This week's casual valuation is PayPal. I hope you enjoy these posts and feel free to add your take.
Disclaimer: I do own shares in Paypal (average price $65.1)
The post is divided into the following sections:
- Introduction
- The formula
- Historical financial performance & the acquisitions effect
- Returning cash to shareholders
- Assumptions and valuation
- Valuation based on different assumptions than mine
Introduction
Below is a simple table that compares PayPal today vs. PayPal 5 years ago.
| LTM (March 31st, 2018) | LTM (March 31st, 2023) | Change | |
|---|---|---|---|
| Revenue (in $m) | $13,804 | $28,075 | 103% |
| Operating profit (in $m) | $2,230 | $4,125 | 85% |
| # of shares outstanding (in b) | 1,187 | 1,116 | -6% |
| Share price | $85.94 | $66.73 | -22% |
| Market cap (in $m) | $102,111 | $74,451 | -27% |
| Customers (in m) | 237 | 435 | 84% |
Twice the size, 27% cheaper.
One of the main reasons for this is the negative sentiment around the company due to the increased competition (Google Pay, Apple Pay, Stripe, etc. ) and the expectations that the future of PayPal isn't as bright as its past was. I think this is a fair concern and should not be ignored.
I describe PayPal as a fintech company, that offers solutions related to online financial transactions, digital wallets, and revolving credit. Of course, there are plenty of other solutions that are part of the portfolio, but if we take a look at the revenue stream, it is quite clear where the value comes from:
– Transaction revenues (91%)
– Other value-added services (9%)
In my opinion, there are 3 important variables to understand how PayPal's ability to generate revenue changes over time:
- Number of users
- Number of transactions per user
- Average transaction size
The higher these numbers are, the more revenue PayPal has.
The formula
I went back to 2014, and the data is quite clear, the management has done an outstanding job and despite the competition, PayPal continues to grow:
- The number of users is up from 161 million to 435 million.
- The number of transactions per user is up from 24 to 53.
- The average transaction size remains at $60.
In the most recent year, the growth comes less from user growth and more from an increase in # of transactions per user.
Historical financial performance & the acquisitions effect
The revenue in the last twelve months (ending March 2023) is up 58% compared to the full 2019 (less than 5 years ago). Although the gross margin has decreased from 45% to 42%, the operating margin stands at 15%, as the operating expenses have decreased (as % of revenue).
However, I will argue that this profitability is understated due to the acquisitions that they've done.
PayPal is no stranger to acquiring companies to improve its ecosystem and of course, some have performed better than others. However, to understand the impact on the company's profitability, let's take the acquisition of “Honey” back in 2020.
PayPal paid $3.6 billion for it and here's what it got on its balance sheet in return:
- Goodwill $3 billion
- Customer lists and user base $0.1 billion
- Marketing-related technology $30 million
- Developed technology $0.6 billion
- Receivables, deferred tax liabilities, other net liabilities -$0.1 billion
What does this mean and why is this important? When a company is being acquired, in most cases, there are certain intangible assets that arise. In this case, I am referring to points 2, 3, and 4. These assets weren't on the balance sheet of Honey, as they are internally generated, and the accounting standards do not allow for capitalization (Otherwise, everyone would do it, which would lead to overstating the profitability).
These intangible assets will be amortized in the income statement of PayPal over a certain period of time. From an accounting point of view, this is a non-cash expense throughout the amortization period. However, PayPal is not going to invest in order to replace them. The customer lists will remain there, and so will the technology. This accounting expense doesn't exist from a cash point of view.
This is how much amortization of this kind was in PayPal's financials over the last 3 years:
2020: $451 million
2021: $443 million
2022: $471 million
These amounts represent roughly 2% of PayPal's revenue.
So the operating profit is actually closer to 17%.
Returning cash to the shareholders
As PayPal is a profitable cash-generating company, one of the questions that need to be asked is – What do they do with all the cash?
Well, other than acquisitions. The answer is – share buybacks. The # of shares outstanding continues to decrease every year, as PayPal buys back more shares than its share-based compensation. The company will spend $3.5 billion until the end of 2023, and there's $14.4 billion in total remaining from the existing buyback program (20% of the outstanding shares).
Assumptions and valuation
Here are my assumptions for the future:
Revenue growth: 7% per year over the next 2 years, then declining over time to 4%. With this assumption, revenue in 10 years' time increases by 64%.
Operating margin: 16% (slightly lower than the operating margin that the company has at the moment)
Discount rate: 10.1% decreasing to 9.3% over time
You might wonder, what about the competitive landscape? My expected growth is much lower than the 15% CAGR over the last 5 years. In addition, the operating margin of 16% is lower than the 16.7% operating margin that PayPal has today (adjusted for the amortization mentioned above).
After adjusting for what is on their balance sheet, as well as the equity options outstanding, the value of PayPal is roughly $71.4 billion ($63.99/share).
For comparison, today’s market cap is $74.5 billion ($66.73/share), which is quite close.
The expected IRR based on my assumptions is 9.3%.
Valuation based on assumptions different than mine
The future is uncertain and my assumptions could be significantly wrong. Let's take a look at how the valuation (per share) changes if we use different assumptions related to the revenue 10 years from now as well as the operating margin.
| Revenue / Operating margin | 14% | 16% | 18% | 20% |
|---|---|---|---|---|
| 50% ($42.1b) | $52.9 | $59.6 | $66.2 | $71.7 |
| 64% ($46.1b) | $56.7 | $64.0 | $71.3 | $77.2 |
| 100% ($56.2b) | $64.5 | $73.1 | $81.6 | $88.9 |
| 125% ($63.2b) | $70.3 | $79.8 | $89.3 | $97.4 |
The sentiment around PayPal seems to be negative as the share price is down a lot. The fear of their competitors taking their lunch is still around, but it isn't reflected in the financials. Based on all of this, I decided to open a position in the company, and should it drop further, I'll buy more.
As always, thank you for reading this post, and for all the support.
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