Description

WESTERN UNION CO. (WU)

BUSINESS SUMMARY  

Western Union is one of the most recognized brand names and one of the oldest businesses in existence. It was founded in 1851. It first traded on the New York Stock Exchange in 1865, and it was one of the original 11 Dow Jones stocks at the index’s inception in 1884.

Spun off from First Data Corp. in September 2006, Western Union is a leading independent provider of consumer money transfer services. WU offers its services through a network of over 305,000 agent locations spanning more than 200 countries and territories. Western Union derives the majority of revenues from fees that consumers pay when they send money. The company's main segments include consumer-to-consumer and consumer-to-business. Western Union allows customers to transfer money to other individuals. The majority of these transfers are originated in cash at Western Union agent locations, although consumers can also send money via the Internet, telephone, credit or debit card and, in some cases, through bank debits.

The company also provides a range of consumer-to-business payment services, which enables payments to various organizations that receive consumer payments, including utilities, auto finance companies, mortgage servicers, financial service providers, and governmental agencies. As of December 31, 2006, the company offered its services through a network of approximately 300,000 agent locations in 200 countries and territories. The company was founded in 1851 and is headquartered in Englewood, Colorado.

INVESTMENT THESIS  

The more borders people cross, the more demand there will be for Western Union’s money-transfer services. I believe that more and more people will cross borders over the next 10 and 20 years. These people will likely be moving from poorer countries to wealthier countries and they will send money back home. Western Union had a 10% market share of cross-border money transfers in 2003. Today, Western Union controls about 15% of the market.

Western Union generated $1.3 billion of operating profit in 2006 with very little investment in tangible assets. Western Union doesn’t have to lease or buy real estate to open a new location. Its software is easy to use, and it fits right into the agent’s existing computer system.

I believe that Western Union will sustain their competitive brand advantage for the foreseeable future—providing ample opportunity for our capital to compound at high rates of return for a long time. When I first began scratching out this write-up, the stock was trading well north of $22. It is down on the fears that a new technology utilizing cell phones will prove a competitive threat. I feel the market has overreacted, as this technology is likely in the distant future, and might not appeal to immigrants who must upload the money from an ATM or credit card which they may not possess. 

STRATEGY 

Western Union’s money-transfer business has grown as the global economy has expanded. From its inception in 1871 through 1995, Western Union grew from zero to 30,000 money-transfer agent locations. Today, 12 years later, Western Union has almost ten times as many locations as it had in 1995.

The more borders people cross, the more demand there will be for Western Union’s money-transfer services. I believe it is safe to assume that population growth in poor countries is and will continue to outpace the growth rate of wealthier countries. Poor people tend to want to move to wealthier countries. When they arrive, they begin to send funds back to their families in the country they came from.  However, what constitutes a wealthy country is changing, as well. As poorer countries become richer, Western Union is finding new sources of business--outbound transfers from Mexico are fairly new and generated $15 million of business alone in 2006.

Western Union has $5 billion in assets. It has more than $5.6 billion in liabilities. Most of its assets are intangibles, and most of its liabilities are debt. Western Union’s negative net worth is in some ways attractive. Until September 2006, Western Union was a wholly owned subsidiary of First Data Corp. First Data bought Western Union 12 years ago. Back then, Western Union was struggling with bankruptcy. A new corporate parent was needed. By 2005, Western Union was producing 40% of First Data’s revenues and about 65% of its operating profit and was clearly ready to make it as a separate corporate entity.

As a part of the spin from First Data, Western Union paid First Data a $2.4 billion dividend. That’s why Western Union has $3.5 billion of debt. To pay First Data, Western Union took out a $2.4 billion bridge loan due in September 2007. While this leverage is no small beer,  one should consider that Western Union is producing a generous stream of cash flow in relation to the relatively small amount of capital in the business. I believe this cash flow is highly predictable and has a great chance of recurring every year for many years to come. Western Union maintains an enduring competitive advantage that generate large, growing, and rather predictable stream of cash profits.

In 2005, Western Union earned about $900 million of cash flow after capital expenditures. It started out the year with about $3.3 billion of total assets. In 2006, they generated about $1.05 billion in cash from operations after funding capital expenditures on $4.6 billion in total assets. With this excess cash flow, Western Union is focusing on paying down debt. By removing liabilities from the balance sheet, Western Union is adding to the shareholders’ equity line. This is why Western Union’s debt does not overly concern me. The company expects to pay down as much as $500 million in debt per year.

VALUATION 

Western Union’s balance sheet shows $2.25 billion in net tangible assets. If the company continues to produce $750 million in free cash flow, they are returning about 33% on their capital -- a rather impressive number. But consider that prior to their spin out from First Data they were generating a 49% return on their capital. The company’s economics are such that adding $2.4 billion in debt to their balance sheet and their ROIC still looks great.

Since 2003, Western Union’s operating profit has grown 12% a year. The company is publicly projecting 12%-14% growth long-term for earnings per share. I'm assuming a conservative growth rate of 10% for about 10 years, 6% growth for another five years, and then no growth after that. If this proves to be correct, I come to a value of about $32 per share today.

This may actually prove too conservative a valuation, as it is probable that Western Union’s pricing power will outpace inflation and that its earnings will so as well. By way of analogy consider that a 6% bond selling at par is really selling for 16.67 times earnings. With the stock around $20.75, WU is selling for around 18 times trailing twelve month earnings. The bond’s coupon can’t grow. Western Union’s coupon is certain to grow in addition to the rate of inflation. I think that someone would have to offer at least 30 times earnings to take Western Union private, maybe more.

Western Union is a business with an enduring competitive advantage, which has proven to be a quite a valuable asset to own. If correct,  buying WE provides you the ability to make a long term investment which will compound at high rates of return for a long time to come.

RISK TO INVESTMENT

Immigration reform can and will impact Western Union’s business. Immigration reform may make it harder for people to come to the U.S. from other countries – especially Mexico. The negative press on immigration reform has had a real impact on Western Union’s business. Western Union’s U.S.-Mexico transaction volume grew 24% a year in 2004 and 2005. But U.S.-Mexico transaction volume growth fell to 10%, year over year in 2006. (U.S.-to-U.S. transactions actually declined 4% in the year ended September 30, 2006. Other international transactions grew 23% for the same period.)

MoneyGram International is Western Union’s main competitor. MoneyGram has more than 100,000 locations in 170 countries. Global Payments is a small competitor, with 835 locations in the U.S. and 40 locations in Europe. Western Union has more than two and a half times as many locations in 30 more countries than MoneyGram and remains the dominant player in this space. It will be exceedingly difficult for a competitor to surpass their global reach.

Catalyst