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Western Union provides a fairly wide variety of services to generate sales, including issuing money orders and prepaid credit cards. Those are sideline businesses, however. The big cash-generating business is Western Union's money-transfer operation.
If you need to send money to someone, you can hand over the cash to a Western Union agent and designate a recipient. Within a short time, usually minutes, the recipient can collect that cash at any of the firm's 285,000 worldwide locations. Western Union charges the sender a pretty hefty transaction fee for that service, generating most of the company's cash. On international transfers, the firm also makes money on the exchange rate. Western Union buys foreign currency on the wholesale markets, but charges retail exchange rates to its customers.
We have assigned Western Union our "wide" economic moat rating. What structural advantages does the company possess?
I think Western Union enjoys two key competitive advantages that warrant a wide-moat rating. First, Western Union is one of the world's most-recognized brands. More importantly, it's a trusted brand. Most of the firm's customers are immigrants to wealthier countries from poorer ones. They're typically sending money home to provide for their families' basic subsistence. They need to know that the cash they send home will be available to their families. After years of reliable service, Western Union has established a solid reputation among migrant communities. Immigrants know that their hard-earned cash will get from point A to point B if they use Western Union. Given how important the transaction is to the customer, it's hard to get him or her to switch to a competing service when Western Union has never let them down.
The second competitive advantage is the size of Western Union's network. With 285,000 agents, the company's network is 3 times larger than MoneyGram's (NYSE:MGI - News), the closest rival. The size of the network attracts customers because the firm most likely has an agent close to the intended recipient. The vast scope of the agent network enhances customer convenience for both the sending and receiving parties. Keep in mind that many of the transfers are bound for countries with poor infrastructures. Not having to travel far to pick up your cash is a huge benefit.
Western Union also enjoys powerful network advantages. Each agent is a possible send and receive location for all of the other agents. As Western Union adds agents, new portals into the network are created, making all of the existing agents slightly more valuable. In simple terms, one Western Union agent is worthless. As soon as a second one is opened, however, both locations suddenly have value. As a third store joins the network, the value of the network and every agent attached to it grows again. That exponential value creation continues as new stores are added. When Western Union adds agent number 300,000, which won't be long now, the existing 299,999 stores will ever-so-slightly increase in value once again.
How do these advantages show up in the financial statements?
Even a cursory glance at Western Union's financial statements indicates that we're talking about a superior business. The firm generates fat margins and astounding returns on invested capital. Western Union enjoys operating margins above 30%, which is twice the margin generated by second-place MoneyGram. Last year, Western Union's returns on invested capital including goodwill were 60%. Needless to say, that's way above the firm's cost of capital.
Western Union is also a cash-generating machine. It doesn't cost much to add a new agent, and maintaining the network requires very little capital reinvestment. Couple the 30% operating margins with low investment needs, and the firm generates a ton of cash. Over the past few years, Western Union has turned an average of 23% of its sales into free cash.
How is Western Union still growing its sales at a low-teens rate? I would think this business would have matured by now.
Western Union has continued to expand sales at a healthy rate thanks to both secular growth and market-share gains. Taking secular growth first, the number of immigrants moving to wealthy countries from poorer ones continues to grow. Most of those immigrants will send a portion of their paycheck to family back home. So, as the migrant population climbs, so does demand for money-transfer services. Different international bodies tracking immigration have different growth figures, but I think it is safe to say that the immigrant population has been growing in the high single digits for some time and shouldn't drop off too much in the near future.
The company has also been taking share from rivals, and there's plenty of room to take more. Western Union and MoneyGram have about 15% and 3% of the cross-border person-to- person money-transfer market. The rest is divvied up among small mom-and-pop outfits and informal transfer channels. For various reasons, these small operators are having a hard time competing with the large concerns.
I would like to make another quick comment about market-share gains. Western Union has managed to steal share despite charging a premium price. Imagine, you're the low-cost producer, yet you still charge a premium price and continue to pound the competition. It's good to be Western Union.
Western Union has also been expanding agent locations by about 20% per year. It's building out its network, enhancing its competitive advantage, and cementing its dominance in small, but emerging markets like China, India, and the Philippines. It takes a few years for a new location to get up to speed, so Western Union's top line hasn't felt the full impact of all these new agents just yet.
It would seem that bank-to-bank transfers pose a potential threat to the business model. Take the Federal Reserve Bank and Banco de Mexico deal earlier this year. Why do you think Western Union will weather the storm?
Bank-to-bank money transfers still have a lot of obstacles to overcome. Trust is an issue. Immigrants often don't trust banks enough to open up an account. Moreover, some of them are illegal and are reluctant to provide personal information to a bank.
Also, many immigrants lead itinerant lives. They move around a lot, following the job market. The bank that is trying to woo their business may or may not have a branch in the immigrant's new town, but I'll bet Western Union does.
I'm also not convinced there's much in it for the banks. Cheap money transfers are being billed as a deposit-gathering tool, but we have to think about the customers. They aren't having their paychecks deposited directly to their accounts. They're often being paid in cash and sending every penny they don't need to their families back home. Will banks find it worth their while to duke it out with Western Union for these customers? I'm skeptical. Besides, the banks that have tried their hand at the money-transfer game over the past couple of years have yet to see much success. Western Union continues to grow just fine.
Bank-to-bank transfers also face hurdles in the receiving country. Remember, there are two parties to this transaction. Trust is also an issue here. In many developing countries, banks have poor reputations. With Western Union, they know the money will be waiting for them, no questions asked.
And as I said earlier, convenience is important. Unlike here in the United States, bank branches are often few and far between in the developing world. Western Union offices are everywhere. If you're sending money home for your parents' basic subsistence, you don't want them to have to travel very far to get it. Again, it goes back to the size and scope of Western Union's unparalleled network.
What about increasing regulation related to gambling, money laundering, and terror financing? Will this raze Western Union's business?
No. There is increasing regulation of money-transfer outfits as the government combats terrorism and the drug trade. However, we need to keep all of this in proportion. The vast, vast majority of money-transfer transactions are entirely legitimate, and the companies handling them are providing a valuable and necessary service to their customers. So, the government may increase regulations, but not to the point of destroying Western Union.
I actually think heightened regulation will help Western Union. Beyond putting pressure on Western Union's gray-market competitors, the rising cost of compliance will fall disproportionately on the small money-transfer shops that hold most of the market share. Western Union can spread those costs across its much larger business. With its scale, I think the firm's market position will be helped by regulations that raise costs industrywide.
Walk me through the main assumptions in your valuation model
We assume the firm's top line grows almost 10% per year on average through 2010. That sales growth estimate is sensitive to two assumptions in particular: growth in agent locations and growth in transactions per location. We expect the firm to boost agent locations 20% this year, adding about 52,000 stores in 2006. We then level agent location growth off at that absolute number, and assume the firm continues to add about 50,000 agents per year. We expect transactions per location to remain essentially flat, and we also expect the fees per transaction to continue to fall at a low-single-digit rate.
We do expect some margin expansion going forward. The firm's operating margins were almost 32% last year. We expect them to dip slightly in 2007 as Western Union absorbs some higher costs associated with being an independent company. By the end of 2010, however, we expect margins to climb to almost 35%.
Any last words?
I could talk about Western Union all day. Let me just say, however, that investors are rarely able to buy a world-class franchise such as Western Union at bargain-basement prices. It's too bad Morningstar analysts are not allowed to buy the companies they cover, because I would buy this one in a heartbeat. I think it's a fabulous investment opportunity.
