Why I’m Banking that this Beating Down Value is Down But Not Out

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It’s been a brutal week here in America with the east coast being pounded by Sandy.  It's followed by another week that begins with a large dose of uncertainty as we head into a brutally contested election.  The nation’s mood is somber and anxious as we had into the back half of the year.

Much like the national scene, the stock price drubbing and future business uncertainty surrounding Western Union (NYSE: WU) has changed investor sentiment.  Shares were battered after the company released earnings and are down more than 30% since that report.  I think the sell-off represents an opportunity to earn some generous options income for my virtual “No Drip, No Mess” Portfolio.

Why WU?

As I’ve traveled the world there are few brands more recognizable than Western Union.  The value of that brand to their core customer is being overlooked by the market.  That being said the company is facing a growing competitive landscape which is forcing them to engage in a series of strategic actions to right the ship.

These actions do come at a cost and 2013 earnings will take a hit as it forced the company to reduce that outlook by 10% to 15%.  The market is seeing this weakness as a sign of a longer term problem that’s leading to uncertainty as to whether management can actually deliver results.  I think that the value of the brand will enable management’s plan to reinvest in the business to pay big dividends down the road. 

What’s Changed?

The competitive landscape is such that it appears that Western Union’s business is stagnant if not in a permanent decline.  Western Union competes on several levels in the money transfer space against the likes of traditional players like MoneyGram International (NASDAQ: MGI) as well as online players like eBay’s (NASDAQ: EBAY) PayPal.  MoneyGram though is a lot smaller than rival Western Union with half the agent networks and a fraction of the equity market cap.

<img src="http://media.ycharts.com/charts/9c71e9dad1d0e3ef7ec54b1c2c847539.png" />

MGI Market Cap data by YCharts

The concern is that Western Union is entering into a margin compressed future or one day will be innovated out of existence.  We’re seeing more players entering the space and even credit card companies like Discover (NYSE: DFS) are getting into the money transfer business through a partnership with PayPal.  Discover account holders can use this free service to send money to someone if you know their email address or mobile phone number through their new Money Messenger service.  It’s an interesting concept where there are no fees to send or accept money, instead both Discover and PayPal are looking to gain customers who’ll then use their networks for other more profitable services.

The thing is these customers are not Western Union’s bread and butter unbanked or underserved customer set.  The company estimates that there are yet 2 billion underserved customers for their half a million agent locations to reach.  That’s a competitive advantage that’s built to last as these are customers that aren’t going to be logging into their PayPal account any time soon.    

Financial Picture

Shares are dirt cheap no matter how you slice them with price to earnings this year and next as well as price to free cash flow all clocking in at single digit multiples.  Western Union has a decent balance sheet with more than $1.4 billion in cash against $3.4 billion in debt which has garnered them an A- credit rating.  Over the past nine months they’ve generated $860 million in cash flow from operations with more than half of that being returned to shareholders via both dividends and share buybacks. 

They’ll be returning even more money to shareholders having just pushed their annual dividend to $0.50 a share annually for a 25% boost.  Given current prices that represents a very impressive 4.2% yield.  Further, they’ll be buying back $550 million more in shares as they raised their authorization up to $750 million between now and the end of 2013.  Given that shares now trade at a $7 billion market cap that’s potentially a 10% reduction in their share count over the next year. 

The Trade:

Despite how cheap shares are, I'm playing it safe and just generating some options income for the time being. Specifically, I’m going to set up a covered straddle on Western Union to earn some income while potentially buying more shares cheaper.  For the portfolio I’ll  be buying 100 shares at around $12 each and then writing a $12 put and a $12 call both striking in February.  This will net around $150 worth of options premium and based on the 2.4% allocation it’s a yield of around 6.25%.  If shares stay below the $12 strike price and business fundamentals haven’t shown any more meaningful deterioration I’ll likely double the allocation over time.  I think shares are beaten down but the market could keep beating them down for some time.  I’d rather earn some generous income than hope for a turnaround.

Risks and Why I’d Sell

Competitors like PayPal and MoneyGram could very well continue to eat away at Western Union’s business and continue to crimp their margins.  Management’s investments could prove to be futile and not produce meaningful returns.  If we see another guidance cut when they report earnings again in three months it could be a sign that the business is deteriorating worse than feared.

Bottom Line

While it’s tempting to be bullish on a company trading as cheaply as Western Union I think that it’s better to play this one safe and bank some options income.  I just don’t see this company disappearing any time soon but it's still to early to bank on a recovery.    

latimerburned owns shares of Western Union. The Motley Fool owns shares of Western Union. Motley Fool newsletter services recommend eBay and Western Union. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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