Try the new FT.com

October 13, 2006 4:45 pm

Mark Sellers: Many reasons to like this quality spin-off

  • Share
  • Print
  • Clip
  • Gift Article
  • Comments

On September 29 this year, Western Union was spun off from First Data Corporation and became a stand-alone company. At the current price of $19.75, I believe the stock sells at about a 30 per cent discount to its intrinsic value, which is why an investment fund I manage currently holds the stock.

Western Union was founded in 1856 and was the successor to Samuel Morse’s original telegraph company, The Magnetic Telegraph Company. It dominated the telegraph industry throughout the 19th and early 20th century, though the telegraph was ultimately replaced by the telephone, fax machine and e-mail. In the 1980s, with its business in decline, Western Union began to focus almost exclusively on wire transfers of money and quickly came to dominate the industry.

There are many things to like about this company. It costs less than $15,000 to open a new location, with almost no capital expenditures – the company partners with existing outlets such as currency exchanges, post offices and grocery stores. Because of the low investment required to open a new location, returns on capital are north of 60 per cent when adjusted for excess cash on the balance sheet. It generates almost $1bn in free cash flow per year and can continue to grow even while using most of its free cash for share repurchases, debt payments and dividends. Same-store sales (at locations open more than one year) are rising 12-14 per cent a year.

This is a company with a very wide economic moat based on the network effect, similar to eBay, MasterCard, MySpace or Google. A network effect occurs when the value of each new “node” in a network increases the value of all the other nodes. Each new location Western Union adds makes it possible to send money to an additional location from every other location. Thus, the value of the network increases exponentially with each new Western Union node.

Because Western Union is almost five times larger than its nearest competitor, MoneyGram International, a customer can send money to vastly more locations than with any competing service. Western Union operates in 200 countries and territories and more than 80 per cent of money transfers involve at least one non-US location.

It is taking a bigger slice of a pie that is increasing in size by 8 per cent a year. Western Union has doubled its number of locations over the past three years, growing money transfer volumes at greater than 20 per cent annually. Yet in spite of its 270,000 worldwide locations, it still has only about 18 per cent of the market.

There is a huge opportunity to take share from niche “mom and pop” money transfer operations, aided by newly stringent government regulations which are raising costs and pushing many small operators out of business.

Spin-offs of high-quality companies are rare. Most of the time, a wide-moat company is the parent and the spin-off is a smaller, less profitable subsidiary. Occasionally, though, it happens to be the other way around. These high-quality spin-offs are almost always a good bet if you hold on to them long enough.

Recent examples include Moody’s (up 350 per cent since it was spun off from Dun & Bradstreet in October 2000), Chipotle Mexican Grill (up 40 per cent since being spun out of McDonald’s in January this year), Zimmer Holdings (up 150 per cent since being spun out of Bristol-Myers in August 2001) and Cognizant Technology Solutions (up 620 per cent, spun out of IMS Health in February 2003). Even Western Union’s main competitor, MoneyGram International, was itself a spin-off. Its stock is up 67 per cent since being spun out of Viad in August 2004.

Why do spin-offs tend to do well? They are often mispriced because investors and analysts lack a full understanding of a company’s business model when it first begins trading. But the most important reason is that the new management team is highly motivated. Managers cut costs, use capital more judiciously and do whatever they can to increase earnings faster than the market expects.

The company currently trades at about 17.5 times forward earnings estimates, less than MoneyGram. I expect Western Union’s price/earnings ratio to expand over the next few years. Based on extensive research and a discounted cash flow model, we are confident the stock is worth between $20 (worst case) and $40 (best case) a share.

Mark Sellers is a hedge fund manager with Sellers Capital in Chicago
msellers@sellerscapital.com

Related Topics

Copyright The Financial Times Limited 2017. You may share using our article tools.
Please don't cut articles from FT.com and redistribute by email or post to the web.

  • Share
  • Print
  • Clip
  • Gift Article
  • Comments

NEWS BY EMAIL

Sign up for email briefings to stay up to date on topics you are interested in

SHARE THIS QUOTE