Value Investors Club / Western Union Company (WU)

Description

This analysis builds on prior postings of WU over the years, most recently by Lars on 2/25/2014.

Since we have been invested in WU, a number of people we have spoken to about this

investment express concern about the possibility of technological disruption to WU’s business.

We have looked into this and, barring the adoption of a cyber currency, e.g., Bitcoin,

technological disruption is not likely. This is because 90% of WU’s business is cross-border –

once money moves across a border, the primary consideration is regulatory issues, not

technological issues. Om fact, regulatory compliance is becoming more burdensome and this

play’s to WU’s scale. A second concern that colleagues have mentioned is the possibility of an

Internet start-up like Xoom damaging WU’s business. All of the Internet startups focus on

customers with bank accounts; 90% of WU’s transactions are for unbanked customers. What

follows are our thoughts on this business.

The Western Union Company (WU) is the largest and most profitable company in the

remittanceindustry. Remittance is a growing market, e.g., WU’stransaction volume grew (on

average) 5.2% a year since 2008. The company generates excellent returns on capital (over 70%

ROE with no adjustments) and may be purchased for 12x trailing fully taxed free cash flow (again,

with no adjustments). There is a theory that WU’s business is going extinct - as a result, 17.5% of

WU’s shares are currently sold short. Interestingly, there is scant evidence that WU’s business is

deteriorating –the factssuggest that WU is uniquely positioned as the low cost provider in a

growing industry with high barriers to entry (e.g., WU’s competitors struggle to earn a positive

return on capital and rising compliance costs are driving competitors out of the business).

The company is conservatively capitalized, yet earns outsized returns on capital. For instance, its

ROE was 65.5% during 2014 (no adjustments). When First Data spun-off WU on 9/29/2006, WU

had equity of -$315 million. As of 12/31/2014, WU’s equity was $1.3 billion, despite having

returned $5.6 billion to shareholders since the spin. Note that WU’s capital returns have fallen -

there are two factors that explain this:

The aforementioned increase in equity capitalization.
$1.8 billion of acquisitions since the spin, none of which are producing significant cash flow.

The acquisitions are a concern; one can only hope that management has learned something from

their recent experience. Of course, there is also the possibility that some of the acquisitions begin

to generate significant returns - as of this writing, this appears to be inexpensive upside

optionality.

Business

WU is in the business of cross-border money transactions; while the company operates in three

segments, 90% of its earnings are derived from moving money from a consumer in one country to

another consumer in another country (C2C remittance). WU’s B2B segment is a money loser.

The segment provides cross-border money transfers for small and medium-sized companies and

is the result of two recent acquisitions: Travelex Holdings (November 2011, $968 million) and

Custom House (September 2009, $371 million). To the extent management can turn this

segment around, future earnings from this segment represents free optionality. Here is what WU

has to say about their C2C business:

We offer money transfer services in more than 200 countriesand territories. In 2013, the substantial majority of our C2C transactions were cash money transfers involving our walk-in agent locations around the world.

Note that most of WU’s C2C business involves customers using WU’s walk-in agents. Central to

the short thesis is that WU’s C2C business is deteriorating, soon to be replaced by digital wallets

linked to banks via smart phones and Internet start-ups looking to disrupt WU’s business. Two

thoughts:

1. Many people who make use of WU’s walk-in agents are unbanked. WU does not

require its customers to have bank accounts, so WU’s walk-in agent service provides a

convenient way to transfer funds. It is possible that over time more folks will get bank

accounts, however, the trend is going the other direction. And lest one fear banks getting

into the money transfer business, WU’s prices are typically less than bank charges and

many banks are actually abandoning the remittance business, e.g., JPMorgan Chase,

Bank of America and Citibank have all recently scrapped low-cost money transfer

services.

2. WU’s transaction volume has grown on average of 5% since 2008.

WU has over 500,000 agent locations, 90% of which are outside the U.S. No individual agent

accounts for more than 10% of WU’s C2C revenue; their top 40 agents have represented WU for

an average of 17 years and generate about 60% of their C2C revenue. WU has the capability to

transfer money in more than 120 currencies. Westernunion.com is WU’s online initiative, which is

growing at double digits; this segment caters to banked customers. All the third party projections

we have come across suggest that the remittance business is likely to continue growing through

2016. WU has a 15% market share of the remittance industry; the next larges competitor is

MoneyGram with a 5% share. WU’s transaction fees as a percentage of funds transferred

(including foreign exchange charges) were slightly over 5% in recent year while industry averages

range between 6% and 8%, i.e., WU, in aggregate, is a low cost service provider.

Yet, if WU charges less than its competitors, how does one explain WU’s high capital returns? Is

WU’s profitability the result of accounting smoke and mirrors? WU generated $9.5 billion of free

cash flow in the last 10 years – not bad for a business we can buy for $11 billion. Since 2007, WU

has returned $5.6 billion to shareholders in the form of share buybacks and dividends: 42% of the

company’s current enterprise value. Seven more years like this and the company will have self-

liquidated its entire enterprise value!

Are WU’s favorable economics characteristic of the entire remittance industry? It doesn’t look

that way. Moneygram International, Inc. (MGI) is the second largest player in the industry, with

5% market share. MGI blew-up in 2007 - an early casualty of the financial crisis. (MGI was (and

continues to be) undercapitalized. Prior to 2008, its balance sheet was stuffed with miserable

fixed-income assets which melted during the summer of 2007). Thomas H. Lee and Goldman,

Sachs & Co. recapitalized MGI during Q1 2008 - Lee and GS are still trying to exit their MGI

investments. A review of MGI’s capital returns since 2006show that the company does not earn

a reasonable return on capital, e.g., its best year was 2013 in which EBITDA / tangible assets

was 5.1%. MGI has negative equity, so one cannot compute an ROE. WU’s capital returns

approach an order of magnitude more than MGI’s. The discrepancy between the two companies

is so vast that if WU had not returned so much cash to shareholders over the last seven years

($5.3 billion), we would suspect accounting fraud. The likeliest explanation for the discrepancy is

C2C remittance economics have strong network effects. While there is no way to prove this, the

empirical data support this conclusion, e.g., WU is much more profitable than its smaller

competitors, banks are leaving the industry because it is too expensive to serve unbanked clients

and satisfy increasingly stringent compliance regulations. One could also develop an anecdotal

narrative to support the network effects theory: WU has more agents (500,000) probably with

more convenient locations, better brand awareness. WU definitelyoperates at larger scale,

which helps spread fixed compliance and overhead costs. Regardless, the empirical data suggest

WU is well positioned in a growing industry. This does not mean, however, that WU does not face

competitive pressures. WU’s transaction volume has more than doubled since 2004, its average

charge per transaction has fallen from $29.36 in 2004 to $18.06 in 2013. This is likely due to

competitve pressure as well as pressure from regulators and governments to reduce remittance

costs.

Regarding competitive pressure, WU has mainted its profitability in the face of falling prices due

to increased volume. Demand for remmitance service is growing and is forecast to continue to

grow for the foreseable future (driven by increased migration). Meanwhile, MGI continues to

struggle to generate a reasonable return on capital and the banking industry is vacating the C2C

remittance business. Other remmitance businesses, such as start-up Xoom Corporation, on the

surface appear to be competitors but in fact are targeting online remitances for banked customers

(4% of WU’s C2C business). It is also noteworthy that, like MGI, Xoom also produces very low

capital returns, e.g., 1.3% ROE during the 6 ME 6/30/2014. Perhaps Xoom’s returns will imrove

with scale – something MGI has been attemtping for years.

Regarding regulatory pressure, during the G8 L’Aqula Summit in 2009, member countries set a

goal to reduce remittance costs from 10% of funds transferred to 5% by 2014. As the charts on

page 5 show, WU is just slightly above the 5% goal as of Q1 2014 and significantly below its

competitors. While the G8 has not set lower remmitance price targets beyond the 5% goal, in a

recent report, they specifically recommend that G20 countries “discourage, limit or ban exclusivity

contracts between remmitance service providers and important distribution networks.” WU’s

distribution network is likely a key competitive advantage – if they were required to open it to

competitors, their profitability would probably decline. On the other hand, to date, greater

government regulations and compliance appear to have accrued to WU’s benefit by making

compliance more costly and making the industry less attractive to competitors, e.g., banks are

abandoning the industry.

Conclusion

We have endeavored to show that WU is the largest and most profitable company in the

remittance industry. Paradoxically, WU is more modestly valued than its smaller, less profitable

competitors. For instance, MGI is trading at 15.6x trailing FCF and 14.9x EV / EBITDA while WU

is trading for 11.9x trailing FCF and to 9.5x EBITDA. Xoom, on the other hand, is producing

negative cash flows and is trading for 82x trailing EBITDA – one would guess Xoom investors are

convinced its profits are likely to zoom.

One more thing. We mentioned above that WU has spent $1.3 billion on acquisitions to enable it

to compete in the B2B money transfer business. To date, these acquisitions have not paid-off.

Worse yet, they have continued to be a drag on WU’s earnings. We have not excluded these

charges from WU’s earnings figures used in this analysis, i.e., WU’s normalized earnings are

higher than what we have used. Furthermore, WU is in the midst of a costly compliance

remediation program – they spent $150 million on compliance in 2013 (over 10% of MGI’s

revenue). Much of the additional compliance costs are the result of a lawsuit brought by Arizona.

We have made no allowance for these costs, so to the extent some of these expenses are one-

tme investsments, reduction in these costs going forward represents free optionality. In the

meantime, increased compliance appears to be driving competitors out of the business and

increasing barriers for new entrants – this bodes well for WU shareholders.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1. One would expect share appreciation if management keeps running the business as they have over the last few years and remitance demand continues to grow as expected.

2. To the extent management is able to improve the performance of the B2B segment, the company's cash flow growth would accelerate.

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			2015	2016
Price:	20.59	EPS	1.60	0
Shares Out. (in M):	546	P/E	12	0
Market Cap (in $M):	11,230	P/FCF	11	0
Net Debt (in $M):	1,937	EBIT	1,150	0
TEV (in $M):	13,167	TEV/EBIT	11	0