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Justin Sullivan
Thesis
Despite the low valuation, we don’t believe PayPal (NASDAQ:PYPL) represents a buying opportunity at this time. The Company faces increased competition in its core lines of business and will likely see reduced revenue growth and/or decreased margins as a result. Payments is a tough business with moats difficult to maintain and management has made a series of questionable acquisitions and policy decisions. Add to this the fact that a leading active investor has exited his position only a year after taking it, despite a steady decline in the share price. While PayPal could become a great investment opportunity at these prices, it could also become a value trap that underperforms the S&P 500.
increased competition
According to KPMG, global fintech investments were expected to reach $105 billion in 2020 and $210 billion in 2021. According to Statista:
As of May 2023, there are 11,651 fintech (financial technology) startups in the US, making it the region with the most fintech startups globally. In comparison, there were 9,681 fintech startups in the EMEA region (Europe, Middle East and Africa) and 5,061 in the Asia Pacific region.
The venture capital industry has poured money steadily into consumer fintech for years. Also, private equity was active in the sector and companies made several deals in fintech to enter new businesses or boost their existing businesses. The end result of all this investment and deal activity is a large number of private companies/startups fighting for market share as well as PE/M&A deals that need to demonstrate their value. These ventures will need to take market share from someone, and PayPal is currently the king with a bounty on their head. Although not all of these fintech companies compete directly with PayPal, many of them have some degree of overlap.
Another source of competition in the future is non-financial technology companies looking to further monetize their user base. An example of this is Apple (AAPL) Pay and Apple Wallet. Google (GOOGL), Amazon (AMZN), and Meta (META) are all looking for ways to integrate payments and financial services into their platforms. Although PayPal definitely has a bigger user base, they just can’t fall short of these companies when it comes to total active users. PayPal is inking deals with these companies such as supporting Apple’s Tap to Pay feature and adding the ability to pay with Venmo on Amazon. The problem is that PayPal’s influence in these deals is likely to decline over time as larger tech companies become more value creators in the relationship.
Mastercard (MA) and Visa (V) are other older payments businesses that will need to adapt to the changing landscape. Many businesses dislike the ever-increasing interchange rates charged by card networks and are actively looking for ways to avoid them. Instead of gradually breaking free of arbitrage, card networks will likely invest heavily in where they see the future of payments. This could overlap with PayPal’s current or future business efforts and would give them the added headache of competing with the deep-pocketed payments giant.
GPN (GPN), Fiserv (FI), FIS (FIS), and Stripe are all involved in the payments/fintech space. As their growth slows, these companies will face pressure from their investors to expand and capitalize on opportunities that lie outside their core business. It’s another collection of deeply experienced financial players that are accustomed to operating in a highly competitive environment, and there could be some competitive overlap with PayPal in the future with respect to SMBs and the payments backend.
FedNow could become a problem for PayPal in the future. Many businesses use PayPal’s payment rail in the background, but if FedNow becomes a truly superior rail system, PayPal will find it extremely difficult to retain these customers. Needless to mention that competition with the government is generally a loss-making affair.
While the current financial position is attractive, the competitive landscape is heating up fast. PayPal has never experienced as much competition as they will face in the years to come. PayPal’s management will need to execute impeccably in order to outperform going forward, and the nature of their business model doesn’t do them any favors.
bottom line and management crisis
In February, Dan Schulman announced plans to step down as CEO. He will be replaced by Alex Criss (a former Intuit executive) in September. Some investors believe this change in management is the beginning of change, but it’s usually not that simple. It doesn’t seem fair to blame Shulman directly. Ultimately, the board chooses the CEO. Many other decision makers also work in the company. Schulman may be to blame for PayPal’s struggles, but his issues are the result of decisions made at multiple levels in the company and by multiple executives besides Schulman. Simply replacing the CEO does not address the underlying issues and ignores other company executives who may be equally responsible for PayPal’s operational struggles.
PayPal has found itself competing in an increasingly dangerous market. It would be fine if investors could be sure that management would be able to execute and innovate. Unfortunately, the management hasn’t done much to instill confidence. The company has gone on an acquisition spree over the past few years (in its quest to build a “super app”) and doesn’t have much to show for it. Venmo monetization has remained elusive, as the nature of the app makes it less attractive the more they try to monetize it. Over the years he has made policy decisions with a sometimes adversarial outlook and his customer service has been abysmal. These things have frustrated some users and weakened PayPal’s already weak position. Active accounts cannot remain in the ditch forever, especially in payments, and especially when users are dissatisfied with the service. There can only be so much discrimination in payments, some segments of the market will eventually become involved in a race to the bottom in terms of price. This ultimately has the effect of lowering margins and slowing revenue growth for companies competing in that market.
Losing a major active investor could be a red flag that shows little hope of PayPal’s situation changing anytime soon.
Disadvantages of the activist investor
In 2022, activist investor Elliott Management took a $2 billion stake in PayPal. There was a lot of excitement among investors about the move, and it looks like management is on board with Elliott on the way forward. Fast forward to about a year later and Elliott sold his PayPal stake in the second quarter of 2023. Active investors can vary in time frame, but generally they stay until they feel no more value can be created. In stocks that are falling in price, an active investor will often continue to buy as the discrepancy between price and value widens and eventually earn even greater returns if their activism pays off. PayPal’s stock has been trending down since Elliott took the stake and opted to exit rather than buy more. This is troubling news for investors and could be a sign that there are more issues lurking in the background. If Elliott had raised his stake instead of dumping it in response to the drop in share price, it would have inspired confidence. How this all pans out remains to be seen and bullish investors may well be proved right at the end of the day.
Price Action and Valuation
PayPal is trading at multi-year lows and is a long way from its 2021 highs. This negative price action has shown no signs of stopping but has slowed down. Valuations have improved massively and a slowdown in price erosion means that the sale has come to an end. The question now will be whether the stock can outperform the S&P 500 going forward. While the current fundamentals look good and investors are certainly getting better value than they were a few years ago, we believe the business will face challenges going forward that will impact their revenue growth and margins. Will put pressure on
Data by YCharts
On a trailing PE basis, PayPal is trading at its lowest valuation in the last five years. This has attracted many contrarian and value investors towards the stock. Despite this perceived valuation discount, we believe the stock is still overvalued due to slow growth and stagnant operating margins.
Data by YCharts
PayPal’s operating margin has been relatively stable over the past five years, and their earnings growth has come entirely from revenue growth. This rate of revenue growth is slowing down considerably. If the company wants to continue to grow earnings at the same pace going forward, they will either need to accelerate revenue growth again or eventually expand their operating margin. We believe this will prove challenging as an increasingly fierce competitive landscape will put pressure on PayPal’s operations, affecting their financial results.
Data by YCharts
This begs the question: What would we pay for PayPal’s stock? Full disclosure that our fund already has long exposure to PayPal. For the reasons mentioned in this article, we are not planning to add anything more in the near future. For us to become more optimistic on PayPal, the company will need to address its slowing revenue growth and improve its operating margin through efficiency improvements. Yet the issue of competition looms large and remains a constant threat to the company going forward. We believe the company is currently trading at fair valuations, but there is nothing to get excited about given the risks. If the fundamental picture remains the same and the trailing PE falls around the 10 area as a result of the capitulation event then we will consider the company to be more bullish. The trailing PE multiple of 10 is important as it puts the market cap very close to our estimated takeover level (the price at which takeover offers will come from both financial and non-financial companies), limits downside risk and improves overall risk appetite. does. /Reward by way of additional margin of safety.
risk
The risk in a bullish case for PayPal is when the company is unable to compete effectively and gradually loses active users over time as well as seeing declining margins.
The risk for PayPal could increase if the company can successfully monetize Venmo and/or increase the added value for PayPal users. This may enable the company to earn more money per active account and their moat will be stronger, leading to increased revenue and higher margins.
We are completely neutral on the company. We like PayPal because current valuations are attractive, but the path ahead looks risky and we don’t believe management can effectively navigate the changing competitive landscape. It’s definitely worth keeping an eye on.
key takeaway
Despite attractive valuations we believe there is too much uncertainty to take a position here. Due to the increasing competitive landscape, PayPal may experience difficulty in growing revenue and earnings at an above-market rate. PayPal could eventually become a value trap that underperforms the S&P 500, and thus we may want to allocate capital elsewhere for some time.
Source: seekingalpha.com
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