A Potential Value Mirage In Western Union

Nov. 8.12 | About: The Western (WU)

Headline

During the Q3 2012 earnings call, Western Union (NYSE:WU) revised 2012 top line growth projection from 4%-6% to 2%-3%, operating margin excluding integration expense from 25.5% to 24.5% and EPS range from $1.68-$1.72 to $1.62-$1.63. The company expects CtoC pricing investments to be mid-single digit as a percentage of revenue in 2013 vs. 1% in 2011 and 2012. Management expects 2013 operating income to decline 10% to 15% but believes there would be positive revenue and operating income trends in 2014. After a 30% price drop since the earnings release on October 30, is WU deep value or a value mirage?

Economics of Consumer-to-Consumer

The economics of the CtoC money transfer business (85% of revenue) has been steadily declining in terms of revenue per transaction and revenue per location.

2004

2005

2006

2007

2008

2009

2010

2011

C2C Transaction Fee

2,390.9

2,724.0

3,059.0

3,286.6

3,532.9

3,373.5

3,434.3

3,580.2

Transactions

96.66

118.52

147.08

167.7

188.1

196.1

213.7

225.8

Y/Y

22.6%

24.1%

14.0%

12.2%

4.3%

9.0%

5.7%

Revenue per transaction

24.74

22.98

20.80

19.60

18.78

17.20

16.07

15.86

Y/Y

-7.1%

-9.5%

-5.8%

-4.2%

-8.4%

-6.6%

-1.3%

Click to enlarge

2011 Q1

2011 Q2

2011 Q3

2011 Q4

2012 Q1

2012 Q2

2012 Q3

Transaction Fee

839.8

898.0

922.2

920.2

872.0

893.6

882.1

Transactions

52.8

56.3

57.64

59.06

56.4

58.5

57.64

Y/Y

6.4%

6.1%

5.0%

5.2%

6.8%

3.9%

0.0%

Rev per transaction

15.91

15.95

16.00

15.58

15.46

15.28

15.30

Y/Y

-2.2%

0.4%

-0.3%

-3.2%

-2.8%

-4.2%

-4.3%

Click to enlarge

Click to enlarge

2007

2008

2009

2010

2011

Agent commissions

1,965.9

2,165.1

2,012.4

2,084.9

2,171.4

Agent locations

335.0

375.0

410.0

445.0

485.0

Unit growth

12%

9%

9%

9%

Commission per location

5.87

5.77

4.91

4.69

4.48

Y/Y

-2%

-15%

-5%

-4%

Revenue Per Location

9.81

9.42

8.23

7.72

7.38

Y/Y

-4%

-13%

-6%

-4%

Click to enlarge

According to the 10K, agent commissions represent approximately 70% of total cost of services. Western Union has been cutting commission, and revenue per location has been declining. In 2001, WU's market share in CtoC is roughly 7% and it doubled to 15% in 2006. The last three years, the market share gain has been stagnant even though agent locations increased 20% per year. The diminishing return per incremental agent location is likely a result of the company opening locations in remote places rather than high-volume corridors where the competition is more intense.

2009

2010

2011

Total remittance market size

414

440

483

Principals transacted

71

76

81

Market share

17.1%

17.3%

16.8%

Click to enlarge

Source: World Bank, 10K

Economics of Business-to-Business

Management expects Business Solutions' profitability to improve significantly in 2013. However, my previous write-up (Business-to-Business will be Western Union's Achilles' heel) has detailed analysis on why the BtoB segment would be barely breakeven in 2013. The stagnant market share in CtoC coincided with the decision to pay 13x and 13.5x EBITDA for Custom House and Travelex in May 2009 and Nov 2011. BtoB has limited synergy potential with Western Union's existing physical agent network because BtoB transactions are mostly done through wire transfers and ACH.

Instead of trying to strengthen its 17% market share position in the CtoC segment, the company acquired 2% share of a $24 billion market dominated by banks. In May 2012, management thought that the business could grow in the low double-digit range for the next several years because of global trade growth being 2X GDP and market share ramp-up. Two months after, the growth expectation was revised down to mid-single digit because of global trade slowdown.

Guidance history: changing tax rate quarter to quarter?

Q4 2011 (Feb 12): Expected revenue growth of 4% to 6%, operating margin excluding integration expenses at 26% and tax rate of 16% to 17%.

Q1 2012 (Apr 12): Reaffirmed full year 2012 outlook

Q2 2012 (July 2012): Maintained revenue outlook at 4% to 6%, margin excluding integration expenses revised down 50bps to 25.5% due to compliance cost from Dodd-Frank and Southwest Border and tax rate of 15% to 16% due to non-recurring benefit during the quarter. EPS guidance was raised.

Q3 2012 (Oct 2012): Updated revenue outlook to 2% to 3%, margin revised down 100bps to 24.5% (half of the decline due to $30million restructuring charge) and tax rate of 14% and 15% due to cost savings initiatives. Management expected 2013 tax rate to be higher.

Restructuring

Per 2008 10K, management incurred $83 million restructuring charge to close several facilities in the U.S. and transition these operations to more cost-efficient locations. Management expected over $40 million in operating expense savings annually starting 2009.

Per 2010 10K, the company started a second restructuring program ($106 million charge) to reduce overall headcount and move positions from various facilities, primarily within North America and Europe, to regional operating centers. Total cost savings of approximately $55 million in 2011 and approximately $70 million are expected to be generated in 2012 and annually thereafter.

During the Q3 call, the management said it plans on implementing cost savings initiatives in Q4 2012 ($30 million charge), including reduction of the company's headcount and the migration and consolidation of positions from various facilities, primarily within the U.S. and Europe to regional operating centers. This third round of restructuring will generate $30 million annual savings in 2014.

It seems the company keeps on finding more U.S. and Europe facilities to move to regional operating centers and there is a fresh round of restructuring once savings offset the initial charge.

P&L: Base Case vs. Consensus

Consensus (FactSet)

FY '12E

FY '13E

FY '14E

Sales

5,644.3

5,584.2

5,855.5

EBIT

1,370.8

1,247.1

1,342.0

Pretax Income

1,211.3

1,179.9

1,167.1

Implied tax rate

15.3%

22.7%

17.8%

Net Income

1,025.4

911.7

959.7

Revenue growth

2.78%

-1.07%

4.86%

Operating margin

24.3%

22.3%

22.9%

Operating income Y/Y

-1.03%

-9.03%

7.62%

Shares outstanding

594

559

512

EPS

1.72

1.63

1.87

Click to enlarge

Base Case

FY '12E

FY '13E

FY '14E

Sales

5,656.1

5,543.0

5,820.2

EBIT

1,349.3

1,158.3

1,358.7

Pretax Income

1,134.3

944.4

1,153.5

Implied tax rate

15.0%

16.5%

16.5%

Net Income

964.2

788.6

963.2

Revenue growth

3.00%

-2.00%

5.00%

Operating margin

23.9%

20.9%

23.3%

Operating income Y/Y

-2.58%

-14.15%

17.30%

Shares outstanding

594

559

512

EPS

1.62

1.41

1.88

Click to enlarge

Pro Forma assumptions that drive 2013 below-Street estimate ($1.41 vs. $1.63)

Sales

Base case assumes the mid-point of management guidance of 2%-4% top line growth. Revenue growth is an aggregate of price investment, FX and transaction. Price investment will be mid-single digit and assume FX will be -2% similar to 2011. Base case assumes transaction growth would offset price investment. Management did 3% and 4% price investment in 2009 and 2010 and revenue declined 3.8% in the first year. 2013 is assumed to be half as bad as 2009 (-3.8%). Consensus sees V-shaped recovery for 2014 with top line growing at almost 5%, a rate similar to 2010.

Cost of Services

This consists of agent commissions, fixed IT infrastructure cost and D&A. Past agent commissions have been roughly 70% of cost of services per 10K. Pro forma agent commissions are estimated as agent locations (Y/Y +9%) and commission per location (Y/Y -5%) through past extrapolations. Historical IT costs are estimated from subtracting D&A and agent commissions from total cost of services. 2012 IT cost is assumed to be flat from 2011 at $740 million and 2013 IT cost would spike +5% due to "significantly increasing investments in IT" at $780 million. From past extrapolations, depreciation is estimated as 30% of PP&E and amortization is estimated as 25% of intangibles.

SG&A

This primarily consists of payroll and marketing expenses. Payroll is estimated as total headcount (per 10K) and wages per employee. Marketing spend is assumed to be +100bps Y/Y in 2013 due to new campaigns of price investment.

Tax rate

Assume tax rate would normalize at 16.5% in 2013.

Dividend

Assume 20% dividend growth and payout would increase from 18% run-rate to 25% in 2012 and 35% in 2013.

CapEx

Management expects capital expenditure to be 4%-5% of revenue in 2012 which will normalize back towards the 3% range. Base case assumes 2012 and 2013 CapEx at 4.5% and 4% of revenue.

Balance sheet constraint

To maintain A- credit rating, the company needs to have gross debt-to-EBITDA of roughly 2x and $1.5 billion cash.

Free cash flow

Base case sees approximately $850 million free cash flow in 2012 and 2013.

Debt paydown

Base case assumes debt ratio could be pushed up to 2.4X at most. The company would need to retire roughly $150 million debt.

Shares repo

As a result of the balance sheet constraint, the repo pace would slow from 70% of free cash flow in 2011 to 60% and 50% in 2012 and 2013, respectively.

Income Statement

2011

2012E

2013E

2014E

Total Revenue

5,491.4

5,656.1

5,543.0

5,820.2

Top line growth

5.8%

3.0%

-2.0%

5.0%

Cost of services

3,102.0

3,271.6

3,373.9

3,457.0

SG&A

1,004.4

1,035.2

1,010.8

1,004.4

Operating expenses

4,106.4

4,306.8

4,384.7

4,461.4

Operating Income

1,385.0

1,349.3

1,158.3

1,358.7

Cost of services (Software Equipment Telecom)

738.0

740.0

777.0

760.0

SG&A % of sales

18.3%

18.3%

18.2%

17.3%

Number of employees

8.0

8.0

8.2

8.4

Wages per employee

97.4

98.0

98.0

99.0

Payroll

784.0

803.6

831.6

Cost of services ex-restructuring % of revenue

56.3%

57.8%

60.9%

59.4%

SG&A ex-restructuring % of revenue

17.6%

16.9%

17.9%

17.3%

Operating Margin ex-restructuring/ integration

26.1%

25.3%

21.3%

23.3%

Depreciation

61

59.4

59.6

62.7

Amortization

131.6

211.9

207.5

193.6

D&A (cost of services)

192.6

271.3

267.1

256.3

D&A % of revenue

3.5%

4.8%

4.8%

4.4%

Depreciation as a % of PP&E

31.0%

30.0%

30.0%

30.0%

Amortization as % of intangible

30.0%

25.0%

25.0%

25.0%

Restructuring/ Integration costs

46.8

In Cost of Services

10.6

In SG&A

36.2

80

20

Marketing % of revenue

4.1%

4.0%

5.0%

4.0%

Marketing expenses (SG&A)

225.1

226.2

277.2

232.8

Interest Income

5.2

Interest expense

(181.9)

(215.0)

(213.9)

(205.3)

Derivative gain/loss

14.0

Other income

52.3

Total Other expenses

(110.4)

(215.0)

(213.9)

(205.3)

Pre-tax income

1,274.6

1,134.3

944.4

1,153.5

Tax rate

8.6%

15%

16.5%

16.5%

Tax

109.2

170.1

155.8

190.3

Net Income

1,165.4

964.2

788.6

963.2

Shares outstanding

634

594

559

512

Diluted EPS

$1.84

$1.62

$1.41

$1.88

Click to enlarge

Bottom Line

Trading at 9x base case 2013 EPS and 6.5x 2014 EPS, the stock satisfies most value metrics. However, consensus is already expecting a V-shaped recovery to mid-single digit revenue growth in 2014. There is a $744 million repurchase program, close to 10% of market cap, but balance sheet constraint would slow down the shares repurchase pace. The 4% dividend yield would likely bring in income-oriented investors. However, with limited visibility at least until Q4 earnings call in February or Q1 earnings call end of April and a declining economics of the core business model, money is better on the sidelines.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.