Fintech leader PayPal (PYPL 0.64%) delivered a solid earnings report on May 9 for the first quarter (ended March 31), with revenue and earnings surpassing consensus estimates. The company is also guiding for adjusted earnings per share (EPS) of $4.95 for fiscal 2023, implying a year-over-year upside of 20%, higher than the prior growth outlook of around 18%.
Yet, shares of the payment network specialist are down by over 40% from its 52-week highs. Wall Street is mainly concerned about the slow pace of year-over-year expansion in adjusted operating margins (100 basis points expected, as compared to the previous estimate of 125 basis points) and a 2 million sequential decline in the number of active accounts in the first quarter. The stock is pressured by a slowdown in the higher-margin branded checkout business (its legacy business that enables merchants to process transactions through PayPal's payment network and includes PayPal's checkout button), intensifying competition from other digital wallets, and currency fluctuations.
However, despite the headwinds, the company's long-term growth story remains intact. With shares trading at multi-year low price levels, patient investors stand to reap huge financial rewards in the long run.
Here's why it might make sense to buy this dip in PayPal.
A force to be reckoned with in digital payments
Although there were some shortcomings in PayPal's recent earnings report, total payment volume grew by 10% year over year to $355 billion, while the number of payment transactions was up by 13% to 5.8 billion. The company saw a sequential acceleration in payment volumes across all business areas -- be it international business, cross-border business, branded checkout, unbranded checkout, or Venmo. PayPal also reported a 13% year-over-year growth in transactions per active account to 53.1 in the first quarter.
PayPal dominates the market in online payment processing software with a share of just over 42%. While the impact of competition from the likes of Apple and Alphabet in the fintech space cannot be ignored, PayPal is still very much a well-established and trusted brand in the online payments space.
Thanks to the user-friendly and secure online payment infrastructure, it has built a broad active-account base of 433 million (including 35 million merchants). Besides facilitating transactions across online and offline channels, PayPal also provides financial services such as debit cards, credit cards, prepaid cards, and lines of credit.
The two-sided nature of PayPal's payment network, providing services to both merchants and customers, has played a pivotal role in expanding its active account base. Coupled with its scale, the company benefits from a solid network effect wherein the value of the payment network continues to grow with increased adoption by users and merchants.
According to Nielsen, PayPal is associated with more purchases, a higher level of repeat buying, and completed checkouts as well as an improved purchase experience and likelihood of buying. This implies that merchants have enough motivation to choose the PayPal payment network, which will continue to attract new active accounts in the coming years.
Hence, despite competitive pressures in the current tough business environment, PayPal will continue to benefit from the secular growth in the digital payments industry, whose transaction value is estimated to grow from $9.5 trillion in 2023 to $14.8 trillion in 2027.
Improving margins of the unbranded checkout business
PayPal delivered 30% year-over-year growth in unbranded processing volumes (online sites which process transactions through PayPal payment network but do not include a PayPal checkout button. This business includes Braintree and the relatively new PayPal Complete Payments or PPCP services) in the first quarter. Although increasing its share in unbranded processing helped boost the company's payment volumes, it has had a negative impact on overall margins.
PayPal, however, is committed to growing its unbranded checkout business, which in turn will deepen the company's relationships with merchants. And the company is also working to improve the margin structure of its unbranded business.
While Braintree focuses mostly on the largest enterprise customers, PPCP (with a target addressable market of $750 billion) is geared more toward the higher-margin small and midsize businesses. The company aims to expand the presence of Braintree and PPCP in international markets and integrate more value-added services such as subscription-based services that provide merchants access to risk management and currency management models.
Cost-cutting initiatives
In the first quarter, PayPal managed to reduce its non-transaction-related operating expense by 12% year over year with strong discipline in areas such as sales and marketing, technology, and customer support. The company aims to further improve its cost structure by leveraging artificial intelligence and updating processes.
Reduced valuation
PayPal currently trades at 26.2 times earnings, far lower than the 12-month average multiple of 37.5. While the structural headwinds cannot be ignored, the recent slump in its share price seems far too exaggerated.
PayPal generated $1 billion in free cash flow in the first quarter and expects $5 billion in free cash flow for all of 2023. The company is also committed to returning value to shareholders, allocating $1.4 billion to share repurchases in the first quarter.
Considering its moat in the payments industry as well as strategic focus on increasing margins and cutting costs, PayPal could prove to be an attractive pick at the current price levels.
