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Western Union: Falling Knife?

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November 07, 2012 – Comments (1) | RELATED TICKERS: WU

Board: Value Hounds

Author: kelbon

WU is among the clatter of recently falling knifes, but it's a knife that stands a reasonable chance of being picked up, dusted off, and put back into the cutlery draw of investor's portfolios.

Western Union (WU). It brings to mind the past. Morse code and telegrams. The market's betting heavily that it is a "buggy whip" company. Possibly though, this is a case of the future not having arrived quite yet.

It is worth considering how rapidly things have changed, and continue to change, with the rapid evolution of technology. Cash, in many countries been surpassed by plastic, with more sophisticated electronic payment methods fast gaining ground. It's easy to think that if this is one's own experience then it's almost everyone else's too. But, not so fast… About half of the world's population don't even have bank accounts, and for them, cash is still king.

About 3% of the world's population live outside their country of origin, and, often they leave behind family members that need financial support. Consequently, the scale of the transference of money is huge. In 2006 26 countries derived at least 10% of their GDP from money transfers! The lion's share of Western Union's customers are immigrants who send cash back home to developing nations.

Mobile phones seem to be a viable money transfer option. However, a lack of electronic payment infrastructure in developing countries limits its practicality. Even so, Western Union is well positioned for the challenges and potential such money transfers offer. Even if those on the receiving end were inclined to go the mobile phone route, unless there was an easy way for them to access their money as cash—which currently there isn't—they would be unlikely to adopt this approach. In developing countries there is a low merchant acceptance rate of electronic payments because these countries are predominantly cash-based. It seems reasonable to think that a trend in mobile phone money transfers would be gradual rather than abrupt. This gives Western Union time to position itself to adapt and benefit from the trend. Never the less, a wide adoption of mobile-to-mobile transfers, some time in the future, would help remove a barrier for competition because a physical agent and location would no longer be necessary. To cite an example of how the future hasn't yet arrived: Global Payments acquired a money transfer company, DolEx, in 2004. Having incorrectly seen the near future of money transfers as card based, not cash based, Global Payments sold DolEx after five years of subpar profitability. To approximately quote Morningstar: "Western Union's customers aren't late adopters, they are last adopters."

There are two reasons why banks are unlikely to successfully poach Western Union's customer base: many people who use Western Union don't have bank accounts with which to either send and/or receive money. And, even if they did, money transfer fees charged by banks are generally higher than those charged by Western Union. (Estimates suggest that about half of the world's population don't have bank accounts).

Because of the advantage of size Western Union has been able to decrease its prices by a few percent a year. The average fee-rate has decreased by 15% over the last four years. In spite of this, the company has managed to slightly increase its customer-to-customer margins over the same period. Presumably, this strategy is designed to keep competition at bay as it would be less profitable to try to compete with Western Union and would likely entail a period of losses for new operators. This seems a smart move by management who are obviously mindful of their business model's vulnerabilities. Theirs is a business that requires relatively little capital spending so would-be competitors don't need insurmountable amounts of cash to launch an attack.

Western Union is the largest global operator, by far, with a revenue base about five times that of its closest rival MoneyGram. Size is key to competitive advantage in this industry as it provides the advantage of lower costs per transaction, somewhat of a network effect, and resources to strengthen the brand.

One issue that's rarely discussed is the value and strength of the brand. It might be very slight in comparison to Coca-Cola's, but it has to carry a little weight for recognition, longevity, and reliability; something that isn't reflected in the balance sheet. The possibility of the perception of the brand being a drag for investors is referenced above, however, from the point of view of their customers, the brand probably has some heft.

Western Union profits on money transfers in two ways: collecting fees and on currency exchange rate spreads. These are split about 80/20. Western Union has over 500,000 agent locations across the globe. Agents include banks, currency exchanges, and retailers. Agents generally view money transfers as not only supplemental income but also as a way to attract customers. This arrangement benefits Western Union too as they don't need to maintain, and finance, a retail network. Agent commissions are about 40% to 50%.

WU's balance sheet is streamlined. The only asset of any size, apart from cash, is goodwill from acquisitions. Because of the relatively modest amount of capital needed for the business and its healthy profitability, returns on invested capital—excluding goodwill—are well beyond the firm's cost of capital. Free cash flow usually equals, or bests, GAAP net earnings, and because of this, Western Union can afford to pay a higher dividend and live with smaller profit margins.

Western Union has increased reported earnings per share every year—except one—over the last five years and aggressively started to raise the dividend in 2009.

For what it's worth Morningstar is bullish on WU at the current stock price. They give the stock a five star rating; meaning that they consider it significantly underpriced. After WU's recent results and guidance Morningstar reduced their "Fair Value" of $29 a share to $25, which is still twice the current stock price. But, the "Wide Moat" rating remains intact, presumably because:

[…]It is the largest money transfer company in the world, with almost 20% market share in international remittances, and one of only two companies with a truly global agent network, with MoneyGram being the other.

All the same, Morningstar has recently acknowledged that Western Union's moat is weakening. A few leaks in the moat, but not the breach that the market seems to think.

Before the baby gets thrown out with the bath water its perhaps worth considering that WU is being valued as a business in terminal decline. It probably isn't. Also, along with the earnings and guidance disappointment the company announced a dividend hike which, at present prices, represents a yield of over 4% with a relatively modest pay-out ratio to boot.

On a risk/reward basis Western Union looks (to me) like a good bet, though there's no telling how long Mr. Market will continue to look down his nose at the stock, or what is in store for stock market prices and the global economy.

This is not a stock recommendation! Do you own due diligence.

kelbon

1 Comments – Post Your Own

#1) On November 13, 2012 at 5:55 PM, jspendmd1 (< 20) wrote:

Kelbon-

     ~100% upside? 4+ % dividend? Sounds good to me. Thx for the evaluation.

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