The Pennies Add Up at Western Union

12/15/2010 2:31 pm EST


Paul Larson

Editor, Morningstar StockInvestor

Western Union’s high margins and competitive advantage in money transfers should pay off as the economy recovers, write Brett Horn and Paul Larson of Morningstar StockInvestor.

At the current market price, Western Union (NYSE: WU) shares represent an attractive investment opportunity.

Management’s strategy is designed to improve the company’s already strong competitive position. We believe the secular drivers of its historical growth remain in place and expect the company to return to faster growth once the economy heals. If the economic recovery is delayed, Western Union offers downside protection, as the business has proven its resilience.

Immigration Drives the Business
About 200 million people, or about 3% of the world’s population, live outside their country of origin. Immigrants primarily flow from poorer to wealthier countries in pursuit of better economic opportunities, often leaving behind family members who need support. To send money back home, they often use money transmitters like Western Union, which maintain networks of outside agents that can collect and distribute cash around the globe.

The World Bank estimates that money transfers totaled more than $300 billion in 2009. While money transfers are global, the US is still the largest source of origination for money transfers by a wide margin. On the other side of the coin, many poor countries have come to rely on money transfers as a substantial part of their economy. In 2006, 26 countries derived 10% or more of their gross domestic product from money transfers.

The money transfer industry consists of a few large global players such as Western Union and MoneyGram (NYSE: MGI), and smaller operators that focus on serving specific ethnic communities. Western Union is the largest operator by a wide margin, with a revenue base almost five times as large as its closest competitor, but still has only about 20% market share.

Western Union’s fees are typically lower than the fees banks charge for international wires, and the service is more convenient because money transfer customers do not need bank accounts and agents’ hours of operations are typically more flexible.

Western Union currently has more than 400,000 agent locations covering almost every country in the world. Agents include businesses such as banks, currency exchanges, and retailers. Since Western Union uses outside agents to collect and disburse the money, it has no need to maintain an expensive retail footprint. Its customers give it cash up front so it has no accounts receivable.

With its processing systems fully developed, ongoing investment on this side is fairly meager. Looking at the balance sheet, besides cash, the only asset item of any real size is goodwill from its acquisitions, which is a result of management decisions, not the needs of the business model. As a result of the small amount of capital in the business and its healthy profitability, Western Union’s returns on invested capital excluding goodwill have averaged 93% over the past three years, multiples above any reasonable estimate of the firm’s cost of capital.

Why Size Matters
We believe that size is the key determinant of competitive advantages in the industry, as it opens the door to three potential advantages: lower costs per transaction, a mild network effect, and greater resources to maintain the brand. Cost advantage is the most important, with the other two playing a secondary role.

Western Union estimates that 35% of its costs are fixed. These fixed costs give Western Union the ability to match its competitors on price and still maintain a very high level of profitability. As can be seen in the graph below, Western Union’s operating margins are almost double that of its closest competitor.

Management at Western Union fully understands its competitive advantage, and the company’s strategy is designed to exploit and widen it. Western Union historically has pushed pricing down 1% to 3% in aggregate each year in order to increase the company’s market share. Since pricing varies by the sending and receiving location, the company can and does target specific areas for pricing decreases, in order to maximize their effect.
This strategy will only further widen Western Union’s competitive advantage over time, as the company increases market share and its size advantage. This strategy does not necessarily compress the company’s margins, as the decreasing contribution of individual transactions is offset by economies of scale. Western Union’s operating margins have been very stable over the past few years.

Don’t Phone Home
The most common concern we hear from investors about Western Union is that the company’s business looks like it will be obsolete given the global trend toward electronic payments. We believe these concerns are overstated.

Western Union’s typical customer is an immigrant who relocated to a wealthier country and is sending money home to support family left behind. For every money transfer, then, there is a typically a sender in a developed country and a receiver in a developing country. For any new money transfer method to gain wide acceptance, the technology must be both available and convenient on both sides of the transaction. As a result, while we do expect electronic methods to slowly gain some traction over time, we think Western Union’s customers will be very late adopters of any electronic payment innovations.

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