By Brett Horn
Western Union (NYSE:WU) clearly dominates the money transfer industry, but we believe the source of its strong competitive position can be easily misunderstood. We have dissected and analyzed the drivers of the wide differential in profitability between Western Union and its competitors; our conclusion is that scale is the predominant source of advantage, with brand and the network playing supporting roles.
The Money Transfer Business Model Can Be Attractive
The money transfer industry is characterized by a few large global players, such as Western Union, MoneyGram (NYSE:MGI), and Euronet Worldwide (NASDAQ:EEFT), and smaller operators that focus on serving specific ethnic communities and intercountry corridors. Money transfer companies generate revenue by collecting fees, as well as realizing a spread between the retail rate of exchange they offer their customers and the rate they can achieve with bulk currency trades.
Money transfer companies maintain large agent networks that allow money to be collected and disbursed conveniently and quickly across the globe. Agents are paid a percentage of the fees they generate. Although the makeup of agent networks can vary from country to country, agents typically include businesses like banks, currency exchanges, and retailers. The commonality is that agents view money transfers as supplemental income and a way to drive traffic to their stores.
Since money transfer companies use outside agents to collect and disburse the money, they have no need to maintain an expensive retail footprint. Their customers give them cash up front so they have no accounts receivable; they actually benefit from a small amount of float. Once processing systems are fully developed, ongoing investment on this side is fairly meager. Looking at Western Union's balance sheet, besides cash, the only asset item of any real size is goodwill from acquisitions, which is a result of management decisions, not the needs of the business model. As a result of the small amount of capital in the business, larger money transfer companies like Western Union generate returns on invested capital that are well above any reasonable estimate of the cost of capital.
Money transfers are primarily conducted in person and on a cash-to-cash basis--the sender brings cash into the sending agent's location and the receiver collects cash at the receiving agent's location. While alternative methods have arisen, they have yet to have a material impact on the industry.
Operating Margins Showcase Western Union's Advantage
Western Union's operating margins are more than twice as high as MoneyGram's, whose margins are in turn almost twice as high as Euronet's. Given that all three companies provide the same somewhat commoditylike service, the size of the spread is somewhat surprising at first glance and demonstrates that the playing field is not at all level.
Recasting operating profits in absolute terms further highlights Western Union's dominance in the industry. In 2011, Western Union's operating income was 9.3 times as high as that of MoneyGram and Euronet combined, up from 5.6 times in 2007. If we assume the rest of the industry has operating margins in line with Euronet, Western Union collected a little more than 60% of the entire industry's profit in 2011, with only 18% market share.
These bottom-line results suggest that Western Union's competitive position might be actually improving, as it is the only company among the top three that has been able to meaningfully improve its operating income in recent years, despite a difficult macro environment.
Where Does Western Union's Advantage Come From?
It is clear that Western Union reaps the lion's share of profits in the industry. But what is the source of this advantage? Given the nature of the industry, the three most likely sources of Western Union's wide economic moat are brand, a network effect, or scale advantages. By analyzing the source of Western Union's profitability, we can estimate which factor predominates.
As with any other consumer service, the perception of brand might play a role in Western Union's profitability. With its long record and 82% global brand awareness, Western Union has a widely recognized brand. Given that customers are entrusting a company with their hard-earned money, it's not unreasonable to believe they might pay a premium to use an operator they trust. If brand were a meaningful advantage for Western Union, we would expect this to show up in higher prices. Having a better network and more convenient locations might also play a role in pricing, but to avoid overcomplicating our analysis, we will attribute any differences in pricing to brand.
The dynamics of the money transfer industry would seem to preclude a traditional network advantage--that is, a network that becomes more useful to all participants as the number of participants increases. Money transfer customers typically send money to and from the same locations repeatedly and shouldn't value the option to send to multiple countries. Agents, however, might see value in partnering with a money transfer company that can send to as many locations as possible and therefore draw a greater number of customers through its doors. We would expect this network advantage to show up in lower commission rates for agents.
The final possible advantage is scale. While money transfer companies' largest cost--agent commissions--is linear, payment processing is typically a scalable business. Western Union's management estimates that 35% of its costs are fixed, which would mean that the vast majority of its costs outside agent commissions are fixed. With Western Union processing more than 3 times as many transactions as its closest competitor, its scale advantage could be meaningful. We would expect this advantage to show up in lower internal costs per transaction.
Differences in Mix Cloud the Picture
Taking Western Union's and MoneyGram's average revenue per transaction and using the two companies' 2011 operating margins and agent commission rates, we can solve for commissions and internal costs per transaction and construct a pro forma income statement for an average transaction. We can then break down the profit differential by the source of advantage, applying the spread in revenue per transaction (minus the portion shared with agents) to brand, the spread due to lower commission rates to the network, and the spread due to the difference in internal costs to scale.
Western Union earns $4.10 more in operating profit per transaction than MoneyGram, and its profit is more than 3 times as large. At first glance, the large spread in average revenue per transaction would seem to suggest that the advantage comes primarily from brand. Western Union's average revenue per transaction is more than $20, compared with only $16 for MoneyGram, and MoneyGram has a stated policy of maintain pricing below Western Union. This suggests Western Union's economic moat is primarily based on brand, which accounts for almost 60% of the spread in profit per transaction in our pro forma exercise. Western Union's edge would then rest primarily on its ability to maintain premium pricing.
However, this ignores an important difference between the two companies: the mix in terms of the origination of transactions. Western Union generates about two thirds of its revenue from transactions originating outside the United States, while MoneyGram generates only about a third of its revenue from transactions originating outside the U.S. This would be unimportant if not for the wide spread in pricing between U.S.-originated transactions and internationally originated transactions (we estimate internationally originated transactions to be priced about 50%- 60% higher, on average, based on the companies' disclosures of the difference in percentage of transactions and revenue by point of origination). This materially influences the average price per transaction, makes the two companies' average prices not truly comparable, and exaggerates the impact of brand. Comparisons across the two companies need to be on a like-to-like basis to be analytically useful.
So, in order to accurately assess the source of Western Union's advantage, we need to determine the average difference in pricing on an apples-to-apples basis, excluding the origination mix. With the two companies serving thousands of corridors and pricing tiers based on the send amount, it is impossible to get a completely precise and accurate view. However, we can estimate it.
Based on the company's estimates of the differential between the percentage of transactions and percentage of revenue by point of origination, we can estimate the ratio in pricing between U.S. and internationally originated transactions. Using these estimates, we can then solve for average prices for U.S. and internationally originated transactions. Performing this analysis, we estimate the difference in pricing as 10%-15% on a like-for-like basis, once we control for origination mix. This suggests the majority of the difference in average revenue per transaction is explained by origination mix, not higher pricing by Western Union. It is important to note, however, that this is only a rough estimate, and pricing varies widely on a corridor-by-corridor basis.
Scale Is the Predominant Factor
Now that we've controlled for mix, we can estimate what drives the large disparity in margins across the two companies. Based on our estimates, even if Western Union's pricing advantage were eroded and it lost its preferential status among agents due to its higher-quality network, it would still generate margins about twice as high as MoneyGram due to its scale advantage (in the following chart, we assume a pricing spread of 12.5% on a like-to-like basis, the midpoint of our range of estimates).
Western Union's Strategy Assumes a Scale Advantage
Further support for scale as the primary advantage comes from management's pricing strategy. Management has pushed pricing down 1%-3% annually for a number of years. If Western Union's advantage were primarily due to its ability to realize premium pricing, we would expect to see deteriorating margins as profitability was sacrificed for transaction growth.
But that has not occurred. The company has reduced fees 14% over the past four years and has seen operating margins excluding one-time items improve 220 basis points over the same period. This margin improvement has largely been driven by lower commission rates paid to agents. But even after stripping out the effect of lower commission rates, we can see that margins from 2007 to 2011 have basically held flat, going from 26.3% to 26.0%. The ability to maintain margins despite ongoing price decreases and a difficult macro environment is further evidence that the company's advantage rests primarily on scale, in our opinion.
Our Wide Moat Rating Is Supported by Western Union's Multiple Advantages
As a company that enjoys a cost advantage due to scale but can still realize premium pricing thanks to a superior brand and a strong network, Western Union is in a strong competitive position. In this light, the fact that the company enjoys operating margins more than twice as high as its nearest competitor is not so surprising. We see scale as the company's most enduring advantage, as it is reinforcing over time and management's strategy is centered on exploiting it. While brand and network advantages might not justify a wide-moat rating on their own, the combination of all of these advantages helps to solidify the company's competitive position, in our view.
While the contribution of the various sources of advantage might be debatable, it seems indisputable that bigger is simply better in the money transfer industry. Western Union's size is the source of its scale advantage, but its size also positively affects its brand advantage (as size increases its marketing budget) and network advantage. We think Western Union's dominant position in the industry is essentially a function of the fact that it was the first to build a truly global network, which created a virtuous circle, as its size advantage magnified its other sources of advantage, which allowed the company to grow, which further improved its size advantage, and so on. We think management understands this, and that is why the company's strategy is centered on steadily taking market share. While management's record is not perfect, we appreciate the fact that its strategy is geared toward widening its economic moat.
Market Valuation Is Too Pessimistic, Given Western Union's Market Position
Western Union currently trades for only 10.4 times projected 2012 earnings and at 63% of our fair value estimate. Given the high returns on invested capital the business generates, this translates into a free cash flow yield of about 9%. As the dominant player in an industry with reasonably good long-term secular growth prospects, this valuation is overly pessimistic, in our view, and would only be warranted if the company's competitive position were at risk. We think the low market valuation is primarily driven by fears of disruption from alternative methods, an issue we addressed in a previous article. But we don't see any major competitive threats emerging in the legacy cash-to-cash business, and the company's position is buttressed by multiple sources of advantage.
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