PayPal’s stock has underperformed the broader market since reaching a new high of $41.75 on March 22. The stock bottomed at $34.00 on June 27 and has since bounced back to close at $38.15 today. Year-to-date, the stock is up 5.4%, slightly behind the S&P 500’s 5.8% total return. Since being spun-off from eBay on July 2, 2015, PayPal is up 3.9%, about 1.4 percentage points behind the S&P.
It is difficult to explain the stock’s underperformance vs. the broader market since March. A certain member of the business media suggested that analysts were down on the company, so that the stock was not likely to stop going down until they became more positive again.
If that is true, then I am not sure why analysts turned negative. PayPal has met or exceeded its performance goals since returning to the public markets a year ago. It has beat consensus earnings estimates in each of the past four quarters. It has also delivered on key performance metrics such as growth in active accounts and transaction volume.
PayPal does not fit neatly into one industry sector, so identifying direct competitors is not so easy. The company facilitates payments, especially between merchants and consumers. Its business overlaps in some areas with credit card giants, such as American Express, Mastercard, Visa and Discover; but it competes more directly against other payment platform providers, such as Global Payments (GPN), Total System Services (TSS), Vantiv (VNTV) and Square (SQ).
PayPal sees its addressable market as the 85% of global consumer transactions that are still settled with cash. This is a huge $100 trillion long-term opportunity. Mobile payments are the key to getting consumers to make the switch. Consequently, the company is working feverishly to build out its end-to-end technology platform that will give merchants and consumers the ability to conduct business as they want – in store, online and through Apple Pay, Android Pay or Samsung Pay, for example.
As the long-time leader in online payments, PayPal starts with a large customer base and strong reputation of trust and safety. It has extended its service capabilities (and market opportunity) through selected acquisitions, including Venmo and Zoom in person-to-person payments; Braintree in APIs that allow merchants to customize their own online payment platforms, including one touch checkout; and Paydiant, a cloud-based merchant payments platform provider.
With these offerings, PayPal has been able to grow its customer base at a three-year compounded annual rate of 13.3%, transactions per customer at 8.2% and transaction volume by 23.4%. This has produced average annual revenue growth of 17.8%.
Over that same three-year period, the company has maintained a GAAP operating margin in excess of 15%, so profits have grown commensurately with revenues. GAAP earnings rose at a three-year average annual rate of 16.4% and non-GAAP earnings at 18.2%.
PayPal believes that its financial performance metrics is sustainable. Thus, it expects to continue to grow transaction volumes at a mid-20% annual rate at least for the next several years. However, It anticipates that revenues will grow at only a 15% annual clip, primarily because the average discount rates that it charges merchants will decline over time, as it obtains relationships with more giant retailers who now account for less than 50% of its overall transaction volume. Under this model, profits and cash flow should continue to grow in line with revenues or better.
The company’s non-GAAP valuation metrics are consistent with this outlook. Consensus estimates anticipate earnings of about $1.50 in 2016 and $1.75 in 2016. At the current share price of $38.15, that translates into forward P/E multiples of 25.6 and 21.6, respectively. On a GAAP basis, which includes employee stock compensation expense and amortization of acquired intangible assets, my forecasted EPS are $1.11 in 2016 and $1.39 in 2017, which works out to forward P/E multiples of 34.4 and 27.5.
PayPal appears to have the leading consumer payments platform at a time when digital payments are poised for continued growth. Although the stock price is not cheap, it is valued roughly in line with peers. (My peer group includes ACIW, FSIV, FLT, GPN, SQ, TSS, VNTV and WU.)
The primary risk, it seems to me, is that a recession could once again cause consumers to curtail or limit their spending. Merchants are already experiencing a squeeze on revenues and profits. They have banded together to challenge the discount rates charged by credit card companies. Recent court cases have taken aim at the oligopolistic power of the major credit card companies and for the right to steer customers to cards with lower discount rates. Although they have reached settlements with most major credit card issuers, they will most likely try to maintain downward pressure on credit card transaction costs going forward.
When credit cards were relatively new, merchants were willing to overlook discount fees because accepting credit cards meant incremental sales. As more payments get digitized, merchants will press for discount rates that are closer to the actual cost of processing the transactions. (Electronic payments do raise productivity for retailers, so they will remain willing to pay a premium above cost for the service, but how much of a premium will be a key point of contention going forward.) Merchants may also lobby for the right to pass part or all of the credit card fee to their customers (in the same way that most gas stations do now). If consumers are required to bear an extra charge for the convenience of debit and credit card payments, it remains to be seen whether they will use their cards as frequently, even with the enticement of the rewards programs offered by card issuers.
In my first report on PayPal (published on Seeking Alpha on Sept. 28, 2015), I established a 2017 price target of $38 for PayPal’s stock. As noted above, the stock reached a high of $41.75 in March and closed at $38.15 today, a full 12-18 months ahead of schedule. Management has so far delivered on its commitments; but given the stock’s relatively high valuation, ongoing risks in the macroeconomic environment and the still significant challenges that the company faces in executing its business plan, I am now downgrading the stock to “Hold.”
July 11, 2016
Stephen P. Percoco
Lark Research, Inc.
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Linden, New Jersey 07036
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