Description

Investment Thesis

Long PYPL, one of the leading payment processing platforms in the world. With network effects from PYPL’s two-sided network, exposure to both online and mobile commerce, a trusted global brand, numerous emerging areas of upside, and pricing power in branded PYPL, PYPL is a high-quality disruptive business driving a structural shift to electronic payments.. PYPL can continue to drive higher engagement levels (DAUs +30%) with its new product revamp, resulting in a 2x/10x uplift to PYPL/Venmo TPVs, respectively. Moreover, new growth vectors like BNPL, Venmo, Super App should lower churn and increase LTV. 

The core branded PYPL business is a very profitable, high incremental margin business that can grow revenue/FCF growth by ~20% annually over the next 3-5 years. PYPL recently raised price in branded while still maintaining a majority share of the payment processing market. The lack of pushback from customers is indicative of the value PYPL provides to SMBs/merchants. We think the current consensus is wrong about lower incremental margins in the future. International expansion via BABA, MELI, Paidy and a current low share of cross-border TPV suggests a long runway for future revenue growth (and margin expansion). As PYPL comps its eBay headwinds in 1H22 (and difficult COVID comparisons), revenue growth should reaccelerate to 20% in 2H22 supported by initiatives like pay with Venmo, offline expansion, BNPL, crypto, and the Super App introduction. 

After a painful 40% share price drawdown from its peak levels in 2021 due to non-recurring eBay headwinds and tough comparisons for loan loss reversals and COVID growth, PYPL shares appear undervalued looking out to the end of 2022 and beyond. Using a historical 35x P/E ratio on a FY23 EPS estimate of $6.65 (vs. consensus $6.63), there is more than 25% upside by the end of 2022 to $230/share. A DCF-driven valuation suggests further upside to $315, assuming PYPL maintains double-digit revenue growth CAGR beyond FY26. 

Business Description

With 400M consumer accounts and 35M merchant accounts, PYPL is the world’s leading payment network. By operating as a payment processor for online vendors, auction sites, and many other commercial users, PayPal serves as an electronic alternative to traditional paper methods like checks and money orders. PYPL started as EBAY’s exclusive payment processor prior to being spun out as an independent company in 2015. Transaction-related revenue accounts for 90%+ of PYPL’s revenue and is comprised of fees charged to merchants for accepting PYPL, foreign currency conversions for money transfers, cross-border transactions, facilitating the instant transfer funds to debit cards or bank accounts, etc.

Source: PYPL

As a two-sided payment platform with visibility over both parties in every transaction, PayPal holds key advantages in data, speed, and security. PayPal also has a long-term vision of building an integrated payments ecosystem that includes both online and in-store purchases, payments (including P2P and B2C), consumer rewards, Buy Now Pay Later, etc. 

Businesses who use PayPal convert 60% of their consumers into PayPal users while PYPL checkout is 34% more efficient than competitors. Users are 54% more willing to buy when a business accepts PYPL, and 59% of PYPL users have abandoned a transaction because PayPal wasn’t an option at checkout. 

PYPL’s 70% appearance rate in e-Commerce check-out is materially higher than any other competitor. PYPL’s conversion rates are 60% higher than alternative digital wallets. 

Source: Wall Street research

Growing eCommerce Penetration Remains a Secular Tailwind

Source: PYPL

While COVID accelerated the world’s digital market penetration, eCommerce and the move to omnichannel retail driving offline expansion remain an ongoing tailwind for PYPL. Globally, eCommerce is expected to grow at a double-digit revenue CAGR through 2025.

eBay. While the loss of eBay has been considered a negative by the market, in reality the partnership constrained PYPL’s ability to expand into other online marketplaces. The loss of eBay exclusivity provides an opportunity for PYPL to enter new merchant agreements, as evidenced by its recent BABA and AMZN announcements. And following the eBay contract expiration, growth rates in core PYPL inflected higher, with two-year stack TPV growth rate of ~80% in most recent quarters vs. a historical 40% trendline, indicating sustained growth rate supported by the COVID pull-forward.

International Expansion. There is a significant potential in new geographies beyond the US and UK, which combined were about 60% of revenues in 2020. As demonstrated by PYPL’s recent acquisition of Paidy in Japan, its ownership of GoPay in China, and partnerships with MELI and BABA, PYPL intends to aggressively expand into new geographies over the coming years. 

Investment Highlights

Focus on incremental transaction margins instead of take rate compression or higher transaction expenses. We believe PYPL is focused on transaction gross profit dollars, with lower take rates in Braintree and new categories offset by lower transaction expenses. We expect a stable net revenue run-rate (or transaction margin dollars) despite a take rate that will look optically depressed due to a higher mix of lower take-rate services such as Bill Payments, Braintree, P2P, etc. PYPL benefits from substantial scale and operating leverage as roughly 75% of PYPL’s non-transaction expenses are fixed. PYPL’s non-transaction expense as a percentage of revenue has declined from 38% in 2015 to 30% in 2020. PYPL should continue to expand operating margins while take rates compress further longer-term due to higher mix of non-branded PYPL services. 

Branded Paypal is a high incremental margin business. PYPL’s highly-profitable, high incremental margin branded business should drive revenue/FCF growth of 20%+ annually over the next 3-5 years. The stickiness and pricing power in this business was recently demonstrated by PYPL’s recent price increase in the branded PYPL segment. Before the recent eBay headwinds, incremental margins increased from mid-20% to mid-30%, indicative of the operating leverage embedded in core PYPL.

Source: kerrcap estimates

Low-cost debit/ACH funding. With a higher mix of ACH and Balance transactions, PYPL’s cost of funding is lower than competitors. This is due to PYPL’s legacy role at eBay funding online transactions by linking bank accounts via ACH and Venmo’s P2P business driving a higher share of balances.

Source: Credit Suisse

Venmo and monetization. We believe Venmo remains under-monetized. With ARPUs of major fintech digital wallets like Cash App approaching $50/user, we see an opportunity for strong ARPU uplift as digital wallets expand into traditional financial services (e.g. Pay with Venmo, BNPL, Instant Transfers, Debit Card, Crypto). Square’s Cash App provides a roadmap for PYPL to leverage, and we expect Venmo revenue contribution to eventually exceed 10% by FY26. Both Venmo and Paypal Super App should help in reducing overall churn and CAC on PYPL’s platform vs. offline/online competitors, and drive user engagement (and LTV) via new monetization drivers. This chart from Credit Suisse illustrates how Venmo could drive a materially higher ARPU, closer to current Cash App ARPU levels. 

Source: Credit Suisse

Our channel checks suggest a positive outlook for Venmo adoption, potentially reaching 10% of checkout share over the next couple of years. PYPL benefits from Venmo exclusivity driving up Braintree adoption as well. According to third-party resellers, Venmo was requested in 50% of their conversations with SMBs/merchants as exposure to the millennial consumer is highly valued by merchants. The AMZN deal alone could add $250M in incremental Venmo revenue, assuming a 5% Venmo penetration and 1% take-rate on a $500B annual AMZN GMV.

Digital wallets should see strong growth over the next few years. By 2024, WorldPay expects 33% of in-person payments globally to be made using digital wallets, while the use of cash falls to 13% from 21% over the next 3-4 years.

Source: Bloomberg

BNPL. PYPL is the leader in buy-now-pay-later (“BNPL”) transactions, with BNPL driving a 21% increase in TPVs at 90% incremental margins. BNPL TPV annual run rate reached ~$8bn, with ~9.5m consumers transacting across ~950k merchants (~65k adopting BNPL upstream). BNPL share of online checkout is expected to double by 2024. BNPL surged 400% Y/Y for PYPL on Black Friday, with BNPL GMV exceeding $1B. Here, PYPL’s existing network and customer data drives higher BNPL approval rate than competitors. According to PYPL, the average cart size for a retailer increases by 37% when they used PYPL’s BNPL checkout option.

Source: Credit Suisse

Super-app. PYPL has ambitions to become a super-app for consumers, focused on payments, shopping and financial services including high-yield savings vehicles, check cashing, etc., and shopping, where PYPL can integrate Honey’s personalized rewards engine.  

Valuation

As PYPL laps eBay headwinds, we expect revenue growth to reaccelerate to 20% by the end of FY22, driving a rebound in earnings growth. Assuming incremental EBIT margins similar to historicals of mid-30%, we calculate FY23 EPS of $6.65 vs. consensus $6.63. Using our FY23 EPS and a 35x P/E ratio, we expect PYPL shares to reach $230 by the end of 2022 vs. current price of $185, suggesting more than 25% upside from current levels. 

Our DCF derived valuation suggests further upside to $330, assuming PYPL maintains a double-digit revenue growth CAGR beyond FY26. 

On a relative basis, PYPL screens favorable on an EV/Sales basis, trading at a 7x EV/Sales multiple vs. peer group at 10x. While PYPL multiples remain elevated vs. the broader market, we believe it deserves its premium valuation due to its status in digital payments and the long runway ahead in revenue and user growth. We believe PYPL will sustain a long-term annual EPS growth trajectory of over 20%, generating attractive returns for investors, especially considering the optionality from its expansion into offline payments and digital wallets (i.e. Venmo). 

Source: Bloomberg, kerrcap estimates

Long-term targets. PYPL’s LT 2025 targets of 750M users and 20%/25% revenue/TPV growth have been a clear source of concern due to a post-COVID slowdown in eCommerce spend and PYPL’s TPV trajectory. Partly, this is a result of providing long-term targets at the peak of COVID tailwinds in 1Q21. Longer-term, we believe there’s an opportunity to target 1B accounts while driving double digit revenue growth. 

Risks

Competition. Competition remains a clear risk within the payments industry. PYPL enjoyed a first-mover advantage over industry competitors, leading to its large active user base in both merchants and consumers. However, the payments landscape is evolving rapidly with well-funded competitors like Stripe and Adyen look to gain share in PYPL’s core markets. We expect PYPL’s Braintree to continue to gain overall market-share given the relatively low market share vs legacy providers. 

Source: Credit Suisse

Pull-forward in eCommerce demand. PYPL benefited from strong uplift in eCommerce due to Covid, and a sustained period of weak eCommerce trends and weak user account growth could remain a headwind for PYPL shares. 

Rising consumer credit deliquencies. Consumer lending in areas like BNPL is showing some initial signs of credit stress, which could negatively impact the perception of PYPL's risk profile. However, BNPL is still a small fraction of PYPL's total TPV.

Catalyst

Resumption of 20% revenue growth in H2 2022, lapping loan loss reversal headwinds and last year's favorable tax adjustments, continued market penetration within ecommerce