PayPal: Investors Gave Up Again After Q2 Results; You Shouldn't

Company Update (PYPL US) (Buy)

Highlights

• PayPal shares have fallen back 19% since August 1

• We believe the strategy is right and the new CEO is a good fit

• Volume grew 11% in Q2, incl. by 30% in unbranded processing

• P/E is 12.3x on guided Non-GAAP EPS, 17.5x on GAAP

• With shares at $60.98, we see a total return of 133% (30.2% p.a.)

Introduction

We review our Buy rating on PayPal after shares have fallen back 19% since the start of August, following Q2 results (on August 2) and the announcement of the next CEO (on August 14). The share price is down 18% year-to-date:

PayPal Share Price (Last 1 Year)

Source: Google Finance (22-Aug-23).

PayPal has been a disaster for investors including us in the past few years. However, we believe this means most investors are too pessimistic to recognise the turnaround potential in the stock and the progress being made. (For a recap of PayPal’s recent history and our involvement, see our first PayPal article on Substack published in May.)

PayPal is progressing on a fundamental turnaround that will inevitably take time. We believe the strategy in place since 2022 is right, the new CEO is a good fit, and there is some evidence of progress. Total volume grew by 11% in Q2 (on a currency-neutral basis), including by “nearly 30%” in unbranded processing. Transaction margin is being diluted, but not as badly as reported figures suggest. Non-transaction expenses have settled at a level 10-15% lower year-on-year. Management believes Transaction Revenue growth is accelerating and Net Transaction Revenue will improve. There is a tail risk of substantial credit losses in the event of a major economic downturn but this is not in base case.

With shares at $60.98, PayPal shares have a P/E of 12.3x relative to 2023 guided Non-GAAP EPS and 17.5x relative to GAAP EPS, which do not seem to have priced in any material recovery. Should PayPal deliver its 2023 outlook and resume growing its EPS at 10% thereafter, we believe it should warrant a 22.5x P/E, which should give a total return of 133% (30.2% annualized) by 2026 year-end. Buy.

Current PayPal Strategy is Right

The current PayPal strategy, put in place during 2022 and reaffirmed regularly since then, focuses on:

• Improving the core branded checkout proposition

• Growing unbranded processing, including though offering more value-added services to merchants

• Driving adoption of its digital wallet

Current PayPal Strategy

Source: PayPal investor meeting presentation (08-Jun-23).

We believe this strategy is the right one. PayPal is a two-sided platform that connects consumers and merchants. This means that, by improving its value-add and market share for one side, it automatically enhances its value-add for the other and can more easily gain market share there, driving a virtuous cycle. As we have discussed in the past, we believe PayPal focused too much on user and volume growth on the consumer side up to 2022, which meant it was competing in commoditised services like peer-to-peer payments and Buy Now Pay Later; becoming an integral partner for merchants and growing share for its digital wallet are also good safeguards against the threat from Apple Pay.

New CEO is a Good Fit

After a search process that commenced in February, PayPal announced on August 14 that its next CEO will be Alex Chriss, currently EVP and General Manager of Intuit’s Small Business & Self-Employed (“SBSE”) segment.

Chriss is a 19-year veteran at Intuit and has led the SBSE segment since 2019. Before that, he had variously served as Chief Product Officer for the Small Business unit, General Manage of the Self-Employed unit, Director of Intuit’s partner platform, etc. He will be taking up his new role at PayPal on September 27.

We believe Chriss is a good fit to lead PayPal. Intuit is a highly successful technology company which has delivered double-digit revenue and earnings growth for many years, with SBSE being its biggest segment. Leading SBSE is likely to have given Chriss strong experience of serving the needs of small businesses, useful for PayPal’s efforts to increase its market share among merchants. Intuit is also a platform where the flow of rich customer datasets across its different products happens seamlessly and enhances their value-add, highly relevant to PayPal’s current strategy.

Current CEO Dan Schulman will remain on the board until the next AGM in May 2024. This will help a smooth transition in the near term but also makes it easier for Chriss to make substantial changes once he has settled in.

We also believe Chriss will be taking over PayPal at a time when its turnaround is already showing some progress.

Volume Growth & Share Gains in Q2

Evidence for progress in PayPal’s turnaround is still limited and mostly anecdotal, but is most tangible in volume.

Excluding currency, PayPal’s Total Payment Volume (“TPV”) grew by 12% in Q1 2023 and 11% in Q2, reaccelerating after a dip in Q4 2022:

PayPal TPV Growth Rates (Last 5 Quarters)

Source: PayPal results presentation (Q2 2023).

Including currency, TPV growth has accelerated more clearly, from 5-9% (or $21-34bn) in each of Q2-4 2022 to 10%+ (or $39bn and $44bn respectively) in Q1 and Q2 of 2023:

PayPal TPV By Quarter (Since 2018)

Source: PayPal company filings.

Importantly, unbranded processing TPV has grown much faster than total TPV, at 30% in Q1 and “nearly 30%” in Q2 (lower than the 40% growth in 2022, but on a much larger base). CEO Daniel Schulman explained on the call how both Braintree (its more bespoke solution for large enterprises) and PayPal Complete Payments (“PPCP”, for SMBs) are gaining traction in the marketplace:

“Many of the largest tech companies in the world are now either using our Braintree capabilities or are in deep strategic negotiations with us to do so …  We have already implemented PPCP with leading channel partners … with more than 25 additional channel partners scheduled to be live by the end of the year.”

Adyen, which competes with PayPal in unbranded processing (and previously replaced PayPal as eBay’s main processor), disclosed in its Q2 2023 results last week (August 16) that they “have seen increasing competitive pressure in North America”, with revenue growth there more than halving year-on-year from 52% to 23% in H1 2023. (Adyen shares have since crashed by 47%.) This provides further evidence that PayPal is gaining share.

PayPal is also at least holding its ground in branded checkout. Branded checkout TPV grew mid-single-digits excluding currency and “roughly in line with the industry in Q2”, including by 6.5% in June. Management believes PayPal has gained share relative to H2 2022 in its top 16 markets.

Peer-to-peer TPV grew just 2% in Q2, which is a sensible outcome given most P2P transactions are free for the user and loss-making for PayPal; Venmo TPV grew 8%, helped by a “70% plus” growth in Pay with Venmo TPV.

Transaction Margin Not as Bad as It Looks

Unfortunately TPV growth on its own is not enough to prove PayPal’s turnaround is succeeding, because volume could have come from businesses with bad economics. Net Transaction Revenue, what PayPal retains in Transaction Revenue after paying for Transaction Expense, has been shrinking and is a key focus for sell-side analysts:

PayPal Transaction Revenue & Expenses (Q2 2023 vs. Prior Quarters)

Source: PayPal company filings.

However, things are not as bad as they look. While Net Transaction Revenue is facing some structural headwinds, notably a negative mix shift to large merchants (which have a lower take rate) and to Braintree (which has a higher expense margin), PayPal was “not seeing pressure on a like-for-like basis” on the take rate, as Acting CFO Gabrielle Rabinovitch stated on the call.

Moreover, the $213m year-on-year decline in Transaction Revenue in Q2 is mostly driven by one-off merchant compensation settlements ($76m) and larger currency hedge gains ($73m larger) in the prior-year quarter. There were also other one-offs and, excluding these, Net Transaction Revenue actually grew by a low-single-digit:

“From a Transaction Revenue less Transaction Expense standpoint, when you make a series of adjustments to eliminate some of the noise this year and last year, you actually get to low-single-digit growth.”

Gabrielle Rabinovitch, PayPal Acting CFO (Q2 2023 earnings call)

While low-single-digit growth is far from impressive, it at least shows that things are moving in the right direction.

(However, the headwind from prior-year hedging gains will persist for 2 more quarters, as such gains were $156m in Q3 2022 and $152m in Q4 2022, while the headwind from prior-year merchant compensation settlements will still be $75m in Q3, before dropping to $10m in Q4.)

Non-Transaction OpEx Settled Year-on-Year

Non-Transaction Expenses have settled at a level 10-15% lower than in H1 2022, indicating continuing cost discipline:

PayPal Non-Transaction Expenses (Q2 2023 vs. Prior Quarters)

NB. Figures on GAAP basis; exclude restructuring & other charges. Source: PayPal company filings.

Lower Non-Transaction Expenses mean PayPal’s EBIT Margin is higher year-on-year on both GAAP and non-GAAP bases, though Non-GAAP EBIT Margin fell sequentially in Q2 and was below guidance (of ~22%), “principally” due to PayPal’s credit portfolio where loss provisions were higher than expected and revenues were lower (more below):

PayPal GAAP & Non-GAAP EBIT Margins (Last 5 Quarters)

Source: PayPal results presentation (Q2 2023).

Management still expects Non-Transaction Expenses to be down 10% for 2023 and Non-GAAP EBIT margin to expand by at least 100 bps. No cost guidance has been given for 2024, but a relatively stable cost base will enable operational leverage, allowing significant earnings growth to be generated even on modest revenue growth.

PayPal’s Business is Accelerating

Management believes Transaction Revenue growth is accelerating and Net Transaction Revenue will improve.

Transaction Revenue growth will accelerate with PayPal’s core business volumes, as CEO Dan Schulman explained:

“In our view right now, we are beginning to see an inflection point … We are clearly seeing a lot of headwinds begin to shift towards tailwinds … We see e-commerce growth accelerating. We think it is at least in the mid-single digits right now … We're also seeing improvements … in cross-border. That's beginning to accelerate again … (In) PPCP, we've got tremendous momentum … Braintree continues to go from strength to strength, and we're seeing a lot of our value-added services now start to take hold … And obviously, branded checkout is accelerating.”

In July, branded checkout TPV growth has accelerated to “over 8%”. while total TPV growth has accelerated into the “low-teens”. Revenue growth was 9% excluding currency, similar to H1, likely with higher Transaction Revenue growth being offset by lower interest income growth in Other Value Added Services revenue (due to lapping interest rate hikes).

Specifically, for Net Transaction Revenue, PayPal expects its margin in unbranded processing to improve as it expands in higher-margin value-added services, the mix shifts towards higher-margin customers in non-U.S. markets and SMBs, and with PayPal lapping a one-off headwind from migrating some volume from legacy stacks onto PPCP.

Credit Losses Are a Tail Risk

Less positively, we fear there is a tail risk of substantial credit losses in the event of a major economic downturn, from its various credit exposure including business loans, Buy Now Pay Later and international consumer credit.

Credit provisions on business loans were higher than expected in Q2, though management attributed this to an intentional widening of PayPal’s “credit box” last year, which has now been reversed (as of Q2 2023, business loan originations were down 75% year-on-year, and receivables were down 30% quarter-on-quarter).

As of the end of Q2 2023, PayPal had $5.55bn in Loans & Interest Receivable, excluding $1.90bn it has agreed to sell to KKR, compared to $5.87bn of Non-GAAP EBIT in 2022. While PayPal has good data on its customers and many of the loans are relatively small, underwriting standards have not been tested by a major crisis for many years.

However, as a major downturn is not our base scenario, this is less of a concern for our investment case.

Full-Year 2023 Guidance

PayPal has kept its full-year guidance unchanged, including:

• Non-GAAP EPS to be $4.95, implying a 20% growth

• GAAP EPS to be $3.42 (was $3.27)

PayPal Outlook (2023)

Source: PayPal results presentation (Q2 2023).

Non-GAAP EBIT Margin is expected to expand “at least 100 bps” and Free Cash Flow (“FCF”) (as defined by management) is expected to be around $5bn (compared to $5.1bn in 2022), though these are less meaningful given the figures exclude substantial non-cash Share-Based Compensation costs.

Compared to guidance given at the last quarter, worse-than-expected headwind from the credit portfolio is expected to be offset by better-than-expected business performance.

Revenue growth in H2 2023 is expected to be “at least in line with” H1, with lower growth in Other Value-Added Services (dropping from ~40% in H1 to mid-teens in H2, primarily due to the lapping of interest rate hikes) being offset by higher Transaction Revenue growth.

Management also provided guidance for Q3 2023, which included ex-currency revenue growth of around 8% and Non-GAAP EPS growth of 13-14%, both lower than H1 due to the headwinds from prior-year comparables mentioned above.

PayPal Valuation: <20x “Real” P/E

With shares at $60.98, relative to 2023 guidance, PayPal shares have a P/E of 12.3x on Non-GAAP EPS ($4.95) and a P/E of 17.5x on GAAP EPS ($3.49). The FCF Yield is 5.0%, based on management’s $5bn FCF figure and subtracting the same amount ($1.60bn) of SBC as in 2022.

Relative to 2022 financials (which do not reflect subsequent growth and cost cuts), shares have a 14.2x P/E on Non-GAAP EPS and a 28.1x P/E on GAAP EPS; FCF Yield, after deducting non-cash SBC costs, is 5.2%:

PayPal Valuation & Cash Flows (2019-22)

NB. FCF restated in 2021 to exclude cashflows on collateral related to derivatives. Source: PayPal company filings.

We believe these figures means that PayPal has a “real” P/E of less than 20x, which do not seem to have priced in any material recovery in its growth rate or profitability.

PayPal Return Forecasts

We keep our forecasts unchanged and extend them by a year to 2026. Our assumptions are that PayPal delivers its 2023 outlook and resumes growing its EPS at 10% thereafter, and its P/E re-rates to 22.5x:

Illustrative PayPal Return Forecasts

Source: Librarian Capital estimates.

With shares at $63.38, our forecasts indicate a total return of 133% (30.2% annualized) by 2026 year-end. The forecasted exit price is less than half of PayPal’s peak share price of around $310 in July 2021. Most of the upside comes from the P/E (relative to Non-GAAP EPS) re-rating upwards from the current 14.2x to 22.5x. These figures represent a positive scenario where PayPal shares generate outsized rewards.

We believe that risks are limited even in a negative scenario where PayPal’s growth never recovers. In that case, the number of accounts should still be flattish and volume per account should grow at slightly more than GDP. This should still allow revenues to grow faster than GDP and earnings to grow at mid-single-digits, especially if costs were to remain flat or be further reduced. The current “real” P/E of less than 20x would still be broadly reasonable. So PayPal’s share price should still grow from its present level, meaning little downside (in nominal terms) for shareholders.

Ends

Stocks mentioned: PYPL 0.00%↑ ADYEN. We are long PYPL.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.