By The Valuentum Team
We’ve been fans of PayPal (PYPL), even since the company was a part of eBay (EBAY) several years ago, and we thank Carl Ichan for being the driving factor behind the split of these two fantastic companies. Though many believe eBay is tech dinosaur from the dot-com era, we still think it has life, but we couldn’t be more excited about the prospects at PayPal. The number of people still paying with cash or check is considerable, for example, and while there is still a long runway of growth at the credit card payment processors, Visa (V) and MasterCard (MA), PayPal’s growth story may even be better, though it does come with some incremental risks – not the least of which is the lost contract agreement with eBay. In any case, PayPal has a lot going for it, and the company may be worth considering as a long-term idea targeting the proliferation of e-commerce and digital payment technologies.
Bitcoin: An Opportunity Not a Threat to PayPal
Bitcoin (COIN) has taken almost everybody by storm, and the blockchain technology backing it is quite interesting. Though we have no reason to disagree with the Bitcoin and cryptocurrency bulls (optimists), we think the conversation rate of Bitcoin and other cryptocurrencies into USD, or their value, is still quite debatable. A discussion behind what a fair price for Bitcoin and other cryptocurrencies is beyond the scope of this article, but what is important to mention, in our view, is that the presence and widespread “notoriety” of Bitcoin may be all the evidence needed to suggest online digital payments are here to stay, whether they are conducted in dollars, another currency, or even cryptocurrency.
In this light, we don’t view Bitcoin as a risk to digital payment technology companies, but rather another source of growth for them. Though merchants and businesses may be concerned with the tremendous volatility of Bitcoin and may wait for the cryptocurrency to exhibit more reasonable trading ranges (store of value), surveys have indicated that as many as 60% of merchants may be interested in accepting Bitcoin as another option for United States dollars. That’s a pretty high number, in our view. It’s possible that merchants, too, may have been caught up in the meteoric rise of cryptocurrency assets, but this may just be phase 1 of broader acceptance of the technology. Awareness is required before trust can be built, and a large percentage of the world is now aware of the potential for blockchain technology and cryptocurrencies.
Square (SQ) may have been an early-mover to accept cryptocurrency technology, but we think other digital payment technology companies, including PayPal, may start to view cryptocurrency as an extension of their business models, if they haven’t already. Many may not recall that PayPal started to incorporate Bitcoin into its applications in 2015, well before the latest buzz in the cryptocurrency that captivated much of the marketplace. Perhaps going full-steam ahead in cryptocurrency doesn’t make much sense right now, as PayPal has mentioned that the volatility of Bitcoin’s price, for example, may completely wipe out a merchant’s margin on a sale. Typically, companies like to eliminate currency risk from their operations. The acceptance of merchants and businesses of Bitcoin at this point may only increase the risk to their operations, given considerable volatility in the store-of-the-value of proceeds from any transaction.
Though Square is taking a more public route to Bitcoin acceptance, in our view (or at least it gets more press), PayPal is not sitting idly by either. The point that we’re trying to make is not so much with respect to the potential proliferation of Bitcoin or other cryptocurrencies, for example, but rather that digital payment technology is becoming more and more mainstream, just given the buzz surrounding cryptoassets. Whereas decades ago, consumers were even skeptical of credit cards, nowadays many are growing more and more comfortable with digital assets – even those have been lost or stolen in the past or have been associated with illegal activity, fairly presented or not – despite tremendous volatility. Widespread acceptance of digital currencies will only drive further acceptance of existing payment technologies, in our view. Long-term, we see more opportunities than threats with Bitcoin and cryptocurrencies at PayPal.
Still A Vastly Under-Penetrated Digital Payments Market
Image Source: 2017 10-K, page 29
For the new generation, it seems as though digital payments technology is the way of the world. Whether one is buying things through Amazon (AMZN), swiping his or her credit card on a merchant’s Square reader, or sending or receiving money through PayPal, everything already seems digital, but it’s not. Where the Internet has already vastly changed people’s everyday lives, within financial services, however, the potential has not yet been completely realized. PayPal would agree that the “traditional financial order remains firmly in place,” and “the way most people move and manage their money hasn’t changed much since credit cards appeared on the scene 50 years ago (source: 2017 10-K, “Message From Our President and CEO).”
As with the credit-card network providers, Visa and MasterCard, PayPal benefits from a powerful network effect — as more and more consumers use PayPal, more and more merchants accept the platform and so on. The company already has tremendous scale, and it would take a major disruption to alter consumer behavior that is rather well-established. At the end of 2017, for example, PayPal had 227 million active customer accounts, including 18 million active merchant accounts. PayPal is handling a tremendous amount of payment volume already, and its brand name still has room for greater acceptance, something that may only take time.
The company’s business model is relatively easy to understand. PayPal generates a fee for providing transaction processing and other payment-related services, and its business model is driven by volume, so a long runway of adoption will be key to further revenue increases. As shown in the image above, PayPal has roughly doubled revenue since 2013, and the separation from eBay may have played a large role in this, as the company now is run by a management team solely focused on growing the organization, rather than growing both it and eBay. Operating income and net income at PayPal have doubled over this time period, too, and we see little to slow down both the top-line and profit gains at this emerging payments giant.
PayPal’s Strong Free Cash Flow and Healthy Balance Sheet
Image Source: 2017 Proxy Statement, page 32
PayPal is a veritable cash-flow-generating powerhouse. During the past three fiscal years, the company has generated more than $2.5 billion in operating cash flow, with the measure eclipsing the $3.1 billion mark in fiscal 2016. Free cash flow, as measured by cash flow from operations less all capital expenditures, has also been robust coming in north of $1.8 billion in each of the past three years, with the mark reaching nearly $2.5 billion in fiscal 2016. PayPal benefits from a capital-light business model, and the scale that it continues to build allows it to spread costs over a larger and larger customer base. We’d expect this dynamic not only to help drive operating margins higher in time, but we think this will also provide considerable support to future free cash flows. Capital expenditures have fallen to ~$670 million in fiscal 2017 from ~$720 million in fiscal 2015, revealing more conservative spending.
Image Source: 2017 10-K, page 42
We couldn’t be bigger fans of PayPal’s balance-sheet health. The company holds cash and cash equivalents (including investments) of ~$7.5 billion at the end of 2017 and just $1 billion in notes payable on the books, translating into a considerable net cash position. Net cash is not only a key driver behind the intrinsic value of any organization, but it provides tremendous flexibility with respect to strategic acquisitions or a capital-return program, including buybacks (the company bought back 4 million shares during 2017 and has ~$5 billion remaining on its share buyback program). We think the executive team is comfortable building a net cash position, and we hope the company will exercise caution in putting that source of intrinsic value to use, whether with buybacks or in other endeavors (at the right price). Though we may like to see greater pursuit of cryptocurrency applications at PayPal, we think perhaps the best approach may be a wait-and-see one, given the tremendous volatility of cryptocurrency assets at the moment. In the meantime, PayPal is building up its patent portfolio related to cryptocurrency assets.
Key Risks to the PayPal “Story”
Though we like PayPal’s long-term growth “story,” its solid free cash flow generation and fantastic balance-sheet health, the company is not without its share of risks. The biggest one is technology-oriented, but we may have seen the next evolution in payments technology with the advent of Bitcoin and cryptocurrencies, and their adoption may be a direct or indirect positive related to the proliferation of digital payments technology. Said differently, Bitcoin and other cryptoassets may be more of an opportunity than a threat, at least for the foreseeable future, as it relates to cutting-edge providers such as PayPal and Square.
The regulatory environment is a big risk to the profit stream at PayPal in the event of excessive payment fee regulation, which could weigh on the stock in anticipation of potential margin pressures. PayPal has already faced a number of data breaches, and while the company is doing all that it can to protect consumer data, even what-appears-to-be honest missteps, as in the case of Facebook’s (FB) Cambridge Analytica fiasco, can cause liabilities. As the company’s business continues to evolve, PayPal may also grow more and more exposed to the credit risk of its merchants and customers. The biggest risk to PayPal, however, may be related to its relationship with eBay, which appears to be going away in coming years. eBay announced February 1, 2018, for example, that most of its payments will go through Adyen in 2021, though eBay will remain a payment option through July 2023, according to Bloomberg.
PayPal’s exposure to eBay is rather large, estimated at roughly $24.4 billion of total payments volume during the important holiday selling season, the fourth-quarter of 2017. Total payment volume processed at PayPal during the fourth quarter totaled $131 billion, so we estimate the impact of the loss of the continuation the eBay contract as a net detraction to payments volume to the tune of nearly 19%. Though we expect PayPal to outgrow its loss with eBay in time and we hope that the company’s will surprise to the upside with a new eBay deal in 2023, it’s still a big blow to PayPal at this time, and one that we wish the company would have been able to avoid. Offering some price concessions to eBay may make sense if they come to the table again, as losing nearly 19% of total payments volume is no “small potatoes.” In any case, it’s just a missed opportunity. PayPal needs to go back to the table and work something out.
The breakdown in the relationship between eBay and PayPal was surprising, and PayPal will have to work hard to replace that payment volume in coming years, but given current growth rates in total payment volume (up nearly 30% on an FX-neutral basis during the fourth quarter of 2017), the entire eBay deal may be the equivalent of just a few months of growth at PayPal. In early April, Amazon noted that it may be interested in getting into the payments business, and according to the Wall Street Journal, utilizing Alexa for voice-activation payments features. There’s a market for these sorts of trendy luxuries, but we maintain the bigger-picture view that there are still 2 billion people on the globe that lack the most basic banking applications. We think the biggest source of growth will rest on general adoption of basic digital features, not necessarily ones that have all the bells and whistles. In any case, the digital payments marketplace is large enough for a great many players, including Amazon and now more-formidable foe Adyen that appears to have stolen eBay’s business away from PayPal.
Image Source: Valuentum
PayPal has a number of competitive advantages and it is locked in to the secular growth related to online payments and e-commerce adoption and technology. We think Bitcoin and other cryptocurrencies may pose more of an opportunity than a threat at this time, and while we are a bit concerned about the loss of business with eBay in 2023, PayPal is growing fast enough where it may replace that entire business in a matter of months, on the basis of current year-over-year growth rates in total payments volume. We’re viewing the relationship with eBay as one that is nice-to-have rather than a must-have at this point, and we hope the two companies will be able to work something out to at least provide PayPal as another checkout option beyond 2023.
Cybersecurity threats, excessive government regulation and PayPal’s ongoing foray into business lines dependent on the creditworthiness of customers further increase its risk profile, as does the entrance of Amazon into payment services and ongoing technological developments by rivals. However, we think the digital payments business is big enough for a great many players, and any competitive impact may only slow PayPal’s pace of growth, not eliminate it. Despite the growing uncertainty related to the company’s prospects, we still like it. We peg our fair value for shares in the low-$70s, slightly lower than where it is currently trading, but the upside of our fair value range implies a value closer to the mid-$80s.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.
Additional disclosure: PYPL and V are included in Valuentum’s simulated Best Ideas Newsletter portfolio.