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1 Troubling Trend for Western Union

Western Union (NYSE: WU  ) is one of the stocks with the most buzz around it this year. Just 12 months ago, the stock traded for less than $12 per share because of competitive concerns from MoneyGram International (NASDAQ: MGI  ) and Xoom (UNKNOWN: XOOM.DL  ) . Since then, Barron's has written a bullish feature story on the stock, and the company has successfully reclaimed market share in key corridors.

The stock peaked at $19.50 before falling below $17 upon management giving disappointing guidance for 2014. Although it is tempting, investors may want to think twice before buying the dip.

Western Union's profitability is in a secular decline
Short-term trends can be ignored or explained away as noise created by the vicissitudes of a competitive environment. Long-term trends, however, must be given significant weight in one's analysis of a company. Western Union's long-term trend is not good:

Source: Morningstar.

Western Union has traditionally enjoyed a wide moat thanks to its enormous agent network, but the company's declining profitability suggests its moat is shrinking:

Source: SEC filings. 

Since there are hardly any variable costs associated with money transfers, Western Union's scale advantage enables it to earn a higher margin. However, as Western Union's operating margin declines, MoneyGram's is holding steady between 11% and 14%.

Western Union's decreasing profitability is the result of increasing competition and higher compliance costs  -- neither of which is likely to abate any time soon.

Competition from MoneyGram and Xoom
Western Union cut its prices this year in key corridors because of increasing competition from MoneyGram. For instance, the company lost significant share in the key U.S.-Mexico corridor because of a regulatory mishap that forced it to terminate many of its agent relationships in the corridor.

In addition, the company's exclusive relationships with some of its highest-volume agents may soon be eliminated. Exclusive contracts have traditionally allowed Western Union to charge premium prices in key corridors, but laws in India, Russia, and other high-volume markets are changing to disallow these exclusive relationships. As a result, the gap between MoneyGram and Western Union's operating margin will continue to close.

Western Union also faces a significant threat from online and mobile-to-mobile competition. Xoom services many of Western Union's key corridors, often at a lower price. Xoom, however, does not have a physical presence; it relies on cross-border bank-to-bank transfers to generate revenue. Western Union does not have a competitive advantage in bank-to-bank transfers, allowing Xoom to take those customers' business. Xoom is unable to service un-banked customers, which make up the bulk of Western Union's customers. Even so, Xoom is another weight on Western Union's profitability.

Western Union will eventually become irrelevant, but when?
It is hardly a bold prediction to say that Western Union's current business model -- international cash transfers -- will eventually become extinct. Sometime in the future -- a decade, two decades, maybe five decades from now -- most people in the developing world will have bank accounts, and hardly anyone will have a need to send or receive physical cash.

However, the timing of Western Union's obsolescence is of great importance to the investment case. According to The World Bank, 75% of the world's poor do not have a bank account. Western Union's business depends on un-banked customers because bank-to-bank transfers are not nearly as profitable. Therefore, one of the keys to handicapping an investment in Western Union is to determine how quickly the world's un-banked will join the modern financial world -- a tough task, no doubt.

Bottom line
Western Union seemed really cheap when it traded below $12 this time last year, but I held off from buying it because of the risks stated above. The company is losing its exclusive relationships in key corridors and faces significant online competition. It also relies on serving un-banked customers, a group that will surely grow smaller over the coming decades.

Western Union is still a good company, and it will earn above-normal profits for several more years. However, the odds that buying at the current price -- about $16.65 per share -- is a great investment are difficult to handicap because of the company's uncertain future. As a result, concentrated investors should consider waiting until the stock gets much cheaper before buying shares.

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