Why I Own PayPal Shares

PayPal Holdings (NASDAQ: PYPL) is one of the 50-plus companies that’s in my family’s portfolio. I first bought PayPal shares for the portfolio in June 2016 at a price of US$38, again in November 2018 at US$83, and yet again in June 2019 at US$117. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with PayPal’s share price being around US$116 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold PayPal shares. 

Company description

PayPal was first listed in the US stock market in February 2002, but it was acquired by e-commerce site eBay just a few months later. The acquisition made sense for PayPal, as the company could tap on eBay’s larger network of users and gross merchandise volume.

Interestingly, PayPal outgrew eBay over time. Eventually, PayPal was spun off by eBay in mid-2015 through a new IPO. On the day of PayPal’s second listing, its market capitalisation of around US$47 billion was larger than eBay – and has since nearly tripled.

It’s likely that even for us living in Singapore, we have come across PayPal’s online payment services. But there is more to the company. PayPal’s payments platform includes a number of brands – PayPal, PayPal Credit, Braintree, Venmo, Xoom, and iZettle – that facilitate transactions between merchants and consumers (and also between consumers) across the globe. The platform works across different channels, markets, and networks.

PayPal recently added discount-discovery services for consumers to its portfolio. It announced a US$4 billion acquisition of Honey in November 2019 that closed earlier this month. According to PayPal, Honey “helps consumers find savings as they shop online.” Honey has around 17 million monthly active users, partners with 30,000 online retailers across various retail categories, and has helped its user base find more than US$1 billion in savings in the last 12 months.

PayPal’s revenue comes primarily from taking a small cut of its platform’s payment volume. This transaction revenue accounted for 90.3% of PayPayl’s revenue of US$12.8 billion in the first nine months of 2019. Other business activities including partnerships, subscription fees, gateway fees, service-related fees, and more (collectively known as other value added services) comprise the remaining 9.7% of PayPal’s net revenue. 

The US was PayPal’s largest country by revenue in the first nine months of 2019 with a 53.2% share. In a distant second is the UK, with a weight of 10.5%. No other single country made up more than 10% of the company’s net revenue.

Investment thesis

I had previously laid out my investment framework in The Good Investors. I will use the framework, which consists of six criteria, to describe my investment thesis for PayPal.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

PayPal’s business is in digital and mobile payments. According to a 2018 PayPal investor presentation, this market is worth a staggering US$110 trillion, as shown in the chart below. For context, PayPal raked in just US$17.0 billion in revenue in the 12 months ended 30 September 2019 based on US$676.2 billion (or just US$0.676 trillion) in payment volume that flowed through its platform.

Around 80% of transactions in the world today are still settled with cash, which means digital and mobile payments still have low penetration. This spells opportunity for PayPal. 

2. A strong balance sheet with minimal or a reasonable amount of debt

PayPal’s balance sheet looks rock-solid at the moment, with US$5.0 billion in debt against US$6.9 billion in cash, as of 30 September 2019. The picture is likely to change with the aforementioned US$4 billion acquisition of Honey, but we will only know when PayPal announces its 2020 first-quarter results (which should take place sometime in April this year).

I’m not worried though, because PayPal has a storied history of producing strong free cash flow which I’m going to discuss later.

3. A management team with integrity, capability, and an innovative mindset

On integrity

PayPal’s key leader is CEO Dan Schulman, who’s 61 this year. In 2018, the lion’s share of the compensation for PayPal’s key leaders (including Schulman and a handful of other senior executives) came from the following:

• Stock awards that vest over a three-year period
• Restricted stock awards that depend on the growth in PayPal’s revenue and free cash flow over a three-year period
• (Specifically for Schulman) Stock awards that depend on the performance of PayPal’s share price over a five-year period

PayPal’s compensation structure for its key leaders has emphases on free cash flow, multi-year-vesting for stock awards, and a dependence on the company’s long-term share price movement. I think this structure aligns my interests as a shareholder with the company’s leaders.

Moreover, PayPal requires its CEO and other senior executives to hold shares that are worth at least three to six times their respective base salaries. This results in skin in the game for PayPal’s leaders. As of 29 March 2019, Schulman himself controlled 719,297 PayPal shares that are collectively worth around US$80 million at the current share price; other members of the company’s senior management team each controlled around US$11 million to US$14 million worth of shares.

On capability and innovation

Some members of PayPal’s senior management team have relatively short tenures with the company, as illustrated in the table below. But together, they have accomplished plenty since PayPal’s separation from eBay.

First, the company has grown its network of users impressively since the spin-off. The table below shows how PayPal’s transactions, payments volume, and active accounts have changed from 2014 to the first nine months of 2019.

Second, PayPal has made a number of impressive acquisitions in recent years under Schulman. They are:

• Digital international money-transfer platform Xoom (acquired in November 2015 for US$1.1 billion). The platform’s money-transfer network covers more than 160 countries.
• iZettle, a provider of solutions to small businesses for the acceptance of card payments and sales management and analytics (acquired in September 2018 for US$2.2 billion).  PayPal acquired iZettle to strengthen its payment capabilities in physical stores and provide better payment solutions for omnichannel merchants. I believe that a retailer’s ability to provide a seamless omnichannel shopping experience is crucial in today’s environment. When iZettle was acquired, it operated in 12 countries across Europe and Latin America, and was expected to deliver US$165 million in revenue and process US$6 billion in payments in 2018.

Third, PayPal has been striking up strategic partnerships in many areas since becoming an independent company. The slides below from PayPal’s 2018 Investor Day event says it all: PayPal had no strategic partners when it was still under eBay!

4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour

I mentioned earlier that PayPal’s primary revenue source is payments that take place on its platform. And when I discussed PayPal’s management, I also pointed out that the company had processed 8.9 billion transactions in the first nine months of 2019 from 295 million active accounts (at the end of 2018, PayPal had 267 million active accounts, of which 21 million are merchants).

I think that these high numbers highlight the recurring nature of PayPal’s business. It’s also worth noting that there’s no customer-concentration: No single customer accounted for more than 10% of PayPal’s revenues in 2016, 2017, and 2018.

5. A proven ability to grow

PayPal returned to the stock market only in 2015, so I don’t have a long track record to study. But I’m impressed by what the company has.

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” PayPal fits the bill. A few key things to note:

• Revenue has increased in each year from 2012 to 2018, and has compounded at a healthy clip of 18.2% per year.
• Net profit was always positive, and has increased by 17.6% per year.
• PayPal has not diluted shareholders too. Its 68% growth in net profit from 2015 to 2018 is similar to the 71% jump in diluted earnings per share (EPS) over the same timeframe. 
• Operating cash flow and free cash flow were always positive in each year, and the two important financial metrics have compounded at impressive annual rates of 23.2% and 28.1%, respectively. 
• PayPal’s operating cash flow and free cash flow in 2018 had enjoyed a one-time boost from the sale of the company’s US consumer credit receivables portfolio in July that year. But even after making the relevant adjustments, PayPal’s operating cash flow and free cash flow for the year would still be strong at US$4.1 billion and US$3.3 billion, respectively. 
• PayPal’s balance sheet was stellar throughout, given the high net cash position. 

PayPal continued to grow in the first nine months of 2019. Revenue was up 14.1% to US$12.8 billion, driving a 32.5% jump in net income to US$1.95 billion (diluted EPS grew 34.4% to US$1.64). Operating cash flow and adjusted free cash flow came in at US$3.3 billion and US$2.8 billion, respectively; adjusted free cash flow was up 25% from US$2.2 billion a year ago.

I see two notable traits in PayPal’s network: 

• PayPal has a global reach. It is able to handle transactions in over 200 markets, and allow its customers to receive money in 100 currencies, withdraw funds in 56 currencies, and hold PayPal account balances in 25 currencies.
• I believe PayPal’s business exhibits a classic network effect. Its competitive position strengthens when its network increases in size. When I discussed PayPal’s management earlier, I showed that the volume of payments and number of transactions increased faster than the number of accounts. This means that PayPal’s users are using the platform more over time – to me, this indicates that PayPal’s platform is becoming more valuable to existing users as more users come onboard.

I also want to point out two payment services providers that are in PayPal’s portfolio; I think that they are crucial for the company’s future growth:

• The first is mobile payments services provider Braintree, which was acquired in 2013 for US$713 million. Braintree provides the technological backbone for the payment tools of many technology companies, including ride-hailing app Uber, cloud storage outfit DropBox, and accommodations platform AirBnB. Braintree helps PayPal better serve retailers and companies that conduct business primarily through mobile apps.
• The second is digital wallet Venmo (acquired by Braintree in 2012), which allows peer-to-peer transactions. Venmo is highly popular among millennials in the US, and PayPal reported that there were more than 40 million active accounts for the digital wallet in 2019’s first quarter. During 2019’s third quarter, Venmo’s total payment volume surged by 64% from a year ago to US$27 billion (and up more than five times from just three years ago in the third quarter of 2016). The annual run rate of Venmo’s total payment volume has also now exceeded US$100 billion. Meanwhile, monetisation of Venmo has progressed at a rapid clip. The digital wallet’s annual revenue run rate in 2019’s third quarter was nearly US$400 million, double the US$200 million seen in 2018’s fourth quarter.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

PayPal has excelled in producing free cash flow from its business for a long time, and has huge growth opportunities ahead. There’s no reason to believe these will change any time soon. 

Valuation

I like to keep things simple in the valuation process. In PayPal’s case, I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value. That’s because the payment services outfit has a strong history of producing positive and growing free cash flow.

PayPal carries a trailing P/FCF ratio of around 38 at a share price of US$116, after adjusting for the one-time boost to the company’s free cash flow in 2018. This ratio looks a little high relative to history. For perspective, PayPal’s P/FCF ratio was only around 28 in the early days of its 2015 listing.

But I’m happy to pay up, since PayPal excels under my investment framework. 

The risks involved

There are six key risks I see in PayPal.

First, the payments space is highly competitive. PayPal’s muscling against other global payments giants such as Mastercard and Visa that have larger payment networks. Then there are technology companies with fintech arms that focus on payments, such as China’s Tencent and Alibaba. In November 2019, Bloomberg reported that Tencent and Alibaba plans to open up their payment services (WeChat Pay and Alipay, respectively) to foreigners who visit China. Let’s not forget that there’s blockchain technology (the backbone of cryptocurrencies) jostling for room too. There’s no guarantee that PayPal will continue being victorious. But the payments market is so huge that I think there will be multiple winners – and my bet is that PayPal will be among them.

Second, there’s eBay’s relationship with PayPal. When the two companies separated, they signed a five-year deal – expiring in July 2020 – for PayPal to help eBay process payments. eBay announced in 2018 that it would not renew the deal when it expires (although PayPal will still be a payment-button on eBay’s site through July 2023). eBay accounted for 8% of PayPal’s total payment volume (TPV) in 2019’s third quarter. But PayPal’s management expects the percentage to fall to “well under 5%” by the end of 2020. eBay’s also a waning presence in e-commerce, so I don’t think it holds any importance to PayPal’s future growth. During 2019’s third quarter, PayPal’s total TPV (excluding currency movements) grew by 27% despite the 3% decline in eBay’s TPV (similarly excluding currency movements) on PayPal’s platform.

The third risk I’m watching is regulations. The payments market is heavily regulated. What PayPal can take per payment-transaction could be lowered in the future by regulators for various reasons.

The fourth risk concerns recessions. I don’t know when a recession (in the US or around the world) will occur. But when it does, payment activity on PayPal’s platform could be lowered. PayPal’s business was remarkably resilient during the last major global economic downturn in 2008 and 2009. Back then, eBay had no revenue-growth from its main e-commerce platform. But the segment that consisted primarily of PayPal produced strong double-digit revenue growth in both years. PayPal’s a much larger company today, so it may not be able to grow through a future recession that easily – but its historical track record is impressive.

The US$4 billion acquisition of Honey represents the fifth risk. I want to be clear: I like the deal and I think it will work out great. But it’s still a risk. Let me explain. Honey’s revenue in 2018 was over US$100 million, with growth of more than 100% –  and the company was already profitable. In a recent article, Ben Thompson from Stratechery shared how the acquisition can lead to upside for PayPal’s business:

“The most important effect, according to Schulman, was on PayPal’s relationship with consumers. Now, instead of being a payment option consumers choose once they have already committed to a purchase, PayPal can engage with consumers much higher in the purchase funnel. This might be one step higher, as would be the case with coupon search, but it could also be around discovery and calls-to-action, as might be the case with the app or notifications and price-tracking…

…Honey is also an intriguing way for PayPal to actually make money on Venmo in particular. Honey’s audience skews heavily female and millennial, which means there is a lot of overlap with Venmo, and there is a good chance PayPal can really accelerate Honey’s adoption by placing it within its core apps (which it plans to do within the next 6 to 12 months)…

…If PayPal, via Honey, knows exactly what you are interested in buying, and can make it possible for merchants to offer customized offers based on that knowledge, well, that may be a very effective way to not only capture affiliate revenue but also payment processing revenue as well. Demand generation remains one of the most significant challenges for merchants… And here the fact that PayPal has 24 million merchant partners versus Honey’s 30,000 is a very big deal.”

But Honey is PayPal’s largest acquisition ever, and the deal comes with a steep price tag of US$4 billion. Assuming Honey can grow its revenue by 100% in 2019, PayPal is effectively paying 20 times revenue for the discount discovery company. I will have to face a situation of PayPal writing down the value of Honey if the integration of the two fails to live up to expectations.

Lastly, I’m mindful of succession risk. PayPal’s CEO, Dan Schulman, is already 61 this year. Fortunately, PayPal’s key leaders are mostly in their mid-fifties or younger.

The Good Investors’ conclusion 

I think the transition from cash to cashless payments holds immense opportunities for companies. I also think a payment company with a wide network of consumers and merchants (PayPal, for instance) stands a good chance of being one of the eventual winners. 

Furthermore, PayPal has a robust balance sheet, a proven ability to generate strong free cash flow, high levels of recurring revenues, and an excellent management team whose interests are aligned with shareholders. PayPal’s P/FCF ratio is on the high end, but I’m happy to pay up for a top-quality business.

Every company has risks, and I’m aware of the important ones with PayPal. They include competition, regulation, and more. But after weighing the risks and rewards, I’m still happy to allow PayPal to be pally with my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.