Mobile Phones Vs. Western Union: Fear Is Opportunity

Mar.14.12 | About: The Western (WU)

By Brett Horn

Western Union's (NYSE:WU) business model remains sound, in our view. We see any trend toward mobile money transfers as evolutionary, not disruptive, and we think Western Union still looks like the long-term winner in the scenario of a gradual shift toward mobile money transfers. We think Western Union's customer base would be best described as not just late adopters of new payment trends, but as the last adopters. With market fears on this issue driving a low valuation on the stock, we believe investors have a good opportunity to invest in a fundamentally attractive business.

Using Western Union's fee percentages and estimates of global cross-border remittance volume, we can estimate the global money transfer industry as a $23 billion revenue opportunity. This would equate to about 1.5% of the revenue base of the global telecom industry. Given that cross-border money transfers are unlikely to move the needle for the telecom industry and also impose regulatory challenges, we think telecom firms' interest could be limited. While Western Union said it has drawn interest from mobile carriers, it also believes the carriers' interest is mainly related to making mobile customers stickier, as opposed to the revenue potential. If true, partnership with an existing money transfer operator would probably be more attractive to carriers than launching de novo operations, as the purpose could be achieved with a much lower investment. This would be very similar to the relationship Western Union has with the banking industry. Many banks are Western Union agents, as offering the service fills a client need and potentially draws in new customers.

No mobile-to-mobile global money transfer option exists today. While there are a few corridors where mobile phones are used as part of the process, Western Union serves 16,000 send and receive corridors around the world, and mobile phones have not had any material impact on its business. We believe only a pure mobile-to-mobile option available on a global basis would be a meaningful threat to Western Union's business model, as hybrid methods (mobile-to-cash, for instance) would still require a physical agent location on one end or the other, and Western Union's traditional advantages would remain in place. Still, the lack of competition today doesn't rule out competition in the future, and mobile-to-mobile money transfers, if widely adopted, do hold the potential to change the dynamics of the industry, as they would eliminate the need for physical global agent networks and remove a barrier to entry.

Serving the Unbanked
Before addressing the potential threat from mobile phones, it could be useful to draw out why customers use money transfer operators as opposed to traditional financial institutions. The simple answer is that many of its customers do not have bank accounts.

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Our analysis suggests mobile phones have a much greater global reach than financial institutions. When we estimate the percentage of the population with mobile phones in the top 20 migration corridors around the world, the weighted average probability of both participants having a mobile phone in the top 20 migration corridors is 63%, much higher than the probability of having a bank account on both sides (25%).

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These percentages were derived by using mobile subscriptions per capita data. In many cases, this probably materially overstates the percentage of the population with a mobile phone, as it is common in many countries for consumers to have more than one phone and switch between phones to use the carrier with the best rates at the time. Still, even after taking this into account, it seems clear that mobile phones have greater reach than bank accounts, and the difference in adoption between send and receive countries is not nearly as stark. Further, unlike bank accounts, mobile phones are a relatively new technology, and the number of global mobile subscriptions is still growing at a double-digit rate, so the reach of mobile phones is continuing to expand. Based on these factors, mobile phones look like an increasingly viable money transfer method, at first glance.

Lack of Infrastructure Limits Electronic Payment Acceptance in Developing Economies
We think the main impediment to adoption of mobile money transfers by Western Union's customer base is the fact that developing economies remain cash-based. Money transfer customers will see little value or convenience in switching to mobile methods if they have difficulty using the money stored in their mobile wallets. We think the lack of widespread acceptance of electronic payments in the developing world will be the limiting factor in the adoption of mobile phone money transfers.

Growth in electronic payments in the developing world has been strong, with noncash transactions increasing at a 14% compound annual rate in developing countries from 2001 to 2009; developing economies are playing catch-up, to some extent. But given the low level of electronic payment use, it will take quite a while for electronic payment acceptance to reach the level of use in developed countries. At the recent growth rate of 14%, it would take 25-30 years to achieve this, and that goal might be aggressive, given the problem of maintaining the same growth rate on an increasingly large base. While it is difficult to precisely estimate the time needed to achieve an acceptance level necessary to make mobile payments effective in the developing world, it would take 20%-plus growth rates for developing economies to catch up to developed economies within 20 years. This supports our wide economic moat rating for Western Union.

Using Western Union's fee percentages and estimates of global cross-border remittance volume, we can estimate the global money transfer industry as a $23 billion revenue opportunity. This would equate to about 1.5% of the revenue base of the global telecom industry. Given that cross-border money transfers are unlikely to move the needle for the telecom industry and also impose regulatory challenges, we think telecom firms' interest could be limited. While Western Union said it has drawn interest from mobile carriers, it also believes the carriers' interest is mainly related to making mobile customers stickier, as opposed to the revenue potential. If true, partnership with an existing money transfer operator would probably be more attractive to carriers than launching de novo operations, as the purpose could be achieved with a much lower investment. This would be very similar to the relationship Western Union has with the banking industry. Many banks are Western Union agents, as offering the service fills a client need and potentially draws in new customers.

A second point is that money transfer volume is insignificant relative to the size of the global economy. As a result, we don't see money transfers as a sufficient force to drive adoption of mobile payments, leaving the trend toward mobile wallets and mobile money transfers dependent on other factors.

Western Union's Scale, Global Network, and Regulatory Expertise Are Advantages
Because of its size advantage and the scalable nature of the industry, Western Union steadily pushes pricing down 1%-3% each year. This results in material decreases in fees over time; Western Union's average fee rate has declined 15% over the past four years. The company has actually increased its consumer-to-consumer operating margins modestly over this period, suggesting that it has the flexibility to be even more aggressive on pricing reductions. This has two implications, in our view. First, cash-to-cash transfers are continually becoming more price competitive, which reduces the threat from noncash methods over time, unless those noncash methods are a supplementary product for a primarily cash-based provider like Western Union. Second, unless mobile money transfers were to take off very quickly, any de novo operator looking to enter the industry with a mobile product would probably be forced to endure years of losses in order to match cash transfer fees and build up sufficient scale.

We believe any trend toward mobile phone money transfers will be gradual, as opposed to quick and disruptive. In this scenario, Western Union looks like the company most likely to be the leader in mobile phone transfers. While it would be fairly easy for many bilateral relationships to be formed outside traditional money transfer operators to provide mobile money transfers (for instance, an arrangement between U.S. and Mexican telecom companies), this would be little different than the competition Western Union has traditionally faced from smaller, corridor-specific players, and the company's global scale would allow it to undercut these providers on price with its own mobile options, much as it has done in the cash-to-cash market over time. Additionally, the challenges in developing bilateral relationships pale next to the investment needed to develop a network that would cover the 200 countries in which Western Union operates. The hurdles in developing a global mobile-to-mobile solution would mainly revolve around developing a global network of mobile carriers and addressing regulatory issues across multiple countries, challenges in which Western Union is uniquely experienced. Further, its current dominance in cash-to-cash transfers would provide Western Union (which has margins about twice as high as its closest competitor) with a source of profitability to fund and scale a mobile money transfer option over time, an advantage no potential entrant would possess.

One potential hurdle for Western Union in a shift toward mobile money transfers is that this would cut out the firm's existing physical agent network and effectively replace it with a network of telecom providers. However, the company has faced similar issues in the past and has successfully launched an online option without resistance from its agent network. We think this demonstrates that Western Union would hold enough leverage over agents to push ahead with a mobile strategy.

Western Union's management team is focused on this issue and recently reorganized the business to create a new segment, Western Union Ventures, which is focused solely on electronic channels (including mobile). The fact that the segment generated 35% growth in 2011 suggests that Western Union can successfully participate in noncash methods, although electronic channels remain a small part of the business at only 3% of revenue. The company has set a goal of generating more than $500 million in revenue through electronic channels by 2015 (which would equate to 9% of current revenue), although mobile is still an immaterial source of revenue. It is likely that the biggest contributor over this time frame will be online transfers, which generated $100 million in revenue in 2011.

Market Valuation Is at Odds With the Fundamental Picture
The macro picture has been and will be a headwind, but the long-term secular drivers of money transfer remain in place. While the U.S. employment picture has improved, weakness in Europe has been a recent drag on growth, and the situation is unlikely to improve in 2012. However, we believe the large disparity in GDP per capita between immigrant and emigrant countries is a long-term tailwind for money transfers. Even if the disparity between developed and developing economies compresses in the coming years, it will stay wide enough to spur immigration for a long time to come, in our opinion.

At the current market price, Western Union's shares trade at only about 10 times expected 2012 earnings. This earnings multiple is especially compelling given the extremely high returns on invested capital the company generates, and the current free cash flow yield of 9% using 2011 results is very attractive. With the stock trading at only 62% of our fair value estimate, we believe the margin of safety is more than sufficient. The stock recently sold off as the market was disappointed with management's 2012 outlook, but management historically has been conservative on this front and significantly outperformed its initial 2010 and 2011 guidance.

Our fair value estimate rests on what we believe are fairly modest assumptions. We assume internal growth stays muted through 2012 and then recovers to 6%-7% in the back half of our forecast period. We also assume some modest operating margin expansion from 26% in 2011 (excluding one-time charges) to 28% by the end of our forecast period, as the investment in building out the business-to-business segment falls off. A 28% operating margin level would approximate the level already achieved in the company's core consumer segment. To reach the current stock price, we would have to assume no internal growth throughout our entire forecast period and operating margins declining to 24% over time.

In our view, the current market multiple is only consistent with a scenario in which Western Union's growth or profitability is disrupted in the near future, which we consider unlikely. On the other hand, it is difficult to identify a near-term catalyst that will drive multiple expansion, as the thesis that mobile phones are a long-term threat won't be disproved in the short term. Further, the company's results will probably be constrained by macro factors in 2012. But even without multiple expansion, the stock offers reasonable return prospects in the near term with substantial long-term upside, as management expects earnings per share (adjusted for one-time charges) to grow 8%-11% in 2012 despite macro headwinds. Also, a 2.3% dividend yield provides some incentive to wait.

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