The Western Union Company (WU), Moneygram International Inc (MGI): An Earnings Beat With Long-Term Potential

When money-transfer giant The Western Union Company (NYSE:WU) reported its second-quarter earnings on Tuesday, the stock soared by as much as 9.5% as the results came in far better than analysts expected. The company cut prices on many of its services to better compete with rival Moneygram International Inc (NYSE:MGI) and upstart Xoom Corp (NASDAQ:XOOM), and while a decline in profits was expected, increased volume caused that decline to be smaller than anticipated.

Total revenue declined 3% while net income fell 27% year-over-year, with EPS falling only 18% due to share buybacks over the past year. The diluted share count has been reduced by 9% since the end of Q2 2012, and the quarterly dividend has been increased by 25% during that time.

The long-term picture

The Western Union Company (NYSE:WU)The Western Union Company (NYSE:WU) throws off far more cash than it knows what to do with, and this results in ample dividends and share buybacks. The company expects cash from operations to be about $1 billion, excluding a one-time tax item for 2013, and with minimal capital expenditures, the free cash flow should be around $800 million – $900 million.

Even as growth in most parts of its business is slow or non-existent, there is one segment which is booming — electronic channels. Electronic revenue grew 26% as westernunion.com saw transfer transactions rise 68%. The company expects this channel to grow rapidly in the coming years and eventually make up a significant portion of total revenue.

One thing to note here is that recent IPO Xoom is currently valued at about $1.1 billion with only $87 million in TTM revenue and no profits to speak of. With The Western Union Company (NYSE:WU)’s electronic business roughly twice the size in terms of revenue, it would be valued by the market at a few billion dollars, a significant fraction of Western Union’s $10 billion market capitalization.

Western Union, then, has a growth stock lodged inside of a value stock, and once the online business grows bigger, the company should resume revenue growth. This is likely a few years away, but Western Union is planting the seeds for this future growth today.

Dividends and buybacks

Even if profits were to remain constant, The Western Union Company (NYSE:WU) offers a compelling opportunity. When I first wrote about Western Union in January, the stock was trading at about $13.50 per share, and since then, it has risen by about 35%. Often, it’s the most boring stocks which can give above-average gains due to a mix of pessimism and shortsightedness by the market. Today, the stock is not nearly as cheap, but long-term, it’s still an excellent choice.

The Western Union Company (NYSE:WU) returns much of its profits to shareholders through dividends and share buybacks. So far this year, the company has spent $140 million on dividends and $314 million on share buybacks, and the company expects to return a total of $700 million to shareholders in 2013.

Let’s imagine that The Western Union Company (NYSE:WU) generates $900 million in free cash flow every year for the next ten years. The dividend, which is currently $0.50 per share each year, rises by 10% per year, and the remaining free cash flow is used to buy back shares. I’ll assume that the average repurchase price rises by 10% per year as well, as using the current share price would be unrealistic.

In this scenario the dividend would grow to $1.30 per year at the end of ten years, and during that time, you would collect $8.77 in dividends per share. That’s a 48% return from dividends alone. The payout ratio would only be about 50% due to the buybacks. The share count would decline by 34%, meaning that each share would now represent a significantly larger portion of the company. If the P/E ratio remains constant, then your total return over ten years would be 82%, or about 6.2% annualized.