Welcome to the second quarter MoneyGram International earnings conference call. (Operator Instructions) I would now like to introduce your host for today’s call, David Parrin, Executive Vice President and Chief Financial Officer.
David J. Parrin
So thanks for joining us again on our second quarter conference call. With me today is Tony Ryan, our Executive Vice President and Chief Operating Officer. If you’ve not seen our earnings release, you can find it on our website, www.moneygram.com. We’ve also posted a brief slide presentation regarding today’s results on our website, and that will be available after the call. During the call we’ll be discussing adjusted measures that do not conform with generally accepted accounting principles, but we’ve reconciled those measures to GAAP measures in our earnings release and in the slide presentation.
The other thing I’d like you to know is that the second quarter the 2008 GAAP financial results are preliminary because we are finalizing the market valuation of embedded securities within our preferred stock agreements. If any of the adjustments for the embedded derivatives are not cash, they will not affect the non-GAAP adjusted measures reflected in the tables that we’ll be discussing. I’ll provide more information on that later.
I must remind you, from the forward-looking statements standpoint, that the various remarks we make about future expectations, plans and prospects constitute forward-looking statements for purposes of Safe Harbor Provisions under the Private Securities Litigation Reform Act of 1995.
Actual results may differ materially from expectations, plans and prospects contemplated in any forward-looking statements as a result of various factors including those discussed in our SEC filings that we make on a regular basis. I encourage everybody to read our SEC filings, including our 10-Q for the period ended June 30, 2008 which is expected to be filed to the SEC on August 11.
I’ll now hand the call over to Tony to discuss our business results.
Anthony P. Ryan
I’ll start by giving you a brief update in our business and the significant strength we continue to see in money transfer. Dave will cover the financials including segment information, and then I will wrap up with the summary of our strategic priorities.
We will work off a presentation for this particular call so that you will get a clear view of our strong financial position and the tremendous growth opportunity we have ahead of us as a result of a clear and focused strategy. Before we begin, I want to first thank our employees for their efforts and contributions during the second quarter. Your commitment to our core values has been instrumental in navigating a challenging period, allowing us to continue to deliver on our primary purposes, to help people in businesses by providing affordable, reliable and convenient payment services.
Starting on Slide 3, I want to start the business update by reminding everyone that the recapitalization was finalized on March 25 and through this transaction we have fully addressed our balance sheet issues. We finished the second quarter with unrestricted assets of nearly $350 million and a highly conservative investment portfolio with negligible risk. The composition of our investment portfolio was nearly 90% cash and 9% agency securities as of June 30.
While there are still some lingering valuation items related to the past investment portfolio issues impacting our financials, it is important to note that they were contemplated by as part of the recapitalization and substantively they do not affect our strong balance sheet. Dave will provide more color on this during his comments.
Our core money transfer franchise delivered another robust quarter, proving that we have not missed a beat. Our growth continues to be supported by rapid expansion and our global agent base which grew 26% year-over-year. Our much smaller official check business was repositioned during the second quarter. We achieved modest profitability even before the full benefits of our repricing initiatives were realized.
We experienced minimal customer turnover thus far as a result of the official check pricing action which now has an average payout rate of FED funds less 85 basis points. The new pricing changes had effective dates of June 1 or July 1, depending on the particular relationship. We also started the exit process of our nine largest customers and expect to see those balances running off over the next 12-18 months. The sum of all these actions is that we believe that we are now in a position to generate profitability on the official check product with negligible portfolio risk.
We had a strong financial performance in the second quarter. Money transfer and bill payment transactions increased by 19% year-over-year and money transfer and bill payment fee revenue by 23%. Importantly, adjusted EBITDA was $58 million for the second quarter, providing substantial cash flow for continued investment in our core money transfer and bill payment products and to pay interest on our debt. On a reported basis EBITDA was $40 million.
Next on Slide 4, I’ll touch on a few highlights for second quarter in our money transfer business which was part of our bigger statement, global funds transfer. Network growth continued to demonstrate strength across all regions as we increased our locations around the world by 26%, from 125,000 in the second quarter of 2007 to 157,000 in the second quarter of 2008. We grew money transfer volume, including bill payment, 19%. The solid performance was driven by network expansion, our strong consumer value proposition and targeted marketing efforts. Domestically originated money transfers including bill payment grew at 20%, driven by continued growth across all of our corridors.
Transactions originating internationally or outside North America grew 23% and now account for 22% of all of our volume. Our international operations continue to capitalize on the opportunities being created by worldwide immigration trends. Transactions to Mexico grew 3%. While economic conditions in the US housing market and immigration concerns have dampened this particular corridor’s growth, we continue to out-perform the market which, according to the Banco de Mexico’s statistics, contracted 1.1% in the second quarter of 2008 compared to the second quarter of 2007.
We’re also pleased to report that we renewed several significant customers, added several new important agents, and acquired two small companies which I will cover in detail more later in this presentation. We increased our revenue in core money transfer and bill payments by 23%, from $207.9 million in the second quarter of 2007 to $254.7 million in the second quarter of 2008, and that’s our fee revenue. This was expected and reflects transaction growth, pricing stability, product mix and a benefit from the stronger Euro.
Now I’ll turn it over to Dave to discuss our financials.
David J. Parrin
As Tony discussed, the second quarter results demonstrate the strength of our relationships with our customers and agents and the commitment of our employees. I’ll take the next few minutes to give you a view of our results, excluding the items that do not have a significant impact on our operations.
As you’ll see from the slides and our earnings release tables, we have adjusted certain measures by excluding net securities gains and losses, market value changes on our swaps, and executive severance and related costs as we believe these adjusted measures provide you useful information in understanding the underlying operations of the company.
Moving to Slide 6, you’ll see that adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) was $58 million compared to $69 million last year. Due to the material changes in our capital structure, EBITDA is a more relevant metric to monitor our performance going forward. We removed significant items that are either non-cash, aren’t expected to recur, or are portfolio-related and reconcile those back to income for income taxes.
The year-over-year decline of adjusted EBITDA is primarily related to significant decline in net investment revenue offset by higher fee revenue, as well as the timing of marketing expenditures. We believe our strong EBITDA provides excellent cash-interest coverage and, therefore, our leverage is very manageable. We actually provide a calculation of our credit ratios in Appendix A for your reference. As you review that schedule, keep in mind that we have liquidity in our unrestricted assets that is not factored into that leverage. We are very comfortable we have adequate financial flexibility to continue to pursue our growth strategy.
Going to Slide 7, the adjustments I just described carry through to the income statement. We had strong fee and other revenue growth of 21% driven by continued growth in money transfer. Investment revenue was down 66%, reflecting reduced yields on significantly lower risk investment portfolio and declining market interest rates. We have positive adjusted operating income of $7 million for the second quarter which reflects the ability of the operations to cover our interest expense despite the lower investment yield and only a partial impact of the official check repricing initiative which occurred late in the second quarter. On a reported basis, we had an operating loss of $8 million.
On Slide 8, we’ll talk about the global funds transfer segment and the segment results total reported revenue for this much larger segment increased 10% despite an $18.9 million decrease in investment revenue and net securities losses of $4.6 million that were recorded from investment portfolio and allocated to this segment. Excluding that securities losses, total adjusted revenue would have increased 12%.
Most importantly, total fee and other revenue increased 22% and continue to be driven by the growth of the money transfer business including our bill payment services. The higher growth of money transfer fees and other revenue over transaction volume growth that Tony referred to is due to changes in our product mix. That is, the money transfer versus bill payment as well as the Euro exchange rate.
Fee and other revenue increased 13% which included our retail money order and property bridge. However, the retail money order fees in the second quarter of 2008 declined 4% compared to the second quarter 2007, and that’s in line with the decline of volume. We anticipated these declines and expect them to continue. Investment revenue and global funds transfer decreased 78% the second quarter because of lower investment balances compared to 2007 and lower yields resulting from the realignment of the investment portfolio to lower risk assets as well as the decline in market interest rates.
For commission expense, the growth was driven by higher money transfer transaction volume. Tiered commission rates paid to certain agents and increases in the Euro exchange rate. The reported operating income of the second quarter was $30.6 million which is affected by lower invest revenue and net securities losses of $4.6 million. The reported operating margin was of 11.2% for the quarter and excluding that security losses the adjusted operating margin would be 12.7%. On a comparable basis, the impact of the lower yield to the low risk investment portfolio and lower market interest rates was about $11 million in operating income. Adjusting for this, operating income margins would be consistent between Q2 2007 and 2008.
Moving on to the payment systems on Slide 9 as we previously disclosed, we initiated a restructuring in the official check business by changing the commission structure and exiting certain large customer relationships. We had termination agreements with nine of our top ten financial institutions, and we anticipate the balance that is associated with these institutions will continue to run off over the next 12-18 months.
Adjusted revenue declined by $47 million due to lower average investable balances and a reduced yield on the lower risk portfolio as well as lower market interest rates in the second quarter of 2008 versus 2007. The reported revenue declined by $72 million, reflecting the marked-to-market on auction rates and other asset-backed securities. The new lower commission rates took affect near the end of the second quarter and had been designed to lower future commission expenses, thus improving our operating performance which I’ll get to in a moment.
Reported commission expense decreased 108% in the second quarter which reflected a lower interest rate environment and an increase in the fair value of swaps of $29.3 million. We did terminate those swaps in June. So excluding that swap gain, the adjusted commissions would have declined 60%.
Reported operating income in the second quarter of 2008 was $3.9 million, reflecting the net securities losses of $25.7 million that were recorded in the investment portfolio and allocated to the payment systems segment as well as the decrease in investment balance and lower yields earned on the realigned portfolio, and that was offset by the fair value gain on those interest rate swaps.
So, if you net the significant items out as we’ve done in the adjustment column on Slide 9, payment systems would have shown marginal profitability. The low risk yields, lower balances and declining market rates effect on investment revenues offset by the impact of the lower market rates and repricing efforts on commissions had about a $12 million negative effect on operating income for the year-over-year comparison.
On Slide 10, I want to talk a bit about the portfolio. So, with the realignment of the investment portfolio away from asset-backed securities and highly liquid assets, at June 30 about 90% of the portfolio was in cash and cash equivalents and another 9% in government agency securities. As you can see on Slide 10, it provides more detail on the portfolio and the shift we’ve had to low risk investments. At the end of the second quarter, we owned option rate securities with a market value of $35 million and CDOs with a market value of $56 million. The CDOs are carried at an average of about 7% of the face value. Our goal is to sell these securities over time. We believe they’ve posed limited risk at the current carrying values.
On Slide 11, at the end of the quarter, we had cash and cash equivalents of $4.5 billion, $1.9 billion in net receivables, $448 million of government agency securities, and $91 million of the auction rates and CDO securities. The payment services obligation was $6.6 billion, so that leaves us with unrestricted assets, as we’ve reported in the past, of $348 million. So to reposition the portfolio radically reduced our investment portfolio risk profile, and the recapitalization was specifically designed to provide liquidity in capital necessary to operate and grown our business.
We’re providing some additional insight into the unrestricted assets because we reported mark-to-market adjustments of $30 million on the auction rates and CDOs that remain in the portfolio. We assumed the zero value for these securities at the time of the recapitalization. So if we assume a zero value for these securities, the unrestricted assets as you can see in the middle of the page was $257 million at June 30, which is the same as the first quarter.
Just a couple comments about what we provided to you in Appendix A. Many of you have had questions regarding our adjusted share calculations. We provide a common share equivalent calculation at the end of the second quarter in the appendix. The bottom portion of that slide shows the calculation to get the impact from the paid-in-kind dividend on the preferred stock.
So, to wrap up the financials, let me provide you a little bit of color for the balance of 2008. We expect continued strong growth in money transfer transaction volume and revenue. We also expect GFT adjusted margins for the full year to be between 12% and 13%. Investment revenue will continue to decline on a year-over-year basis in both segments with a change in that investment strategy as well as declining balances.
Official check balances will decline although the repricing will have a positive effect in future quarters. We expect the net spread for the payment systems segments to be between 135 and 145 basis points for the remainder of the year. The adjusted operating income is expected to remain positive. Just a cautionary note, given current market expectations, we may see some additional mark-to-market loss on the auction rates and CDOs, although the potential market value losses do not affect our liquidity again as we ascribed a zero value to them at the time of our recapitalization.
Finally what I’d like to do is talk to you a little bit about the GAAP financial results in what we’re calling “Preliminary Second Quarter 2008 Results”. Series B preferred stock issued on March 24 of this year contains a conversion option, allowing the investors to convert the Series B preferred stock into shares of common stock. But it doesn’t explicitly state that a net cash settlement is not required in the event that the company is unable to affect the conversion.
As a result, the complex guidance around this issue results in recording a liability equal to the fair value of the embedded derivatives with a corresponding reduction in the value of the Series B stock recognized in our mezzanine equity. Any changes in the fair value are recognized in the income statement. We are in the process of finalizing the value of the embedded derivatives, and the estimated fair value of the liability is about $24 million at June 30, 2008. And the change in the fair value of approximately $12 million since the March funding date will be reflected as a gain in our second quarter earnings.
To deal with this accounting issue, the company and the investors expect to enter into a separate binding agreement that clarifies and explicitly states that a net cash settlement is not required in the event the company is unable to effect the conversion. The agreement when finalized will allow us to eliminate the liability in the fair value accounting which we would expect in the third quarter of 2008.
So with that I will turn it back to Tony.
Anthony P. Ryan
As you can see from Dave’s presentation, we are in a strong position financially and have comprehensively dealt with our balance sheet issues. Importantly, we have $348 million in unrestricted assets and are generating substantial cash flow for investment in the business. Now I’d like to look to the future and discuss those investment opportunities by wrapping up our prepared comments with an overview of our strategic and corporate priorities.
On Slide 13, we have our four key growth strategies which support our brand position in providing control and choice to our customers. These are expand our distribution, provide our worldwide consumers with a superior value, deliver a superior low-cost service platform to our agents and customers, and deliver an enhanced payment product.
On Slide 14 I’d like to provide more detail on our primary strategy of expanding distribution. Over the past decade we have been building a premier global agent network that now includes the world’s two largest retailers; the world’s largest bank, based on market capitalization; several of the large post office partners around the globe; in the US, the largest check casher, the largest payday loan company, the largest pharmacy retailer; and many of the top grocery store chains offer our money transfer and urgent bill payment products.
Our agent network is one of our key competitive advantages and we are working hard to expand and maximize our relationships with our partners. One example of a past success in maximizing an existing relationship is the UK Post Office, which has grown considerably due to our strategic focus on providing a well-integrated service. The integration of agency connect platform led to the rollout of an additional 11,000 locations in 2007, and we have accelerated our growth in the UK.
This quarter, we began expanding our rollout with Carrefour, the second largest retailer in the world after Wal-Mart. We first had a relationship with Carrefour in Spain and are now rolling out the money transfer service in France, which will double our network in this important market.
And we are pleased to announce that we have recently renewed agreements with Canada Post and Thomas Cook, signing them to multi-year contracts. Both agents will be adding additional locations over the next year. Canada Post will add several thousand locations to our existing relationship. Thomas Cook merged with an entity offering a competitive money transfer service and chose to switch those locations to MoneyGram.
Slide 15 illustrates the breadth and diversity of our agent partners. Our network includes a mix of major retailers, international financial institutions and several major post offices. Among the benefits of the large and diversified network are locations of longer store hours, the ability to pay out larger transaction amounts, and extensive coverage in rural areas. We now have 35,500 locations in North America, over 23,000 in Latin America, over 48,000 locations in Western Europe and the Middle East, 13,000 locations in the Indian sub-continent, and over 16,000 locations in Eastern Europe, complimented by 14,000 locations in Asia Pacific and 6,000 locations in Africa.
On Slide 16, it shows that we will expand our distribution by optimizing high potential markets through the addition of new agency relationships. During the quarter, we added 5,000 locations to our global network which now stands at 157,000, up 26% from the prior year. We have delivered strong network growth in emerging regions such as Eastern Europe, up 44%; Asia Pacific, up 27%; and Africa, up 28%. We are targeting 15-20% annual network growth over the next few years and will be adding to our network in a fiscally disciplined and operationally efficient manner.
Recent accomplishments regarding the addition of new relationships include the initial rollout of our CVS relationship. We are now in over 500 locations currently and expect to be in the majority of their 5000+ locations by year-end. We also signed and installed trans-network in Mexico which gave us more than 850 new locations including a significant retailer, Soriana, and Famsa, a pharmacy chain.
Moving onto Slide 17, the final way we will seek to expand our distribution is by controlling our network in selected markets where it makes sense due to regulatory, competitive or other factors. An example of a prior success with this approach is France where we opened our first company-owned store in 2006. We now have 20 locations in France, and they have become highly productive, outperforming our average European agent locations in Spain, Italy and the UK by a factor of 80:1. We now have 32 stores open in Germany, and they are also performing well.
In addition to running our own stores, we have been driven to growth in Italy by acquiring our super agent. Super agents typically help us manage sales and selected operational functions within a particular market. We completed this acquisition in 2005 and have expanded the network from 800 to more than 2,600 locations. This has given us improved control over our product delivery and provided us with stronger economics. We plan to expand that model to another key market with our recent acquisition of two super agents in Spain. The acquisition of these two super agents gives us a platform for managing an independent agent network in that country as well as sales and operational staff.
Another key channel for growth on the send side has been our online money transfer service which we launched in 2003. This is an example of utilizing additional technology as a way to deliver our service. Online money transfer transactions are up 50% year-on-year.
Moving to Slide 18, our second key strategy is to provide our consumers with a superior value. We will continue to focus on maintaining our price leadership position, balanced against an appropriate return on investment. We remain committed to providing our consumers with simple and transparent fee structures.
Also from a value standpoint, we are focused on rewarding our most loyal consumers in the US by providing faster transactions at the point of sale and tiered discounts based on usage. An important part of the value equation is to provide senders with notification that the recipient has received their funds. We also offer account management via Mymoneygram.com.
In January 2008, we launched our new loyalty program called MoneyGram Rewards. We nearly doubled our loyalty program membership in the first six months of the year, and over 60% of the enrollees are not only new to the program but also are new to MoneyGram, and we’re witnessing members transacting more frequently than non-members. The MoneyGram Rewards program is currently offered on a transaction initiated in an agent location in the US. We also continued the rollout of our multi-currency platform which provides greater choice for currency payout options. We now offer local currency or a choice of currencies in 116 countries and territories.
Next on Slide 19, the third element to our strategy is to deliver a superior low-cost service platform to our agents and consumers. We continue to distance ourselves from the smaller, regional players by continuing to invest in core infrastructure like settlement systems, compliance and fraud prevention. We are also enhancing service at the point of sale with loyalty card based transactions for frequent users and adding new capabilities to our agent point of sale platforms. We will soon begin to unify our retail point of sale platform at our company-owned stores and acquired super agents.
Additionally, we are in the initial stages of evaluating the delivery of our point of sale solution via the web. The goals are faster transaction times, integration with the agents’ internal systems, and cost efficiencies within the MoneyGram operating platform. Recent accomplishments include completing the first phase of testing on our new settlement systems which will give us enhanced reporting capabilities and more scalability and efficiency as we add volume. We expect a full implementation in the first half of 2009. Another accomplishment was reducing transaction time and providing greater control for our consumers by increasing loyalty card based money transfers by 62% year-over-year.
On Slide 20, our final strategy is to deliver enhanced product offerings for our consumers. We are working hard to enhance onsite capabilities like e-money transfer. Our online transactions are growing 50% year-on-year and are supported by a proprietary decision engine that helps us improve automation and prevent frauds. Shortly, we will be utilizing our form-free platforms to deliver transactions through an ATM/PIN kiosk. We are also in early discussions with the company to develop a mobile phone money transfer pilot. We believe that mobile phone money transfer will gain importance over the next 3-5 years.
On the receive side, we are providing consumers with a better choice and better control over how their money is being delivered to recipients. In Poland and Mexico, we recently launched cash-to-account service, and we implemented home delivery service in Vietnam and Pakistan. We are also focused on rolling out the MoneyGram Rewards programs to several European markets and Canada next year. We will also be adding new consumer benefits including SMS notification to senders that their funds have been delivered to the recipient.
On Slide 21, in addition to our strategic priorities, we have five key corporate priorities. First, we will pursue profitable global growth. Money transfer is a $400 billion-a-year market and growing 8% and will present opportunities well into the future, especially overseas. We will maintain a disciplined approach to running business cases on each agent to ensure that our agent expansion meets our profitability goals.
Second, we will look for operating efficiencies to drive margin expansion. Our scale on money transfer should help drive leverage on key expansion lines such as marketing and received commissions. Our new settlement system will provide scale in our back office as well as greater speed to market on new product features. We will also be looking for expense opportunities related to our legacy paper-based products.
Third, we will invest in capital only when meeting appropriate ROI thresholds. We run business cases on each project requiring capital and we have specific thresholds for each agent deal we sign. We will maintain this discipline into the future.
Fourth, we will emphasize driving free cash flow. We will achieve this through operational execution and disciplined capital deployment. Finally, we will maintain an investment portfolio strategy with negligible risk and volatility. The current portfolio composition of approximately 90% cash and 9% agency securities clearly reflects this philosophy of our newly adopted investment policy.
Finally, on Slide 22 and in summary, MoneyGram is financially strong. We have a solid balance sheet with nearly $350 million in unrestricted assets. We are generating substantial cash flow that will allow us to invest in our core business and service our debt. We remain very enthusiastic about the global money transfer market. We are one of only two global money transfer players that combined have just over 20% market share.
We see significant opportunities to improve our global position in this $400 billion market which continues to benefit from secular growth driven by global immigration. Our international brand, vast agent network and superior delivery platform position us to capitalize on these opportunities as evidenced by the 23% fee revenue growth in money transfer and bill payment in the second quarter and the 26% growth in our agent network.
We have repositioned the official check business and we are expecting improving results as the full impact of the re-pricing takes effect. Importantly, we are well situated to drive profitability in this product with negligible portfolio risk. Finally, we have a sound plan for future growth in an enormous global market supported by our four key strategies and our corporate priorities. This plan will allow us to fulfill our brand promise of providing consumers with more control and choice over the way they transfer money.
We thank you for your time today and now we will open it up for questions.
(Operator Instructions) Your first question comes from [John Derusso - Robotti].
[John Derusso- Robotti]
In light of developments in the auction rate securities market is any of that write-off on your auction rate securities, is any of that going to be reversed in the future in your opinion?
David J. Parrin
I think at this juncture until that market comes back we just don’t see a lot of possibility there. And if you’ll recall we talked about that factor in the recapitalization, we assumed a zero value for that. So, we can, from a liquidity and capital perspective, handle further declines in the value. Of course our hope would be that at some juncture we’ll be able to recoup the investment we have there.
[John Derusso- Robotti]
So all this litigation that’s taking place in New York doesn’t have any kind of positive.
David J. Parrin
Best I can tell from looking at that that mostly relates to individual retail investors and small businesses. They’ve not come back to their institutional customers at this juncture.
There are no additional questions at this time.
David J. Parrin
If there are no additional questions, then we’ll wrap it up, and I want to thank everybody for their time this afternoon in listening to our second quarter earnings release. We look forward to talking to you next quarter and discussing the opportunities that we have. Thank you very much.
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