Here's Why Xoom Jumped More Than 10% After Earnings

Xoom (NASDAQ: XOOM  ) is up more than 10% after reporting revenue growth of 48% and EPS of $0.06. This is $0.10 better than the consensus loss of $0.04. Clearly, this blows away expectations, but we need to look at what is behind the upside to see if future surprises are in the cards. Competition is heating up with Wal-Mart (NYSE: WMT  ) beginning to offer its own solution and Facebook (NASDAQ: FB  ) announcing that it will be entering the industry. However, Xoom's business is insulated from the competition.

Competitive advantage is ease of use, cost advantage is icing on the cake
To understand Xoom's competitive advantage, first take a step back and look at the industry. Traditional vendors like Western Union and Moneygram accept cash and initiate an electronic transfer that takes several days to process. The transaction is time-consuming and the labor involved justifies a high price for the transfer. Xoom, on the other hand, only focuses on a subset of this market. It only works with people who have existing bank accounts, which lowers the cost of the transaction. Rather than pad margins, Xoom passes this savings on to customers. This helped Xoom build up a customer base of 1.1 million people who placed a transaction in the last year (more on this later).

The key driver of upside in the quarter was revenue growth 
As the number of transactions grew from 2.7 million to 2.9 million, revenue grew by 48% year-over-year and by $4 million in just one quarter. Besides the number of transactions increasing, volatility in the Rupee allowed the company to capture a wider spread as money was shifted overseas. Since management can't predict currency movements, guidance only includes the transaction business, so currency volatility is actually a benefit.

Reduced fraud helped as well
But, revenue growth isn't the only reason for upside in the quarter. Because Xoom links directly to bank accounts, it is in a position to know how much money a person has. Using this knowledge, rather than physically transferring the funds, it advances money to the recipient at the same time the transfer is initiated. Since Xoom knows there is money in the account, it can keep fraud rates to a minimum, collecting the money it lent a day later when the ACH transfer goes through. This was one of the reasons Xoom beat estimates, the fraud rate dropped to 0.17% from 0.25%. This number will be volatile over time, but remains at the top of the industry.

Competition will drive new functionality
Xoom has built a substantial customer base, but as Facebook and Wal-Mart enter the industry, it needs to tighten the relationship and offer features the other guys do not. Wal-Mart will rely on its domestic physical presence and its balance sheet to transfer money from store to store within the United States. Facebook, on the other hand, is clearly intending to become a force in emerging market financial transfers. Facebook is starting out in Ireland, which will give it access to the EU, but emerging markets are a focus and will follow along shortly. Since India has 70 million Facebook users, it will likely follow along shortly, putting substantial competition into Xoom's backyard.

The key for Xoom is to differentiate itself from other services. Ease of use should continue to be a differentiator when competing with Wal-Mart, but Facebook has the ability to build funds transfer into its smartphone app. To compete effectively against Facebook, Xoom will need to build functionality into its app that goes beyond the scope of Facebook's business plan. The company is doing that now by adding a feature similar to Bill Pay, thanks to its acquisition of BlueKite.

Explosive earnings not likely near term
Xoom is seeing an acceleration in its traditional payments transfer business, but to insulate itself from the competition, it needs to provide functionality that is unique. Xoom has already innovated on two fronts, meaning it is possible to do again, but this means additional investment. So, it's unlikely you will see an earnings explosion in the near future.

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