Is PayPal Stock A Buy Now After Pullback? Question Its Moat And Earnings

Summary:

• I give reasons why PayPal Holdings, Inc. stock slumped after its – superficially quite good – first quarter results.
• A closer look at a number of performance and cost metrics confirms reasons for a slowdown. PayPal’s moat may not be so wide after all, and its scaling effects appear limited.
• I present earnings – and discounted-cash-flow-based valuation and show why investors should think twice before taking the seemingly cheap valuation at face value.
• Like other technology companies, PayPal’s management makes excessive use of stock-based compensation, resulting in rather ineffective share buybacks.
• Given the intensifying competition, rather weak cash flow growth, and only modest economic moat, I continue to avoid PayPal Holdings stock.

Introduction

I first covered PayPal Holdings, Inc. (NASDAQ:PYPL) stock in October 2022, in the midst of the bear market when the stock was still trading above $90. In my article, which focused on the concept of duration, I rated PYPL stock a “Sell” because there were still significant growth prospects priced into the stock. Since then, the stock has lost about a third of its value and is a whopping 80% below its 2021 all-time high. Due to the severity of the earnings-driven selloff, it’s time to reassess and see if PYPL is now a buy or should continue to be avoided.

In this update, I explain possible reasons for the pullback in PayPal stock, what investors should (not) look for going forward, and whether I consider the stock a buy now. After all, I’m a dyed-in-the-wool value investor and always make sure I don’t overpay for my investments. While I don’t mind paying up for quality, I hate paying overly lofty multiples for promised and potentially unachievable growth.

Why Is PayPal Stock Down?

PayPal Holdings, Inc. recently released its first quarter 2023 results, and while on the surface the results were quite good, the stock plunged nearly 20% in just ten days. Total payment volume (TPV) grew 10% year-over-year (YoY), and net revenues grew 9%. The company’s GAAP operating margin increased 322 basis points to over 14% and 201 basis points to nearly 23% on a non-GAAP basis.

Free cash flow was down slightly year-over-year despite significantly higher net income (+56% and +28% on a GAAP and non-GAAP basis, respectively). This was largely due to lower depreciation and amortization (-18% YoY) and a $235 million decrease in income taxes payable. While I wouldn’t go so far as to infer earnings management from the significantly lower depreciation, I still think it’s important to keep a close eye on the company’s accounting for depreciation and amortization in upcoming earnings releases. For example, Intel Corporation (INTC) announced that it has increased the estimated useful life of certain production machinery and equipment from five to eight years (p. 4, full-year 2022 earnings release), and Alphabet Inc. (GOOG, GOOGL) has also chosen to boost its operating margin by increasing the estimated useful life of its servers and other equipment (see my recent article).

Of course, largely stagnant free cash flow is not a great performance for such a growth-oriented company, but I would not over-interpret this due to potential timing issues and as long as cash flow growth remains intact on an annual basis. Largely due to the pandemic-driven growth in e-commerce in 2020, PayPal saw significant free cash flow (FCF) growth, followed by a decline in 2021 and 2022, based on numbers that were adjusted for stock-based compensation (more on that later) and normalized with respect to working capital movements (Figure 1).

However, I doubt that investors attached much importance to the relatively weak free cash flow in the first quarter of 2023. What stood out – and overshadowed the abovementioned operating margin improvement – was the report of a decline in active accounts (-0.5% quarter-over-quarter). While this decline is hardly noticeable in Figure 2, it is the longer-term trend that looks more troubling. In my view, the de facto stagnation in active accounts since Q4 2021 could be an early sign that it is becoming increasingly difficult for the company to fend off competition.

Similarly, TPV growth also doesn’t look that strong when zoomed out (Figure 3, blue). Granted, 10% year-over-year growth is definitely nice, but I would like to see the company maintain its growth trend in the coming quarters. That being said, management was quite upbeat during the earnings conference call, reporting that PayPal gained share during the quarter. However, don’t forget that on page 6 of its 2022 10-K (Key Performance Metrics), PayPal elegantly avoided the “Gaining Share” statement for the first time since 2016 by referring to TPV growth year-over-year as “Growing Payment Volume.” On a more positive note, PayPal’s strategy of focusing on growing transactions per account is bearing fruit (Figure 3, red) and the growth trend in this context is unbroken.

Against this backdrop, I do not believe that PayPal’s performance deteriorated materially in the first quarter. However, there is considerable uncertainty about the true extent of its economic moat. Competition from Visa Inc. (V), Mastercard Incorporated (MA), Block, Inc. (SQ), and increasingly Apple Inc. (AAPL) and to some extent Alphabet Inc. is intensifying. I would argue that PayPal’s network is significantly weaker than Visa’s and Mastercard’s, while I also wouldn’t underestimate Apple’s largely untapped potential in connection with its iPhone franchise. What I find worrying in this context is the disproportionate rise in PayPal’s transaction costs (Figure 4).

To stabilize operating profitability, PayPal is cutting back on its other expenses. For example, customer support and operations expenses decreased from 9.7% of net revenues in 2017 to 7.7% in 2022, while general and administrative expenses, technology and development expenses, and sales and marketing expenses have decreased 198 basis points, 147 basis points, and 52 basis points, respectively, since 2017. As an aside, I didn’t compare the numbers from prior years because of a change in categorization at the time. I think it’s especially important to keep an eye on customer support, technology and marketing expenses, as cost reductions in these areas can backfire pretty quickly and contribute to the erosion of the economic moat.

What Should Investors Watch?

With PayPal clearly showing signs of slowing down, it is of course important to keep a close eye on familiar performance indicators such as TPV and active accounts. However, I think it’s equally important to track PayPal’s expenses, especially transaction, customer support, and technology development-related expenses, also in light of the recent margin guidance. Management previously expected operating margin expansion of 125 basis points (now down to 100 basis points), so there may be an incentive to cut costs aggressively and boost profitability. Such short-term improvement can potentially result in long-term damage.

As PayPal also grows through acquisitions, investors need to watch out for potentially expensive deals that could be a sign the company is desperately trying to defend its economic moat. That said, PayPal has a strong balance sheet (long-term A3 credit rating from Moody’s) with de facto zero net debt at the end of the first quarter of 2023, so it has plenty of balance sheet capacity for acquisitions. Management is exploring the sale of its international money transfer service Xoom, potentially to fund an acquisition that better fits its dual growth strategy (merchant/consumer).

More importantly, however, I address what investors should not pay attention to or base their own assessment on. My regular readers know that I don’t usually look at earnings per share (EPS) because it’s fairly easy to manage and therefore not a good indicator of underlying operating performance. PayPal is no exception in this regard. For example, Figure 5 confirms the systematic positive divergence between non-GAAP and GAAP EPS – averaging 40% since 2015. Stock-based compensation is by far the largest non-GAAP adjustment, and while some agree with management and intentionally ignore this seemingly “non-cash” charge, I prefer to consider it in my evaluation. After all, stock-based compensation eventually becomes cash-effective, and that is best demonstrated by the effectiveness of share repurchases – or lack thereof.

Since 2016, PayPal has spent $16 billion on share repurchases, and the number of weighted-average diluted shares outstanding has decreased by 71 million over that period, translating to 5.8% of the weighted-average diluted shares outstanding in 2015. Admittedly, putting the money spent on buybacks each year in relation to the average price of PYPL stock is far from an accurate assessment, but a comparison with the actual number of net shares retired (Figure 6) is adequate to make a point. Most of the time, the effectiveness of share repurchases has been severely limited by dilution due to the exercise of stock options. Against this backdrop, and after learning that management expects to adjust 2023 GAAP earnings for approximately $1.6 billion in stock-based compensation and related payroll taxes – a new all-time high – I had to chuckle a bit when I read management’s comments in the same earnings press release:

“In Q1’23, repurchased approximately 19 million shares of common stock, returning $1.4 billion to stockholders.“

Page 3, PayPal Q1 2023 earnings press release.

Clearly, the significant divergence between GAAP and non-GAAP results, largely due to stock-based compensation, has a material impact on PayPal’s stock valuation – let’s see how much.

How Much Is PayPal Worth Now And Where Is PYPL Stock Heading?

With a whopping 80% decline from the exuberant all-time high of nearly $300 reached in 2021, one could argue that PayPal stock must now be in deep value territory at $60. However, since market exuberance rarely knows bounds, I would be very cautious about buying PayPal stock without correlating share price to earnings and cash flow – after all, recency bias can be extremely treacherous.

According to FAST Graphs (Figure 7), PayPal stock is trading at a blended price-to-earnings (P/E) ratio of less than 14 – for the first time since at least 2015. Considering that the company has grown its adjusted operating earnings per share by an average of nearly 18% per year over the same period, the resulting price-earnings-growth (PEG) ratio of just 0.77 would surely be endorsed by legendary investor Peter Lynch, wouldn’t it?

However, Peter Lynch would certainly take a closer look and notice the significant EPS adjustment for stock-based compensation. Adding stock-based compensation (and largely minor other adjustments) back in, PayPal stock currently trades at a blended P/E of 24, or a PEG ratio of 1.4. In my view, this is still a relatively demanding valuation given the prevailing uncertainties surrounding PayPal’s moat and the company’s highly uncertain growth prospects. I still do not consider PYPL stock to be a bargain at this level, even though the severity of the recent decline suggests otherwise.

A look at PayPal’s valuation from a discounted cash flow (DCF) perspective suggests that the stock is currently fairly valued if the company is able to grow its 2020-2022 average free cash flow at a rate of 3.8% per year in perpetuity and the investor is comfortable with a cost of equity of 9.0%. Note that the free cash flow used for this DCF analysis has already been adjusted for stock-based compensation. Granted, PayPal has grown its normalized FCF at a compound annual growth rate of 10% over the past eight years, but given disproportionately rising transaction costs, stagnant account numbers, and increasing competition, I still think a terminal growth rate of 3.8% is not a conservative expectation with a margin of safety. Therefore, I maintain that PayPal stock is not the oft-touted “deep value” opportunity.

Considering the sharp decline in the share price after the announcement of the first quarter results, it’s reasonable to expect a brief rebound, also from a technical perspective. However, from a long-term perspective, I still don’t think the valuation is compelling and PayPal’s prospects are highly uncertain.

Conclusion

In principle, PayPal stock is a straight-forward investment case for those who want to participate in the secular trend towards cashless payments. It’s a huge market that still has a lot of growth ahead of it, but above-average returns on invested capital should be considered temporary due to naturally increasing competition.

I don’t think PayPal is in a bad position because of its long history and leading experience in e-commerce. The business model is asset lean and in principle scales very well. However, given the disproportionate increase in transaction-related expenses in recent years, I would keep a close eye on the company’s overall cost structure, and I’m also not a big fan of the relative decline in customer support and technology development spending. The slowdown in TPV growth and stagnation in active accounts are also concerning and should continue to be closely monitored.

Considering the sharp decline in the share price since 2021 and also after the announcement of the first quarter results, I would argue that the stock could be ripe for a short-term rebound, also from a technical perspective. However, from a long-term perspective, I still think the valuation is not very compelling, and PayPal’s outlook is highly uncertain. There is no point in looking back at the exuberant highs, and investors should also be careful to include stock-based compensation in their own assessment. PayPal’s adjusted earnings and reported free cash flow paint a very different picture, and the stock is therefore still not cheap in light of the company’s current challenges.

Granted, PayPal could provide a positive surprise thanks to potential acquisitions and/or if recent signs of a return to gaining market share prove sustainable. However, given the significant (and growing) competition, I would not over-interpret PayPal’s moat and its (still) strong position in e-commerce.

E-commerce is very dynamic, and I expect the increasing use of artificial intelligence in credit risk management and data analytics to disproportionately benefit larger and better diversified companies. PayPal Holdings, Inc. faces competition not only from incumbents Visa and Mastercard, but increasingly from Square and, of course from Apple and Alphabet, which stand to benefit greatly from their iPhone and Android franchises, respectively. Finally, competition from Asia (WeChat Pay and Alipay) should also be taken into account, due to potentially significant support from local authorities or outright restriction or prohibition of foreign service providers.

For these reasons, I continue to avoid PayPal Holdings, Inc. stock and instead focus on better opportunities, i.e., companies operating in less volatile industries, where the corporate landscape is more consolidated, and where valuations are focused on short-term cash flows and only to a limited extent on growth far into the future.

As always, please consider this article only as a first step in your own due diligence. Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there is anything I should improve or expand on in future articles, drop me a line as well.

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