By Spin-Off Insights :
PayPal ( PYPL ) was built in the early days by a group of Silicon Valley icons - Peter Thiel, Max Levchin, Elon Musk, and Reid Hoffman, among others (collectively referred to as the "PayPal Mafia"). After being part of eBay ( EBAY ) for over a decade, PayPal was spun off in mid-2015 after pressure from well-known activist investor Carl Icahn.
Since 2014, the year just prior to the spin-off, revenue has increased from roughly $8 billion to $11.4 billion in 2017 as active customer accounts have increased from 162 million to 227 million and payment transactions per active account have increased from 24.5 to 33.6.
Like many spin-offs, PayPal is a unique company without a clear pure play, public competitor. This has caused some confusion in the marketplace for analyzing PayPal's competitive position, unit economics, and ultimately their valuation.
In the second quarter of 2018, Dan Loeb's activist investment firm Third Point invested in PayPal . Third Point is known for doing deep research and shaking up large corporations, but their investment in PayPal looks to be a little different. They believe the CEO, Dan Schulman, is excellent and aren't advocating for any changes. Instead, their thesis is predicated on four main pillars:
- Dominant Competitive Position
- Untapped Pricing Power
- Large Incremental Revenue Opportunities as they Evolve into a Broader Commerce Solutions Platform
- Significant Margin Expansion Potential
We investigate each pillar of Third Point's thesis - some that we agree with (Incremental Revenue Opportunities and Dominant Competitive Position) and others where we have concerns (Untapped Pricing Power and Significant Margin Expansion Potential).
Dominant Competitive Position
PayPal's dominant position is predicated on the network effect created by their 244 million active registered accounts and 19.5 million merchants. Merchants want to sign-up to accept PayPal because they can then easily accept payments from nearly a quarter of a billion active PayPal accounts - which convert at nearly twice the rate of credit and debit cards. On the other hand, individuals continue to create PayPal accounts because more and more merchants accept PayPal, which is a much better user experience, as it allows consumers to seamlessly check out at online merchants, as well as increasingly offline merchants, all while protecting consumer payment data.
Simply put, PayPal has solved the "chicken or the egg" puzzle that all networks have to overcome and continues to grow and grow as the network feeds on itself and becomes larger and larger.
Untapped Pricing Power
Third Point believes that PayPal has significant pricing power as they move away from a broader, "one-size-fits-all" approach for merchant pricing to a dynamic pricing model that reflects the value-add of a growing suite of products. For example, PayPal has a standardized 2.9% plus $0.30 pricing structure for their merchants with little differentiation from merchant to merchant regardless of size or other needs. However, now PayPal is segmenting their customer base, seeing where they can add more value, and then increasing pricing in those areas and actually reducing pricing in areas where they are priced too high.
One way to measure pricing power and any potential trends is by looking at their "Take Rate" which is the net revenue divided by Total Payment Volume (TPV) and the "Transaction Take Rate" which is the transaction revenue divided by TPV. These ratios effectively measure how much PayPal gets paid on average for processing a payment.
As you can see, the take rate has declined over time which means either their like-for-like pricing is deteriorating or the take rate on incremental TPV is lower than the historical take rate. Management has indicated that the latter explanation is the main reason for the take rate decline. Person to Person (P2P) payments, which includes their popular platform Venmo, has grown rapidly, generating incremental TPV, but generates very little revenue. Therefore, the overall take rate has declined.
For PYPL to demonstrate pricing power, investors will need to see an improvement in the transaction take rate. This could be represented by a slowdown in the decline, a stabilization, or an outright improvement. As you can see below, to date, there has not been any clear trend indicating an improvement.
We do not believe this to be the case. All the major online payment gateways (PayPal, Stripe, Authorize.net, and Amazon ( AMZN ) Payments) charge the same transaction fee of 2.9% + $0.30. While there are nuances for different costs around fraud protection, recurring billing, international cards, chargebacks, and other customizations, there is not an obvious area where PayPal's pricing structure is drastically lower than direct competitors. As a result, any increase in prices above competitor rates could lead to merchant attrition or merchants favoring other payment gateways over PayPal.
PayPal's plan to segment customers and find ways to add more value to improve pricing doesn't sound like pricing power in the purest sense. Instead, it appears that they will have to invest in development, service, and support in order to justify any pricing increases. Thus, the flow-through of any pricing benefit to the bottom line will be more limited.
Large Incremental Revenue Opportunities As They Evolve Into A Broader Commerce Solutions Platform
Third Point believes the incremental revenue opportunity beyond the online payments growth will come from three key areas:
- Venmo Monetization
- Dynamic Pricing
- Offline Payments
Venmo is a rapidly growing (TPV up 78% in Q2 2018) P2P payments platform owned by PayPal's Braintree division. Historically, Venmo has not been a significant contributor to revenue. However, PayPal is trying to monetize the platform through fee-based services including instant transfers, co-marketing with other financial services providers, Venmo-branded debit card, and paying with Venmo at merchants. The monetization efforts are showing traction with 17% of Venmo users engaging in a monetization experience since the launch. We can make some rough estimates to get a sense of the impact of monetizing Venmo.
The above estimate has a number of flaws, namely that they cannot monetize Venmo's current TPV at anything close to that number. However, the key to monetizing Venmo isn't necessarily monetizing the current TPV, although that is possible and they have efforts in place to do so, but monetizing the incremental TPV growth. In other words, the largest opportunity is for each incremental dollar of TPV that gets processed through Venmo to have a higher probability of being monetized than the previous dollar. If they are able to execute, then Venmo could eventually produce hundreds of millions or even over a billion dollars in revenue for PayPal.
We discussed this point above when we talked about pricing power. We have no doubt that PayPal can create additional features, such as reporting, compliance, cross-border transactions, etc., and upsell them. However, the opportunity - and ultimate impact to the bottom line - is difficult to quantify.
PayPal, along with others, has been trying to crack the offline payments opportunity for a number of years but has yet to gain much traction. In order to gain a strong position in the offline market, in May 2018, PayPal announced the acquisition of iZettle , the "Square of Europe," for over $2 billion. This immediately makes PayPal a player in the offline market ($21 trillion in global addressable spend according to Third Point). Whether they can cross-sell iZettle to their existing merchant customer base is another question.
Overall, we think PayPal has a number of opportunities to grow and leverage their brands outside of the secular growth of e-commerce.
Significant Margin Expansion Potential
Third Point believes that PayPal has a massive opportunity to improve their margins. They point out that PayPal's 25% operating margin on net revenues (after transaction costs) is 20% - 40% lower than large-cap payments peers (Visa ( V ), Mastercard ( MA ), Worldpay (WP), etc.). They cite opportunities to reduce expenses in IT, customer service, and credit servicing and collections.
We are more skeptical of PayPal's margin improvement opportunity. Simply put, we believe PayPal's business model requires significant investments in development, IT, and customer support and operations - while transaction costs cap the ultimate upside potential. To demonstrate this, let's look at PayPal's cost structure and how margins have trended over the last handful of years, a time during which revenue and TPV have grown significantly.
As you can see in the table below, PayPal has done a nice job managing costs within their control ("In Control Costs"). Customer support and operations, sales and marketing, product development, and general and administrative costs have all been leveraged (gone down as a percent of revenue) as revenue has grown. These costs have decreased from over 42% of revenue in 2013 to roughly 35% of revenue in 2017.
The main reason PayPal hasn't shown significant margin expansion is because their transaction expenses have grown faster than revenue, going from ~27% of revenue in 2013 to nearly 34% of revenue in 2017. Transaction expenses are costs PayPal incurs to accept a customer's funding source of payment. These costs include fees paid to payment processors and other financial institutions in order to draw funds from a customer's credit or debit card, bank account or other funding source they have stored in their digital wallet (you can read more about transaction expenses in the 10-K here ). The reason these costs have increased is twofold.
- Transaction expenses are tied to TPV whereas revenue is generated from TPV times the take rate. Therefore, even if there is TPV across PYPL's platform that doesn't generate any revenue for PayPal, they still incur some level of transaction expense. As this type of TPV grows, revenue doesn't grow, but transaction expenses do.
- Transaction expenses are being driven higher by a greater percentage of customers using credit cards to fund transactions rather than bank accounts. Since PayPal has to pay the fees associated with a credit card, it is a lower margin transaction than if a customer uses their bank account or PayPal balance as the funding source. In other words, the funding mix has been negative in recent years.
Unfortunately, there is not a whole lot PayPal can do about this dynamic after signing agreements with the credit card companies ensuring that PayPal presents credit cards as a clear and equal funding option.
As a result, we are skeptical that PayPal can significantly increase their margins without a drastic shift in the take rate or funding mix which doesn't seem likely. Thus, we don't think it is prudent to compare PayPal's margin structure to Visa or Mastercard. They simply execute different business models.
PayPal is a great business solving real customer needs that has a long runway for growth driven by secular tailwinds, unpenetrated markets, and under-monetized assets. However, we do not think this business has significant untapped pricing power or massive margin expansion potential. As a result, like Carl Icahn who was a key driver for the spin-off and has since completely sold out, we do not think there is the massive mispricing in PayPal's shares as some other market participants believe.
See also Owens & Minor Inc. 2018 Q2 - Results - Earnings Call Slides on seekingalpha.com