A Value Driven Analysis Of PayPal

| About: PayPal Holdings, (PYPL)

Summary

Short-term headwinds have deflated the stock of a company that has shown consistent and sustainable profitability and growth.

Recent agreement with Visa illuminates PayPal’s values regarding volume of transactions and cost of transactions.

Catalysts for future success include the strong growth of recently acquired services such as Venmo coupled with strong performances derived from PayPal’s established position in the mobile payments industry.

Q2 Earnings Report

PayPal's (NASDAQ:PYPL) second quarter report was strong on paper. The company reported a 15% growth in revenue (even higher if you disregard fluctuations in currency), a 26.5% increase in free cash flow compared to a year prior, and an 11% increase in active customers. Additionally, PayPal's acquisitions, such as Venmo, have shown very strong growth. This growth has been exhibited in past quarters and are expected to be sustained through future quarters. Yet despite these factors, the stock dipped over 7% the day following its earnings report due to how investors regarded PayPal's new deal with Visa (NYSE:V).

With PayPal's new agreement with Visa, it becomes necessary to examine the risk and reward tradeoffs between the increased transaction volume and increased transaction costs resulting from this deal. I believe that when considering the still expanding fintech industry, a choice to increase PayPal's total payment volume (TPV) and market share, even at the expense of higher transaction costs, is the correct path to take for long-term success. The partnership with Visa further cements PayPal as an established player in the industry and eliminates the previous fears of Visa siding with a competitor or becoming a direct competitor itself. PayPal's increased presence in the market long term will decrease the sway of merchants, lenders and banks, allowing the company to exert greater influence in negotiating transaction and other costs.

That being said, those interested in PayPal in the short term should remain less optimistic. For the next quarters, there's an expectation that profits and margins will dip with the rise in transaction costs associated with consumers using funds from a credit card in place of transferring funds directly from their bank. Additionally there is the risk that those who previously used a lower transaction cost fund source, such as a bank, may be swayed to switch to their Visa card if it is more convenient. Following the dip in PayPal's stock, there has been no immediate rebound as investors recognize the impact on upcoming revenue and margins.

PayPal as An Opportunity

The decline in stock price should not be solely viewed as the consequence of PayPal acquiescing to unfavorable terms of a popular and strong payment provider. Rather it should be seen as an investment for future success for it makes PayPal less vulnerable to competitors in the short term and sets up the company for a more dominant future. Let us delve into both the positive and negative drivers for PayPal as it continues its trajectory forward after its departure from eBay (NASDAQ:EBAY) last year.

Short-Term Drivers

PayPay's stock price immediately dipped following the company's 2Q16 announcements. Future earnings reports will be impacted negatively as users take advantage of the higher transaction cost Visa services. At the same time however PayPal will continue to see strong growth in recently acquired divisions. Venmo's TPV was up 141% this quarter and is not near its peak for potential. Additionally PayPal as a company has been focused on keeping its services available on mobile devices and tablets as those platforms show continued growth in use. Xoom saw nearly three quarters of its transaction take place on a mobile devices.

The mobile wallet and payments industry is undergoing strong growth and PayPal's established position in the industry allows it to reap a large portion of the success of the industry in the short term. In addition, PayPal is a beneficiary of merchants who seek alternative payment services from PayPal's competitors such as Google (NASDAQ:GOOG) (NASDAQ:GOOGL), which have close relations with banks opposed to more independent service providers such as PayPal.

Long Term Drivers

In the long term, PayPal will benefit from a trend of conglomeration in the mobile payments industry. Currently filled with many competitors and startups, this industry will ultimately begin to mature as consumers begin to side with larger payment options, such as PayPal, due to accessibility and simplicity. Additionally there is expected to be greater cohesion between banks, lenders and firms going into the future.

It is not insignificant to consider management's active role in improving the stock price of PayPal. In early 2016, the Board of Directors authorized a stock repurchase program that provides for the repurchase of up to $2 billion of common stock. PayPal already has returned $300 million of this to shareholders this quarter. Management is heavily incentivized to raise the price PayPal's stock, and CEO compensation consists of 69% performance based compensation.

With regard to the direction of the company, it is too early to say where PayPal will put its efforts into expanding (perhaps money lending), but its decision will play a large role in its long-term success.

As an incumbent player in the digital market, PayPal has inherent competitive advantages that come into play with attracting potential customers. Although I would not say that PayPal has a definitive moat, the company benefits from, and will continue to benefit from, the network effect with regard to the appeal of its products. Additionally there is increased cohesion in PayPal's various services that will serve to strengthen the company's offerings. Newer offerings such as Venmo can be used in conjunction with traditional PayPal services in a number of mobile apps for payment. Additionally Braintree is now powering many popular services, such as Uber.

Key Risks

PayPal's business is not without its inherent risks. The company's mobile business is heavily impacted by physical device manufacturers and companies such as Apple (NASDAQ:AAPL) and Google, which have the power to hamper PayPal's integration into mobile devices. Furthermore, the mobile payments industry is extremely competitive with relatively few barriers currently keeping innovative start ups from making a dent in more established players' market shares. Alternatives such as startups WePay and Intuit will try to out-compete PayPal. However, as stated earlier, there will be increased incentive for consumers to gather around larger players in the industry due to their wider breadth of offerings and availability. In recent quarters, PayPal has seen success with growth and profits, and investors may have reason to be wary should PayPal's management decide to remain stagnant in its success. That being said, given the company's past of strategic acquisitions and new product offerings, I do doubt that now would be the time for it to slow down its plans for future growth.

Key Takeaways

    • The recent dip in price is due to short-term headwinds.
    • PayPal's fundamental business underneath is still strong with a number of drivers of revenue growth.
    • Long term, the mobile payments industry will trend toward conglomeration.

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.