PayPal (NASDAQ:PYPL) is benefiting from at least three secular trends: a) increased adoption of e-commerce, b) globally growing online consumption and c) the increasing use of digital, cashless & mobile payment solutions.
With its clear focus on the online business and mobile payments, PayPal is one of the payment services providers of the 21st century and is seen as one of the standard payment solutions in the internet.
At least that is the opinion of the stock market, because since the separation of eBay (EBAY), the stock has delivered a gain of 440%, outperforming both the S&P 500 and the Nasdaq 100 by far (see following chart).
(PayPal's performance since July 2014 vs. major indices. Source: YCharts).
With a performance of over 80%, the share is also a clear outperformer year-to-date, driven primarily by increased e-commerce adoption and online consumption due to the coronavirus pandemic (see following chart).
(PayPal's year-to-date performance vs. major indices. Source: YCharts).
Consequently, in this article, I would like to discuss if it is still reasonable to invest in PayPal after its steep rise and evaluate how much further potential the shares could have.
(PayPal logo. Source: Pixabay)
In the following, I have listed five key reasons which, from a fundamental perspective, favor a continued robust and promising future for the company.
First, the area of payment services - alongside cloud computing, e-commerce and tele health - is one of the most promising growth sectors, with annual double-digit growth rates. The companies are usually profitable and/or have increasing, positive free cash flows.
With regard to PayPal in particular, growth has even accelerated as a result of the coronavirus pandemic, so that the company has raised its guidance for FY 2020.
As the following figure illustrates, total payment volume grew by 30% in the last quarter, while cushioning a decline of around 60% in volumes from travel and event sectors.
(TPV processed by PayPal in Q2 2020. Source: PayPal)
With regard to revenues, the company registered its highest revenue growth since the separation from eBay with a growth rate of 25% year over year (see following figure).
(PayPal's revenue growth in Q2 2020. Source: PayPal)
Additionally, the following figure illustrates the double-digit growth in earnings per share (non-GAAP). As shown in the figure, earnings per share (EPS) grew by 49% in Q2 2020, despite including credit loss reserves, which reduced EPS by $0.07. EPS grew by 26% year-to-date. Excluding the year-to-date impact of macroeconomic factors, EPS grew by 44%.
(PayPal's non-Gaap EPS growth over time. Source: PayPal)
Second, although PayPal is mainly known as an online and e-commerce payment system, the company generates more revenue than Mastercard (MA).
In terms of quarterly revenues in Q2, the company has now even overtaken Visa (V). If, for example, the travel industry does not recover quickly from the effects of the coronavirus pandemic, it can be assumed that PayPal will soon leave Visa and Mastercard behind in terms of annual revenues as well (see following figure).
(PayPal's revenue compared to Visa and Mastercard. Source: YCharts)
While payment providers such as Visa, Mastercard and also Square (SQ) (if one excludes Square's revenues generated with Bitcoin, which in my opinion is questionable reported) suffer a decline in revenues, PayPal even got an additional growth boost despite or due to the pandemic.
In this context it is noteworthy that Mastercard, together with Visa, are the two largest credit card providers (apart from the Chinese Union Pay; see following figure).
Global market share of credit cards providers as of 2017; Quelle: Payments Cards & Mobile
Third, while the online and e-commerce sector is showing accelerating growth, Paypal is entering into strategic partnerships to further expand its presence in the mobile payment sector.
In this context, the partnership with Instagram Checkout, which was concluded in 2019, can be mentioned on the one hand. Peggy Alford, Senior VP Core Markets of PayPal, even got a seat on the Facebook board.
Instagram Checkout allows users to make purchases of the desired product within the app. Previously, users were redirected to external websites of merchants. According to company statements, approximately 130 million monthly active users (MAUs) click on product offers within the Instagram app. Analysts estimate the sales potential of Instagram Checkout at more than $10 billion by mid 2021.
Additionally, based on the management's statements during the earnings call, PayPal closed commercial partnerships with Gojek, MercadoPago as well as MercadoLibre (MELI), all of which are among the leading merchants in their home markets. Moreover, the company intends to expand its capabilities in China by partnering with China's UnionPay and other leading Chinese player for this purpose.
On the other hand, PayPal continues to show very rapid growth in terms of new accounts and P2P across its platforms PayPal, Venmo, Honey and Xoom. The number of active accounts in the quarter increased by 21% or 21.3 million year over year. This represents the strongest quarterly growth in the company's history (see following figure).
(PayPal's active and net new accounts in Q2 2020. Source: PayPal)
With further regard to mobile payments, PayPal is aiming at an increasing monetization of its mobile wallet and P2P payment platform "Venmo", which is currently a U.S.-only service. According to the company, the transaction volume by Venmo increased by 52% to $37 billion in the last quarter.
Additionally, management plans to further diversify and expand the business. The management mentioned during the earnings call for the last quarter, among other things, the introduction of new omni channel check-out options in both PayPal and Venmo, new bill pay, subscriptions and rewards management solutions as well as new types of credit and budgeting tools (see figure below).
(PayPal's In-Person Payments Strategy. Source: PayPal).
Fourth, the recent acquisitions of Hyperwallet (international platform for payments across different countries and currencies) and iZettle (provider of POS terminals in the retail sector) express PayPal's ambitions in the payment sector and should gradually translate into growth. There is even speculation that PayPal intends to build up its own card network, similar to Visa and Mastercard.
Fifth, PayPal has a solid balance sheet. Therefore, PayPal could make further acquisitions if necessary, buy back own shares or even pay a dividend in the future, which could further boost the stock price. PayPal's cash, cash equivalents and investments amounted to $16.2 billion, while the debt amounted to $9 billion as of June 2020.
Going forward, the company expects revenue growth of around 25%, non-GAAP EPS growth of around 25% and GAAP EPS growth of around 45% in Q3 2020. Additionally, the company expects to generate approximately $5 billion in free cash flow in FY 2020, a $1 billion increase over the previous forecast.
Although PayPal generates more revenue than Mastercard and is on the brink of surpassing Visa, as already mentioned in the section above, its market capitalization is still substantially below that of Visa and Mastercard, despite a rise of 80% for the year.
As you can see in the chart below, PayPal's market cap is 40% below that of Mastercard and 80% below that of Visa. Based on PayPal's closing price of $199 on August 7, 2020, a parity with Mastercard would mean a price of $279 per share and with Visa a price of $358 per share.
(PayPal's market cap in peer group comparison. Source: YCharts)
With regard to the P/S ratio, it can be said that PayPal's P/S ratio is also substantially lower compared to the peer group, despite a currently much higher growth rate.
While PayPal has a P/S ratio of around 12, its peers Mastercard and Visa have a P/S ratio of around 20. Consequently, the stock could have an upside potential of at least 66% based on a P/S ratio approach to catch up with the peer group in terms of valuation (see figure below).
(PayPal's P/S ratio in peer group comparison. Source: YCharts)
Two most likely reasons for this valuation disparity are probably the operating income and the operating cash flow, which for PayPal is still below its peers. A further explanation could be that the market underestimates PayPal's potential and thus prices in a higher risk discount (see figure below).
(PayPal's OCF and operating income compared to peers. Source: YCharts)
In this context, a margin expansion of PayPal can be expected in the future. This assumption is related to the diversification and scaling of the business model as well as the results of the previous quarters, which confirm these assumptions.
According to the management's statements during the earnings call, operating margin for the previous quarter came to 28.2%, improving over 500 basis points year-over-year. At the same time, this represented the highest level of operating margin improvement the company reported in its history, which is attributable to the operational strength across all areas of the business, CFO John Rainey told analysts.
Nevertheless, I prepared a calculation of PayPal's fair value based on a DCF model in order to make a more accurate assessment of the valuation.
In order to choose a conservative approach, I have chosen a growth rate of 20% and a growth decline rate of 10% per year in terms of the free cash flow, which is largely in line with analysts' estimates for the next few years provided by MarketScreener.
Furthermore, I have chosen a multiple of 30 for the last FCF, which is below the average Price/Cash Flow multiple for the last five years of PayPal (33.55), Visa (30.80) and Mastercard (33.13), according to Morningstar.
Based on my valuation method, the fair value is $346,30, which corresponds to an undervaluation of the stock of 74% (see calculation below).
(Fair value calculation. Source: Author's calculation)
The calculation does not include the impact of the potential and ongoing buyback programs. Share buyback programs are very likely to provide a further boost to the share price.
With its online and mobile focus as well as its dominant role as an internet payment provider, PayPal seems to be one of the best long-term investments to participate in the digital and cashless payment trend.
The global pandemic has exceeded e-commerce growth forecasts by several years, which also triggered a growth boost for PayPal.
PayPal has numerous growth factors which, together with a diversification and scaling of the business model as well as monetization of its several platforms and digital wallets, should ensure continued double-digit growth in the coming years.
Additionally, the company closed several strategic partnerships such as Instagram Checkout, MercadoLibre and MercadoPago, which should further propel its growth and role in the digital payment world.
Interestingly, the company still has a substantially lower valuation than its peers, despite generating more revenues than Mastercard and being on the brink of surpassing Visa in terms of revenues. This valuation disparity could offer a chance for potential investors.
Based on my fair value calculation, the stock has an upside potential of around 75% and could be worth around $350 per share.
Nevertheless, even if the shares appear fundamentally undervalued, unexpected events are always to be expected on the stock market and there is no guarantee of rising share prices. Investors should always bear in mind that stock prices are volatile and should not be influenced by price movements alone, but rather should pay attention to the underlying fundamentals. In this respect, investors should always pay attention to their individual risk tolerance.
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Disclosure: I am/we are long V, PYPL. 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.