Investment Thesis – Thriving in the pandemic and building for the world beyond
We see PayPal (NASDAQ:PYPL) as the best-in-class digital payments company, well positioned to benefit from the move to e-commerce during the pandemic and beyond. We see the recent growth in e-commerce sales as sustainable driven by the stickier new customer cohort of older aged customers, coined by management as “Silver Tech” and merchant’s launching not only new use cases for online businesses but also adopting a digital-first strategy.
We are most excited about the potential for mobile payments in the US. We see PayPal as best positioned to capture the biggest market share in the form-factor pivot of payments to mobile given its scale both on the side of consumers (150 to 175m US consumers) and merchants unlike any other player in the payments space.
Tech savvy CEO Daniel Shulman took the helm in July 2015 and has been instrumental in transforming the business from a product (PayPal Checkout) company to complete digital platform company, boasting of some of the leading fintech products in the industry such as Venmo, Xoom, iZettle and Honey among others.
We initiate coverage on PayPal with a Buy recommendation and price target of $229, imputing a 20% upside to its current share price. Post the pandemic, PayPal’s short to medium-term growth trajectory has been upgraded, warranting a higher PE multiple of 47x which we explain more in our valuation section below.
Pandemic accelerates structural growth of E-commerce
The spread of the pandemic has accelerated the penetration of e-commerce in Q2 alone by three to five years. The penetration or the diffusion rate of e-commerce in Q2 2020 increased to 16% from 12% in Q1 2020, a 400bps change vs 20 to 50bps historical change per quarter. (Figure below).
E-commerce penetration accelerated by almost two to three years in a single quarter driven by Stay at Home measures
Source: US Census Bureau and AlphaTech Equities
We see the growth in e-commerce penetration as sustainable
Encouragingly, management recently reported that it saw digital payment volumes remain at elevated levels vs pre pandemic in areas where STH measures were relaxed, and people were going out to eat at restaurants and shop at brick and mortar businesses.
We believe there are several factors that are driving confidence in the sustainability of e-commerce penetration including…
- Visa payment volumes for Card-Not-Present (NYSE:CNP) shows elevated levels of growth in Q3 2020 despite reopening of most of the US economy
- “Silver-Tech” cohort has broadened userbase
- Emergence of new e-commerce use cases
1. Visa Card-Not-Present volume shows elevated levels of growth in Q3 despite reopening of economy
Our view on the sustainability of e-commerce is driven by evidence in that “Card-Not-Present” volumes (which stands for payments made online, phone, recurring payments and invoices) reported by Visa increased by 30% excl. travel throughout July and August. It is important to note that these are levels which are much higher than the volumes seen in April which should provide significant upside for PayPal‘s Q3 payment volumes.
CNP volumes rebounded strongly in Q2 and continues to remain at elevated levels in Q3
Source: Visa 8-K
2. “Silver-Tech” cohort continues to expand userbase
In the Q1 earnings call, management reported that older cohorts which it termed “Silver Tech” had for the first time started to use e-commerce. This remains the fastest growing cohort of net new actives for PayPal in H1 2020. This elderly aged cohort, seemingly assisted by their children or family members, explaining them on how to use PayPal’s products has been an important win for PayPal given that they are the most financially well-off segment of the society. To gauge the stickiness of customer relationship of new cohorts, PayPal estimates that customers that complete three or more transactions in the first 10 days of using PayPal, typically turn out to be life-long customers. PayPal explained that from preliminary evidence, a good majority of the Silver Tech cohort should be life-long customers. At the end of Q2, management estimated that these new cohorts could end up accounting for 6% of its total customer base.
3. Further penetration driven from new e-commerce use cases
In addition to the “Silver Tech” cohort, PayPal sees new use cases as one of the most important drivers in the sustainability of e-commerce growth. Management reported new industries beginning to launch digital products given that was the only form of business available for many areas in the US during STH orders. Verticals including Education, Healthcare, Fitness, Restaurants and Entertainment all significantly pivoted to the online business model and adopting a digital-first strategy. Brands in these industries are for the first time selling to consumers directly online. Industries like Groceries and Home & Garden have experimented with online sales previously but given the move to online are seeing close to triple digit growth in online sales.
PayPal’s checkout product still core to its digital platform, sits extremely well with merchants selling online. When a PayPal option is added at checkout, online sales on average typically increase 50% for merchants, given how much more seamless the payments process is for consumers.
Furthermore, JP Morgan also estimated the recent jump in e-commerce sales as “sustainable”, consequentially increasing its long-term US E-commerce penetration rate to 35% to 40% from 30% previously (Figure below).
JP Morgan expects long-term penetration of e-commerce to increase to 35-40% up from 30% previously
Source: JP Morgan Estimates
PayPal has built an impressive portfolio of digital assets
We have been very impressed by CEO Daniel Shulman who has been instrumental in transforming the fintech from a product (PayPal Checkout) company to a complete digital platform company, boasting of some of the leading fintech products in the industry such as Venmo, iZettle, Xoom, iZettle and Honey among others. PayPal currently has some 80 software releases a day versus eight software releases a year when Daniel took charge in 2015, highlighting the steep technology curve PayPal has climbed in his time there.
Figure: PayPal has transformed itself from a product to a digital platform company
The company has a balanced approach in adding digital products to its platform architecture using bolt on acquisitions and organic product launches. PayPal has acquired several digital fintechs (figure below) to expand its product offerings, some of which we highlight below.
Figure: M&A has been a key driver of product expansion
Source: AlphaTech Equities and PayPal press releases
PayPal’s Checkout is the flagship product
Previously known as PayPal Express Checkout, PayPal Checkout is a module that simplifies a buyer’s secure checkout experience by presenting them with the most relevant payment types to make online purchases.
When a customer clicks on the PayPal Checkout button, a transaction is set up via PayPal’s Orders API, allowing users to log in and pay via their PayPal account. Upon approval of payment, PayPal automatically fills out the user’s details before returning the user to the WHMCS shopping cart to complete the checkout process. To implement the checkout button however, a merchant’s e-commerce website must contain an HTTPS secured connection to create a link between WHMCS and PayPal.
Figure: PayPal Checkout process.
Merchants incur a fee when a transaction is conducted via PayPal Checkout. For sales within the US, merchants incur a 2.9% fee in addition to a $0.30 fee per transaction. International sales incur a higher transaction fee at 4.4% with an additional fixed fee based on the receiving currency.
PayPal reported a 40% YoY growth in PayPal Checkout volumes in Q2 2020, highlighting the upside from the incremental move to e-commerce it benefited from during STH orders.
Honey Science Corp – Discount eCoupons
PayPal acquired Honey Science Corp in 2020 for $4bn. Honey operates as a browser extension that aggregates and automatically applies online coupons to e-commerce websites. The extension is available on all Chromium-based browsers in addition to Safari, Firefox, and Opera. Prior to being acquired by PayPal, the extension boasted a strong 17 million monthly active users and 30,000 partnered online retailers, generating more than $1 billion in consumer savings during 2019 alone.
Honey takes advantage of large sets of data and hyper-personalisation to tailor unique deals for each of its individual customers. It operates a massive database, cataloguing the price of every item on retail websites and notifying users when there is a price drop on an item listed in their drop-list. If a user makes a purchase from a select number of partner merchants, Honey receives a commission, which it then distributes a portion to its users via its cashback program. Honey’s Net New Active Accounts (NNAs) were 3x the level in Q2 2020 versus that of Q1, highlighting how the fintech benefited during the STH period.
Figure: Screenshot showing how Honey compares prices on Amazon
Xoom – International funds transfer
PayPal acquired Xoom in 2015 for $890m. Xoom facilitates electronic fund transfers to over 158 countries worldwide via its website and mobile application. In a select few countries, customers may also pay their bills and reload their mobile credit via Xoom. The company was acquired by PayPal in 2015 to solidify PayPal’s position in the cross-border transaction industry.
Xoom primarily generates revenue via a servicing fee and the difference in foreign exchange rates. The service fee varies depending on the customer’s country, the recipient’s country, source of funds, payout currency, and overall transfer amount. Transferring from a US bank account incurs the least fees but requires a maximum of four business days for Xoom to receive funds. Customers paying via a credit or debit card would incur higher fees, but the transaction will be processed significantly faster. Xoom charges some of the lowest fees in the market. International money transfer from the US to popular countries such a Mexico or the Philippines costs only $4.99, irrespective of the transaction amount. Xoom NNAs were up over 600% in Q2 versus Q1 2020.
Figure: Xoom fees calculator
Source: Xoom’s website
iZettle – Card terminals for merchants
PayPal acquired Swedish POS manufacturer, iZettle for $2.2bn in 2018. As the first company to develop a solution to mobile commerce, iZettle commands huge popularity within the industry. Its latest card terminal, which was launched in 2016, has replaced all its previous card readers in Europe, and it was the first mobile payments company to accept contactless payment within the UK. iZettle is a major competitor to Square and was acquired by PayPal to expand its in-store presence with SMEs and significantly grow its presence within Europe.
iZettle provides payment and point-of-sale solutions, offering two distinct products: iZettle Go and iZettle Food & Drink. The iZettle Go application is free to download, it turns any smartphone or table into a point-of-sale system, facilitating cash, card, and invoice payments. Card payments through the app incurs a fixed transaction fee of 1.75%, regardless of the card processed by the iZettle reader. Payment links, invoices, and transactions made via e-commerce websites incurs a fixed 2.5% per transaction made through the iZettle system. At the price of £29 per month per device, iZettle Food & Drinks allows users to track sales, staff, and waste, print orders, and split bills in addition to all the features included in iZettle Go.
Figure: Image displaying the full range iZettle store kit
Digital wallet Venmo is the crown jewel in PayPal’s portfolio, boasting 60m users at the end of Q2
PayPal acquired Venmo as part of its $800m Braintree acquisition in 2013. Venmo is a peer-to-peer (P2P) payment application available on both the iOS and Android operating systems. The app facilitates payments by acting as a third party and is extremely popular in the US with the phrase “to Venmo” becoming synonymous with making P2P payments.
While PayPal’s digital wallet has many of its features, Venmo is an entirely different product proposition as it is unique to both users and merchants. Unlike other payment applications, Venmo is a payments platform build around its social capabilities. The platform encourages users to share their experiences after each transaction, facilitating conversation around their purchases. This high level of engagement acts as free advertisement for merchants.
Digital wallet monetisation remains a key driver of growth for PayPal
At the end of 2019, PayPal reported a revenue run rate of $450m for Venmo on a 52m user base. Since then Venmo has seen the number of users increase to 60m by the end of H1 2020. Both PayPal and Venmo together have c. 150 to 175m users in the US alone. The revenue per user run-rate of $9 in Q4 2019 for Venmo is much lower than that of rival Square at $30 in Q4 2019 and $45 at the end of H1 2020. This underscores the potential of growth for Venmo going forward, especially if, much like Square, PayPal can offer trading of crypto assets on its digital wallets. PayPal already monetises Venmo by allowing its users to pay at merchant locations, use its debit card or making instant P2P transfers. With the aim to increase monetisation for Venmo, PayPal has announced plans to issue credit cards at the back end of 2020 for user in partnership with Visa.
Square has increased its rev per use by 3x in the last three years primarily on the back of adding new revenue generating products
The pandemic has triggered a seminal point to unlock the QR-code opportunity
Investing in QR code payment opportunity is vital for PayPal, given that it allows to broaden its payments offerings to offline brick and mortar businesses which constitutes >80% of all retail sales. Given the increased free cash windfall from the pandemic, management announced an additional $300m of investment in H2 2020, majority of which will be dedicated to building its QR-code payments network in the US.
In terms of PayPal’s QR-code unit economics, sighting the pandemic, PayPal is not charging merchant for any payments until the end of 2020. However, beginning 2021, merchants will pay 1.5% of transaction value + €0.10 per transaction in the UK.
PayPal sees itself benefiting from a “HALO” effect as consumers using it online also more likely to use it for offline purchases given the positive brand identity it enjoys. We see PayPal’s QR code offering as a significant driver of growth in the medium to long term given…
- PayPal is best positioned of all payment companies to drive QR code adoption in the US given it has c. 150m digital wallet users on its platform
- The onset of the pandemic is driving merchants to demand touchless payment solutions
- Strong value proposition for using digital wallets will fuel user adoption
1. PayPal is best positioned off all payment companies to drive QR-code based payments in the US
Unlike any other payment company, PayPal’s is the best positioned to drive QR-code based payments given that its scale. Venmo and PayPal combined have between 150 to 175m users in the US at the end of H1 2020, an extremely attractive proposition for merchants of any size. Versus competitors, Square comes closest with a digital wallet which had 45m users at the end of H1 2020. Visa and Mastercard do not have a digital wallet serving customer directly. Zelle, another P2P payments platform back by banks and credit unions in the US is another big player in the digital wallets space which had forecasted to overtake the number of Venmo users (40m in 2018 versus 60m in Q2 2020) back in 2018.
Figure: US mobile payments penetration is significantly lower than China
2. The onset of the pandemic is driving merchants to demand touchless payment solutions
Furthermore, with the onset of pandemic, users are more likely to use touchless payments such as QR-codes, driving merchants to reach out to PayPal and ask for touchless payment solutions. Currently, PayPal is working with more than 100 large retailers across US and Europe including the likes of pharmacy giant CVS to provide QR-code based payments.
3. Strong value proposition for using digital wallets will fuel user adoption
The ability to add reward points for customers every time they pull out a PayPal or a Venmo digital wallet will be a key driver of adoption. Acquisition of Honey will provide further impetus for users to use the Venmo and PayPal apps to make offline purchases as it allows merchants to integrate some of Honey’s discount offerings. Merchants could also use proximity messaging feature to provide customers with offers to increase sales.
Multiple risks remain which we monitor closely
- eBay contract expiry – PayPal expects eBay contract expiry to result in a 1% revenue growth headwind this year. Management made a good case on how the expiration will allow PayPal to add more and forge deeper relationships with current marketplaces, which it was unable to do previously given eBay contract stipulations, restricting PayPal to work with competitors.
- E-commerce growth may not be as sustainable – We have highlighted several reasons why we are aligned to management’s view in the sustainability of the move to e-commerce. However, PayPal remains exposed to the risk of e-commerce underperformance which we see the most important lever for its medium-term growth.
- Venmo monetisation execution – PayPal’s significant component of medium to long-term growth expectations is anchored on its ability to execute on its monetisation goals as it launches new products and migrates users to higher revenue generating payment cards. We believe Square has pulled away with stellar execution in monetising its Cash App recently benefiting from the off-the-charts increase in the Bitcoin trading on its platform. We see PayPal following suit, but execution risks remain.
- End of stimulus program – Government stimulus has been a core driver of monetisation for digital wallets as customers have used digital wallets to receive benefit money – then going on to use higher revenue generating products such as the in-app debit card to make purchases online and in stores. Furthermore, the stimulus has been a core driver of growth in e-commerce sales during STH orders. With further stimulus still being debated, PayPal’s second half results will provide a good indication on how much of the recent growth of digital wallets and e-commerce is sustainable.
Pandemic has upgraded medium-term financials but multiple levers of growth remain for the world beyond
After posting stellar Q2 results, PayPal has upgraded its full year 2020 revenue guidance to 22% from 17-20% it set out earlier this year. Additionally, management also upgraded its full year EPS growth guidance by 9% to 25%. Given the CNP volumes of 30%, Visa reported for July and Aug, we see PayPal’s Q3 results beating its full year guidance comfortably. On a three to five-year basis, we see PayPal’s revenue increase by ~20% and EPS to increase by c. 18-24% driven primarily by operating leverage despite taking into picture PayPal’s incremental investments to roll out its QR-code infrastructure across the US.
Our financial model estimates 24% EPS growth over the period 2019-2024E
Figure: We estimate a 20% revenue growth and 23% EBIT growth over the next five years
Source: AlphaTech Equities
PayPal shares are expensive for a good reason but offers decent upside
PayPal’s 12-month forward PE ratio has increased from an average of 35x in the two years prior to the pandemic to an average of 47x post the pandemic (See figure below). We believe the current multiple range of 43x to 51x as the new normal unless the growth story breaks for any of the risks mentioned above.
Forward PE ratios are now trading at all time high range given higher growth prospects
We see PayPal as one of the few companies that will see long-term sustainable benefits of the incremental move to e-commerce during the pandemic. Additionally, we draw increased confidence from Square’s monetisation of its Cash App and see PayPal doing the same with its digital wallets which boasts almost 4x the user base of Cash App. We see PayPal outperforming its medium to long-term guidance of revenue growth from 17-18% CAGR (vs our forecast of 20%) and EPS from ~20% (vs our forecast of 23%).
We initiate coverage on PayPal with a Buy recommendation and a price target of $229, imputing an upside of 20%.
Figure: We use forward PE to get a 20% upside on current share price
Source: AlphaTech Equities
Conclusion: PayPal is best positioned to unlock the opportunity of the move to mobile payments
We see PayPal as the best-in-class digital payments company, well positioned to benefit from the move to e-commerce during the pandemic. We see the recent growth in e-commerce sales as sustainable, driven by the 1. Stickier new customer cohort of older aged people, coined by management as “Silver Tech” and 2. Merchant’s launching not only new use cases for online businesses but also adopting a digital-first strategy.
We are most excited about the potential for mobile payments in the US. We see PayPal as best positioned to capture the biggest market share in the form factor pivot of payments to mobile payments given its scale both on the side of consumers (150 to 175m US consumers) and merchants.
Tech savvy CEO, Daniel Shulman took the helm in July 2015 and has been instrumental in transforming the business from a product (PayPal Checkout) company to complete digital platform company, boasting of some of the leading fintech products in the industry such as Venmo, Xoom and Honey among others.
We initiate coverage on PayPal with a Buy recommendation and price target of $229, imputing a 20% upside (12 months target price) to its current share price. Post the pandemic, PayPal’s short to medium-term growth trajectory has received a boost which warrants it a higher PE multiple of 47x which we explain more in our valuation section below.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.