Newsletter Value Investor Insight carried an interview on June 30 with Ric Dillon of Diamond Hill Investments. Dillon's firm manages $4.5 billion in assets; its flagship Diamond Hill Long-Short mutual fund has earned an average 10.6% per year since July 2000, vs. 2.9% for the Russell 1000.
Here's an excerpt from the interview, where Dillon's colleague Thomas Schindler discusses portfolio holding MoneyGram (MGI), which was trading at $27.95 at the time of the interview (current price here):
MoneyGram operates in two primary segments, global funds transfer and payment systems. The funds-transfer business is the fastest growing and largest, generating about 70% of revenues and close to 80% of operating income. The bulk of that business is consumer-to-consumer electronic transfers around the world through a network of nearly 115,000 agents. It’s still a very fragmented market: MoneyGram has a 4% market share, second only to Western Union, which controls about 16%. The payment-systems business does things like provide official bank checks on an outsourced basis and rebate-check processing. It’s a decent business, but it isn’t what’s driving our interest.
What is driving your interest is the money-transfer business?
TS: That’s the primary attraction. MoneyGram is increasing its share of a huge and still growing market. Global consumer-to-consumer dollars sent last year by money transfer were more than $270 billion, and the market is growing about 8% per year. That’s driven by global economic growth fostering increasing levels of immigration, with most of those immigrants sending money back to their native countries to support families left behind. MoneyGram has done a great job expanding its agent network, which has resulted in its share of the market going from 1.6% in 2002 to 4% last year. They have been a value leader, pricing below Western Union. For a $300 transfer, for example, MoneyGram would charge a 3-4% commission, while Western Union would likely be closer to 5-6%. MoneyGram also has a big agreement with Wal-Mart for in-store transfer services, which has driven a lot of growth.
How do MoneyGram’s margins compare to Western Union’s?
TS: That’s where we see potential for improvement. Western Union’s consumer-to-consumer operating margins have been in the 30% range over the past four years – a level reached over a long time through operating leverage. MoneyGram is years behind that, with funds-transfer margins we estimate at around 15%. As it continues to grow – we think funds-transfer revenues will grow 20% annually over the next five years – costs won’t increase commensurately and margins should expand. How do you see that translating into upside for the shares, now at $28? TS: We see total revenues growing about 14% per year over the next five years and operating margins increasing from just under 16% to 17%. Some of the margin gains in funds-transfer are likely to be offset by margin compression in the money-order and other businesses.
Overall, we expect EPS to increase 15% annually and at a terminal 16x multiple in five years, our five-year target price is $50. Discounted back, our intrinsic value today is around $34.
What are some of the key risks that have weighed on the stock in the past year?
TS: Immigration reform is a perennial risk. While some type of reform has been talked about for years, we still don’t see a groundswell of support for much tougher enforcement on illegal immigration. It’s something to carefully monitor, but the risk of reform isn’t weighing heavily on our thesis. A broader concern we have in the back of our minds is that it shouldn’t cost as much as MoneyGram or Western Union charge to send money around the world. But the issue is that most funds transfer customers don’t have the bank accounts or credit cards or PayPal accounts that could facilitate cheaper money transfers. The cash has to get into and out of the system, which requires a large network of agents on both ends. That’s where MoneyGram and Western Union have a real competitive advantage.