A Bargain Stock Any Way You Slice It

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

Sometimes it's the oldest, most boring companies which offer the greatest opportunities. While some invest in cutting-edge tech companies trading at astronomical multiples on the hope that someday they'll actually turn a profit, I prefer companies with a long history of success and a durable competitive advantage. Often these types of companies carry with them a premium, but Western Union (NYSE: WU) is trading at multi-year lows after an earnings miss last year. Couple that with a recent 25% dividend increase and Western Union may be one of the best deals of the year.

What does Western Union do?

I think that Western Union is somewhat misunderstood by investors because it's a service aimed at those without easy access to banks or the internet. Western Union's website says:

"Our vision is to be the preferred financial services provider for the under-served, which means finding new products, capabilities, technologies and partners to better serve our current customers, and potentially two billion consumers with unmet financial service needs. It also means meeting the evolving needs of under-served businesses to make cross-border payments, allowing them to grow, create jobs and better compete in the global economy."

People tend to like investing in companies which they use or buy products from, but I'm willing to bet that investors and Western Union's customer base are mutually exclusive groups. People hear the name Western Union and think of telegraphs, not a modern financial services company. But Western Union has been thriving as the total money-transfer market has grown.

Most of Western Union's revenue comes from customer-to-customer transactions. Immigrants in developed countries sending money to family in undeveloped countries are a common type of customer. Western Union makes money from transaction fees as well as from the spread between the exchange rate they offer their customers and the exchange rate their agents are able to get. For these types of people there is often no alternative to Western Union. About half of the world is unbanked, creating a huge market for Western Union.

Wester Union has a network of over 500,000 agents in more than 200 countries. One thing which makes the Western Union model successful is that the cost of adding a new agent is insignificant. Anyone, once approved, can offer Western Union services. This makes it very easy for the company to expand.

Competition

Western Union is by far the largest money-transfer company with a 20% market share, and processes about four times the number of transactions as the next-largest money-transfer company MoneyGram (NASDAQ: MGI). Although many people claim that services like Paypal from eBay (NASDAQ: EBAY) will destroy Western Union's business, it's important to understand that they serve different customers. Most of Western Union's customers don't have a bank account which makes using Paypal much less convenient. In addition, many people who receive money-transfers in undeveloped countries don't have access to the internet, making Western Union the only option. In contrast, Paypal deals mainly with online purchases.

The best value

Let's look at dividends first. Western Union recently increased its dividend by 25%, raising the yield to about 3.7% based on the most recent quarterly dividend. This puts the payout ratio using current TTM free cash flow at about 30%. Western Union is also aggressively buying back shares, with $750 million approved for the rest of 2013. This means that most of the company's free cash flow is going back to the investor one way or another.

MoneyGram hasn't paid a dividend since 2007. eBay has never paid a dividend. From a dividend investors perspective, Western Union is the clear choice.

Now let's look at each company's profitability.

TTM Values in millions USD

<table> <thead> <tr><th> </th><th>WU</th><th>MGI</th><th>EBAY</th></tr> </thead> <tbody> <tr> <td>Revenue</td> <td>$5,671</td> <td>$1,309</td> <td>$13,459</td> </tr> <tr> <td>Operating Income</td> <td>$1,402</td> <td>$48</td> <td>$2,768</td> </tr> <tr> <td>Operating Margin</td> <td>24.7%</td> <td>3.4%</td> <td>20.6%</td> </tr> <tr> <td>FCF</td> <td>$930</td> <td>$20</td> <td>$2,183</td> </tr> <tr> <td>FCF Margin</td> <td>16.4%</td> <td>1.5%</td> <td>16.2%</td> </tr> <tr> <td>P/FCF</td> <td>8.9</td> <td>50.9</td> <td>33.2</td> </tr> </tbody> </table>

Data from Morningstar

The discrepancy between Western Union and MoneyGram really shows that scale is everything in this business. Western Union has an operating margin of nearly 25% and a FCF margin of over 16%. This compares to low single digits for MoneyGram. eBay, although perhaps not directly comparable given that Paypal is not the company's only business, has a comparable FCF margin to Western Union.

But the P/FCF ratio tells the real story. Western Union is dramatically cheaper than the other two companies. The P/FCF ratio is almost ludicrous given Western Unions margins and dominant position in the industry. On top of that, regulations regarding money-transfers create a barrier to entry, leaving Western Union with an economic moat.

How much is it worth?

I'll use a discounted cash flow analysis to estimate the fair value of a share of Western Union. For my discount rate I'll use both 12% and 15% to define a fair value range. For growth, I'll assume that the FCF/share grows by 6% annually for the next 10 years and then by 3% in perpetuity. Using the above parameters and subtracting the $2.60 in net debt on the balance sheet I arrive at a fair value range of $13.36 - $19.08. The current stock price is at the very lower end of this range.

A different perspective: Dividends

Along with being a value stock, Western Union would be ideal for a dividend investor. I'll use the dividend discount model to estimate the minimum dividend growth rate necessary for the stock to be fairly valued on the basis of dividends. I like to use an 8% discount rate for this method, which is roughly the long term growth rate of the market as a whole. The results are below.

<img src="/media/images/user_13886/wu-div-top_large.png" />

<img src="/media/images/user_13886/wu-div-bottom_large.png" />

The dividend must grow by about 8.45% annually for the next ten years for the stock to be fairly valued to a dividend investor. Given a payout ratio of just 30% and the high level of stock buybacks this seems doable. Interesting fact: if Western Union spends all $750 million on buybacks this year and pays the current market price the float will decrease by a little over 9%. That means that keeping the total amount paid in dividends constant the dividend/share will rise by that same 9%. So even without any growth in earnings or the payout ratio a dividend growth rate above the required rate can be easily achieved.

The bottom line

Western Union is a boring company, but often boring companies get overlooked by the market. Undervalued on both a discounted cash flow basis and a dividend discount basis and far superior to its peers Western Union is a bargain at today's prices. And with the company returning so much money to shareholders through dividends and well-timed buybacks investors should be rewarded handsomely.


TheBargainBin has no position in any stocks mentioned, but may buy shares of Western Union within the next month. The Motley Fool recommends eBay and Western Union. The Motley Fool owns shares of eBay. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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