Western Union (WU 0.79%) didn't have the most exciting quarter report -- but compared to the market's low expectations, the numbers weren't too bad. The money-transfer service reported flat revenue in the fourth quarter, lower margins, and 23% decline in earnings per share. Let's take a closer look at those earnings by asking four crucial questions about the company and its potential as an investment.
1. Does the company have a sustainable competitive advantage?
Probably, based on forecasted margin improvements. But without a durable competitive advantage -- what Warren Buffett calls a "moat" -- it's hard for a business to reliably generate above-average returns for investors. And Western Union's moat seems to be shrinking.
Based on scale, brand, and network effects, I've always thought that Western Union had a wide moat. But while its most recent profit margins were quite high -- with a 17% operating margin in the fourth quarter -- they are trending in the wrong direction. For the past two years, margins have come down, and the company has admitted that it needed to lower prices to bring in more business. Obviously, Western Union has a few gaps in its armor.
But in its outlook for 2014, management indicated that it'll be able to ease up on those price cuts, which will improve operating margins to 19% to 20%. This is a key proxy for pricing power and competitive advantage, and investors should be tracking this figure closely over the next several years.
2. Does the company serve a useful purpose, generating value for customers, and will its market opportunity persist and/or grow?
Based on the last two quarters, Western Union gets a "yes" for this one.
A useful business with a growing (or at least stable) market can reward investors for years. Based on World Bank data, remittances -- sending money home -- is a huge and growing market. That's great news for Western Union, but it always faces the risk of disruption by new technology, shifting regulations, market-specific employment issues, or any number of other potential perils.
Trying to track and forecast all those variables won't do you much good. Instead, the most important metric for tracking the viability of Western Union's service is consumer-to-consumer (C2C) transaction volume -- the number of times consumers use Western Union's service to send money.
C2C transaction fees account for more than 80% of Western Union's revenue, and they're also a key indicator of whether people are using the service. In its latest quarter, C2C transactions increased 9%, representing the third consecutive quarter of transaction volume growth.
3. Does the company generate cash and use it wisely?
Yes and yes. Western Union generates a lot of cash relative to its market value. The market currently values the company at less than $9 billion. Yet for the full year, it cranked out $1.1 billion in operating cash flow, consistent with its results from the past five years. Next year, management plans to generate $1 billion in operating cash flow, excluding a one-time tax payment. Since the company doesn't need many capital expenditures to maintain its business, a huge portion of that cash winds up as free cash flow that can be used for shareholders' benefit.
Management has been paying out some of that cash to the tune of $671 million in dividends and share repurchases in 2013. The board has authorized another $500 million to buy back shares. It also pays a dividend in excess of 3%.
4. Will this company outperform the S&P 500 over the next three to five years?
Yes, but perhaps not by a wide margin. The company doesn't offer much in the way of growth, but it seems relatively inexpensive if it can sustain its current cash flows.
Western Union could put up double-digit sales growth if we experienced a very robust, global economic recovery. But if the world economy continues to muddle along, I wouldn't expect much more than single-digit revenue growth. I do think the company's cash flows are sustainable, because I don't think the next revolution in global payments for the unbanked will happen anytime soon -- but of course, I could be wrong.
In terms of valuation, Western Union looks pretty attractive. According to management, the company expects to earn $1.40 to $1.50 per share in 2014, which puts the stock at around 11 times earnings. And those earnings are backed up with plenty of cash generation. Even without much growth, the company could be a market-beater by continually generating cash and paying it to shareholders.
In conclusion ...
The stock market is full of fast growers, dynamic cultures, and innovative leaders -- the types of companies that you can really get excited about. Western Union is not one of those companies. But if its pricing, growth, and margin issues turn out to be temporary, it could still be a winner.
