Description

First Data (FDC) / Western Union (WU)

 

 

Western Union (WU) will be spun from FirstData Corp (FDC) on September 29, 2006. The stock is currently trading when issued at $17.25/share. For each share of FDC, shareholders will receive one share of WU. WU recently completed the pre-spin road show in which management provided disappointing guidance for the near future, which has pressured the stock. One reason cited by management for disappointing near term growth is a slowdown in U.S. to Mexico remittances due to immigration politics. Compounding this issue is a story in today’s news that the state of Arizona will seek a warrant to seize money transfers from 28 states to 26 locations in Sonora, Mexico (this action would apply only to transactions above a certain size, which is greater than the average U.S. - Mexico transaction anyway). The combination of the usual spin-off dynamics, the disappointing guidance, and the above mentioned immigration issues have created the chance to buy a great business at an attractive discount to its peers.

 

 Description:

 

Western Union provides money transfer services, and generates revenue by charging fees based on the amount of money transferred and the locations it is transferred between.  Money transfer fees account for 84% of revenues.  Transfer agents are third party operators who receive a percentage of the transfer fee as a commission.  These independent agents are responsible for their own infrastructure and staffing costs, simplifying and lowering WU’s cost structure.

 

The remaining 16% of revenue is derived from foreign exchange fees, which arise from international money transfers involving two currencies.

 

Transfers between individuals (consumer-to-consumer) comprises 85% of transaction revenue. Consumer-to-business, 15% of transfer revenue, allows consumer to transfer money to companies and bill collectors such as utilities, auto finance, credit card companies etc.

 

Consumer-to-consumer is growing at close to 20%. The leading use of money transfers is for remittance to home countries by international and migrant workers.  Transfers from the US to Mexico comprise 10% of total revenue and China and India comprise 3% of total revenue. The US is the largest point of origin for remittances, sending more than $236b to foreign countries in 2003, with about 2% annual growth in migrant worker population. International transactions excluding Mexico, (70% consumer-to-consumer revenue) have grown at over 20% for the past three years and transfers to Mexico (10% consumer-to-consumer revenue) have grown at over 15%.

 

Free Cash Flow and Returns

 

WU has grown revenue 14.5% annually since 2001 due to strong growth of transaction volumes (18.4% ann. growth since 2001).  Consumer-to-consumer revenue has led the growth with over 20% annual transaction growth. Foreign exchange revenue, although a small piece of revenue, has grown over 20% due to increased international transactions.  This 20% top line annual growth is matched with consistent operating margins in excess of 30%, generating strong cash flow.  WU’s main expense is the commissions it pays to its 270,000 agents, which is a fixed percentage of total revenue generated.  This enables WU to continue growing its business with little capital investment while maintaining margins in excess of 30%. 

 

Assuming only 10% annual revenue growth and 25% operating margins in the future, WU can generate a free cash flow margin greater than 13% per year, increasing as the company uses its cash to pay down debt and reduce interest expense. On a conservative basis WU should be able to grow free cash flow by over 11.5% per year with only a 10% increase in revenue.  Management has guided revenue growth to 10-12% for 2007 and operating income growth of 6-9% with long term annual operating income growth of 10-12%. 

 

Western Union is one of those rare businesses that can continue to grow while maintaining high returns.  With ROTA of 30% and a ROE (pre split) of 33% over the past 4 years, WU has managed to grow with very little capital investment. 

 

Management has stated that they plan to use this strong cash flow to pay down debt and buy back stock.  After the spin off WU will have $3.5b in debt, costing them about $200m a year in interest expense.  Management has said they will pay down $500m in debt, buy back up to $400m in stock and may issue a dividend in 2007.  Management is obviously interested in returning value to shareholders.  The reduced debt will increase future cash flow (through lower interest expense) while the lower share count will increase EPS.  

 

Competition

 

Western Union is 4x the size of its closest competitor, Moneygran Int’l (MGI). MGI has aprox. 100,000 agent locations, verses WU’s 270,000, and generates about $1.1b in revenue, verses WU’s $4b.  The money transfer business has a strong network effect.  The more agents a firm has, the more customers they attract and the more customers a firm has, the more business they can offer to attract agents.  With 2.7x  the number of agents as MGI, WU is able to generate almost 4x the revenue and over 7.5x operating income. MGI currently trades at a 19.3x P/E.

 

A third competitor, Global Payments (GPN), has numerous business lines in addition to money transfer.  GPN’s total revenues (for all businesses including money transfer) are $0.9b. GPN’s operating margins are 23% verses 16% for MGI and 33% for WU. With only 875 transfer agents (only 40 internationally) GPN’s money transfer business is smaller that both MGI and WU. GPN is currently trading a 24.2x P/E, a premium to both MGI and WU. Western Union’s large scale and low cost operations allows it to generate return far superior to its peers. 

 

Why is the stock cheap

 

There are two main issue pressuring Western Union

1)      Management’s guidance on the road show was weaker than expected.  Management guided 2006 revenue growth of 11-12% and Operating Income growth of only 4-6%.  While this is slower than historical growth, it reflects some one time spin-off costs and higher costs for Vigo (acquisition in the Mexican market). Guidance is for $1.08-$1.10 per share for 2006.  Management still expects 10-12% Rev Growth and 12-14% EPS growth over the long term. 

2)      Q2 06 weakness in Mexico – Mexico growth was lower than expected in Q2 06.  Management claims this is the result of increased attention to immigration issues in the US making immigrants, particularly illegal immigrants, cautious about sending money home. This problem will resolve itself over time as most immigrants don’t have access to banking services at both ends of the transaction and using WU or one of the lesser competitors is the only option apart from mail, which is not safe for sending cash. Mexico only accounts for 10% of total revenue anyway, and other parts of WU’s business are not affected and continue to grow apace. The recent acquisition of Vigo increased expenses in the Mexico market temporarily as it is integrated.  Integration expense should decrease in the medium term (1 year). Medium to long term, volumes should return to normal levels as noise over Mexico and immigration dies down. The demographics of immigration worldwide, which is more important than Mexico alone, is on a growth trajectory. Other international markets (like Russia) continue to grow rapidly.

Catalyst

Based on management’s guidance of $1.08/share, WU is trading at 16x 2006 EPS, which is a significant discount to MGI (19.3x) and GPN (24.2x). Even if WU only achieves $1/share in 2006 they are trading at 17.2x earnings, which is still a discount to MGI and GPN. WU is the dominant player in the money transfer market with a bigger network and higher margins. Normally this suggests a higher multiple to peers, not a lower multiple. At 21x WU is worth about $22.6, a 31% premium to today’s price on the when issued market. As the company uses its significant free cash flow to pay down debt and reduce the share count, WU’s intrinsic value will become apparent.