Premise – Capitulation Closer, Execution Needed
The premise of our follow-up (initiation here) is to assert that after PayPal’s (NASDAQ:PYPL) 1Q earnings report, sentiment on the stock is much closer to a point of capitulation than prior. In our initiation we identified that in spite of our fundamental bullishness on the business, stocks generally don’t bottom until the bulls reach full capitulation.
We think after the stock’s reaction to the 1Q report, sentiment in the bull camp is much closer to a capitulatory point than it was prior. For long-term bulls hunting for opportunities to DCA into a larger position, this is very much a positive.
That being said, after this print, the sell-side bar has certainly been raised. The company took up its full year earnings growth guidance from ~18% to ~20%. The setup for only makes sense if management can execute against their guidance for the year. Simply put, expectations for 20% earnings growth could be lofty. If a consumer-oriented recession hits in 2H, or if continued competitive pressure forces take rates down, you don’t have a low bar that you’re trying to clear.
Overall, we think sentiment is likely still closer to the bottom, but management needs to execute against their opportunity in order for investors to capitalize.
Our Bull Case
Here’s our long-term bull case for PayPal:
- core branded processing revenues grow in-line to slightly below eCom terminally w/stable margins
- Braintree continues to drive the business’ top-line growth and margins eventually stabilize their
- The stock trades at 13x this year’s earnings, w/room for HSD/LDD EPS CAGR
- new management can sell a new growth narrative in 2024+
- Still optionality in the business (i.e. Venmo particularly)
Our first point is that the core money-maker of the business, where gross profit dollars really come in, the branded processing business, will continue to grow durably. Our bull case assumes that competitive payment buttons weigh on growth, leading towards trend (global eCom growth) or slightly below trend top-line expansion terminally. We think that the terminal risk to the branded side of the business is exaggerated. Our evidence would be the entrenched nature of PayPal’s network effects (~400m customers, ~35m merchants). We think it’s going to be hard to pull spend off of an established third-party payment processor for a new alternative in online eCom. That being said, we appreciate the evolving nature of the industry, and do think that competition should have some negative effect on take rates and potential new dollar growth in TPV. The key distinction being that competition isn’t going to completely upend the value proposition for their 400m+ customers.
The next thing we’d point to is PayPal continuing to grow and stabilize margins in its unbranded processing business. Transactions margins recently have been falling as the broader revenue mix shifts towards unbranded, where margins are currently lower. Our bull case assumes management finds a way to stabilize margins in this business while continuing to grow internationally. Again the risk here is established competition.
The next and continuing part of our bull case is PayPal’s valuation. While it isn’t quite yet at that capitulatory point, it has certainly gotten cheap. The stock trades at ~13x consensus ’23 earnings and a ~6.7% FCF yield. Again, maybe that’s not the multiple where you full on sink your teeth into the stock. Nevertheless, if you’re confident in the long-term health of the business, this isn’t a disagreeable multiple. If you think they can make steady long-term progress (especially on unbranded) on the margin front while growing the top-line 5-10% CAGR, 13x isn’t a bad entry valuation.
Additionally, we think that the potential in the stock might be getting choked by management. Management has witnessed some churn over the last couple of years (see John Rainey’s departure as CFO) and has been slow to move on important problems facing the company (notably Apple (NASDAQ:AAPL) Pay’s traction) of recent. Additionally, management has failed to capitalize on their P2P base with Venmo. We think that a younger, more growth-centered vision for the business in 2024 and beyond could another catalyst for the stock. Obviously, this assumes Schulman is out as CEO by ~2024, and considering the lack of truly concrete transition details the Street has gotten, it’s hard to say with conviction that this will happen. Even still, it’s a possible catalyst the Street could reward.
And finally, while management to date has failed to capture and monetize the optionality in its business with regards to Venmo, we still think that largely represents an opportunity. It’s very obviously PayPal’s most under-monetized asset. If new management can offer something compelling on that side of the business to re-invigorate the growth narrative, then you’re probably looking at a stock that can fundamentally re-rate from here multiple-wise.
What’s The Narrative Now? – Conclusion
The narrative on the stock as it stands is that PayPal is a business struggling with terminal pressure on margins and growth. On the margin front, transaction margins have been under pressure and could head lower as more competing branded payment buttons come to market and grow in merchant/user adoption. Additionally, as management focuses on unbranded processing for growth, that’ll shift the gross profit mix to a lower margin business (for now). Additionally, Apple Pay is seeing a spike in interest right now, which has been a key point for the Street narrative that PayPal’s moat is eroding.
Additionally, investors point to seemingly unrealistic out-year earnings growth expectations and the current high bar for earnings this year, begging the question of whether or not the stock is a value bargain or a value trap. Our conclusion would be as follows: while the stock might not have bottomed, and we think there could be more pressure to come over the next couple quarters on earnings, it’s certainly cheap.
Let’s just say, the bear case is now well understood and well articulated, and there is a very ‘terminal value’ element to the bear case on the stock right now. Estimates are indeed high for this year and likely next, which doesn’t make the prime setup. That being said, if you think this business is probably fine over the long-term, and that it should be able to steadily grow revenue and earnings HSD/LDD, this probably isn’t the worst valuation to be long at.
We need a little more capitulation from the bull camp, and a management team that can execute against the bear case.
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