Western Union (WU) has been one of the worst performers in the S&P 500 this past year. At a trailing P/E of just 6.76, it certainly looks cheap. But as intelligent investors know, cheapness doesn't necessarily signal value. Most times, there will be good reasons why a company sells at such low valuations relative to the rest of the market. However, in this article, I will argue that Western Union has been oversold on animal spirits based on misunderstanding by analysts and many others.
BRIEF MACROECONOMIC OVERVIEW
Some salient facts about our economy:
1) We are going through one of the most fragile "recoveries" in the history of the United States despite trillions of dollars in fiscal stimulus and multiple rounds of quantitative easing by the Federal Reserve:
Velocity of money has collapsed to its lowest point since the 1960s, at the same time that the Fed began its policy of paying interest on excess reserves. This type of setup is akin to flooring a car's accelerator while in neutral: It just creates a lot of noise. The lack of a meaningful recovery has even prompted some members of the Fed to endorse a negative interest rate policy to reverse the trend in money velocity. I have also begun to see market currents like this one, one too many times on Seeking Alpha.
2) We are in a secular range-bound/sideways market (since 2000):
According to Vitaliy Katsenelson, author of Active Value Investing(2007):
Every long-lasting bull market in the 20th century has led to a stagnating, long-lasting range-bound market (the Great Depression that followed a prolonged bull market was the only exception).
For those not familiar with cycles, an historical perspective is in order:
The Rhythm and Rhyme of History (The Last 200 Years)
(Data from Katsenelson's Active Value Investing and Michael A. Alexander's Stock Cycles)
To summarize, the minimum duration of a range-bound market for the past 200 years has been 8 years. The maximum duration has been 18 years, with the average around 13 years. If the past is any indication, we are still years away from the end to the misery of a sideways market due to the monstrous magnitude of the previous bull market. In fact, Katsenelson used the analogy of a Chinese water torture to describe how a range-bound market might feel like to an average investor. If we factor in the idea that the only true winners in this market has been HFT-based, it truly has been torturous.
On a side note, maybe this is the reason why author/philosopher Nassim Taleb warned against future aspirations in finance: Not only are the returns lacking punch, but what true meaning and satisfaction can we honestly expect from a market that feels so rigged against value investors?
3) Beware of the coming margin compression: Many investors forget that mean-reversion usually entails that something (net margin, P/E ratios) will go past the midpoint on its way down before settling near its mean. This concept ties in with my arguments concerning Western Union. The central point of some of the short theses has been that Western Union will experience margin compression from the likes of Xoom.com (expected to IPO this year) using efficient technologies such as mobile and the Internet. To me, there is no question that Western Union will feel a margin squeeze: The real question is will it be enough to prove the shorts right over the long run?
Cost-push inflation will erode margins in general.
Margin spreads for many companies from layoffs have already reached its peak.
IDENTIFYING WESTERN UNION'S VALUE:
As a brief mention, Western Union has been around since the middle of the 19th century and was at one time a monopoly in the telegraph industry. Today, it is the most dominant firm in the money remittance industry with about 2X the number of agents than MoneyGram International, its nearest competitor.
1) Quality: I like to invest in companies that generate sustainable free cash flows with relatively low capital expenditures and juicy dividends.
Western Union boasts the highest free cash flow relative to market capitalization among some of its immediate peers. It also has a relatively low maintenance capex (quarterly) requirement that has been averaging $13.89M for the past five years (from Ycharts.com).
However, more important than the simple existence of free cash flows is what management does with it. Western Union has wisely decided to throw off cash in the form of increasing dividends.
And lastly, Western Union's Net income and operating cash flows have moved in the same direction for the past 5 years indicating quality of earnings:
2) Growth: Western Union does not deserve the fall from grace in the manner of Zynga (ZNGA). Simply put, the company has grown at steady rates even in one of the most competitive markets in the world. Management has grown the company by expanding to new markets while retaining the ability to lower and raise prices. Most importantly, its EPS has outpaced net income as management has authorized $750 million for buybacks for the next 13 months starting in November of 2012.
WHY DID WESTERN UNION'S PRICE COLLAPSE LAST YEAR?
To be honest, the price performance of Western Union hasn't been up to par for the past three/four years. But it experienced a dramatic decline on worries of margin compression last year, and the possible erosion of Western Union's competitive position from that margin compression. Furthermore, the loss of the Vigo brand in Mexico, and increasing competition in certain corridors of the global market ended up having negative impacts as well. But it seems analysts have short-changed this company on the basis of invalid assumptions. The assumption is that Western Union's profit margins will decrease and stay at depressed levels permanently, similar to expectations of Apple (AAPL), given that Apple will no longer come up with technological breakthroughs.
Consider the example of a $500 remittance to Mexico during November of last year:
- Western Union using agent: $25
- MoneyGram International (MGI) using agent: $10
- Western Union online: $7
- Xoom.com online: $5
The difference in these prices is the reason why the bears believe Western Union's margins will collapse along with its share price. They are essentially assuming that Western Union will standby idly while MoneyGram International and Xoom.com steals all their business. However, according to this article by Gregory Vousvounis, Western Union's scale has the potential to price smaller competitors out of the market. Lo and behold, consider the same $500 remittance to Mexico today:
- Western Union using agent: $8 for all types of transactions.
- Western Union online: using bank account for 3-day transaction -> $8, using credit/debit for "money in minutes" -> $7.
- MoneyGram International using agent: using bank account for 3-day transaction -> $8, using credit/debit for fast service -> $16.
- Xoom.com: $5 dollars using bank account, $13 using credit/debit.
Using an agent for Western Union is actually cheaper than MoneyGram International for certain transactions. Furthermore Western Union's "money in minutes" online transaction using credit/debit is cheaper than Xoom.com's rapid credit/debit transaction. Yes, profit margins will go down if Western Union and its competitors wage a price war. But I believe Western Union's dominant market position will give it the ability to outlast any and all of its competitors. And this is ignoring the value that comes from Western Union's brand equity. Transferring large amounts of money back to your home country to sustain your family is no small matter. Given multiple choices, I believe the average person would pick the most trusted and popular brand instead of opting for another product priced just a couple of dollars lower.
A second false assumption held by the analysts involves the fallacy of composition: Just because something is true of the part doesn't mean that it is also true of the whole. Let me explain by laying out the theoretical cost structure assumed of companies like Western Union:
- Home-agent Fee: 30%.
- Abroad-agent Fee: 20%.
- Bank Charges: 10%.
= Cost of Sales 60%
What this assumption ignores is the fact that the technology that allows companies like Xoom.com to avoid costs associated with agent fees is available to everyone in the money remittance space. In fact, according to Alexa.com, Western Union ranks 4,667th in terms of query popularity, while MoneyGram International ranks 12,862nd, and Xoom.com ranks 11,444th. This assumption also ignores the fact that one of the largest costs for the money transfer industry is the compliance cost, which is a fixed cost faced by most all of the firms in the industry, yet one that Western Union has an advantage in from its scale of operations.
I do not believe 2013 will be a good year overall for Western Union as it embarks on an aggressive pricing strategy. Profit margins will get squeezed, but not to the levels indicated by the collapse in its share price. Simply put, Western Union is worth much more than its current value implied by the market.
Valuation: Triangulating Western Union's Position
1) Relative Valuation: 2-Stage Equity Multiple Model
- Net Margin = Net Income TTM/Sales TTM = 21.87%.
- Sales/BV of equity = 4.94.
- ROE = 21.41 * 4.94 = 105.77%.
- Retention Ratio = 79.75%.
- Expected Growth Rate (revised down) = 24.47%.
- Assuming expected growth rate in net income will drop to 4%.
- Stable period payout ratio = 80%.
- Cost of equity = 15%.
Output P/E Ratio: 11.49
Current P/E TTM: 6.76
2.) Sector Regression: (using current Ycharts.com data)
|American Express Company (AXP)||3.428||26.36%|
|MoneyGram International||4.41 (AVG)||32.72%|
|UEPS technologies (UEPS)||0.6609||9.33%|
|Wright Express Corp. (WXS)||3.786||13.77%|
|Heartland Payment Systems (HPY)||4.786||26.89%|
|Total System Services (TSS)||2.912||17.80%|
|Global Payments (GPN)||2.812||13.03%|
|Fidelity National (FIS)||1.544||6.54%|
|Lender Processing Services (LPS)||3.914||9.06%|
|Alliance Data Systems (ADS)||15.03||137.7%|
|Discover Financial Services (DFS)||2.029||25.84%|
|Capital One Financial (COF)||0.9008||8.84%|
*Substituted average data for MoneyGram International
*Used a broadened definition of money remittance companies to enlarge sample size of dataset
- Sector Regression Equation:
- P/BV = 2.17 + 6.85(ROE) R^2 = 63%
- Western Union predicted P/BV = 11.48
- Current P/BV = 7.271
The regression suggests Western Union is significantly undervalued.
*Data from Ycharts.com
As indicated by the graph above, Western Union is the only firm located in the lower-righthand corner indicating a low Price/BV given its high ROE.
3) Absolute Valuation: (from Vitaliy Katesnelson's Active Value Investing)
- Using analyst estimates of growth of 9%.
- Dividend yield of 3.54%.
- Basic P/E = 17.15.
- Using average(to keep it conservative) characteristics of business risk, financial risk, and earnings visibility Fair value P/E = 7.24.
- Using 17.46% margin of safety, buy P/E = 6.16.
- Sell P/E = 14.0.
*Data from Ycharts.com and Yahoo.com
4) Free Cash Flow to Equity: Stable Growth Model
- Cost of equity = 15% (conservative).
- ROE = 135.9%.
- Estimated expected growth rate = 8.35%(lower than analyst estimates).
- $17.76 per share.
In conclusion, even if we do see Western Union's profit margin fall in the future, it should revert to its mean in due time. More importantly, there seems to be a large disconnect between expectations and intrinsic value. As a result, Western Union may not be the value trap that analysts, bears, and the shorts hope it to be.