This Could be One of the Best Income Plays of the Year
When a stock appeals to investors looking for safety and income, it usually won’t get much attention from growth investors. That’s because when a company is focused on returning money to its investors through dividends and buybacks, it usually doesn’t have the growth opportunities to take the share price significantly higher.
Once in a while, though, an established cash machine finds a new high-growth opportunity.
One of the oldest companies in America is on the verge of a growth spurt, and today’s trade could make this one of the best income plays of the year.
An Old Leader Gets a New Strategy
Founded in 1851, Western Union (NYSE: WU) offers payment transfer services in 200-plus countries with 500,000 agent locations. The company benefits from one of the strongest global brands in any industry and a cash-rich business model where customers pay upfront.
Its size gives it a significant advantage by helping keep costs low. Full-year 2015 revenue of $5.5 billion dwarfed the nearest competitor, Moneygram (NASDAQ: MGI), which posted $1.4 billion in sales. And Western Union’s 20% operating margin shows a clear advantage over its smaller rival’s 1.1% margin.
Maturity in the traditional money transfer market has made Western Union a cash machine, generating more than $1 billion in operational cash flow in each of the past three years. The company booked more than $800 million in free cash flow in each of those years, and thanks to low capital spending requirements, it has been able to return a good portion of that to shareholders in the form of dividends and share buybacks.
While WU’s dividend yield is a very respectable 3.2%, its total yield is much higher.
Total yield calculates how much capital a company is returning to its stockholders through dividends and stock buybacks as a percentage of the firm’s market capitalization.
Western Union returned $817 million to shareholders in 2015 through dividends and share repurchases, which divided by its market cap of $10 billion gives us a total yield of about 8.2%.
But growth has been slow, with sales increasing just 1.1% on an annualized basis over the past five years, and the shift to digital payments threatened the company’s leadership in the space… until recently.
Western Union has gotten serious about digital transfers, growing the electronic side of its business by 26% in 2015. Digital transfers currently account for just 7% of sales and are only available in 35 countries, so the company could see huge growth ahead as it builds out digital capabilities across its geographic reach.
The new digital push could help attract growth investors and close a valuation gap with e-payment companies like PayPal (NASDAQ: PYPL). Shares of WU trade for just 12.5 times trailing earnings compared with more than 40 times earnings for PayPal.
Investors shouldn’t have to worry about increased capital spending weighing on share repurchases or dividends either. Western Union has $2.5 billion in cash on its balance sheet against just $2.2 billion in long-term debt, giving it plenty to spend on digital growth plans while keeping cash flowing back to investors.
How to Boost Your Return on This Cash Machine
Western Union has gained 13% since the beginning of the year and still trades only slightly higher than its five-year average P/E of 11.2. While shares may not zoom higher, the push into digital services should develop over the next few years, with consistent revenue from traditional transfers supporting profits.
In addition to long-term capital gains, dividends and buybacks, we can boost our return with a simple covered call strategy.
In fact, by doing just that, one of my colleagues was able to earn an additional $46,360 from the stocks in her portfolio last year alone. Find out exactly how she did it here.
With WU trading at $20.18 at the time of this writing, we can buy 100 shares and simultaneously sell one WU Aug 21 Call, which is trading around $0.75 ($75 per contract). This gives us a cost basis of $19.43 per share, which is 3.7% below the current price.
If WU closes above the $21 strike price at expiration on Aug. 19, our shares will be sold for that price. In this case, we will make $0.82 in capital gains, plus the $0.75 we received for selling the call and the June dividend payment of $0.16 for a total return of $1.73 per share.
This represents a profit of 8.9% over our cost basis of $19.43. Since we’d earn that in 121 days, it works out to an annualized return of 27%.
I like the trade as long as you can get in for a cost basis of $19.55 per share, which still leaves you with an annualized gain of 25%, which is pretty impressive for a mature income stock.