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BUSINESS DESCRIPTION

Western Union (WU) is the largest money transfer company in the world. The company's consumer to consumer (C2C) business accounts for the majority of the firm's revenue (81% of 2012 revenue) and provides consumers with a mechanism to transfer money from one location with a Western Union to another. Western Union's Consumer to Business division (11%) offers consumers the ability to pay bills and make recurring payments to vendors. In 2011, Western Union acquired Travelex Global Business Payments. Travelex (6%) delivers currency management solutions for small and medium sized businesses.

INVESTMENT THESIS:

Western Union is priced for flat to negative growth for the foreseeable future largely based on the notion that the company will be overtaken by newer technologies. This thesis ignores four critical advantages the market is underpricing: the company's customer base, the growth of the remittance market, Western Union's strength relative to its traditional competitors, and the ability of Western Union to co-opt or directly compete with new technologies.

Target Consumer. Western Union's core C2C business relies on customers walking into a store and making a money transfer to another Western Union location. The process is somewhat time consuming and expensive relative to an online funds transfer. The majority of Western Union's customers are migrants that are sending remittances from the US, EU, or the Gulf to a developing country. Although they may have access to internet in developed countries, the recipient may not have access to the internet, formal banking channels, or in some more limited instances, a mobile phone. In many areas such as rural India and Pakistan, Western Union is often the only provider of remittance services. This not only gives Western Union monopoly pricing power in certain regions, but also gives Western Union unparalleled brand recognition. Furthermore Western Union's average price of approximately 7.20% (Spread + Fee) is lower than the global remittance corridor average of 7.5% and the global average of 9%.

Remittance Growth. Companies that are priced for virtually no growth typically operate within industries that are in secular decline, for example physical DVD rentals. However Western Union operates in a market that is growing extremely quickly and which will only benefit from additional globalization. As seen in the table below, global remittances are set to grow by high single digits over the next three years. Therefore even if Western Union is subject to market share declines, the firm will hold a smaller share of a much larger pie.

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Traditional Competitors in C2C. Western's two largest money transfer competitors are MoneyGram (MGI) and Euronet (EEFT) the owner of Rio. Combined both firms are only slightly larger than Western Union on a number of agents basis and produce only half of Western Union's revenues. Similarly, both firms combined only produce a fifth of Western Union's EBITDA. Historically MoneyGram has intentionally priced its offerings slightly lower than Western Union. Although Western Union continues to have higher pricing in several corridors and will therefore be subject to further price erosion of 1-5% overall, Western Union has made significant pricing inroads especially in Mexico where it is now the low price offering.

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Co-Opt or Copy Competition. The company has been extremely successful at forging partnerships with fast growing firms. For example, Western Union has a partnership with Safaricom, the company behind M-Pesa, Africa's most successful mobile payments company. In addition, Western Union has forged partnerships with several major banks in the US, Brazil, India, and the EU to provide fund transfer services. The strength of Western Union's balance sheet also gives it potential room to make acquisitions. The firm has $1.5 billion in cash which is enough to buy out its fastest growing payment processing competitor, Xoom, twice.

Growth Catalysts

Going forward there are three major sources of growth for Western Union; its digital and prepaid businesses, a retrenchment of its Mexican business, and further growth in Russia and China. Western Union.com currently accounts for 3% of the firm's revenue, but has witnessed y-o-y gains of 16% revenue and 46% transaction growth. Management has indicated a willingness to grow the business to $500m in revenue a year. In Q3, 2012 the company steeply sold off, primarily as a result of the implementation of its "Southwest Border Agreement" with the Arizona Attorney General. After the implementation, 7,000 of the company's agents in Mexico were forced to drop Western Union because of an inability to comply with the heavier anti-money laundering provisions set forth in the agreement. Within the next two years, the street anticipates that the company's traditional competitors, Moneygram and Rio, will be subject to the same agreement. As a result, Western Union will have the opportunity to quickly regain affiliates. Another significant growth catalyst is the Chinese market where Western Union has 1/6 of the agents it has in the US and offers a premium priced product. Russia offers a smaller but much faster growing opportunity. Prior to 2011 it was illegal to conduct retail money transfers in Russia. The company now expects to double its network in Russia over the next two years.

Valuation

The company is undervalued on both a DCF and a comparable basis. I utilized a DCF model with a 3% terminal growth rate, 12.9% cost of equity, 4.3% cost of debt, and 10.3% WACC. I assumed a 2% decline in 2013 in line with management's guidance, a 5% increase in 2014 revenues on the back of transaction increasing price reductions, and then 3% revenue growth in years 3-5. Based on the firm's maturity and a shift toward lower cost online transfers, I assumed a .5% decline in COGS annually. In addition I assumed a decline in SG&A to 19.5% to reflect a larger agent network from 21% in 2013 to 19.5% in 2016-2018. Using these figures, I produced a valuation of $16.50 a share. On a forward EBITDA basis Western Union currently trades at approximately 8.1X consensus 2013 EBITDA $1.38B versus a traditional money transfer peer group average of about 8.2. Given Western Union's healthier margins and the growth prospect of Westernunion.com, I believe it warrants a higher multiple of 10X EBITDA which would imply a valuation of $19.77. Using a blended average between the DCF value of $16.50 and a comparable value of $19.77 results in a price target of $18.13 and a potential upside from current price levels ($16.02) of 13.17%. This upside does not include the roughly 3.2% annual dividend yield the firm currently offers.

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INVESTMENT RISKS:

The company may continue to hemorrhage Mexican affiliates. A prolonged downturn in the global economy could hurt global remittance growth. Similarly, a more rapid movement toward newer payment technologies in the developing world could reduce Western Union's ability to co-opt or acquire competitors as valuations rise.

Source: Western Union: Grossly Misunderstood Value

Additional disclosure: I am a member of a student investment fund that also holds a position in the company.