This weekly round-up comes to you after a wild week in the global market. Big tech (and medium-sized tech) earnings were the focus during this volatile week, either sending mega-cap companies catapulting into the stratosphere (Google and Amazon) or reintroducing them to the forces of gravity (Meta and PayPal).
In this week’s update, we will take a look at the developments from the largest US technology business Apple and the impact of these developments on other companies in the sector, alongside a review of PayPal’s latest earnings release.
Rotten Apple Spoils the Bunch
If we equate investing in global equity markets to apple farming, a whole lot of produce has been spoiled since Apple decided to make changes to its iPhone data tracking policy (IFDA). In fact, Business Insider suggests $315 billion in market value has been squandered from the likes of Meta, Pinterest and Twitter since the changes went into effect last year — that's a whole lot of apple juice!
Of course, Apple wishes to use this move to bolster its own advertising ambitions, making Apple’s solution more competitive to the likes of Facebook, which still remains the most efficient ad-conversion machine. This has had an adverse effect on Facebook, which reported a $10 billion impact expected in 2022 as a result of Apple’s new policy.
Apple also looks to get on the front foot in the payments space through Apple Pay. And given Apple’s competitive stance in other areas, the market certainly was worried that Apple would start to steal customers and engagement from the likes of PayPal and other digital finance platforms with its own solutions. Apple’s ambitions in payments can be seen front and centre in the latest earnings call, with comments from J.P Morgan analyst Samik Chatterjee and Apple CEO Tim Cook below:
Samik Chatterjee: Where are the biggest opportunities [...] that you may not be tapping into currently and have an opportunity in?
Tim Cook: I would say that I think Apple Card has a great runway ahead of us. It was rated as the No. 1 midsized credit carding customer set by J.D. Power and [...] has fast become [the...] main credit card for many, many people. And the growth of Apple Pay has just been stunning. It's been absolutely stunning. And there's still obviously a lot more there to go [...] because there's still a lot of cash in the environment. And so I think that both of these, and whatever else we might do, have a great future ahead.
In the last few years, Apple has continued to leverage its powerful position as the ubiquitous smartphone operating system controller — over the last decade, the iPhone and iOS have supplanted other competitors to become the market leader in Western markets such as the US.
One of the most important features of Apple’s iPhone dominance can be seen in the billions of dollars in payment that Google makes to Apple on a yearly basis to be the default search engine on iPhone devices. Apple’s ability to extract such a figure from a company like Google shows the sheer power of its position, a position from which Apple can continue to wreak havoc for other businesses relying on users accessing their software through their iPhone device.
In 2020, The New York Times reported that Apple makes about $8-12 billion a year for making Google the default search on its devices. Google’s 2021 payment to Apple to maintain this status quo could be up to $15 billion, the analyst said.
PayPal: Damage Assessment
During the week, former market darling and current portfolio holding PayPal was brutally sold after earnings disappointment. With current jittery markets, I am eager to understand the long term implications of recent news for PayPal so I can decide what to do with my holding given the drop in share price.
PayPal released its Q4 and full-year earnings report on February 1, 2022, and despite the shares falling roughly 40% over the last 6 months, the market reacted strongly to PayPal’s
conservative guidance and operating challenges, with its share price falling 26% from $175.8 to $130.94.
Highlights from the report:
A conservative outlook for 2022 for both revenue and earnings, but confidence in medium-term guidance. Revenue growth is expected to be between 15-17%, rather than the 18% initially predicted three months ago in Q3, due to inflationary pressures.
Expectations for operating margin to be in the range of 23% for 2022 (down from 25% in 2021). For the year, PayPal is expecting to deliver $4.60 to $4.75 in non-GAAP earnings per share, which will be flat YoY vs 2021.
There was a change in tack from PayPal towards greater capital allocation on user engagement rather than acquiring new users to its platform, after 4.5 million illegitimate accounts were created due to incentive campaigns in 2021.
The report wasn’t all bad. PayPal had a strong 2021, with revenues growing 18% to $25.4 billion and its non-GAAP EPS growing by 19% to $4.60. PayPal surpassed $1 trillion in annual TPV (total payment volume) for the first time in its history, with TPV for the year growing by 33%. It had a record 5.3 billion transactions in Q4 alone, up 21% from the prior year. PayPal also generated $5.4 billion in annual free cash flow.
Omicron and Inflation Impact PayPal Adversely
PayPal cited the Omicron variant (due to its effect on travel and event bookings) and the effect of inflationary prices as impacting the business and its guidance for 2022. Decreased personal consumption, combined with labor shortages, supply chain issues (which impacted cross-border volumes and small business merchants) and overall weaker consumer sentiment resulted in weaker guidance for 2022, with revenue growth expected to be between 15-17% rather than the 18% initially predicted in Q3.
Contrasting this with results from Visa and Mastercard suggests that PayPal’s customer base has been disproportionately affected by inflation (high weighting to small business accounts) or that there are other factors weighing on PayPal’s payment volume growth versus industry peers. PayPal also noted the impact from reduced stimulus payments towards the end of 2021, suggesting PayPal’s core customer felt the impact of reduced stimulus more than those using other payment methods.
Loss of Confidence
There was a significant change in strategy evident from PayPal’s earnings call, one that parts ways with earlier guidance from management. This strategy change came as a large shock to Wall Street analysts and investors, significantly impacting faith in PayPal’s management.
2021 saw Paypal offering a referral bonus of up to $10 to existing users to sign up a friend with an account. This offering was connected to around 4.5 million illegitimate accounts being created on the platform. These illegitimate accounts, although described as ‘immaterial’ to PayPal’s overall base of 426 million customer accounts, affected the Company’s ability to achieve its guidance.
In the future, Paypal will instead focus on sustaining growth and driving user engagement in its current base of customers rather than growing its users. The vast majority of Paypal’s business comes from about a third of its customer base, meaning that, unlike a subscription model where more users equates to more revenue, stronger returns are made through engagement initiatives rather than incentive campaigns. PayPal said to expect that quarterly net adds would reduce substantially over the next twelve months as these plans are put into place. Guidance for net adds now stands at between 15-20 million net new customer accounts in 2022, with PayPal stating that the 750 million medium-term account aspirations are ‘no longer appropriate’.
The eBay Effect
eBay also put pressure on PayPal in the year, amounting to $1.4 billion of pressure on PayPal’s top line. Excluding eBay, PayPal’s revenue growth for the year was strong, growing 29% on a spot basis for the full year and 22% in Q4. In 2022, PayPal is expecting eBay to put an incremental $600 million of pressure on its top line (approximately $400 million in Q1 and $200 million in Q2). Excluding eBay, PayPal has consistently grown at rates above 20%.
PayPal’s CEO suggested the business has to endure 5 more months of eBay transition, which will likely be finished by the final quarters of 2022.
Finding The Positives
Whilst PayPal's earnings clearly fell short of market expectations, I think we can find several positives in the report for PayPal over the long term.
Firstly, regardless of the challenges PayPal is facing, its financials are in great shape. The company is highly profitable, with operating margins of 25% in 2021 (likely to end 2022 at around 23%). PayPal generates healthy FCF at $5.4 billion and its expectation is to generate around $6 billion of FCF in 2022. Lastly, for its size, PayPal is one of only a few companies to target 20% revenue growth at the scale of $20+ billion per year.
The eBay shift has remained a drag on revenues and will continue to create headwinds in 2022. However, there are two key positives here. Firstly, the underlying business is growing very quickly when you exclude eBay comparables (29% ex-eBay growth in 2021 and 19-21% ex-eBay growth expected in 2022). Secondly, the removal of the eBay partnership allows PayPal to sign more partnerships with other eCommerce providers. PayPal signed a deal with Amazon to allow Venmo (a PayPal business) payments as a checkout option for US customers in 2021. More partnerships are expected going forward.
The new strategy PayPal has employed (engagement prioritised over new account growth) makes sense. The marginal returns to each new PayPal user is significantly smaller than the return from increased engagement of its existing user base. This strategy is not only likely to boost profitability for PayPal, reducing customer churn and avoiding wasteful incentive spend, but there are already signs that this strategy is very much achievable.
PayPal’s customer engagement, measured by transactions per active account (TPA), has grown at a steady trajectory, as PayPal’s services become more useful to the user base and more merchants opt for PayPal solutions at checkout. Additionally, as you can see below, PayPal has built several features into the digital app already, which increase engagement and provide data for the parent to learn methods of boosting engagement further.
Lastly, PayPal remains a highly competitive entity and has an outstanding position in payments as the leader of the digital payments industry. PayPal remains the leader in merchant acceptance by a considerable margin. As a two-sided network, competitors must not only win over PayPal’s customer base (426 million accounts) but also erode partnerships and merchant relationships where PayPal has become the preferred payment option. The sheer size and fragmentation of PayPal’s merchant base means this serves as a significant barrier to the erosion of PayPal's business.
Existential Threat From Apple Pay?
Digital payments is a competitive and fast-evolving space. PayPal is already under pressure from pure-play digital payments companies such as Block, the owner of Square. However, I think that the most important competitor is Apple. We covered Tim Cook’s ambitions to take Apple further into the payments space earlier in this article and I can imagine one of Apple’s ambitions is to close the gap on merchant acceptance of the Apple digital wallet versus PayPal.
The Verge reported Apple’s incoming ability to turn the iPhone into a point-of-sale device allowing merchants to take payments directly from their phone, rendering the need for a contactless POS device such as the iZettle or Square POS. This is potentially more damaging for Block’s Square, which has a much higher portion of revenue from POS systems than PayPal’s iZettle business generates for the parent. However, it showcases the continued threat from an all-encompassing ecosystem business such as Apple.
As I mentioned above, PayPal’s broad merchant acceptance and its specialism in the payment industry should act as relative insulation from the threats of Apple. However, this is a dynamic situation and any potential investor in PayPal needs to be aware of the continued threat.
Summary and Valuation
The c.25% drop in PayPal shares last week means that PayPal is trading for 27x forward earnings (on a Non-GAAP basis). This is well below the multiple investors have paid for PayPal over the last 3 years at an average of 50x earnings.
The latest results from PayPal show the business is undergoing challenges and the change in strategy has worried investors and likely reduced faith in PayPal’s ability to achieve its medium term revenue and profitability goals (with a revenue goal of $50 billion in 2025 and a goal of $10 billion FCF).
However, I still see many positives for the business, which, excluding the drag from eBay (now only 3% of revenues), remains to grow at over 20% levels despite hitting revenues of $25 billion in 2021. PayPal’s broad acceptance at merchants, with its digital wallet acceptance over nearly 2x the levels of its nearest competitor, showcases the competitive barrier of PayPal's two-sided network. These strengths should keep TPV rolling in (expected $1.5 trillion in 2022).
Personally, I was overweight PayPal before this latest fall in share price. Given the possibility of an existential threat from Apple, there is a limit to the portfolio weighting I can give to this business if I am to keep in mind risk management. However, I think the price today reflects the challenges PayPal is facing and so I'm happy to hold.
That's all for now folks,
At the time of writing, James did own shares in PayPal and did not own shares in Apple.
To see the first 20 portfolio holdings in both of James' portfolios, click here.
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