PayPal: Deteriorating Results Stokes Apple Competition Fears

Summary:

• Despite an apparent 33% y/y growth in EPS, PayPal’s Q1 2023 earnings reveal concerning trends, including a decline in active accounts and increasing pressure on margins.
• Apple’s strategic expansion into the financial services sector, including high-interest savings accounts and BNPL services, poses a significant competitive threat to PayPal.
• PayPal’s financial and valuation metrics indicate slowing growth and potentially over-optimistic forecasts, casting a shadow over the company’s future prospects.

In this article, we delve into PayPal’s (NASDAQ:PYPL) precarious position as it faces mounting challenges on multiple fronts. The first quarter of 2023 has not been kind to PayPal, as evidenced by its less-than-stellar earnings report and a troubling decline in active accounts. Even more concerning, the digital payments giant is up against a formidable adversary in Apple, which is making strategic inroads into the financial services sector. As PayPal grapples with these internal and external pressures, investors are left wondering about the future trajectory of the company. We aim to dissect these challenges and provide a comprehensive analysis of PayPal’s current situation, as well as the growing threat posed by Apple. After careful consideration, we assign a Sell rating on PayPal due to its deteriorating fundamentals, and concerning compulsive threats.

Q1 Earnings Spooks Investors

PYPL’s Q1 2023 earnings report, despite exhibiting a façade of robust numbers, has been given the cold shoulder by the market, with the stock spiraling down by a worrying 12.7%. The revenue growth of 8.6% y/y, hitting the $7,040 million mark, merely scraped by consensus estimates, and while the EPS growth rate of 33% y/y exceeded consensus by 6.4%, it simply wasn’t enough to stem the tide of investor disappointment. It’s a stark reminder that superficial figures can veil deeper market sentiment and underlying issues.

PayPal’s Q1 results had some positive developments, but they were overshadowed by concerning trends that raise serious questions about the company’s future prospects. While unbranded processing grew by a healthy 30% y/y, a result of new wins and share gains among enterprise-level customers, this growth could dilute take-rates and margins, a scenario far from ideal for a company like PayPal.

The impact of this growth is already evident, with margin pressures from expansion in Braintree and mix surpassing expectations. This is a bitter pill to swallow and casts a shadow over the future of the company’s margins.

Adding to these woes is the startling revelation that active accounts decreased by 2M on a quarterly basis, marking the first such decline since at least 2014. This is a red flag that cannot be ignored. A drop in active accounts does not bode well for any company, let alone a market leader who dependents on network effects like PayPal. This troubling decline, along with the accompanying share loss debate, adds another layer of complexity to the challenges facing the company.

This leads us to what we believe to be the most significant long-term risk we see for PayPal: its apparently deteriorating competitive advantage in an arena of strong competitors. In a sector as dynamic and competitive as digital payments, maintaining a competitive edge is paramount. Any signs of faltering, as seems to be the case with PayPal, can have devastating implications for the company’s future market position.

Apple Competition

Recently, we highlighted Apple’s (AAPL) strategic expansion into the financial services sector, a move that not only promises significant growth potential for the tech giant but also presents a formidable competitive threat to companies like PayPal. Apple’s latest offering, a high-interest savings account for Apple Card holders, developed in partnership with Goldman Sachs, marks its entry into the US banking deposits market. This seemingly modest venture signifies a broader shift towards financial services, which could soon encompass lending products, positioning Apple as a direct rival to PayPal. For example, Apple is now poised to compete directly with PayPal Working Capital.

The new savings account, with a competitive 4.15% savings rate, might not considerably affect Apple’s bottom line, but it’s an astute maneuver leveraging Apple’s colossal install base to infiltrate new markets. This offering makes Apple a direct competitor to PayPal Savings, which is offering a similar rate but doesn’t have Apple’s scale advantage, technological prowess, and brand reputation.

Shortly before the savings account announcement, Apple unveiled its Buy Now, Pay Later (BNPL) service, Apple Pay Later, in the U.S. Similar to PayPal’s Pay in 4 service, this allows consumers to split purchases into installments, making Apple a direct competitor in the BNPL space.

Apple Pay, despite a slower adoption rate after its 2014 launch, now stands to challenge PayPal’s dominance in the digital wallet market, especially with its growing popularity among the smartphone-savvy generation in the US. The recent addition of the “Tap to Pay” feature, enabling vendors to accept payments directly on their iPhones, further intensifies the competition. This feature targets the micro-sellers market, worth roughly $446 billion, a segment where PayPal has traditionally been strong.

Indeed, as a part of our investment philosophy, we generally steer clear of companies facing competition from considerably larger entities. The numbers make this quite evident in the case of PayPal and Apple. With PayPal’s market cap standing at $74 billion, it is dwarfed by Apple’s whopping $2,720 billion market cap.

In terms of free cash flow, the disparity is just as stark. In 2022, PayPal generated $5.6 billion, while Apple generated an astounding $111.4 billion. To put this in perspective, Apple generated in just about 18 days what PayPal achieved over an entire year.

In light of such a stark difference in size and financial power, it’s clear that PayPal is up against a Goliath in Apple. With its vast resources and expansive user base, Apple has the potential to pose a significant threat to PayPal’s operations in the financial services sector. This is a classic case of David vs. Goliath, and in the world of investing, it isn’t a good idea to bet on David.

Financial & Valuation

Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.

Although Q1 results with EPS growing 33% y/y appears strong, these fleeting glimmers of hope are overshadowed by the looming specter of slowing revenue growth. With a historical CAGR of 15.7% over the past three fiscal years, the projected growth rate of 6.8% this fiscal year is a precipitous drop.

The EBIT margin trend is another harbinger of potential trouble ahead. Over the past three fiscal years, the EBIT margin shrank by 2.0% points, from 23.2% to 21.3%, signaling a squeeze on profitability. The rosy consensus forecast of an EBIT margin rebound to 22.8% this fiscal year and further to 23.4% the following year seems more like wishful thinking than a realistic outlook given recent trends.

PYPL’s share repurchase strategy, which resulted in a 4.6% decrease in diluted outstanding common shares over the past three years, feels like an attempt to prop up EPS growth in the face of the declining profitability of the business. The EPS growth at a CAGR of 10.0% during the same period lags behind revenue growth, showing a disconcerting trend in the company’s financial dynamics.

Turning to PYPL’s capital structure, the company’s leverage ratio of 0.3 times relative to its expected current-year EBITDA of $7.6 billion doesn’t inspire as much confidence as it should have given its lack of a dividend payout. In a market where the S&P 500 offers an average dividend yield of 1.6%, PYPL’s absence of dividends is a glaring omission that may leave investors feeling short-changed. A reasonable question the market might ask is why would a growth-challenged company like PayPal not pay a dividend when leading growth companies like Microsoft (MSFT) yield 0.9%?

PYPL’s concerning underperformance over the past year, trailing the S&P 500 by over 19% points (not including dividend reinvestments) and delivering a pitiful -16% in absolute return, is a clear red flag. While the company’s valuations may look tempting with an EV/Sales multiple of 2.4x, an EV/EBIT multiple of 10.1x, a P/E multiple of 11.7x, and a FCF multiple of 10.7x, these discounts may simply be a reflection of the risk to consensus estimates and PYPL’s troubles rather than a true investment opportunity. Moreover, a PEG ratio of 0.9 may seem like a bargain, but the underlying growth may be far from guaranteed.

In sum, PYPL’s Q1 2023 earnings report, coupled with its performance and projections, paints a less-than-rosy picture. Investors should approach with caution, keeping a keen eye on the storm clouds gathering on the horizon. The company has much to prove before it can truly regain the market’s confidence.

Conclusion

PayPal’s current predicament is a complex blend of internal challenges and external threats. The Q1 2023 earnings report has left a sour taste in the mouths of many investors, with several red flags that cannot be ignored. While growth in some areas remains, it is being overshadowed by disturbing trends such as the decline in active accounts and margin pressures.

Simultaneously, the looming specter of Apple’s aggressive push into the financial services sector presents a formidable challenge. Given Apple’s scale, reputation, and resources, it’s clear that PayPal faces a significant uphill battle. As we navigate these choppy waters, investors must remain vigilant, cautious, and, most importantly, adaptable to the rapidly evolving digital payments landscape. PayPal’s future seems to be at a critical juncture, and only time will tell how this David vs. Goliath story unfolds.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of MSFT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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