PayPal: Strong But Expensive

Summary

• PayPal is an excellent business with strong competitive advantages.
• The company is well positioned in large and attractive market.
• However, the stock is trading at a high valuation and faces difficult comps.

JasonDoiy/iStock Unreleased via Getty Images

PayPal Holdings Inc. (NASDAQ:PYPL) is a high quality business that enjoys strong competitive advantages. However, recent results significantly benefited from COVID, a tailwind which will unlikely repeat again. As a result, the company faces difficult comps going forward, while valuation remains high even after considering its above-market growth rate.

This article will discuss PYPL's latest earnings, business, financials, trading & valuation, and risks so readers could reach their own informed decision.

(Note: Unless otherwise noted, all forecasted financials refer to consensus estimates and all historical financial data comes from the company.)

Earnings

We will start by quickly going over the company's latest earnings to level-set everyone before moving to the main topic of considering the company's business fundamentals.

PYPL reported FY Q2 earnings (FY ending Dec) on 07/29/2021, resulting in the stock trading down 6.2% on the day after earnings.

Revenue grew 18.6% y/y to $6,238 million, in-line with consensus estimates. Gross margin came in at 53.7%, while operating margin came in at 26.5% compared to 28.2% a year ago. EPS for the quarter was $1.15, up 7% y/y and beating consensus by 2.3%.

FY21 revenue and EPS were reaffirmed.

While these are respectable results, it simply isn't good enough given elevated buy-side expectations (see Valuation section). Earlier-than-expected roll-off of eBay played a role in dampening results:

Source: company

Business

PayPal is a leading digital payments company that enables digital and mobile payments on behalf of merchants and consumers worldwide. The company's goal is to enable merchants and consumers to manage and move their money anywhere globally, anytime, on any platform, and using any device when sending payments or getting paid. PayPal facilitates person-to-person (“P2P”) payments through PayPal, Venmo, and Xoom and personalizes shopping experiences for consumers through its Honey Platform.

Source: company

PayPal earns revenues primarily by charging fees for completing payment transactions for customers and other payment-related services typically based on the volume of activity processed on the Payments Platform. In addition, the company generates revenue from consumers on fees charged for foreign currency conversion and instant transfers from their PayPal or Venmo account to their debit card or bank account and from interest and fees from its credit products. Another source of revenue is value-added services, which is a catch-all category that includes partnerships, subscriptions, referral fees, gateway services, and others.

PayPal's Payment Platform is comprised of PayPal, PayPal Credit, Braintree, Venmo, Xoom, iZettle, and Hyperwallet. The Payment Platform is a two-sided network that connects over 350 million merchants and over 30 million consumers' accounts across more than 200 markets.

Source: company

COVID Acceleration

The COVID-19 pandemic has impacted consumer behavior and has accelerated the shift from traditional in-store shopping toward e-commerce and buy online and pick up in-store. As a result, PYPL experienced a significant acceleration of revenue growth in 2020, going from +15% y/y in 2019 to +21% that year.

Source: company

Source: company

The company is growing rapidly because it provides tremendous value to its customers. On the consumer side, PayPal enables consumers to exchange funds more safely with merchants using various funding sources. The company's PayPal, Venmo, and Xoom products also make it safer and simpler for friends and family to transfer funds to each other.

On the merchant side, PayPal offers merchants an end-to-end payments solution that provides authorization and settlement capabilities, as well as instant access to funds. The company also helps merchants connect with their customers, manage risk, and engage in cross-border transactions.

Competitive Advantage

Broadly speaking, the company enjoys two key competitive advantages.

Source: company

First, the company's two-sided network and scale offer a unique end-to-end product experience while allowing PayPal to gain valuable insights into customer behavior. Leveraging big data, analytics, and new technologies such as AI, the company could further improve the attractiveness of its products, which attracts more customers, and the virtuous cycle goes on and on. In addition, the more products and services a customer uses, the stickier they are. As a result of network effects, the company's competitive advantage tends to grow over time.

Source: company

Second, PayPal has one of the world's most recognized and trusted brands, and trust is the lifeblood for fintech companies. Merchants love using PayPal because 54% of customers are more willing to buy when a business accepts PayPal, while 59% of PayPal users have abandoned a transaction because PayPal wasn't at checkout. As a result, merchants face the choice of implementing PayPal or losing potentially significant sales. PayPal's brand is the result of significant investments in marketing and the result of significant investments in security. Customers trust the company to keep their information secure and minimize the risk of fraud.

Growth Opportunities

Source: company

PayPal's total addressable market ("TAM") is massive at around $110 trillion. Over the next five years, management believes the company can grow from around 377 million active accounts to 750 million, driven by new product and service introductions that will allow the company to serve a bigger piece of the TAM.

The company's cadence of introducing new products and services seems to be accelerating. In 2020, the company introduced a record number of products, and management plan to increase that pace in 2021. New products and services that should drive growth today include cryptocurrency, in-store, and BNPL (buy now, pay later).

Source: company

In addition, PayPal plans on aggressively expanding internationally. For example, the company's in 2019 acquisition of GoPay in China gives it ownership of a domestic payments license. The company's partnerships with MercadoLibre (MELI) gives PayPal access to the South American, Central American, and Mexican markets.

Financial

PYPL's revenue grew by a CAGR of 17.9% over the past three fiscal years. Sell-side consensus is forecasting revenues to grow by 20.1% this fiscal year, reaching $25.8 billion, and to grow by 22.5% the following fiscal year, reaching $31.6 billion. One reason for this expected acceleration in revenue growth is the roll-off of the company's eBay business.

PYPL is a solid margin expansion story. Over the past three fiscal years, PYPL's EBIT margin increased by 3.9% points, from 21.2% to 25.1%. Consensus is forecasting EBIT margin to expand by 75 basis points this fiscal year to 25.9% and expand by 68 basis points the following fiscal year to 26.5%.

Over the past three years, PYPL spent 6.1% of its revenue on share-based compensation (SBC). Over the same period, diluted outstanding common shares decreased by 0.7%, suggesting that management used share repurchases to more than offset shareholder dilution.

As a result of the revenue, margin, and share dynamics, EPS grew at a CAGR of 26.9% over the past 3 fiscal years, outpacing its revenue growth. Going forward, consensus is forecasting EPS to increase by 21.6% to $4.72 this fiscal year and increase by 24.7% to $5.88 the following fiscal year.

Return on invested capital is strong at 16.2%.

The company's balance sheet is excellent. With net debt of $3.2 billion, PYPL is 0.4 times levered to its expected current-year EBITDA of $7.7 billion.

Trading & Valuation

PYPL currently trades at around $276 per share, a market value of $324 billion, and an enterprise value of $327 billion. The stock does not pay a dividend compared to a dividend yield of 1.3% for the S&P 500.

PYPL performed well over the past year, returning 6% points more than the S&P 500, or 43.1% in absolute return. Despite the recent pullback, trading momentum remains positive. The stock is trading 10.7% above its 200-day moving average, 11% below its 52-week high of $310.16, and 61% above its 52-week low of $171.63 per share.

Short interest is low at 0.9% and has been declining, suggesting little skepticism.

Using consensus estimates for next fiscal year's results (FY2), PYPL is currently trading at an EV/Sales multiple of 10.4, an EV/EBIT multiple of 39.1, a P/E multiple of 46.9 and an FCF multiple of 43.2.

Relative to the S&P 500, PYPL is trading at an EV/Sales premium of 277.3%, an EV/EBIT premium of 110.7%, a P/E premium of 130.8%, and an FCF premium of 91.8%. PYPL's FY2 PEG ratio is currently 2.0 compared to the S&P 500's PEG ratio of 1.2, a premium of 63.1%.

Risks

Competition is PayPal's biggest risk. The fintech industry is rapidly evolving and increasingly crowded with large tech giants, startups and VC money, and PayPal is viewed as more of an old-school fintech company.

PayPal does not operate its own network, but rather utilizes the ACH network and debit and credit networks operated by others, such as MasterCard (MA) and Visa (V). Thus, the company is at risk of being disintermediated if these companies offer eWallet services.

Tech giants with massive reach, including Apple (AAPL) and Alphabet (GOOG) are going after PayPal. Both Apple Pay and Google Pay have achieved tremendous growth in recent years. By November 2020, Apple Pay was active on 507 million iPhones, significantly more than PayPal's total active users across all platforms. Also in November 2020, Alphabet launched a major redesign of Google Pay to further accelerate growth after reaching 150 million active users.

In P2P, PayPal's Venmo faces fierce competition from Square (SQ) Cash App, which offers similar capabilities but is growing much faster.

In China, a market where PayPal is trying to gain a foothold, the market is dominated by Tencent (OTCPK:TCEHY) WeChat and AliPay. In addition, Chinese regulator will unlikely allow non-Chinese financial institutions to gain a dominant market position in the country.

Takeaway

I believe the risk-reward of PayPal is well balanced, leaving me neutral on the stock. The attractiveness of the company's business and end market is unquestionable, yet valuation remains high on difficult to achieve expectations. In final analysis, I am sitting on the sidelines until a more attractive entry point emerges.

I look forward to discussing PYPL with you in the comment section below. If you found this article helpful, please share the article. Thank you for reading!

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.