MA

Mastercard Inc. 10-Q Summary: Period Ended September 30, 2005

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 2005, and the nine months ended on that date. Mastercard Inc. provides transaction processing and related services for credit, debit, electronic cash, and ATM payment programs. The company is currently executing a plan to transition from a privately held entity owned by financial institutions to a publicly traded company. This involves a proposed Initial Public Offering (IPO), the establishment of a charitable foundation (The MasterCard Foundation), and a new governance structure with a majority of independent directors. A special meeting of stockholders is scheduled for November 28, 2005, to approve these changes.

Key Financial Metrics

Note: All figures in millions unless otherwise noted. Data derived from unaudited consolidated financial statements.

Material Changes vs. Prior Period

• Revenue Growth: Net revenues increased 18.6% for the quarter and 16.3% for the nine-month period compared to 2004. This growth was driven by a 14% increase in Gross Dollar Volume (GDV), higher transaction counts, and pricing changes implemented in Q2 2005.
• Operating Expenses: Total operating expenses rose 24.3% for the quarter and 12.1% for the nine months. A significant portion of this increase was due to a $48.2 million legal settlement reserve recorded in September 2005 related to currency conversion litigation. Excluding legal settlements, operating expenses increased 18% and 10% respectively.
• Net Income: Net income increased 8.2% for the quarter and 35.0% for the nine months. The nine-month increase was bolstered by a $17.5 million gain from the settlement of a customer business agreement.
• Legal Reserves: The company recorded an additional $48.2 million in legal reserves in September 2005, bringing total reserves for currency conversion cases to $62.3 million.
• Accounting Change: A catch-up adjustment of $19.1 million (pre-tax) was recorded in Q3 2005 due to a change in the methodology for recognizing costs associated with Executive Incentive Plans.

Guidance, Outlook, and Risks

• Proposed IPO and Governance: Mastercard intends to use the majority of net proceeds from the proposed IPO to redeem shares from existing financial institution stockholders. Approximately $650 million of proceeds will be retained for capital expansion and legal defense. The company expects to record a significant net loss in the quarter the offering is completed due to the donation of 10% of equity to The MasterCard Foundation.
• Legal and Regulatory Risks: The company faces significant litigation risks, including:
  • Currency Conversion Litigation: Ongoing class actions in the U.S. and state courts regarding a 1% currency conversion fee. A $48.2 million reserve was added in Q3 2005.
  • Interchange Fee Challenges: Regulatory scrutiny and litigation regarding Multilateral Interchange Fees (MIF) in the European Union, United Kingdom, and other jurisdictions. The UK Office of Fair Trading (OFT) recently ruled that UK MIFs contravene competition law, though no penalties were imposed initially.
  • Antitrust Litigation: Ongoing proceedings involving the Department of Justice, Discover Financial Services, and American Express regarding governance structures and "Honor All Cards" rules.
• Settlement Risk: Mastercard guarantees payment for transactions in the event of member failure. As of September 30, 2005, the net uncollateralized settlement exposure was approximately $13.1 billion. The proposed governance changes may require the company to reassess the fair value of these guarantees.
• Market Risk: The company is exposed to foreign exchange fluctuations, particularly the Euro, which impacts the translation of European operating results. The devaluation of the U.S. dollar contributed to revenue growth in the reported periods.

Key Facts for Investor Verification

• Legal Reserve Adequacy: Verify the sufficiency of the $62.3 million reserve for currency conversion litigation, as the company notes this estimate may be revised based on future developments.
• IPO Impact on Earnings: Confirm the expected timing and magnitude of the non-cash expense related to the donation of 10% equity to The MasterCard Foundation, which will significantly impact the effective tax rate and net income in the quarter of the IPO.
• Regulatory Outcomes in Europe: Monitor the outcome of the European Commission's sector inquiry and the UK OFT's decision on interchange fees, as adverse rulings could materially impact revenue models in key markets.
• Settlement Exposure: Review the $13.1 billion net uncollateralized settlement exposure and the company's ability to assess members for losses under the new governance structure.
• Rebate Trends: Assess the trend of rebates and incentives, which increased to 20% of gross revenues in Q3 2005 (from 17% in 2004), potentially moderating future net revenue growth.