PayPal: The Simplest And Most Powerful Investment Thesis (NASDAQ:PYPL)

My first article on Seeking Alpha featured PayPal (NASDAQ:PYPL), a company that was priced in the market as if it wouldn’t grow at all for the next 10 years. At the time, PayPal was trading at $60 per share and has not done much since, but was I wrong in my assessment? There have been two quarterly reports since then, and PayPal is, in fact, still growing across all key performance indicators. In this article, I will revisit the thesis, expand upon my thoughts, and derive a conclusion.

Any growth equals undervalued, the most powerful investment thesis

The investment thesis for PayPal is simple, straight-forward, and easy to grasp: if PayPal grows at all, then it is currently undervalued. That’s it-it is that simple. It is a powerful thesis and a very rare one, in my opinion. This is because the company is trading at a level that implies that it won’t grow for the next 10 years, and by not growing, I mean 0%.

To test this, we can perform a reverse discounted cash flow (DCF) model. I have taken the 2023 results and extrapolated them, and 2023 was a weak year in terms of free cash flow margin, which empowers the thesis further as it creates a safety margin by having the base period be a weak one.

In the above image, I have modeled 4 different scenarios: one where PayPal does not grow revenue or their margin for 10 years, one where revenue grows at a 5% compounded annual growth rate (CAGR), one where revenue grows at a 10% CAGR, and a fourth scenario where both the margin and revenue grow. They all use the same assumptions for terminal growth at 3% and a discount rate of 9.08%, which is the sum of the implied equity risk premium for the US market (Source: Aswath Damodaran) and the risk free rate. Here are the summaries:

Click to enlarge

Through these reverse DCF scenarios, we can see that the intrinsic value output, where assumptions have no growth, is where PayPal is currently trading. The only caveat here is that PayPal is, in fact, growing, which shows us how abnormal the current trading levels are. PayPal reported stronger adjusted FCF margins in Q1 of 2024 (16.37%) than Q4 of 2023 (15.25%), which is the holiday quarter and historically the strongest margin quarter for PayPal. While it may be too early to tell if PayPal under new management will prosper and expand, we can at least deduce that PayPal is not drastically weakening.

My intrinsic value for PayPal is around ~$110 using 11% weighted average cost of capital and 2% terminal growth rate assumptions. The model is featured in my previous article and grows FCF at a CAGR of 12.87% through ~10% revenue growth and by expanding margins from ~17% to 20% by 2033.

Summarizing, investors have a significant margin of safety by purchasing in the current trading range, currently implying no growth for the coming 10 years. However, if PayPal were to grow revenue over this period, expand margins, or even both, there would be significant upside to intrinsic value. The only risk we are facing is if PayPal loses revenue or significantly drops their FCF margins, which seems unlikely to me for several reasons.

Why the market may be wrong

Why, then, does the market price PayPal this way? One common argument is that the payments industry is a race to the bottom, meaning there are too many competitors vying for the same dollar. There’s no shortage of payment solutions. Bears are quick to point out that Apple Pay, Google Pay, Stripe, and Adyen are coming for PayPal’s lunch.

The following chart shows a time period where all the aforementioned competitors were launched. While the competition may have eaten away at the take rate, the FCF has steadily been increasing.

It may look alarming to see that FCF has been trending down the past two years, but worth noting is that 2021 and parts of 2022 saw a large increase in consumers transacting online, credited to the pandemic. The trailing 5-year FCF margin is ~17% on an adjusted basis, where EBIT is adjusted for stock-based compensation, restructuring expenses, and amortization of intangible assets. This is 200 basis points higher compared to our reverse DCF assumption of 15%, creating even further safety margins for us as investors.

The most important questions to ask ourselves in regards to the thesis are:

• Does PayPal lose market share to its competitors?
• Is PayPal growing?

Remember, the market is implying that PayPal will have no growth moving forward. Therefore, for our thesis to have some merit, we have to find evidence of PayPal growing. In fact, PayPal is gaining market share despite the tough competition.

We can come to some conclusions by looking at the worldwide digital payments transaction volume (Source: Statista) and comparing it to PayPal’s Total Payment Volume (TPV).

During the 2018-2023 periods, PayPal TPV grew at a 22.3% CAGR, while worldwide digital payments grew at an 18.9% CAGR. This implies that PayPal has gained market share in the digital payments space, all the while operating amongst a vast number of competitors.

Even if PayPal were to lose market share in the coming years, it would still not break our thesis. Remember, PayPal is currently priced for no growth in the stock market, all the while we have evidence of growth faster than or at parity with the global digital payments market. If PayPal grows at all in the coming 10 years, then it is currently undervalued. For our thesis to be invalidated, PayPal has to drop market share drastically and have negative results for the next 10 years, something that the data currently does not support.

Another angle bears look at that could signal that PayPal is on the decline is the total number of active accounts decreasing from fiscal year 2022 to 2023. Management has spoken on this for several quarters, citing the churn of poor-quality accounts that stemmed from a past campaign that PayPal ran. These were based primarily in Latin America. The counterargument to this is the fact that the active accounts are transacting more on average, a trend that has only been positive since the company went public. As an investor in the company, this is a net positive: PayPal retains high-quality accounts while churning low-quality accounts; the accounts that stay use PayPal more for every year that passes.

Aside from the two main bear arguments relating to active accounts and take rate, stock-based compensation (SBC) is in the background as a negative aspect of the business. To me, the SBC is not outrageous at PayPal. It is more or less in line with peers and has been steadily around ~5% for the better part of a decade. We also know that management is reducing SBC and will instead increase cash compensations moving forward.

Another minor gripe bears have with PayPal is the balance sheet risk the company undertook during the pandemic fallout. The delinquency risk for consumers and merchants has been heavily reduced and is, in my opinion, under control.

Summary and the carrot to stay patient

The investment thesis is very simple and straight-forward, PayPal is currently undervalued if the company grows at all in the future. The company is currently priced as if it won’t grow FCF for the coming 10 years, which we can deduce by simulating a reverse DCF model with 0% growth assumptions. However, the company is, in fact, growing and gaining market share in the global digital payments space while facing competition from companies such as Apple, Adyen, and Stripe.

The original investment thesis is intact and sound, despite the stock price not reflecting it, and as such, we have an asymmetric opportunity with PayPal. There are many hints investors can point to as evidence of PayPal’s continued growth in the future. In addition, the bear arguments for PayPal’s demise can be dismantled. PayPal is seeing FCF margin expansions as per quarter-over-quarter as of Q1 2024, a very impressive feat considering that Q4 is the strongest quarter historically due to holiday shopping. For the thesis to be invalidated, PayPal would need to see heavy declines in FCF margins and negative revenue growth.

Another reason I am comfortable waiting for PayPal to become fairly valued is the fact that PayPal is aggressively repurchasing shares. The company is taking advantage of the suppressed (and, in my opinion, unjust) stock price and returning shareholder value through buybacks. The company is pledging most of their FCF towards this purpose, and I anticipate that to continue while the stock price is undervalued. Until the stock reflects reality, PayPal remains a strong buy and one of the best opportunities in the market.