PayPal: Lessons From American Express Losing Costco

Summary

• In investing, the more things change, the more they stay the same.
• This article shares the lessons I learned from American Express when it lost the Costco account, and how these lessons apply to the current PayPal situation.
• It will take time for its stock price to recover from the loss of a significant account (it took American Express about 3 years).
• But I see the recovery as inevitable given its stable profitability and the scale (just like in American Express’ case).
• Looking for more investing ideas like this one? Get them exclusively at Envision Early Retirement. Learn More »

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Thesis

In investing, the more things change, the more they stay the same. And the recent development surrounding PayPal Holdings, Inc. (NASDAQ:PYPL) reminds me of the episode when American Express Company (AXP) lost its Costco account during 2014 and 2015. For those who are not familiar with the American Express episode, the following chart shows the key timelines. This article shares my thoughts on the similarities between these two situations. You will see there are many similarities as the remainder of this article will elaborate on later.

First, both stocks were trading at a substantial premium prior to the incidents. In other words, they were in a bubble regime to start with anyway. So, a sizable correction was inevitable anyway even if there was no loss of account. PYPL was in a bubble regime at a PE of ~82x when its price peaked above $300. And AXP was traded at a peak PE of 17.5x during 2014~2015 before the divorce with Costco, also at a substantial premium. To put things under perspective, its average valuation during those years is about 12.5x.

Second, the market reaction was similar and quite dramatic. PYPL has lost about 70% of its stock price since its peaked last year at around $300 after it announced the loss of the eBay relationship. In American Express' case, it lost almost half of its stock price after the Costco divorce was announced.

So, the first two key lessons are as old as investing itself. Market swings between extreme fear and greed and business fundamentals are often ignored at either extreme. Currently, PYPL is in the extreme fear extreme. Looking forward, I see more similarities to unfold:

• First, it will take some time to recover from a loss of a significant account. In American Express' case, it took about 3 years for its stock price to recover.
• Second, both stocks were/are maintaining stable profitability after losing a key account. So, losing a key account is a blow, but business fundamentals remain intact.
• Finally, both stocks had/have the critical scale. Neither was/is the scale leader, but both had/have the critical scale to recover.

And we will elaborate on these similarities immediately below.

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Lesson 1: it takes time to recover

During 2014~2-15, American Express and Costco ended their 16-year marriage. The divorce came as surprise, and AXP's stock price nosed dived by about 50%, as you can see from the above chart.

The loss of the Costco Account was indeed a major blow for AXP at that time, as you can see from the following chart below. For one out of every 10 AXP cards in circulation at that time, one of them is a co-branded card with Costco. To make the picture even darker, consider that about 23% of AXP cards are co-brands overall at that time. So the Costco account represented about half of the co-branded cards in circulation at that time. It took AXP about 3 years for its stock price to recover.

Nilson Report

PYPL faces a similar situation now. The loss of the eBay account is also a substantial blow that will take some time to recover. When PYPL reported its Q2-2021 earrings last July, its CFO John Rainey remarked (the emphases were added by me):

So last year in the second quarter, we grew revenue 22%, and in that number, there was a benefit of 5 percentage points of growth from eBay. So 22% revenue growth for 5 percentage points of benefit from eBay. This year in the second quarter, we grew revenue 19% and that number included 800 or 8 percentage points of headwind related to eBay's business.

All told, the loss of the eBay account caused about $0.27 per share earnings impact at that time, eBay Marketplaces revenue declined 51% at spot, and eBay Marketplaces expected to be a ~7 point drag to revenue growth in the next a few quarters.

As you can see from its most recent earnings release reported on April 27, 2022, the negative impacts of the loss of the eBay account are still unfolding in many key metrics. TPV growth ex-eBay is reported at 17% spot. Earnings were reported at $0.88 non-GAAP EPS, a $0.34 decline compared to $1.22 in Q1-21 before it lost the eBay account. Out of this $0.34 decline, about ~$0.20 headwind was related to lower transaction margin dollars from eBay.

PYPL Q1-22 Investor Update

Lesson 2: stable profitability is key

However, both stocks were/are maintaining stable profitability after losing a key account as you can see from the following chart. This chart compares the profitability of both businesses. Note that because of the different nature of their business models, the profitability for AXP is measured in terms of ROE (return on equity). And for PYPL, it is measured in terms of ROCE (return on capital employed). In this analysis, I considered the following items as capital actually employed: 1) Working capital, including payables, receivables, inventory; 2) Gross Property, Plant, and Equipment; and 3) research and development expenses as also capitalized.

As seen, the profitability of AXP stayed very stable at about 29% ROE (which is also its long-term average) before, during, and after the loss of the Costco account. And in PYPL's case, the picture is very similar. Its average ROCE has also been stable at around 53.5% (which is also its long-term average) and has not been impacted by the loss of the eBay account.

So in both cases, losing a key account was a blow, but fundamental profitability remained intact.

Author

Lesson 3: critical scale is critical

Neither stock was/is the scale leader, but both had/have the critical scale to recover. In the Costco episode, American Express was facing pressures on many fronts at that time. Overall, it was among the top 4 players on the field. It was definitely behind Visa (V) and Mastercard (MA) and was fighting for the 3rd spot with Discovery. In terms of the number of total cards in circulation in the U.S., it was behind Visa, Master Card, and also Discovery. In terms of total U.S. purchases, it was behind the Visa, Master Card, but above Discovery. Finally, in terms of U.S. acceptance locations, it was behind all three.

PYPL is in a similar situation. PYPL is in competition with other, larger payment companies. With a total payment volume of $1.25 trillion in 2021, PayPal is still substantially smaller than Visa (which has a total payment volume of around $3 trillion per quarter) or Mastercard. However, it has reached a critical scale and is a leader among several sub-segments. It is ranked third among the most popular mobile payment methods (lumping all credit cards as one method and debit cards as another) accepted by online merchants worldwide. As such, it can leverage operational efficiency, reduce cost, and boost margins. Worldwide, it has 392 million verified users and merchants as of 2021, and it processes a mindboggling 41 million transactions every day on average. Its Venmo partnership with Amazon will further boost its scale in the near term.

PYPL Q1-22 Investor Update

Valuation

In terms of valuation, PYPL's current valuation is compressed both in absolute and relative terms. There is about $8.6 of cash behind each PYPL share, about 8.6% of the share price. Therefore, in absolute terms, adjusted for the cash position, PYPL's owner's PE is only about 17x.

Looking forward,

• I see PYPL's total return in the long term in the double-digit range (projected to be ~12%). The total returns are a balanced combination of current earning yield (about 5.2%) and organic growth rates (about 6.5%) assuming a 10% reinvestment rate.
• Finally, you can see the similarity with AXP continues in terms of their valuation and return potential. AXP is currently valued a bit lower than PYPL, and hence offers a slightly higher earnings yield, but both are excellent businesses with double-digit long-term return potentials.

Author

Conclusions and other risks

The recent development surrounding PYPL reminds me of the episode when AXP lost its Costco account. Studying history helps us to better navigate the future. Market swings between extreme fear and greed. And business fundamentals are often ignored at either extreme. PYPL stock was in the greed extreme when it was priced at a PE of ~82x. It was due for a sizable correction whether it lost the eBay account or not. Now, I see it in the fear extreme, just like when AXP lost almost half of its stock price after the Costco divorce was announced.

Looking forward, it will take some time for PYPL and its stock price to recover from a loss of significant account. In the American Express case, it took about 3 years. But then I see the recovery inevitable given the stable profitability and the scale of PYPL (just like AXP).

Finally, a few words about a few other risks facing PYPL:

• The competition in mobile payment is heating up. Going forward, Visa or Master Card may not be PYPL's major competitors anymore. Apple Pay and Google Pay might be the real threat.
• The ongoing Russian/Ukraine situation is also another risk. PYPL reported ~$0.03 EPS drag from the suspension of transactional services in Russia in the most recent quarter. And it is uncertain when the Russian/Ukraine war would end and how much impact it creates for the global markets and PYPL.

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.