Description

MGI is not your average LBO.  In addition to being a cheap (read, “highly levered”) option, an investment in MGI is also an opportunity to buy a fantastic company at a bargain price.  For context, the only pure-play public comp trades at a 68+% premium, just a few months ago there was a credible bid for the Company at a 99% premium, and the stock traded at 3x current levels less than a year ago.  Arguably, MGI is in better shape now than ever due to a new contract with Wal-Mart, a revamped balance sheet, and the scrutiny of some sophisticated and highly vested majority shareholders.  But here’s the real kicker.  As a result of technical pressure on the shares (most institutional investors who owned the stock when it had a multibillion-dollar market cap are forced sellers now that the value of MGI’s public float is only $145mm), you can invest in MGI at cheaper levels than the well-dressed Wall-Street titans, who recapped the Company less than two months ago.  As a result, you effectively relever the LBO and enhance your returns even more.  So, kudos to the Deal Kings at TH Lee and Goldman Sachs (for the purposes of this write-up we’ll just call them the “DKs”) for cutting such a favorable deal for themselves.  And, I’d be remiss to not thank Mr. Market, who has graciously offered us the shares at a 30% discount to price paid by the DKs.  Impossible as it may seem, MGI is truly a “Value LBO”.

 

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To appreciate an investment in MGI, one must first understand the events that transpired over the past year involving the Company (for regular readers of financial news this is likely stuff you already know).  Twelve months ago, MGI was a high flying “growth” stock enjoying a period of rapid global expansion in the funds transfer industry.  Increased immigration served as the main catalyst for this growth as funds typically travel from developed to undeveloped country (mainly people sending money back home).  As the #2 player in an industry with no formidable #3 (Western Union is #1), MGI is particularly well-positioned to take advantage of this secular trend.  While smaller players can compete in specific markets, size and scale (for MGI, 150,000+ agent locations in 180 countries/territories) rules the day in the money transfer business.  In addition, post-9/11 regulatory scrutiny favors larger players.  With 19% revenue growth in 2006, the stock climbed as high as $36 (15x EBITDA) in May 2006. 

 

Too good to be true?  15x EBITDA rarely lasts forever.  In MGI’s case, mixed Q2 results released in July 2007 were only the beginning of the end.  The more significant issues began to surface when MGI filed its 10Q a couple of weeks later.  In it, the Company disclosed gross unrealized losses of $117mm in its investment portfolio.  How does a fee-based business take $117mm of losses you might ask?  In addition to its core Money Transfer business, MGI also has a Payment Systems Segment (representing 17% of profit) that various financial institutions outsource their transaction processing to (checks, automated clearing house and money orders).  MGI is paid a very modest fee for this commoditized service and further juices returns by earning a spread while they hold funds for the benefit of the payment obligations until the checks and money orders clear.  In reality, they can invest the cash in much longer duration assets as new inflows cover the outflows – cash is fungible.  Though growth essentially stopped in the Payment Systems Segment in 2006 and 2007, MGI increased profit from this business by over 50% Y-O-Y in 2005.  How?  MGI stretched for yield by investing their float in mortgage backed securities; the same securities that began to show their ugly face in the form of the unrealized losses MGI began to report in Q2.

 

As you already know where this story is going, I’ll fast forward to the last chapter.  In Q3, the mark-to-market losses had doubled and by January 2008 when the Company issued an 8K discussing the DKs’ massively dilutive bailout plan for the first time, it became clear that the losses were not “unrealized,” but, in fact, very real, especially to the shareholders, who watched the value of their holdings fall by 86% over a period of just five months.  By the time the deal was finally consummated in March, the public float represented only 21% (details later) of MGI’s fully-diluted shares.

 

There is one very important chapter that I intentionally left out of the story so that I could end on a more positive note.  About two months after Q3 results were announced, Euronet (a more diversified payment services business that recently entered the money transfer space through a couple of small acquisitions) sent a letter to MGI proposing a business combination between the two companies in a stock-for-stock deal which valued MGI’s shares at $20 (~30% premium to MGI’s share price at the time).  Of course, the deal was subject to due diligence undoubtedly focused on the toxic investment portfolio, but things never got that far.  MGI needed cash and was likely already in talks with deeper pockets.  More on this later.

 

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There is a moral to this story.  MGI is a combination of a good business (Global Funds Transfer), which represents 83% of profits, and a smaller mediocre business (Payment Systems).  Unrelated to these two fee-based businesses, MGI sits on billions of dollars of cash which it invests at its discretion.  The point is that MGI’s business (largely the core Funds Transfer segment) generates significant and growing earnings independent of the investing activities that got MGI into so much trouble.  As a result, MGI’s operating difficulties can be fixed very quickly and easily (granted also costly).

 

In fact, MGI’s problems are already behind it as the DKs structured an extremely favorable deal for themselves whereby MGI had to dispose of their toxic investment portfolio prior to closing.  As disclosed in 2007 10K, “subsequent to December 31, 2007, [MGI] sold substantially all of [its] investment portfolio.”  And further, “after the realignment of the investment portfolio…[MGI’s] credit risk primarily relates to the concentration of assets in U.S. government and government sponsored entities.”  Also, liquidity is no longer an issue.  With $305mm of revolver availability and $395mm of unrestricted assets, regulatory and contractual requirements are no longer a concern.  But there’s more.  In addition to dealing with problems of the past, with the help of their newfound Wall-Street muscle, MGI also was able to better position the Company for the future by extending its contract with its largest Funds Transfer agent, Wal-Mart, through 2013.

 

So despite all of its missteps, I would argue that MGI is a more valuable entity today than it was a year ago.  33% growth in profit in the second of half of 2007 seems to support this thesis.  Go figure.

 

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Let’s try to put ourselves in the wing-tipped shoes of the DKs for minute.  They were able to purchase a majority stake in a solid and growing company because they could easily derisk the business prior to closing the deal.  Furthermore, they were able to buy this company at a bargain price, because they negotiated with a forced seller (as MGI was under immense pressure as a result their regulatory and contractual requirements).  “Be greedy when others are fearful.”

 

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I am only a few short paragraphs away from getting to the valuation so try to bear with me.  But before I do, I must clear my conscience and disclose one important detail regarding MGI’s revamped capital structure.  Remember that pipsqueak at the back of the lunch line in elementary school (I admit, it was me)?  With regard to MGI’s capital structure, we are that pipsqueak.  MGI’s public equity represents just 8% of MGI’s capitalization in a first-loss position.  The greedy DK’s built in some additional downside protection by injecting their money in the form of preferred stock with liquidation preference over the common equity and a hefty dividend to boot. 

 

PF Cap Table				LIBOR	2.77%
		Rate	PF Interest	Maturity	3/25/2008	% of Cap.
Revolver - $250mm		3.50%	9.1	Mar-13	145.0	7.6%
Term Loan A		3.50%	6.3	Mar-13	100.0	5.2%
Term Loan B		5.00%	19.4	Mar-13	250.0	13.1%
Total 1st Lien			34.8		495.0
2nd Lien Notes		13.25%	80.1	Mar-18	500.0	26.2%
Total Debt			114.9		995.0
B Shares					767.5	40.2%
Public Market Cap					145.4	7.6%
Total Capitalization					1907.9
Net Debt (Total Debt - PF Unrestricted Assets)					599.7

 

Now don’t jump to conclusions and yell at me for leading you on.  I wouldn’t trick you into reading all of this if I didn’t think it was worthwhile.  Unless everything goes wrong for MGI (if you think this is a likely outcome, do not invest in MGI regardless of its cap structure), the DKs’ preferred stock is as good as common stock to us.  In fact, TH Lee’s 13D disclosed that dividends “are expected to be accrued and not paid in cash.”  The reason is that as the preferred accrues, the conversion ratio adjusts to compensate holders with more common equity.  The DKs, who have tons of inside information, prefer owning additional common equity at a price of $2.50 a share to a 10% cash dividend.  For me, that’s pretty comforting as we’re buying in at a price significantly below $2.50. (See Risks section for more on this.)

 

The Excel paste below walks you through the math to come up with the DKs’ actual pro forma ownership.  Though I’ve used LTM financials to value MGI later, I’ve assumed the dilution that would result from 2 years of accretion on the preferred for conservatism.

 

B Shares - $s			495.0
B-1 Shares - $s			265.0
B-1 Shares - Fees - $s			7.5
Total New Pref Shrs - $s			767.5
Interest Accrual Rate			12.5%
Accrued - 2 yrs			203.9
Total New Pref - $s			971.4
Conversion Price			$2.50
Total Common Shrs.from pref  (mm)			388.55
Total Common Shrs.from pref  (mm)			388.55
Existing Common			82.60
Total FD Shares OS			471.14
% Ownership Public Common - FD			17.5%
Market Cap
Share Price			1.76
Shares Outstanding			471.14
Market Cap			$829.22
Plus: Net Debt			599.7
Enterprise Value			$1,428.95

 

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The valuation as promised…

 

Because MGI has been growing earnings at over 15+% a year, it is not an easy company to value.  Further complicating matters is uncertainty regarding the severity and duration US economic downturn and how it will affect MGI (see “Risks” for a brief discussion of this).  Thankfully, we have lots of helpful data points outlined below. 

 

Euronet Bid (99% upside).  Euronet’s unsolicited bid from a few months is still very relevant.  If Euronet was willing to pay $20 a share for MGI and MGI is essentially the same business now than it was then (arguably better), why wouldn’t Euronet still be willing to pay a similar price for MGI shares?  The only reason I can think of is that EEFT’s shares have fallen about 40% since they bid for MGI so I’m not sure if they can afford it anymore.  So while I don’t expect Euronet to purchase MGI any time soon (I don’t think the DK’s would sell at that price anyway), it is comforting that a strategic was willing to pay roughly double the current share price for MGI.

 

Relative Value to Western Union (34-55+% upside).  WU is the industry leader with more size and scale as well as higher margins.  That said, there is simply no justification for the massive valuation discrepancy between the two companies.  Comparing MGI to WU is especially valuable as WU’s stock price reflects the market’s view of the recession risk for money transfer businesses. (Disclaimer: I don’t subscribe to the efficient market theory.)  I’ve discounted WU trading multiples by ~25% because WU deserves a premium multiple.  Importantly this comparable analysis assigns value to MGI’s Money Transfer business ONLY, and completely ignores the Payment Systems Segment, which has generated $35+mm of pretax profit in each of the past three years.  While more conservative investing practices will surely depress earnings, there is likely some value in this business especially with the main competitor, First Data, pulling back. 

 

MGI 52-wk Hi Price (206% upside).  The macro environment for MGI has changed a lot since July 2007 so this is not exactly a fair comparison.  I thought it was worth including because the economy will eventually sort itself out and MGI should still have plenty of runway ahead of it when it does.  Again, macro factors aside, I believe MGI is a better business today than ever.

 

		Comp. EBITDA X		Comp. EBIT X		Euronet		52wk Hi
Global Transfer Stat - LTM			221.3		173.8
Implied Multiple			6.5x		8.2x
Comp Multiple - LTM			10.0x		11.0x
Actual Stock Price							20.00		30.67
Implied Stock Price @17.5% FD Ownership							3.51		5.38
Upside			55%		34%		99%		206%

 

It is worth briefly mentioning another potential pocket of value.  MGI has substantial NOLs that the Company accumulated as a result of the ABS losses ($442mm at 12/31/07, but will grow after Q1 results).  The NOLs are not obvious as the 10K characterizes them as a “basis difference in revalued investments” because they were not “realized” at the time the Company filed their 10K.  While MGI stated that “due to the amount and characterization of losses, the Company determined that it was not “more likely than not” that the deferred tax assets related to the losses will be realized”, I have a hunch that the DKs will be able to extract some value from these NOLs. 

 

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MGI is too cheap to ignore at current levels.  On a relative basis, MGI’s only comp trades at a 68+% premium (assigning no value for the Payment Systems Segment), and there was recently a credible bid from a strategic that implies a double from current trading levels.  On an absolute basis, MGI generated ~$120mm of after tax profit out of its Funds Transfer Segment alone in 2007.  That implies a 12x unlevered earnings multiple for business with tons of room to grow.  While the economic headwinds may slow MGI, the margin of safety more than compensates you.

 

In addition to having great downside protection, the DKs are undoubtedly working very hard as we speak for their home-run payday, which I have yet to mention.  Representing less than 5% of the global money transfer market, MGI has substantial opportunities to grow both organically (mainly internationally) and by rolling up smaller second and third tier players (domestically and internationally).  If MGI can take advantage of these opportunities, the DKs’ eventual exit from their investment could be spectacular.  Not only is MGI a highly leverable asset (predictable cashflow generation) that will attract a ton of private equity interest, it also it a logical acquisition for strategic players.  In addition to Euronet, I think a global bank would potentially be very interested in acquiring a network of 150,000 agent locations located in 180 different countries/territories.  MGI is an excellent cross-selling opportunity for banks.  Of course, the DKs could also just do a secondary offering. 

 

If you don’t mind the small public float and can tolerate going along for a ride with some Wall-Street heavyweights, MGI is great bet with great downside protection and substantial levered upside.

 

Risks

SEC Investigation / Shareholder Lawsuits:  The SEC is currently conducting an “informal, non-public inquiry relating to the Company’s financial statements, reporting and disclosures relating to the Company’s investment portfolio and offers and negotiations”.  There are several shareholder lawsuits as well.  It is difficult to assess the probability of MGI paying fines in either case, however, we can get a sense for the magnitude of any potential fines. 

 

In terms of litigation, assuming damages of $2.4bn (which equates to the value destruction from the 52-wk high price to today’s price), I estimate a $24mm settlement with shareholders (based on similarly sized cases, which settled for approximately 1% of “estimated damages”).  Potential SEC fines are a little more difficult to quantify.  However, as they will be focused on the amount of any fraud or misrepresentation (and not decline in market value), it is likely that these will be manageable as well.  In addition, it seems likely that the SEC will try to avoid punishing MGI’s new shareholders, who orchestrated the bailout, too harshly, and may instead focus their energy on the Company’s officers.

 

I also get some comfort from the fact that the DKs and MGI’s new debtholders have presumably diligenced this risk prior to making their investment. 

 

Minority Shareholder Issues:  As common equity holders, we are at the whim of some notoriously greedy DKs.  However, there is significant legal protection for us should the DKs choose to risk their reputations by enhancing their position at the expense of minority shareholders.  In addition, MGI’s largest public shareholder, Blum, has a history of actively protecting shareholder interests.

 

However, despite these facts, the Independent Directors have elected to accrue interest on the DKs’ preferred stock.  This sweetheart deal for the DKs destroys value for public shareholders.  From our perspective, the additional dilution is significantly less favorable than paying a 10% dividend to the DKs in cash.  Management and the Board, who both unfortunately have no real stake in the common stock, are clearly not “independent”.  I am surprised shareholders have let the DKs get away with this so far.

 

Economic downturn:  It is difficult to quantify this risk, but MGI will not escape a prolonged downturn unscathed.  The good news is that the stock is not trading on fundamentals (technical overhang) given where it trades relative to WU.  From a fundamental standpoint, MGI has withstood the slowdown in housing / construction (a significant portion of domestic customer base) and its international business, which already represents 25% of sales and is growing at over 30% annually, should provide some insulation. 

 

Catalyst

(1) One or two quarters of clean results (without investment losses) will bridge the valuation gap between MGI and WU.

(2) Transition of shares away from legacy institutional shareholders, who have likely lost interest and a lot of money in MGI.

(3) The DKs potentially buy out public shareholders at a significant premium to current trading levels and take MGI private.

(4) Big payday exit for the DKs (and us) vis-à-vis sale, merger, or public offering.