PayPal: Much More Expensive Than You Think
Summary
- PayPal has grown strongly since its 2015 spin-off, and management's medium-term outlook envisages a further period of strong growth.
- However, the stock is more expensive than it seems, with high stock-based compensation costs excluded from non-GAAP figures presented.
- Growth has been capital-intensive, with large spend on acquisitions and loan receivables; the pending loss of eBay business will be a headwind.
- We prefer Mastercard as a better investment in the payments space, given PayPal has not been disruptive to existing card companies.
- At $111.74. PayPal shares are on a 46.1x P/E on non-GAAP EPS (65.3x on GAAP EPS) and 1.7% FCF Yield. Our recommendation is Neutral.
Introduction
PayPal (NASDAQ:PYPL) has grown strongly since its 2015 spin-off from eBay (EBAY), with its Total Payment Value ("TPV") growing at a CAGR of +25.3% and its net revenues growing at a CAGR of +17.8% during 2014-18 (as shown in the charts below). Management's medium-term outlook envisages a further period of strong growth, with revenue CAGR of 17-18%, an "expanding" operating margin, and an EPS CAGR of around 20% in the next 3-5 years (see below).
| PayPal TPV (2014-18A)
PayPal Net Revenues (2014-18A) Source: PayPal company filings. | PayPal Medium-Term Outlook Source: PayPal investor day (May-18). |
However, we believe that PayPal stock is more expensive than many investors think and that incumbent payment provider Mastercard (MA) offers a better risk/reward profile (see my article on Mastercard in April). This is due to a number of reasons, which we will explore below.
Non-GAAP Figures Exclude Stock-Based Compensation
One of the key reasons that PayPal stock is more expensive than it seems is that both management and many investors focus on non-GAAP (Generally Accepted Accounting Principles) figures, which do not include the costs of stock-based compensation.
As shown in the example slides below, non-GAAP figures typically form the centrepiece of results and guidance that management present to investors:
| PayPal Results Presented by Mgmt. (2018)
Source: PayPal results presentation (18Q4). |
However, among the non-GAAP adjustments, the largest one by far is the exclusion of stock-based compensation costs, as shown on the left below. In 2018, stock-based compensation costs were $920m, or 27% of the non-GAAP operating income; and they were similarly significant in preceding years.
We believe the exclusion of stock-based compensation costs gives a misleading impression of earnings, as stock-based compensation dilutes shareholders' ownership of company earnings and, thus, represents a real cost to them.
PayPal's non-GAAP EPS is typically around 30% higher than its GAAP EPS and 40% higher in 2018 (as shown on the right below). For 2018, non-GAAP 2018 EPS of $2.42 implies a P/E of 46.1x at the current share price; but GAAP EPS of $1.71 implies an even higher P/E of 65.3x.
| PayPal - GAAP vs. Non-GAAP Op. Income (2016-18)
Source: PayPal 10-K (2018) |
| PayPal - GAAP vs. Non-GAAP Financials (2014-18)
Source: PayPal company filings. |
High Capital Intensity & Low Distributions
Another reason that PayPal stock is more expensive than it seems is that a large part of the earnings is being spent on acquisitions, loan receivables, and minority investments. This means PayPal's growth is quite capital-intensive, and only a minority of the Free Cash Flow ("FCF") is distributed to shareholders.
PayPal's historical net income and shareholder distributions are shown side by side with Mastercard's below, with PayPal comparing unfavourably:
- PayPal has a much larger gap between its GAAP and non-GAAP net income. Where Mastercard has a gap, it is mostly due to litigation and tax costs.
- Relative to net income, PayPal's share-based compensation costs are much larger than Mastercard's.
- Mastercard distributes substantially all its earnings to shareholders in buybacks and dividends; PayPal distributes much less, only about 50%. (PayPal's large buyback in 2018 was a one-off, funded by proceeds from the $6.9bn sale of its U.S. consumer loan receivables to Synchrony (SYF).)
| Shareholder Distributions vs. Net Income
Source: PayPal & Mastercard company filings. |
The reason PayPal shareholders receive less of its earnings is the company's large spending on acquisitions, card receivables, and minority investments. PayPal's net acquisition spend and loans receivables balance are shown below:
| PayPal Net Acquisition Spend (2014-18A)
Source: PayPal company filings. | PayPal Loan Receivables Balance (2014-18A)
Source: PayPal company filings. |
PayPal has been an active acquirer, spending $2.1bn net on acquisitions in 2018 alone (primarily, the acquisition of iZettle). It is also funding an aggressive expansion of lending to customers, with its loan receivables balance up $1.2bn year on year in 2018. Loan receivables have historically grown at a fast pace, though the U.S. consumer portfolio was sold in 2017.
In addition, PayPal has been making large minority investments, especially in marketplaces. In 2019 year to date, it has invested $500m in Uber's (UBER) IPO, and another $750m in MercadoLibre's (MELI) IPO.
The high spend on acquisitions is set to continue. Management's medium-term outlook explicitly assumes $1-3bn of M&A spend each year, and only 40-50% of the FCF will be available for capital return (and some of this will merely offset the dilution from share-based compensation discussed above).
PayPal's earnings growth thus needs to be considered in the context of the high capital intensity required to achieve them, as well as the limited extent to which shareholders actually benefit from earnings being distributed.
Pending Loss of eBay Business
Another reason that PayPal stock is more expensive than it seems is the pending loss of its existing eBay relationship, by far its largest source of revenues, in 2020.
As announced in 2018, eBay has decided to "intermediate" payments on its platform once its current agreement with PayPal expires. This means that eBay will itself serve as the link between its merchants and shoppers, a role hitherto performed by PayPal. eBay with be partnering with payment processor Adyen (OTCPK:ADYYF). PayPal will be just one of the payment options on eBay, alongside others.
eBay is far PayPal's most important partner, worth 11% of its TPV and 17% of its revenues in 2018 (management does not disclose the profit contribution). While eBay's contribution in PayPal's mix has been shrinking (as shown below), it may still be as much as 10% of PayPal's revenues in 2020.
| PayPal's TPV & Revenue from eBay (2015-18)
Source: PayPal results presentation (18Q4). |
While the pending loss of the eBay revenues may not be total and has been included in management's medium-term outlook, it does make achieving the outlook harder.
Not Disruptive to Card Companies
One reason we believe PayPal does not offer the best risk/reward profile in payments is that it has not proved disruptive to existing card companies like Mastercard and Visa (V).
While PayPal's volume growth materially exceeds that of Visa and Mastercard, Visa and Mastercard have continued to achieve respectable growth rates, and their volumes still dwarf PayPal's:
| PayPal & Peers' Volume Growth Y/Y (Constant Currency)
Source: PayPal, Mastercard & Visa filings. | PayPal & Peers' Total Payment Volume (2013-18A)
Source: PayPal, Mastercard & Visa filings |
(Note: Visa growth rates in CY17H1 are not shown, as they are not meaningful with the acquisition of Visa Europe in 2016; volume figures are in dollars, so growth appears smaller in 2015 due to the dollar strengthening then.)
Nor is PayPal materially undercutting card companies in price. PayPal's transaction take rate (what it charges each transaction) has been above American Express's (AXP) merchant discount rate until recently, as shown below. (American Express is used for comparison because it is an end-to-end platform like PayPal, and because it charges more than other card companies.)
| PayPal Transaction Take Rate vs. American Express Merchant Discount
Source: PayPal and American Express results presentations. |
And, PayPal's transaction take rate decline is not due to price cuts but is instead largely due to mix, with a falling share of higher-margin eBay and cross-border volumes and a rising share of lower-margin peer-to-peer volumes.
Far from being a disruptor, PayPal has been partnering with card companies and banks (including both Visa and Mastercard since 2016), as shown below. Where PayPal has been issuing credit and debit cards, these have been on the Mastercard network. It also pays out about 35% of its revenues to banks and card companies in "transaction expenses", mainly to draw customer funds.
| PayPal Partnership Strategy Source: PayPal investor day presentation (May-18). | PayPal Debit Card
Source: PayPal website. |
PayPal Growth is Incremental to Industry
Another reason we believe PayPal does not offer the best risk/reward profile in payments is because its growth is largely incremental to the industry.
PayPal's growth is largely incremental because it often comes from new areas such as marketplaces, small businesses, and peer-to-peer ("P2P") payments. This is a natural result of where PayPal's competitive strength is - its end-to-end 2-sided platform, which provides more contextual knowledge of the parties involved and allows it to deal more easily with parties which were hitherto too small to be served by card companies and banks.
Marketplaces are particularly relevant, given the large number of small merchants involved. PayPal's largest partner has been eBay, and many of its next top 20 partners are also marketplaces, as shown below. In 2018, the top 20 partners after eBay were 15% of PayPal's TPV, having grown 41% year on year, vs. 27% for all other non-eBay partners.
| Example PayPal Top-20 Marketplaces/Partners
Source: PayPal results presentation (19Q1). |
Falling Transaction Take But Flat Transaction Expense
Another reason that PayPal stock is more expensive than it seems is the headwind it faces as its transaction take rate declines while its transaction expense rate remains flat, as shown in the left below. This means that, for each incremental new dollar in volume, PayPal has been receiving less revenues but incurring the same transaction expenses. The decline in transaction take rate has been due to mix (as described above).
PayPal has kept flat or slightly-rising margins by reducing its other expenses margin, and it guides to an expanding margin over the next 3-5 years. However, a transaction take rate that is falling while the transaction expense rate stays flat is an unfavourable sign of PayPal's business model.
| PayPal Transaction Take Rate vs. Expense Rate Source: PayPal company filings. | PayPal EBIT Margins (2014-18A)
Source: PayPal company filings. |
Valuation
At $111.74, PayPal shares are trading on 46.1x P/E relative to its 2018 non-GAAP EPS of $2.42 (but 65.3x on GAAP EPS). Management's FCF figure was $3.15bn for the year, excluding the one-off sale of the U.S. consumer loan receivables (as shown below); subtracting $853m in share-based compensation costs, the "real" FCF is $2.30bn, implying a 1.7% yield. We regard both the P/E and the FCF yield as expensive.
| PayPal Free Cash Flow (Management View)
Source: PayPal results presentation (18Q4). |
By comparison, Mastercard shares (at current price of $251.48) are about 15% "cheaper", on a 39.1x P/E and a 2.1% FCF yield (on 2018 figures).
In terms of medium-term EPS growth, PayPal medium-term outlook is for a CAGR of around 20% while MA is for "high-teens" (as shown below).
| PayPal Medium-Term Outlook Source: PayPal investor day presentation (May-18). | Mastercard Medium-Term Objectives
|
If PayPal were to achieve its 20% EPS CAGR outlook and also to maintain its current valuation multiple, then the 20% EPS CAGR would translate into a 20% p.a. return for investors. However, we are concerned that PayPal's high valuation multiples are more vulnerable to a de-rating.
Compared to Mastercard, simplistically, a difference of 5% in growth rates and one of 15% in current valuation multiples means that it would take 3 years of growth for the two companies' valuation multiples to catch up.
Conclusion
PayPal has demonstrated strong growth since its 2015 spin-off and will be an integral part of the wider payment ecosystem. However, the stock is more expensive than many investors think, due to high stock-based compensation costs, high capital intensity (in acquisitions, loan receivables and minority investments), and the pending loss of the eBay business in 2020.
At $111.74, PayPal is trading on a 46.1x P/E on 2018 non-GAAP EPS (65.3x on GAAP EPS) and a 1.7% FCF yield - which we regard as expensive. The shares would generate an investor return of 20% p.a. if PayPal were to deliver on management outlook and also retain its current rating, but the stock may be vulnerable to a de-rating.
Existing payment providers like Mastercard have also shown strong growth, with little disruption from PayPal. Ultimately, we prefer Mastercard for being slightly cheaper and carrying less risk, albeit with lower growth. Our recommendation on PayPal is Neutral.
This article was written by
Disclosure: I am/we are long MA. 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.