Since Seeking Alpha published my recent article, Western Union (WU) has been repeatedly bombed with negative headlines. Recent equity performance has lagged. To summarize:
- The CFO quit
- Moody's downgraded from Baa1 to Baa2, with a stable outlook
- Reportedly, the CIA is tracking money transfers
- Shares broke below the 200-day MA, near which they remain
- Negative analyst comments have continued (here, here, here)
My goal in this article is twofold. First, I will explore each event, examining its implications. To do so, I must express informed opinions and make forward-looking judgments. I will carefully separate those from facts and analysis. While press and analyst buzz is likely to remain negative, my core argument is that nothing material has changed. Western Union remains a solid investment trading at a steep discount. Second, I will interweave a review of Western Union's cash and debt position. While the balance sheet is not stressed, management faces possible strategic trade-offs. I will explore these, describing downside exposure while ruling out extreme speculation.
CFO resignation
On November 14, Western Union announced the resignation of its CFO effective December 31. He will continue to assist the management transition through early 2014. The new CFO is a senior finance executive from within the company. Thus, there is no succession or stability issue.
This news surprised investors and dinged the shares. To speculate, drivers for such a management change might have included:
- No driver
- The size and range of the compliance cost increase, as disclosed, might have been poorly communicated or anticipated
- Possible CEO and Board dissatisfaction with the forward-looking cash plan, or with recent execution of the share repurchase
- Possible need to provide political cover for a hypothetical change in cash or balance sheet management strategy
- Reaction to the Moody's downgrade, when Western Union is actively refinancing debt
The purpose of this speculation is to highlight issues explored in detail below.
Compliance cost increase: a review
In the most recent, 3Q13 conference call, Western Union management revealed a projected compliance cost increase in the range of $55 M to $110 M per year, for a negative annual earnings impact of 10 to 20 cents per share. Management clearly guided, for 2014, to a flat outlook for profit and a rising outlook for revenues, due to application of pricing power and rising transaction volumes, thus offsetting this entire increase in compliance costs.
It is logical that this statement thus reflects a projected revenue increase sufficient to generate at least $55 M to $110 M in additional profit. Operating margins in 3Q were 21%. To approximate with a slight hedge, at 20% operating margins, this means $275 M to $550 M in new revenue, or roughly 5% to 10% annual revenue growth.
Based on recent results, this forecast is realistic, rather than a stretch goal or an upward inflection from the growth path, which in 3Q included:
- strong transaction growth in traditional and digital channels
- strong transaction growth in price-promoted and in other corridors
- demonstrated pricing power through market dominance
- the fact that pricing is now at lows as dictated by the pricing strategy revealed in 3Q12, leaving headroom for measured price increases
Since compliance costs and procedures affect the entire market space (even hypothetical competitors like Bitcoin), and since the competition is far smaller and less able to absorb cost penalties, an uptrend in prices is more likely than persistent industry undercutting amid rising costs.
Cash position and strategic options
Management recently confirmed that
- $700 M will be returned to shareholders in 2013
- $400 M of that will be returned through share repurchase
- Thus, $300 M will be through the dividend
- Due to limitations on United States cash, share repurchases are expected to be minimal in 2014
Before exploring what is meant by "limitations," let's begin by tabling simpler matters. These statements suggest that the next dividend payment is safe. With 552 M shares outstanding and a dividend of 50 cents per year, $276 M would cover four quarters' worth of dividend. Since (47 M) shares have been aggressively repurchased over the past three quarters, the share count used to be higher (599 M), which is where the dividend figure "ballparks" to $300 M. To be fully precise, a persistent short position, built in the spring and now running at about 8% of outstanding shares, has unburdened Western Union of perhaps 5% of its dividend commitment to date during 2013, but this savings of perhaps $15 M, outside management control, would not figure in projections.
After 3Q, Western Union has $1.7 B in cash. While this balance is ample to avoid distress, the details are less favorable to investors than the headline balance might suggest. Obviously, Western Union operates globally. Reportedly, half the cash is offshore. Offshore cash cannot be used for share repurchases or dividends without repatriation, with attendant negative tax implications. Thus, in the United States, the cash balance is about $850 M.
Through 3Q, despite the steep price cuts, the company generated $811 M in cash from operations, extrapolating to $1.1 B in annual cash generation ability. With the flat profit and rising revenue projection already cited, and being a zero-cash-cycle, zero-inventory business, it's reasonable to assume that 2014 cash generation will be no lower. However, 75% of new operating cash is generated offshore, which suggests that United States cash generation is $275 M per year. This is the same size as the dividend, which suggests that the dividend is running at capacity. This suggests two things: first, the dividend is sustainable at present levels, but second, if the dividend were to change, a cut is far more likely than an increase.
Of the $850 M in "steady-state" onshore cash, some of it is restricted, and some of it might be consumed by other purposes. However, the strategic picture is unlikely to change, positively or negatively. To examine some possible drivers:
- Funding compliance costs, even at the pessimistic end ($110 M) entirely with domestic cash (a severely penalizing case, as some of those costs are likely incurred abroad, since every market has a financial regulator) probably wouldn't alter the strategic cash picture, as $740 M would still be ample domestic cash.
- Debt refinancing is cash-neutral, except through interest expense savings. As noted below, this savings is significant in terms of EPS, but also does not materially change the strategic cash picture.
Thus, there emerge four options with respect to the cash balance:
- Repatriation
- Cutting the dividend
- Raising new (not refinanced) debt
- Not taking precipitous action, and actively monitoring the situation
Repatriation is rare, and I will rule it out by fiat. Financial reports show that Western Union enjoyes a low tax rate, and a surprise tax penalty would be punitive to investors. Cutting the dividend, which now exceeds 3%, would conserve cash, but it could damage the investment case and strain investor relations at a jittery time. Under present conditions, it is also probably not called for. Raising incremental debt, within limits not triggering another downgrade (see below), would reduce the positive EPS impact of refinancing at favorable rates without improving operating cash generation. Facing a flat profit projection, Western Union should not forsake easy incremental EPS. Operating cash generation is stable with upside bias, but even an optimistic performance case would not provide enough new cash fast enough to fully alleviate the possible trade-offs.
What's the takeaway? My conclusion is that management will stay the course, and will not take radical action, because no radical action is now required. My working assumption is that the dividend is safe for now, in 4Q and probably beyond 4Q. However, investors should be alert that cash, in future, could be redirected into the treasury, away from the dividend, amid a future presentation of changed capital priorities, pending or after CFO transition. Also, the risk of a dividend cut after 4Q would increase significantly if there were to be disappointment in 4Q performance. While 3Q results were strong, and surpassed a strong 2Q, fueling rational investor optimism, of course 4Q results are unpredictable.
Moody's downgrade, refinancing implications
The silver lining is that even newly downgraded to a Baa2 rating with a stable outlook, Western Union stands to reap significant interest savings from debt refinancing. This is because prevailing interest rates are so low and Western Union's liquid operations make it a good risk.
Western Union recently sold $250 M in 3.35% notes in an otherwise slow debt market. Examination of the debt maturity profile shows that the new interest rate compares favorably with the 6.5% interest rate borne by the $500 M in debt due in February 2014. Refinancing the whole $500 M at similar rates would yield about $16 M per year in reduced interest expense. More speculatively, eventual refinancing of the 5.93% $988 M due in October 2016 could yield, at a future time, roughly $32 M more in annual interest savings. With monetary policy likely to remain loose under new Fed Chairperson Yellen, investors can still expect reduction in interest expense, probably at least 3 cents per share per year, and eventually more, simply through routine refinancing. With compliance costs forecast to increment 10 to 20 cents per share annually, saving 3 cents in interest expense is significant, particularly should compliance costs be nearer the more optimistic estimate. Having a Baa1 rating instead of a Baa2 rating would not make a big difference - less than 1 cent per share per year.
Alternatively, should additional debt be raised, the total interest expense is likely to be fairly stable while available domestic cash could significantly increase. In a nutshell, the future of Western Union's balance sheet holds two near-term options: either a decline in interest expense through advantageous refinancing or some improvement in the domestic cash position through low-interest net debt issue at heightened risk of another downgrade.
What is the risk that Western Union might suffer another downgrade? The next step down, Baa3, is the lowest investment-grade rating from Moody's. I have not researched the terms of each piece of debt on the balance sheet. Delving to that level of granularity, when there is no reason to postulate hurdles to refinancing, would be analysis-paralysis and would detract from the larger strategic points. Instead, I simply assume that any downgrade to below investment grade would be extremely negative for Western Union - an intolerable event management would do virtually anything to prevent. Such downgrades often inflict severe credit-driven penalties. Given Western Union's clear dependence on refinancing, even a risk of losing investment grade credit rating could be a distress signal.
Moody's helpfully explains that the following criteria could trigger another downgrade to Baa3 (which, again, is still investment grade):
- Adjusted debt to EBITDA exceeding 3X on a sustained basis
- Operating margins drop to below 18%
- Loss of market share
- Declines in revenue
- Adverse regulatory action
Of these five points, two are flatly not concerns based on most recent performance. Western Union is gaining share and revenue is uptrending. Recent deeper penetration of China and India and a new (incremental, not rollover) agreement with Walgreens (WAG), the largest drugstore chain in the United States, point to new growth in 2014.
How much additional debt is an option for Western Union under the Baa2 rating? Extrapolating one quarter from three quarters of results, Western Union is on track for over $1.4 B in EBITDA in 2013. Taking 3X that figure yields over $4.2 B in debt capacity at Baa2. Current debt is $4.0 B, leaving headroom in the $200 M to $250 M range. While that is limited headroom, that headroom alone would almost fund the current dividend for the next year. Note that that is simply a capital-needs benchmark - I'm certainly not recommending borrowing to the threshold of a downgrade just to pay a dividend when cash to pay that dividend is already being generated through operations. That's just a data point, not a prediction. Since debt capacity grows at 3X EBITDA, any meaningful growth in EBITDA will widen this headroom.
Note that Moody's would probably not regard refinancing-restricted or rollover-imminent debt issues as sustained growth in indebtedness, even if such actions were to temporarily increase nominal debt beyond the 3X mark. On the other hand, interest savings from refinancing won't grow EBITDA, while EBITDA will be pressured by increased compliance costs. Thus, revenues must grow (as projected by management), through transaction volume and pricing, to grow EBITDA and to expand capital headroom. With management statements and results as guides, full price promotions are now in place, leaving room for price increases. Transactions and revenue are uptrending, both in promoted and unpromoted corridors, so Western Union is probably in the relatively good position of needing to keep doing what is already working.
This leaves, as remaining concerns, operating margins and regulatory action. If compliance costs rise from 2.5% to 4.5% of revenue (the $110 M scenario), reaching the pessimistic boundary of management prediction, and if prices are not raised, but remain at present reduced levels reflecting the past year's strategic cuts that drove share, operating margins - 21% in 3Q - could fall two points to 19%, even if revenues grow with volume. This is if anything comforting, because it would probably take an additional, significant negative surprise, in addition to all known pessimistic case margin pressures combined with no price increases or other improvements elsewhere in the business, to drive margins below 18%.
Adverse regulatory action is beyond management control. However, here I also think the outlook is optimistic.
Regulatory outlook
Recent news that the CIA is taking an interest in Western Union transactions, and indeed all money transfer, should not have come as a surprise. In today's world, such an article could appear at any time. Twelve years after the terror attacks on New York, heightened security is the norm from the TSA to the NSA and everywhere in between. These security upgrades have not reduced air travel, mobile phone use, web use, bank account use, or use of any other mass-market systems subjected to the additional security.
Criminals or others wishing to avoid regulatory screening and detection already have options outside the mainstream of commercial money transfer. Western Union, MoneyGram (MGI), Xoom (XOOM), and similar services are increasingly poor choices for money laundering, but remain excellent choices for law-abiding transfers. Based on the experience of the airlines, telcos, tech giants, and social media - services no one has abandoned, despite growth in the security state - I predict an insignificant volume impact on global money transfer from increasing regulatory scrutiny.
Moreover, commercial money transfer conduits represent regulatory enforcement opportunities and potential transparency, rather than a situation regulators can't control. Once the requirements are met, regulators would only want more transfers flowing through the scrutinized channel. Government identification is universal. Money transfer recipients, even at the low end of the developing economies, would be willing to prove identity to receive money, just as is required to travel, vote, marry, attend school, or engage in a variety of other normal activities. Thus, I do not believe that it is responsible to extrapolate compliance costs into an ever-rising spiral of margin pressure that eventually crushes the industry by government fiat. Oppressing a compliant industry would only drive transactions into unregulated channels (because, of course, the need to transfer money would not end) and would thus defeat the regulators' real goal.
Technical breakdown
After repeated "whammies" Western Union shares are now struggling to stay above the 200-day moving average. Orthodox technical trading theory would suggest that a sustained share price journey below that benchmark could be the harbinger of sustained selling pressure.
It's impossible to predict future stock price movements, but there are several countervailing factors. A smart institutional investor's team of analysts would be able to figure out everything I have demonstrated in this article. Performance in 3Q was strong across the board; the compliance cost increase was inescapably negative news, but it is an industry issue, not a performance issue. By most market and peer benchmarks, Western Union shares trade at a large discount, with a forward PE only 2/3 that of the index. Even with a flat near-term profit projection, that is a low multiple. Profits and cash are healthy. Management is conservative and there is more upside opportunity in the flat profit projection than there is downside risk. As the market surges to records, discounted blue-chip stocks become more scarce, attracting investors.
Negative analyst bias
In my earlier article, I mentioned, but did not develop, the point that there exists a steady negative drumbeat in the press, to the end that Western Union is troubled or doomed. Despite my opinion to the contrary, consistently bad press can be a powerful driver of selling. There have since emerged at least three separate new examples of this negativity. I have classified this negativity into three bins: subtle knocks, exaggerations, and more extreme statements, sometimes tantamount to virtual misrepresentations, reflecting at best a surprising level of analytical carelessness or negative selectivity in presentation.
Three subtle dings are found here, in which Western Union's operating income of $1.12 B is revealed to be "the lowest since 2004." This statement is factual. However, the tone is negatively leading, because the article drops the topic there. It does not mention that management spent the past year intentionally executing a price-cutting strategy that led to revenue recovery on higher transaction volume while the competition, traditional and digital, conspicuously stagnated.
The second ding is the factual, but needless, revelation that Western Union "abandoned" its telegraph business in 2006. While the company's history is iconic, it's been quite a long time since the telegraph drove Western Union's prosperity. Using Bloomberg as a soapbox to portray Western Union as "abandoning businesses" or "only recently realizing the telegraph was a thing of the past" belies the ample proof of its total domination of the money transfer industry including in the digital space.
Third, despite the inattention noted above, the article is suddenly careful and analytically granular in itemizing the hypothetical penalties borne by the $250 M in (refinancing) debt Western Union just raised at 3.35% should Western Union's credit be downgraded (two more steps) to below investment grade. The chance of these penalties being triggered is insignificant - as noted above, even one more downgrade is unlikely.
In my opinion, these dings pale in comparison to the statements made in the Zacks Investment Research commentary on the downgrade, though the Moody's release on which it is based, which should be more of a formal statement, also contains surprising, apparent inconsistencies.
The Zacks piece, which in certain stretches uses strings of words remarkably similar to those in the Moody's piece, begins by citing "huge" compliance costs, contrasting to Moody's report of "high" compliance costs and an "inability to contain costs." Management clearly bounded compliance costs - it did not say that it faced unbounded or repeated increases. At the outset, a sensational, negative tone is set for the rest of both pieces.
Two paragraphs later, Zacks claims that strategic cash constraints "compel" Western Union to use "incremental debt" to "provide funds for a purpose such as a share buyback, which will further weaken its leverage position." Moody's uses the word "would" in its piece, and avoids the word "compel," but still references a share buyback.
As any reader of the conference call transcript should be aware, Western Union has already disclosed that no (actually, "minimal") share buyback should be expected in 2014. In my opinion, "minimal" means an administrative buyback, for background purposes of executing share compensation plans and the like. It means no meaningful commitment of cash and no perceptible decrease the share count as was done in 2013 (from 599 M to 552 M shares, or an 8% decrease). In other words, I expect the share count to be 550 M shares for all four quarters of 2014.
Given this plain statement, Moody's and Zacks are only speculating, rather than illuminating, balance sheet overextension risks by citing a future share buyback that management has specifically denied. Yet not only the hypothesizing ("such as"), but the categorical language ("compel," "will") is misleading. While increased leverage is an option, Western Union is not "compelled" - not by any means - to increase leverage. Management faces possible balance sheet trade-offs, not predictable or acute stresses.
Zacks and Moody's also agree that competitive pressure and a challenging macroeconomic environment will negatively impact performance. This was true one year ago, but in light of strong 3Q results, this statement is out of date, or at best empty of real content, as all companies have competition and face economic headwinds. The Zacks piece goes on to state that emerging technologies and pricing pressures cause Western Union to "suffer." In reality, Western Union is making its competition suffer, particularly web startup Xoom. As noted, in 3Q, Western Union grew sharply in both traditional and digital spaces and stated that revenue increases in 2014 were projected to cover compliance cost increases. By contrast, Xoom warned of a decline in 4Q revenues. Unconvincingly, Xoom blamed the Indian rupee - a situation seemingly unique to Xoom, and one that didn't affect Western Union's rapid digital growth. Moreover, as stated, Western Union's digital revenue is more than 2X that of Xoom, which leaves Xoom no excuse for lagging. Finally, Western Union generates vast profits, while Xoom is breakeven.
If it were really true that Western Union were losing out to nimble competitors leveraging emerging technologies, it would show in the results. Revenue and transaction volume would stagnate or decline, while Xoom's would tear ahead, as digital users ditched the cumbersome dinosaur and flocked to the sexy new entrant. Instead, the exact opposite is happening, showing that Western Union is the real emerging technology leader in the space, and that the dynamic is not what it is relentlessly propounded to be by a press maybe too eager for another simplistic Blockbuster/Netflix story. Reality continues to be no match for theory and rumor in this space - a compelling reason to consider a value investment, because the truth tends to win in the end, particularly when the truth is so profitable.
Zacks goes on to agree with Moody's that to "preserve" and "grow" market share, Western Union must cut its own margins by
- pricing cuts
- R&D expenditure
- M&A
- increased promotions
- increased agent commissions
Anyone following Western Union knows that pricing cuts disclosed in 3Q12 (one year ago) have been fully rolled out. These have successfully grown transaction volume, with 3Q13 performance sequentially superior to 2Q and with growth faster than market even in corridors without the promotions. These results were achieved with no M&A and no marked upturn in R&D. Growth of this magnitude also represents likely market share increases, so Western Union is doing better than "preserving" share. Western Union has the strongest brand in the space, as its size and this success demonstrates. Since each Western Union agent is twice as productive as each MoneyGram agent, Western Union can also offer agents superior commissions without injuring its business.
Moody's cites "delays" in restoring revenue growth. There have been no delays. There was a successful, intentional pricing strategy executed by management, on a pre-announced schedule, that has already restored revenue to over 99% of its former levels on higher transaction volumes while damaging the competition. There is no new or incremental set of price cuts, "on top of" existing price cuts, planned in response to new competitive pressures. Moody's and Zacks seem to be repeating year-old news, as if it were today's news. While any price war in any space is negative for participants, in this space it's a war Western Union, the big dog, will always win.
Curiously, Zacks and Moody's also concur that Western Union management is wrong, and that 2014 will bring "low single digit" revenue growth and a 9% reduction in operating cash flow (from $1.1 B, down to $1 B). No evidence is given for these assertions, which would be sequentially inconsistent with recent results. Moody's also predicts that remittances to the developing world will grow at "high single digit" rates. Moody's is therefore predicting that Western Union will significantly lag the industry growth rate. However, in 3Q, Western Union grew faster than the space, while a key competitor forecast a lag instead. Despite this reality, according to Moody's and Zacks, growth will abruptly reverse, with no clear driver.
While negative bias is hard to quantify, or even to explain, in my opinion, it is clearly evident. After doing this due diligence, I was left thinking that perhaps Moody's should stick to its famous analyses of mortgage-backed securities, while Zacks should find a more convincing narrative to seemingly parrot.
Trying to define reasons for this negativity would be entirely speculative. But with the forward PE below 12 and profitable growth faster than the space, I think there is strong ROI in the real story, and that I cannot be the only one who sees the opportunity.
Conclusion
In light of recent developments, what are the truly new risks a Western Union investor faces?
- Risk: A new CFO might change the capital plan, which could lead to a cut in the dividend.
Such radical action in the absence of a new driver seems unlikely. A dividend cut is not now mandatory to maintain the current credit rating or refinancing flexibility. The present dividend, funded by domestically generated cash, was not cited as a factor in the downgrade. Moody's did mention - quite reasonably - that adding incremental debt could pressure the existing rating, but Western Union need not add debt to maintain the dividend. Moody's communicated a stable outlook, rather than a negative one. Western Union's recent 3.35% bond issue shows how receptive markets are to its paper. The overall situation bears careful monitoring and attentive due diligence, but it's also important not to allow anxieties to eclipse the plain facts.
- Risk: Recent performance is not sustainable, and the growth engine will sputter in 4Q.
Looking backward, the fact that 3Q outperformed 2Q and that transactions in corridors without pricing promotion also grew remarkably quickly suggests that underlying performance drivers are sustainable. Also, Western Union reports that digital growth is not significantly cannibalizing traditional channels and is instead bringing new customers to the brand and service.
Looking forward, Western Union management has told investors that incremental revenue will cover compliance costs in 2014 and that it will open agents at Walgreens locations. By contrast, Xoom has told investors that revenue will decline in 4Q.
These data points should reassure the Western Union investor. Of course, the above observations constitute no guarantee that 4Q will deliver or that the dividend will be maintained. All forward looking projections are uncertain. A prudent investor should regard all options as being on the table, so to speak.
But my conclusion, after examining these details, is that barring a new, major, surprise negative event, growth will continue, while management will avoid balance sheet disruption. Specifically, this means existing debt will be comfortably refinanced, significant new debt will not be added, and the dividend will be maintained. These assumptions are forward-looking and contingent, but recent performance has been strong. Management has guided upward on revenues and agent network quality. Uncertainty in the flat profit projection is probably to the upside, while 2013 comps are advantageous. My money remains long on my risk-sensitive but ultimately unchanged expectations of consistent value delivery. My expectations are boosted by the hope that the negative press narrative will eventually change to match the positive performance.
Disclosure: I am long WU. I have no positions, and no plans to initiate any positions, in any other stocks mentioned, within the foreseeable future. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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