First Data Deepens Its Moat

Yesterday, First Data's (NYSE: FDC) Western Union subsidiary announced that it purchased a 30% interest in an Italian money-transfer agent, following up on a similar July purchase in another agent. These acquisitions might seem small, considering First Data's nearly $35 billion market cap, but they're positive steps nevertheless.

First Data, like many of the other Inside Value picks, has two extremely important characteristics: strong free cash flow and significant competitive advantages. Shareholders love it when companies have both, since it suggests not only that the company's making money now but also that it has a good chance of doing so in the future.

However, free cash flow and barriers against competition aren't a permanent guarantee of success. Eastman Kodak (NYSE: EK) had these attributes, but the rise of digital photography has threatened its existence. And there are nearly constant rumors that AT&T (NYSE: T), once dominant in both characteristics, will be sold off for scrap. So, although these two elements do allow companies to take economic body blows without crumpling to the ground, they still have to use their free cash flow to fight back.

And that means using that cash to benefit shareholders, grow the business, and increase barriers to entry. Historically, First Data has used its cash to good effect: repurchasing shares at prices less than intrinsic value, investing in the businesses, and acquiring companies.

But acquisitions aren't always good -- they can go poorly, as seen in Krispy Kreme's (NYSE: KKD) purchase of Montana Mills, or JDS Uniphase's (Nasdaq: JDSU) and Nortel's (NYSE: NT) massive write-offs of buys they made during the tech bubble. Acquisitions must be more than just attempts by management to become a bigger fish by eating minnows. Instead, such purchases should be in areas in which the company can both leverage and increase its existing competitive advantages.

First Data's acquisitions seem to fit these criteria. First, Western Union understands the businesses of which it's become a partial owner. Consequently, it will most likely be able to leverage its knowledge of these types of businesses to make them perform better. Second, because these agents are the channels through which Western Union sells its product to consumers, its partial-ownership interest may help it sell other First Data products through those channels. And third, the tight partnership with agents will provide a buffer against competition. Western Union will be more aware of competitive issues that agents face and may be able to respond more quickly to threats.

For a large multinational like First Data, these deals aren't as important as they would be for smaller companies. But relatively small deals like this help deepen, drop by drop, the moat that keeps competitors away.

Find other Foolish information on these related topics:

• Companies with strong cash flow and competitive advantages
• Reasons to love First Data
• Different types of competitive advantages

Richard Gibbons wants a moat around his townhouse. He owns shares and call options on Krispy Kreme but on none of the other securities mentioned in this report.