The Digital Payments Space Heats Up, and PayPal Is On Fire

The war on cash is raging, and PayPal (PYPL 1.41%) is rocking it. In this week's episode of Industry Focus: Technology, host Dylan Lewis and Motley Fool contributor Matthew Cochrane take a closer look at the digital payments industry, where PayPal sits in it, and what to make of its $2.2 billion acquisition of "the Square of Europe."

Competition is heating up, and credit card companies are offering a pretty compelling alternative to PayPal's wildly successful One Touch -- but how worried should PayPal investors really be? Did PayPal overpay by spending billions on a company that'll only generate some $160 million this year? What sets PayPal apart? Tune in to find out more.

A full transcript follows the video.

This video was recorded on May 25, 2018. 

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, May 25th, and we're talking payments news and PayPal. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com's Matthew Cochrane. Matthew, how's it going?

Matthew Cochrane: It's going alright, Dylan. How's it going with you? Do you have plans for Memorial Day?

Lewis: I do. I'm going to be doing some prep. I'm going to be taking a cross-country road trip with my girlfriend. She lives out in LA and is moving to D.C. So, I need to work on our itinerary a little bit, because we're leaving on Wednesday.

Cochrane: That's a long trip. Good luck with that!

Lewis: Yeah, I think it's going to be an interesting test of our relationship, but I think it should be pretty good. Austin, man behind the glass, what are you up to this weekend?

Austin Morgan: I don't have any crazy plans, mostly just trying to keep it light, maybe get some yard work done, clean the car out or something.

Lewis: That's the life of a homeowner, enjoying your holiday weekends by doing some yard work. Matt, what about you? Anything fun?

Cochrane: As you might know, my wife and I have four kids together, but this weekend, all four kids are camping with their grandparents. So, my wife and I have a whole weekend to ourselves.

Lewis: Wow! And what a weekend to have it, three days to relax.

Cochrane: Big times!

Lewis: I'm excited to have you on, Matt. Listeners, you may recognize Matt's voice. We had him on our Pitch show last year during the writer's conference when we had a bunch of folks over here at HQ. Matt, you're someone that focuses on the payments space a lot. There's been a lot of news in the payments space. So, I wanted to bring you on to talk about all that news, specifically how it relates to PayPal.

Cochrane: Well, there's a lot of news going on. There's been a lot of acquisitions in the industry lately, a lot of consolidation. Just going back the last few years, Visa acquired Visa Europe, so they're growing internationally. MasterCard has made a number of acquisitions. And, of course, PayPal just made an acquisition the other day of iZettle, which kind of puts them in direct competition with Square.

Lewis: And we're seeing that there's also some competitive pressure coming from these legacy companies, some news about that. Before we get into all of that, though, why don't we do a quick couple of minutes on the story with PayPal, how things have looked over the last couple years, and what investors are watching?

Cochrane: Sure. I think, most people are semi-familiar with PayPal. It's the world's largest open digital payment platform, which consumers can use to move and manage their money. Every time consumers use PayPal to make a transaction, PayPal takes just a little off the top. We're talking about a fraction of a percentage point, but it quickly adds up, when you're talking about billions of transactions. 

PayPal also has Venmo, which is very similar to the core platform, though it is more popular with millennials and has a bit of a social element to it. Venmo is still primarily used for P2P, or person-to-person, transactions, so the company is beginning to roll the platform out more for other types of transactions that can be monetized. Another PayPal subsidiary is Braintree, which offers payment processing solutions to merchants, with one of Braintree's most prolific customers being Uber.

Lewis: You mentioned Braintree, you mentioned Venmo. They're strong in mobile. We've seen that this company is a company that's kind of ahead of the curve with the payments industry, a little bit. One thing in particular that stands out to me is what they've been doing with One Touch. Not only are they really focusing on making mobile payments easier and removing some of the friction there, they're also doing that with the standard e-commerce experience for customers.

Cochrane: Correct. Mobile payment volume on PayPal has exploded in the last quarter. It was up 52% year over year. The company definitely gives most of that credit to One Touch. One Touch's sales conversion rate is 89%, which is about double the industry average. When we're talking about mobile sales conversion rate, what that means is basically, once a consumer or a customer of an online merchant begins the checkout process, how often do they finish that checkout process? This is a big issue for merchants. If a customer is on your site and they've expressed interest in buying an item or product or service that you sell, you want that customer to complete the sale. You don't want the customer to get bogged down in the payments process and be like, "Oh, I'll come back to it later," and then they never do. So, this is a big thing. 

One Touch allows a user to register a device -- say, your smartphone -- and from now on, when the consumer is shopping online and using that device and they come to a website's checkout page, they can simply click the PayPal button, and they're done. There's no need to enter their credit card number, their expiration date, the billing address, the shipping address. It's more secure and more convenient. 

Personally, I find it easy to use. I probably literally get annoyed every time an online merchant doesn't offer it. And I'm not alone. Yesterday, at PayPal's investor day, they said 31% of consumers -- this is according to a comScore survey -- would not even complete a purchase without PayPal One Touch. One Touch now has 92 million consumers enrolled and 8.6 million merchants enrolled.

Lewis: And it seems to me like the legacy payment companies have taken note, because based on some recent comments from Visa, I think, in particular, but several of the credit card companies, we're seeing that they are now focusing on making these payment options a little bit easier for customers. I think people don't want to be putting in 16 digits, an expiration code, and a three-digit code on the back every single time they make a purchase. They're focusing now on this, too.

Cochrane: Correct. There's a little quote. The credit card companies have always offered their own digital wallets for the last couple of years. MasterCard has Masterpass, Visa has Visa Checkout, American Express and Discover have digital wallets that nobody uses and nobody knows what they're called, but the four have decided to gang up, essentially, and make a common e-commerce checkout standard, the goal of which is to rid the need to enter cumbersome data such as lengthy credit card numbers when making online purchases, which sounds an awful lot like the PayPal One Touch platform.

Lewis: And I think this is probably something that rightfully worries PayPal investors a little bit. So much of the strength of it has been, "We're making things easier than almost anyone else is to make these payments happen." How worried are you about this, as an investor?

Cochrane: Well, it's too early to tell. I personally think that the digital payment space is so big, there's more than enough room for two players in this space. That being said, it's something you're going to have to wait and see. Fortunately for PayPal investors, they do have some time. The MasterCard CEO, Ajaypal Banga, in his last conference call, he was saying the effort was going to be transformative for the industry. When he was asked about the timeline, he said, "You're going to begin to see the first fruits of this effort maybe by the end of this year, and you're not going to really see a real push until the beginning of next year." So, it's one of those things, one, PayPal does have time, and we're just going to have to see how it plays out.

Lewis: You think about the user growth that they have, and so much of what makes payments easy is the idea that I can easily send money to you. We have the P2P side of things, and then we also have the ability to interact with merchants. That's the wonder of, maybe, the long-term vision of PayPal. I think, if they go further out and say, "This is going to be something that hits a year from now," Venmo isn't going to be standing by doing nothing during that period. They're going to be continuing to get stronger, they're going to be adding users, and that base is going to get stronger.

Cochrane: Correct. So, you have a year, which is another year of growth for Venmo, another year of growth for PayPal's core platform. What you were talking about, P2P payments, I think that's a big draw for PayPal. PayPal can offer a whole entire suite of services to consumers. This standard will be nice for when you're checking out online, but if I want to send money to you because we split a dinner tab last night, I'm not going to be able to use this standard for that. PayPal, I can do everything from one platform. 

You only have so much space on your phone. People aren't going to sign up for a million different apps. So, the more you can offer an entire suite of services, I think, the more attractive you're going to be, and I think that's where PayPal falls in a really sweet spot.

Lewis: We're going to talk about another sweet spot that PayPal is playing into thanks to an acquisition. Alright, Matt, the legacy payment companies might be turning up the heat a little bit, but PayPal is not going to just sit by and watch. They're getting a little bit more aggressive. Our second news item here is that they went shopping.

Cochrane: That's correct. Just earlier this week, they actually acquired iZettle for about $2.2 billion in an all-cash deal. That represented about one-third of PayPal's $7.8 billion war chest. 

The shortcut to understanding what iZettle does is to call it the Square of Europe. Why is it called the Square of Europe? Well, Square first got on the map by, for small merchants that didn't have the resources to buy expensive hardware to accept card payments -- think food trucks or farmer's markets -- they came up with a simple and elegant design with a dongle that can attach right to a smartphone, and within minutes, that merchant could then start accepting card payments. 

Well, remember, Europe switched over to EMV chip credit cards years before the United States did. And iZettle was the first company to come out with a solution that could plug into a smartphone and accept chip card payments. So, they both got on the map with very similar solutions that met the needs of small merchants in their respective markets. 

Also, the other day, Global Payments Incorporated, another payment processing company, their CEO was on CNBC right after the acquisition. They asked him, "Are you guys competing with iZettle in Europe?" And he said, "You know what, not really. iZettle goes for the smaller merchants. Global Payments, we're into merchants who make more than $250,000 in sales. iZettle goes for those smaller, almost micro-merchant types." Who does that remind you of? It reminds you of Square.

So, the shortcut to understanding this acquisition is to call it the Square of Europe, which is pretty much what the media has been doing. Last year, iZettle facilitated $6 billion in total payment volume, and they've been increasing their revenue at about a 60% rate since 2015, which is incredible.

Lewis: Yeah. This was not a cheap acquisition for PayPal. They should be generating about $160 million in revenue in 2018. So, they paid a hefty premium for iZettle. The idea here is, it opens up some new business for them, both in terms of business operations and also geography.

Cochrane: Correct. This acquisition was not made to be immediately accretive to PayPal's earnings. In fact, I would not look at this acquisition saying, "Look, oh, my goodness, PayPal paid almost 20X sales for this small European payment processor!" It's a strategic acquisition, for two reasons. 

Yesterday, at the investor day, the CFO for PayPal, John Rainey, he was saying, "All of our acquisitions have to have a compelling strategic rationale." And what PayPal believes now is that this gives them the best in class omnichannel offering to merchants to provide payment processing services. They can cross-sell iZettle to PayPal merchants, and vice versa. 

The second strategic reason that this makes sense for PayPal is, it gives them an in-store payment processing presence in geographic markets where they really did not have any presence before. That includes Brazil, Denmark, Finland, France, Germany, Italy, Mexico, Netherlands, Norway, Spain and Sweden. This gives PayPal a more global presence. Merchants with a global presence want that, obviously. And, it just makes sense for what they can now offer to a merchant, the payment processing services they can offer to a merchant.

It's a very strategic acquisition. I wouldn't look at it from a numbers perspective.

Lewis: Yeah. If you're getting hung up on the details of the deal here, you look at that $2.2 billion and think about PayPal's overall market cap, it's a tiny, tiny fraction of what the business itself is worth. So, this is very much something that will plug in and be worked into their operations, not something that's immediately accretive.

Looking at this news, looking at the competitive news, you're a shareholder, I'm a shareholder. Matt, how are you feeling about this?

Cochrane: Look, I'm very bullish on PayPal. I've been a shareholder for about two years, and I don't have any plans to sell my shares any time soon. I think what makes PayPal attractive is, one, like we were saying earlier, it can offer an entire suite of payment services to consumers. Again, are the credit cards coming out with their own standard for e-commerce checkout? Yes. Will that compete with PayPal's One Touch? Yes. But you can't use that platform to make P2P payments, for instance. 

Then, another reason why I like PayPal, and this goes back to everything, it does seem like, at times, that everybody is gunning for them. You have Apple Pay, you have Google Pay or Android Pay, or Square with the Cash app. But, most of these are specific to a device. Like, if you want to use Apple Pay, you have to have an Apple device. Same with Android Pay. For credit cards, for their digital wallets, you have to have that kind of credit card to use. For an operating system, etc. PayPal is agnostic. You can use it across any device, any operating system. It doesn't matter what bank you have. The banks rallied around Zelle earlier, to promote Zelle, which is another great P2P platform. But it doesn't matter. You have to have a bank that participates in that program. PayPal, you can use it across any bank, any device, any service. It really is that universal digital payment platform.

Lewis: And I look at the acquisition they made, specifically iZettle, and say, this looks like something that will continue to fuel the virtuous cycle that we've seen with this company before. You have member growth because people are already using apps. There's the network effect of, you're able to pay your friends with Venmo or something like that. Then, as merchants come on to the platform, they're coming on because consumers are there, and the merchant acceptance fuels more consumer growth. 

So, you continue to have different parts of the business feeding each other. I think, if they have a really great payment facilitation option in Europe, that will help a ton with customer acquisition there. It just continues to feed something that's already worked so well for this business.

Cochrane: Absolutely. The more PayPal account holders utilize their accounts, the more merchants want to sign on to PayPal's platforms. And the more merchants on PayPal's platform, the more customers use their accounts. And on and on that network effect goes, absolutely.

Lewis: I think this acquisition also shows a little bit of the optionality that a company like PayPal has, a company like Square has. We're talking about PayPal here, I don't think Square is a bad business, by any stretch. You look at both of them, though, they are disruptive payment companies, Square has been able to do a lot of things after getting merchants involved, where they've layered in all these extra services. I would not be shocked to see PayPal be able to do the same thing, now that they're moving more into that space. 

Cochrane: No, absolutely. In fact, yesterday, I was listening to some of the presentations at PayPal's investor day, and when they talk about their merchant services, they have really co-opted Square's language that they use. When they talk about democratizing payment services, and empowering small merchants to compete with the big boys in their industry ... they absolutely have their eyes on some of the same exact markets.

Lewis: Yeah, understandably so. It's a compelling one to be looking at. Matt, anything else before I let you go today?

Cochrane: No. Again, I'm bullish on PayPal because they offer an entire suite of services. Other platforms don't really have that entire ecosystem of digital payment services that PayPal offers. And, they're agnostic. I really think, if there's going to be a universal digital payment platform, I think PayPal is a horse to bet on.

Lewis: I think that's a good place to end this one. Thanks for hopping on, Matt!

Cochrane: Thanks, Dylan!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at [email protected] or tweet us, @MFIndustryFocus. 

Quick housekeeping out here, I mentioned I'm going to be traveling starting next Wednesday. The next two Friday episodes have been pre-recorded. If anything crazy happens in the market, give us a little slack there, because it was a scheduling issue that we had to overcome. 

Of course, if you're looking for our episodes, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. I hope he enjoys a nice Memorial Day in his yard. For Matthew Cochrane, I'm Dylan Lewis. Thanks for listening and Fool on!