Description

Investment Thesis:

We believe Western Union’s (WU) business is challenged, and management is engineering earnings “beats” that are driven by accounting manipulations while at the same time key executives have been dumping their shares.

We think WU is a short because of (1) significant and accelerating competitive threats (2) declining profitability metrics (3) aggressive accounting manipulation (4) high levels of insider selling. WU was most recently been written up by chris815 and lars. For a comprehensive overview of the business and the bull thesis, we suggest you refer to those write ups.

A Challenged Business

Beneath the surface, we think the company's financial condition has been eroding for several years, and management is now engineering earnings beats through aggressive accounting manipulation to keep the WU story alive.

On an absolute basis, WU’s financial characteristics might seem appealing to many investors. However, once we put the company’s financial performance into context we believe there is a significant cause for concern especially as the majority of WU’s key financial metrics have continued to decline over the past several years.

As shown below Table 1, the company’s pre-tax income has been in decline. However, management has been able to offset the decline in pre-tax income with a lower tax rate. Ultimately, the combination of a lower tax combined with the company buying back shares has driven earnings per share growth despite the deterioration in pre-tax profits.   

Other notable financial metrics have shown a stark deterioration over the past several years. For perspective, the company generated operating margins of over 25% throughout 2008-2011; however, since then operating margins have deteriorated 600-700bps. Other key metrics such as return on capital have decline as well.

Perhaps, most worrisome, is the decline in pricing in the wake of increased competitive activity in the industry, especially North America. It appears transaction fees per transaction have been declining over the past several years as WU fights to be more competitive in effort to drive volume growth.

We believe WU faces growing competition that is unlikely to alleviate the ongoing pricing pressure. The payments industry is experiencing a sizable shift to online and mobile transactions as a growing number of upstarts and even large companies that are all vying for an increasing share of the electronics payments industry. Payment companies such as PayPal are strongly committed to improving their competitive positioning, witnessed by their acquisition of XOOM in 2015. In addition, banks have upgraded their technology platforms to provide consumer with option to transfer money electronically.  We think WU is engaging in aggressive accounting in an attempt to hide the deterioration in the business.

Table 1:

Accounting Concerns

The deterioration in the company's competitive positioning and financial condition has forced management to engage aggressive accounting over the past several quarters. Our primary concerns relate to the capitalization of expenses of employee contracts, software costs, and capital expenditures.

Management has historically capitalized all of these costs over time to minimize reported expenses; however, we think management has taken the accounting manipulations to an elevated level. Based on our analysis, correctly accounting for these expenses would have driven earnings misses over the past several quarters.

We believe management started their aggressive accounting actions in 2Q15 with the surge in the capitalization of employee contract expenses. Contract expenses represent the incentive fees to attractive and retain agents. Instead of expensing the costs, the company disproportionately capitalized the costs for initiating or renewing contracts with agents. During 2Q15, the company's capitalization of contract costs increased from $17mn in 1Q15 to $58mn in 2Q15 as shown Table 2 below. We estimate that if the company had not capitalized the incremental $30mn expenses, it would have led to 5c reduction in earnings per share. We have not found any reason why the capitalization rate should change so much. In our view, it appears the company is attempting to keep the rising costs of acquiring new agents off the income statement in order to report earnings that exceed consensus expectations.

Based on our analysis, we think the management took additional steps to depress expenses during 3Q15 when the company reported a sharp increase in capital expenditures. For perspective, capital expenditures had been around $15mn per quarter before the sudden increase in 3Q15 to $39mn – double the historical run rate. Again, it is our belief that WU would have missed earnings in 3Q15 if it were not for the higher levels of capitalized expenses.

In our opinion, management has taken its accounting manipulations to new extremes with its 4Q15 earnings report as both capitalized software costs and capital expenditures experienced notable increases. Capitalized software costs had a run rate of around $10mn per quarter. However, in 4Q15, this expense doubled to $19mn. Capex was also double its current previous run rate. All in, we believe the company would have reported earnings per share 4c-5c lower if it had appropriately expenses these items. Lastly, we would highlight that after years of depreciation and amortization increasing, it was down in 2015 relative to 2014 despite capex increasing 40% and capitalization contract costs increasing 68%. As we show in Table 3, in aggregate capitalized expenses increased nearly 50% in 2015.  

Table 2:

Table 3:

Insider Selling

We think WU executives understand the challenges facing the company which drove management to begin a large scale insider selling spree starting last year. Hikmet Ersek, WU's CEO, has a history of timely buying and selling of WU shares. Starting in May of 2015, Ersek dumped 230,000 shares - one of his largest that we are aware of. In addition, several senior executives began selling options well before they were about to expire last year which represented the largest insider selling we had seen in such a short time frame. Ersek entered the market again during August of 2015 by selling 36,000 shares of common stock under a newly established 10b5-1 plan, his second plan during 2015. We would note that opening two 10b5-1 plan is highly unusual during the same calendar year. The most recent insider selling was driven by John Thompson, head V.P. of Global Operations and Technology. Thompson sold out of nearly 50% of his position in October 2015. Importantly, nearly half of the trades were options he sold that had 5-7 years left on them and had a strike of around $18. Insiders have been less active over the past several months. We think this is largely due to the fact the leadership team has little value in their options holdings, and they are restricted from selling incremental stock due to executive ownership policy guidelines.

Conclusion: WU is facing mounting headwinds in its core business which has driven management to engage in aggressively accounting manipulation to try masking the erosion of the business.

Risks:

·         A better than expected consumer spending environment driving higher volumes

·         A more benign competitive environment

·         The company has moderate leverage and generates free cash flow which could allow the company to more aggressively return cash to shareholders

Catalyst

Earnings misses, greater awareness of accounting manipulations