Is It Too Late to Buy PayPal Stock?

PayPal's (PYPL 2.90%) stock plunged 12% on Aug. 3 after the digital payments leader posted its second-quarter earnings report. Its revenue rose 7% year over year to $7.29 billion, just narrowly beating analysts' estimates. Its adjusted earnings grew 24% to $1.16 per share and matched the consensus forecast.

Those headline numbers weren't disastrous, but a deeper dive exposes a few red flags. Let's review those issues and see if it's too late to bet on PayPal's turnaround.

Image source: Getty Images.

It's losing active accounts as its free cash flow turns negative

PayPal ended its second quarter with 431 million active accounts, but that marked its second consecutive loss of accounts on a sequential basis. Its free cash flow (FCF) also came in at negative $350 million, compared to positive $1.3 billion a year ago.

Data source: PayPal. YOY = Year-over-year.

PayPal didn't directly address its loss of active accounts during its earnings call, but it was likely caused by slower e-commerce sales in a post-pandemic market, inflationary headwinds affecting consumer spending, and competition from other payment platforms. Its final decoupling from eBay likely exacerbated that slowdown.

On the bright side, PayPal's payment transactions per active account still grew 3% sequentially and 12% year over year during the quarter, which offset its loss of active accounts and boosted its total revenue. Therefore, PayPal will likely face more pressure to monetize its existing users with higher fees or new services if it continues to bleed active accounts.

That's why PayPal expanded its ecosystem with buy now, pay later (BNPL) options, cryptocurrency purchases, and deeper partnerships with credit card companies like Visa and Mastercard. It's also been adding in-store payments to its peer-to-peer payments app Venmo. Unfortunately, none of those new features are significantly boosting its total revenue yet.

For the third quarter, PayPal expects its revenue to rise about 8% year over year. That would merely match its 8% growth in 2022 and compare poorly to its 18% growth in 2021.

As for its FCF, it turned negative because the company set aside $1.2 billion during the quarter to pay off some bad loans. However, it expects the sale of its European BNPL loans later this year to offset that decline and drive it toward its goal of generating $5 billion in FCF for the full year.

Focusing on its operating margins and earnings growth

As PayPal's growth cools off, it's cutting costs to stabilize its adjusted operating margins. It's also repurchased about 6% of its shares since the end of 2021, and it plans to spend all of its FCF this year on additional buybacks. That's why its adjusted operating margin expanded by 228 basis points year over year in the second quarter, while its adjusted EPS growth outpaced revenue growth for the third consecutive quarter.

Data source: PayPal.

For the full year, PayPal expects its adjusted operating margin to expand by "at least" 100 basis points from 21.3% in 2022. But that would still be significantly lower than the 24.8% and 25.1% it posted in 2021 and 2020, respectively. Management is guiding for 20% full-year earnings growth, reversing its 10% decline last year.

Its low valuation reflects its uncertain future

PayPal's stock looks historically cheap at just 13 times forward earnings, but that low valuation reflects its uncertain future. CEO Dan Schulman, who has led the company since its spin-off from eBay in 2015, will retire at the end of the year. The board hasn't named a successor yet, and it's unclear if the next CEO will follow Schulman's lead on cutting costs and buying back stock -- or sacrifice its near-term margins to aggressively court new users, expand its ecosystem, and widen its moat.

Without a clear roadmap, investors are left with a company that is losing active accounts, struggling to differentiate itself from its competitors, and facing tough macro headwinds. So for now, investors should avoid PayPal until it appoints a new leader, lays out clearer plans for its future, and shows that it can keep growing in this tough market.