PayPal's Core Strategy May Pay Off Long Term

| About: PayPal Holdings, (PYPL)

Summary

Technology upgrade deserves exponential growth, and Braintree is the engine.

Payments is a hard business, but PayPal has an awesome core strategy (to be) proven by Venmo, XOOM and its next target.

PayPal is a strategic partner of social media providers, business services and e-tailers in shaping the future of commerce, namely contextual commerce – a lot of trendy games to play.

On January 28, 2016 PayPal (NASDAQ: PYPL) reported a strong fourth quarter and posed even stronger prospects. Witnessing PayPal's accelerated growth, upgraded value proposition and $2 billion share repurchase plan, the market reacted moving ~15% upward so far. PayPal's continually gaining share to some extent addressed investors' concern on competition, proved its capability of being a winner in payments. However, whether double-digit growth is sustainable might be a question mark for many investors given Venmo monetization being slow, taking rate coming down, etc. In my opinion, PayPal is a sophisticated player knowing how to play the hard payments business, a thoughtful leader utilizing its first-mover advantage beyond payments, as well as an experienced business consolidator capable to execute through and create synergies. In short term, I see a further upside with PayPal's execution becoming visible or substantiated over time. Meanwhile, in a world of "mobile making technology universal and shaping the future of commerce," PayPal is your best long-term play. My investment thesis points are as follows:

  1. Technology upgrade deserves exponential growth, and Braintree is the engine
  2. Payments is a hard business, but PayPal has an awesome core strategy (to be) proven by Venmo, XOOM and its next target
  3. PayPal is a strategic partner of social media providers, business services and e-tailers in shaping the future of commerce, namely contextual commerce - a lot of trendy games to play

1. Technology upgrade deserves exponential growth, and Braintree is the engine.

Braintree was founded in 2007. It possesses leading tokenization technology and one-stop payment capabilities for both mobile apps and websites, providing various services including merchant account, payment gateway, recurring billing, credit card storage, PCI compliance solutions, as well as international payments. Working towards its mission of "connecting the world and empowering people through payments," so far Braintree has supported payments in 130 currencies across 40 countries.

Braintree has been PayPal's best asset since acquisition in 2013. Braintree's technology fueled PayPal's One-Touch and itself serves those merchants from sharing economy and "in-app" economy. Looking at the future of One-Touch and Braintree's merchant services, you will find "Braintree as the engine" pretty much self explanatory.

One-Touch is PayPal's innovation at its core, and so far has been adopted by 15 million users and enabled in over 30 countries. The next step is to expand to 100 countries within the next 6 months. One-Touch simplified the checking-out process and allows consumers to pay with One-Touch across different devices and merchants. When consumers activate One-Touch, cart-abandonment rate will be significantly reduced and conversion rate will be increased. In the following table, I made a conservative assumption that One-Touch in 2016 will drive 500bps incremental growth in payment transactions per active accounts over 2015. Given its current user adoption rate below 10%, this estimation is very realistic. In consequence, One-Touch is expected to drive 560-1480 bps incremental growth in 2016 TPV.

2014

2015

2016E - Base Case

2016E - Bull Case

Payment transactions per active accounts

25

27

30

32

% Payment transactions per active accounts growth Y/Y

7%

12%

17%

22%

Number of Users (million)

162

179

198

204

% User (million) growth Y/Y

14%

11%

11%

14%

% Total Payment Volume growth

22.0%

24.3%

29.9%

39.1%

Click to enlarge

Source: Company Filings

Braintree's growth has been impressive; in the fourth quarter, cards on file grew 111% y/y, authorized payments volume grew 119% y/y, which is not a surprise, as Braintree's clients are OpenTable, Uber (Private:UBER), Airbnb (Private:AIRB), LivingSocial, Rovio, HotelTonight, Pinterest (Private:PINIT), etc., all growing at a CAGR of 200% or 300%.

Click to enlarge

Source: Company Filings

Click to enlarge

Source: Internet

Tokenization is a popular technology with a few other players on the market, such as Stripe, Apple Pay, and Samsung Pay etc. However, Braintree is able to distinguish itself from all the other competitors and remain as the top choice of large merchants, as it is device agnostic, accepts PayPal and Venmo, and supports seamless payments (in-app payment vs. redirected to a new page for payment, Braintree vs. Stripe). In 2014, Braintree announced its merchant base doubled. Although PayPal did not disclose the exact number of Braintree's merchants in 2015, the expansion should be impressively positive.

Braintree's In-App Payment, Source: Internet

Stripe Payment, Source: Internet

Meanwhile, PayPal has signed a strategic agreement with First Data (NYSE:FDC) to enable the acceptance of PayPal's tokenized payments in-store by First Data's acquiring clients and businesses. This is an important step forward in driving availability of PayPal at the point-of-sale, which has been very much concerned by the market. First Data, the largest U.S. merchant processor with approximately 40% market share, is expected to be PayPal's strong partner that can bring at-the-POS users to PayPal.

To quantify Braintree's contribution to PayPal, I should first estimate Braintree's effective take rate. Because Braintree provides both full stack payment and gateway payment (with a much lower take rate), its overall take rate is lower than PayPal's. Because PayPal did not disclose the breakdown of Braintree, the best way to estimate it is to base on the y/y take rate decrease (assuming the decrease is due to Braintree only, Venmo is ignored as it is still small) to calculate the implied take rate of Braintree. Assuming PayPal would have been able to maintain its flat take rate as 3.31% in 2014 (excluding Braintree's dilutive effect), the revenue dilution in 2015 vs. 2014 is attributed to the incremental transaction volume of Braintree. I can get the implied take rate of Braintree as 0.54%. This number is close to what Braintree disclosed in 2014 (payment volume $23 billion and revenue $122 million, revenue yield is equal to 0.53%).

2014

2015

TPV ($million)

66039

81523

Revenue ($million)

2189

2556

% Take Rate of PayPal

3.31%

3.14%

Braintree transaction Volume ($million)

22800

50000

Revenue dilution attributed to Braintree ($million)

146.25

Braintree 2015 vs. 2015 revenue increase ($million)

27200

% Implied Take Rate of Braintree

0.54%

Click to enlarge

Braintree's Take Rate Estimation, Source: Company Filings

Based on the above take rate of Braintree as 0.54%, I calculated the revenue contribution of Braintree in the following table. My first assumption is that Braintree transaction volume is growing with incremental 2000bps y/y because of the fast growth of its existing merchants and the future expansion of its merchant base. The implied Braintree's take rate remains as flat as 0.54%, and PayPal's revenue growth is as steady as 17%. In this way, Braintree is expected to contribute nearly one-third revenue by 2018.

Braintree's Payment Volume (in billion$)

% Braintree Payment Volume growth

Braintree revenue (in million$)

% Implied Braintree Take Rate

PayPal Revenue (in million $)

% PayPal Revenue growth

% Braintree Revenue contribution

2014

23

-

122

-

-

-

2015

50

119%

270

0.54%

9248

17%

2.92%

2016

120

139%

645

0.54%

10820

17%

5.96%

2017

310

159%

1671

0.54%

12660

17%

13.20%

2018

864

179%

4663

0.54%

14812

17%

31.48%

Click to enlarge

Braintree's Revenue Forecast

2. Payments is a hard business, but PayPal has an awesome game plan (to be) proven by Venmo, XOOM and its next target

Payments is a hard business, for example, Square (NYSE:SQ) currently has 45% credit (funding cost 300bps) and 55% debit (funding cost 80bps) mix, which leads to 64.8% transaction cost. PayPal's economics look better that it has a nearly 2x of Square's transaction margin, which PayPal is not satisfied with. Instead PayPal has an awesome game plan to make payments a more profitable business. The past years, PayPal worked as a strong business consolidator (acquired Modest, XOOM, Paydiant, Braintree & Venmo, Bill Me Later etc.) in hoping to enable money movement and money management on the globe. This is essentially the innovative way for PayPal doing payments business, because with the expansion of PayPal's ecosystem, it can significantly improve its funding mix through an increasing funding within itself.

In the following table, I simulated the future funding mix of PayPal, assuming its diverse portfolio (such as Venmo, PayPal Credit) is able to change the funding mix. The conclusion is, with the expansion of PayPal's ecosystem, the future transaction margin is expected to increase by 119bps or 270bps, which will possibly turn around the take rate's downward trend. (Please note the calculation of take rate did not take Braintree's and Venmo's dilutive effect into account, the numbers may not represent the accurate forecast of the future take rate. However, the transaction margin increase is significant.)

Funding cost (bps)

Current Mix

Base Case

Bull Case

Credit

200

45%

30%

10%

Debit

35

10%

8%

5%

ACH

3

30%

40%

40%

PayPal Balance

0

12%

12%

12%

PayPal Credit

0

3%

8%

15%

Other *

0

0%

2%

18%

100%

100%

100%

Overall Funding Cost (bps)

94.4

64

23

Take Rate

3.14%

3.72%

4.49%

Loss Rate

0.30%

0.30%

0.30%

Transaction Margin

63.70%

75.38%

91.17%

Click to enlarge

PayPal's Funding Mix, Source: Company Filings

Click to enlarge

Source: Company Filings

This is definitely a game worth playing, as exactly what PayPal has been doing. In a nutshell, PayPal's core strategy is to acquire a new business at a reasonable price, ramp up users by leveraging its scale, providing easily accessible service to consumers, and finally monetize from the merchant side. Venmo's success has proved this a viable strategy. From 2013 to 2015, Venmo's payment volume grew from $521 million to $7500 million with a CAGR of 143%. This viable strategy enabled Venmo's monetization at the right timing and the right side. Since Q4 2015, PayPal launched "Pay with Venmo" for selected online merchants. With new features (pay with Venmo in mobile or in store) being released this February, I expect a substantial amount of Venmo balance to be converted to non-dilutive TPV in 2016.

2014

2015

2016

2017

2018

Venmo Payment Volume

2388

7500

18225

44287

107617

% Monetization Rate

0

0

20%

20%

20%

non-Dilutive TPV

0

0

3645

8857

21523

PayPal's TPV

66039

81523

100273

123336

151703

PayPal's Revenue

2189

2556

2991

3499

4094

PayPal's Take Rate

3.31%

3.14%

2.98%

2.84%

2.70%

Venmo's Revenue contribution

0

0

109

251

581

% Venmo of PayPal Revenue

0

0

3.64%

7.18%

14.19%

Click to enlarge

Venmo's Revenue Forecast

XOOM is the next demonstration of PayPal's core strategy. XOOM is a leading digital operator in the global remittances market, serving 1.6 million users in 30 markets and 31,000 payout locations. XOOM enables customers to send money internationally, typically charging $5 to $10 depending on the size of the exchange, as well as pocketing the difference in the exchange rates it sets.

XOOM will soon be integrated into PayPal's platform, from where PayPal will have more than one way to ramp up users. First, Xoom Bill Pay, a cutting edge technology platform that transforms cross-border bill payments, allows people to pay bills or their beloved ones' bills online. Currently, Xoom cross-border Bill Pay has reached Mexico, Guatemala, EI Salvador, Nicaragua and the Dominican Republic. It has the potential to become a popular service for all domestic and cross-border users. Second, Xoom ACH money transfer, powered by Xoom's best-in-class ACH fund management capability, provides immediate transfer at the lowest cost. Both Xoom Bill Pay and ACH money transfer are good businesses that previously were limited within 30 markets and 1.6 million users, and now it can potentially reach PayPal's 200 markets and 179 million users. You may not know when the synergy will be substantiated. However, you won't be surprised some day when PayPal offers consumers a button "Pay with Xoom" after its scaling-up.

3. PayPal is a strategic partner of social media providers, business services and e-tailers in shaping the future of commerce, namely contextual commerce - a lot of trendy games to play

Order a Uber Ride via FB Messenger, Source: Internet

"Contextual commerce" is the potentially game-changing idea that allows merchants to seamlessly implement purchase opportunities into everyday activities and natural environments. In other words, people can buy anything, anytime, anywhere, with the click of a button. Fitness Tracker "buys" sports drinks. Recipe website prompts purchase of key ingredient. Facebook (NASDAQ:FB) reminds you to buy a birthday gift for your friend.

Braintree has been an early mover in this area, as it powered Pinterest's buyable button. In December 2015, Braintree, Facebook Messenger and Uber had another nice try that allowed users to book Uber ride via Facebook messenger - a particular example of contextual commerce. However, the implications are crucial: first, Braintree is the enabler of contextual commerce as it fulfills the seamless payment transactions at the backend; second, social media providers are into contextual commerce, and Braintree will be able to expand in the B2B markets through partnerships with all the future contextual commerce pioneers.

Moreover, besides working in the background, with Modest's expertise (building apps, integrating apps, buy-button into apps, order management, etc.) in contextual commerce, Braintree now has the end-to-end capabilities to power PayPal's industry first contextual commerce platform and attract more and more e-tailors. Braintree so far served payments for many of Bigcommerce's 90,000 merchants, and it obviously has the ability to bring some of them to PayPal's mobile commerce platform.

In order to visualize the future effect of contextual commerce, let's take a step back thinking about PayPal's 10 million merchants and 179 million consumers. Mobile makes technology universal, and contextual commerce is making commerce universal by connecting every consumer and every merchant in various contexts. That said, PayPal's contextual commerce is as big as 10 million merchants multiplied 179 million consumers. On top of this massive network, Braintree and Modest will be exceptionally transformative for PayPal's future.

Conclusion

In summary, I think PayPal has all the attributes of being a long-term leader in Payments, and also a growing giant in mobile commerce. Everything is there, the assets, the innovation, the network, the vision, etc., it just has to take some time to execute through. I expect PayPal to be a best long-term play.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.