A Stellar Quarter if You Ignore the Missing $1 Billion

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I hate it when $1 billion goes missing don’t you? Much to my surprise, in Visa’s (NYSE: V) most recent earnings, the company reported stellar growth by nearly every metric investors could ask for. Between strong growth, and a new multibillion-dollar stock repurchase program, the market reacted positively to the company’s earnings. However, the company’s outlook leaves a rather large question unanswered, and if I were an investor I would be more concerned with what the future holds than what happened in the last three months.

The Quarter That Was
I would have to be crazy to question Visa’s excellent performance over the last few months. The company reported 20% earnings growth, which is better than MasterCard's (NYSE: MA) last quarter increase of 16%. This performance also places Visa significantly ahead of American Express (NYSE: AXP) and Discover Financial Services (NYSE: DFS), which reported earnings growth of 10% and 2% respectively.

To say that Visa is capitalizing on the move towards more electronic transactions would be an understatement. The entire industry should benefit from this continued trend, but Visa significantly improved their processed transactions on a quarter to quarter basis. Last quarter, Visa reported a processed transaction increase of 6%, which was half of MasterCard’s increase of 12%, and less than the increase American Express reported of 7%.

Considering that last quarter Visa only beat Discover's 1% increase in processed transactions, some investors might have questioned if the company was falling behind. Those fears should be laid to rest, as this quarter Visa reported total process transactions jumped 14%.

Another way that Visa has consistently led its peers is by reporting a higher operating margin, and this trend continued into the current quarter. Visa’s operating margin came in at 60.91%, and the only competitor to get close to this number was MasterCard at 58.08%. While Discover carries a decent operating margin of 52.05%, American Express doesn’t come close to its peers with a margin of under 28%.

Visa’s widely reported new share repurchase authorization should continue the company’s commitment to returning value to shareholders through decreasing the company’s diluted share count. That being said, two of Visa’s peers have actually retired a greater percentage of their shares on a year-over-year basis. Leading the way is Discover with a diluted share decline of 6%, followed by American Express with a 5% decline. Visa’s share buybacks have decreased the company’s diluted share count by 3.45%, which is slightly better than MasterCard’s decline of 3.15%.

However, if you look at Visa’s performance overall, it’s hard to quibble over the company’s share repurchase program. Most investors would be more than happy to trade a percentage point of share count for strong current earnings growth, transaction growth, and class-leading expected earnings growth as well.

A One With Nine Zeros Behind It
I sometimes worry that investors don’t read earnings reports carefully enough. What’s amazing is some companies don’t even say anything is wrong, but traders read between the lines, sell the stock, and ask questions later. In Visa’s case, the company clearly stated that their free cash flow could be significantly different between 2013 and 2014, and yet the stock is up.

Visa is fairly specific about their expectations for 2013, in that the company is calling for “low 20s” diluted EPS growth and “about $6 billion in annual free cash flow.” The company is equally specific about expectations for 2014, calling for “mid to high teens earnings growth" and “about $5 billion in annual free cash flow.” Does anyone other than me notice the fact that the company is calling for a full $1 billion drop in annual free cash flow between 2013 and 2014?

Given that Visa is experiencing strong earnings growth, and expects this to continue into next year, what could be the cause of this $1 billion decline? Even more important, in the last nine months Visa spent $4.7 billion on share repurchases in dividends. One has to wonder how the company could continue spending this amount if a projected $3.75 billion would be available in free cash flow. If these assumptions are accurate, something is going to have to give, and it seems more than likely that share repurchases would have to be curtailed.

Long-term investors should be asking the question, what will Visa spend this $1 billion on instead of share repurchases and dividends? If the company wisely spends these funds on future expansion that’s one thing, but if the company is just going to generate less free cash flow, that’s another story altogether. In fact, I wonder if the stock should be charging ahead given this worrisome outlook.

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Chad Henage has no position in any stocks mentioned. The Motley Fool recommends American Express, MasterCard, and Visa. The Motley Fool owns shares of MasterCard. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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