The Long Slow Short
Plus: Robinhood/Distressed Investing, Banker Hours, Compound Treasury
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The Long Slow Short
It normally takes a lot less time to destroy a thing than to create it. That’s true on building sites, in careers and of reputations. “It takes 20 years to build a reputation and five minutes to ruin it,” said Warren Buffett. Such is the nature of entropy.
Yet in business, the reverse can often seem the case. It’s never been easier to start up a new company. In the US, business formation is running at the highest level on record. Companies can be spun up from idea to $2 billion valuation in the space of fifteen months. And, at the larger end of the scale, Facebook is a reminder of how quickly value can be created – this week, it became a $1 trillion company after being around for just seventeen years (I have cardigans older than that!) These companies open new markets and/or promise to disrupt existing ways of doing things.
On the other side though, the incumbents they disrupt can often hold on for a lot longer than anyone thinks possible. Kodak, Blockbuster, Sears – they all took years to be put out of their misery.
Warren Buffett makes the observation about autos that, “what you really should have done in 1905 or so, when you saw what was going to happen with the auto is you should have gone short horses. There were 20 million horses in 1900 and there’s about 4 million horses now. So it's easy to figure out the losers, you know the loser is the horse.” But you would have needed a lot of staying power to have been short horses. Historic horse prices are hard to come by but, using Buffett’s proxy, the number of horses stayed above 20 million for a further 25 years after he says you should have gone short.
One of the reasons there’s a lot more money in venture than in short-selling is precisely because it can take so long for a business to destruct.1
A good example of this on the periphery of financial services is Western Union. I was short the stock once on the Buffett principle that it is easier to identify the loser than pick the winners – in this case in digital payments. I underestimated two things – one, how long the market shift would take to occur; and two, how much free cash flow Western Union would generate along the way.
Actually, there was a third factor that I’ve only recently understood: this is a company that peaked in 1878. My short wasn’t exactly a novel idea! Faced with disruption from the telephone, the fax, the personal computer, the internet, and now digital payments, Western Union has been on a steady decline for over 140 years. When it comes to operating in markets that are collapsing around it, Western Union has form. And yet it's still going.
This is the cautionary tale of Western Union
What Hath God Wrought?
When Samuel Morse, inventor of the Morse code, sent the first telegram from Washington to Baltimore on May 26, 1844, he ushered in a new communications age. That first telegram read: “WHAT HATH GOD WROUGHT?”
Several companies sprung up around the US to capitalise on the new technology. In 1856, two of them got together to form The Western Union Telegraph Company. The new company snapped up smaller competitors, consolidating its position across the country. Demand for its services boomed and in 1861 the company opened the first transcontinental telegraph wire, allowing messages to be sent near-instantaneously from coast to coast. Before even the railroads, Western Union became America’s first industrial monopoly.
Between 1858 and 1876, Western Union’s capitalization rose from $385,700 to $41 million. Along the way, it introduced the first stock ticker – designed by an employee called Thomas Edison – and launched a money transfer service. When Charles Dow compiled his stock index, Western Union was one of the original eleven constituents.
But it was all downhill from there.
Things started going awry in March 1876, when Alexander Graham Bell patented his telephone. To bring it to market, Bell sought funding from angels. His father-in-law pitched Chauncey Depew, a senior executive in the Vanderbilt railroad group. Here’s how Depew recalls the pitch (emphasis mine):
One day he said to me: “My son-in-law, Professor Bell, has made what I think a wonderful invention. It is a talking telegraph. We need ten thousand dollars, and I will give you one-sixth interest for that amount of money.”
I was very much impressed with Mr. Hubbard’s description of the possibilities of Professor Bell’s invention. Before accepting, however, I called upon my friend, Mr. William Orton, president of the Western Union Telegraph Company. Orton had the reputation of being the best-informed and most accomplished electrical expert in the country. He said to me: “There is nothing in this patent whatever, nor is there anything in the scheme itself, except as a toy. If the device has any value, the Western Union owns a prior patent called the Gray’s patent, which makes the Bell device worthless.”
When I returned to Mr. Hubbard he again convinced me, and I would have made the investment, except that Mr. Orton called at my house that night and said to me: “I know you cannot afford to lose ten thousand dollars, which you certainly will if you put it in the Bell patent. I have been so worried about it that contrary to my usual custom I have come, if possible, to make you promise to drop it.” This I did.
Depew was clearly not familiar with Chris Dixon’s idea (from Andreessen Horowitz) that the next big thing starts out looking like a toy. If he had been, he could have been very rich. “...if I had accepted my friend Mr. Hubbard’s offer, it would have changed my whole course of life. With the dividends, year after year, and the increasing capital, I would have netted by to-day at least one hundred million dollars.”2
Internally, Western Union dismissed the idea, too:
“This ‘telephone’ has too many shortcomings to be seriously considered as a means of communication. The device is inherently of no value to us.” — Western Union internal memo, 1876.
So Bell and his father-in-law brought the product to market by themselves, creating the Bell Telephone Company in 1877. Before long, Western Union saw the potential of this new technology and went after it too. But amidst a patent infringement case, it pulled out, giving up telephone rights to Bell. (Orton wasn’t just wrong about the toy, he was wrong about the validity of his prior patent.)
Meanwhile, demand for telegraph technology stagnated. By 1909, Bell, now known as AT&T, dwarfed Western Union, and that year acquired it to form an integrated telecommunications company.
Clayton Christensen cites the case as a classic in his theory of disruption:
Alexander Graham Bell’s telephone was initially rejected by Western Union, the leading telecommunications company of the 1800s, because it could carry a signal only three miles. The Bell telephone therefore took root as a local communications service that was simple enough to be used by everyday people. Little by little, the telephone’s range improved until it supplanted Western Union and its telegraph operators altogether.
We’re Not Telegraphers
AT&T only owned Western Union for a few years. Under threat of antitrust prosecution, it spun it back out in 1913.
Shortly afterwards, Western Union stumbled across the consumer charge card, years before Diners Club and American Express would popularise them. Customers could pop into any one of Western Union’s numerous locations and pay for a telegram on their centralised account. In order to identify the customer to the billing system, Western Union issued them with a small rectangular piece of card, containing the account number, the name and address of the person or company responsible for paying the charges, and a signature line. The card identified the billing account, and the signature could be used to authenticate the cardholder.
Unfortunately for Western Union, it didn’t spot an opportunity to monetise its charge card, even while telephone continued to eat away at its core telegram business.
Domestic telegram traffic dropped from 234 million messages in 1929 to 212 million in 1930 and down to 192 million ten years later in 1940. There was a brief uptick during World War II from military communications, but demand subsequently resumed its decline, falling to 179 million messages in 1950. After the war Western Union struggled to turn a profit.
That didn’t stop Western Union from trying. Under its post-war leadership, the company developed a number of new business lines (oh, but for charge cards):
💡 The Telex. In 1931, AT&T introduced a teletypewriter exchange service that allowed customers to send and receive messages directly from a machine installed on their premises. Western Union launched something similar, called Telex. The service was a lot less labour-intensive than its core telegram business, allowing Western Union to cut costs. Western Union ultimately acquired AT&T’s service to consolidate the market, taking its footprint from 26,000 terminals to 66,000 terminals in 1968. By the late 70s, Telex took over from telegram as the largest source of Western Union’s revenues.
💡 Leased communication systems. The company looked to leverage its communications infrastructure by offering turnkey communications networks for government and industry. In 1950, it set up a teleprinter network connecting nearly 200 major banks. By 1960, about 2,000 companies were leasing turnkey communications networks from Western Union.
💡 Information processing. In the late 1960s, Western Union redefined its market. Its CEO at the time declared about his team, “we’re not telegraphers,” and explained: “We are in the communications service business, but this entails a new concept of communications. We have to broaden communications to include the processing of information as well as the handling of it.” His plan was to install computers at key locations across the country; these computers would integrate telegram and Telex services into a single system, with excess capacity offered to customers to perform real-time information services.
Underpinning all of this, the company upgraded its legacy pole lines with a network of microwave towers. Later, it launched a series of satellites as well. However, the legacy telegram business did not provide sufficient cash flow to finance the infrastructure build. By the end of the 1970s, the company’s debt exceeded its equity. Meanwhile, one by one the new business lines stumbled.
The strategy to go after information processing was always going to be challenging given the number of competitors. Hundreds of firms from IBM down were addressing the same market. Consumers, where Western Union had an edge, were not that interested and the market didn’t grow that big. The entire online data processing services industry was worth $1.3 billion in 1975, against the $569 million that Western Union was earning in revenue from its core business. Nor were regulators that comfortable with the strategy. The Federal Communications Commission (FCC) wanted Western Union to park the new business in a separate entity and imposed demands on the company in keeping with its monopoly position in domestic telegraphy. In 1976, Western Union's on-line data services revenue amounted to just $64 million.
As for the telex, who remembers those? Subscribers peaked in 1981 at 141,000, the same year IBM released its personal computer. A personal computer plus printer plus modem could replicate the telex and offer so much more. For smaller users, the growth of inexpensive fax machines provided an alternative (but who remembers those?)
Western Union lost money over 1983, 1984 and 1985, partly from investments in an email platform (yes, it was still trying), partly from write-downs on legacy infrastructure. In 1987, investor Bennett S. LeBow acquired control of Western Union through a complex leveraged recapitalization backed by Drexel Burnham Lambert. Over the next few years, Western Union’s management sold off capital assets including the satellite network to Hughes and the Telex network to AT&T. By 1990, all that remained was a money transfer business, which, in 1994, got sold along with the Western Union brand to First Data Corp.
The money transfer business had been a sleeper through most of Western Union’s existence. The company processed its first money transfer in 1871. Interestingly, although the cost of telegraphy has come down significantly since then, the cost of money transfer, less so. A copy of an early Western Union transfer for $300 shows fees of $9.34 or roughly 3%. Credit card fees can be as high as that today, and money transfer fees can be higher.
It wasn’t until the mid 80s, when deregulation allowed a previously domestic service to expand internationally, that the business took off. Before that, Western Union never developed sophisticated-enough security – cryptography, identity verification and the like – to make money transfer services core.
First Data spun Western Union back out as a public money transfer business in 2006, a few months after it dispatched its last telegram. Its business model was straightforward. Consumers could take cash into any one of its 270,000 agent locations around the world and have someone else, say a family member, pick it up in another location. Most of the agents are independent businesses authorised to offer Western Union’s services. They provide the physical infrastructure and staff required to complete the transfers and get paid a commission based on a percentage of revenue (shared between the “send agent” and the “receive agent”).
Today, there are 550,000 agents in 200 countries (although 35% of them are dormant). However, while it has broadened its reach, revenues haven’t really gone anywhere. In fact, Western Union came back to the market in 2006 on the back of peak revenue growth (12.5% in 2004 and 2005). Since then, revenues have grown at a compound rate of 0.6%.
Part of the reason for flatlining revenue is price; average revenue per transaction has come down from $28.0 in 2005 to $14.40 in the first quarter of 2021. That includes around a 15% pricing premium versus the market across the entire footprint. But the company is also losing market share. Using World Bank global personal remittance data, Western Union’s share of cross-border money transfers has fallen from 17% in 2008/09 to 14% in 2020.
And the reason it’s losing share is that yet again, Western Union is being disrupted – this time by digital payments. Wise (formerly Transferwise) lists in London next week (we discussed it here two weeks ago). Although both companies do international money transfer, Wise doesn’t categorise Western Union as a competitor because Western Union deals mostly in cash. The problem is that cash is going the way of the telegraph.
As before, Western Union is trying. It now does 23% of its business from digital and is on track to do $1 billion in revenue from digital this year. However, although they are digitally initiated, most of these transfers pay out at a retail location so it’s still fundamentally a cash business.
When Facebook launched Libra in 2019 (now Diem, discussed here) it had its sights on the global remittances market. Its ambitions have been tempered somewhat but whether it’s Diem or other stablecoins or central bank digital currencies (discussed here) or digital wallets, the forces against cash are mobilising. But this is a movie Western Union has seen before. It took thirty years for the volume of telegram transactions to halve, and the same amount of time for the number of horses to halve. It’s a long, slow process.
Christopher McDonald’s piece, Western Union's Failed Reinvention: The Role of Momentum in Resisting Strategic Change, 1965-1993 was helpful, as was David Hochfelder’s, Turning an Elephant around in a Bathtub. I was told Joshua Elias Lachter’s senior thesis, The Western Union Telegraph Company’s Search for Reinvention, 1930-1980 is good but I couldn’t get hold of it online.
More Net Interest
When Robinhood received a margin call from the DTCC earlier this year (discussed here), it was forced to raise emergency funding. At the beginning of February, the company issued $3.55 billion convertible notes in two tranches. Of the company’s existing investors, Ribbit Capital was at the forefront of the the rescue, taking down $502 million of the issue, equivalent to 14% of the total; two other investors (Index Ventures and New Enterprise Associates) took another 4% between them.
When the company goes public, investors in this emergency round will get a large payoff. If the IPO prices below $54.70, the notes they bought convert into Robinhood stock at a 30% discount. One tranche of notes had warrants attached, which exercise at a 30% discount. If Robinhood prices above $54.70 then the notes convert at a fixed price of $38.29, so an even higher discount (in the case of the larger tranche; the maximum conversion price on the other tranche is slightly higher). The notes also carry accrued interest, payable in kind, at a rate of 6%, which adds to the payoff.
As at end of March, no more than eight weeks after the securities were issued, these securities were fair valued on Robinhood’s balance sheet at $5.04 billion. And that’s with a 10% discount built in. On the day of the IPO, they will be valued closer to $5.8 billion, assuming an IPO price below $54.70. That’s a 62% return over a six month holding period, or $2.2 billion in real money.
Distressed investing is high return and venture investing is high return, but when the two come together, the returns can be very high.
In November 2013, Goldman Sachs sent out a memo to its banking staff:
All analysts and associates are required to be out of the office from 9PM on Friday until 9AM on Sunday (begins this weekend)
Earlier this year, in response to complaints from junior bankers, CEO David Solomon recorded a voicemail for staff in which he committed to step up enforcement of the rule.
Now, some researchers have looked at the impact bans like this have on bankers’ work-life balance. Using data from 16 million taxi rides from ten large investment banks to residential destinations, they compare late-night and weekend rides from banks that have adopted such rules to those that haven’t.
Their conclusion is simple. Bankers who don’t work on Saturdays simply make up for it by staying later during the week. The effect is particularly marked over the summer when interns are on site. At one level, this reflects a classic problem of unintended consequences in regulation, where the response to the regulation is not taken into account in its design.
At another level, it reflects a problem in certain jobs where it is difficult to model individual contribution. Banks have historically used a willingness to work long hours as a proxy for some valuable, yet hard to observe, characteristics of employees. The long hours also create a barrier to entry which solves a selection problem. As Mike Dariano, who alerted me to the paper, notes, “Long hours in investment banking are the Peloton Christmas commercial: not for you. Unless it is. Then it’s really for you.”
As you know, I’m being slowly drawn into the web of decentralised finance (DeFi). A few weeks ago in My Adventures in CryptoLand, I wrote about a protocol called Compound. More recently, in Reinventing the Financial System, I wrote:
We spend a lot of time at Net Interest thinking about fintech, which is largely the front end of financial services. Entities like Maker DAO innovate at the back end. When they meet in the middle, interesting things will happen.
This week, Compound launched a new product called Treasury, designed for businesses and financial institutions to access the features of the Compound protocol without dealing with the complexities of crypto. It has already been picked up by neobank Current to offer customers 4% APR on cash balances. In the UK, Ziglu offers consumers something similar (5% on sterling deposits) but it solves the back end by itself. By making the back end easy for all institutions, Compound Treasury is a step towards the convergence of DeFi and traditional finance.
One example of a sudden corporate decline (outside of fraud) is the case of Ratners, a chain of UK jewellery stores. In April 1991, its chairman, Gerald Ratner, made a speech where he said, “People say, ‘How can you sell this for such a low price?’, I say, ‘because it's total crap.’” He went on to say that one set of earrings on sale was “cheaper than a prawn sandwich from Marks & Spencer’s, but I have to say the sandwich will probably last longer than the earrings.” After the speech, the value of his company fell by around £500 million and never really recovered. However, the episode occurred during a recession when consumer spending fell at its highest rate in at least twenty years, so it is difficult to isolate just how much of the demise was caused by Ratner’s comments.
Despite missing out on at least one hundred million dollars, Chauncey Depew imparts great advice: “I have no regrets. I know my make-up, with its love for the social side of life and its good things, and for good times with good fellows. I also know the necessity of activity and work. I am quite sure that with this necessity removed and ambition smothered, I should long ago have been in my grave and lost many years of a life which has been full of happiness and satisfaction.” — Depew, Chauncey M. (Mitchell), My Memories of Eighty Years, Published 1922