Monday, December 17, 2007

Western Union - Whats the catch! - Is it a value trap?

WU has a number of well known competitive advantages like huge distribution network that dwarfs competitors, very high profit margins and growth that is not capital intensive. In spite of these advantages, Berkshire sold it's entire stake in Western Union. What could we be missing that Berkshire recognized?

I have to confess that Berkshire selling stakes in WU got me thinking more about what could be wrong with WU's business model. Obivously, no one Knows why Berskshire sold it's stake in WU. It could very well be a distaste for small positions (around $300 million originally...yes it is small for Mr. Buffet!). But it is worth thinking about other aspects as well.

I read WU's annual report to find out. One sentence captured my interest. In it, it is stated that due to pricing actions, revenue reduced 3% and further that this trend will continue into future. In the recent quarter, the management said that revenue reduced 3.3% due to pricing action. This kept me thinking as to why WU will have to reduce price if they have such a strong brand and further that why such price reductions will need to be ongoing. This needs additional thought.

WU has the biggest distribution network among all money transfer firms (3 times bigger than their immediate competitor Money Gram). In exclusive money transfer corridors (where there is little or no competition), they have enormous pricing power. But that is not the case in corridors where they compete with other money transfer companies, especially a big one like Money gram.

Money Gram (MGI) is expanding it's network at a fast rate and as a by product of that, WU starts to lose exclusive corridors of money transfer. This in turn results in Western Union losing pricing power. It is well known that Money gram prices just below western union. While WU has first mover advantage, it is far from being a permanent advantage. This loss of exclusive money transfer corridors results in reduction in pricing and hence revenue. I think that over long term, both operators can co-exist but not at profit levels that WU is currently experiencing.

Oracle of Omaha does like pricing power as a result of strong brand. Brand is just a means to pricing power and is not end all by itself. Think GM vs Coke. Both are powerful brands and only one of them carry pricing power. The key question then is whether WU's brand helps it maintain pricing power which can become a more sustained advantage?

WU's brand symbolizes reliability and convenience. But the relevant question to me is whether Western Union's brand is strong enough to convince a customer to pay a premium price (higher than competitor) and use Western union even when a viable cheaper alternative exists (Money Gram). Or in otherwords, will customers pay a higher price to transfer money through WU if Money gram agent is available in the both send and receive locations? This question is key to determine long term pricing power and share holder returns.

If the answer to above question is 'Yes', it's advantages are sustainable and loss of exclusive corridors don't matter much and Western Union will continue to earn excess returns over long periods of time. If the answer is 'No', it's returns are dependent on competitor having rational pricing and other factors affecting the industry (or in other words, starts to resemble commodity type business over long run).

My view is that it does lose pricing power as as Money Gram expands. But longer term, both companies can co-exist (like Coke, Pepsi or UPS and FEDEX). But it will need to be at lower margins than Western Union currently has. So it will be somewhere between excellant business (franchise as Warren Biffet would call it) and commodity type business.

The money transfer business is high fixed cost and low variable cost. So the last dollar earned goes directly to bottom line. So 3 % revenue lost in pricing actions are going to directly affect the bottom line.

Some offsets to revenue reduction in medium term could be faster international growth or Money gram stumbles in execution due to subprime issues etc. It is true that international segment margins are lower. But that does not explain the 3% reduction in revenue due pricing action.

All in all, I think WU is a good business but will likely not be a great business as it was in the past. Disclaimer, I do own WU. I think it has decent prospects due to international segment (especially Asia and middle east) and due to low capital requirements. But likely will not be a great business as it's numbers currently imply. Any thoughts on this is welcome!


Marisa said...

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