Paypal Investment Thesis

Published on 03/13/21 | Saurav Sen | 3,466 Words

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  • This is our thesis as posted on February 5, 2020 - now in magazine format.
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Thesis Summary

As of February 5, 2020: Paypal started the cardless movement and is now competing with many “newbees”. But it remains a dominant company that’s aiming to be a “network-of-networks”, which could significantly increase revenue as cash flow in the next 2 years.

Competitive Advantage - The Castle: 

  • Core Competency: Technology to make digital payments cardless, frictionless.
  • Product Differentiation? Need more. Aiming to become the “network of networks”.
  • Revenue Growth? Solid. 20%-ish a year, due to growth in number of Active Users.

Durability of Competitive Advantage - The Moat: 

  • Competition/Threats? Card Networks, Banks, Neobanks, Big Tech firms.
  • Economic Moat? Inherent nature of product discourages switching; plus Network Effects.

Management Quality - The Generals: 

  • Strategy? Good. Thinking in terms of ecosystem to widen Moat. But too acquisitive.
  • Return on Equity? Mid-teens. Need to find a way to improve margins.
  • Sustainable Free Cash Flow? ******Redacted.

Competitive Advantage: The Castle

Core Competency: Technology to make digital payments cardless, frictionless.

Paypal started as a peer-to-peer payments tool – hence the name. Over time it has evolved into an industry-standard alternative to the traditional, antiquated payments options. Obviously, Paypal is a cash alternative. But so are credit cards. However, you couldn’t pay your buddies with a credit card until very recently. And – this is a “first-world” problem – cards themselves seem antiquated, especially in the last 2-3 years.

Smartphones will be the new wallet. It’s already getting there. The future is cashless, cardless, contactless, and hassle-less – this is what we discussed in Investing in Cashlessness – Part 1 and Part 2. This was always in Paypal’s DNA since its formation – to take out inefficiencies of the traditional banking system. Now, Neobanks and big-tech firms like Apple are stepping into traditional banking territory. Paypal unleashed this world, and it’s now trying to compete with all the “newbees”.

The proliferation of smartphones was a boon for Paypal. Its core offering is “making payments between any two parties as frictionless as possible”. Smartphone, Apps, and all the gizmo trappings of the latest phones – like face recognition – play right into this phenomenon.

Paypal’s goal is clear: to be THE go-to App for any kind of payments, to anyone. In our worldviews on Cashlessness, we had pointed out that there are essentially 4 types of money transactions:

  1. B2B: Business to Business
  2. B2C: Business to Consumer
  3. C2B: Consumer to Business
  4. C2C: Consumer to Consumer – also known as P2P or Peer-to-Peer

Innovation – such as Paypal’s original web-based payment system – started at the bottom of this list: P2P. The idea was to make payments frictionless. Even businesses like that. So, the new world of cashless, cardless, contactless, frictionless is slowly but surely seeping into the B2B arena.

Paypal’s core value-add is twofold:

  1. Ease-of-use,
  2. And related to #1: Universal Acceptance

Ease-of-use depends on Paypal’s technology stack – the nuts-and-bolts that make Paypal a useful App. This involves things like user-interface and user-experience, and also connecting the App to all the traditional forms of payment such as bank accounts and credit cards. For Paypal’s original goal – P2P payments – this was good enough.

But as Paypal’s ambitions have grown – to go from P2P to B2B – Universal Acceptance has become a challenge. As Paypal sets its sights on B2C, C2B and B2B, it needs to find ways to be accepted everywhere – to become a network or a platform. This will require work.

Product Differentiation? Need more. Aiming to become the “network of networks”.

Paypal is trying to be the ultimate digital wallet. In other words, it’s trying to be the platform that connects with all methods of payment – a network of networks, if you will. Paypal is positioning itself as the one neutral party that allows you to make a payment to anyone regardless of:

  1. Their network association: Visa, Mastercard, Amex, Union etc.
  2. Whether they are a consumer (peer) or a business
  3. Country or currency
  4. Operating System: iOS or Android (Apple Pay or Google Pay)

So, if I use an Amex card (let’s say because I like its rewards program), I should be able to pay a merchant who uses Visa via my Paypal App. I have actually done this, so I know it works. The key detail here is that the merchant accepted Paypal. This is Paypal’s big challenge as it travels from P2P up to B2B. How do they incentivize merchants to sign up?

It’s a chicken-or-the-egg situation. Businesses are interested in Paypal if consumers or other businesses use it. Consumers will use Paypal if businesses accept it. Visa and Mastercard have, well, mastered this. They’ve built up a card network over decades. And now they’re leveraging that impregnable fort to gain from the ongoing trend in Cashlessness AND Cardlessness. They’ve become natural allies to this movement, which explains their sky-high valuations. Paypal started the cardlessness trend, and it’s still looking for a distinct place in this movement.

Paypal is building its network largely through acquisitions. Venmo (via Braintree) was its big acquisition in 2013, which was a good move. Its most recent acquisition is a company called Honey, which continuously searches for discounts and coupons for online shoppers and informs them even on checkout. Along the way, Paypal bought iZettle – a point-of-sale payments hardware and software package. It also bought Hyperwallet, which allows businesses to make payouts such as rebates and insurance claims to customers.

Paypal is buying every good product it can find to incentivize businesses or customers. Right now, Paypal is unique in the spectrum of payments products it offers. It has a leading P2P payments App – Paypal and Venmo. It has an online payments tech stack – Braintree. It has point-of-sale devices aimed at small-to-medium businesses – iZettle. It has technology for payouts – Hyperwallet. And it recently bought a coupons App called Honey. Paypal made many more acquisitions along the way. Each acquisition – theoretically – makes Paypal more appealing.

Paypal has all the technology and Apps it needs to allow business and consumers to make almost any type of payment to any type of recipient – business or consumer – regardless of their card network, country or system. It’s not there 100%, but it’s getting there.

Revenue Growth? Solid. 20%-ish a year, due to growth in number of Active Users.

Paypal’s volume growth has been solid. In fact, almost all the growth has come from growth in number of Monthly Active Users:

The main caveat in the numbers above is that some of that growth is inorganic – via acquisitions. Normally, I frown upon that type of strategy. But as I discussed in the previous section, Paypal needs to do this to become the network-of-networks. Fortunately, while it goes on these acquisition binges, it still generates more than $3 billion in Free Cash Flow.

While Volume has grown, Pricing has been stable. If you look at Paypal’s Revenue as a % of Total Payments Volume over the last few quarters, it has barely moved:

The key insight from these historical trends is this: We can make a case for continued volume growth. We, at The Buylyst, love tailwind. And on the volume front, we think there will be significant tailwind. But on the Pricing front, the best we can hope for is stability. And that’s because of significant competition from all fronts. Can Paypal protect itself? Cue in the next section.

Durability of Competitive Advantage: The Moat

Competition? Card Networks, Banks, Neobanks, Big Tech firms.

Everyone wants to make payments easier. The payments industry was dormant for decades when the credit card was the latest big invention for a long time. Then suddenly, about 5-7 years ago, everyone – card networks, banks, neobanks, big tech firms and even governments – wanted to update the payments landscape. 2 things kickstarted this sudden rush:

  1. Smarphones
  2. Paypal

Paypal is working hard to carve out its own position in this busy world of digital payments by being a “one-stop-shop” for all kinds of payments. The flip side is that all the parties mentioned above are trying to be as universal as possible and as frictionless as possible.

Visa recently launched a P2P technology to pay people within their network. It’s called Visa Direct. This attacks Paypal’s core app and its star product Venmo. Mastercard has a similar product.

Apple Pay and Google Pay obviously act as digital wallets. People can send payments to other users within the same App.

Governments around the world have built up technology stacks to allow citizens to transact digitally – from bank account to bank account – using their smartphone. Australia and India are good examples.

All of the above are formidable threats. But again, Paypal’s value proposition is this: No matter what card network you use, what operating system you use, or what country you live in, you can pay anyone, anywhere, anytime.

No one else is really aspiring to be that network-of-networks.

Economic Moat? Inherent nature of product discourages switching; plus Network Effects.

The thing about payments apps is that if it ain’t broke, no point changing it. Bills get attached to it. Regular merchants or customers get attached to it. Even if smartphones are replaced, all that information stays intact. Switching costs are high mostly because of the inconvenience. If an App like Paypal can guarantee me that I can pay anyone, anywhere, anytime, then why should I change it?

I would change it if Paypal charges too much in transaction costs. This is anecdotal, but it’s true: A European friend of mine tried to pay me using Paypal while I was in Europe. Paypal apparently quoted a fee of $15 for the transaction. That’s lower than what traditional banks charge but it’s still hefty. Things like that would make people switch if it hurts them regularly. But that’s a controllable factor for Paypal. I have trouble imagining that fees on cross-border payments is a big chunk of their revenue. And they have a product specifically for low-cost cross-border P2P payments: Xoom. This is also anecdotal but true: I have used Xoom on multiple occasions and I’m satisfied with it. The cool thing is that when I downloaded the Xoom App, it auto-filled all my information from my Paypal account. I was ready to send/receive money in a few minutes.

The last point sounds a bit academic, but I’ll mention it anyway: Network Effects. This is the name given to the phenomenon that a product/service gets better as more people start using it – think Social Networks or Visa or Mastercard. The Network Effect is an inherent feature in Paypal’s line of work. The more people – businesses and consumers – use it the better it will be for everyone. Amazon’s Jeff Bezos calls it The Flywheel Effect.

Paypal is looking to kick-start its Flywheel effect by making the right acquisitions. This is a phenomenon we discussed in Investing in Global Dominators 2020: if a Global Dominator is leveraging Cloud/AI to deliver its product, it is incredibly hard to uproot it, and even harder when they just keep buying out the latest threats to their business. Global Dominators can improve their products with the latest updates or with the latest acquisition almost real-time. The flywheel can accelerate really fast. Look at Adobe or Intuit.

Overall, Paypal has a discernible Moat but it can be wider. It’s not there yet. What Paypal needs is more seamlessness: in technology (all apps under one roof) and in user-experience. A unified interface is a challenge when most of the new technology is acquired.

But judging by Paypal’s numbers, so far so good.

Management Quality: The Generals

Strategy? Good. Thinking in terms of ecosystem to widen Moat. But too acquisitive.

Paypal has Elon Musk’s and Peter Thiel’s fingerprints all over it. I don’t know if that’s a good or bad thing. But current Management also behaves like a Tech team. They are all about growth. The only difference between them and most other tech companies is that Paypal actually generated Free Cash Flow – more than $3 billion of it. Fortunately, management has made it clear that they don’t intend to sacrifice FCF for growth. We’ll take their word for it.

Paypal’s strategy is based on acquisitions. And I don’t think that will stop in the next couple of years. This is always dangerous. Companies – especially in the tech space – tend to overpay for acquisitions. Paypal just paid $4 billion for Honey, which has a technology that makes finding coupons and discount codes easier. Is it worth $4 billion? It’s hard to tell because Paypal’s return on this investment is based on the overall impact of it on the “full-stack” Paypal revenue. This is hard to quantify.

Overall, Management has done a good job of growing through acquisitions without sacrificing cash generation. Yes, they’re on an acquisition binge but this – as we discussed in our last worldview – is one way for a Global Dominator to remain one. Case in point: Paypal acquires Venmo and Braintree in 2013. If you can’t beat them, buy them.

Return on Equity? Mid-teens. Need to find a way to improve margins.

Management’s ultimate short-cut report card is Return on Equity. Paypal’s is luke-warm at around 15%. The issue is margins. It’s a provider of a middle-man technology that skims a bit off the top every time a transaction is made. As we saw earlier, Paypal seems to make about 2.5% on average on every transaction. That, as we’ve pointed out before, is unlikely to increase because of stiff competition. There can be some operating leverage as transaction volume grows. Maybe once acquisitions slow down, operating leverage will kick in.

Overall, the somewhat middling ROE number tips the balance from “Watch” to “Buy” regarding Paypal’s stock. As you’ll see below, I think PYPL is a about fairly valued. A high ROE profile could have convinced me to buy this Global Dominator even with a lower margin of safety. But I’ll wait for the stock to drop to start building up my position slowly.

Sustainable Free Cash Flow? About $7 billion. Translates to roughly $120 per share.

As per The Buylyst estimates, Paypal generated just a little over $3 billion in Free Cash Flow in 2019. So, the jump from $3 billion to $7 billion seems aggressive. It is. But it’s not unreasonable.

Here’s the big assumption: In the next 2 to 3 years Paypal revenue will jump from $17.7 billion to $29 billion. This seems like a big leap. But it’s based on the following assumptions:

Assumption: Number of Active Accounts grows by 20% each year to about 40% over current levels:

Assumption: Number of payments Transactions per Active User grows to 12 per quarter:

Calculation: The result of the prior 2 assumptions is that the Total Number of Transactions grows to 5,124 million.

Assumption: Amount per transaction modestly increases to $58.

Calculation: Total Payments Volume increases to $297,192 million per quarter.

Assumption: Revenue/TPV – our proxy for pricing – remains stable at $2.5

Calculation: Total Revenue increases $7,430 million per quarter

The end result is that Total Revenue – annualized – is roughly $29 billion. 

We think that is achievable, and even probable (probability >50%) given the assumptions above. The wild one, if you will, is the 40% growth assumption in Active Users. But consider this: Active Users grew by about 20% in 2019. Another 2 years of this – while Paypal’s technology stack gets better and more complete – gets us to 40%. That’s the argument then: will Active Users grow by 20% for the next 2-3 years? We would bet YES. But that’s our subjective assessment based on our view of the payments landscape in which Paypal is already a dominant force.

The rest of the assumptions are standard and match up with historical trends, except one: EBITDA margin improves to 32% from 30%. We assume that some operating leverage will kick in as revenue increases by about 50-60%.

Now, as mentioned before, if this scenario plays out, it will take 2-3 years. And usually, we’re willing to hold a stock for that long. But not unless we expect at least a 30% return. In this case, it appears PYPL is already fairly valued. So, we’ll wait for a market correction to buy in.

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