Introduction

Over the last three months, we published two industry-related articles on Western Union. In the first article, we examined the threat of online money transfer posed by Xoom (currently under PayPal’s umbrella) and other digital players. In the second article, we did a deep dive into the company’s core inbound markets, such as India and Mexico. In the present piece, we shift gears and focus on Western Union’s upcoming earnings.

We are providing this preview for three reasons: 1) to update investors on our expectations for the quarter; 2) to publish our new estimates, which also affect the company’s valuation; and 3) to provide our thoughts regarding the 2020 guidance.

4Q Quarter Preview

Expect largely in-line quarter, with lackluster top-line growth: We are estimating 0.6% Y/Y constant currency revenue growth, with total transactions at approximately 0.9% Y/Y growth. The company’s C2C business remains stable, but unimpressive, with few levers capable of boosting it. We expect the top-line profile of the fourth quarter to resemble that of the previous two quarters, where soft C2C business was somewhat offset by traction in the C2B business.

See mid-single-digit Y/Y revenue growth for C2B segment: With WU bill pay becoming less important in the payments industry, as consumers more and more rely on their banks for electronic bill payment, Western Union nevertheless is able to rely on its sticky network of customers that is not going away at present. We, therefore, believe this revenue base is here to stay through at least 2020, supporting 4%-6% Y/Y revenue growth. At the same time, we have to remember that C2B is only 10% of total revenue for the company and can move the needle only marginally. Further, it has a fairly limited presence in the international markets.

Compliance costs are on the rise: We expect a 30 bps increase in compliance costs as percent of total revenue at Western Union. Money transfer, as we wrote many times in the past, is a heavily regulated industry with know-your-customer and know-your-agent incurring new restrictions and, therefore, demanding higher investments from the company.

Mild margin contraction: We expect mild margin contraction during the quarter as a result of compliance costs, as well as higher marketing expenses in non-international markets. The size of margin contraction will determine the margin guidance for 2020.

Cannibalization effects: With recent online marketing campaigns taking place for WU.com, we believe that cannibalization of the offline business is on the rise. Recall, the company says that 80% of online customers are new to the Western Union brand; however, we believe this number to be somewhat lower, around 60%-65%, which may translate into a 15-20 bps revenue headwind.

Valuation:

We have followed Western Union’s story for a long time, and our key reason for a below-comps-multiple for the company has been its focus on offline money transfer business during an age that is largely online and digital. As such, we view WU as falling behind the curve, with the near-term catch-up unlikely. Therefore, we are applying a P/E multiple of 10x, which is at least 3x below Western Union’s peer group. When we apply this multiple to our 2020 EPS estimate of $1.87 (up from $1.81), we get the target price of $19 (up from $18).

2020 Guidance Expectations:

The company will also issue 2020 guidance when it reports earnings in late January. There are four issues to consider ahead of the guidance:

1) Revenue growth acceleration: Will the company guide above 2%, or will the outlook stay in the 1-2% range? We are estimating about 1.7% Y/Y growth: any upside to this may compel us to revisit our estimates or even the multiple.

2) European business: Are we seeing improvement in remittance rates in that region and if yes – are they eating up into the margins? The United States has a fairly healthy remittance and margin profile, but volumes from Western Europe have been on the decline. We look forward to any commentary from management on this issue.

3) Buybacks: Western Union has been very aggressive with its buyback strategy over the years, repurchasing as much as 3% of total shares annually. There has been some discussion of scaling back, which we believe may go down to about 2% range. At the same time, we expect any retreat in buybacks to be partially matched by a dividend increase (current yield is about 3%).

4) EPS: We expect $1.85-$1.95 as an EPS guidance range, with our estimate at $1.87, at the lower end of the range. Western Union is not always conservative when it comes to bottom line guidance, while SG&A and compliance costs can make a difference from quarter to quarter.

Risks to the Bear Thesis:

We would like to highlight the following two risks to our Bearish thesis. We no longer see buybacks improvement as a substantial risk, instead focusing solely on pricing and offline-online equilibrium.

1. Pricing stabilization between Western Union, MoneyGram, and Euronet Worldwide could lead to an equilibrium that would prevent or at the very least lessen market share loss for Western Union.

2. The most important upside risk is for Western Union to shift its focus from the offline space to the online business. That would essentially alter the company’s business model and position it against digital money transfer players, such as PayPal. Such move would be a game changer, since transaction and revenue growth is in solid double digits for the online space (usually, at least 20%), whereas the offline business is growing in low single digits. Furthermore, operating margins for the online business are much higher, since there are no origination fees that have to be paid to agents.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2020-01-17