During the Second Quarter, we initiated a long position in PayPal (NASDAQ:PYPL), a $100 billion market cap online payments company that processes ~20”30% of all ecommerce transaction volume globally (ex”China), led by the excellent CEO Dan Schulman. With 237 million active accounts and 19 million merchants using the iconic PayPal checkout button online, PayPal enjoys a dominant competitive position with a 10x scale advantage relative to peers. Consumers love PayPal because it enables hassle”free, one”touch checkout across millions of online merchants; merchants love PayPal because it drives higher sales, with a checkout conversion rate of 89% – almost 2x that of credit/debit cards. We see parallels between PayPal and other best”in”class internet platforms like Netflix and Amazon: high and rising market share, untapped pricing power, and significant margin expansion potential. PayPal is in the process of evolving from a pure”play “checkout button” to a broader commerce solutions platform, expanding into adjacent verticals (e.g. in”store payments, B2B) organically and through M&A. We forecast above”consensus EPS growth driving shares to $125 within 18 months, for ~50% upside.
In the near term, we see three large incremental revenue opportunities for PayPal: (1) Venmo monetization, (2) dynamic pricing, and (3) offline payments. PayPal is just starting to monetize Venmo, a P2P (Peer to Peer) platform that has grown 25x in four years, and now accounts for ~10% of PayPal’s transaction volume. PayPal launched a “Pay with Venmo” button in early 2018 for commercial transactions, as well as a new Venmo”branded debit card that consumers can use to fund commercial transactions both online and offline. We think Venmo can contribute $1 billion in incremental annual revenue for PayPal within three years. Second, PayPal is just scratching the surface on pricing power: the company recently shifted away from a “one”size”fits”all” approach in merchant contracts to a dynamic pricing model that reflects the value”add of a growing suite of products. Finally, in May 2018, PayPal announced the $2 billion acquisition of iZettle, a fast”growing provider of mobile POS systems for offline merchants in Europe and LatAm. We expect iZettle’s growth to accelerate as PayPal cross”sells iZettle into its existing network of 19 million merchants. This deal takes PayPal from the world of online commerce ($3 trillion in global addressable spend) to that of offline commerce ( $21 trillion in global addressable spend). We believe PayPal has multiple top”line drivers in the years ahead, with core online volume growing in the mid” 20% range, latent untapped pricing power with merchants, Venmo on the cusp of monetization, and the potential to gain scale in the vast offline payments market.
In addition to faster revenue growth, we also expect more cost discipline from management. Despite revenue scale approaching that of peers, PayPal’s 25% operating margin on net revenues (after transaction costs) is ~20”40 points lower than that of large”cap payments peers (e.g. Visa, Mastercard, WorldPay). Margins are an area where PayPal management has a clear opportunity to deliver, even as the company invests for the future. We think there are opportunities for expense reduction in IT (PayPal just completed a company”wide tech infrastructure overhaul), customer service (half of the company’s 18,000 employees work in customer service, a function that can increasingly leverage automation), and credit servicing and collections (PayPal can reduce overhead in its consumer credit business, which was recently sold to Synchrony Financial). Moreover, PayPal’s changing relationship with eBay presents opportunities on both costs and revenues. PayPal can cut substantial costs associated with its legacy eBay contract while capturing incremental revenue by signing new contracts with eBay’s faster”growing competitors (PayPal’s ability to work with eBay’s competitors was restricted under the terms of the legacy eBay contract, which is set to expire in 2020).
PayPal is covered primarily by financial services analysts and currently trades at 37x 2018 and 31x 2019 “street” estimates which makes it appear expensive to certain investors. However, we believe that PayPal is as much a fast”growing internet company as a consumer financial services company and that a premium multiple is warranted – particularly given the company’s sizable net cash position. Looking forward, our analysis suggests PayPal trades at just 18x 2020E EPS, excluding net cash. Given PayPal’s multi”year revenue growth path, margin expansion opportunity, and opportunistic acquisition strategy, we expect upward earnings revisions and P/E multiple expansion as management delivers. PayPal was started in 1999 but is only three years into its life as a standalone public company. Management’s new strategy – embracing partnerships with banks and networks, expanding the suite of services offered to merchants, and deploying the balance sheet through M&A and buybacks – make PayPal a very “new” company for most investors and one that is not yet well”understood.
From Daniel Loeb (Trades, Portfolio)'s 2nd quarter 2018 Third Point shareholder letter.
