The legendary investor Warren Buffett favors companies that he likens to operators of an unregulated toll bridge -- they display some characteristics of an oligopoly and thus have relative freedom to raise prices and earn superior profits.

As we see it, in the business of processing credit-card transactions, MasterCard (market capitalization: about $36 billion) and Visa (market capitalization: about $64 billion) come to mind as examples of highly successful toll-bridge operators. They qualify for these three reasons:

*  They have little competition -- only two competitors, American Express and Discover. According to JPMorgan Chase and the trade publication The Nilson Report, Visa has a 52% market share; MasterCard, 28%; American Express, 17%; and Discover, 4%. However, MasterCard and Visa have a unique competitive advantage: unlike American Express and Discover, they assume no credit risk. If an American Express cardholder, for instance, fails to pay his account balance, American Express is on the hook. In contrast, if the holder of a MasterCard or a Visa card becomes a deadbeat, it’s the credit-card issuer -- typically a bank or other financial institution like Citi, Bank of America, and Capital One -- that absorbs the loss, not MasterCard or Visa.

Defaults: what, me worry?

Your average consumer tends to think of MasterCard and Visa as credit-card companies because he sees their logos on the cards. But actually MasterCard and Visa serve as transaction-processing companies for the cards: they collect a fee by electronically coordinating consumers’ credit and debit transactions between the merchants and the card issuers. Although MasterCard and Visa gain no interest and monthly charges on card balances (those payments go to the card issuers), they also are completely unexposed to any account defaults from the hundreds of millions of MasterCard and Visa cardholders worldwide. As a result one Wall Street analyst with a fondness for metaphors called MasterCard and Visa "islands of growth in a sea of credit risk."

In that sea, credit-card delinquencies are rising, and profits at the credit-card units of the issuers are falling sharply. In an effort to prevent further damage to their income statements and tighten credit, the issuers are lowering the credit limits of some cardholders, setting aside more money for expected loan losses, hiking interest rates on the cards, and rejecting more card applicants.

*  Reflecting the lack of competition and the benefits of the scale of their operations, MasterCard and Visa generate profit margins that are among the highest in financial services, exceeding 30%. We estimate that both MasterCard and Visa can increase their earnings per share by at least 20% annually over the next two years and sustain high profit margins.

*  Their business has high barriers to entry. Indeed, it would take a deep-pocketed company to build their own toll bridges -- transaction-processing networks -- large enough and sophisticated enough to represent a serious competitive threat to MasterCard and Visa. Scale is all-important in this business: the fixed costs to operate transaction-processing networks are high, but once the volume of credit-card transactions and fees reach a certain critical mass, the revenue goes directly to MasterCard and Visa’s bottom lines.

The weighted average processing fee on credit-card purchases is 1.85%, according to The Nilson Report. MasterCard and Visa get just a fraction of that fee, about 17 cents per transaction. (Most of the fee goes to the card issuer.) That 17 cents per transaction really adds up: MasterCard and Visa’s piece of the action -- more than $10 billion currently -- makes for a great growth business, in our view.

We think it may continue to prove a great growth business going forward mainly because it capitalizes on the increasing preference of consumers around the world to buy all manner of goods and services with plastic rather than with cash or a check. The number of credit-card transactions is growing 10-12% annually and the number of debit-card transactions is growing at a slightly higher rate, according to Keefe, Bruyette & Woods, a financial-services firm.

Even in the U.S., the most mature credit-card market, the trend in transactions is up. Credit-card and debit-card transactions domestically account for more than 40% of all retail purchases, compared with 25% in 2000, according to The Nilson Report and JPMorgan Chase. Projections are that credit and debit cards will be used for 56% of all such transactions by 2010. The growth rate in the volume of credit-card transactions has been twice that of personal consumption in this decade, JPMorgan Chase estimates.

Our contacts in the industry point out a revealing phenomenon: when the domestic economy slows, as is the case now, consumers may not necessarily increase their spending much, if at all, but they nevertheless use their credit cards more frequently to do that spending, generating more fees in turn for MasterCard and Visa.

The number of transactions is rising at least partly because budget-stretched consumers of average means, in the struggle to live from paycheck to paycheck, are charging more of the basic necessities such as utilities, insurance, mortgages, and rents on credit cards. At the other end of the income spectrum, the more than 3 million consumers who are millionaires in the U.S. are striving to keep up with the Gateses and earn reward points for additional purchases or cash by charging big-ticket items like Cartier jewelry and even paying their income taxes on credit cards.

Charge!

Overall, credit cards have become so deeply ingrained in the woodwork of American shopping habits that consumers, be they rich or poor, hardly think twice about using them to make purchases as small as $5 for a half-gallon of fudge ripple ice cream at a convenience store. Visa reports that its volume of purchases under $25 is increasing at a double-digit annual rate and that its second-largest merchant today is not Neiman Marcus, L. L. Bean, Macy’s, or some other traditional merchandiser but fast-food titan McDonald’s. And according to MasterCard, the number of credit-card purchases of less than $5 (or "micropurchases," in industry jargon) totaled 350 billion last year, and the company expects them to rise steadily going forward.

Consumers elsewhere are developing cases of creditcarditis chronicus as well. In fact, senior managers at MasterCard and Visa think their companies’ greatest growth prospects lie outside the U.S., especially in developing nations like Brazil, India, and China. The highest growth rates in credit-card use, JPMorgan Chase research indicates, are in Latin America, the Middle East, Asia, and Europe, in descending order. Latin America’s growth rate is 27%, compared with 13% in the U.S.

With affluence escalating in developing nations, a vast new customer base for credit cards is materializing. Asia alone is home to nearly one-third of the world’s millionaires, with their wealth expected to grow 8.5% a year between now and 2011, according to Merrill Lynch and consulting firm Capgemini. For instance, MasterCard projections are that China will have 75 million credit cards by 2010, up from 3 million in 2005.

Traffic should grow

In all, we think global traffic on MasterCard and Visa’s toll bridges should grow for years to come. But we think two speed bumps, now small, could become more prominent on those bridges to impair the two companies’ fundamentals:

One, a growing convoy of lawsuits by merchants and federal legislation such as the Credit Card Fee Act is bearing down on MasterCard and Visa, with the intent to regulate or lower the credit-card fees charged to retail businesses. Most companies worry about your basic run-of-the-mill business risks like economic downturns, formidable competitors, the loss of major customers, and staying solvent. But tellingly, MasterCard and Visa are more concerned about the legal and regulatory risks they face and highlight those risks at great length in their Securities and Exchange Commission filings. For instance, they are wary of complaints by litigation-minded lawyers and publicity-minded Congressmen that many small retailers are paying more in credit-card fees than they earn in profits.

Two, MasterCard and Visa may find it harder to dominate the retail e-commerce market to the same degree that they have their traditional retail markets. We estimate that retail e-commerce is settling into a nice, sustainable growth rate of 12-14% annually, down from 35% in 2004. Among the companies with designs on that market: PayPal, which already has a 25% share of transaction processing online, and Google, which has introduced an electronic payment service and a no-fee credit card.

Visa IPO sets record

However, we don’t anticipate that either speed bump is likely to significantly impede MasterCard and Visa’s ability to keep growing at an above-average rate in the near term. Wall Street doesn’t think so, either, if the soaring prices and high valuations accorded lately to MasterCard and Visa shares are any criteria. Both MasterCard and Visa are relatively new public companies. MasterCard went public in 2006; Visa, this year. Visa’s initial public offering raised $19.7 billion, a record that surpassed the previous largest IPO, the $10.6 billion AT&T Wireless deal in 2000.

Of the two companies, Visa is bigger -- the biggest transaction processor in the credit-card business, handling at least 40% more transactions than its three rivals do combined. We calculate that Visa’s revenue may exceed $7 billion this year, compared with revenue of about $5 billion for MasterCard. In our estimation, both companies may process more than 77 billion credit-card transactions worldwide this year, or about 2,437 transactions every second.

That’s heavy traffic, but we think Visa and MasterCard’s toll bridges should be able to efficiently -- and profitably -- accommodate it.