Last Friday money-transfer company Xoom Corp (NASDAQ:XOOM) had its IPO, with shares rising from the initial price of $16 to around $25 by the end of the day. This puts Xoom’s market capitalization at just about $800 million.
The first question you should ask about any IPO is whether or not the expectations are too high. Xoom has yet to turn a profit and recorded just $80 million in revenue in 2012. Investors are clearly expecting fantastic growth, but how realistic is this?
Size matters
I recently wrote an article about fellow money-transfer company The Western Union Company (NYSE:WU), a company which dominates the business with about $5.6 billion in revenue in 2012. Smaller competitor Moneygram International Inc (NYSE:MGI) recorded $1.3 billion in revenue, but the real difference is in the profits. Western Union has a free cash flow yield of over 16%, while the smaller MoneyGram only achieved a FCF yield of 11.6% in 2012. This isn’t a bad result, of course, but clearly this is an industry where scale allows for significant advantages.
A growing concern
Xoom was founded in 2001 and has grown its annual revenue to $80 million since then. The company saw 60% revenue growth between 2011 and 2012, which an impressive number even considering the small size of the company. Net income and cash flows have yet to turn positive, which makes any kind of future estimates extremely fuzzy. I’ll make a few simplifying assumptions to estimate values for the next few years.
- Revenue grows by 45% annually, the 3-year growth rate
- COGS grows by 27% annually, the 3-year growth rate
- OPEX grows by 45%, the 3-year growth rate
| Year | Revenue | Net Income |
|---|---|---|
| 1 | $116 | $-2.39 |
| 2 | $168.2 | $2.7 |
| 3 | $243.9 | $11.8 |
| 4 | $353.6 | $27 |
| 5 | $512.8 | $51.8 |
| 6 | $743.5 | $91.2 |
All values in million USD
At this point Xoom would have reached the size of MoneyGram in 2004 in terms of revenue. From that point until now MoneyGram has grown revenue at an annualized rate of 6.2%. In the same period Western Union has grown revenue at an annualized rate of just over 6%. But look at the net income:
| Company | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|---|---|---|---|---|---|---|---|---|
| MoneyGram | $86 | $113 | $124 | $-1,072 | $-261 | $-2 | $44 | $59 | $-49 |
| Western Union | $752 | $927 | $914 | $857 | $919 | $849 | $910 | $1,165 | $1,026 |
All values in million USD. Data from Morningstar
Size matters in this industry. Both companies grew revenue at about the same rate but MoneyGram has gone in and out of profitability while Western Union is a model of consistency, growing net income at an annualized rate of 4% since 2004.
I’ll do a reverse discounted cash flow calculation to determine exactly how fast the market expects Xoom to grow. The first six years are dictated by the table above, with $91.2 million in net income in year six. I’ll use a discount rate of 12% and calculate at what rate Xoom must grow its earnings after year six to justify the current market cap of $800 million.
The answer: 5%.
The market is assuming that not only will Xoom become profitable by growing its revenue by 45% over the next six years, making $91 million by then, but also then be able to grow net income by 5% in perpetuity, faster than market leader Western Union has done and far faster than MoneyGram has done.
There is absolutely no reason to believe that this will happen.
Xoom doesn’t sell some hot tech product that everyone needs. Xoom transfers money. They do the exact same thing as Western Union. Western Union has an enormous network, a powerful brand, and over a century of experience. The expectations put on Xoom by the market are downright outrageous.
The Bottom Line
An absurdly optimistic scenario must play out in order for Xoom to be reasonable at its current market price. Xoom may very well end up being a successful company, but it will be a long time before it’s actually worth $800 million. Warren Buffett once said
“An investor needs to do very few things right as long as he or she avoids big mistakes.”
Buying Xoom is a big mistake.
The article Xoom Goes Zoom: Are Expectations Too High? originally appeared on Fool.com and is written by Timothy Green.
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