Western Union: Old Name, New Opportunities
Western Union (WU) has a long and very interesting history that plays an integral part in America's Manifest Destiny, and that story continues today in the company's leading role in international remittances. The company was one of the original members of the Dow Jones Transportation Average in 1884 and has endured every market cycle and new disruptive technology since its inception in 1851.
Western Union is positioned for long-term success because of the combination of demographic trends, new market opportunities, and its advantages of scale. The company is poised to expand its share of the global remittance market, and that should support continued strong cash flow, allowing shareholders to be rewarded with acquisitions, share buybacks and increased dividends.
The business consists of these operating segments:
Consumer-to-consumer (C2C): Money transfer services between consumers. The global financial crisis has certainly dampened growth in this, the most important of Western Union's business segments. At least 200 million people live outside their country of origin. Primarily, immigrants move from poorer to wealthier countries in search of opportunity. When these immigrants leave their nations of origin, they often leave behind family members in need of support. Most money transfers are typically sent to cover the living expenses of relatives residing in other countries.
Global Business Payments (B2B): Payments made by consumers or businesses to other businesses. This business primarily caters to "underbanked" customers and allows for the payment of bills direct to businesses — even internationally, or on someone else's behalf.
Other Operating Segments: Money order and prepaid services. The company offers Visa (V) and Mastercard (MA) branded prepaid credit cards. Prepaid cards act as a store of value for customers who do not have access to traditional checking accounts. This business segment has come under regulatory scrutiny as it is seen as a highly effective mains of laundering money internationally.
Competition - As large institutional banks expand into developing markets, Western Union is facing increasing competition from international banks offering remittance services.
Technology - As customers in developing nations have increased access to the Internet, the company faces competition for online payment firms such as PayPal. Likewise, as customers gain access to mobile devices this expands the options for transferring funds. Yes, there's an app for that.
Immigration Reform - Any change in immigration laws worldwide could make it harder for people to relocate to developed economies, which would hurt money transfer volume.
Regulatory Reform - The Consumer Financial Protection Bureau, established by the Dodd-Frank Act, makes way for more scrutiny of remittances and leaves open the on-going possibility of further regulatory action. Regulation of any industry tends to favor the largest operators and promote industry consolidation in that it raises the barriers of entry, but typically also puts pressures on margins by either setting price limits or increasing operating costs.
Brand Value - The name Western Union is synonymous with sending money. While the company has earned a reputation as a safe and reliable way to send money, it is very unlikely that customers feel any attachment or a have a sense of loyalty to financial institutions in general or Western Union in particular.
Demographics - The demographics behind immigrant population growth are firmly in place for the foreseeable future. Slow population growth in developed nations and the vast disparity in standards of living for poorer nations is what pumps the blood of the C2C market, the heart of Western Union. With around four billion under-banked people in the world, Western Union's global network has great potential to provide a variety of customer services.
Scalability - Western Union is the clear leader in an industry where size confers strength. They process almost five times as many transactions as their next closest competitor, MoneyGram International. The money transfer business is scalable because the cost of processing additional transactions is minimal. This gives the company a cost advantage over rivals. Also, the company's size creates a network effect, as each new agent makes using Western Union more convenient for customers. Western Union currently has about 460,000 worldwide agent locations.
Growth - On a related topic to scalability, Western Union still has plenty of room to grow as it has barely penetrated the remittance markets of India and China. Also, with only a 20% market share, the company can continue to grow its market share in established markets because its unique cost advantage allows it to price out competitors.
Technology - Instead of a threat, I think new technologies will allow Western Union to grow remittance volumes and capture greater market share. For example, low priced cell phones have prompted the explosion of mobile banking in Kenya, where banks have not successfully reached large segments of the population. Reading recent conference transcripts, the company is intensely focused on expanding its product offerings to monetize the network through initiatives in online payments (ACH transfers), mobile-to-mobile payments, prepaid card services and micro-lending services. The company can use its agent network, brand recognition, international compliance capabilities, and global reach to make moving money around the world faster and easier. Like First Date Corporation, or Visa and MasterCard, Western Union is in the business of driving transaction volume, and new technologies promote that end.
Western Union is a strong generator of free cash flow. Cash flow is important because it gives management the opportunity to increase shareholder value through actions like paying dynasty building dividends, buying back shares, and funding organic business growth. The reinvestment needs of the company are quite small. New agents often require little more than hanging a sign in the window. The company's leading market position effectively allows it to set prices for the industry, pushing prices down to a level that competitors simply can't match.
The company does have over $3 billion in long term debt but management is obviously content with its ability to generate enough free cash flow to cover its debts as the company has focused instead on buying back shares, increasing its dividend and making tuck in acquisitions.
Since its IPO in 2006 Western Union has reduced its shares outstanding from 777 million to 632 million and plans on making an additional $890 million investment in share repurchases in the second half of 2011. Additionally, the company has rapidly increased its dividend from $.01 in 2006 to its current payout of $.08 per quarter. Obviously that rate of dividend increase is unsustainable on a percentage basis but the company has established a track record of dividend payments, and with a pay out ratio of 20% there is a wide margin of safety and plenty of room for growth.
Interested readers can look to their favorite financial websites, like GuruFocus or Morningstar, for a quick view of the company’s financial records and will likely be impressed by the high margins and returns that Western Union has been able to deliver, even in the recession years. (http://www.gurufocus.com/financials.php?symbol=WU)
Although the company has a limited history operating as a stand-alone business, I have grown fond of Western Union’s management. In addition to shareholder friendly services like share repurchases and dividend increases, I am very impressed with the clarity with which the company communicates with its shareholders. CEO Hikmet Ersek and CFO Scott Scheirman have been forthright both in quarterly conference calls and in interviews about the various challenges Western Union faces and how the company intends to deal with those issues. This in and of itself signifies nothing of the company's ability to stave off economic, competitive or technological threats but the fact that management is willing to openly discuss the company's shortcomings shows that they are in tune with markets and prepared for change. The majority of these concerns are regarding the threats of new technologies such as mobile apps and how the company is positioning itself to compete in this space.
I’m not interested in writing a PR piece for the company, but interested readers can learn more about managements initiatives online or by reading conference call transcripts.
Using the GuruFocus Fair Value Calculator, our starting point for valuing the business is $29.85 which we derived using the following assumptions: growth rate of 8.6% using the average growth rate of the last five years; a terminal growth rate of 3% based on popular assumptions of inflation; a discount rate of 11% because that is what was recommended on the site; and a book value of 0.43 based on last quarter's report. All of which implies a margin of safety of 36% which is awfully good for a proven industry leader.
You may of course take issue with any or all of the variables I used and come up with a wide variety of possible fair value estimates.
If we adopt the reverse DCF method, in order to reach the stock's current price of $19 per share based on a terminal rate of 3% and a discount rate of 11%, the market is currently pricing Western Union at 0% growth.
I understand the pessimism given the current outlook for the European and American economies, but even if revenues are flat for 10 years the share buyback program will drive EPS growth above 0%. That is the true measure of the margin of safety in this stock — it is literally being priced for failure, as in a negative real growth rate after buybacks and dividends. I think this makes Western Union one of the lowest risk investments available in today's market.
Given the impact on Western Union’s core C2C transactions volumes caused by the recession, it is reasonable to assume that the company could achieve growth in the low double digits in a return to “more normal” operating conditions. The company was forced to withdraw the long term earnings growth forecast of 15-18% it made in its IPO year of 2006 due to the financial crisis, and a 12% growth forecast effectively splits the difference from its previous bubble optimism and today’s recession level 8% EPS growth. That represents substantial upside to our DCF model.
Let’s not hide behind political correctness. Western Union serves immigrant workers, the people most severely affected by the housing market crash and subsequent recession. Any improvement in employment or housing markets will eventually show up on Western Union’s bottom line. The market is over emphasizing weakness in the US - Mexico corridor transaction volume in the short term. Longer term Western Union is becoming a much more global brand while still expanding its market share in mature markets, even in the face of weak employment. Western Union could almost be considered a leveraged play on a rebound in global employment rates.
Western Union's moat can be a little hard to understand. They serve the under-served, some would say the bottom of the pyramid, but I see it as the future of the world — the emerging middle class. The person sending the money typically has numerous options at his/her disposal from traditional banking operations. However, the person receiving the funds does not. Herein lies the strength of the company. While it may seem obvious that global economic growth and new technologies will chip away at Western Union's position serving under-banked customers, these same factors also allow the company to expand into a much larger financial institution offering services beyond C2C and B2B international remittances, primarily in online and mobile payment solutions, and prepaid card services.
Western Union is the type of company a younger Warren Buffett might have liked (he used to be a shareholder, FYI). A strong generator of free cash flow, selling at an attractive price. The reinvestment needs of the company are quite small. The company's market position effectively allows it to set prices for the industry, pushing prices down to a level that competitors can't match. It is also aggressively expanding its global agent network and expanding its product offerings to monetize the network.
If management remains focused on changes in the market, new technologies should prove to be a source of growth rather than a threat. The company is making meaningful progress in electronic channels, westernunion.com, account-to-cash, mobile payments and pre-paid cards. These efforts will continue to give the company access to new customers and provide more choice for existing customers to continue doing business with Western Union.