PYPL

1 Undervalued Growth Stock Down 79%: But Don't Buy and Hold Until You Know These 3 Risks

The S&P 500 and Nasdaq Composite have been on an impressive run since the start of 2023. This bullish sentiment might have investors worried that they can't find attractive buying opportunities.

Yet, there are still cheap businesses to buy, and I think PayPal (NASDAQ: PYPL) is one of them. Shares of the online payments service have cratered over the past few years and recently sat nearly 80% below their peak price. But the stock now trades at a bargain forward price-to-earnings (P/E) ratio of 12.3.

Don't rush to buy and hold PayPal just yet. Here are three risks you need to know about with this digital payments pioneer.

1. Intense competition

The broad secular growth story of cashless transactions, coupled with how lucrative these businesses can be at scale, has drawn lots of competition to the space. PayPal deserves credit for being the first pure online payments provider, developing a strong brand known for trust and security. But things are getting crowded.

Braintree is PayPal's merchant-facing solution. Its growth has been spectacular recently, with payment volume rising 30% in 2023. However, it's going up against heavyweights like Stripe, Adyen, Worldpay, and Fiserv's First Data, to name a few. Competing on price, ease of use, and product features is what Braintree tries to do, but it will have to be on top of its game if it wants to grow market share.

It's the same story on the consumer side. PayPal's digital wallet has wide acceptance, but there are numerous other players focused on individuals and their needs.

Apple Pay, and to a lesser extent, Alphabet's Google Pay, are digital wallet providers that should keep PayPal's management up at night. Because these dominant tech firms control the two most popular mobile operating systems, they can place their payment services ahead of PayPal's.

PayPal's user base at the end of 2023 -- 426 million active accounts -- was down 2% year over year. If the business can't keep competition at bay, this key metric will continue trending in the wrong direction.

2. Capital allocation

Dan Schulman, who was the company's previous CEO, might have squandered capital on wasteful acquisitions that weren't necessarily core to PayPal's operations. The company paid $4 billion for Honey and $2.7 billion for Paidy, to name the two biggest purchases. Schulman was also focused on building a super app that rivaled the ones found in China, a strategy he didn't follow through on.

Previous leadership might have made poor capital allocation decisions. There's always a risk that the new CEO, Alex Chriss, might also follow this path. I understand that he's focused on product innovation, especially with the advent of artificial intelligence. He's trying to find ways of integrating this technology into PayPal's various offerings.

But if I were running the business, it would be hard for someone to dissuade me from wanting to use all the cash produced and on hand to repurchase shares. To be fair, PayPal spent all of its free cash flow on buybacks last year, with the intention of doing the same this year.

The company currently has a net cash position of $6 billion. Maybe it's smart to use some (or all) of this to repurchase even more shares, particularly when the stock is trading at a dirt-cheap valuation.

3. The Venmo problem

In 2023, Venmo represented 18% of PayPal's total payment volume. It's a sizable business line, but investors worry that monetization has been a challenge. I'd suspect that the vast majority of Venmo usage, which is people sending money to one another, earns no revenue for PayPal.

Venmo's biggest competitor, Block's Cash App, has arguably been much more successful at monetizing its user base. Cash App has 56 million monthly active customers, and it generated $4.3 billion of gross profit in 2023. That's because it's catching on with lower-end consumers who view it as a banking substitute.

A valid argument can also be made that PayPal can find a way to merge the PayPal and Venmo apps into a single consumer-facing app. They have many of the same features, anyway.

Now that you understand what I think are three big risk factors, you can make a more informed decision about the stock.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Adyen, Alphabet, Apple, Block, and PayPal. The Motley Fool recommends the following options: short June 2024 $67.50 calls on PayPal. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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