Over the past year, the technology complex of stocks has enjoyed substantial gains, significantly outperforming the technology-focused Nasdaq Index. Unfortunately, PayPal Holdings Inc. (PYPL, Financial) has severely underperformed all other technology stocks as it fell 24% over the past year while the Nasdaq Composite Index rose 34% over the same period.
The issues plaguing PayPal have been well documented, with the fintech giant succumbing to a wide range of endogenous and exogenous factors. The company has recently seen a rotation in its management, with Alex Chriss and Jamie Miller joining PayPal last year as CEO and chief financial officer.
The new CEO did give some early glimpses of what changes to expect as PayPal transitions in 2024, but his clearest guidance on its pivot to growth was given as management announced a slew of customer-focused innovative features last week.
After carefully reviewing the innovation roadmap and evaluating PayPal's financial statements, I believe the stock is undervalued.
Business model recap
The foundational offering of PayPal was to provide users with digital wallets, enabling them to easily transact online. Over time, the company's aspirations to become a fintech super app saw it make many acquisitions to rapidly expand its reach into newer extensions of its core fintech market. Venmo and Paidy are some of its well-known acquisitions and integrated as part of its Consumer Checkout business. Braintree was another acquisition made by PayPal and integrated as part of its Unbranded Processing business. Consumer Financial Services and Merchant Services are two of its other business units that help PayPal facilitate over 22 billion global financial transactions. In addition, the financial payments giant also ventured into complementary businesses such as cryptocurrency trading and buy now, pay later, which has became hugely popular in the post-pandemic era.
Since PayPal is in the business of facilitating financial transactions, it collects a take rate for facilitating transactions between parties. Therefore, growth in the volume of total payments it processes is paramount for its businesses. In addition, it may also collect additional fees based on certain products, such as loans, merchant credit, foreign exchange, etc. to process payments on its platform.
PayPal is positioning itself to “shock the world” and pivot to growth mode again
In an interview with CNBC earlier this month, Chriss hinted at some innovation-focused strategies the company will be adopting this year that will “shock the world." PayPal's management later followed up the interview by launching new innovative products at a special event a week later. While I believe the special event was a step in the right direction, I think the broader investor community would have benefited from some more direct, long-term financial guidance based on the product launches. Still, I think PayPal's management has received the feedback, and I firmly believe it will push management to issue more detailed guidance in the upcoming fourth-quarter 2023 earnings call.
In my view, a majority of the strategic direction was given by the CEO in the CNBC interview that I pointed to earlier in this section. The first milestone as part of management's transitional strategy is to focus on launching more customer-focused and merchant-focused products that drive higher transactions among PayPal's existing user base. Management's plan is to incentivize the existing user base by rewarding them with cash back. In addition, the company also plans to leverage the large warehouse of transactional and customer data and use artificial intelligence to personalize the customer's buyer journey experience with cash back incentives. Based on the third-quarter results that I have added below, I noticed a meaningful uptick of 15% year-over-year growth in the total payment volume. To me, these are some early but very encouraging signs of the fundamental health of the business. I mentioned previously that a higher TPV widens the scope of PayPal's take rate, which eventually drives up its margins.
The second milestone PayPal aims to achieve is higher usage among small and medium-sized businesses. Chriss is a veteran at building products and solutions for SMBs. Before joining PayPal, he led the product ecosystem for Inuit's (INTU, Financial) Small Businesses and Self Employed group. On the recent earnings call, he underscored his commitment to focusing on the SMB market while further adding, “small businesses are a passion of mine” and “This is not only important to PayPal and has been in the past, it's really been the lifeblood of the organization.” Deploying more solutions for small businesses will allow PayPal to collect subscription fees and platform fees for all the solutions, such as marketing, credit and e-commerce solutions that the company has in the product pipeline for its SMB merchants.
The third milestone that Chriss covered in the CNBC interview was management's initiative to divest its businesses so as to focus on the core transaction processing businesses that generate margins for the company. In my opinion, PayPal attempted to hastily expand into emerging categories of the fintech market by acquiring companies that would not be margin-positive for the company. On the last earnings call, management announced it sold Happy Returns to UPS (UPS, Financial) for $465 million for a meaningful profit. This year, I expect management to double down on their initiatives to divest parts of the business that are not contributing to the company's profit margins or core functions.
Through this year, I anticipate PayPal will be able to drive significant improvements in their margins based on the strategies Chriss alluded to in the interview.
Investors are severely discounting PayPal's value
Given that PayPal's margins have not been stable over the past two years, I will estimate its value using the reverse discounted cash flow model. Before I move over to free cash flow, I will note its balance sheet carries about $10.6 billion in a combination of senior notes and operating leases. A majority of the debt is senior notes, which it previously held, while a portion of the debt was acquired due to the nature of its BNPL business. I do not see this as a risk since PayPal holds about $11.5 billion in cash and short-term securities.
Moving onto PayPal's free cash, I see management is guiding for more than $4.6 billion in free cash for fiscal 2023. Still, I will take the trailing 12-month free cash of $3.18 billion for my model. Assuming a terminal growth rate of 2% and a discount rate of 9%, I see the markets are currently pricing in an average annual free cash flow growth rate of 6.80% for the next 10 years at the current price level.
With the initiatives that management has planned for PayPal in 2024, I believe there is significant room for growth beyond the 6.80% that markets are pricing in at PayPal's current levels.
Risks and other factors to consider
The single biggest threat to PayPal's entire business is the fierce competition in all the different segments of the fintech target market. Within its core digital wallet market, PayPal has already lost a significant share to Apple Pay (AAPL, Financial), causing investors to lose faith in the company as an active user account. Apple Pay also competes with PayPal in the nascent but fast-growing BNPL market, which is also hotly contested.
Newer players such as Affirm (AFRM, Financial) and current BNPL market leader Klaarna already innovate at a rapid pace, while PayPal's direct competitor, Block (SQ, Financial), acquired Afterpay to compete here. Block's Square competes with PayPal directly in many fintech market segments, such as digital wallets, cryptocurrency trading, transaction processing and merchant solutions. PayPal also operates in the e-commerce transaction processing market by processing transactions via its PayPal-branded checkout and lower-margin unbranded checkout solutions, powered by Braintree. Over the past few months, the company has been able to gain market share in this space, especially in the North American region, at the expense of other incumbents such as Adyen and Stripe. But it has done so at the cost of lower transaction margins by accepting a lower take rate, which is not healthy for the business.
Since my valuation already prices in the worst, I do not expect any significant changes in PayPal's market position in each of these markets this year, but I will be monitoring this space since the fintech market is rapidly evolving.
Takeaways
Based on my analysis, I believe investors have priced in the worst for PayPal. Its recent customer innovation announcement did not resonate with the explicit long-term financial targets that markets were expecting, but I am encouraged by the CEO's outlook on his strategy for this year, leading me to believe the stock is undervalued as of today. PayPal reports its full-year 2023 earnings results next week.
