PayPal Inc. was a pioneer in the digital payments space, and it is still riding the wave of a massive user base. Yet several quarters of declining bottom line growth and very high multiples attributed during the pandemic, sparked fear among investors leading to selling pressure. At this valuation we argue the company is modestly undervalued and may be positioned to low-teens growth during the following years. Management team is well aware of the intensifying competition and committed to improve the value proposition of the company.

• Warning! GuruFocus has detected 5 Warning Sign with PYPL.

Fintech Sector Overview

The fintech sector is growing rapidly, in particular thanks to the increasing adoption of digital transactions either online and offline.

Total Addressable Market (TAM) of transaction in the Digital Payments market is projected by Statista to achieve a compounder annual growth rate (CAGR) of 16%, especially in the US as a top 2 country by volume of transactions.

Source: Statista data

The trend is supported by catalysts as: e-commerce expansion, mobile payments adoption, and ancillary services (called value-added services, or VAS in the industry jargoon) such as Buy Now, Pay Later (BNPL).

As of the start of the year, PayPal retained a dominant market position, holding a market share of 45 percent as per Statista . The closer competitor (Stripe) was way lower at 17%. Digging deeper in the methodology of data extraction, it can be noted that the metric is not flawless. Datanyze (which supplies data to Statista), discloses that market share data are calculated by taking the number of websites using a technology and dividing it by the total websites using any technology [web domains of companies, Ed. Note] in the same category.

Source: Payment Processor and Market Share, datanyze.com - Note that Mastercard, Visa and AmEx are not in the chart.

Business Model

You may be familiar with PayPal already. The company offers a global online payment platform and earn[s] revenues primarily by charging fees for completing payment transactions for our customers and other payment-related services, which are typically based on the volume of activity processed on our payments platform. We also generate revenue from customers for currency conversion, for instant transfers from their PayPal or Venmo account to their bank account or debit card, and to facilitate the purchase and sale of cryptocurrencies, as clearly explained in their annual report.

In particular there are two revenue streams, one detailed above and a capital-wise smaller one deemed Value Added Services (VAS). VAS, primarily comprise revenue earned through partnerships, interest and fees from our merchant and consumer credit products, interest earned on certain assets underlying customer balances, referral fees, subscription fees, and gateway services according to PayPal's 10-k.

What's more the company experience no particular seasonality (aka no quarter accounting for more than one third or revenue), yet it's exposed to another risk. Currency risk. Indeed due to the real international nature of the business, it generate around 42% of revenues in non-dollar denominated markets - outside the US. More on that in the risks section.

Transaction Take Rate, A Key Performance Indicator (KPI)

The transaction take rate is the fee or commission charged by the company to its clients for the services provided, in particular transactions, hence the name. It is calculated as a percentage of the total payment volume (TPV) processed by the various units of PayPal using the simple math formula: fees / TPV. In the image below you can find the different take rates for the main PayPal competitors. Of note Visa and Mastercard has the lowest of all, being the biggest and most mature businesses in the industry. Stripe and Square are generally charging similar fees to PayPal.

Source: Transaction Take Rate Comparison vs. peers - FinChat.io

Let's untangle further. PayPal has the biggest market share in the digital payment processor sector as measured by website offering its service vs. other. Yet you can use PayPal (or other competitors like Stripe) with a Visa or Mastercard-branded card. So to be clear: (i) the biggest transaction volume for digital payment is processed in the end by Visa, followed by Mastercard and by a wide margin by American Express; (ii) that volume can be done either through traditional or digital banks offering branded credit/debit cards or by payment processing services as PayPal that put its infrastructure as an added layer in the payment processing algorithm.

Going back to the specifics of the PayPal business, it is worth noting that PYPL's mean transaction take rate declined over time as the number of non-retail clients increased. It started at 3.4% in 2012 and ended at 1.7% in FY2024. This average 5% yearly decline is alarming. Think twice.

Financials Highlights

As displayed on the chart below, the company achieved growing top and bottom line, despite the declining KPI.

Over a 10-year period, total revenues increased to the tone of a CAGR of 14.7% similar to that experience by net income (14.5%). The result was pure growth, since it was achieved with relatively stable operating margin (total change of 8.6% for the period was modest, CAGR of 0.9%). This indicates that profitability kept pace with revenue growth, suggesting functional operational model.

This expansion was driven by both domestic and international markets. United States grew 17.0% per year, while total international revenue grew by 366.7% (or 13.7% CAGR). As noted above PayPal is a true international business. Interestingly, ex-US revenues average 42% of the top line mix.

Progress was likewise achieved by the two revenue streams. Transaction revenue increased over the decade by 473.6% (15.7% CAGR), other VAS revenue with CAGR of 13.7%.

Source: FinChat.io

It is evident that the management team decided to reposition the company to gain more market share and TPV offering more value to its clients. Mostly by lowering fees. Yet, as referred in several recent earnings calls, more emphasis will be put in acquiring higher quality transactions going forward. Jamie Miller, PYPL's CFO and COO, in a Q3-24 earnings call said:

As part of our price-to-value strategy, we are moving deliberately and making decisions that prioritize healthy, profitable growth rather than targeting a high proportion of processing volume at low or even negative margins.

The current executives are also prone to sustain shareholders in a well-know tax-efficient (and Warren Buffett (Trades, Portfolio) (Trades, Portfolio) favored) way: shares buyback. The weighted average shares outstanding diluted decreased by 15.5% over the past decade, enhancing shareholder value due to increasing business ownership. The Board of Directors has authorized additional $15 billion to be deployed along with the remaining $4.9 billion approved in June 2022. PayPal's total buyback capacity represents about 28% of the current $70 billion market cap.

Moreover the directors said they are planning to repurchase $6 billion worth of stocks this year, hence yielding a tax-efficient indirect dividend to shareholders of 8.57%. Please note that the company currently does not pay any direct, classic dividends.

Valuation

Relative to its peers and historical averages, PayPal's valuation may appear attractive, yet the investor may want to look deeper. Is it a value trap?

A target value was arrive at, based on the current free cash flow (FCF) of $6.8 billion and implying a growth of 11% for the next five years, followed by a slowing 8,6% for the following half-decade. The terminal multiple was inputed at 11 times the Terminal Value obtained by a discounted cash flow with a discount factor of 15%. At these conditions price target was near the GuruFocus price of $89.15, as presented in the image attached.

Source: Valuation - GuruFocus

Other conditions were considered and gauged. Particularly a non double-digit FCF growth in the first half-decade would come up with much tamed target prices, like $57 for a 8% growth.

At the current market price it seems reasonable to allocate a small percentage of the portfolio to this resilient compounder. Investors should also consider the potential devastating impact of stronger competitors that could further reduce the transaction take rate of the Company and hence hurt the bottom line.

On a price to earnings (PE) assessment, PayPal's 17 seems quite attractive.

Risk to my Case

The American payment service provider (PSP), PayPal, has a simple business model, a very focused management team and is profitable and cash-flow positive since a decade. All of these come with some strings attached though, namely: increasing competition, forex risk, macroeconomic factors, and cybersecurity.

Let's start with the classic competition risk. The fintech sector is highly competitive, and PayPal tried a risky hand with the reducing take rate to win market share since the race to the bottom is seldom a long-term winning option. On a positive note the network effect the company endures, have so far helped it to cut small competitors out of the frame.

Since around 42% of revenues are obtained in non-US-denominated currencies, the foreign exchange risk is tangible. Nonetheless, thanks to hedging strategies via various contracts, the directors estimated the risk to be minimal, around 0.6% ($25 million of net negative impact, divided by FY24 net income of $4147 million). Here's an extract from the company's 10k:

Adverse changes in exchange rates of a hypothetical 10% for all foreign currencies would have resulted in a negative impact on income before income taxes [EBIT, Ed.Note] of approximately $470 million and $417 million at December 31, 2024 and 2023, respectively, without considering the offsetting effect of foreign exchange contracts. Foreign exchange contracts in place as of December 31, 2024 would have positively impacted income before income taxes by approximately $445 million, resulting in a net negative impact of approximately $25 million [for FY24, Ed.Note]. Foreign exchange contracts in place as of December 31, 2023 would have positively impacted income before income taxes by approximately $400 million, resulting in a net negative impact of approximately $17 million [for FY23, Ed.Note].

Macroeconomic factors such as economic downturns could reduce consumer spending and impact payment volumes, but also changes in interest rates could impact top line. As noted by Jamie Miller in the last earnings call of Q4 2024:

In 2024, we had a two-point benefit from interest on customer balances. For 2025, our guidance includes about a $150 million or about a 1 point headwind due to interest rate cuts. Excluding interest on customer balances, we expect transaction margin dollars to grow by at least 5% compared to 4.6% growth in 2024. In the first quarter, we expect minimal benefit from growth of interest on customer balances and then a headwind for the remainder of the year. Impact is real yet not one to disrupt the business."

On a minor note, it's worth mentioning that PayPal is held in the portfolio of the famous Mason Hawkins (Trades, Portfolio) of Southeastern Asset Management. A positive clue on one hand, yet the reason I categorized it among the risks is that the manager explained that:

Much of what we envisioned at our initial investment has materialized quicker than anticipated.

Will the growth slow down going forward? That's for sure something to periodically reassess.

Last but omnipresent, the cybersecurity threats could damage PayPal's reputation and lead to financial losses for several reasons e.g. data breaches.

Conclusion

I still believe PayPal is a great turnaround pick in the fintech industry, with a small moat but a significant market presence that it's unlikely to cede to other competitors.

PayPal's execution is crucial to retain the market share and improve its margins (especially stabilizing the sector-darling transaction take rate) in order to win back the market's sentiment. Indeed the current valuation seems to discount all the negatives, forgetting the potentiality of the indirect 8.57% dividend and the attractive current valuation. Investors should carefully monitor following earnings release and do not pile up on the company just yet.

This article first appeared on GuruFocus.