Western Union (WU) has four primary competitive advantages:
· A global network with over 500,000 agent locations (banks, post offices, retail locations etc.) to take in and hand out cash. Western Union is the dominant force in the remittance market, enjoying 17% market share vs. 3% for the second-largest competitor, MoneyGram. Some agent locations are with government entities like post offices, which make this agent network almost impossible to replicate for new entries.
· High brand awareness: At the Investor Day in May 2012, management said that their global brand awareness is about 80% and they spend 4% of revenue every year in marketing.
· Western Union dedicates 600 employees and spends $60 million every year on anti-money laundering and regulations. The company has built an extensive and robust compliance and legal infrastructure to comply with various local rules and regulations.
· Light asset requirement: According to the 10K, agents provide the physical infrastructure and staff, and Western Union provides central operating functions such as transaction processing, settlement, marketing support and customer relationship to the agents. Normalized Capex is ~3% of revenue, and consists of amount paid to agents with establishing or renewing contracts (usually five to seven years), purchased and developed software and purchases of PP&E. This light asset requirement drives 25% return on invested capital from 2009 to 2011.
C-to-C market share stagnant and under threat
In various earnings calls, management has been emphasizing its market share growth in remittance from 7% in 2001 to 17% in recent years. However, using Western Union's total Consumer-to-Consumer principals transacted disclosed in 10K and World Bank estimate for the total remittance market size, WU's market share in the remittance market has been stagnant at 17% since 2009.
Total remittance market size
Source: World Bank, 10K
With economic pressure, customers will be always looking out for cheaper options to do money transfer and existing customers are not very happy with Western Union's fees. One example is the $5 for $50 campaign, a 10% transaction fee. It is doubtful that this kind of fee is sustainable in the long run. And C-to-C market share stagnation coincides with the two acquisitions that diversify Western Union away from its core competency in C-to-C money transfer.
Business-to-Business will be Western Union's Achilles' heel
Western Union's competency is in consumer-to-consumer and consumer-to-business (bill pay) money transfer through its expansive network and compliance expertise. Then, the company extended its reach to the B-to-B sector servicing SMEs by acquiring Custom House in Sep 2009 and Travelex in Nov 2011.
Western Union paid $370 million or 13x EBITDA/ 4x revenue to acquire Custom House. And the company bought Travelex for £606 million or 13.5x EBITDA (£150 million and 30% margin) (Source: Travelex acquisition call). Western Union has paid a steep price to enter a brand new segment with limited synergy potential with its existing physical agent network because B-to-B transactions are mostly done through telephone or internet. Business-to-Business payments are made predominately through wire transfers and ACH, and in some cases, checks are remitted to Custom House/ Travelex. (Source: 10K) During the Travelex acquisition call, management commented that WU gained additional products and functionality and a local banking network in over 70 countries.
Management is betting on two things with the B-to-B segment: organic market share growth and operating margin improvement. According to the Investor Day, Western Union's B-to-B is 15% of overall WU's revenue and has 2% of market share when banks have 90% - 95% market share. Management estimated that market share ramp-up should drive a low double-digit growth. With tightening regulations putting pressure on bank leverage and profitability of traditional brokerage business, banks are looking for new revenue sources. According to WSJ, banks are ready to partner with Western Union. Banks have to partner with WU to capture the C-to-B or C-to-C business since the money transfer is still transacted through physical locations on the receive side in emerging markets. However, banks might not be willing to surrender their market share in the B-to-B space to WU. In Q2 earnings call, management has revised down '12 B-to-B outlook to mid-single digit top line growth, and the comment was shifted from focusing on organic market share growth to blaming global trade sluggishness.
C-to-C operating margin is 28%-29%. Business Solutions (C-to-B and B-to-B) operating margins at 17% - 18% is below the company average of 26% ex-one timer. Within Business Solutions, C-to-B operating margin is 20+%, but Business Solutions reported $15 million operating loss in Q1 and Q2. There will be $50 million annual amortization related to Travelex and Custom House and $50 and $20 million integration costs in '12 and '13, respectively. Using the transaction data that Travelex and Custom House had $300 million and $100 million revenue ($400 million total) and assuming the quarterly run-rate of operating loss (i.e. $60 million operating deficit in '12 for Business Solutions), 5% revenue growth or $20 million incremental revenue in '13, $30 million less integration cost and $30 million synergy saving (Source: earnings call), Business Solutions segment would be barely breaking even in '13. Even assume 10% revenue growth or $40 million incremental revenue, Business Solutions segment would show ~10% operating margin (40/ 450).
Bears focus on the wrong thing
The bear thesis has two key points: issues in the Mexico and Russia corridor and threat of alternative payment methods. Though the Southwest border compliance issue in Mexico and the loss of agent exclusiveness in Russia can't be ignored, each country account for less than 6% of total revenue.
Another key fear is that pure mobile/electronic money transfers will eliminate the company's existing physical agent network and replace it with a network of telecom providers. That fear is remote since WU's targeted customer demographics' adoption curve of technology should be slow. In addition, the company has established a new business segment called Western Union Ventures, focusing on alternative money transfer channels like electronic and mobile. Even though Ventures is only 3% of revenue, its 35% growth in 2011 proves that Western Union can participate in these noncash methods.
Western Union has an economic moat from its expansive agent network, brand awareness, compliance capability and asset light requirement. The stock flashes many value signals - 10% free cash flow yield, 10x P/E and 25% return on invested capital. The outlook for the moat is negative because the company is using its cash to overpay for businesses outside its core consumer-to-consumer business and its core C-to-C market share is stagnant and under threat. Western Union does not have clear advantage in high traffic money transfer corridors when it often has to invest in price (1-2% price investment according to 10K) to compete with niche money-transfer players. The company needs to keep signing up agent locations in remote places to expand the receive locations' possibilities for incremental revenue growth. In that case, the return on incremental agent locations would decline. As a result, there isn't much visibility of free cash flow growth or P/E expansion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.