Today I want to take a short detour off of the usual mission of finding Magic Formula® Investing's best stocks. For some time now, we have offered our own set of similar screens. For the most part, our method has correlated well with the official list. But, due to many potential factors (calculation differences, categorization of certain financials, treatment of foreign stocks, etc.), the screens do bring up different stocks too.
One such stock looks particularly interesting and I wanted to bring it to MFI investors' attention in this article. The stock is Western Union (WU).
Western Union runs a very simple-to-understand business. The company provides money transfer services through a global network of about 510,000 agents in more than 200 countries and territories. The sender goes to a Western Union agent (be it a partner bank, 3rd party retail location like Wal-Mart, online, whatever) and chooses the receiving agent and amount to send money to. The recipient then goes to the receiving agent, provides some simple information about the sender, and receives the money, often in cash. Western Union collects a fee from the sender (75% of company revenues), and an additional fee if currency exchange is necessary (23%).
The majority of Western Union's transactions are from immigrants in developed countries sending back money to relatives in their home country, and are often non-discretionary for their families. Consider that transfer flows to low-income countries are nearly 6% of their collective GDP, and over 10% in countries like El Salvador and Haiti! Services provided by firms like Western Union are extremely important, and should only grow in volume as immigration to developed countries like the U.S. shows no signs of slowing.
It's also an excellent business model. Costs are scalable by transaction volume - WU's operating margin has remained right around 25% since going public in 2006 - even through the massive 2008-09 recession. Capital costs are low as there is very little equipment involved in the business, and adding new agents costs no more than setting up an agent account and sending them a Western Union sign. As a result, WU generates voluminous and stable free cash flows - about 20% of revenues consistently over the past 5 years.
Also, let's consider the firm's strong competitive advantages. WU is by far the largest transfer company in the world, with 20% market share and about twice as many agents as its only real competitor - MoneyGram (MGI). This allows a significant scale advantage, with WU's 25% operating margin dwarfing MGI's 15%. Western Union's ubiquitous and respected brand allows it pricing power, while its profitability allows it to compete on price if necessary. Finally, this is a business with high barriers to entry. Implementing a global network of agents and building brand equity and respect is a daunting task. Put it all together, and Western Union's economic "moat" is substantial, in my opinion. This can be seen in the firm's historical stability.
All of this makes the stock's current 13% earnings yield perplexing. This is a real trough valuation for Western, by far the cheapest the stock has ever traded. The 5-year average earnings yield is 8.7%. Even just getting back to that would net investors a 60% gain. In addition to that is a 4% dividend yield that is well covered (only a 20% payout ratio) and has been substantially raised each of the past 4 years. Finally, WU buys back lots of stock, reducing share count by an impressive 5% annually since 2007.
So what dramatic risks have investors shunning this company so severely?
A big Q3 miss sent the stock tumbling over 30% back in November. The numbers were not horrible - both revenue and operating income grew modestly - but forward guidance of a 10-15% income drop for 2013 spooked investors. There are some competitive pricing pressures going on here, particularly in the U.S.-Mexico portal, and WU is taking pricing action to regain market share.
To me, the more important question is if there are serious secular threats to Western Union's business model going forward (the so-called "sky is falling" thesis). Transferring money has taken on a lot of new forms in recent years, from pre-paid cards to PayPal to sending funds via cellphone. However, I don't see these as direct assaults on WU's core cash transfer business. The reason is simple but profound - Western Union recipients don't need any kind of financial account. All the recipient needs is the sender's name, transfer control number, and answer to a test question. According to one study, there are 2.5 billion adults in the world who do not have a financial account. That's more than half of the world's adults. For them, Western Union's services are far easier to access than anything requiring a bank or PayPal account.
No, I see Western Union's current problem as a direct offshoot of global economic woes, particularly in Europe where about a quarter of revenues originate. Transaction levels are relatively stable (flat last quarter), it's the amount per transaction that's declining (down 7%), another hit against the "sky is falling" argument. While it may take time, global economic activity has generally stabilized and grown over the long term.
With a great business model, huge competitive advantages, voluminous cash flow, and shareholder-friendly policies of returning cash, along with a lowest-ever valuation and reasonable growth prospects, Western Union makes a great choice for a new position today. My fair value estimate is $21, over 65% upside from current trading levels.