One of the biggest hedge fund managers is Dan Loeb, manager of the sometimes-activist Third Point Capital. Third Point's Offshore Fund has returned an impressive 15.1% annualized vs. 8.1% for the S&P 500 since 1996.
When a manager like Loeb makes a large bet, it's probably a good idea to listen. Back in July Loeb outlined a new position: PayPal (PYPL -1.14%). With the recent market sell-off, PayPal has now fallen below the levels it was trading at back then, and is 40% below Loeb's $125 price target -- so now may be a good time to take a look at this digital payments leader.
Competitive advantages
As a first-mover in digital payments for e-commerce (and, more recently, mobile commerce), Loeb claims PayPal has a 10x scale advantage over competitors. As of last quarter PayPal has grown its network to 244 million customers and 19.5 million merchants, and processed 2.3 billion transactions in the second quarter alone. That was good for 15% customer growth and an even greater 28% transactions growth.
Image source: PayPal.
Customers tend to become familiar with PayPal by sending money either over PayPal or "millennial-focused" subsidiary Venmo. Eventually, these customers become comfortable using PayPal to make online purchases, where PayPal charges merchants to make money.
Merchants pay PayPal's take rate because PayPal makes it really, really convenient for customers to buy things online without entering credit card information. In fact, PayPal's convenience has enabled a checkout conversion rate of 89% -- double that of traditional credit cards. That closing power is hugely beneficial to merchants, and explains why they fork over the roughly 2.9% plus $0.30 PayPal charges on transactions.
Growth prospects
Many investors appreciate PayPal's advantages, which is why it's priced at a relatively high 27 times forward earnings. Still, Loeb believes that PayPal could outperform due to its underappreciated growth potential in three specific areas.
Venmo monetization
It may be comforting for shareholders that despite 23% revenue growth last quarter PayPal isn't even really monetizing key property Venmo yet. The platform is a peer-to-peer payments app with a social media flair that appeals to millennials, which increased payment volumes by a whopping 78% last quarter.
While PayPal hadn't monetized Venmo since it acquired the start-up in 2013, that's about to change. Late last year PayPal introduced Pay with Venmo, and has been adding merchants to the platform, with the recent addition of Uber. PayPal also launched a Venmo credit card in June, which allows customers to use their Venmo balance to pay for offline purchases or get cash from an ATM.
All of these initiatives should leverage the powerful Venmo brand into actual dollars. Loeb thinks Venmo can add $1 billion in annual revenue in three years (PayPal made $14.5 billion over the last 12 months).
Dynamic pricing
Loeb also thinks PayPal has another lever to generate growth via dynamic pricing. PayPal has traditionally charged the same rate to all retailers and merchants; however, the company has recently switched to a more dynamic pricing model based on a growing suite of services in artificial intelligence, fraud detection, and big data, along with its core processing service. With almost 20 million merchant customers, PayPal has a large customer base to which it can sell other value-add products.
Expansion to offline commerce
Finally, while the online payments space addresses $3 trillion in global spend, the offline shopping market is much bigger at $21 trillion. While PayPal has traditionally been an online payments provider, it's now moving into that offline market via the recent acquisition of iZettle. iZettle is sometimes referred to as the "Square (SQ -1.68%) of Europe" -- a point-of-sale service in Europe and Latin America. PayPal paid $2.2 billion for iZettle, and likely hopes to cross-sell iZettle to existing merchants, while also making it easier for iZettle customers to accept PayPal. It seems like a great match, as it diversifies PayPal geographically while also giving it a cross-sell opportunity and a competitive counter to Square, which is seen as a rising competitor.
It all makes sense
The younger generation is much more inclined to gravitate toward digital payment solutions, and while PayPal's PE multiple is somewhat high, I think it's warranted. The company recently sold off its PayPal Credit portfolio to Synchrony Financial (SYF -0.80%), which means PayPal doesn't have lending risk anymore, and lenders generally garner lower valuations than payment processors. Now that PayPal is more of a pure play processor and service provider, Loeb's contention that the stock is actually cheap at today's "high" PE multiple has merit.
