Via online business online marketing online business opportunities PayPal: Leaning Towards The Bear Case (Part 2)

Via online business online marketing online business opportunities

This is part 2 of my two-part series on PayPal (PYPL).Part 1was focused on understanding the trends in the overall digital payments industry as well as how it relates to PayPal. I also examined PayPal’s business model and how it generates revenue from its various services and offerings.

Part 2 will be centered around an analysis of both the bull and bear case and why I believe that PayPal is over-valued especially considering increasing competition, continued margin contractions and slowing revenue growth.

Via online business online marketing online business opportunities Financial Performance

Since 2014, PayPal has enjoyed YoY revenue growth of mid to high teens (15-20%), with stable operating and net income margins, approximately 15% and 13% respectively.

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  • Transaction Revenue: transaction fees charged to merchants and consumers based on total payment volume (TPV) completed on PayPal’s Payments platform. Also includes additional fees on transactions settled in foreign currencies for cross-border transactions.
  • Value-added Services Revenue: revenues earned through partnerships, subscription fees, gateway fees and other services provided to merchants and consumers including interest earned from loans/working capital provided to merchants. Despite launching more value-added services and deepening the engagement in existing services, value-added services growth was a paltry 9% in 2018. I believe that this is largely due to the fact that PayPal offers many of these services at little to no cost (particularly to consumers) in order to grow engagement and attract more users.

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  • Geographical Breakdown: the geographical breakdown for PayPal’s revenue has been remarkably consistent from 2016 to 2018. US revenue makes up 53% of total revenue, UK revenue makes up 10 – 11% of total revenue while others make up 35% of total revenue. (discussed further in headwinds/risk)

Via online business online marketing online business opportunities Bull Case – Future Margin Expansion and Strong Revenue Drivers

  1. Venmo monetization– just starting to monetize Venmo, a P2P (Peer to Peer) platform that has grown 25x in four years, and as of Q2 2019 accounts for ~14% of PayPal’s transaction volume. Management indicated that TPV should reach ~$100 billion for 2019. Venmo has more than 40 million users and approximately 15 million have engaged in a monetizable transaction. There are 3 ways that PayPal monetises Venmo.
    • Firstly, Instant Cash Out function that allows Venmo users to instantly transfer money from Venmo to their bank account at a $0.25 fee.
    • PayPal also earns a small fee when Venmo users use their Venmo debit card.
    • Finally, PayPal earns a small fee (2.9% + $0.30) from merchants when Venmo users pay merchants using their Venmo account. Over 2 million merchants that accept payment by Venmo including Uber, Foot Locker & Lululemon. *Note that paying with Venmo is only possible for online transactions or in-mobile app transactions.via  online business  online marketing  online business opportunities
    • Long runway for growth in Pay with Venmo: According to management, half of Venmo’s revenue is derived from its Instant Cash Out function (nearly doubling revenue from Pay with Venmo). However, management has also said that paying with Venmo would be the bulk of Venmo’s revenue in the future hence they clearly more users would begin to pay with Venmo as more merchants are onboarded.
    • Demographic complement: Currently, with regards to paying for eCommerce or mCommerce, there is no significant difference between paying with your ordinary PayPal account or Venmo except that you can split your bills with your friends or ‘share’ your purchases. However, I believe that there is a demographic complement between the two. As of July 2017, ~61% of PayPal’s mobile payment users were 35+ as compared to ~27% of Venmo’s users. Hence the bulk of Venmo’s users are 18-34 which complements well with PayPal’s more mature demographic. Even if both services are similar, I anticipate that cannibalisation would be minimal. Nick Jain ofCitizen Asset Managementbelieves that Venmo can contribute $1 billion in incremental annual revenue for PayPal within three years (2021). Believe that monetization of Venmo can add $0.5-1.0B of extra Ebitda, i.e., increasing PYPL’s current Ebitda by 16-33%via  online business  online marketing  online business opportunities

  2. Continued expansion of eco-system (future revenue drivers)– increase in services will increase engagement and use & continue to drive revenue growth while expanding PayPal’s TAM. This is important as I believe that core PayPal transaction revenue as its core business in e-commerce transactions will begin to mature. Beyond Venmo, there are 3 key future revenue drivers for PayPal – POS for offline merchants, international money transfer & small business loans.
  • PayPal announced the $2 billion acquisition of iZettle, a fast-growing provider of mobile POS systems for offline merchants in Europe and LatAm. Hence, this deal takes PayPal from the world of online commerce ($3 trillion in global addressable spend) to that of offline commerce ($21 trillion in global addressable spend).
  • International money transfer: PayPal is expanding further in Europe by launching its international money transfers service Xoom in Britain and 31 other countries across the continent. Xoom allows customers to transfer money abroad to more than 130 markets internationally, including India, Pakistan, Nigeria, Kenya, Poland and China. This helps it grab market share in the US$689 billion global remittances market, building on previous launches of the service in the United States and Canada.
  • With its PayPal business loans & working capital, PayPal has entered the small business loans industry. In Q3 ’18, PayPal has said that it ranks among the top 5 small business lenders in the US. There is a huge opportunity for PayPal considering that according to the Federal Reserve’s Small Business Credit Survey, about 70% of merchants were rejected from traditional loans whereas PayPal has about a 56% approval rate due to its access to the business’ data.Mediciclaims that the TAM for the US small business lending market is about $186 billion. PayPal is going for an even bigger TAM by expanding its credit services overseas having launched its Working Capital loans in Germany.
  1. Continued long-term growthin core business– I believe that PayPal’s unique competitive moat (network effect) will enable it to grow core business in the low teens for the medium term future. Furthermore, PayPal enjoys long term secular growth trends witheMarketerestimating that retail ecommerce will more than double from 2018 to 2023, growing at a 5 year CAGR of 17.4% and PayPal’s TPV should also continue to see double digit percentage increases.via  online business  online marketing  online business opportunities
  • Despite increasing competition in its core business – payment gateway for eCommerce & mCommerce (discussed below under Competition), PayPal’s network effect (235 million users and 40 million Venmo users) means that retailers and merchants still want to have paying by PayPal as an option. This can be seen in Uber where it has to use both Adyen and PayPal as payment gateways due to the popularity of paying by PayPal/Venmo among its customers.
  • PayPal is also fighting back against competitors by shoring up its weakness in in-store/omnichannel payments through its acquisition of iZettle. It has also worked to increase its presence in traditionally weaker areas such as LatAm through its investment in MercadoLibre.
  1. Stable and expanding margins after 2021 for the bull case.
    • Gross margin contraction in recent years: PayPal has seen continued gross margin contraction from 59.1% in 2016 to 55.5% in 2019. This is linked directly to the falling take rate (3.01% to 2.67% in the same time period) as an important aspect of cost of revenue, transaction expense has remained at around 0.96% of TPV. I expect take-rate to fall even further to around 2.4% as the use of Venmo continues to pick up. PayPal’s low take-rate is partly due to the abysmal take-rate of Venmo (estimated at around 0.27%).
    • Stable and growing gross margins after 2021:I believe that 2021 would see an inflection point for Venmo where Pay with Venmo (2.9% transaction fee + $0.30) would become a greater part of Venmo transactions thus lifting Venmo’s take-rate. I also see 2021 as the year that other paid services would become available and more widely used in Venmo including a stock brokerage service, cryptocurrency wallet & small loans.
    • Stable operating margins: despite the contraction in gross margins, PayPal has managed to keep operating and net margins relatively stable at 14-15% and 13% over the last 3 years. This is due to PayPal’s ability to cut operating costs (as % of sales), particularly customer support costs and product development costs. I believe that operating costs can be further reduced, in particular, customer service costs as half of the company’s 18,000 employees work in customer service, a function that can increasingly leverage automation. It also appears that product development costs as a percentage of sales have decreased as PayPal seem to tend in the direction of development through M&As.

Via online business online marketing online business opportunities Bear Case – Competition & Other Headwinds/Risks

Competition from payment gateways which facilitate payments in the e-Commerce & m-Commerce space.

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  • While PayPal may have had a significant first movers advantage in terms of being the go-to payments processor/gateway for online retailers and businesses, the space has become increasingly crowded in recent years. Competitors include Stripe, Adyen, Wirecard, Square, etc. ThisForbesarticle puts it best “volume is finite, and the competition is fierce.”

  • I will be more focused on discussing PayPal’s competitors among payment aggregators such as the above mentioned as compared to true merchant account providers such as First Data. This is because they have quite different products and processes where true merchant account providers issue exclusive merchant IDs for businesses thus require more formal vetting and approval. This is compared to PayPal and similar businesses where businesses will utilise PayPal’s merchant ID hence there is a focus on speed and convenience at the expense of higher fees.

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Stripe: known to be payment gateway for technological startups who deal mostly with online transactions.

  • Pros: For businesses that require customizable and complex features.Despite the high technical requirement, Stripe basically offers everything that PayPal offers plus a free credit card reader. Stripe is meant for businesses that need a highly customizable and tech-based solution for payment processing where your business requires numerous features and deals specifically online payments. This has made it particularly popular among many large technological companies such as Doordash, Lyft, Shopify, Amazon and Spotify among many others.
  • Pros: Has made Asia (high growth area) a particular focus, first launching in Singapore in 2016 and has been successful in gaining several important customers such as Grab and Didi Chuxing.

Adyen: Like PayPal & Stripe, it fulfills the roles of Gateway, Risk Management, Processing and Acquirer. It generally caters to big international operations (Nike, eBay, Netflix) which has allowed them to increase TPV from $10 billion in 2012 to $177 billion (159 billion euros) in 2018, 47% YoY growth.

  • Pros: Cheaper costs as can be seen from it displacing PayPal as eBay’s main payment processor. eBay has said that it made the change in part due to lower fees for sellers.
  • Pros: Not just limited to B2C/C2B payments but also has acquired B2B customers such as Tiffany & Co, Uber, Netflix and easyJet.
  • Pros: provides payment processing for both physical, online & mobile sales hence Adyen which processes payments underneath one system allows for convenient omnichannel retailing which large international corporations prefer. For example, after Nike chose Adyen in 2015, it no longer needs to pay for different POS systems across geographies nor does it require a different payment processor for online/mobile sales.
  • Pros: equipped with local payment methods such as Alipay in China, etc., and accepts more than 150 currencies and over 200 methods of payment.

PayPals Pros & Cons

  • Pros:Network of PayPal users– consumers who want to pay with PayPal or Vennmo and merchants who want to receive money in their PayPal account. As seen below, PayPal is still a very popular method of payment and merchants still appreciate it for its high sales conversaion (high 80% vs 50% for other methods of payments.via  online business  online marketing  online business opportunities
  • Hence, as paying by PayPal is not available in Stripe or Adyen, PayPal (& Braintree) still has a value-add as a payment gateway. This has helped in keep several large merchants (Six Flags, Sky Scanner, Airbnb, etc.), however, it seems that PayPal is particularly popular as a payment processor among SMBs. For example, Krispy Kreme uses Braintree as its online payment gateway and 35% of corporate clients paid Krispy Kreme using PayPal. Hence as long as PayPal & Venmo are popular methods of payment, PayPal as a payment gateway will still be popular.
  • Pros:Continued investments in different companies to gain strategic partners. PayPal continues to invest in other companies (Uber, MercadoLibre & Walmart) in order to ensure that these sites will allow customers to pay using PayPal or for PayPal to serve as its payment processor & gateway. For example, PayPal is already Uber’s lead payment processing partner in the US and Australia and their $500 million investment should allow it to expand this to more cities at the expense of Adyen.
  • Cons:Poor omnichannel and in-store presence – not popular among large corporations. Following its acquisition of iZettle, PayPal gained in-store payment processing capabilities in 11 markets (Brazil, France, Germany, etc.) and allows it to accelerate its omnichannel commerce solutions in its mature markets. However, it is already far behind. For processing large companies, 10% of Adyen’s TPV in 2018 came from its in-store POS system while Square already has in-store payment processing locked up for SMBs in the US.

Competition from “providers of card readers for mobile devices and of other point-of-sale and multi-channel technologies”

With its acquisition of iZettle, PayPal has made it clear that it is going after in-store payment processing (POS hardware and software) as it bolsters its current PayPal here offering. This would also allow PayPal to provide omni-channel payment processing/gateway for online retailers who also want to have an offline presence. However, this is a very crowded space, one where I don’t think PayPal has any real competitive advantage since there is no real demand to pay by PayPal in-store. Besides Square, there are also numerous other companies offering similar products such as Worldplay, Shopify, Vend, Wirecard, Stripe and Adyen, etc.

Square:I believe that Square is the most appropriate competitor in this space especially because Square and PayPal have similar demographic targets – SMBs.

  • Pros: Clear value-add: Square was the pioneer of value-added services beyond payment processing as it allows merchants to manage every aspect of your business: inventory, sales, employees, customers, and more ― all for free.
  • Pros: Different POS softwares: Square also offers two niche POS software – one for retail and one for restaurants. Square understands that different businesses have different requirements hence have created for personalised functions for merchants in the restaurant & retail industry. For example, Square for Restaurant also allows the manager to track seating, split bills, automatic gratuity, dining options and table maps, etc.

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  • Pros: Also allows physical businesses to bring their business online with Square’s eCommerce solution where merchants can design a free online store and take payments or integrate Square’s payment gateway services on current eCommerce platforms. Hence, merchants who run an offline business using Square no longer have to switch to other payment gateways when establishing their online presence.

Venmo’s competitors:Square’s Cash App, Zelle, etc.

Square’s Cash App: closest comparison to Venmo though Venmo has the first mover’s advantage. Both started out as P2P payments but has since expanded to allow consumers to make both online/offline transactions through debit cards and act as an extension of the Square/PayPal eco-system of financial services.

  • Pros: Appear to be more popular among the unbanked (significant target group for both).Reportsstarted to surface in 2018 that Square’s Cash App was especially popular among low-income consumers in cities like Atlanta where unbanked rates are high. Jack Dorsey, Square’s CEO, has said that “people are using [the Cash App] as their primary banking account, and in some case it’s their only bank account.” Ark Investment has found that the Cash App dominates in the southern states where the rates of the unbanked are highest and there is a correlation between unbanked rates and Cash App searches.

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  • Pros: More value-added services: While Venmo has focused on the social aspect of its use, Cash App has focused on creating more financial services for its users. For example, the Cash App introduced Direct Deposits in 2018 which generates routing and account numbers thus allowing for the deposit of paychecks directly into Cash App. Square was also ahead in launching a debit card linked to its Cash App which widened the use of Cash App beyond P2P payments, Venmo would soon follow suit. Finally, Cash App is also able to hold Bitcoin deposits, another feature that Venmo has yet to have

Weakness in high growth geographies leading to underperformance.

  • Ecommerce retail growth is weakest in North America and Western Europe which are PayPal’s key geographies. As previously shown, PayPal’s percentage of revenue (ex UK and US) remains stagnant from 2016 to 2018 at 53% of total revenue. This is in spite of higher ecommerce retail growth rates (seen below) and non-cash transaction growth rates in Asia Pacific, LatAm and CEMEA.
  • I believe that this can be attributed to PayPal’s weakness in these geographical areas. This will become increasingly problematic as the UK and US ecommerce markets begin to mature.

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Temporary margin contraction until at least 2021.Despite improvements in operating expenses (as mentioned previously), gross margins will see further contraction until at least 2021. While one of the tailwinds for PayPal is continued improvements in operating expenses as well as possible future margin expansions, this will probably not occur until 2021, if at all.

  • Gross margins will definitely contract for the next 2 years (minimum) due to the low take-rate of Venmo. TPV is being driven by increased utilisation of Venmo and cost of revenue is directly related to TPV hence an increase of TPV greater than revenue would lead to continued gross margin contractions.
  • Gross margin expansion is predicated on increasing monetization of Venmo by 2021. Obviously there is a risk that this does not happen and the current lower margins could instead be the standard for PayPal due to competition.

Via online business online marketing online business opportunitiesValuation

  • PayPal is covered primarily by financial services analysts and currently trades at>50x 2018 and nearly 50x 2019 earnings estimates as provided by management’s guidance. This is certainly expensive especially when compared to some of its peers especially Visa and Mastercard. For example, Visa enjoyed comparable revenue growth (11% vs PayPal’s 12%) in the most recent quarter despite Visa having a higher revenue base. Furthermore, Visa’s operating and net margins are significantly better than PayPal (63% operating margin & 53% net margin) and should increase further with scale. Despite this, Visa trades at 40x 2018 and around 34x 2019 earnings estimate.
  • However, with regards to a P/FCF basis is valued exceptionally well against its peers (x19.12), with only First Data rated higher. However, this is in part due to PayPal’s high stock based compensation and transaction & loan costs which when added back to FCF, adds nearly $2 billion in 2018. Hence, I am more inclined to use PE ratio as a comparable valuation metric and a reversion to a more sustainable average of 35x and assuming a 2019 net income of around $2.6 billion, this suggests an approximately 35% downside. Furthermore, I believe that a 35x PE multiple is more realistic given slowing growth, contracting margins and uncertainty around Venmo monetization timeline.

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  • DCF: On a 2 stage 10 year DCF basis with a WACC of 10% and terminal growth rate of 3%, PayPal appears slightly overvalued with a price target of around $86.25 and this was derived under the assumption of a uptick in take-rate and margins by 2021.

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*Those interested in the complete write-up please comment or message me.

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.

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