Long investors in Western Union (WU) enjoyed a fleeting moment of afternoon delight on October 29 when 3Q EPS of $0.39 cleared analyst estimates of $0.35. Shares momentarily topped $20 after hours. Then, the market digested the entire press release associated with the earnings release. Buried on the third page was unwelcome news that compliance expenses in 2014 are forecast to increase 40% to 80%, thus possibly negating all profit growth in 2014. Shares reversed and experienced an after-burner effect, moving downward throughout the rest of the after-hours session. After closing at $19.24, they next opened at $15.73, though they swiftly recovered to well above $17.
Western Union shares have behaved similarly before. One year ago, shares crashed from similar levels to below $12 when management announced a price-discounting strategy after otherwise healthy 3Q12 earnings. This strategy was in response to flat revenues and operating performance, driven by both price competition from MoneyGram (MGI) and digital competition from Xoom (XOOM). For the next 12 months, the beaten-down shares proceeded to outperform the S&P 500 index by a factor of roughly 2X.
The independent investor could be compared to the captain of a ship: in command of the ship, to be sure, but the ocean, or the market, is truly in charge. After these two storms, now is a good time to pull up and to unfold the component parts of the Western Union performance picture, to look at key drivers, and to consider the bear case, to see if the shares still represent a good investment.
Western Union is the clear leader in money transfer
Western Union is, of course, a money transfer service. That's all it does, to the point of domination:
- Western Union's digital revenue alone is well over 2X the size of the whole of digital startup competitor Xoom (annualized 3Q13: $280 M v. $120 M - note that Western Union describes "electronic channels" as "5% of revenue" while Xoom's 3Q total revenue was $33 M).
Despite this large size, there remains ample room to grow. For example, though impossible to precisely quantify, the largest share in money transfer is reputed to be controlled by black-market operators.
Western Union operates in all major money transfer and value storage spaces, including
- cash over-the-counter (not account-linked)
- digital / web / device (account-linked)
- C2C, C2B, B2B
The mainspring of Western Union's money transfer business is C2C, which represents 80% of transaction volume. Despite a full range of digital service offerings, it remains primarily cash over-the-counter at roughly half a million agent locations worldwide. MoneyGram is similarly structured, but with about half as many agent locations. A third public company in the space, Xoom, has a different, almost exclusive digital operating structure. The boundaries of the peer set are usually drawn there. Despite some overlap, Euronet (EEFT) is primarily a B2B operator with a significant ATM business, and will be excluded from the scope of this article.
Xoom, though marketed as a disruptive and nimble web startup competitor, is best understood as offering only a subset of Western Union's range of services, within a less comprehensive, less productive infrastructure. The digital focus that was supposed to have been such a threat to Western Union is turning out to be more of a straitjacket for Xoom. Xoom's high degree of dependency on bank account links and secure web or device access is emerging as a growth-limiting factor. Its weaker brand is also confined to the digital space, while Western Union's brand is ubiquitous. Similar logic would apply for other potential competitors such as PayPal, wholly owned by eBay (EBAY). PayPal has no agents. Account-linked transfers, like bank transfers, often take several days. Cash over-the-counter requires an in-person counter visit, but after that visit, transfer is instantaneous. Counter-intuitively, "digital" is not necessarily "faster" in money transfer.
Western Union and MoneyGram agents are paid on commission to perform money transfer as a side business (from the agents' perspective) at convenient locations. Agents are not significant "bricks and mortar" cost or asset presences for either firm. The size, scope, flexibility, and first-mover global presence of Western Union's agent network is thus a competitive advantage and a barrier to entry, rather than a dated cost burden waiting to be undermined by a digital entrant such as Xoom. The analogy that Western Union is like Blockbuster Video or Borders Books and Music, and Xoom is like Netflix (NFLX) or Amazon (AMZN), is false, and where held or expressed, reflects a severe misunderstanding of the industry.
Western Union and MoneyGram cash over-the-counter patrons need not have a bank account. To use digital-point-of-access money transfer services under any brand, a bank account (plus, of course, secure device access) is generally required, at least for the sender and possibly also for the recipient. In the United States, a significant share of households lacks a bank account, and in the developing, remittance-dependent world (see here and here), the unbanked and underbanked share of households is much larger. People in the developing world also frequently trust banks less, and prefer tangible cash and immediacy more, than people in the developed world. These remittance and underbanked or unbanked customers - enormous potential customer bases - remain Western Union's main target markets. Even as a subset of households in the developing world increases use of digital devices, Western Union will continue to be able to serve their needs with its own digital services. Users need not switch to Xoom just to be digital.
With 4X the revenue and only 2X the agents, Western Union's agents are 2X more revenue-productive per agent than MoneyGram's. At the operating margin line, that productivity gap per agent widens roughly to 4X (see here and here). In 3Q13, a typical quarter, Western Union achieved 21% operating margins. Free cash flow margins are approximately 18% (over $1 B in free cash flow, on $5.6 B in revenue). Western Union is the original network business (since 1857, with the first telegraphic money transfer in 1871) and there is no inventory and no cash conversion cycle. While there is some currency impact on performance, it tends to be noise (1% to 2% of revenue), as Western Union is big and global.
For some strategies, this simplicity is investment-thesis positive: there are just not a lot of moving parts to the business, it's a tollbooth business, and Western Union is the undisputed big dog. Even a novice independent investor would have little trouble doing enough due diligence to understand Western Union's operations and its sector domination.
Results of the pricing strategy
Beginning in 4Q12, Western Union staged a rollout of price cuts and promotions across key competitive, high-volume money transfer corridors. While Western Union did not publicly specify all of the targeted corridors, based on subsequent reporting, one was clearly United States-Mexico. Other such corridors might include United States-Philippines, France-Morocco, Germany-Turkey, and any other pair of countries an observer might logically associate with concentrations of workers who send remittances.
These price cuts and promotions ramped over time in planned stages. They reached full force only in 3Q13, the quarter just reported. What can an investor know about the results of this specific strategy? A pricing strategy probably would be deemed a success if:
- it drove growth faster than the market
- it drove share, and hindered the competition
- revenue was ultimately not impaired, meaning that new volume generated by the price cuts drove revenues back to their level before the discounts
A firm achieving all these results according to plan probably successfully executed the pricing strategy, and by extension has a strong brand and ample pricing power in the space.
The numbers conclusively show that the pricing strategy succeeded brilliantly. First, in 3Q13, there was a significant EPS beat despite opening the full throttle on price cuts. Revenues have recovered to over 99% of their 3Q12 levels, prior to the price cuts. Second, the investor presentations show strong transaction volume growth both over the counter and through electronic channels. Third, the competition is feeling the pain.
How much pain? The duopoly of investors who participated in MoneyGram's 2008 recapitalization (Goldman Sachs (GS) and a private equity firm, Thomas H. Lee) want out. But, they recently failed to sell MoneyGram to The Carlyle Group (CG) or to anyone else, despite abundant rumors and an unusual public "Hey, we're for sale!" announcement. This exit probably wouldn't be so aggressively pursued if MoneyGram were seen by its own institutional investors as improving in its ability to compete with Western Union. A sale of MoneyGram at current prices would represent roughly a breakeven outcome for both institutions. Zero would be a remarkably poor five-year ROI. Regardless, as of October, like an overpriced house sitting on the market too long, MoneyGram is no longer for sale.
Despite commanding a premium valuation, Xoom warned of declining revenues in 4Q13. This is surprising, because
- Xoom is a new, supposedly growth-stage web startup, while Western Union is older than the Civil War
- Xoom's total revenue is much smaller than Western Union's digital revenue
- Western Union management confidently forecast that 2014 revenue increases would make up for compliance costs
Digitally, Western Union is growing rapidly from a bigger base while Xoom is stagnating at a smaller one. This suggests that Xoom is failing to win new customers and failing to convert Western Union customers to Xoom digital services, withering as the competitive promotional onslaught of Western Union reaches its peak.
Moreover, Western Union reports in its 3Q13 conference call that 80% of the customers in the past 12 months at westernunion.com are new to the franchise. Meanwhile, Western Union transaction growth hit a three-year record in 3Q13. This in turn suggests that digital services are primarily complements to, rather than disruptive replacements for, cash over-the-counter services through networks of agents. Digital services favor the leader, not the entrant. In profit, there is already no comparison, as Xoom is barely break-even while Western Union earns at least $1.40 per share per year.
How stark is the contrast? Record Western Union transaction growth also means that growth accelerated in 3Q13 sequentially compared to 2Q13. This growth is not only faster than the competition, it is evident in all regions and even in corridors where the pricing strategy was not applied (see slide presentation here and conference call transcript here).
Where else is the established market leader blowing the growth doors off the web startup in the digital space? In years of independent investing and analysis, I have seen the results of successful pricing and share strategies, but I have never seen this level of total domination. The Western Union stagecoach is, with a few cracks of the pricing whip, leaving the competition in a cloud of dust. Brand matters in money transfer, because people care about their money. Agent locations matter because people care about convenience and confidentiality. Scale matters because of the fixed costs of systems and regulatory compliance. Western Union always was the leader in almost all categories. Now it is also the growth leader.
Strong volume growth across the board
Transaction volume in priced corridors:
Revenue/transactions in the electronic/web channel:
Strong growth, when compared to Xoom's revenue warning.
C2C transaction share of WU total mix:
There is no erosion in the core segment. Transaction growth by region and percent of total revenue is also stable. This means the business is strong everywhere.
Western Union brand transactions/principal amount of transactions
Account based transfer revenue/transactions
The only revenue decline was in prepaid, which is not a significant component of revenue.
To continue to grow transactions, Western Union has signed Walgreen (WAG), the largest drugstore chain in the United States, to an agency agreement, and is increasing penetration in India and China (see here for the potential volume).
Declining margin trend
Operating and EBITDA margins increased a full percentage point in 3Q13 over 2Q13. However, over time, margins are downtrending. For the past year, the decline was driven by price discounting. In the coming year, margins are at more risk due to increased compliance expenses. Declining margins are normally a bearish sign. For Western Union, do mitigating factors counter the declining margins?
First, as noted in detail above, Western Union is exercising pricing power (intentionally pressuring its own margins) to gain share and to crush the competition. This strategy is working. Second, even after pricing actions, Western Union remains steadily a 20%-21% margin business. Thus, pricing is probably no longer a driver of declining margins.
Unfortunately, compliance cost pressures on margins are increasing. To recap, shares fell 18% after the 3Q 2103 conference call on news that these costs are forecast to increase 40% to 80%, thus consuming all profit growth in 2014. This increase represents additional costs of $55 to $110 M in 2014, or a negative impact on annual EPS of roughly 10 to 20 cents per share, depending on factors yet to be revealed (capex, opex, scope, etc.) Again, profit is expected to be flat, not to decline, so this impact is isolated to the cost increase. This impact range is wide, and management has promised full details in coming months. Though shares bounced and quickly partly recovered, they have since made up only about half the post-earnings plunge.
There are multiple mitigating factors even to the compliance cost increase. First, management confirmed that Western Union would grow revenues and profits enough to cover these costs. Current performance suggests that this prediction is realistic. Second, the entire industry faces enhanced compliance requirements - they are a true cost of doing business. This cost increase improves the competitive operating position of Western Union because its healthy margins and scale leave it most able to absorb the costs. Enhanced compliance expenses will constrain the ability of MoneyGram and Xoom to respond to the pricing actions by Western Union, actions with which they already appear to be struggling. Third, increased compliance costs represent another barrier to entry in a stock with a moat wide enough to be included in Morningstar's Market Vectors Wide Moat ETF (MOAT). Fourth, Western Union management is conservative. Given recent strong performance exceeding management promises made a year ago, it's possible that the flat profit forecast in the conference call will be revised upward if growth continues and as compliance cost increase figures become more sharply defined.
End of the share buyback
Western Union pays a dividend of roughly 3% and executed a share buyback in late 2012 and 2013 on the order of $400 M. In the recent conference call, management announced that this buyback would not be repeated in 2014.
However, the buyback is already over. In 3Q 2013, less than $30 M of corporate cash was spent on a buyback, and this low figure was entirely predictable based on past quarters' buyback benchmarks. Management also fully executed the promised buyback and even Barron's cited Western Union as one of the few buybacks whose full execution investors could actually count on. Shares advanced in 3Q and recovered rapidly from the recent plunge despite lack of a buyback. Thus, all in all, this event is not a surprise and does not reflect any failure by management - if anything, it reflects the completion of the execution of a promise.
Other new digital entrants
Square recently released a means of cash transfer by email. However, this interesting service is available only within the United States, is not instantaneous (it moves at the speed of bank transfer), and requires both sender and recipient to have bank accounts linked to debit cards. It is also far from the first similar service. Therefore, it is more of a competitor to PayPal or Google Wallet than to Western Union.
If Xoom, a firm founded specifically to target Western Union on the theory that Western Union was not digital enough, is warning on revenues while Western Union is growing, Square is not going to be able to impact Western Union with an experimental, slow service that only appears to move at the speed of email. Management dismissed Square during analyst Q&A on the conference call. The fact that an analyst even chose to use his precious call question to ask about Square, however, reflects another, completely different kind of problem.
Possible analyst negative bias
This is entirely a personal opinion, but having been long Western Union throughout 2013, I have detected a negatively biased narrative from some Street analysts.
This bias has multiple strands of pseudo-factual argumentation:
1) Somehow, by some undefined but inevitable means, "the web" will kill Western Union. This argument has several strands, but the rumored vehicle is usually either PayPal or Xoom (though it has also been Google). Both PayPal and Xoom are Bay Area headquartered and are relatively new companies, while Western Union is headquartered in Denver and dates to 1857, which I believe contributes to this image distortion that Western Union is an old-line, unhip company.
This argument is patently false. To repeat - but to counter a rumor, repetition is sometimes needed - both Xoom and Western Union are network businesses and Western Union has both a larger and faster-growing digital business than Xoom. The comparison with PayPal has already been covered - PayPal requires a bank account, secure digital access, and waiting time, while Western Union does not (though Western Union also can be used in conjunction with the same tools that PayPal requires). Neither Xoom nor PayPal is likely to challenge Western Union's vast agency business.
In its space, Western Union is both the traditional and the digital dominator. Modern Wall Street loves the nimble competitor digital takedown story, but in reality, Western Union's domination is increasing, not being eroded.
2) MoneyGram must have an advantage. because it has a Wal-Mart (WMT) partnership, has Goldman and a PE shop as institutional investors, and commands a higher P/E. But as noted above, Goldman and its PE partner seem unusually highly motivated to exit their investment in MoneyGram.
Indeed, MoneyGram's strategy is marked by high-profile but ineffective attempts to compete. Not long ago, MoneyGram signed up with Wal-Mart in an attempt to rapidly boost topline agent locations. But, the MoneyGram agency at Wal-Mart is usually, if not always, located at the Wal-Mart customer service counter. This means a MoneyGram customer must stand in line behind everyone returning various Wal-Mart purchases to send or receive a MoneyGram. I have personally sent a MoneyGram from Wal-Mart, to test the experience, and due to this queue of Wal-Mart customers, it is markedly inconvenient. Worse for MoneyGram, many Wal-Marts contain a bank (a third party bank, with a contract to operate within the Wal-Mart). Some of these banks offer Western Union, negating the exclusivity of MoneyGram to the location and defeating much of the purpose of MoneyGram signing with Wal-Mart. Partnering with Wal-Mart - which is, as a retailer, also not booming - hasn't proved to be the silver bullet for MoneyGram that it superficially might have seemed to be at the date of the announcement.
Financial evaluation and comps
Western Union shares closed Friday, November 1, at $17.48. The 52-week high, reached just before the EPS release, is $19.50.
Profit guidance for the year is between $1.38 and $1.43. Call it $1.40 to pick a number. This means that shares trade for a PE of about 12.5 based on 2013 profits. At the 52-week high of $19.50, the PE would be just under 14. According to the Wall Street Journal, as of November 1, the S&P 500 trades at a trailing twelve months PE of 18.7 and a forward PE of 15.9. Thus, even if it recovered the 52-week high, Western Union would still probably be trading at a discount to the index. Also, the index has a 2% dividend yield, while Western Union's is closer to 3%. Given cash generation, the dividend seems relatively safe. Shares also trade for less than 10X free cash flow.
Should profits indeed be flat in 2014, these PE figures will be stable. However, 3Q 2013 EPS of $0.39 given full pricing actions and fast growth even in corridors with no pricing actions point to possible management conservatism in forecasting profit growth, as even that quarterly EPS annualizes to $1.56, not $1.40. Though compliance expenses are clearly forecast to significantly increase, revenues are also forecast to grow from present levels, while prices are not forecast to fall from present levels. Finally, Western Union management could take more costs out of the business, or the B2B segment, the former Travelex, could finally start turning a profit. The net result could prove to be that profit growth is better than flat, while pricing power improves.
Western Union has abundant cash and cash generation. Debt is manageable and the balance sheet is strong.
The shares have borne a persistent short position comprising roughly seven trading days to cover since early in 2Q 2013, and about $650 M in total size. According to NASDAQ short position reporting, this short has lost significant money - at best, has maybe neared breaking even if the whole position was quickly covered below $16 within minutes of the market open after the 3Q conference call. Given the speed and volume of the bounce, that cover event might actually have transpired.
As noted, Western Union revenues and volumes are growing faster than the economy, the space, and the competition, while Western Union clearly has all the pricing power to be had in the space. Its competitive domination is waxing, not waning. Also, Western Union is a domestic name with high exposure to a basket of emerging markets, which generally grow faster than developed markets.
Comparing Western Union to MoneyGram and Xoom in terms of their valuation is futile, as the comparison is one among apples, bananas, and oranges. First, the investment decision is one whether to buy Western Union relative to other equities, not merely relative to its money-transfer peers. Second, the investor composition and perception profiles of the three companies differ radically. Western Union is held by the public, including institutions, as an ordinary company. MoneyGram is heavily owned by two institutional investors who are seeking exit, distorting its valuation. Xoom trades like a dot-com - its market capitalization is similar to MoneyGram, despite MoneyGram having 12X larger revenues. In my opinion, these factors render peer comps of limited value. However, as this article shows, making the comparisons shows that Western Union - the size, scale, pricing, profit, and lately even the growth leader - is significantly undervalued relative to both its weaker peers and the index.
As an investor, would stock in a company with these qualities interest you?
- Dominates the sector by 4X in revenue
- By far, the highest margins in the sector (safe, 20%+ margins)
- Roughly 70% of index PE
- Trades for about 1.5X revenue
- Market cap about 9X free cash flow
- Faster growth than the competition and the sector
- Industry-leading productivity, by far, per operating unit
- Bigger and faster-growing digital revenue than its web competitor
- Healthy balance sheet, abundant cash, copious cash generation
- Minimal fixed asset presence
- Transparent, tollbooth business
- Strong, trusted brand
- Dominant pricing power
- Management delivers in operations and for investors
- Truly global
Most good investments have some negatives - often, an investment's price becomes attractive because recently expressed negatives are overemphasized and distorted. Here, modestly higher compliance costs affect the entire industry. Fortunately, Western Union has the margins, scale, and scope to prosper through the new regulations.
For this investor, after considering the full picture, focusing on facts, and dismissing rumors and distortions, the choice is clear. If you agree, consider adding Western Union to your portfolio.
Additional disclosure: I have no positions in any other stocks or tickers mentioned.