Description

The Western Union Company (WU)

Conclusion:

Buy shares of WU common equity.  WU is a high ROIC business with growth, and a capital structure that is waiting to be optimized.  The reason for the mispricing is that temporary issues are intensifying misplaced structural / secular concerns regarding the core business.  These temporary issues are set to subside, and could actually result in substantial share gains for WU.  I expect an investment in the common equity of WU to yield a +20% IRR over a multi-year period.

Business description:

WU is the market leader in the money-transfer industry with a presence in over 200 countries and 16,000 corridors.  The company has over 500,000 agent locations, over 100,000 ATM locations, and settlement capabilities in over 120 currencies.  The majority of WU’s revenue is generated outside of the U.S., and the majority is from cross-border transfers.  WU’s market share is in the mid teens, ~4x the size of its next largest competitor (Moneygram, ticker: MGI) whose network is roughly half the size of WU’s network.  The company reports revenue in 4 segments: Consumer-to-Consumer (~80%), Consumer-to-Business (~10%), Business Solutions (~5%) and Other (~2%).  The company is headquartered in Englewood, CO.

The company presents a very strong value proposition to its agents as a way to drive incremental revenue and foot traffic with little to no capital investment.  The company also benefits from scale advantages and network effects driven by the size of its network, its high brand awareness, and its anti-money laundering and regulatory capabilities.  These competitive advantages are evident in the productivity of WU agents vs MGI agents, the long tenure and very high retention rates of WU top agents, the lack of new entrants that focus on both unbanked and cross-border customers, and traditional players exiting the business due to increased compliance measures.

Within the Consumer-to-Consumer segment the company derives revenue through fees charged to the consumers to transfer money, as well as the difference between the exchange rate set by WU and the exchange rate that WU or its agents are able to acquire the currency.  Over 85% of Consumer-to-Consumer transactions involve at least one non-United States location, and no individual country outside the United States accounts for more than 7% of the segment’s revenue.  WU pays its agents, both on the send and receive side of the transaction, based on a percentage of revenue.  Agents include post offices, banks and retailers, and ~90% of agents are located outside of the U.S.  No single agent represents more than 10% of the company’s revenue.  WU’s top 40 agents have been with the company for 17 years on average.  The company’s digital product is currently 5% of total revenue and growing double digits.

Within the Consumer-to-Business segment the company derives revenue mainly from fees charged to consumers who are provided transactions with businesses such as utilities, auto finance companies, and mortgage servicers.

Within the Business Solutions segment the company derives the majority of its revenues from foreign exchange revenue from the facilitation of cross-border, cross-currency transactions involving small and medium sized businesses.  This segment is made up primarily of WU’s Custom House (acquired in 2009 for $370m) and Travelex Global Business Payments (acquired in 2011 for $1b) acquisitions.

The Other segment includes the company’s money order, prepaid services and mobile money transfer products.

Why WU is cheap / misunderstood:

I believe that WU is cheap / misunderstood because misplaced structural & secular concerns are being intensified by temporary headwinds.  I think that this dynamic is evident in the fact that short interest in WU has grown from  roughly 10m shares to greater than 50m shares (~10% of the float, and +10 days-to-cover) in the last 18 months as the temporary issues I discuss below have emerged.  Finally there are two areas of potential “hidden value” in two of the company’s smaller products / segments.

Shorting WU over the last 18-24mos has been a profitable trade, and the short has been especially impressive relative to the bull market returns of the broader market.  The short thesis on WU has, in general, been that emerging competition like Xoom and MPesa will cause pricing pressure and market share loss at WU, thus pressuring ROIC and cash flow.  The bears suggest that this is already happening, as evidenced by the company’s declining returns on capital since it was initially spun off from First Data in the early-mid 2000s.  I believe that while the shorts have been “right” (i.e. profited on the trade), they have been right for the wrong reasons.  The main causes of WU’s underperformance (two, in particular) are transitory, not structural nor secular, and the declining ROIC has in fact very little to do with the core business, and nearly everything to do with the company’s tax and corporate structure, and their resulting capital allocation program over the last decade.

The main temporary headwinds that have intensified the structural and secular concerns were the recent restructuring of WU’s U.S.-Mexico corridor (fall of 2012), and the recent pickup in compliance costs (fall of 2013): if you pull up a 2yr chart of WU, the impact of both issues are clearly evident in the share price performance.  Competition from players like Xoom and MPesa has had very little, if anything, to do with WU’s woes over the last 18-24mos.  Also, when talking about share loss, I think it is important to keep in mind the fact that WU does business in a market that is expected to continue growing in the mid-single digits (i.e. the pie is growing).  Compared to WU who operates a mainly cash-to-cash network in 16,000 corridors and 200 countries, Xoom requires the use of a bank account or bank card, operates in only 36 countries, has only one send market, and derives +90% of its revenues from just three corridors.  Xoom is a different product than WU’s core business of cash-to-cash international money transfers.  Xoom is comparable to WU.com which management cites has having only 20% customer overlap with their core business.  Furthermore, WU.com is larger and growing more quickly than Xoom.  MPesa on the other hand services mainly unbanked customers, however it is an inter-country solution.  MPesa actually partners with WU and makes up a significant amount of their receive volume in some markets.  MPesa also operates in an environment with unique regulatory and telecom industry structures.  Rather than being a negative for an investment thesis in WU, MPesa highlights both the large un-banked and under-banked markets that WU serves, as well competitive advantage of WU’s robust regulatory and compliance operations that allow it to cross so many borders.

The first temporary headwind that WU has faced over the last 18-24mos was the repositioning of its U.S.-Mexico corridor.  This was WU’s only market where it had a significant non-WU branded (nearly half its agent network) product.  As a result, when it had to install additional compliance measures as a result of their Southwest Border Agreement, they lost their non-WU branded agents who wouldn’t or couldn’t adopt the additional compliance measures.  Faced with the choice of being a high-priced #2 in the market, or repositioning the business for growth, the company chose the latter.  Prices were cut significantly and transactions have since rebounded significantly.  Furthermore, the company has re-signed as many, if not more, agents as they initially lost, who should ramp over the coming quarters.  I do not expect anything like this to repeat given the unique circumstances of WU’s market positioning in this corridor prior to their compliance and pricing actions.  The second temporary headwind that the company faces is a significant increase in compliance costs that will cause earnings next year to stay flat.  While the stock has sold off hard on the near-term profit effect, I believe this actually helps to increase their scale advantage in compliance and regulatory requirements, and we have seen anecdotal evidence of this in several banks exiting key corridors (including U.S.-Mexico).

Regarding the company’s declining ROIC over the past decade, despite the above issues, the margins and ROIC in the core C2C money transfer business has been remarkably stable.  That highlights an often overlooked positive of WU’s business model – it has extremely low capital requirements, and little fixed cost (~35% of total), so the business model flexes well with demand and returns do not crater in periods of weakness.  I believe, and find that data supports my view, that nearly the entire decline in the company’s ROIC has stemmed from the fact that the majority of their cash flow is generated overseas.  This has caused the company to do transactions like acquire the Mexican remittance business Vigo which had an operating loss, acquire international “superagents” who they were already consolidating and/or were dilutive transactions (thus hundreds of millions in invested capital, but little to no impact on NOPAT), as well as acquire Travelex and Custom House (over $1b of invested capital), neither of which generate a profit.  Furthermore, the company has issued U.S. debt to fund their share repurchases and dividends while cash (mostly non-U.S.) has built up to over 30% of revenues (and at times over 40% - pre Travelex and Custom House).  Looking at the balance sheet, after the $1.6b of goodwill from FFMC’s acquisition of WUFSI in 1994 (FFMC was later acquired by First Data), nearly the entire remaining $1.5b of goodwill is due to the international acquisitions of Vigo, Fexco, Custom House, Costa, Finint, Travelex and some other smaller deals.  The same is true with intangibles – nearly the entire balance is a result of these same deals.  If I adjust ROIC for the invested capital impact from these deals, and keep cash steady at “only” 15% of revenues (approximately where it was when it was initially spun from First Data), ROIC has been generally consistent at levels over 100%.

Lastly, as I mentioned before, I believe there are some areas of hidden value in WU.  WU as a consolidated entity is currently very cheap - +10% FCF yield for an extremely high return company that will be growing again in short order.  If one were to look at WU’s individual business units and products, WU.com and the B2B business stand out.  On the former, WU.com is larger and growing faster than Xoom – valued at the same multiple would make WU’s core business even cheaper.  On the latter, WU’s B2B business consists mainly of Travelex and Custom House – the company spent over $1b to acquire these businesses, and they generate no earnings.  Ascribing any value to those businesses would again suggest that you can buy WU’s core business at an even cheaper multiple to the already cheap consolidated one.

Earnings power:

As WU cycles past the U.S.-Mexico repositioning and the global economy continues growing (particularly the U.S. and western Europe, the company’s two largest send markets), I expect the business to resume low single digit revenue growth.  This expectation is bolstered by the fact that the increased compliance costs in the industry have already caused some players to exit the market.  Citi no longer participates in the U.S.-Mexico corridor, RBC and Barclays have exited certain Africa and Asia channels, etc.  WU could gain some material share from these players.  Price impact on revenue should also dissipate.  After the significantly negative hit from the U.S.-Mexico repositioning, it should return to the historical 1-3% annual range.  I also believe that WU’s pricing is misunderstood and that many perceive their price reductions to be blanket cuts across all corridors that are necessary to maintain share.  WU actually raises prices in corridors and remittance $ volumes where it has the strongest position.  Price cuts occur to grow new markets or new volume levels (for instance the $0-$50 level in the U.S. back in ‘09/’10).  I believe the pricing strategy is much more detailed and ROI-focused than most believe.  While the company did cut prices in some corridors outside of U.S.-Mexico last year, it was in markets where their premium was as much as 40-60%.  The company views these one-time resets as complete, still prices at a premium supported by their competitive advantages (network, brand awareness, etc.), and has not seen a competitive response to their price cuts.

While FCF may decline this year due to the step-up in compliance costs, I expect that to normalize and for FCF to begin growing thereafter.  Interest expense should come down as they retire their 6.5% (5.6% effective rate) ‘14s and refinance their 5.9% ‘16s (the company recently issued at below 3% - even after an outlook downgrade by Moody’s on the same misplaced concerns I discuss above).  While I expect a significant amount of capital to become available to investors, the leveraged FCF impact of this is minimal given that the bulk of it is coming from the cash balance an ongoing FCF of the business.

I expect the business to generate $900m-$1b of levered FCF, annually, over the next several years.

Valuation:

I expect an investment in WU common equity to compound at a +20% rate over the next five years.  This implies an exit FCF yield of approximately 7% (which I think is cheap for a stable, high-return, growing business), and billions of dollars worth of stock repurchased (just announced a $500m program that is expected to be completed this year) as the company addresses its tax / corporate structure situation and keeps their current gross leverage target but increases their flexibility with their existing cash balance and future cash flows.

Through share repurchases and retiring the $500m 5.6% notes due this year, I expect the company to drive cash as a percent of revenues down towards 20%.  The company is currently taking interim steps to better access its offshore cash: on the latest call they discussed a working capital program that will allow them to access a significant amount of cash through better managing their intercompany payment flows.  The company believes there are several more initiatives like this available to them.  In addition, they have the option and possibility of finding a more effective permanent solution, either through a more effective repatriation program by engaging an international tax advisor, or through a tax inversion to another country like the U.K.

Balance sheet & liquidity:

The company is rated investment grade (which it believes is a competitive advantage) and has a huge amount of liquidity in their ~$2b, and growing, cash balance.  The company aims to keep a gross leverage target of roughly 2.5x.  Maturities are fairly staggered between now and 2040, with the biggest being $1b due in ’16 (should be an opportunity to cut the rate on that capital in half).

I think it’s worth noting that it is unclear whether or not WU needs an investment grade rating.  I assume that they keep it, but going to high yield would allow the company to access a significant amount of incremental U.S. cash.  This is meaningful considering the equity trades at a +10% FCF yield while the company was recently able to finance itself at 3.35% with 5yr notes the day after Moody’s downgraded them to Baa2 from Baa1.  Interest expense on the issue will increase only 25bps if the company loses its investment grade rating.  Other companies like HRB have actually seen their equity multiples expand in light of the prospect of ditching investment grade for a large capital return in the form of share repurchases.  WU’s largest competitor, Moneygram, is not investment grade.  The company has noted that the merits of investment grade status are frequently discussed/debated at board meetings.

Catalysts:

• Improved fundamentals:
  • Continued transaction growth – expected this quarter
    • Continued Mexico growth from re-positioning, 10k new agents in Mexico ramping over the next year, as well as accelerating worldwide remittance growth (per World Bank)
  • Return to revenue growth – expected in ‘14
    • Transaction growth
    • Favorable YoY pricing actions as the business rolls off of Mexico re-positioning
  • Return to profit growth – expected in ‘15
    • Leverage from revenue growth
    • Peaking compliance costs
• Announcement of new CFO  – expected in ‘14
• More permanent solution to the company’s tax / corporate structure – timing unclear

Additionally increasing U.S. (WU’s largest send market) employment and compliance-driven bank exits from the remittance market are tailwinds for WU.  Lastly, Immigration reform, a minimum wage hike, and a repatriation holiday are option value for an investment in WU.

Risks:

• Ratings downgrades
• Inability to efficiently structure the tax situation
• Economic weakness
• Worse-than-expected competitive environment
• Worse-than-expected regulatory environment

Appendix: Activist Potential

I believe that WU has significant potential for an activist investor.  WU has had an activist in the past, but the engagement was limited (in time and influence) and was more focused on growth vs dividend policy (from what I’ve heard).  I believe the real opportunity for an activist would be to a) highlight the real driver of declining ROIC (i.e. tax / corporate structure and the resulting capital allocation), b) drive a solution to the tax / corporate structure by putting in place a more favorable remittance structure or a U.K. tax inversion, c) recapitalize the business mainly be taking ~$1b out of WU’s cash balance and accessing another ~$1.5b by deciding that the company no longer needs to be investment grade, and d) drive a multiple re-rating as ROIC and ROE improve.  Shopping the business to a European private equity or holding company (i.e. anyone who can keep and use cash outside the U.S.) would also be a possibility for an activist.

Catalyst

Catalysts:

• Improved fundamentals:
  • Continued transaction growth – expected this quarter
    • Continued Mexico growth from re-positioning, 10k new agents in Mexico ramping over the next year, as well as accelerating worldwide remittance growth (per World Bank)
  • Return to revenue growth – expected in ‘14
    • Transaction growth
    • Favorable YoY pricing actions as the business rolls off of Mexico re-positioning
  • Return to profit growth – expected in ‘15
    • Leverage from revenue growth
    • Peaking compliance costs
• Announcement of new CFO  – expected in ‘14
• More permanent solution to the company’s tax / corporate structure – timing unclear

Additionally increasing U.S. (WU’s largest send market) employment and compliance-driven bank exits from the remittance market are tailwinds for WU.  Lastly, Immigration reform, a minimum wage hike, and a repatriation holiday are option value for an investment in WU.