Pat Dorsey’s, The Little Book That Builds Wealth” does a superb job of laying out the characteristics of a moat and demonstrates how to find companies that have this essential advantage. The bottom line is that companies with moats should continue to generate great profits for an extended period of time and have clear advantages over their competitors that cannot soon be overcome.
Dorsey points out that investing in companies with strong moats provides for investment discipline and lowers the chances of overpaying for the stock if it truly has a competitive advantage.
Some of the characteristics of moats are laid out for the reader below:
First is the company with intangible assets that separate them from their competitor. It may come in the form of patents, trademark or brand names. Examples include the likes of Coca Cola (KO) or Tiffany’s (TIF) who each can charge more because of their recognized brand name. People will pay more for a product simply perceived as being better.
Another characteristic is that of switching costs. The often used example is that of one bank over another. The cost of switching may not only cost you the customer in fees, but also time and to very little advantage, except to the bank which will get larger fees. That is why most people disdain changing banks, but the banks love it. After all, it means higher return on capital.
A company, such as an electric company or local cable company may have a regulatory advantage because competition is limited and they may be protected against another company attempting to take away market share.
There is also the company that has the advantage of lower costs due possibly to size or efficiency. Walmart has undoubtedly been the retail leader in this area for a very long time, though their moat has been under attack by companies such as Target (TGT) and the smaller type of stores such as Dollar General (DG), Family Dollar (FDO) or Dollar Tree (DLTR). Size still matters because Walmart continues to demonstrate an ability to expand its reach into other areas, continually redefining the company and expanding their advantage over others.
Dorsey also talks about what he labels the “Network Effect”. This is where a company maintains a competitive advantage because it would be so very difficult for any competitor to enter the market and replicate the business. How long and how fast a competitor can enter the market and begin taking shares is of primary importance in evaluating the network effect. Oddly enough, Dorsey actually talks about Western Union (WU) having this advantage over its closest competitor because of their large amount of networks throughout the world. He states that their network is three times bigger than their closest competitor but they perform five times as many transactions.
The most important thing to remember about the moat concept is that they are structural characteristics of the company that permit them to possess advantages for years to come, sometimes even much longer. As Walmart demonstrates though, bigger is not always better. Just because you have or have had a great product with a recognized name or are a low cost leader doesn’t mean you have a moat that cannot be attacked by a competitor. If switching cost advantages are not sufficient, the moat can possibly disappear in short order. This is not to insinuate that Walmart’s moat is gone. I don’t believe that it is. Nor does great management or market share necessarily afford a company a competitive advantage indefinitely.
This brings us to Western Union (WU). Western Union has been a great company; many will argue that it still is. People will always be passionate when it comes to placing hard earned money in some stock and someone comes along and tells them why it’s not a great stock or why you should take an alternate view of it. You can make arguments for every stock, both long and short. There is a third, and that would be to avoid it altogether until a clearer picture is available.
When it comes to Western Union (WU), there appears to be stresses on the business model that are eroding the moat that has kept this such a great company. Here are some things to consider before taking a position.
Nomura analysts, along with others conclude that the business model is in decline:
While many claim that the brand name sets them apart, people do not appear to be ready to pay more for the services provided by this company. In fact, anecdotal evidence is everywhere that the prices were just too high. This has allowed new competition, most notably Walmart, to enter the arena and quickly grab market share. While Western Union insists that it can maintain their superior position as the leader in money transfer, it has already been forced to make price cuts. Prices are going down and the latest margins from Western Union indicate such. Bloomberg provides an example of a $900 transfer transaction with a fee of approximately $76, while Walmart will offer the same service at $9.50. Motley Fool concludes:
There is no size or efficiencies that separate this company from its existing or new competitors to the business. In fact, Forbes recently ran an article regarding Walmart’s entry which had an interesting statistic that 95% of Americans live within fifteen miles from one of their stores. How’s that for convenience? Ultimately, all the signs of moats are slowly disappearing and it remains to be seen how Western Union will respond.
There is one issue that caught my attention in the Western Union annual report that is disconcerting. The 2013 Annual Report, Note 6 regarding Related Party Transactions is couched in language that is less than forthcoming. A considerable amount of money (over $260 million) was involved with various agents along with commission expenses paid to agents related to the director. Some of these transactions may have been based upon some earlier acquisitions, however, not enough information is provided. While this issue along is not enough to indicate any transgressions, it serves as a warning that the investor must seek out additional information on this item.
The following portion from the annual report indicates that though Western Union is, overall using conservative assumptions for its pensions, it continues to fall behind in its unfunded status. In the current economic environment, 7% seems a stretch which may lead to a higher liability in the future:
While Western Union has been able to maintain over all high margins, note that the trend on gross margins, operating margins and net margins are declining.
Another issue which allows the company to paint a better picture is the tax rates shown in their annual report. While tax rates shown out of the normal range should be reason for concern, there may be legitimate reasons for the decline. Rates below 30-35% can indicate signs of tampering and studies indicate that companies below the normal range perform worse than those at a higher tax rate. The company reports that the lower tax rates currently used go back to a decision from a settlement with the Internal Revenue Service in 2003 and the rates reflect the judgment. Still, one can see that rates are moving toward the normal range, though still low and with diminished margins and pricing power may feel the full affect before too long.
The following chart indicates the revenue growth over the last five years, including the trailing twelve months and how both cost of goods sold and selling, general and administrative costs are besting the revenue growth. Once again, with decreasing margins and pricing issues, this will cost earnings dearly in the future unless Western Union can find a way to redefine the business.
Some other metrics of concern include return on invested capital (ROIC) and the interest coverage ratio. The interest coverage ratio indicates how well a company can pay its interest payment obligations. While the interest ratio is still well covered, it is definitely trending downward. Return on invested capital has also taken a decisive turn downward.
In addition to that mentioned, one must consider the weak global economy, the more stringent regulations by governments all around the globe tied to currency war, capital controls and various new tax strangulations. Also are the new kids on the block such as PayPal and other new technologies that are becoming available by cell phone, the future does not look bright unless they can somehow reinvent themselves. The business is in decline without Walmart entering into the fray. This is merely a way for Walmart to pick up some needed revenue and keep shoppers in their stores.
Each investor should complete their due diligence. I can only state that at best, one would be better off watching this one from the sidelines.
Be careful what you say. From Moneymorning.com:
Worst Tech Prediction No. 2: The Telephone, 1876
When Alexander Graham Bell approached Western Union Co. (NYSE: WU) with his invention, the company president wrote an internal memo: "This 'telephone' has too many shortcomings to be seriously considered as a means of communication. The device is inherently of no value to us."
Disclosure: Long WMT