Summary

• PayPal's stock price has more than doubled since the IPO.
• We identify and assess the drivers of the price appreciation: strategic decisions, strong business performance and a shift in investors' narrative.
• We comment on Q4 2017 results and earnings conference call, including the likely impact of eBay's transition to in-house payments intermediation.
• We dissect the hypotheses backed in the current stock price and conclude that although there may be still some room for further appreciation, the easy money has been made.

PayPal (PYPL) has been in our market-beating portfolio since August 2015, a few months after the separation from eBay (EBAY).

Two and a half years later, the stock is up some 140%. With Q4 2017 earnings just behind us, it is the right time to revisit the original long thesis in the light of substantial business developments and a spectacular stock price appreciation.

The original long thesis

In August 2015, a few months after the separation from eBay, PayPal's common stock was trading in the low $30s. The business was very profitable, had a cash-rich balance sheet, and mid-term guidance was calling for mid to high teens annual growth for the foreseeable future.

Besides, in 2013, while still an eBay division, PayPal had acquired some assets of extraordinary franchise potential, namely Venmo and Braintree, for a meager $800 million.

After due diligence, we concluded that the stock offered great potential at a large margin of safety to intrinsic value. And we bought aggressively.

The abridged history of PayPal: from IPO to 2018

With the benefit of hindsight, the IPO price seems like a bargain. But why was the stock so modestly priced at the time? Or maybe rather, why is the business so richly priced today? Has the value of the underlying business really increased some 140% in 29 months?

We start by making two observations:

(1) Even though in 2015 we were much more optimistic than the market about PayPal's prospects, actual business performance has exceeded our expectations.

In a later section, we will estimate intrinsic value following Q4 2017 results to throw some light on whether the stock price appreciation can be explained based on financial outperformance alone.

(2) Investors' narrative has undergone significant shifts within the span of these two and a half years.

After the IPO, investors' focus was on the over-reliance on the legacy eBay business and on impending competition from payment products by better capitalized competitors such as Apple Pay (AAPL), Google Wallet/Android Pay - today unified into Google Pay (GOOG/GOOGL), and Samsung Pay (OTC:SSNLF).

Then in 2016, CEO Dan Schulman shocked the markets when he announced a bold bet on customer choice. PayPal balance would no longer be enforced as the preferred payment method. Instead, customers would be given the choice to select one of their credit cards, debit cards or bank accounts as preferred payment method. Agreements with Visa (V), Mastercard (MA), Facebook (FB) and other industry giants promptly followed.

The direct financial impact was an ugly one: higher transaction costs, as PayPal would be sharing payment processing fees with banks and credit card platforms. The promised benefits, namely stable long-term pricing agreements with the credit card companies on terms allegedly beneficial to PayPal, and above all, better customer acquisition and engagement, and lower support costs, as a result of a more flexible service, were much more ethereal. And so the stock price backed that skepticism.

But to the credit of Dan Schulman and his management team, PayPal's performance accelerated across the board in the following quarters thanks to the embrace of choice. Companies previously seen as threats were now strategic partners. And PayPal was no longer a narrow payments button, but a dominant payments platform. Once again, fear succumbed to enthusiasm, and the stock price doubled in 2017.

Q4 2017 earnings conference call

Then came Q4 2017 earnings conference calls from PayPal and eBay last week. The latter announced that it would start to intermediate payments on its marketplace platform, with Dutch payments processor Adyen becoming its primary provider behind the scenes, replacing PayPal. If PayPal's Q3 2017 Q&A session was a party, Q4 was an interrogation, with 90%+ of analyst questions delving into eBay, and PayPal management on the defensive.

Our opinion in the matter: just as the move to customer choice, despite initial lukewarm reception, eventually played to PayPal's advantage, so will the move to partner choice. In letting a marketplace go, PayPal opens dozens of doors to much more promising venues.

More generally, Q4 was a strong quarter and 2018 guidance is solid, calling for almost 20% growth and revenues and earnings, when adjusted for the transaction with Synchrony Financial (SYF).

Valuation

In 2015, we believed that FCF (free cash flow) net of SBC (stock-based compensation) was the most appropriate metric to value PayPal, and we still believe it today.

The chart below shows PayPal TTM (twelve trailing months) revenue and adjusted FCF margin for the last 7 quarters. Adjusted FCF margin is the fraction of FCF net of SBC to revenues.

For Q4 2017, FCF has been adjusted to account for the impact of held for sale accounting related to the sale of U.S. consumer credit receivables to Synchrony Financial.

PayPal TTM revenue (million USD) and adjusted FCF margin (source: Investment Works)

Revenue growth

2017 revenues came in at $13,055 million.

Revenue has grown at a CAGR (compound annual growth rate) of 19% from Q2 2016 to Q4 2017. For full year 2018, the company is guiding to 14-16% growth on an FX-neutral basis, which includes an expected impact related to the sale of U.S. consumer credit receivables to Synchrony Financial of ~3.5 percentage points. But the sale should have a positive impact on cash flow generation, with increased FCF margin more than offsetting reduced reported revenue (this is before accounting for the one-time cash inflow of at least $6.4 billion when the transaction closes). Had PayPal decided to retain the U.S. consumer credit receivables, PayPal would have guided to 18.5% growth at the midpoint (15+3.5%) on a FX-neutral basis, or 19.5% growth without Forex adjustment.

Adjusted FCF margin

As shown in the chart, TTM FCF has fluctuated between a minimum of 17.6% and a maximum of 18.8%, ending 2017 at 18.7%. Adjusted NOPAT margin (net operating profit after tax, using a 21% tax rate) has been consistently lower, in the 15% ballpark, even though our adjusted NOPAT figures capitalize S&M and product development expenses in an attempt to estimate the margins the company could sustain with zero growth. The difference between adjusted FCF and adjusted NOPAT is due, first, to the accounting for transaction and loan losses in earnings and, to a lesser degree, to a systematic mismatch between D&A (depreciation and amortization) and capex. However, FCF margin has remained fairly stable, which suggests that it is sustainable and that the company was conservative in its reserves for transaction and loan losses.

Finally, we note that although PayPal's take-rate has decreased every single quarter since the IPO, the company has so far managed to retain its high margins through operating leverage.

The value of current earnings and return on capital

With a discount rate of 6% (selected in light of the low level of interest rates and the recurrent and relatively safe nature of PayPal's CF), the value of 2017 FCF comes in at $39.2 billion ($2.35 billion / 0.06). We can see this number as the Earnings Power Value (EPV), or the value of a constant stream of FCF.

The company has some $7.7 billion in excess cash and cash equivalents, which brings the value of equity, assuming no future growth, to $46.9 billion.

In using a 6% discount rate, we have applied a 16.7 multiplier to 2017 adjusted FCF. We believe PayPal deserves a much higher multiple of current distributable CFs, given its sustainable competitive advantages (as the dominant digital payments platform) and immense growth potential (the continuing shift from cash to digital payments is all but certain, and the cash payments TAM is enormous). But how much larger?

The book value of equity in Q4 2017 balance sheet was $16 billion. $7.7 billion of those assets are cash and cash equivalents that played no role in the generation of cash flows. But we believe that they are approximately offset by the investments required by a new entrant to reproduce PayPal's payment platform, brand reputation and number users and merchants, which we estimate somewhat above 3x annual S&M and product development expenses of some $2 billion a year. So both things considered, we estimate the real value of PayPal's productive net assets at about $16 billion.

The fact that EPV ($39.2 billion) handily exceeds net asset value ($16 billion) confirms our observation that PayPal has powerful competitive advantages (companies without competitive moats cannot sustain EPV above net asset value).

Correspondingly, PayPal's ROC (return on capital) comes in at 14.7% ($2.35 billion/$16 billion), well above the assumed 6% cost of capital. This again speaks to powerful competitive advantages.

Nb.: If any of these financial concepts is unknown to you, or you want to learn more about the underlying logic, we recommend you pay a visit to the Investment Works Academy.

Discounted cash flow analysis

We are not big fans of discounted cash flow analysis, for it places the same weight on metrics that are known today with relative certainty (such as balance sheet on current earnings items) as on uncertain forecasts of the far future.

Nevertheless, given that PayPal is growing at rates much larger than its current cost of capital, there is no way around it. (Constant growth models require growth rates below cost of capital, for a company able to sustain growth equal or larger than its cost of capital would be worth the entire universe).

Rather than coming up with a concrete estimation of intrinsic value, which would be very uncertain given the uncertain nature of forecasts of the future, we reverse-engineer the current market cap of $94.1 billion (1,228 million diluted shares at $76.6/share).

Intrinsic value matches current stock price under the following assumptions:

• A discount rate of 6% during the next 5 years.
• FCF annual growth of 15.2% during the next 5 years.
• A 20 multiple on 2022 adjusted FCF.
• Distributable adjusted FCF (net of SBC) of $2.35 billion in 2017.
• $7.7 billion in excess cash and cash equivalents as of January 2018.

Takeaways, recommendation and future coverage

Are the assumptions backed in PayPal stock price of mid $70s realistic?

In our opinion, they are not out of touch with reality. In fact, they leave some room for future price appreciation once the effects of the eBay breakup are digested. The annual growth rate of 15.2% and the 20x FCF multiple may prove too conservative. And as said, there is enough TAM for many decades of growth.

But the assumptions don't leave much room for a margin of safety either. A faster than expected interest rates ramp, for instance, could render the 6% discount rate and even the 20 multiple, too optimistic.

And the narrative could turn even nastier as Apple, Google and Samsung Pay make inroads in mobile payments. While the potential effect of competition from these three giants is presently out of the conversation, we suspect that there will come a day when a PayPal earnings conference call Q&A session will be all about the switch of iPhone and Mac users from PayPal to Apple Pay for their mobile and online payments. After all, the integration of PayPal platform into an Apple product will never be as seamless as that of Apple Pay. And there is nothing that PayPal can do about that. So reader beware.

This is not a relinquishment to the long investment thesis. It is just an attempt to moderate expectations.

To sum up: the easy money has been made.

PayPal is not expensive relative to the broad US stock market. But the US stock market is expensive by historical standards.

Our recommendation is for long investors to maintain their position.

Investors without stakes in the company may consider initiating a long position, but we believe there are more compelling opportunities in the market.

If you have enjoyed the read, Subscribe to notifications. We will update our thesis after the Q1 earnings conference call in May. In the meantime, we will keep publishing research on potential stock picks and other positions in our portfolio.