Stock Analysis: MoneyGram International (MGI)

Company Description:

MoneyGram International, Inc.was incorporated on December 18, 2003, is a global payment services company. MoneyGram operates its business in two segments: Global Funds Transfer and Payment Systems. Global Funds Transfer segment provides money transfer services, money orders and bill payment services to consumers. The Company's Payment Systems segment provides financial institutions with payment processing services, primarily official check outsourcing services and money orders for sale to their customers.

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 12/31/06):

Business Overview

MoneyGram International, Inc. is a leading global payment services company. Our core purpose is to provide consumers with affordable, reliable and convenient payment services. We offer our products and services to consumers and businesses primarily through our network of agents and our financial institution customers. The diverse array of products and services we offer enables consumers, many of whom are not fully served by traditional financial institutions, to make payments and to transfer money around the world, helping them meet the financial demands of their daily lives.

Our business is conducted through our wholly owned subsidiary formerly known as Travelers Express Company, Inc., which has been in operation since 1940. In June 1998, we acquired MoneyGram Payment Systems, Inc. (MPSI), adding the MoneyGram branded international money transfer services to our group of services. We were incorporated in Delaware on December 18, 2003 in connection with the June 30, 2004 spin-off from our parent company, Viad Corp.

During 2006, we continued to develop our retail strategy in Western Europe. Due to licensing requirements and marketing constraints in certain European countries, operating Company owned retail stores and kiosks in addition to our typical agent model is a preferred method of expanding the number of locations offering our services. In May 2006 we formed an entity in France, MoneyGram France S.A. In order to offer the MoneyGram service directly to the public in France, our French subsidiary was required to become a licensed financial institution. We were granted the license in September 2006 and opened our first store in France shortly thereafter. As of year-end, we are operating Company owned retail stores or kiosks in France and Germany. We expect to open additional locations in these and other markets on a targeted basis.

Sales and Marketing

As an investment in our money transfer brand recognition, we increased our marketing expenses by 39 percent in 2006 compared to 2005. Our sales and marketing efforts continue to be supported by a wide range of consumer advertising methods. A core focus of building our brand awareness is signage, both ensuring that our signs are displayed at agent locations, as well as maintaining consistency in our signage globally. We introduced our “red shops” concept, which consists of an agent location heavily branded with MoneyGram signage, including red paint for the front of the store.

We also reach our consumers using traditional media such as television, radio and print. Finally, we utilize street teams that consist primarily of contractors who engage in a variety of activities including attending local ethnic festivals and events to introduce our products and services to potential consumers. We redesigned our website in 2006 and made it available in 44 languages and introducing a “price-it” tool to assist our customers with money transfer pricing questions. We also made a new agent location function available on our website. We continue to look at ways to enhance our brand awareness.

Product Development and Enhancements

Our product development activities have focused on new ways to transfer money and pay bills through enhancements to our current services and the development of new products and services.

Product Enhancements. In 2005, we developed our multi-currency platform, an enhancement that allows a sender of a money transfer to choose among currencies to be received by the beneficiary. The currencies available depend on the send and receive country. We began implementing this enhancement in February 2006 and released it in 34 countries during 2006. We also developed directed sends in 2005 to allow a sender to direct a money transfer to a specific address, onto an ATM/debit card or into a bank account. Additionally in 2006, the Company released a new transaction management tool which allows its ExpressPayment billers to review a consumer payment on-line prior to accepting or rejecting the payment. This technology is particularly useful within certain industries such as the mortgage, auto loan and insurance industries that may have time-sensitive financial or legal implications, such as repossessions or foreclosures. Finally in 2006, we received clearance and were able to begin offering consumers in Mexico the ability to send money from Mexico to other locations domestically and internationally.

New Products. We continued to offer the MoneyGram Prepaid MasterCard card program in 2006, with the cards available for purchase and reload at designated MoneyGram agent locations throughout the United States. In 2006, we also began the implementation of a full suite of ACH and electronic bill payment services that provide consumers with pay-by-telephone, pay-by-IVR and pay-by-web options. In November 2006, we began a limited pilot of a new utility bill payment service, utilizing the same point-of-sale platforms as our money order, money transfer and ExpressPayment products. We plan to implement our new utility bill payment services throughout the United States in 2007.

Infrastructure Development. The Company is currently working to implement a new system to provide for improved connections between the agent and our marketing, sales, customer service and accounting functions. The new system and associated processes are intended to increase the flexibility of our back office, thereby improving operating efficiencies and relationships with external parties.

Competition

The industries in which we operate are very competitive and we face a variety of competitors across our businesses. Consolidation among payment services companies, and money transmitters in particular, has occurred and may continue.

We compete for agents and financial institution customers on the basis of value, service, quality, technical and operational differences, price and financial incentives paid to agents once they have entered into an agreement. In turn, we compete for consumers on the basis of number and location of outlets, price, convenience and technology.

Money transfer, money order and walk-in bill payment services within the Global Funds Transfer segment of our business compete in a concentrated industry, with a small number of large competitors and a large number of small, niche competitors. Our primary competition in Global Funds Transfer comes from The Western Union Company, a former subsidiary of First Data Corporation, which has greater transaction volume, a larger agent base, a more established brand name and greater financial and marketing resources than we do. Other competitors in this segment are other providers of money transfer services, such as banks and niche person-to-person money transfer service providers that serve select send and receive corridors, and other providers of money orders, including the U.S. Postal Service and a subsidiary of First Data Corporation. The electronic bill payment services within the Global Funds Transfer segment of our business compete in a highly fragmented consumer-to-business payment industry. Competitors in the electronic payments area include financial institutions, third parties that host financial institution and biller payment services, third parties that offer payment services directly to consumers and billers offering their own bill payment services.

As new technologies for money transfer emerge allowing consumers to send and receive money in a variety of ways, we face increasing competition. These emerging technologies include mail and commercial courier services, online money transfer providers, and card-based options, such as ATM cards and stored-value cards.

Intellectual Property

Certain rights in processing equipment, software and business processes held by us and our subsidiaries provide us with a competitive advantage, even though not all of these rights are protected under intellectual property laws.

Our U.S. patents have in the past given us competitive advantages in the marketplace, including a number of patents for automated money order dispensing systems and printing techniques, many of which have expired. We also have patent applications pending in the United States that relate to our money transfer, money order, PrimeLink and bill payment technologies and business methods. We anticipate that these patents, if granted, will give us continued competitive advantages in the marketplace. However, our competitors are also actively patenting their technology and business processes.

Employees

At December 31, 2006, we had approximately 1,782 full-time employees in the United States and 294 full-time employees internationally. In addition, we use contractors to support certain of our domestic and international sales and marketing efforts.

Risk Factors

• If we lose key retail agents or are unable to maintain our Global Funds Transfer agent network, our business and results of operations could be adversely affected.
  

• If we lose large financial institution customers in our Payment Systems segment, our business and results of operation could be adversely affected.
  

• If we fail to successfully develop and timely introduce new and enhanced products and services or we make substantial investments in an unsuccessful new product or service, our business, prospects, financial condition and results of operations could be adversely affected.
  

• If we are unable to adequately protect the intellectual property rights related to our existing and any new or enhanced products and services, or if we are unable to avoid infringing on the rights of others, our business, prospects, financial condition and results of operations could be adversely affected.
  

• Our agents and MoneyGram are subject to a number of risks relating to U.S. and International regulatory requirements which could result in material settlements, fines or penalties or changes in their or our business operations that may adversely affect our business, financial condition and results of operations.
  

• The Company conducts money transfer transactions through agents in some regions that are politically volatile and/or, in a limited number of cases, are subject to certain OFAC restrictions.
  

• We face security risks related to our electronic processing and transmission of confidential customer information. A material breach of security of our systems could harm our business.
  

• Our business involves the movement of large sums of money, and, as a result, our business is particularly dependent on our ability to process and settle transactions accurately and on the efficient and uninterrupted operation of our computer network systems and data centers.
  

• We face credit and fraud risks from our retail agents.
  

• An increase in fraudulent activity using our services could lead to reputational damage to our brand and could reduce the use and acceptance of our services.
  

• Litigation or investigations involving our agents or MoneyGram which could result in material settlements, fines or penalties may adversely affect our business, financial condition and results of operations.
  

• We are subject to credit risk related to our investment portfolio and our use of derivatives.
  

• Our financial condition and results of operations could be adversely affected by fluctuations in interest rates.
  

• A material slow down or complete disruption in international migration patterns could adversely affect our business, financial condition and results of operations.
  

• Our business may require cash in amounts greater than the amount of available credit facilities and liquid assets that we have on hand at a particular time, and if we were forced to ultimately liquidate assets or secure other financing as a result of unexpected liquidity needs, our earnings could be reduced.
  

• An inability for our agents or for us to maintain adequate banking relationships may adversely affect our financial condition.

Properties

Company has two global operations centers and corporate headquarters in Minnesota and a call center in Lakewood, CO. We also have a number of other smaller office locations in New York, Florida, Tennessee and in the United Kingdom, as well as small sales and marketing offices in France, Spain, Germany, Hong Kong, Greece, United Arab Emirates, Russia, Italy, South Africa, Australia, China and the Netherlands. We believe that our properties are sufficient to meet our current and projected needs.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Our Separation from Viad Corp.

On July 24, 2003, Viad announced a plan to separate its payment services segment, operated by Travelers, from its other businesses into a new company, and to effect a tax-free distribution of its shares in that company to Viad’s stockholders. On December 18, 2003, MoneyGram was incorporated in Delaware as a subsidiary of Viad for the purpose of effecting the proposed distribution. On June 30, 2004, Travelers was merged with a wholly owned subsidiary of MoneyGram and Viad distributed 88,556,077 shares of MoneyGram common stock to Viad stockholders in a tax-free distribution. Stockholders of Viad received one share of MoneyGram common stock for every one share of Viad common stock owned.

Summary

Following are significant items affecting operating results from continuing operations in 2006:

• Global Funds Transfer segment revenue grew 26 percent in 2006, driven by 32 percent revenue growth in money transfer.
  

• Our money order transaction volume declined four percent in 2006 as expected, which is slightly less than the trend for paper-based instruments. Based on current industry information, the trend in paper-based payment instruments is estimated to be an annual decline of five to eight percent.
  

• The net investment margin of 2.31 percent improved over the 2005 net investment margin of 1.91 percent primarily due to higher yields on the portfolio related to higher short-term interest rates and a successful hedging strategy.
  

• Fee and other revenue increased 26 percent in 2006, primarily from growth in money transfer transaction volume.
  

• Marketing expenditures increased over 39 percent as we invest in our brand.
  

• Our effective tax rate of 29.8 percent increased in 2006 compared to 23.3 percent in 2005 primarily due to tax exempt investment income declining as a percentage of total pre-tax income.

In 2006, we operated in a flat yield curve environment, where short-term and long-term interest rates were about the same. This is a challenging environment for our official check business as it puts pressure on our net investment margin by holding investment yields down while investment commissions increase more quickly. Despite this pressure, we realized growth in our net investment margin through a successful hedging strategy and adjusting pricing to reflect the current interest rate environment as contracts renew. The credit quality of our investment portfolio continued to improve, as evidenced by the cash recoveries on previously impaired investments and lower impairment charges taken in 2006.

Segment Performance

Global Funds Transfer

This segment provides global money transfer services, money orders and bill payment services to consumers through a network of agents. Fee revenue is driven by transaction volume and fees per transaction. In addition, investment and related income is generated by investing funds received from the sale of money orders until the instruments are settled.

Total revenue includes fees on money transfers, retail money orders and bill payment products, investment revenue and securities gains and losses. Total revenue increased 26 percent in 2006 over 2005, primarily driven by the growth in the money transfer and bill payment services, as total transaction volume grew 41 percent. Domestic originated transactions (including bill payment) increased 46 percent with growth across all corridors, while international originated transactions grew 30 percent from 2005. Transaction volume to Mexico grew 29 percent in 2006 over 2005. Our Mexico volume represents 11 percent and 12 percent of our total transactions in 2006 and 2005. The growth in money transfer is a result of our network expansions and targeted pricing initiatives to provide a strong consumer value proposition supported by targeted marketing efforts. The money transfer agent base expanded 24 percent over 2005, primarily in the international markets, to about 110,000 locations.

Payment Systems

This segment provides financial institutions with payment processing services, primarily official check outsourcing services and money orders for sale to their customers, and processes controlled disbursements. Investment and related income is generated by investing funds received from the sale of payment instruments until the instruments are settled. In addition, revenue is derived from per-item fees paid by our financial institution customers.

Total revenue includes investment revenue, securities gains and losses, per-item fees charged to our official check financial institution customers and fees earned on our rebate processing business. Total revenue increased five percent in 2006 compared to 2005 due primarily to higher investment revenue, partially offset by net securities losses. Investment revenue increased due to higher yields on the portfolio related to the increase in short-term interest rates. Total revenue for 2006 includes $10.9 million of cash flows from previously impaired securities and income from limited partnership interests.

Acquisitions / Divestitures

On May 31, 2006, MoneyGram completed the acquisition of MoneyExpress, the Company’s former super agent in Italy. In connection with the acquisition, the Company formed MoneyGram Payment Systems Italy, a wholly-owned subsidiary, to operate the former Money Express network. The acquisition provides the Company with the opportunity for further network expansion and more control of marketing and promotional activities in the region. MoneyGram acquired MoneyExpress for $15.0 million, subject to purchase price adjustments. The acquisition cost includes $1.3 million of transaction costs and the forgiveness of $0.7 million of liabilities.

In April 2005, we acquired substantially all of the assets of ACH Commerce, an automated clearing house payment processor. The acquisition provides the Company with the technology and systems platform to expand its bill payment services.

In March 2004, we completed the sale of our subsidiary, Game Financial Corporation, for approximately $43.0 million in cash, to continue our focus on our core businesses.

Stockholders’ Equity

On November 18, 2004, the Board authorized a plan to repurchase, at the Company’s discretion, up to 2,000,000 shares of MoneyGram common stock. On August 19, 2005, the Company’s Board of Directors increased its share buyback authorization by 5,000,000 shares to a total of 7,000,000 shares. In 2006, we repurchased 2,129,050 shares of our common stock under this authorization. As of December 31, 2006, we have repurchased a total of 5,175,000 shares of our common stock under this authorization and have remaining authorization to purchase up to 1,825,000 shares.

During 2006, we paid $14.4 million in dividends on our common stock. In addition, the Board of Directors declared a dividend of $0.05 per share of common stock on February 15, 2007 to be paid on April 2, 2007 to stockholders of record on March 16, 2007. During 2006 we increased the quarterly dividend from $0.04 to $0.05 per share. We intend to continue paying a quarterly dividend of $0.05 per share in 2007, subject to Board approval, which will be funded through cash generated from operating activities.

Financial Highlights:

Revenue Growth (1-yr): 19.0%

Net Income Growth (1-yr): 10.7%
Net Income Growth (2-yr average): 41.5%

Earnings-Per-Share Growth (1-yr): 11.5%
Earnings-Per-Share (2-yr average): 42.4%

Net Profit Margin (current): 14.0%
Net Profit Margin (2-yr average): 14.0%

Return On Equity (current): 19.2%
Return On Equity (2-yr average): 19.0%

Valuation:

Given that this is a financial services firm, it’s impossible to use a discounted cash flow analysis I typically rely on in my valuation of stocks. Therefore, I have to largely rely on Morningstar’s valuation, my assessment of the financial information that is available to me, and looking at comparative P/E ratios. So here are the results that I have from this ad-hoc assortment of resources:

• Morningstar values this company at more than twice the current market price of $16. By substituting free cash flow for net income in the DCF model, my valuation is lower at around $30/share. Assumptions that I used in such a model were 10% annual net income growth for the next ten years, perpetual growth of 3%, and a discount rate of 11.5% (above average risk as I’ll discuss below at “Cons” section).
  

• Trailing P/E of 11.4 is at a 40% discount to Western Union’s P/E of 19.2. Even though Western Union is significantly larger and does have a sustainable size advantage, that kind of discount is too pessimistic of MoneyGram future growth and earning power.
  

• Since it only went public in 2004, the company does have a very short public financial history of only two full fiscal years: 2005 and 2006. This makes it difficult to judge MoneyGram on its past performance, although so far it has done fairly well as can be seen in revenue/net income growth and ROE.

Pros:

• Half of the MoneyGram’s revenue comes from a lucrative money transfer market that organically growth 8% a year and MoneyGram can grow substantially faster than that by acquiring smaller player in this highly fragmented market as it has already done in the past two years.
  

• Company has a second largest network of money transfer agents in the world after Western Union.
  

• MoneyGram is diligently increasing the size of its network at the cost of current profit margins; it aggressively spends on marketing to boost its brand; prices its products just under Western Union’s rates and pays its agent just above Western Union’s rates.
  

Cons:

• Aside from the money transfer business, second half of revenue comes from profitable, but slow-growth businesses such as money orders and other paper-based payment systems.
  

• A potential sale of the company’s official check business, which is currently under review by J.P. Morgan Chase at the company’s request, would result in a lower intrinsic value since it is currently a bad market to sell such a business and MoneyGram isn’t likely to fetch a fair price for it.
  

• If MoneyGram’s net investment margin were to significantly fall, which is possible, its intrinsic value would decrease by approximately 10%.
  

• Company has a very short history of being a public company (2 years), not quite enough to judge it on.
  

Final Decision:

MoneyGram has a solid business model that I like. The business will in much better shape once money transfer unit will contribute a larger share of the revenue and net income, but at the same time right now is not a good time to divest its other businesses because it’s a buyers market out there. Even though MoneyGram has a significant upside in its severely underpriced stock, it also has a fairly good chance of dropping further over two main concerns that I currently have: sale of its businesses such as official check business and possibility of its investment margins getting squeezed. Either one of those problem-makers would send the stock even lower or at the very least depressed for an extended period of time. So, until those risks are resolved or eliminated, I’m in the waiting mode. Also, I’m not particularly fond of the fact that company has been public for only about three years and has only two sets of financial statements, for 2005 and 2006. I plan on avoiding companies like this in the future because of unproven history of operations.