PayPal (PYPL -1.14%) started the year by rising 24% to an intraday high of $88.63 on Feb. 2, as many optimistic investors believed the Federal Reserve was close to ending its relentless rate hikes and the economy could achieve a soft landing -- an excellent scenario for this business. However, investors lost interest in the company after subsequent events showed the chances were high the economy would instead have a hard landing, a sharp economic slowdown. As a result, investors worry about a further deterioration in PayPal's revenue growth.
Now that today's stock price is closer to where it started the year, should you use the pullback in the stock's price to buy, or should you sit on the sidelines and wait until the danger of recession has passed?
Let's take a look at that question.
The top dog in e-commerce payments
PayPal started in 1998 and was among the first to market payment services between merchants and consumers in the then-emerging e-commerce industry. Thus, it established strong brand recognition and customer loyalty well before significant competition appeared.
Additionally, because it operates on both sides of the payment transaction, it enjoys a two-sided network effect.
The value the consumer gains from using its network is determined by how many merchants accept payments from PayPal. Conversely, the number of consumers who use the payment service determines the platform's worth for merchants. Thus, the value of the payment platform increases with each new consumer or merchant joining the network.
PayPal used these two competitive advantages to increase its total payment volume through its platform to $1.36 trillion in fiscal 2022 -- making it a powerful global payments platform.
As of September 2022, PayPal is the No. 1 player in the online payments industry, with a market share of about 42%, according to market research company Statista. Considering the company's dominance in online payments, it makes you wonder why investors have abandoned the stock over the past 18 months or so.
A poor economic environment and increased competition
Growth investors familiar with seeing the company producing double-digit percentage revenue growth started aggressively selling their shares in late 2021 into 2022 as revenue growth began its steep fall into the single digits, as shown in the following chart.
PYPL Revenue (Quarterly YoY Growth) Data source: YCharts
Quarterly reports over the past year have not helped investors feel better about the company. For instance, its fourth-quarter 2022 results continued to show several deteriorating key metrics, despite the headlines of revenue and earnings beating analysts' expectations.
For example, the growth of active accounts, defined as registered PayPal accounts that completed a transaction over its network within the last 12 months, slowed to a crawl, showing only 2% growth compared to the previous year's 13% year-over-year growth. In addition, TPV showed a sharp deceleration from 23% year-over-year growth in the fourth quarter of 2021 to a measly 5% in the fourth quarter of 2022 -- yikes!
No wonder revenue growth fell off a cliff. Management has blamed the deterioration of active accounts, TPV, and revenue on multiple factors, including a weaker macro economy and slowing e-commerce growth.
Investors have also recently been displeased with the company's operating margins, thinking a savvy management team and its competitive advantages would build a moat around PayPal's profitability. Yet, operating margins began deteriorating starting in July 2021, as seen in the chart below (though they've rebounded some in the past few quarters).
PYPL Operating Margin (Quarterly) data by YCharts
Many believe PayPal's deteriorating fundamentals have causes beyond just a cyclical downturn. The company's competitive advantages may have eroded, resulting in it spending more to stave off its adversaries, which decreases operating margins.
On the merchant side, PayPal faces competition from companies like Stripe, and on the consumer side, platforms like Apple Pay are chipping away at its payment dominance. Shareholders also worry about Block competing on both sides of the payment transaction, with Square on the merchant side and Cash App on the consumer side.
Why you should put PayPal on your buy list
Despite the competition, PayPal is still the lead dog and a preferred only payments partner. Revenue growth probably will recover once e-commerce growth rebounds -- but when that occurs is anyone's guess. The good news is that this management team has focused on things it can control, which is cutting costs in areas not producing enough bang for the buck while fully staffing and funding the most productive areas of the company to pursue profitable growth.
PayPal is already seeing progress in its cost-cutting initiatives, resulting in its non-GAAP (generally accepted accounting principles) operating margin widen by 115 basis points year over year to 22.9%, up sequentially for two straight quarters. Meanwhile, it continues to invest in its most-promising growth initiatives like the modernization of the checkout experience; scaling growth at Braintree, a PayPal-owned payments processor; and fully ramping up its unbranded service to small and mid-sized businesses. The unbranded service is its checkout technology that appears on a third-party merchant's website without displaying the PayPal button.
PayPal today trades at a price-to-sales (P/S) ratio of 3.12, hovering near its lowest valuation since its separation from eBay in 2015.
Suppose you believe PayPal's revenue growth will bounce back to double digits percentages once the global economy improves and e-commerce growth rebounds. Through continued cost control, the company should achieve solid margins and increase profits rapidly, making today's valuation look mighty tempting to an investor. And it would be a great time to grab a few shares of this undervalued stock.
