Description

We are recommending purchase of Paypal shares.  

Quick Background:

Paypal was spun out of EBay in late 2015.

Paypal has scale on both the consumer (188mm active accounts) and merchant (14mm merchants accept Paypal payments) sides of the payment world.

The company processed 4.9bn transactions in 2015, with Total Payment Volume (TPV) of $, generating $8.1bn in transaction revenue.

Business model:

Paypal makes money by taking a fee that is a % of total payment volume.  The fees (and presumably margins of the related businesses) vary widely, some services being entirely free at this point.  On average, the company took in 2.8% of volumes in 2015.

This fee has been declining for several years as the company moves away from transactions on Ebay and towards large merchants and P2P.  We expect this decline to continue, but transaction payment volume growth discussed below should offset this.

On the expenses side, Paypal must pay out to the networks they use to process the transaction.  The card networks (V, MA, AXP), an estimated 55% of volumes, charge 2-3% fees, while ACH, the bank network, charges significantly less.     Traditionally, Paypal has ‘steered’ customers towards ACH as its fees are so much lower.  The company generates gross margins on transactions of approximately 60%.

We believe Paypal has a number of growth drivers that should allow for significant upside in the coming years:

Continued growth in ecommerce and growth in share:

Paypal has given medium-term guidance for 20% growth in transaction volumes.  A good chunk of this growth will come simply from the growth in its overall operating environment.

Ecommerce is still in its infancy.  It was approximately 7.3% of all US retail sales in 2015, growing nearly 15% y/y, while overall retail sales grew under 2%.  Simply by maintaining share, Paypal should continue to grow its topline.

In addition, Paypal should be able to grow some of it share among merchants.  Paypal has 75 of the top 100 retailers that Paypal can sell to now that it is independent of Ebay.

Paypal also operates Braintree, a competitor to Stripe, which helps online and mobile merchants to easily integrate a number of payment options onto their websites and mobile applications.   Braintree’s customers include Uber, Airbnb and Opentable.

Potential monetization of Venmo:

Venmo is the mobile P2P payments solution currently used by a significant number of millennials.   These customers did $4bn in P2P payments in 2q, growing 140% y/y.  It currently generates little revenue.  Thus, it generates transaction volume but helps to bring down the rate of revenue generated from dollar value of transactions.

Over time, though, Paypal is introducing Pay with Venmo that will allow merchants to take Venmo payments.  It will be easily integrated through Paypal’s Braintree system.  Venmo will charge merchants the same fees Paypal charges.  We expect merchants to be attracted to the easy integration, the millennial customer base, and the social aspect of payments on Venmo, which will provide essentially free advertising for the merchants.

Recently announced deals with Visa and Mastercard:

Paypal stock has been somewhat weak recently due the deal it announced with Visa.  Today, it announced a similar deal with MasterCard.

With these deals, Paypal essentially agreed to steer Visa and Mastercard customers towards higher-cost network processing and away from the cheaper ACH processing.  In exchange, Paypal gets several benefits discussed below.

As these deals get underway, investors are concerned that Paypal will see more volumes processed through the card networks and see higher expenses/gross margin compression as a result.   Estimates vary, but the sell-side estimate we’ve seen indicate a hit of 1-10c in EPS in 2017.

But the long term effects of these deals should make Paypal more attractive for merchants and consumers:

Among merchants:

• Online merchants who have Visa Checkout and MasterPass, the digital wallets, can now accept PayPal.

• PayPal will be integrated into offline applications for both Visa and Mastercard, for merchants who use their NFC options.  Paypal thus gets another toehold in the much larger space of physical retail.   

Among consumers:

• Users can move money from PayPal and Venmo accounts to bank account in real time with Visa Direct and MasterCard Send.  So far, movement of money has taken several days transaction time.

Potential operating leverage:

The company’s EBIT margins have stayed around 16% and EBITDA margins have remained around 21% the last several fiscal years.

On 2015 numbers, Paypal’s cost per transaction was $1.48.  Paypal has indicated that a little under half its costs per transaction are variable.  Another 13% are semi-variable.  Approximately 40% are fixed.

Thus, we would expect to see some leverage on operating expenses as volumes grow.  This leverage should help to offset some of the potential compression from the V/MA deals.

Free cash flow generation:

Historically, the company’s CFO less capex has run at approximately 20% of revenues.  The company is guiding to over $2bn in FCF this year, a 5% yield on its EV.   

This year, the company has executed $900mm on a $2bn buyback program.

Valuation:

At year-end 2017, we expect PYPL to trade at an EV/EBITDA of 15x 2018’s estimated EBITDA of $3.6bn, implying 34% upside from here.

Risks:

Paypal is operating in competitive spaces that have drawn competition from, among others:

• Apple, Google, Samsung in mobile payments

• Amazon and Square in one-click/merchant solutions

• Visa, Mastercard and AXP for digital wallet

• ClearXchange/the big banks in P2P

So far, Paypal has managed to use its scale and its singular focus on payment processing to maintain significant share in its products.  We also believe that the size of the overall market will allow for several players.  

Catalyst

• Continued growth in transaction volumes

• Monetization of Venmo

• Operating leverage to offset potential margin compression