The Rise of Smart Phones Leads to Western Union’s Kodak Moment

For years, Western Union (WU) was a great business, exploiting a network effect.  A web of access points that sold the service across the globe made Western Union not only the first but sometimes the only option available for sending funds.  The rise of the internet put a chink in WU’s armor, but the company stood strong.  However, the global adoption of Smartphones should lead to an era of negative growth for the company that we do not believe is priced into the stock.  While not operating in the same industry, we do see some similarities to Kodak, another iconic company that was marginalized by the rise of digital competition.

• WU is cutting pricing, and ongoing price cuts are expected to continue into the future.  A loss of pricing power is a sign of a business in decline.
• The rise of Smartphones in emerging economies will accelerate the decline in WU’s business. Using Business Insider estimates, we calculate that Smartphone penetration in Western Union’s core demographic will rise to 61.7% in 2015 from 28.4% in 2012.
• U.S. investors have been able to gloss over the rise of Smartphones which has thus far only slowed WU.  However, this will change as Smartphone growth takes off overseas, where over 85% of the company’s revenue takes place.
• Non-digital competition (MoneyGram) is also getting much stronger and taking share.
• WU’s valuation at roughly 10X 2013 consensus EPS estimates appears cheap but will not be when the company may be encountering 9% - 20%+ annual declines in Net Income.
• We believe that WU is in the most expensive part of the market, a mature large non-mega cap company with a decent dividend.
• We see a declining business with very little possibility of upside catalysts.

Business:

Western Union (WU) is a rather simple business. Over 80% of revenues is consumer-to-consumer payments.  The typical transaction occurs when a person who has moved to a developed country sends money home to his or her family, but the transaction could be any payment from one person to another. WU takes a cut of these payments.  With the most points of sale across the world, Western Union exploits its network effect to dominate the payment industry.  Consumer-to-business payments make up over 10% of revenues, and business solutions and other payments derive the rest.

Western Union has been a great business, with an ROE well above 100% for the past three years and an ROIC above 20% since at least 2005 (WU was spun out from FirstData in 2006). WU has also been a growth business, with annual revenue growth of over 6% from 2005-2012. However, that growth has come to an end, with revenue expected to fall over 2% YoY in 2013. The company attributes this fall to a onetime large decrease (as much as 25%) in some regions’ prices. The price cuts do not seem to be working, as consumer-to-consumer transactions declined by over 2% YoY in 1Q. We believe that declining transactions will be an ongoing and accelerating trend for Western Union.

Increasing Competition from MoneyGram:

Western Union’s problems go beyond Smartphones. WU’s competitive advantage is being significantly eroded offline, while the company’s 510,000 agent locations are still greater than MoneyGram’s (MGI) 321,000, the gap is closing fast. MGI has more than doubled their number of agent locations since 2007 and has been growing over 15% annually for the past 18 months. By comparison, Western Union has been increasing the company’s number of agent locations by under 5% annually since 2010. If this pace continues, MoneyGram and Western Union will have an equal number of locations in just five years. The effect is clear; MGI is taking large amounts of share from Western Union. In the last quarter, while WU’s transaction count declined, MoneyGram’s transaction count increased by 11% YoY.  There is plenty of room for MoneyGram to grow at Western Union’s expense.  MGI produces roughly 26% of the revenue that WU produces and only 41% as much as WU produces per agent location.  We believe that if MoneyGram continues to close the location gap, there is no reason to expect that the revenue per location difference cannot be substantially closed as well.  It is also important mention that MGI appears to undercut WU on price.

The rise of Smartphones in Emerging Economies:

While many people view Smartphones as phones with the added benefit of mobile internet, the true transformative effect of the Smartphone is not deal comparisons while shopping at Best Buy but cheap internet access that will expand web access to millions of more customers.  This has already happened to some extent in the U.S. and the developed world, with Smartphone penetration now at over 60% in the U.S., according to Business Insider. But the developing world, where the bulk of WU’s business takes place, is just starting to adopt Smartphones. Using data and forecasts from Business Insider, we believe that Smartphone penetration (see exhibit 1 below) in WU’s core demographic will grow from 28.4% at the end of 2012 to 61.7% by the end of 2015. 

To obtain our estimates, we simply used data and forecasts from Business Insider.  We then assumed WU’s core demographic to be any person outside of the U.S. and assumed a population 60% of that size to be an age above 18 and eliminated 25% of the world’s population that is likely too poor to use WU’s services and will not own a Smartphone.  We would note that our estimates likely understate the growth of Smartphone’s within the company’s core demographic, since we simply calculated the rest of the world and do not strip out other developed countries.

The Smartphone is a devastating weapon against WU. Western Union charges around 4% - 10%+, depending on location and transaction size (see pricing calculator https://wumt.westernunion.com/WUCOMWEB/priceShopperRedirectAction.do?method=load&countryCode=US&languageCode=en).  Some internet services are actually free for consumer-to- consumer transactions and are certainly far cheaper than WU when fees apply.  A bank account is not a barrier to entry here, as many of these services do not require a bank account.  Indeed the digital revolution has seen a huge rise in products marketed to the unbanked. For example, prepaid card sales have grown in the U.S. In addition to the high fees WU charges, online services are simply much more convenient.  The need to commute to a WU location burdens customers without automobiles, and it is worth avoiding.

So with roughly 28% penetration, why have Smartphones not significantly affected Western Union yet?  The answer is simply that the network effect has not taken off yet.  If you have a Smartphone in an emerging economy and want to send a payment to someone else there, the chance of that person having a Smartphone is only around 25%.  As we can see from Exhibit 1, this is about to change very quickly.  There is also bound to be a short lag between Smartphone adoption and online payments.  It is clear to us that we have only hit the tip of the iceberg in terms of the Smartphone’s ability to take massive amounts of share away from non-digital consumer-to- consumer payment options.  According to Smartphone adoption forecasts, this trend accelerates over the next few years.

Valuation:

WU does not appear to be very expensive at first glance (see exhibit 2 below).  Note that earnings are roughly in line with free cash flow.

However, we believe that earnings are likely to not only disappoint but decline, at a fairly rapid clip. We believe that a prediction of an approximate 5% drop in sales from 2013 to 2014 is fairly conservative; Driven  by a 3% decline in transactions and 2% in price, this would translate to a net income decline of 9% - 19.7% (see exhibit 3).  To obtain our estimated decline in net Income, we used three different scenarios: one stable SG&A, two rising SG&A of 3% (vs. 17.9% in 2012 and estimated 4.5% in 2013) and the last rising SG&A and a decline in Gross Margin.

With double digit and likely accelerating declines in earnings, a double digit PE multiple may be unsustainable.

Conclusion:

We believe that Western Union is in the current sweet spot of the market.  WU is a mature, large dividend paying (3.1% yield) company. The yield-starved environment appears to have led to a bidding up of these stocks.  We see continued declines in earnings leading to at least a slow decline in the stock price of WU.  In the current environment, it is difficult to see WU trading much below 10X earnings, but this could change, leading to a further decline in stock price.  We also believe there is a chance that the declines in WU’s business could be much worse than we are forecasting, and Western Union could be a “buggy whip” business.

 Risks:

We see very little chance that WU will be able to reaccelerate their business again.  In a very liquid credit environment, the possibility of a private equity bid is always a risk. However, the lack of physical assets (the company has negative tangible equity) and declining business should limit the amount of leverage that can be added.  WU’s low tax rate (15%) also dilutes the benefits of financial engineering.

Continued Transaction decline, where the company and analyst see this as something that will end after 1Q.

Continued pricing declines. While most analysts are forecasting 1%-3% pricing declines, the company believes it can raise prices post the current shift.  We believe with growing lower-priced competition, this would be highly unlikely and future large pricing decreases are likely.

A change to the U.S tax code could be very damaging to WU, as the company currently enjoys a very low tax rate (roughly 15%).

Continued Earnings short falls (WU is scheduled to report 2Q earnings between July 22 & 26).

A strong U.S. dollar should be a headwind for WU’s earnings.