PayPal: A Winner In Digital Payments

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About: PayPal Holdings, Inc. (PYPL)
by: The Profit Hunter
Summary

PayPal provides digital wallet solutions and lies at the center of mobile and e-commerce.

Partnerships and collaborations are extending the company’s ecosystem.

Looking beyond the high PE ratio and valuation is attractive on a forward-based free cash flow multiple.

Rapid growth and acceptance around the world has propelled PayPal (PYPL) to become a leading digital payment provider. Following its 'divorce' from eBay (NASDAQ:EBAY), we explore how PayPal has adopted a partnership approach to extending its ecosystem whilst adding a high level of service and value to its customer base.

PayPal is a technology platform which facilitates mobile and digital transactions on behalf of customers and merchants. The business was spun out of eBay on 17 July 2017. In the second quarter of 2019, the company reported 277 million customer accounts, of which 255 million are consumers and 22 million are merchants. As indicated in the table below, user growth has been accelerating since the spin-out.

PayPal’s User Growth Rate

Year

User Growth Rate

2016

11%

2017

15%

2018

17%

2019 Q1

17%

Source: Company Reports

This is possibly attributable to senior management’s emphasis on rolling out initiatives which drive customer satisfaction. For instance, consumers now have the choice of how to fund their digital wallets – either through credit cards, debit cards or bank transfers. Funding was previously a clunky process which involved direct wire transfers from bank accounts which served as a friction point for consumers and their bank partners. Whilst these measures risked reducing PayPal’s margins since direct bank account funding is costless to PayPal, it is a decisive measure to put the customer’s needs ahead of the business. Given CEO Dan Schulman owns over $58 million of stock, management is clearly well aligned with shareholders.

On paper, this is a very good business. The company operates a two-sided network which benefits from classic network effects, such that the more people who pay through PayPal, the more merchants are incentivised to offer digital payment through PayPal. When checking out on a website, consumers can protect their personal information as PayPal shields the merchant from accessing sensitive payment information, such as card details or bank account numbers. It is also quick to log into PayPal either through mobile or desktop than having to enter one’s card details. In short, PayPal serves a useful role in reducing friction at the point of payment. The recently rolled out “One-Touch” button further enhanced speed, allowing consumers to breeze through check-out. It also saves the hassle of having to enter a password. The company recent reported that 136 million consumers have adopted One-Touch.

Finally, the service offers payment protection and dispute resolution to guard against fraudulent transactions.

My interviews with vendors reveal that many merchants that have dropped PayPal have returned because of lost sales. According to ComScore, check-out conversion using PayPal measures 88.7% versus 55.3% for other digital wallets and 48.7% for all payment types.

Collaboration is King

The company is not standing still. The acquisition of Venmo in 2013 was an early signal of the group’s ambition to dominate the payment and money transfer market. Whilst still a drag on free cash flow today, Venmo has proven a social phenomenon given it is the main way young people are sending each other money. Venmo processed $62 billion of volume in 2018, a year-on-year growth rate of 79%. Through the first quarter of 2019, run-rate volume expanded to $85 billion and generated $300 million in annual revenue run-rate. The company only started monetising Venmo in early 2018 and the unit now generates revenue from fees on instant deposits to bank accounts, a Pay with Venmo button on key e-commerce sites (available on sites such as Gametime, Shopify, Grubhub, Poshmark, Uber and Hulu).

To further reinforce its durability, management has entered into strategic collaborations with other players in the payments ecosystem through partnerships and investments. During the first quarter, the group announced a deal with Facebook (NASDAQ:FB) to process payments on Instagram. Major issuing banks electing to partner with PayPal include Barclays (NYSE:BCS), Citibank (NYSE:C), JPMorgan Chase (NYSE:JPM) and American Express (NYSE:AXP). Each is seeking to improve the banking and payment experience for their customers. In October 2018, American Express signed a deal with PayPal to improve the digital payments experience for their customers paying with Venmo and PayPal and partners for loyalty spending and peer-to-peer transfers. This initiative will allow American Express card members to use membership reward points for purchases across the millions of PayPal’s online merchants.

PayPal’s $750 million investment in MercadoLibre (NASDAQ:MELI), the ‘Amazon’ of Latin American e-commerce, allows for the integration of its payment services into the platform’s e-commerce activities, which should accelerate growth in the burgeoning South American market.

Valuation: Look through headline PE multiples

PayPal generates over $3 billion of free cash flow annually which is set to grow significantly in coming years on the back of continued new customer adoption and mid-teens growth in digital commerce more broadly. Mobile commerce accounts for 41% of PayPal’s volume which exposes the company to high growth markets. Rather than distribute excess capital, it is expected that management will continue to make strategic investments and acquisitions. Trading on an estimated 22.8x multiple of 2022 forecast free cash flow, the shares offer good value given attractive future growth prospects.

What are the risks?

There is no shortage of payment solution providers all vying for a share of consumers’ digital wallet; however, PayPal has built the largest network of online vendors. Facebook’s Libra currency potentially poses a threat, though it is too early to quantify such a risk. Within peer-to-peer there is a massive land grab emerging involving Venmo, WhatsApp, ApplePay Cash and Zelle all vying to become the dominant cashless solution.

Conclusion: A Leading Payment Provider in a Growing Market

PayPal accounts for 82% of the top 500 online retailers in the United States, dramatically higher than other digital wallet peers, including Google Checkout. Ultimately, the service enables a seamless payment experience for the consumer and merchant by serving both sides of the network effectively. The strength and potential durability of this value proposition may be underappreciated by investors.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PYPL over 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.