Over the past few weeks, Clime has presented its rationale for local investors to maintain portfolio exposure to major international companies. It is our view that equity markets will remain volatile, and indeed this has been a feature of markets in recent days leading up to the Brexit vote in the United Kingdom.
In managing our international portfolio, we believe the focus should remain with US multinationals that have strong brand names, business “moats”, robust balance sheets and potential to sell into high growth emerging markets. Price volatility creates attractive trading opportunities in some large and highly liquid companies. Often we see steady earnings performance and outlooks that belie short term price volatility. Rather than simply observe volatility, it is better to exploit it.
One US multinational with strong growth prospects is PayPal (PYPL.OQ).
Multi-country studies show that online commerce is expected to grow by 13% compounded annually while mobile commerce is expected to increase by 42% compounded annually over the coming years. Furthermore, some 85% of existing commercial transactions are still legacy cash transactions and there is growing consensus that there will be an ongoing shift away from cash payments to other forms of electronic payments over the foreseeable future. For companies who benefit from the explosive growth in both e-commerce and the resultant increase in electronic payments that flow from this, strong growth is expected in the coming years.
One company which will benefit from this secular growth trend is PayPal, a company we have been watching with a keen interest since its IPO almost a year ago. PayPal engages in the digital and mobile payments on behalf of consumers and merchants worldwide. When PayPal released its most recent results the CEO made it clear that the company sees itself as a leader in the growing market of digital and electronic payments. The company accepts payments from merchant websites, mobile devices, and applications; and at offline retail locations through payment solutions across its payments platform, including PayPal, PayPal Credit, Venmo and Braintree products.
PayPal offers strong growth prospects
Despite the increasing competition from major players such as Apple, Google and others, PayPal is the leader in its industry. PayPal has a small share of the total online payments market and whilst 75% of the top 100 Internet retailers in the U.S. and Europe, the Middle East and Africa accept PayPal, it needs to gain more of their sales in order to get the operational benefits of increased volumes over time.
PayPal is well diversified by region and it has a strong presence in the US. Over time we would expect the company to expand more outside of its US home base.
Figure 1: PayPal Revenue by Region 2015
Source: Company Financials, Clime Group
PayPal’s global scope is a competitive advantage and barrier to entry for potential competitors. PayPal processes transactions in 30 currencies and more than 200 markets, each often with its own regulations. Its cross-border volume rose 26% in 2015, twice the rate of Visa and MasterCard combined. As commerce increasingly flows across borders, PayPal’s expertise is a differentiator. It accepts payments in 100 currencies and it is allowed to hold cash balances in 26 currencies. It comes with little surprise that it was the 41st most visited website in the world with over 19 million daily visits in 2015.
What are the risks and opportunities for PayPal?
The rise of competing online-payments options is a challenge for PayPal, though its dominance gives it some advantages. It may be able to convince Amazon to add it as a payment option if it agrees to take less than its 3% average rate. Alibaba, which operates the similar AliPay, may also benefit from adding PayPal as an option. Digital wallets Visa Checkout, MasterPass, Google Wallet and Amazon Payments haven’t been widely adopted and card issuers have been slow to introduce their own branded payment applications.
PayPal has identified person-to-person, or P2P, payments and lending as potential growth opportunities. Venmo, acquired in 2013, has become a verb for young consumers sending cash to each other (“Venmo me”). The next challenge for PayPal is monetising this product. While PayPal does not yet have a P2P lending product, its more than 165 million active users and its underwriting expertise may help it enter the market.
What are the future return prospects for PayPal?
After becoming once again a public company in July 2015, PayPal has been trading around its initial public offering price for the past 10 months. It was a classic case of a good business where the price was too dear when it listed. A price earnings ratio of 20 times based on 2018 estimated earnings per share is not cheap. Having said that we recognise that as millennials grow up and increase their consumer spending, as baby boomers get used to this new way of shopping and as mobile devices get even more widespread and used in payments the strong growth prospects for PayPal remains in tact.
PayPal has a light capital structure, a defensive profile, no debt (it actually ended the first quarter with $6.4 billion in cash and cash equivalents) and generated $605 million of free cash flow in those 3 months. The company commands operating margins above 20% and EPS will grow at least double digits compound over the next 5-7 years.
In our opinion a price below $35 per share would represent a decent entry point into this name given its future growth prospects, attractive balance sheet and high return on equity profile.
Written by Louis Jamieson, with excerpts from John Abernethy.