An Industry in Which All Companies Make Huge Profits

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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 (NYSE: V), Mastercard (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's logo appears on 63% of all credit cards in the world, while MasterCard's share is 31%. Discover 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, MasterCard, and Discover 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, MasterCard, and Discover 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 is similar to Visa, 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 is the odd one out. The company is primarily a credit card issuer -- and is a distant second to American Express in this market. But the company also operates a global payment processing division that includes its Pulse network.

Although Discover is far behind MasterCard and Visa, 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, MasterCard, 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.

Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends 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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