rate, and allowing merchants to have the choice of payment processing network can certainly hurt VISA and MasterCard, we think the market has reacted a little too much. After the drop, we have become bullish on VISA considering that:

  • This is still a proposal. The final outcome could be different.
  • VISA has strong growth in international markets, particularly in emerging markets.
  • Payment options are increasingly moving towards electronic processing, including social security and other federal benefits.
  • VISA has a strong balance sheet. The large drop in price has provided downside support.
  • It will take time for other payment networks to catch up to challenge VISA and MasterCard, and these giants will not sit idle waiting to be slaughtered.

Stock prices of MasterCard and VISA have stabilised after their drops, with VISA trading at ~$68/share now. For people who believe that VISA now offers limited downside and potential upside, there are many ways to trade the stock. A few of them are:

  1. Buy the stock, waiting for the stock to go up.
  2. Buy call options on the stock to lower capital cost and capture more upside if the stock rebounds.
  3. Write put options and buys the stock only if it drops further. In essence, committed to buying the stock at a lower price, or just collecting the premium if the stock trades up.

In our case, we choose a mix of (2) and (3) to go long the stock. In choosing the time frame for the options, we don’t think VISA will have any sudden pop unless the Feds suddenly reverse their proposal. A more likely scenario, we believe, is that as final outcome becomes clearer, the market will digest the news and realises that VISA still offers substantial value, or the proposal gets shaped into a less drastic change. Therefore, we want to choose a longer time frame for the options. We also do not want to buy too out-of-money, but something around the trading range before the huge drop, so just a trade back to the price level before the large drop would be sufficient for us. To achieve this, we bought a Jan 2012 75 call option for $5.85.

$5.85 for a $75 call is not a light premium, and it implies a break-even point at $80.85. At the same time, we feel that VISA has limited downside if it drops below $60, and we are willing to hold the stock for long term investment at that price. Therefore, we wrote a Jan 2012 55 put for $3.57. With this long call and short put strategy, we will now:

  • break even at $77.28.
  • lose up to $2.28 if VISA trades between $55 and $77.28
  • committed to buying the stock if it drops below $55/share, and assumes the cost of $57.28/share.
  • committed to any margin requirement necessary to maintain the trade.

While this strategy may seem complicated, it boils down to funding a call option with a put option, and committing to buying the stock if it drops below a certain price. The trade may or may not pan out, but it illustrates a way to go long on a stock other than just buying the stock outright.

* Another fallout from this proposal is that retailers should get a boost from this. In the case they don’t pass along the reduction in bank fees to them, their margin just went up without doing a thing. Of course, if they start lowering their prices for consumer, the Feds can yell ‘Deflation!’, and just gets another pass to print more money (uh, I mean, purchasing treasury securities).

Daniel Ho is the founder of 10xreturn.com, a financial portal providing financial information and market statistics for investment professionals.

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