PayPal: Shifting Gears On A Busy Freeway

Summary

• The total addressable market in which PayPal operates can be estimated at around $110 trillion and the company enjoys only 1% market share.
• The company has been efficiently allocating capital manifesting its spawning DNA. Is the business good enough to own a part of?
• In order to remain ahead of the competition, PayPal must differentiate its products and services from those offered by the competitors.
• Is PayPal poised to be an investment delivering mediocre results for a longer period of time or is it just a temporary stumble?

Spencer Platt/Getty Images News

On February 19, 2019, the CEO of PayPal Holdings (NASDAQ:PYPL) - Dan Schulman - told CNBC that the digital payments industry is likely to grow to a $100 trillion market. Two years later, during the investor's day, he reiterated this thesis by saying that the total addressable market (TAM) in which PayPal operates can be estimated at around $110 trillion and the company enjoys only 1% market share. However, several days after releasing Q3 FY2021 earnings, the stock hits a 52-week low marking its long-lasting downtrend. Is PayPal poised to be an investment delivering mediocre results for a longer period of time or is it just a temporary stumble?

The business

A common misconception when investing long-term is focusing on financials and metrics before even understanding what the business does. Going through the balance sheet, financial reports, and hour-long conference calls just to realize that although the numbers a company delivers are decent, the business is terrible, is very time inefficient. In order to find great businesses this way could be a discouraging experience. We'll approach it by looking at the business first. There is no better place to get acquainted with the business model than the company's annual report. PayPal summarizes its business model in its recent 10-K in the following way:

PayPal Holdings, Inc. was incorporated in Delaware in January 2015 and is a leading technology platform and digital payments company that enables digital and mobile payments on behalf of merchants and consumers worldwide. PayPal is committed to democratizing financial services to improve the financial health of individuals and to increase economic opportunity for entrepreneurs and businesses of all sizes around the world. Our goal is to enable our merchants and consumers to manage and move their money anywhere in the world, anytime, on any platform, and using any device when sending payments or getting paid. We also facilitate person-to-person (“P2P”) payments through our PayPal, Venmo, and Xoom products and services and simplify and personalize shopping experiences for our consumers through our Honey Platform. Our combined payment solutions, including our core PayPal, PayPal Credit, Braintree, Venmo, Xoom, iZettle, and Hyperwallet products and services, comprise our proprietary Payments Platform.

There are two things that might encourage a potential investor to further analyze the company - the simplicity of the business model and PayPal's well-known brands, even for somebody with little knowledge of the fintech industry. An additional advantage that is not addressed directly, is the international scale of the business. That alone gives the enterprise countless possibilities and an enormous total addressable market.

Financial Health

PayPal went public around six years ago what provides us with enough data to look at and assess the progress company has made. When looking at high-growing tech companies, revenue is a first reference point. The last thing we want to see is stagnant or declining sales.

Source: PayPal's Investor Day - Presentation

What we see in the diagrams above is solid growth in all important aspects. The company's revenue has doubled, total payment volume (TPV) has tripled, free cash flow has almost tripled and the non-GAAP operating margin has grown by 400 basis points in five years as of the end of FY 2020 (PayPal's FY 2021 results haven't been released yet). Besides that, the company returned approximately $8.5 billion to shareholders through share repurchases what is usually a good sign. What makes the business even more compelling is its capital allocation strategy. As we can read in the latest financial report:

Brands - we have built and strengthened well-recognized and trusted brands, including PayPal, Braintree, Venmo, Xoom, Hyperwallet, iZettle, and Honey. Our marketing efforts across multiple demographic groups play an important role in building brand visibility, usage, and overall preference among customers.

The company has a long history of successful acquisitions which have had a compounding effect on PayPal.

Source: Author's graphic

• In September 2013, PayPal acquired Braintree, a payment processor aimed at high-volume e-commerce businesses, for $800 million. As a part of the deal, a Braintree subsidiary, Venmo, was bought for $26.2 million.
• In July 2015, PayPal carried out another significant acquisition of Xoom Corporation for $890 million. Xoom provided its users with support of digital transactions from the US to 70 other countries.
• In May 2018, the company bought iZettle, a mobile payments company offering a wide range of financial products to small businesses, for $2.2 billion.
• The next month, PayPal led another acquisition of Hyperwallet for $400 million. Hyperwallet is aimed at growing organizations providing them with transparent ways to send funds almost anywhere in the world in many different currencies.
• In November 2019 took place the most recent PayPal's acquisition of Honey for $4 billion. Honey searches for deals and discounts that can be applied when shopping online on a mobile device or on a desktop.

Now, when we look at the highlights from the most recent quarter related to the acquired brands, it becomes clear how well these acquisitions played out for the company. PayPal can be referred to as a "spawner" which was described in detail in my recent article. As of Q3 FY 2021:

• 13.3 million new active accounts, with strength across PayPal, Venmo, and Honey.
• P2P payment volume, which includes PayPal, Venmo, and Xoom, increased by 24% to $92B and represented 30% of total payment volume (TPV). Venmo itself experienced volume growth of 36% to $60B.
• The number of transactions per active account grew 10% y/y driven by transaction growth from Braintree, Venmo, and PayPal core.
• Transaction revenue grew 10% on a y/y basis driven again by Braintree and Venmo.
• Big news broke out on November 9, when it became official that Amazon (AMZN) would introduce Venmo as a payment method on Amazon.com starting in 2022.

A quick look at PayPal's financial performance can give us a better overview of the company's financial health.

Source: Author's diagram - based on PayPal financial data (Seeking Alpha)

PayPal has shown constant growth in revenue over almost a decade combined with strong margins across the board.

Source: Author's diagram - based on PayPal financial data (Seeking Alpha)

Similarly, the company's EPS growth reflects business strength since its IPO. A significant increase in earnings can be seen in 2020 due to the pandemic and stay-at-home environment.

Source: Author's diagram - based on PayPal financial data (Seeking Alpha)

Widely underestimated metric, retained earnings, demonstrates exponential growth over the last five years since the company went public. Retained capital is used to maintain the operations or it's reinvested back in the business. PayPal has proven that it's capable of efficiently using retained earnings by investing them in business ventures that have been generating more earnings. That makes PayPal a great compounder.

Source: Author's diagram - based on PayPal financial data (Seeking Alpha)

Many stick to the phrase "cash is king" when choosing an investment and it's totally understandable. However, in the low-interest-rate environment and high inflation, this statement should be taken with cautiousness. The diagram above shows PayPal's cash position in relation to the company's debt. In 2019 debt started piling up before almost doubling in the pandemic year. At the same time, cash was growing and offsetting the debt growth. Currently, PayPal's Cash/Debt ratio equals 1,37 which means that the whole debt could be covered with the available cash and there will be still over $3.0 billion remaining capital on the balance sheet.

PayPal's numbers demonstrate a healthy financial structure and solid fundamentals. The numbers suggest that the business is firing on all cylinders. With that in mind, let's look at the valuation.

Valuation

So far we've got a fast-growing, asset-light company with global exposure, as well as a great compounder returning cash to the shareholders through stock repurchases, at the same time efficiently allocating capital manifesting its spawning DNA. It sounds like a good business to own a part of. Let's assess how the business will most likely evolve and if the current price reflects the outlook.

Source: Statista (Update October 2021) - Digital Payments

Digital payments' compound average growth rate (CAGR) is estimated to be 14.6% by 2026. All the following numbers derive from this estimate. For the years 2026 - 2031, the growth was kept at the same rate. Although it might be logical to assume the growth on lower levels, a $110 trillion total addressable market should be somewhat considered. A 14.6% CAGR result in a $24.25 trillion market in 2031, which is still quite far from what PayPal's management counts on.

The following estimates are as follows:

• PayPal expects to increase its market share to 24% by 2025
• Total Take Rate which is expressed as Revenue/TPV was set to 2.0%. It has been falling in recent quarters and currently equals 1.99% as of Q3 FY 2021.
• Total revenue corresponds with what's company's projects, which is over $50 billion in 2025.
• Net margins are estimated to increase by 10 basis points a year.
• Shares outstanding will decrease accordingly to the annual 10% decrease of the remaining value of shares to be repurchased under the repurchase program authorized in July 2018 by the management.
• A P/E ratio is a resulting number from the division of the current price, which is as of writing the article $186.22 per share, and the EPS.
• The P/S ratio is an average from the last five years and the fair value is calculated as P/S * Revenue / Shares Outstanding for the corresponding fiscal year.

With all the estimates included in the calculation, we arrive at a fair value of $186.95 per share. The table also shows that PayPal reaches a $1.0 trillion market cap only in 2031, assuming 16% earnings growth from 2026, which might be considered an overly bullish outlook. However, when we look at how PayPal has expanded over the years and we project this sort of expansion in the future, the strong growth in the mid-teens isn't unrealistic.

Source: PayPal's Investor Day - Presentation

PayPal used to be solely a payment processor. Today, it's much more than that and the expansion continues. Among advancements that the company is planning to introduce are financial services like high-yield savings accounts, direct deposits, and investment capabilities. These are all bullish signs that investors assign to PayPal. Moreover, we deal with a shift in a customers' behavior. The pandemic has influenced it and resulted in a broad willingness of touchless payments. Customers don't want to handle cash anymore. Similarly, they'd rather not touch a keypad on a point of sale device. PayPal catches this trend in an excellent way with the new features it's launching such as QR-code payments. Besides that, the company is introducing buy now, pay later with its volume surging almost 400% on the past Black Friday.

Risks

With all that mentioned, one could think that the stock price is climbing higher and higher and it's being bought hand over fist. What actually is happening is the complete opposite. The stock price has been dropping down for months. This week PayPal hit its 52-week-low. But there were a few events that caused the sell-off along the way including the rumors about acquiring Pinterest (PINS), Q3 earnings considered weak by Wall Street, a broader outflow of funds from the high-growth stocks, and growing competition in the fintech space. It would be ignorant to state that PayPal is not exposed to any risks. Risks to the business are covered on 14 pages of the company's 10K. However, the most visible risk, that PayPal faces is the competition. Fintech space has grown in recent years with the combined valuation of the 11 biggest still-private U.S. fintechs of $214.8 billion, not to mention the publicly traded ones such as Visa (V), Mastercard (MA), Ant Financial, Intuit (INTU), Block (SQ) or Coinbase (COIN). In order to remain ahead of the competition, PayPal must differentiate its products and services from those offered by the competitors, and constantly drive value to its customers. It won't be an easy task, but the company has demonstrated its strength on many different fronts what has resulted in a strong performance.

Conclusion

PayPal is a great business and it's selling for a fair price. As Charlie Munger - one of the fathers of value investing once said:

A great business at a fair price is superior to a fair business at a great price.

It seems that PayPal is experiencing an unjustified sell-off and it might be a great time to buy while it's hitting its 52-week-lows. With the outlook and the possibilities ahead, a great management team, and a stellar balance sheet, PayPal seems to be a rare investment opportunity in the still highly-valued market.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of PYPL either through stock ownership, options, or other derivatives. 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.

Comments

[Alpwolf]

When the Tide goes down…etc.etc
HobbitsCwm

[AnalogNomad]

Price when this article was published: $184 a share. Present price, $84 a share. How to become a millionaire? Invest about 2.5 million in this recommendation, wait a few months, and... bam! You've got a million.

Never... ever... underestimate a company's ability to become it's own worst enemy, once it begins to take it's users, and position in the market for granted.

[Piotr Kasprzyk]

@AnalogNomad By no means was the article a recommendation. Initializing a position at $184 doesn't mean you are down 50% on the stock. Investing in individual stocks by retail investors is a part of personal finance which is personal. If you disagree with the thesis, don't like the risk, or don't have a process, please don't rely on anybody's opinion. Do your own due diligence and invest accordingly.

[roblasorsa]

Wow! When you “experts” are wrong, you need to be held accountable.

With all due respect how can some of you live with yourselves? How much money did you just lose for people that followed this advice on PYPL?

This is the same as going with the advice on tv talking heads.
I urge people not to listen! If you do, you will lose lots of money in the long run.

[Piotr Kasprzyk]

@roblasorsa Thank you for your comment. I can be held accountable and since the publication, I increased my stake at PayPal. I welcomed the drop since the business just got cheaper. My thesis hasn't changed. PayPal hasn't suddenly become a lousy company just because it disappointed Wall Street.
Remember that you only lose money in the stock market when you sell. If you know why you invested in the stock and the thesis didn't change, you keep buying the stock when the price drops.
Besides that, the article isn't supposed to be investment advice and I didn't encourage you to go and buy the stock. The article expresses my point of view and I hope it gives a better picture of PayPal's valuation. If I'm right or wrong, we'll see in 10 years since this is the time horizon I presented. Just because the stock price moved up or down after two months doesn't say anything.
Please, do your due diligence before making investment decisions. Seeking Alpha is a great source of information, but in the end, the investor takes responsibility for the investment decisions he makes.

[roblasorsa]

@Piotr Kasprzyk Well, I never purchased the stock - but It m sure a lot of people did. The stock is down almost 50%, which means to get back to “even” PYPL has to DOUBLE in price. To get up to $400 - what many experts were calling for - the stock has to go up over 150% from its current levels. These are the people that I want to see “called out.”

[Looking_Forward]

@Piotr Kasprzyk Bought a £1000 stake at around $200 and of course the company tanked. Bought far more today at around $104 and I only wish I had more money to buy some more. Venmo being used as a payment method on Amazon is reason alone to own this company.

[william66]

By launching Vermo credit card, Paypall/Venmo is becoming a huge digital bank. Venmo's 450milion uresrs will apply more and more vermo credit card. And it will be one of key to monitize the huge verno ecosystem that Paypall has just begin. Here are just some of the retailers that accept Venmo credit and debit cards (Visa and Master Card) as payment:

Adidas
Amazon
Coach
Dick’s Sporting Goods
Home Depot
Kohl’s
Macy’s
Nike
Nordstrom
Samsung
The North Face
Under Armour
Walmart
Wayfair

Mr. Kasprzyk, how do you think abou my point?

[Piotr Kasprzyk]

@william66 Thank you for the comment. I agree and I believe the market is overreacting by sending the stock 25% down.

[sanberdoo]

In the fact of increasing competition, it will take some doing for PYPL to double its market cap.

How 'bout investing in one of the newer, smaller fintechs that analysts believe can compete effectively with PYPL and thus with a little effort might be able to double its market value within a relatively short time-frame.

Perhaps some of the SA savants can offer suggestion(s) in this regard. We live in hope.

[canyon]

@sanberdoo
You comment about buying the smaller ones ignores the advantage (someday that becomes a moat) that is scale. As PYPL (like SQ) becomes an eco-system play, scale really, really matters.

[John D. Edwards CFA]

Thanks for the article. Can you go into more detail on how you determined fair value for PYPL shares? Thanks!

[Piotr Kasprzyk]

@John D. Edwards CFA Thank you for the comment. What exactly would you like me to explain?

[John D. Edwards CFA]

@Piotr Kasprzyk in the article it says you determined the value of PYPL shares as $186 but unless I just missed it, there was no explanation of how you arrived at that value. So I was hoping you could explain how you arrived at that number.

[Piotr Kasprzyk]

@John D. Edwards CFA "The P/S ratio is an average from the last five years and the fair value is calculated as P/S * Revenue / Shares Outstanding for the corresponding fiscal year." All the numbers are summed up in the table.

[Respect the Game]

A good article, a template for how to evaluate a stock.

Thx

Hugh

[drbob512]

Good article on PYPL, thx! How about writing on SQ & SOFI next? Fintechs will storm back with a vengeance, imho.

[Murad Shawar]

@drbob512 I own V/MA as well as PAYPAL and SQ and SOFI these are the fintech of the future

[Likrat ha-Tiferet]

Large part of PYPL's earnings in recent years has been due to reported appreciation of their equity investments; looking at most recent 9 months earnings report, we will probably not see that this year; and judging by the dramatic sell off in all payment processor stocks, we might actually see a write down. it is quite likely that PYPL will record a 10% earnings per share drop this year.

in which case you are probably paying 44x earnings for earnings that will drop. usually, when this happens in momentum stocks, they cave

seekingalpha.com/...

on a more realistic note, this company has been growing its normalized earnings in line with sales, about 19% per year. why would you pay 60x for the normalized earnings?

[dgi123]

@Likrat ha-Tiferet Interesting points. With this mentality, does Visa's PE (FWD) of 28 seem like a better buy to you? It's well below its 5 year average

[Likrat ha-Tiferet]

@dgi123

i have yet to look at visa's accounts, but i already see a suggestion of a similar problem there. Visa's EBIDTA has only grown about 10% per year over the last five years, but their reported per share earnings have grown 20%. A head scratcher, yes? Only about 1.7% of that excess growth seems to be accounted for by stock buybacks, meaning that there is some weird unexplained 8% profit growth per year phenomenon going on there, too. my guess is that those are also portfolio gains, though perhaps not on equity holdings but on their "float" (they have a huge cash pile and that probably sits in US treasuries and those have done really well over the last several years but will either do nothing or actually decline going forward). since SA has refused to take any interest in my article on PYPL's profit mystery (the editor helpfully wrote that "we see no value in your work"), i will probably not bother delving into V's earnings on this platform. i do not own any of these stocks. i think they are set up for a huge splat

[Piotr Kasprzyk]

@dgi123 thank you for your comment. Visa is still a bit overvalued in my opinion. I'm not convinced that Visa will keep current growth rate for the next 5-10 years.

[i27]

Nice article and thanks for the long-term valuation/ growth model. Re-entered into a position under $200 recently when I thought that its correction seemed done and I appear to be averaging around your fair value. Took a minute to compare your model to the JPM 2023 model: Yours is only slightly more positive on EPS and therefore expected P/E. JPM’s current TP is $272 for Dec ‘22 (recently reduced their TP from $318 on lower estimates). It still looks like a good long-term investment if PYPL can deliver on expected CAGR.

[Piotr Kasprzyk]

@i27 Thank you for your comment. I appreciate it. I'm glad you liked the article and I hope you'll find my future contributions valuable as well.

[johnwilkie18]

Venmo is growing, as of this year most of my tenants pay rent thru Venmo. I like it as I can usually transfer the money to my account faster than getting a check. As well our kids activities and fundraisers are taking Venmo payments. This caught my attention so I started researching PayPal further and like what I see. Started a small position on Friday that I plan to average into.

[GARPdude]

@johnwilkie18 How is PayPal making money from Venmo? It’s free to pay friends and family.

[johnwilkie18]

@GARPdude Did Facebook make money at first? Once you have the users than you can monetize it further. It’s only one slice of the PayPal pie, it’s growth caught my attention and I did further research.

[canyon]

@GARPdude
How does Facebook make money, it's free to use. But...

Venmo is more than Peer-to-peer transfer, that's how. Do some research.

[MC22]

Thanks Piotr, Well written report. Also, nice to read, as I bought PYPL on Friday. And will continue to average down if it goes lower.

[Piotr Kasprzyk]

@MC22 I'm happy you liked the article. I hope it was helpful to you.

[tony1957]

I like Pypl a lot
But market doesn’t look good so I would wait to purchase
$160 my target

[quotation]

@tony1957 it's already 40% down and definitely not a Alibaba on the freefall.

You might as well not yet time the market and miss it's run back past $200

[nickfrancois]

Fully agree with the piece.

The 40 percent selloff in PYPL is a great chance to buy a top quality stock at a fair price. And accumulate a position.

The past quarter had plenty of noise, some negatives, such as finalizing the divorce with eBay and some positives such as Venmo’s deal with Amazon.

But beneath the noise, PYPL is a steady growing business with revenues growing at 20 percent per year on the back of the global move to digital finance and PYPL is generating a regular stream of cash flow.

I am buying the dip.

[Philip Russell]

Excellent article-SQ and PYPL will thrive in the years ahead!

[Piotr Kasprzyk]

@Philip Russell Thank you! I'm glad you liked it.

[bil1026]

Did anyone else notice how Honey became virtually useless about a day after $PYPL overpaid for them?
(Long PYPL but would love to get out @ breakeven).

[JB170]

@bil1026 how is honey useless? I still use it often,and now it's integrated into Safari on iOS as well.plus it seems like their backend has been transferred into the main PayPal app, where instead of honey gold they're now applying Cashback to you paylaly

[Alpwolf]

@bil1026
Classic example of some see and some do not!
Have you seen the change in the app ?

[DividendGangsta]

Vert well written article. I have been buying in stages on the way down. Doubled my position yesterday at $180.25 and added more to my son's Roth account (he will thank me later in life). All of which I see as an early Christmas gift from Mr. Market.

[Piotr Kasprzyk]

@DividendGangsta Thank you for the comment! I'm happy you liked the article.

[Ffeldt]

You hit the nail on the head!

[Radcon3]

The key to picking the winner in the competitive fintech space is to watch the young crowd and follow their money. Like banks, many stick with the same institution once they start, as long as the company keeps up with the service and technology.
Many years ago a bunch of my sons college friends were sitting in restaurant, when the check came to settle up, instead of reaching for their wallets, they settled up with Venmo on their cell phones. I bought PayPal the next week.
Now much older, I recently asked my son if he and his friends still used PayPal/ Venmo. “Yup, more then ever”

[Marek Kriz]

Very well written. I was thinking about writing some facts about $PYPL but right now, I'm redirecting everyone to your article.

[Piotr Kasprzyk]

@Marek Kriz Thank you. I highly appreciate it :)