PayPal (PYPL, Financial) also detracted from performance during the quarter as investors panicked in the face of the well-telegraphed run-off of eBay’s revenues. We have been aware of the runoff of eBay’s revenues since at least the third quarter of 2017.2 Although markets are supposedly efficient, maybe markets are only as efficient as long as the same shareholders are in the stock. When a shareholder base turns over several, if not dozens, of times over a 5-year time frame, perhaps old news periodically becomes “new” to a market riddled with transient shareholders. In any case, we increased our weightings in the stock for the first time since 2018 as the only thing “new” to us was the highly attractive multiple for a competitively well-positioned business in the e-commerce industry.
PayPal Holdings
Since we last wrote to you about PayPal in the third quarter of 2020, it has been an eventful time for this long-term holding, and we thought we would take an opportunity to provide you with our most recent thoughts.
As we highlighted in our prior commentary, the COVID era has been a clear positive for PayPal, doing nothing but accelerating the long-term trends driving the Company’s growth: specifically, the penetration of digital versus cash payments, and the penetration of digital/virtual transactions versus in-person transactions. Obvious examples of this contrast would be the long-term shift toward e-commerce versus brick-and-mortar retail, or online ordering and carry-out versus sit-down meals at restaurants. Acceleration of these long-term trends, helped by temporary lockdowns that forced transactions into the digital realm, led to a tremendous acceleration in growth for PayPal during 2020-2021, as you can see in the 2-year growth rates of 2019-2021, below:
Comparison of key metrics, end of 2021 vs. end of 2019 (2-year change)
| 2019 | 2021 | % change | |
| TPV, in billions | $712 | $1,250 | 76% |
| Non-GAAP operating income, billions | $4.1 | $6.3 | 54% |
| Active accounts, millions | 305 | 426 | 40% |
| Annual transactions/account | 40.6 | 45.3 | 12% |
TPV = Total Payment Volume, in $, of transactions executed using PayPal family of services source: company reports
The stock responded very favorably to this acceleration in growth, tripling in value through the first several quarters of the COVID era. In the last couple of quarters, things have become a bit more complicated. First, there has been an expected deceleration in the Company’s growth rate, as the world has begun to return to something resembling normalcy. With very difficult comparisons to elevated growth rates in prior periods, self-evident mathematics led to an eventual slowing in growth rates. We do not attribute any importance to this COVID-influenced acceleration/deceleration itself but note that the Company continues to grow at very healthy absolute rates.
The next issue to arise in the second half of 2021 was the rapid unwinding of the relationship between PayPal and its former parent eBay. This certainly shouldn’t have been news to anyone, as it has been clearly laid out in the Company’s financial statements for many years, and it has been discussed at length by the Company over that time. We wrote about this in 2017 in our client letter, and fairly hilariously in hindsight, we trimmed the stock way back then, thinking that the market might eventually notice the modest pressure the unwinding of the eBay relationship would put on PayPal’s results. Fast-forward to the second half of 2021, and this still appears to have been too much of a surprise to the market. It is fair to say, at least, that the relationship ended up winding down more precipitously than either we or the Company had anticipated. PayPal’s growth outside of eBay has reduced the absolute size of the eBay business to a very moderate level, and – again – the unwinding of this relationship has been well-known for a long time.
Completely coincidentally, the eBay-related pressure on the business model is happening at the same time elevated COVID-driven growth rates are moderating, making the deceleration in growth appear even more dramatic. The quarterly growth rates in payment volumes, below, shows the reported numbers as well as the growth rate excluding eBay. You can see that growth began to accelerate in the second quarter of 2020, driven by COVID effects; when we first started to lap that growth in the second quarter of 2021, that also happens to be when we saw the negative impact from eBay picking up its pace.
| PayPal TPV Quarterly Growth | ||||||||
| Q120 | Q220 | Q320 | Q420 | Q121 | Q221 | Q321 | Q421 | |
| TPV growth | 19% | 30% | 36% | 36% | 50% | 40% | 26% | 23% |
| TPV growth (ex- | ||||||||
| EBAY) | n/a | 31% | 38% | 40% | 54% | 48% | 31% | 28% |
TPV = Total Payment Volume of transactions executed using PayPal family of services; growth adjusted for changes in currency
source: company reports
However, we would highlight from this table that the Company entered the pandemic with TPV growth running around 20%. We left 2021 with a fourth quarter growth rate around 20% (even better excluding the eBay wind-down). The Company is guiding for an exit growth rate around 20% in 2022, as well after eBay finishes running down in the first two quarters of the year. Looking past the fluctuations of COVID acceleration/deceleration, and the much higher growth rates generated during 2020-2021, we think the absolute worst that one could say about PayPal is that it generates roughly the same growth rates post-COVID as it did pre-COVID. Furthermore, it is generating this similar growth from a much higher base of users, transaction volumes, and profits.
Another issue that arose in the fourth quarter – not exclusive to PayPal – was an unexpected slowdown in the growth of e-commerce, seen broadly across the online retail industry. We would note, for example, that Amazon’s own first-party online retail business grew revenues only 1% from the prior year, and it somehow managed to lose money in both its domestic and international e-commerce businesses in its seasonally strongest holiday quarter. With digital commerce being an important component of PayPal’s business, this weighed modestly on results in the quarter. We view this as nothing more than a temporary quirk, driven by a variety of issues. These include very difficult comparisons to online retail growth in the 2021 holiday season, global labor and supply chain bottlenecks impacting holiday product deliveries and availability (meaning there clearly could be no transactions for these unavailable products), plus some readjustment of consumer behavior patterns between online/brick-and-mortar shopping, after a 2021 holiday season in which COVID issues kept more people away from brick-and-mortar retail than otherwise may have been the case. We don’t expect there will be any change to the long-term secular shift toward e-commerce, so we view the recent e-commerce slowdown as a temporary issue.
Finally, there is no doubt that some portion of the market did not like the Company’s guidance commentary around user growth in 2022. As you can see from the table provided at the top of this note, the Company has had no problem attracting new users, with 40% growth in the two years between the end of 2019 and the end of 2021. In fact, as COVID led to additional digital payments penetration, PayPal ran promotions to try to attract even more new users; or, to gain a greater share of the flood of new users and use-cases driven by COVID. Eventually management concluded that many promotions had been ineffective in driving profitable growth; in short, many promotions drew users who only showed up for one or two transactions, on the promotional terms, and then disappeared. Smartly, management decided to end these promotions for 2022. The effect of this will be some pressure on the growth rate of new users, but we and management both view 2021’s user growth as being inflated somewhat by new promotion-driven accounts that were not generating value in terms of profits or cash flows. Offsetting this will be the reduction in promotional spending that had drawn in these less profitable or unprofitable user accounts.
We would note a few additional items in relation to this discussion: Management has great credibility in growing the Company, considering any metric you like, and doing so at attractive levels of profitability. Furthermore, the Company told us ahead of time that it is pursuing this initiative. If this were a company with a history of growing users at all costs, with no regard for profitability, and if it suddenly tried to defend a slowdown in user growth – after the fact – as a suddenly-conceived fascination with profitability, we might be a little more skeptical. That is not the case here. In addition, tech investors are used to dealing with companies that do not generate profits or cash flows, meaning investors need to focus on other things, such as user growth, upon which to base their valuation of the company. We suspect that many such investors have found their way into PayPal over the past couple of years, as user growth accelerated. We would expect such investors to run for the hills when a company says it is deliberately not chasing user growth. We are not such investors, although, of course, we see growth in users as one of many drivers of the value of the company.
To elaborate further on this point, we believe the stock attracted a variety of new investors because of COVID, and that many people viewed PayPal as a “Pandemic Stock.” Far too many of these investors may not particularly care about things like profitability, the long-term outlook, or how that outlook may have changed as a result of COVID. Furthermore, they may not have been aware of, or cared much about, the information that has been publicly available for years concerning the Company’s relationship with eBay. We think many investors only bought the stock because it was working, during a period when very little was, and they scrambled for the exits at various times as momentum turned. We were well aware of this risk, by the way, and were fully aware that the outsized growth we saw during the COVID period eventually would moderate, and this explains why we trimmed the stock in January 2021.
As a result of the confluence of all these factors over the past few quarters, the stock has lost roughly two-thirds of its value since last summer. This drubbing is too extreme in our view, even allowing for the general valuation compression seen across the entire market. If you consult the table at the beginning of this commentary, you can see that in the two years since COVID struck, PayPal has grown considerably, whether you want to look at payments processed, user accounts, user engagement, or profits. We (and most observers, we believe) also think the long-term drivers of PayPal’s business model have advanced considerably over these two years. Despite this, we note that the stock is now just about flat over the past two years, and it is trading at an all-time low valuation on some metrics – at just 21X 2022 EPS and 17X 2023 EPS. Stock is cheaper still after considering the $15 billion in cash on the balance sheet and the fact that the Company has been over-investing in growth capex relative to maintenance capex. As a result, we made two additions to our PayPal position in the first quarter.
From David Rolfe (Trades, Portfolio)'s Wedgewood Partners first-quarter 2022 letter.
