Thursday, July 12, 2012

Are Western Union and Moneygram Value Traps?

Western Union $WU and, its rival Moneygram $MGI will give results this week. Near term, there maybe some positive profit drivers but thinking further out, I suspect these businesses have the makings of a value trap. This article will focus on Western Union, but much of the issues discussed are equally applicable to MoneyGram or Green Dot $GDOT.

The essence of my argument is that the core business is being challenged by technological changes. Western Union stock is, on a superficial basis, very attractive for a portfolio, yet it contains structural dangers which may see its core business of cash to cash (c2c), cannibalized in the future or at least suffer protracted margin declines.

Western Union Profit Drivers

The stock actually has a number of things going for it.
  • Good exposure to the expected rise in employment this year
  • Very favourable demographic trends of globalization and migrant workers
  • Increasing utilization of technology to capitalize on the potential of pre-paid cards and mobile money transfer
  • An expanding network of 80,000 agents and 16,000 corridors and a global leading position in money transfers
  • Highly cash generative business model
It's not hard to see why many would conclude that Western Union is a great stock to buy. As employment picks up in the developed economies, the kind of low level service personnel that uses Western Union's services will see an increase in income.

Furthermore, increasing growth encourages more migration and this helps Western Union in its remittance business. For example, around 9% of Western Union's business involves remittances from USA to Mexico and, 85% of revenues are c2c. Putting all of these things together and it is likely that Western Union will see potential upside in the future. Looked at it as purely a play on Globalization, Western Union does seem attractive.

To understand why I'm worried, its better to look at the business in more detail.

Growth Strategies

Essentially, Western Union flourishes in environments whereby its customers do not have access to existing banking facilities. This is why cash based international remittances of lowly paid workers are the core business for the company. Whilst this end market is guided by macro economic considerations (as discussed above) it is also being affected by technological changes. In response, Western Union is seeking to stay ahead of the technology curve by expanding sales of pre-paid cards and establishing a long term position in mobile money transfer.

This is laudable but, I think, will prove challenging for Western Union. The world is full of companies of who, in recent history, suffered as their business models became obsolete as a consequence of technological change. What is always surprising is how quickly these companies can succumb to these pressures. Similarly, Western Union and MoneyGram are facing significant challenges.

The Future of Money Transfers?

Here are the six main challenges facing c2c transactions.
  1. Email transfer banking and internet based transfers
  2. Micro Finance companies (many which are non-profit) expanding activities/lending in emerging markets
  3. Mobile phone based transfer payments
  4. The Federal Reserve may force them to fully disclose fees and exchange rate charges, in line with the Dodd-Frank laws
  5. Financial services firms in recipient countries may offer cash transfer services themselves
  6. Increasing banking penetration in emerging markets, for example, Latin American banks servicing workers with branches in US
Every one of these factors is a long term threat to Western Union. Pricing is a key issue here and, investors would be advised to listen carefully to what management is saying on pricing in the conference calls. Western Union's management is arguing that this is part of a strategy to win market share via promotions. And pricing has been coming down over the last few years. Volume growth is compensating for it, but what if the pricing reductions are due to trends that will eventually catch up and take away the c2c business?

I have my doubt about the efficacy of price reductions. I think the company is trying to stem back the advance of inevitable technological change. History does not look too kindly on companies that have tried to do this. The problem is that the disruptive technology (internet, mobile based payments) that enables them to cut costs short term, could also eventually cannibalize their core markets.

Similarly, in terms of bank penetration, I think it is fair to say that some of the poorer countries in Africa are not going to see dramatic increases in banking penetration any time soon. However, countries with growing financial infrastructure such as China, India, Turkey and Mexico may be far better positioned.

For example, Spain's Banco Bilbao Vizcaya Argentaria is a huge bank that claims to be the largest financial institution in Mexico. What is to stop them chasiing growth by going after the Mexican migrant worker in the US? A similar opportunity might exist on a global scale with an Indian bank like ICICI Bank or HDFC Bank.

In addition, it is a price competitive industry where customers are likely to have a high degree of price elasticity. In other words, if you are a migrant worker currently using Western Union and sending home $200 a month, you will gladly switch to another reputable firm even if it is only a dollar or two cheaper.

A Value Trap?

In value terms, the stock is very cheap and immediate growth prospects look good. In addition, these companies may report good results next week. The stock price may well recover simply because of the valuation metrics and the appearance of improving prospects.

However, for longer term investors, it is the potential structural challenges that threaten the core market of c2c transfers which will be of concern. Before investing, I would suggest evaluating the sector in the context of these concerns and what the companies are doing to address them.

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