PayPal (PYPL 0.64%) was already a growth stock when the novel coronavirus started to spread early this year. But as the lockdown to halt the advance of COVID-19 took hold, a brief drop in the stock gave way to a boom as in-person spending was rapidly replaced by e-commerce. As a result, shares of PayPal are up over 70% so far in 2020 as of this writing -- even after an early September double-digit percentage pullback.
After such an epic run, why is PayPal a buy now if you're worried about another broader market crash? For two reasons: Consumer behavior is rapidly changing, and PayPal's profits are on the rise.
Touchless payments going mainstream
As was to be expected, digital payment networks Visa (V 0.33%) and Mastercard (MA -0.07%) reported respective revenue declines of 17% and 19% during the worst of the economic lockdown in the spring of 2020. No such bad luck at PayPal. Because it doesn't rely on in-person card transactions at stores but instead generates the vast majority of its income from e-commerce, its revenue accelerated to 22% during the second quarter of 2020 (up from 12% growth in the first quarter). A pace of 23% year-over-year growth was said to be expected during the summer months.
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In fact, while some of its older digital payment peers have matured and their long-term growth trajectory has slowed, PayPal should enjoy robust expansion for some time. Helping its results in no small part this year has been its subsidiary Venmo, which allows for mobile transfer of money between individuals and is increasingly being used by many consumers as a daily checking account. PayPal said active Venmo accounts exceed 60 million, and the total payment volume the app processed in Q2 grew 52% from a year ago.
Other initiatives for the "new normal" are underway, including touchless QR code-based payments at physical stores and new credit tools for merchants like a new payment method that allows customers to pay for a purchase over a six-week period with interest-free installments. Venmo is also integrating directly with merchants, giving everyday users of the app more options to pay, and a Venmo credit card to complement the Venmo debit card (which operates on Mastercard's network) is also on the way later this year.
Put simply, whether resurgent COVID-19 cases cause another economic tumble or e-commerce loses steam in favor of in-person shopping again, PayPal has plenty of levers at its disposal to keep growing. Another market meltdown isn't going to upend this growth story anytime soon.
A booming bottom-line
Still, mid-20% revenue growth isn't enough to push shares some 70% higher all on its own. This is surely an overheated tech stock ripe for a crash, right?
Not exactly. PayPal and its subsidiary businesses are reaching a more profitable scale as they add more users and payments activity to the platform. Case in point: Though revenue rose 22% in the last quarter, free cash flow (revenue less cash operating and capital expenses; basically what gets added to or subtracted from the balance sheet each quarter) rose 112% year over year to $2.2 billion as its purchase of Honey (for $4 billion in 2019) and iZettle (for $2.2 billion in 2018) start to pay off. And though already a large service in its own right, Venmo is still in the early stages of being monetized as well.
This profit margin expansion could help keep this stock afloat for many years. In fact, PayPal is a far smaller business (by market cap) than both Visa or Mastercard even though its revenue has already surpassed Mastercard's and is now quickly homing in on Visa's. The reason is lower free cash flow over the last year. But as its steady pace of acquisitions start to contribute to the bottom line, the situation will change and favor PayPal. And while Visa and Mastercard still fetch lofty valuations of 38.7 and 42.4 times trailing-12-month free cash flow, still-growing PayPal goes for a relative value of just 40.1 times trailing-12-month free cash flow -- even though there is far greater upside potential for PayPal's margins.
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In the years ahead, higher use of digital wallets, e-commerce services, and touchless payments should help PayPal keep its foot on the gas -- and the bottom-line stands to grow at an even faster rate as the software-based payments firm reaches a more profitable scale along the way. If you're worried about a short-term market crash, this resilient financial technologist trades for a relative value to its peers and is worth a buy.
