Once money-transfer company Western Union (NYSE:WU) reported earnings a few weeks ago, shares initially rose. The company beat analyst estimates for both revenue and earnings, with earnings per share of $0.39 and revenue of $1.1 billion. But once investors digested the earnings release, shares crashed.
The company stated that compliance costs are expected to rise in 2014, the result of an increasingly complex regulatory environment, and that this will lead to a flat operating profit next year. The stock opened the next day down 18%.
This huge decline was clearly an overreaction, as investors completely missed the point. These developments actually make Western Union stronger compared with rivals MoneyGram (NASDAQ:MGI) and Xoom (NASDAQ:XOOM), not weaker.
The regulatory environment
Western Union's earnings report was generally positive. The company has been lowering prices to remain competitive, which cut into margins a bit, but the initiative seems to be working. The quarter was the strongest -- in terms of the transaction-growth rate -- in three years, as lower prices attracted more customers. Electronic channels were strong, with revenue growing by 29% year over year. And the outlook for the full year was largely unchanged.
The reason for the massive decline in the stock price can be found in the following excerpt from Western Union's press release:
While the company has increased its investments in compliance considerably in recent years, significant additional investment in 2014 is now anticipated in light of the current environment and our internal reviews of the increasingly complex and demanding global regulatory requirements.
As a result of the increased investments, Western Union expects its compliance related expenses to increase from approximately 2.5% of revenue in 2013 to a range of approximately 3.5% to 4.5% of revenue in 2014, based on preliminary reviews of the programs. Although the company is in the early stages of its 2014 budgeting process, it still expects revenue growth in 2014, but no longer expects growth in operating profit due to both these incremental costs as well as potential business impact from new compliance procedures.
With operating profit guided to be flat next year because of these increased costs, investors bailed on the stock. Western Union recently completed compliance with the Dodd-Frank remittance transfer rule, which had a deadline of Oct. 28, and new anti-money laundering and fraud-prevention enhancements were implemented in Spain and the U.K. earlier this year.
The compliance and regulatory environment is getting more complex, and Western Union's presence in more than 200 countries greatly complicates the situation.
However, this is ultimately a long-term positive for Western Union, even as short-term profitability is negatively affected. Compliance and regulatory costs act as a barrier to entry into the money-transfer business, and increasing costs actually strengthen Western Union's position. The biggest players in the industry can absorb these costs, while smaller players will have a tougher time as they try to expand.
The other guys
MoneyGram is Western Union's largest competitor, with about one-quarter of Western Union's revenue. MoneyGram has a far lower margin than Western Union -- 12.5% compared with 21% in the most recent quarter, a fact that shows that scale is very important in this industry.
MoneyGram has been aggressively expanding, with agent locations increasing by 14% year over year in Q3. But MoneyGram is subject to the same regulatory environment as Western Union, and in its most recent earnings release, the company cited compliance costs to explain falling margins. While both companies will probably see increasing compliance costs in the future, Western Union should come out stronger on a relative basis because of its scale.
Xoom is much smaller, having just recently IPOed. Xoom recorded trailing-12 month revenue of just $112 million, and in the most recent quarter, revenue grew by 60% year over year. Xoom has posted profits in the past two quarters, with the operating margin hitting 9.5% in Q3.
Xoom, however, faces an uphill battle as it tries to expand into new markets. Not only is Western Union's brand well known and trusted, but a more complex regulatory environment bodes also poorly for a company with such a small presence.
Profitability will certainly suffer, and with Western Union getting aggressive with price cuts, Xoom may not grow as fast as the market assumes. The stock is trading at about 10 times trailing-12-month sales -- a difficult multiple to justify regardless of growth. Xoom faces a difficult road ahead, and the market seems to be overly optimistic.
Smaller players such as MoneyGram and Xoom will be hit the hardest by Western Union's announcement of higher compliance costs, and this makes Western Union's position in the industry much stronger.
The bottom line
While increased compliance costs for Western Union will hurt profitability in the short term, these costs actually strengthen the company relative to competitors in the long term. The large decline in the stock price was a knee-jerk reaction, and the lower price offers a buying opportunity for long-term investors.
Timothy Green owns shares of Western Union. The Motley Fool recommends Western Union. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.