The Market Is Overly Pessimistic About PayPal

Senior Equity Analyst

Brett Horn

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PayPal’s development of a network of both merchants and consumers early in the evolution of e-commerce allowed the company to build and maintain an enviable competitive position. Historically, PayPal’s growth had been driven by the ongoing shift toward electronic payments and the rise of e-commerce, which the coronavirus pandemic further accelerated. However, the company is now seeing some headwinds in the near term as the positives from the pandemic reverse and the macroeconomic situation worsens. Management is attempting to combat the pressure on top-line growth with a greater focus on margin improvement, and we see this evolution as the right move.

Longer term, we see a mix of competitive opportunities and threats that create a fairly wide range of outcomes. PayPal remains a somewhat unique player within the payments space. We think this remains its key strength, but its position on both the merchant and consumer side could be challenged over the long run. Traditional point-of-sale acquirers are building out their online capabilities, and, in our view, it is notable that the commonality in the wave of M&A in 2019 was the combination of acquirer and issuer operations. This suggests to us that competitors are interested in replicating the PayPal model. Fintech innovation also appears to be concentrated in the e-commerce space, which has given rise to some new competitors. On the consumer side, services such as Apple Pay represent competition for PayPal. Competition on both sides could chip away at PayPal’s position. On the other hand, PayPal remains a preferred partner in the online space, and could leverage this into a growing presence in point-of-sale transactions. In balance, we think the company can hold its own, but we recognize the potential to veer in either direction.

An additional attraction is Venmo. Efforts to monetize the platform are in still in the early stages and Venmo will likely not be a major driver anytime soon. While its long-term future is difficult to predict, we believe it has the potential to create upside above our current fair value estimate.

Business Strategy & Outlook

Payment processing of any type is highly scalable, as once a payment platform is established, there is little incremental cost to additional transactions. If viewed through the lens of the acquiring industry, PayPal has material scale with over $1.4 trillion in annual volume but falls short of the volumes handled by players such as Fiserv and FIS. However, the acquiring industry contains niches, and within the e-commerce space, PayPal is a clear leader, which we think places a narrow moat around PayPal’s operations.

However, PayPal is not really an acquirer, its relatively unique model centers around a two-sided platform, with PayPal enjoying relationships with both merchants and consumers. We think this approach has material benefits and was instrumental in allowing PayPal to develop its current foothold in the industry. Having information on both sides of the transaction gives PayPal a meaningful edge in combating fraud, which was a very meaningful factor in the early days of the internet, and remains a key issue. With an ability to combat fraud, PayPal was in a position to become a valued partner on both sides of a payment. Further, the relative ease of using PayPal in an online transaction materially boosts conversion rates, with PayPal transactions converting at a rate of almost 90%, compared with an industry average of about 50%. This highlights the ease of checkout for consumers and the attraction for merchants. With these dynamics in place, PayPal was able to generate a network effect, and the company had 435 million active accounts at the end of 2022. 

We typically think of a network effect as a very strong source of advantage, and one that often gives rise to a wide moat. In PayPal’s case, though, we think the effect is much more mild, as the company is a relatively small piece of the overall electronic payment infrastructure. We think PayPal will remain a preferred partner in the online world, given the relative convenience and security of its platform, but its market position is not so strong that the company can dictate terms to other players or gobble up increasing amounts of market share. In our view, the limitations of the network effect are most apparent in the company’s decision a couple of years ago to switch to neutrality in terms of payment choices (that is, to allow consumers to choose their method of funding, as opposed to being defaulted to funding options that are more advantageous for PayPal). 

Outside of its legacy PayPal business, we think its Braintree operations also benefit from a narrow moat due to scale-based cost advantages. While Braintree is smaller than competitors Stripe and Adyen, it is growing quickly and looks to be carving out a positon as a long-term leader. We think Venmo benefits from a network effect. However, moats in this area are somewhat speculative, given the lack of profitability and uncertain long-term economics. 

Given the limited capital needs of the business, historical returns on invested capital have been higher than any reasonable estimate of the cost of capital. Over the past five years, return on invested capital has averaged 33% annually once goodwill is excluded.

Narrow

Economic Moat

PayPal

iZettle is a European fintech startup aquired by Paypal for $2.2 billion in May 2018. Sweden-based iZettle was founded in 2010 as a mobile credit card payment service much like Square but evolved into providing small businesses a gamut of services such as software support and financing solutions across Europe and Latin America. It raised $47 million (40 million euros) in its last funding round in December 2017, giving it a $975 million valuation reported Techcrunch.

iZettle

Xoom is an online money-transfer platform focused on remittances. Xoom has more than 1.3 million active U.S. customers using its platform to send international remittances, which amounted to $7 billion in 2015. PayPal is targeting emerging markets in India and China as key growth territories, and sees the Xoom online money-transfer platform PayPal anticipates enormous potential for mobile international remittances in the growing, worldwide migrant worker market. PayPal acquired Xoom Corporation for $890 million in 2015.

Xoom

Venmo is a mobile payment service owned by PayPal. It allows users to transfer money to one another (within the U.S. only) using a mobile phone app or web interface. It handled 17.6 billion dollars in transactions in 2016. In Q1 of 2017, it handled 6.8 billion dollars in transactions, which more than doubled its volume in Q1 of 2016.

Venmo

Swift Financial is a Delaware-based firm. Swift Financial was founded in 2006 and at the time of acquisition had provided funding to over 20,000 small businesses. PayPal Working Capital since its 2013 launch had given access to over $3 billion in capital to more than 115,000 businesses.

Swift Financial

Paydiant is a platform with the ability to integrate complete mobile wallet capabilities into their own mobile apps. The acquisition helps PayPal further develop its relationships with merchants and capture a bigger share of the mobile wallet space.

Paydiant

TIO Networks is a Canadian bill payments platform aquired in early 2017. The $233 million deal helped PayPal expand its footprint into bill payments by leveraging TIO's cloud based, multi-channel payment platform.At the time the deal was announced, TIO served 14 million consumer bill pay accounts and had processed transactions worth more than $7 billion in the year before (2016).

TIO Networks

Modest is a small, Chicago-based fintech company, to help it expand into an emerging branch of the e-commerce ecosystem called contextual commerce. Modest’s technology enables online merchants to drag and drop buy buttons to any application, social media page, email or blog post where a consumer might encounter their products. Instead of having to be redirected back to the merchant’s website or shopping portal, consumers can click the buy button wherever they are and complete the transaction. The Modest acquisition serves PayPal’s desire to expand its e-commerce reach among merchants. The Modest technology team is working with PayPal’s merchant services provider, Braintree, to provide online merchants with a one-stop set of tools for embedding buy buttons wherever they can, while supporting the back-end payment processing.

Modest

Braintree Payments is a mobile payment solution in the hotly contested P2P payments space. In the second quarter of 2016, Venmo processed nearly $4 billion in P2P money transfers, up 141% over the prior year. The Venmo payments app is popular among restaurant customers, who use it to split the tab between multiple diners. Although Venmo's payment volume represents a small portion of PayPal’s mobile payment volume, it is the fastest-growing platform. Venmo faces stiff competition from the likes of Apple, which is ramping up its P2P payment app in 2016.

Braintree Payments

PayPal Holdings, Inc. engages in the development of technology platforms for digital payments. Its solutions include PayPal, PayPal Credit, Braintree, Venmo, Xoom, and Paydiant products. It manages a two-sided proprietary global technology platform that links customers, which consist of both merchants and consumers, to facilitate the processing of payment transactions. It allows its customers to use their account for both purchase and paying for goods, as well as to transfer and withdraw funds. It also enables consumers to exchange funds with merchants using funding sources, which include bank account, PayPal account balance, PayPal Credit account, credit and debit card or other stored value products. It offers consumers person-to-person payment solutions through its PayPal Website and mobile application, Venmo and Xoom. The company was founded in December 1998 and is headquartered in San Jose, CA.

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In the fintech space, PayPal (NASDAQ: PYPL ) remains a top stock investors watch very closely. The leader in many facets of digital payments, PayPal remains a top holding of many large funds and is widely held by many investors with any sort of index fund.

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