A Spin-Off We Love

We've written in the past about spin-offs--new companies created when larger companies break themselves apart--and how they often present good value. Well, there's one we're pretty excited about that started trading a few weeks ago:  Western Union (WU). Pat Dorsey, Morningstar's director of securities analysis, recently featured the company in one of his video reports, and Paul Larson, who manages the Tortoise and Hare portfolios for Morningstar StockInvestor, added Western Union to the Hare Portfolio in early October.

Why do we like it? Below you'll find excerpts from my Western Union Analyst Report, which was published for Premium Members on Oct. 2. With our estimate of fair value at $32 and the stock trading in the low $20s, we think there's plenty of upside.

Thesis
Now that  First Data  has spun off Western Union, investors have an opportunity to invest in one of the world's most outstanding franchises on its own.

Western Union dominates the lucrative money-transfer market. People immigrating to wealthy countries from poorer ones annually remit several billion dollars to their countries of origin. With its massive agent network, Western Union handles approximately 15% of those transactions.  MoneyGram , the company's closest rival, controls about 3% of the market.

Western Union enjoys very attractive growth prospects. The money-transfer market continues to expand as more people emigrate from poorer countries to wealthier ones. Western Union's revenue has grown by almost 15% per year since 2001, and it should continue to expand at a healthy rate for the foreseeable future.

The firm is also a cash cow. With operating margins above 30% and low reinvestment needs, Western Union generates cash flows beyond the reach of most businesses. Over the past three years, Western Union has converted an enviable 23% of sales into free cash flow, on average.

Growth and high profits attract competition, but we think the firm has a wide economic moat that will protect its excellent returns for years to come. Western Union is one of the world's most recognized and trusted brands. In a business where trust is paramount--people are often sending money home for their families' basic subsistence--having a strong brand is a tremendous advantage. The company spends heavily to maintain this advantage. The marketing budget in 2005 was 1.5 times second-place MoneyGram's entire operating income.

Western Union's network of 271,000 worldwide agents is almost 3 times larger than the closest rival's and is a second competitive advantage. The size of the network creates economies of scale for the company and makes its services more convenient for customers. Moreover, competition in the money-transfer industry is often localized, transmitting funds from a particular neighborhood in Los Angeles to a particular neighborhood in Mexico City. If competition drives down prices in one corridor, Western Union maintains pricing power along other routes. The firm's advantage grows each year as it adds locations. In recent years, Western Union has added the post offices in France, Germany, China, and India to its network, cementing its global dominance.

Valuation
We think Western Union's fair value is $32 per share. We expect sales to increase 9.5% per year on average through 2010. Our sales growth is driven primarily by 15% average annual growth in the number of agent locations, offset by 4% price compression in money-transfer fees and only modest growth in revenue from consumer-to-business transactions. Our model is sensitive to our forecast of transactions per store. We don't anticipate any material change in the average number of transactions per location. However, if government immigration controls prove effective, the number of transactions per location could decline. If we assumed that transactions per location fall by 3% per year, our fair value estimate would fall to $16. We expect the firm's margins to get squeezed a bit in 2006 as Western Union incurs some extra costs associated with the spin off from First Data. The company enjoys significant operating leverage and has managed to expand margins even as fees per transaction have decreased. We think margins will continue improving after 2006, adding 300 basis points to operating margins by 2011.

Risk
As governments continue to combat the money laundering associated with the drug trade and terrorism, money-transfer firms like Western Union are bearing heavier regulatory costs. Stricter immigration laws could also curtail Western Union's growth. The firm faces growing competition from rival remittance channels, including the Internet, ATMs, and banks.

Management and Stewardship
Western Union starts life as an independent company with a seasoned management team. Christina Gold, president of the Western Union subsidiary of First Data since 2002, remains at the helm. Most of the other top executives have long tenures with the money-transfer firm. Jack Greenberg, former chairman and CEO of  McDonald's (MCD), left the First Data board to take over as chairman of Western Union. The board of directors looks solid and brings a lot of business experience to the company. Given how new the directors are to Western Union, however, we'd prefer to see their compensation more heavily weighted toward stock instead of cash. Directors and executives as a whole beneficially own less than 1% of the firm's outstanding shares. Western Union hasn't released a proxy statement yet, but we have gleaned some insights into the firm's stewardship practices from its registration statements. We were pleased to see that the chairman and CEO roles will be separate. However, we would like to see Western Union trim its fairly substantial antitakeover defenses. In particular, we'd like to see the entire board stand for re-election every year.