Western Union

Western Union is mostly in the business of transfering money from place to place and was recently spun off by First Data Services. Spinoffs can often be fertile grounds for excellent investments so Western Union is certainly worth a look.

16 year old investor Michael Pricerecently did a decent review of Western Union's history and an analysis using the tennants of Robert Hagstrom's classic book the Warren Buffett Way.

http://mikesnewsletterinvesting.blogspot.com/

Price concludes that although Western Union is certainly a great business with a wide moat, it was pretty close to fully valued. Trading at 20X next years earnings, no one would argue that Western Union is cheap. But can a stock trading at multiple that is 20-30% higher than the long run multiple of the S&P 500 be a value?

Price touched on the numbers a little bit and showed that Western Union's long-term track record is certainly impressive:

*Return on average capital 45%

*Operating Profit Margin 30%

As Price mentioned, the company is levered but with net debt at about 2X EBIT, the company is clearly not overlevered. In fact, the leverage did not enhance sales or earnings but was simply used to pay a dividend to First Union Shareholders.

There are a couple of interesting things that Price didn't mention that show what a great company Western Union is.

#1 The company nearly doubled its operating income over a four year period at a nearly 18% rate.

#2 They have been able to grow with virtually no capital. When Western Union signs up a new agent, the only thing they are responsible for is the new software, and machines so that the agent can operate. They are not responsible for any new buildings or staff .

#3 The company has a network effect that is very hard to break. When customers send money, they are likely to do so through a Western Union agent because there are likely to live near one. On the other side of the transaction, the person receiving the money, most likely also lives near a Western Union agent and will be more likely to use their service.

#4 Much of Western Union's revenue is recurring, as many workers who transfer money tend to do so on a regular basis. This makes the revenue base very low risk.

Additionally, the agents, which tend to be convieniece stores and supermarkets, tend to stay with Western Union because they drive the most customers through the door. It also makes the receivables very collectable.

Valuation:

Price uses a discounted cash flow model to value Western Union. Since Western Union has a pretty predictable business its actually propper to use a discounted cash flow model. However to be safe, I used a five year model as opposed to the ten year model Price uses.

Price's discounted cash flow model, however, presents a couple of problems.

#1 Most analysts predict 10% revenue growth. Though Price does not predict margin expansion in his analysis, if Western Union builds its revenue base its margins will expand due to its significant operating leverage.

Most of Western Union's costs are fixed, including a $243M cost for advertising. As Western Union grows, its total cost to transfer each dollar of money will most certainly fall. For example the advertising that promotes the service will be spread over more customers, and more transaction dollars.

#2 As more money is transfered overseas, Western Union's tax rate will fall. Western Union has a lower tax rate overseas than it does in the United States. Money transfered throughout Asia for instance will be taxed at the country rate which is often lower than in the U.S.

#3 Price uses a discount rate of 11%. To me that is too conservative. I used a rate using Western Union's weighted average cost of capital or WACC.

Western Union's variable rate debt is at 5.6%. I used 6.5% to account for a possible rise in interest rate. After tax this computes to a cost of debt of 4.22%

As for Western Union's cost of equity, I used 10%. Given the nature of Western Union's revenue base, this is still extremely conservative. Equities in general are expected to return about 8% over time. Certainly, Western Union's cash flows have below average risk.

With $3.5B in debt and $17.7B in market value of equity we get a WACC of about 9%.

#4 Price assumes a terminal growth rate of 3% with a discount rate of 11%. This implies a final EV/Cash Flow of 12.5X(1/(11%-3%)). To me that's quite a bit low. To look at it another way...if Western Union really did manage to grow 10% over the next 5-10 years, would it really be sold for 12.5X cash flows? I believe the answer to that is no.

I assumed several terminal values ranging from 10-15X EBIT to 19-21X FCF to 12-17X EBITDA. Further, I assumed that Western Union would reinvest its cash in paying off debt over five years and by reducing shares outstanding by 2% every year.

The model shows a range of values from $25-$42 for an average of $32. This average by the way is exactly what Morningstar says the fair value of the company is.

Another way to look at Western Union is to look at what multiples comparable companies trade at. But what are the comparable companies? Western Union essentially has two assets, its brand and its agent network. Therefor instead of comparing it to the two other money transfer businesses, it instead should be compared to companies that have a strong network and a strong brand.

Four companies come to mind, Choice Hotels (CHH) a network of several low priced hotel brands, Pepsi Co. (PEP) one of the strongest international brands in the world, and EBAY (EBAY) which has built its online auction site into a strong brand and an even stronger network of sellers and buyers, and Coca-Cola (KO).

Using the trading multiples of these to cash flow, EBITDA, and EBIT, we compute a enterprise value between $19B and $34B for an average of $24.25B. Take away the $2.2B in net debt the company carries you get an equity value of just over $28 per share.

Take the $28 per share and average it with the per share value of our discounted cash flow model and you get $30 per share which is a coservative value of Western Union.

I'd reccomend buying Western Union shares under $24 a share to get a great company at at least 80 cents on the dollar.

Disclosure the author owns shares of Western Union.

Valuation:

Valuation is a funny thing. If you talk to ten different people about it, you will get ten different answers. There are two important concepts I'd like to cover in how I think about valuation:

Steak vs. Sizzle:

Famed value investor Michael Price once told a class of Columbia students that he wanted to invest in steak ,what actually was, and buy the sizzle, the hopes and dreams of the company for free.

As an example he used pharmaceutical companies. It is pretty easy to find out how much revenue a drug is generating. He assumed that 80% of this stream of revenue would fall to the bottom line until the patent on the drug expired. He would discount these readilly reliable cash flows throughout the life of the drug, and subtract the net present value of these cash flows from the enterprise value of the company.

The remaining amount was how much the market valued the drug company's pipeline. The pipeline of course wasn't generating any cash flows and many of the drugs in the pipeline might never generate any cash flows if they weren't approved. Those that were approved however, could generate massive cash flows for years to come.

Price saw the drugs already on the market as "steak" and the pipeline as "sizzle". Steak is easy to value, and sizzle is difficult to value. Ideally, Price wanted to buy drug companies at the point where he was paying for the steak and getting the sizzle for free.

DCF vs. Multiples or What is Intrinsic Value?

There are generally two ways to value a company.

#1 Forecast the company's future cash flows from now till the end of time.

#2 Slap a multiple on a metric such as earnings, earnings before interest taxes and depreciation, book value, revenue...etc.

Such a number is based upon what comparable companies are trading for or the price they've been sold for. This is extremely usefull in industries that are consolidating.

My take on this is that the DCF can often have a "hubble telescope problem". Slight changes your expectations will give you a completely different outlook on the value of the company. If you turn your telescope an inch, you look at the world a completely different way.

Hence, I tend to look at what smart buyers have paid for assets.

Yet I don't always tend to look just at traditional multiples. I also look at what assets are actually generating revenue for the company. After all, when you invest in an asset, you are investing in the qualities of the asset that will generate cash flow in the future.

Case Study

Lets look at one industry where the assets tend to be similar. Cell phone tower companies. Cell phone tower companies do one thing. They lease out cell phone towers to cell phone carriers such as Sprint or Verizon Wireless in hopes of generating a long-term revenue stream. Lately the industry has been consolidating with hopes that cell phone companies will need to pay more for cell phone towers as they update their networks. The most recent deal was reported in the Wall Street Journal on October 7th. Crown Castle International, the second largest company in this industry, bought Global Signal, the third largest company in this industry. According to the story, this was the third large transaction in this industry in the past two years. In fact there have been seven such mergers in the past two years. Three were mergers of public companies four were not. One way to look at these mergers is to look at is how much these deals are on a per tower basis.

Total Average= $454,000/tower
Average of public companies purchased = $502,000/tower
Range = $320-$546/tower

After the Crown/Global Signal deal is completed, there will be two public companies that own 20,000+ towers. The remaining one, SBA Communications, with many fewer towers is an obvious aquisition candidate.

Is this already reflected in the stock price?

SBAC currently has a enterprise value to towers of $678,000. Of course SBAC has several sites that aren't producing revenues. Such sites are the equivlent of undrilled oil wells. They may produce cash flows one day but they may not. They are the sizzle in our steak

What might I pay for SBAC?

6078(revenue producing sites)
X 504000
= $3.06B
- $1.45B (debt)
= $1.62B/103.76M (shares)
= $15.55

At that price I'd stand a good chance of not losing money in an aquisition and I might make even more if SBAC increased its revenue per site or rented out their non-revenue producing sites.

NEXT....Can an expensive stock be a value?

What is Value Investing?

The following is yet another value investment blog. The internet is filled with them. From Gannon investing, to Rick's Value Investing discipline and countless others. Many are quite good and quite impressive. Yet I still feel I have something to add I hope.

First I'd like to start with interpretation of what value investing is.

Marty Whitman in his fine book on value investing said it best. Value Investors are only concerned with what "is". That is, the factors that effect the value of the business. What is the value of a business? The value of a business is what a buyer might pay for the business. The value of a business is also what the discounted cash flows for the business from now to eternity.

As a value investor we are only concerned with two questions. How good a business is this? And what's it worth? Nothing else matters. Anything else might effect volatility or the price of the stock. Yet volatility might just give you an opportunity to buy a set of assets at a lesser price than you did before. Anything that effects the value of future cash flows over the life of the business is something you need to be concerned about. Anything else? Its just noise. The best investors have an uncanny ability to seperate what's important (news) from what's noise.

So what's noise? The first type of noise is easy. Its noise that has absolutely nothing to do with the business or its prospects its mostly the noise that has to do with the stock and not the business. There are some investors that are obsessed with this noise. It includes.

#1 Volume

#2 Momenutum

#3 Specialist

#4 Institutional buying

#5 Virtually anything to do with technical analysis.

What do any of these factors have to do with the value of the business? If you look through the pages of INC magazine you will see privately held businesses that are sold every day. Do you think the buyers and sellers of these businesses are concerned with the MCADs or Bollinger Bands? No way. If you want to invest in a businesslike fashion you shouldn't be either.

There are other factors that may or may not have an effect on the short-term cash flows of the stock...and certainly on the direction of the stock...but overall they do not effect the value of the business.

#1 A change in the near forecasting of macro factors.

#2 Changes in analyst estimates and earnings warnings.

#3 The anouncement of a change dividend policy.

#4 Accounting scandals and "headline risk"

#5 Any factor deemed to be temporary and fixable and not permanent.

#6 If the stock is listed or will continue to be listed on an exchange.

Some of these will be contriversial. Aren't stocks that pay dividends supposed to be better? Aren't we supposed to be concerned about accounting? Doesn't a change in interest rates effect the future cash flows of the business? If earnings estimates are "future cash flows" don't changes in them effect the business?

First off, we need to remember that the value of future cash flows is the only thing that effects the value of assets. Any smart buyer of assets assumes that a business will have cyclical upturns and downturns. For some businesses these turns maybe sharper than others, but all will have them. Eventually, the cash that the assets of the company generate will be returned to shareholders. Does it really matter if the company returns it through dividends or by sharebybacks when the stock at a low point? An accounting scandal may effect your ability to determine the value of a company. But does the accounting a company uses effect how much cash its going to generate?

If anything factors such as these can create temporary depressions in stock prices that could be buying opportunties. To be short if there is negative news about a company its something that I need to look at. If a stock is going down by a great deal its something I need to look at. If there is a major change in a company that will effect the long-term future cash flows of the company...like a restructuring or a change in CEOs, its something I need to look at.

Value investors use noise and news to their advantage. An excessive amount of noise will push a stock downward so that it might be a buying opportunity. In the meantime, some news will also be pushed aside or underrated and create a buying opportunity.

I hope you all enjoy this blog...and I welcome any comments. But no matter how you feel about a comment please try to keep it clean.