Is PayPal cheap enough to ignore the blunders and headwinds?
Intro
Since July 2021 Paypal has been laid out on the chopping board. The company fell almost 82% since then and it just cant seem to find a bottom. Its now up only 58% since going public.
I’ve largely ignored PYPL 0.00%↑ over the years because it always struck me as a decent business at a very lofty priced. I usually try to find exceptional businesses at a fair price, but I’ve also been known to go shopping in the clearance aisle if you know what I mean. PayPal is certainly on sale right now so it has a lot of value investors interested, me included.
Company overview
Description
Most of us are familiar with PayPal but for those who aren’t, PayPal is a technology platforms that enables digital payments on behalf of merchants and consumers globally.
They do this through multiple platforms including PayPal, PayPal Credit, Venmo, Braintree, Xoom, PayPal Honey, PayPal Zettle, Hyperwallet, and Paidy.
They currently have 431 million active accounts, of which 35 million are active merchants and 369 million are active customers. They do $1.4 trillion in total payments volume (TPV) in 200+ markets.
This is a massive payments company with a huge global reach.
They generate revenue primarily from fees for completing a transaction, which is based on the volume of activity processed on their platform.
They also generate revenue in the following ways
Fees from foreign currency exchange
Fees from Instant transfers to bank accounts from a PayPal account
Facilitating the sale of cryptocurrencies
Revenue through partnerships
Interest and fees from their merchant and credit products
Interest earned on certain assets underlying customer balances
Referral fees, subscription fees, and gateway services
A brief history
It was founded as Confinity in 1998 by Max Levchin, Peter Thiel, and Luke Nosek.
The Company rapidly grew over a million users in just 2 years and then was acquired by Ebay a few years later in 2002. While at Ebay the company went on to dramatically grow its users both organically and through acquisition, specifically the Braintree/ Venmo acquisition.
Then PayPal was spun off from Ebay in 2015 after pressure from activist investor Carl Icahn. The Spin off was actually a difficult separation considering how much integration and data was shared between the two companies, but after all was said and done, the spin off essentially created two fortune 500 companies.
In recent years, specifically since 2021, PayPal has been subject to serious competitive pressures and margin pressure which we will get into in a bit.
Leadership
PayPal had a number of leaders through out the years. Below is the order in which they served as CEO.
Max Levchin
Peter Theil
David Sacks
Scott Thompson
John Donahoe
Dan Schulman
Alex Chriss (current)
As you can see, PayPal has basically played musical chairs with their management, however, each leader has helped shape PayPal into what it is today, for better or for worse.
As of September 2023 Alex Chriss was appointed as the new CEO. Chriss was previously at Intuit INTU 0.00%↑ for 19 years where he worked in various leadership roles such as Vice president and general manager of small business and self employment.
My thoughts on leadership
Personally, I prefer companies that are founder led where management has significant ownership in the company. But occasionally if the price is right, I’ll consider companies like this too, especially in a turn around situation like this where new management could be crucial in turning the company in a new direction. In these types of situations you’d definitely want to know about the CEO’s past performance.
With that being said, there isn’t a ton of information on Alex Chriss’ early life or personal life, but we do know a few key things about his professional life.
First, at Intuit, the small business unit’s customers and revenue grew at around 20% and 23% annually under him.
Chriss also led the Mailchimp acquisition for Intuit in 2021, which is a bit concerning considering the total acquisition price was $12 billion, when Mailchimp was probably only doing around $800 million in revenue at the time. That means the acquisition was probably around 15-16x sales. Yikes, let’s just hope Alex doesn’t do any more of that because PayPal doesn’t need any more overpriced acquisitions as you’ll see in a minute.
On a better note, while in search of a new CEO, PayPal’s search team met with a group of 20 investors and selected Chriss out of a group of 9 other candidates, so there seems to be a lot of support for him, especially amongst investors. It probably because of his small business experience, which seems to be PayPals focus going forward.
Acquisitions
Over the years they have growth though organic and inorganic growth. They’ve made various acquisitions, some big, some small, some excellent and some horrible. Below are some of the big acquisitions they’ve made and the approximate costs of those deals. Note: Some of these numbers may not be 100% accurate but they are the best I could do with the limited information and resources I found online.
Xoom - $890 million, 2015 (international money transfers) Paid 5x sales, good price but company does not perform very well.
Paidy - $2.7 billion, 2021 (buy now pay later) Paid roughly 16x sales, yikes!
Braintree/Venmo - $800 million, 2013 (unbranded processing) Paid roughly 8x sales and possibly did over $1 billion in earnings in 2021, home run!
Zettle - $2.2 billion, 2018 (POS terminals and payment solutions) Paid roughly 13x sales, yikes!
Hyperwallet - $400 million, 2018 (payments platform)
Honey - $4 billion, 2020 (web browser extension that tracks discounts) Paid roughly 10-20x sales, yikes!
Honey
A quick note on the Honey acquisition before we move on. Honey was acquired for $4 billion in 2020 and added $3.1 billion in goodwill to PayPals balance sheet, which means the fair value of Honey was roughly $1 billion and the rest was goodwill.
Honey essentially finds retailer discounts and refers people to different retailers through their affiliate network and collects a referral fee, similar to Groupon. According to Dan Schulman, Honey was doing $100 million in revenue in 2018 and growing at 100%, and it was profitable.
Let’s give Dan the benefit of the doubt and say it grew at a 100% CAGR until acquired in 2020. Thats $400 million in revenue, which means they paid 10x sales for a private company, I personally don’t think the company grew that fast, and I think they paid a higher multiple, but for the sake of the thought exercise, let's just say it grew at 100% and they paid 10x sales.
Theoretically 10x sales could be justifiable if they were extremely confident that the company would continue to grow at 100% for 4-5 years after the acquisition with a 10% profit margin, in which case Honey would be doing between $1.6 billion - $3.2 billion in revenue and potentially between $160 and $320 million in profit in 2024 or 2025. This would be between 12.5x and 25x earnings.
But again, this whole valuation hinges on Honey growing at 100% from 2018 to at least 2024, which is highly unlikely. Im almost certain that isn’t the case because they seemed to have stopped talking about Honey in conference calls. Also, their revenue from payment processing makes up about 91% of their revenue and the other 9% ($2.3 billion) is split between all 5 other “value added services”, and Honey is only one of them.
It’s safe to say they overpaid for Honey, and you don’t want to see them making any acquisitions like this again in the future.
Total payment volume
Transaction revenue makes up about 91% of their revenue and below are the segments that make up the the volumes processed.
PayPal really has three important transaction segments
Braintree (unbranded processing)
PayPal (branded check out)
Venmo (peer to peep payments)
P2P ex-Venmo is basically peer to peer payments done through PayPal and Xoom.
Other merchant services includes revenue from Paidy, Hyperwallet payouts, and revenue from Zettle pos solutions.
Ebay is basically irrelevant at this point.
Branded and unbranded
Unbranded is primarily comprised of Braintree’s card processing services but it also includes the PayPals debit and credit card processing services.
Braintree
PayPal acquired Braintree in 2013 for $800 million, along with Venmo, which was owned by Braintree at the time. Braintree is PayPals primary unbranded payment processing service. They process payments for merchants without having the yellow “PayPal” branded button, instead merchants can customize their checkout experience to fit their own brand.
Their newest service from PayPal is called PPCP (PayPal complete payments) which is essentially white label check out for small and mid sized businesses. PPCP has been rolled out in the US and will be rolled out globally within the coming months. Braintree historically served larger firms like Uber, Krispy Kreme, Airbnb and TikTok, allowing them to have a custom checkout experience. But now, PPCP offering is an effort to bring Braintree to small and medium sized businesses that want a more customized checkout experience.
Unbranded makes up for 30% of total payments volume and is at 40% annualized, but it’s also lower margin, especially for larger merchants who can negotiate lower fees because they do very high transaction volumes.
Small and mediums sized business don’t have this kind of bargaining power, so they pay higher fees, which means higher margins for PayPal. This is partially why PayPal is making a big bet on small and medium sized businesses.
Branded
This is PayPals yellow button and accelerated checkout service that you would see on many websites. This is their legacy product, and it has higher margins and makes up for a large portion of their total payments volume (30%). This segment is growing slower, especially in 2022, as we saw in the slide above.
Merchants want a more customized experience that matches their brand so we can probably expect less demand for this product and more demand for the Braintree product offering. Branded will grow at slower rate than the other two transaction segments, however, I Imagine it will continue to produce large amounts of cash flow.
Venmo
Braintree owned Venmo when PayPal acquired it so it was a two for one acquisition. They got a real sweetheart deal considering both businesses could potentially account for 48% of their TPV in 2022. 48% of their TPV is about $672 billion, If you apply their total take rate of 1.94%, that means the two companies could be generating roughly $13 billion in revenue (47%). With a profit margin of around 10%, that could be $1.3 billion in earnings just from an $800 million dollar acquisition.
Venmo began as a peer to peer payments platform, and evolved into a platform that serves businesses and offers various other products such as debit and credit cards, “pay with Venmo”, and their crypto platform. Venmo’s user base grew from 3 million in 2015 to around 78 million in 2022, an amazing of 59% per year.
They generate revenue primarily through fees charged to merchants who accept payments with Venmo (1.9% standard and 2.29% for contactless payments). And while peer to peer payments remain free, if you want the money settled instantly (within 30 minutes or so) they charge a fee of 1.75%. They also have various other fees such as interchange fees from their debit card, check cashing services and interest earned on from funds in customers accounts.
A few key pieces of data for Venmo
Average transaction amount is $65-$75
50% of users between the age of 25-34
Accounts for approximately 16% of PayPals revenue
Users average 5 transactions per month
Competition
Competition is taking a toll on PayPal and taking market share away. Some of the obvious competitors are Stripe, Apple Pay, Square, Meta Pay, Google Pay, ShopPay, Klarna, Affirm, Afterpay, Adyen, and so forth. These are all serious competitors that could potentially take a lot of customers from PayPal and continue to put pressure on their take rate.
Below is just a few of the competitors that you’ll find on a typical e-commerce website. There’s intense competition for that branded check out spot and its becoming obvious.
Customers tend to use the most convenient option, while merchants are more likely to choose the lowest priced option. For the customers there is hardly a switching cost, so people aren’t really incentivized to stay loyal to any one form of payment especially considering how easy it is to set up a new account with Google or Apple or some other convenient service.
Below we can see PayPals take rate has consistently declined year after year. This is partially because of competition from competitors.
Another reason it’s declined is because their take rate is calculated by dividing their total transaction revenue by their total payment volumes. PayPal p2p and Venmo are free services so there’s a lot of transaction volume but no revenue, which dilutes their take rate.
The $18 billion dollar waste
PayPal has been a cash flowing machine, but it hasn’t been quality cash flow. Since going public, PayPal has spent nearly $18 billion on share repurchases, and yet their shares outstanding are only down by about 8.7%.
Think about that for a second, PayPal is only worth $61 billion right now, they’ve spent nearly 29% of their entire market cap on share repurchases, and yet the shares outstanding are only down by 8.7%. This is partially because $14 billion of the $18 billion spent, was used to repurchase shares between 2017 and 2022, where shares were trading at an average P/E of 50.
It’s also because their repurchases only served to offset their stock based compensation up until recently when their buybacks exceeded their stock based compensation.
Most of us already know what SBC is but in case you don’t, SBC is essentially a non cash expense that allows companies to pay employees with stock rather than cash. Since less cash is leaving the business, it affords a business to generate more free cash flow. But shareholders ultimately pay the bill because SBC dilutes shares outstanding, resulting is less value per share for shareholders.
It’s kind of like “yay more cash flow!” but you also have to share that cash flow with more people.
Financials
PayPal is doing pretty good financially, they have $10 billion in cash equivalents and short term liquid investments. Their debt/equity ratio is about 0.5 and their operating cash flow ($5.8 billion) would pay off their $10 billion debt in less that two years if it was absolutely necessary.
Their revenue has slowed down and margins have been squeezed because of a few things. First, their transactions expense in 2022 as a percentage of revenue jumped from 40% to 44% and credit losses as a percentage of revenue jumped from 4% to 5.7% in 2022, resulting in a lower operating margins.
Second their interest expense and income tax provision ticked up also adding pressure to their bottom line.
At the end of the day, this is a competitively challenged, yet profitable business, that generated $5.1 billion in FCF in 2022. They have a plan to grow organically by focusing on small and medium sized businesses (PPCP) and seem to be moving more towards a strategy with less acquisitions and more stock buybacks.
Valuation
For my valuation I’m assuming a few scenarios all of which have slower growth. I’m assuming the company grows 5-9% over the next few years and margins expand a tiny bit to between 16.5-18%, and an end multiple of between 15-23x. I think it’s reasonable to assume the multiple will either stay the same or expand a bit considering all the fear that’s already baked into the price today.
Final thoughts
This is really not my favorite type of investment, although I own a small position because its so cheap. They’re under competitive pressure and they also over payed for their share repurchases and they also overpaid for most of their acquisitions. Sure, Braintree was a home run that made up for all their capital allocation blunders, but still, It’s obvious they were reckless with shareholder capital.
Competition isn’t going anywhere any time soon so they need to be very intentional about what they do going forward. No more paying 15x sales for acquisitions and no more buybacks at 50x earnings.
If the turn around is successful, there could be a lot of upside over the coming years. If not, we’re possibly looking at mediocre returns, or less.
Thats it for this week, thanks for reading!
Leave a comment below if you have a different thesis.