Summary: despite a 30% ytd decline in Western Union, it is a better short today now that the cat is out of the bag on structural change to the model. At the very least, it will be an ongoing value trap as longs (along with the company) mis-allocate capital to a business that will carry structurally lower margins going forward. Over time, WU should be a single digit stock with the potential for 50%+ downside from current levels based on CY14 EPS of < $1
What was once a recurring stream of solid FCF in the C2C money transfer business is being changed by the rise of the smartphone/Internet as a channel for money transfer. Yes, the technology was around in the peak earnings year (2012), its strongest year of headline EPS growth (2008) and when it was spun off from First Data (2006). MGI was around, too. But the difference today is the critical mass we have finally hit on acceptance and ease of use to transact via smartphone/Internet.
Apologies for the non-traditional memo format, but since WU has been written up on multiple occasions on VIC, I thought a little Q&A would get a real discussion started...
Q: I thought WU had a competitive advantage given its large network of agents?
A: for many transactions, location is still the key. But let's consider the unit economics of a $500 remittance to Mexico.
Bricks and mortar WU agent: $25
Bricks and mortar MGI: $10
Online WU transaction: $7
Online Xoom transaction: $5
For the traditional transaction, that revenue is rougly $5 in FX and $20 in fees. The sending and receiving agents both get a cut that adds up to ~45% on the $20 or $9. That leaves WU to keep the remaining $11.
For the online transaction, only the receiving agent (where your relative picks up the cash) gets paid.
So, even if Western Union were to keep all that business as it shifts from offline to online, the absolute revenue and margin dollars to WU shrink dramatically. I layer on top of that the ideas that (1) the customer does care about the price paid for the money transfer, (2) WU's most lucrative clients are remitting money to family abroad on a regular basis and (3) those customers are increasingly likely to gravitate towards the lower-priced options whether it is a 'trusted brand' like WU online or trialing a new option like Xoom. Further, online's growth as a channel is a game changer because it does not require the recipient to be a 'banked' consumer anymore whereas a few years ago methods like Paypal did require the other end of the transaction to be banked.
This also does not address the growing competitive threat that is Moneygram. The distant #2 to Western Union, MGI grew its agent network double digits in its most recent quarter and is catching up. MGI is priced 20%+ below WU in a number of channels.
Q: so prices are lower, but only in select channels. How does this map forward?
A: one of the reasons I think the opportunity is so good here is that management is in denial about how price discovery will play out. WU says that after a hard reset in 2013, they will get back to 1-3% pricing power across all channels. I view price discovery as a virus - it is spreading rapidly and will not be contained to any one channel or geography. Yes, some customers will be sticky and always use bricks and mortar because they're comfortable with it. But as the convenience of the location fades away it's not just lower revenue for WU.
The next problem that arises is the power of the agents that own/operate the locations in the network. Agents may be able to bear some of the pain from lower revenue, but over time will (1) demand higher commissions to replace lost revenue and/or (2) demand other money transfer brands besides WU to generate traffic.
Q: but they already guided lower, the sell-side now hates it and I 'missed' the opportunity?
A: to be practical, the company has $750m authorized to repurchase stock. That cannon is loaded and I believe the company is in the market daily buying back its stock. I base this upon the CEO's public comments at Citi's FinTech conference last week where he said (paraphrasing) "our stock is undervalued and we will be buying it when the window is open." I would think that a sustained use of that $750m would last about a month or more at 20% of the volume. While 2013E estimates have come down recently from $1.91 to $1.51, the street is still underestimating the margin compression that comes with lower prices, higher competition and increasingly unhappy agents. The longer-term debate should be whether earnings can really grow and what multiple those cash flows ultimately deserve.
Q: okay, so if it is 'broken' then how broken is it? How/when do we get paid?
A: Over the coming quarters we will start to see a trifecta: declining volumes, declining prices and declining margins. The risk with each passing quarter is that investors reevaluate the long-term earnings power of the business. Optically, the balance sheet is not going to look much better as cash that flows in will flow right back out via the buyback. The Xoom IPO should happen in 1H13 which sheds more light on the pricing angle as do quarterly results from MGI which is getting more competitive (not to mention refinancing expensive debt next year gives it more leeway to compete). Finally, while I don't need any cyclical headwind in an idea like this, it could be considered a free put option (or call if you're bullish, I suppose).
Q: but management is on the tape buying stock, aren't they?
A: $500k might seem symbolic but it's a pittance. CEO Ersek's relatively low level of holdings could be something for bears to criticize, but I would not view the recent open market purchase of ~$100k of stock as a sign of confidence or a leading indicator. In an unrelated payments business, Doug Bergeron bought ~$5m of PAY stock in early July only to lower guidance when they reported in early September. I would not put much weight behind the insider purchases, but good on them for doubling down or showing shareholders they really don't think the model breaks further from here.
Q: what other risks should I worry about?
A: it does seem feasible someone could come in and think they could do a better job. Does this seem like the type of name where you'd come in one morning to a headline that an investor like Icahn has taken a stake? There is certainly precedent, at least on the debt side when Icahn was active with predecessor entity New Valley Corp in the early 1990s. I would suggest that was a much different investment and time/place. Any activist taking a look at the business today would see a risk of lower margins from both price and volume compression. I'm not sure there's enough fat to cut given the massive operating leverage associated with cutting price. Could someone execute better? Probably. But I have a hard time putting together a short list of folks who would be willing given the current setup. You simply cannot map that FCF out into future years with any degree of conviction.
I do not hold a position of employment, directorship, or consultancy with the issuer. I and/or others I advise hold a material investment in the issuer's securities.