PayPal Downgraded: Do Not Panic!

| About: PayPal Holdings, (PYPL)

Summary

PayPal downgraded by analysts at Compass Point.

Management looks to improve efficiency and cost structure.

PayPal looks to invest in its mobile platform.

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PayPal (NASDAQ:PYPL) has been a great business that has outperformed since its spin off from eBay (NASDAQ:EBAY) last year. PayPal management has made it clear that they will be cutting costs and improving its mobile platform, while striving for improving its earnings going forward. Now that PayPal has spun off, there are excellent opportunities present for management to drive efficiencies and improve margins, while investing in a superior mobile payment platform that looks to give its users the greatest user experience possible. While PayPal faces tough competition in Apple Pay (NASDAQ:AAPL) and Google Wallet (NASDAQ:GOOG) (NASDAQ:GOOGL), it appears that PayPal is planning to offer a solution that is different from its uprising competitors, as PayPal CFO John Rainey stated that "PayPal is truly different, we are the only company in the world that is 100% focused on digital payments. And perhaps more importantly, what is unique to us is that we are technology and device and operating system agnostic."

PayPal downgraded by analysts at Compass Point

PayPal stock was recently downgraded by analysts at Compass Point as they rated PayPal at neutral from its initial buy rating, while dropping the target price by a dollar from $41 to $40. Analysts stated that they were not impressed by PayPal's choice to buy money transfer company XOOM for $890 million in 2015. Compass Point also stated the "company's continued focus on acquisitions in a seller's market" implies that they're concerned that PayPal will continue paying premium prices for potential acquisitions going forward. I believe the downgrade concerns are overblown, however. With PayPal having a PEG ratio of 2.5, the stock is very expensive, given its growth potential that will soon be very competitive with tech companies jumping into the payments industry. PayPal does have fantastic free cash flow, as it created $1.8 billion in free cash flow in 2015. PayPal currently has a value-to-FCF ratio of 24, which is quite expensive given the current price of the stock. Compass Point raises some legitimate concerns in its latest downgrade investors should do their homework and consider if they are willing to pay a premium for such a stock that will be facing headwinds from competition in the near future.

Management looks to improve efficiency and cost structure

PayPal's CFO made it very clear that the management team intends to focus on efficiency as well as implementing a new cost structure. CFO John Rainey stated at the KBW symposium that "pricing is a lever that has virtually been untapped for PayPal for decades, and it is a true value driver." This sounds like PayPal is planning to play around with the pricing until they find a sweet spot that will give them the highest return while still being competitive. He realizes that the company could increase revenue and drive value by lowering prices in certain areas, while increasing prices in other areas, where PayPal has more pricing power. The CFO spoke about improving efficiency in variable expense and volume related spending, such that the merchant may benefit from lower costs to use the service. PayPal also planned on reducing its customer service costs by allowing work from home, which saves PayPal vast amounts of office space and allows their customer service representatives to live a more flexible life and potentially allow for a higher quality of service. PayPal's CFO realizes that there's potential for PayPal to unlock value now that it is spun off from eBay. I believe PayPal will continue to improve its operational efficiency, which will increase margins and deliver steadily higher earnings over the long term.

PayPal looks to invest in its mobile platform

The improvement of PayPal's mobile platform will be what gives PayPal the edge over competitors as it combines online and in-store payment solutions. PayPal's most recent acquisition, pay processor Braintree, will integrate into PayPal and will give the ability for a consumer to check out quickly on third-party websites. As CFO Rainey stated, "PayPal is the only company in the world 100% focused on digital payments." Apple Pay on the other hand is a convenient way of paying in a store as 15% of mobile devices are iPhones, but for those who don't have an iPhone, PayPal will be the safe choice of payment by merchants. PayPal currently has over 180 million customers that have the ability to make payments easily through their mobile app, which appears to be more versatile than payment solutions which depend on the device being used at checkout.

Conclusion

PayPal looks to be a very solid digital payment processor. Going forward, it can be expected that management will drive its bottom line by increasing efficiency in its operations and optimizing its pricing strategy, which is something it was unable to do as a part of eBay. Currently, the stock trades at a 39.3 P/E, which is quite expensive considering the industry average is 17.3. I would wait for a pullback in the price of PayPal's stock before considering initiating a position. There may be issues regarding the premiums paid for PayPal's acquisitions, but it appears that PayPal is determined to invest in their mobile platform in order to gain the upper hand on competition.

Disclosure: I am/we are long AAPL.

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.