On October 30, 2013, Western Union's (WU) shares took a big hit, down more than 12%, when the company announced that it does not expect earnings growth in 2014 because compliance costs would rise to 4.5% next year. Here is an excerpt from the earnings announcement:
"Although the company is in the early stages of its 2014 budgeting process, it still expects revenue growth in 2014, but no longer expects growth in operating profit due to both these incremental costs as well as potential business impact from new compliance procedures. The company will pursue additional efficiency initiatives to optimize its overall cost structure."
The two key phrases from the above quote are "growth in operating profit" and "additional efficiency initiatives." The company has grown revenues in each of the last two years (5.5% in 2011 and 3.1% in 2012). Let's assume that growth will remain stagnant this year and revenues would break-even at the end of 2013 to 2012 levels. The company will still be able to maintain its dividends and would be in a healthy shape overall. To be conservative, let's consider revenue growth of 3%-4% next year as there is no guidance by the management on an exact number. The management is essentially saying that any excess operating profit due to revenue growth next year will be eaten up by higher compliance costs. So in aggregate, the company's financial position should not change much materially and the only negative would be that its dividend payout ratio might go up. This would be due to increased capex on compliance costs and slightly lower net income (if any). The company should be pretty much in the same financial position as it is now, without any major shock to the balance sheet. Now as you will read below, the company is taking some powerful initiatives to increase revenues (such as the new contract with Walgreen (WAG)) and since compliance costs would remain a fixed expense going forward, any increase in future revenues will directly benefit the bottom line provided there are no other major cost hiccups down the road. So in 2014 and going forward, the company would find itself in a much enviable position with minimal capex and a powerful cash generation due to steady increase in revenues. Thus Western Union is an excellent investment opportunity for long-term investors.
Now let's look at the short-term outlook. The company reported a profit of 39 cents a share, beating forecasts for 35 cents. Western Union also said that it would earn $1.38 to $1.43 a share in 2013, slightly below the forecasts for $1.44. EBITDA margin was 25.8% compared to 30.0% a year ago. Now let's take a look at the positives and negatives and see how bad this is really going to be and whether investors have overreacted by recently pushing the stock more than 12%.
For the benefit of those who are a bit new to WU, here is a quick introduction:
Western Union operates in 3 segments:
The Consumer-to-Consumer operating segment facilitates money transfers between two consumers, primarily through a network of third-party agents.
The Consumer-to-Business operating segment facilitates bill payments from consumers to businesses and other organizations, including utilities, auto finance companies, mortgage servicers, financial service providers, government agencies and other businesses.
Business Solutions (B2B):
The Business Solutions operating segment facilitates payment and foreign exchange solutions, primarily cross-border, cross-currency transactions, for small and medium size enterprises and other organizations and individuals.
The company's President and Chief Executive Officer Hikmet Ersek had the following to say during the October 29, 2013 conference call with analysts:
"Our business continues to generate strong cash flow and margins, and in the third quarter we produced our highest quarterly consumer-to-consumer transaction growth rate in three years. Electronic channels delivered robust growth and now represent 5% of our total revenues, while Business Solutions generated a double-digit constant currency revenue increase."
A recent concern about Western Union has been a decline in transaction volume in Mexico, but please notice that the volume increased 15% including Vigo and Orlandi Valuta (Western Union owned local brands) while Western Union branded transactions showed an increase of 24%.
A very important growth initiative for Western Union is to increase distribution by partnering with Walgreens, which has 8,000 locations throughout the nation. Now some of you might be thinking who would go to Walgreens to pay their utility bills not to mention sending money to loved ones? Let me tell you this - many seniors are still uncomfortable paying their bills online (including my mother-in-law) and they might as well pay their utility bill at Walgreens while picking up their prescription medication. Furthermore, many blue collar workers, especially within immigrant communities, are much more comfortable paying their bills in person. So adding all or a portion of revenue from all 8,000 Walgreens locations will be more than a drop in the bucket.
Western Union also renewed its agreement with their largest global agent in Europe, La Banque Potale, which has been offering its services in France for more than 15 years. The company also extended its services to over 3,000 locations in Europe alone. The company is paying special attention to increasing its electronics account based money transfer, which showed a revenue increase of 55% while C2C transactions growing 68%. In Western Union Business Solutions (B2B), revenues increased 6% in the quarter or 10% in constant currency terms. The company is well positioned for growth in this segment. In addition to the online banking access and westernunion.com, the company's money transfer services are available at approximately 115,000 ATMs around the world. Electronic channels, which is the fastest growth area for the company, now represents 5% of total company revenue. The company has recently added to its capabilities by expanding its direct-to-bank services to China from various markets and extending its relationship with U.S. Bank to include mobile and money transfer services. Western Union signed new Mobile Money Transfer service agreements in Nigeria, Tunisia and Nepal and recently released an enhanced version of westernunion.com mobile app, which has received a good response.
Now turning to the U.S. domestic money transfer, revenues were down 1% in the third quarter on transaction growth of 6%. Lower principal bands and domestic money transfer continue to perform well, but these were offset by declines in higher principal transactions. Revenue in the Middle East and Africa region increased 1% compared with the year-ago quarter, with no impact from currency, and transactions grew 10% in the quarter. Transactions from the Gulf States are delivering strong growth and pricing actions from Europe to Africa continue to gain traction.
Asia Pacific region revenue declined 3% in the quarter, including a negative 2% impact from currency translation, while transaction growth in the region accelerated to 10%. Both the Philippines and India contributed to the strong growth, with India aided by both pricing initiatives and the depreciation of the Indian Rupee.
Latin America and Caribbean region revenue was down 3% from the prior-year period, including a negative 8% impact from currency, while transactions increased 4%. Constant currency revenue in the region was positively impacted by geographic and product mix.
The company has returned nearly $700 million back to shareholders via dividends (about 7% of market capitalization) year to date through September.
Compliance issues - a major investor concern:
Now let's discuss the main cause why Western Union's stock got hammered on October 30, 2013, when its CEO said that compliance costs would go up in the future.
Let me ask you a question first - which one of the following two scenarios would you prefer?
- A company takes timely steps to comply with regulatory requirements and earnings take a temporary hit due to this increased but necessary expense.
- A company procrastinates and puts regulatory compliance on hold due to the fear of reduced earnings and a negative Wall Street reaction. In the meantime, some cartel transfers money illegally across borders and now the company is levied a fine by the regulators that can be substantial.
I think I would prefer option #1.
All financial institutions including banks have compliance costs. This does not mean that one would stop investing in banks because they have to comply with regulations incurring expenses. We need to understand that it is just another cost of doing business without which a financial institution cannot survive. Also it is important to note that these costs are typically higher initially, when systems and procedures are being set up, but once everything gets going, it becomes a routine ongoing expense with an exact known value. I have shown you a scenario at the beginning of this article that compliance costs might give a bump to Western Union's operational costs starting 2014 but these costs would gradually even out. As we are aware that regulatory requirements and expectations around financial service firms are escalating around the globe and it is very prudent on Western Union's part to invest in compliance early on thus making sure that it does not fall victim to any fines imposed by the regulators (which are typically large). These fines directly hit the bottom line as regulators prefer a cash payment for a fine (incidentally they don't accept stock options). This destroys shareholder value. Dodd-Frank rule required the company to initiate agent procedures at 50,000 agent locations and the company implemented it well in time with an October 28 deadline. The company has recently hired a Chief Compliance Officer who has brought in a highly experienced team. As far as regulators are concerned, compliance is NOT a matter of "if" but "when" and "how." So being shareholders, we should be happy to see the company is covering its bases and not leaving any open loopholes for regulators to complain about.
Most importantly, all competition will have to comply with all these requirements as well so Western Union is not alone in obliging. Due to this fact, compliance expense would not change Western Union's competitiveness in any way since competition will have to do the same. As a matter of fact, due to scale, Western Union is better positioned to take advantage of these compliance systems and by installing across the board, would benefit from economies of scale.
Let's take a look at the competitive landscape and see how well Western Union fares. Please see the chart below, which shows select key metrics for comparison of Western Union with those of competitors.
Profit Margin, ttm
Dividend Yield (forward)
ttm = trailing twelve months
A quick glance at the numbers makes it clear that Western Union easily trumps the competition and is a stalwart among its peers. It seems to me that competitors would have a much harder time than Western Union in dealing with those above mentioned compliance costs.
Year-to-date cash flows from operating activities totaled $811 million. The company returned $89 million to shareholders in the quarter, consisting of $20 million of share repurchases and $69 million of dividends, and has returned $543 million year-to-date through September. WU continues to expect full year share repurchases and dividends to total nearly $700 million, which represents approximately 7% of current market capitalization.
P/E multiple approach:
Talking of P/E multiples, we observe that since 2006, the company has traded at the highest multiple of 21.9 (2007) and the lowest multiple of 8.1 (in 2012). The trailing twelve month multiple is 10.7. If we average out all P/E yearly ratios since 2006, we come up with 14.2. To be conservative, let's use 12 as the forward P/E multiple. Please see the table below that shows stock price with different scenarios of P/E and EPS.
P/E = 12
P/E = 13
P/E = 14
It seems to me investors just rely on this relatively simple P/E multiple approach to value stocks and thus ignore the real long-term potential of a given company, which can only be observed using the Free Cash Flow or FCF approach as below.
This is the method I like the best and is used for accurately valuing a business in my opinion. Actually this method is the holy grail of value investing. Below are the key assumptions:
- Earnings growth for the first 10 years (year over year)
- Perpetuity Growth after first 10 years
- Free Cash Flow metric is used (also called owner's earnings)
- Inflation component = 1% (year over year)
Applying different discount rates, we come up with the following scenarios:
Bear Scenario: (year over year earnings growth of 3% per year for the 1st 10 years and 2% perpetual)
Discount Rate (%)
Intermediate Scenario: (year over year earnings growth of 5% per year for the 1st 10 years and 2% perpetual)
Discount Rate (%)
Bullish Scenario: (year over year earnings growth of 6% per year for the 1st 10 years and 3% perpetual)
Discount Rate (%)
The above scenarios clearly indicate that Western Union is way too undervalued with the current stock price being $16.86 as of this writing. All above scenarios with the exception of the most bearish scenario with the highest discount rate (which is quite harsh for a stable company like WU) gives a value lower ($14.44) than current stock price. Otherwise all other much reasonable scenarios give a much higher valuation than the current market price.
I believe that Western Union represents an excellent value for investors today and with the recent run-down in price, it brings about a great buying opportunity. This company has minimal costs for doing business and once a branch is set up, it is there to generate income for years to come. You might be impressed with its footprint in the U.S. but its unmatched infrastructure in developing countries is the most prized possession, since it is much more challenging to set up shop in developing countries. Furthermore, a tougher regulatory environment will just strengthen Western Union's competitive position in the industry by increasing barriers to entry. Regarding investor concerns about higher costs of compliance, you cannot penalize a firm when it is adeptly complying with the laws and regulations that are mandatory anyway, and more importantly, all competitors MUST also comply with the same laws. Western Union is in an enviable position to spread these compliance costs and scale these across its network of operators. I would not mind if the company was being singled out for some increased cost inherent only to Western Union's business, which competitors don't have to bear but when everyone else must deal with enhanced compliance costs, this becomes a moot issue. Most importantly, fooling with governments is the last thing I would want to see a firm doing in which I have invested my clients' money.
Thus Western Union is doing a great job in dealing with compliance issues and attacking the problem head-on. This is the type of management that I would like to see running a company, who has the courage and tenacity to do the right thing early on and not be afraid of the short-term market gyrations.