PayPal - A discussion of moats and sauces and spoons to stir the pot
PayPal (NASDAQ:PYPL) is soon to report earnings for its fourth quarter and 2016 and to provide a guidance update. The call is scheduled after the market closes on Thursday, 1/26. Is this a good time for investors to enter the name? I wrote about PayPal in a positive fashion back about six months ago, and have written about several other payment companies as well. Not to hold anyone in suspense. I will be reprising and updating the positive investment case for the name based on the specifics of its strategy and the macro environment in which the company exists. But more than that, I think for those contemplating making an investment in PayPal shares, the time to do so is most likely before rather than after the earnings release and conference call.
In the July quarter, investors were unhappy with the results although they were basically in line and the shares fell 10% in 10 days while tech shares, in general, appreciated marginally. Back in October, the shares appreciated by 10% the day after earnings. Almost all the alpha the shares have seems to take place in the wake of earnings calls and that was certainly the case the last two quarters.
I don't purport to have an informational advantage on how this quarter might have turned out. Given that e-commerce sales were strong this late holiday season and that apparently the trend toward mobile e-commerce continued unabated, I would imagine that PayPal may have seen a corresponding upside to its business. And as there are some high-profile analysts who do not think that can happen, it suggests that there is the potential for positive alpha in the wake of the earnings call. But I am not about to suggest that I have anything like second sight.
The payment space is highly competitive with a host of companies that are sustaining organic growth in the mid-single digits and have had incredible stock-market performance over the past decade, although 2016 was a year in which the share value for most companies in the space more or less marked time. A couple of months ago, a contributor on this site advanced a thesis suggesting a 70% downside risk in the shares of PayPal. The shares are perhaps relatively controversial in the payments space. 41 analysts report their ratings to First Call. 26 either like it or love it, with the "like its" marginally outweighing there more enthusiastic brethren. The naysayers number 13 and there are two lonely underperform ratings. The average price target for the shares shows 12% appreciation for the year, with revenues forecast to grow by 17% and EPS forecast to increase by 15%.
17% revenue growth for one of the largest payment companies is no mean feat when most of the rest of the payments pack is growing in the mean single digits. Rivals Visa (NYSE:V) and MasterCard (NYSE:MA) are both forecast to grow at an 11% rate.
With so many commentators spewing electrons on this name, it is not an easy undertaking to find unique and insightful things to say. I saw another commentator on this site apologize the other morning about perhaps being redundant or boring - of course, he was commenting on one of my favorite dart targets, Paul Krugman. I won't apologize for writing about PayPal but will hope that I am producing some better understanding of the company that leads readers to make more informed investment decisions.
PayPal's Recent Past
I first wrote an article about PayPal back in July. The shares are up 15% since I initially wrote my article despite not beating headline estimates in either of the quarterly reports since that time. Over the same period, the IGV index rose by 7% and Visa shares rose by 9%. So, there has been some modest level of positive alpha for the shares over the past six months. A significant level of controversy has grown up amongst some analysts simply because of the share price performance and concern that the company will be unable to exceed estimates going forward.
Although it has been months since last quarter's results were released, some of the numbers that were part of the earnings presentation bear a bit of current scrutiny to see if the concerns about the potential for the company to beat current consensus expectations might have some validity. The overall growth of the payment business is and has been quite a bit faster than the growth in retail sales and that is likely to continue that trajectory for the foreseeable future. Mobile payments are increasing their wallet share of the total payments pie. Just about all payment vendors offer some kind of mobile payment option, and mobile payment growth is an increasing component of the landscape. If there is one single factor that has and is likely to continue to set PayPal apart from its competitors, it is the success it has in mobile. At the end of the day, PayPal's growth numbers, when compared to the other larger payment vendors, are really on a different trajectory altogether.
Last quarter, PayPal recorded an 18% growth in revenues - 21% in constant currency. That was a bit faster than the growth in Q2 and was driven both by increases in transaction revenue but also by other valued-added services which grew by 28% in CC.
Part of that growth was a product of the company's One Touch mobile solution and Venmo, which is a way of sharing payments and sending money to friends. Apparently, amongst millennials, Venmo facilitates cool exchanges that somehow enhance the payment experience. I actually have a Venmo account that a friend tried to set up for me - needless to say I have never used it as I simply am not cool enough to have fun paying for something. If I knew how, I would probably close the thing - but far be it for me to gainsay what is working.
I am not going to try to rank either One Touch or Venmo in terms of their user experience or functionality compared to other options that exist for achieving the same result. I am the last person to ask how engaged users of these services feel when they buy something or send money. But I do know that both services exist in a fast growth environment and their results suggest that potential users see their benefits. Venmo processed almost $5 billion in payments last quarter, a 131% year-on-year improvement in that metric.
Mobile payment volume for PPYL increased by 56% last quarter to nearly $26 billion. The growth in mobile and Venmo payments are the main drivers of what has allowed PayPal to grow share in its space and they really represent the opportunity the company has to exceed estimates in 2017. Last quarter, mobile payments reached 29% of TPV, up from 24% all of 2015.
Although a bit hard to see, the company is enjoying some leverage at scale. Excluding Xoom, a company PayPal acquired a year ago, its other expenses grew 9% compared to total revenue growth as reported of 18%. That is a commendable achievement for a company of this scale.
The biggest risk to this company's future is the longer-term decline in take rates and transaction margin. This is likely to be offset by continued improvements in operating expense categories as Xoom is integrated and despite further increases in spending on global branding and security.
Perhaps the biggest single issue that PayPal stock is dealing with relates to the relationship the company has with Visa and MasterCard and the revenue sharing to which has agreed with those vendors. Back in September, the company announced an extension of its partnership with MasterCard. The precise terms of the agreement have never been revealed but many observers felt that the agreement would negatively impact PayPal's revenues. Indeed, one reason why PayPal shares lifted in October was that the company's guidance belied that apprehension that the deals would lower margins.
In answer to a specific question, CEO Dan Shulman said, "So Visa, MasterCard and the issuer implementations, those will happen as we go through next year. But we don't assume a lot of either revenue or volume increase as a result of that. So, we are trying to be reasonably conservative on the - on what we will see next year from that. "
How can PayPal grow its market share?
One answer provided by Mr. Shulman during the Q3 conference call of some interest related to the broad brush that e-commerce at the moment is 10% of retail sales and that PayPal is 1% of e-commerce. Notionally, then, the TAM for PayPal is the other 99% it doesn't have. Management has actually presented a three-year projection extending through the end of this decade that has forecast that the company will double the amount of payment volume that it processes, will increase its revenues by more than 60% and will maintain current non-GAAP operating margins. Free cash flow is forecast to grow in line with revenue which means that the company will either institute a dividend or more likely continue its share repurchase so that EPS by the end of the period will be up 75% from the current consensus forecast of EPS of $1.50 for 2016, i.e. EPS of about $2.60-2.70. Needless to say, trying to forecast the EPS for 2019 is not a task undertaken lightly and suggesting that EPS will be in any kind of tight range should not be taken too seriously by investors. But it does suggest the overall quantitative parameters by which management is driving operations.
In early 2017, I think it can be said that PayPal has a set of capabilities that might reasonably lead it to achieve its longer-term goals. Perhaps, most importance of these capabilities is its overwhelming brand recognition and the recognition of several of its different platforms. It also has substantial scale advantage; it is the leading provider in its space by some recognizable amount. And it has developed capabilities in risk management regulatory capabilities and the ability to connect merchants and consumers simply and efficiently. Are these adequate capabilities to provide the company with sustainable competitive advantage? I think they are - clearly, there will be a wide spectrum of opinions on that point. I do think it is important to understand that this company will innovate in terms of the services that it offers and that taking a snapshot today and freezing it is probably not a useful tool in analyzing the company's competitive moat.
It is hard to overstate the influence of the trend toward mobile payments where PayPal has a significant leadership position in terms of the company obtaining the overall market share that it is projecting. While there all kind of metrics and all kinds of competitors in the space, I think the major factor that PayPal has in its favor is marketplace momentum.
Part of that momentum is a product of PayPal's acquisition of Braintree a bit over three years ago. I think it is fair to say that Braintree has been one of the more seminal acquisitions in the payment space - it is one of those deals that keep on giving. Braintree payment volume quadrupled in the first two years it was owned by PayPal and it continues to grow. Payment volume reached $50 billion at an annual rate by Q3 2015 and it will cross $100 billion of payment volume in the next 12 months according to management forecasts.
Part of the Braintree acquisition was Venmo. Braintree had actually bought Venmo the year before its acquisition by PayPal for just $26 million. It too is showing explosive growth.
Braintree, prior to its acquisition, had secured customers such as Airbnb (AIRB), Twilio (NYSE:TWLO) and Uber (UBER) for its platform. I also believe that Bill Ready, who was the founder of Braintree is one of the stars of the PayPal management team. The erstwhile CEO of Braintree is now the COO of PayPal and had been the company's chief product officer until his recent appointment. Not to make too much of a single individual, but to the extent that PayPal develops the recipe for secret sauces, Mr. Ready is most likely to be the responsible chef.
Venmo and Braintree, for the most part, have lower take-rates and higher volume per account than what might be called core PayPal. As Braintree has become a larger component of the total company, take rates have declined some - about 19 basis points year on year. The company has forecast that this metric will continue to decline. Investors are typically quite concerned that a take-rate price war might break out and hurt the profitability of this company. There is no real sign that a price war is imminent.
Venmo is still a relatively small contributor to payment volume - a bit less than 6% of the total last quarter. That said, however, it achieved 131% growth in payment volume. I do not suppose anyone thinks that the Venmo phenomena can continue along its current trajectory. As I said earlier in the article, not being a millennial, I have no deep understanding about what makes a payment platform cool for users. But while Venmo is still small, looked at another way, it is providing 20% of PayPal's growth in TPV.
PayPal has a small business in extending credit to the customers of some of its merchants. PayPal credit has been a subsidiary of PayPal for the last eight years. One of the contributors to this site feels that extending these kinds of loans to the customers of its customers is a very risky business for the company. The numbers do not bear out this concern.
The company is not likely to become a major consumer credit supplier anytime soon. Its receivables outstanding are just $4.5 billion and on its call it said that its strategy is to partner with financial institutions to create solutions where it supplies technology and others supply capital.
PayPal spent $1 billion to acquire Xoom. The transaction closed 14 months ago. Recently, Xoom was integrated within PayPal and customers can use their wallet balances to make Xoom payments. Xoom had revenues of $42 million and was losing money when it was acquired. Its growth was modest - in the high-single digit range. The company doesn't report Xoom revenues so we can't determine if it has been a significant growth contributor. My guess is that it was not specifically because it would have a material impact on PayPal's growth but would have significant revenue synergies. The company hasn't chosen to quantify the financial results of its cross-selling activities with Xoom and it is probably a bit early in the game for it to be meaningful.
Again, I have no way of sitting here on January 16th 2017 and writing that PayPal will meet or exceed estimates that it has presented for the next three years. I have no such second sight. I really don't have the ability to know what number the company is going to print in two weeks. The company has a significant product roadmap and Bill Ready and the entire PayPal product development team have a record of innovation and imagination that I am sure will create service offerings as yet undefined and certainly not quantifiable. But I think it is reasonable to suggest that there is a reasonable and substantive case that can be readily made supporting the company's aspirational objectives.
For the most part, other than the report of one outlier that I have cited earlier, most of the issues surrounding these shares relate to their valuation more than concerns regarding the company's business. The company has a current share count of 1.21 billion shares and has a market capitalization of $55.7 billion as I write this before the market opens on Tuesday. The balance of the company's cash and investment accounts is $6.4 billion. So the enterprise value is $49.3 billion. The analyst consensus and company sales projections are $12.6 billion for the current year which puts EV/S at a bit under 4X, reasonable enough for a business forecast to grow revenues, earnings and cash flow at 17% or so over the next three years.
The P/E sits at 24X, again based on the consensus estimate and the company's forecast for 2017 results. PayPal uses stock-based comp. Stock-based comp, at $317 million represented, 31% of the reported earnings through nine months while it was $257 million or 29% of reported earnings for the same period a year ago.
Cash flow from Operations is substantially greater than net income. The largest differences between the two metrics are the provisions for transaction and loan losses, depreciation and stock based comp. Overall, cash flow turned out to be about 2.2X reported net income through nine months compared to 2.1X for the same period in 2015. The company raised its estimate of free cash generation to $2.2 billion and said that cash flow would track reported non-GAAP earnings next year. That suggests that free cash flow this current year will be approximately $2.6 billion, a free cash flow yield of just over 5%. I think that is a very reasonable ratio for a company forecasting that it will be able to grow that metric by more than 60% over the next three years while reducing the number of shares outstanding.
I think that the above valuations reflect tensions between those who think management will be able to accomplish its goals and those who think that competition, in particular, will bring down growth and margins. I have, I hope, presented the positive case for what the company needs to do to achieve its aspirations. I think the odds favor that it will be able to do so. If it does, I think that the company can and will create a significant level of positive alpha for investors going forward.
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.