David Rolfe Comments on PayPal Holdings - Oct 15, 2015

During the quarter, we initiated positions in PayPal Holdings (NASDAQ:PYPL), a leading provider of digital payment acceptance and merchant payment solutions. Recently spun out from long-time parent, eBay Inc., PayPal operates in over 200 markets with over 50% of net revenues derived from non-US markets.

A pioneering force in online payment acceptance, PayPal traces its roots back to the late 1990’s most notably with the founding of PayPal. At the time, emerging online marketplaces, such as eBay, while growing rapidly, were in need of a digital payment solution to parallel that growth. PayPal fulfilled that demand and was particularly successful, in part, due to its simplicity and novel approach of aggregating small and mid-sized merchants onto its platform, allowing many emerging online merchants to bypass the prevailing and expensive process of using a merchant bank.

Despite rapid growth of non -eBay merchants, PayPal’s business quickly became disproportionately concentrated with eBay merchants, so PayPal shareholders sold the business to eBay in 2002. eBay aggressively reinvested in the PayPal platform, expanding its reach to more non-eBay merchants, adding services beyond acceptance, including mobile, and broadening its geographical presence, increasing the platform’s relevance in the lucrative cross-border exchange market. All told, prior to eBay’s purchase, PayPal was handling just over $2 billion in total payment volume (TPV). Over the last 12 months through June 2015, PayPal cleared over $250 billion in TPV.

Not to be understated, we believe eBay’s online marketplace expansion was a crucial element that fostered PayPal’s tremendous scaling in the small and mid-sized merchant payment market. While there are several merchant aggregating start-ups and competitive offerings by players in adjacent markets, we believe they all lack the low/no cost marketing exposure that PayPal possessed when it was naturally offered along-side eBay’s multi-decade, marketplace expansion. So while the internet certainly makes it easier to compete, at least compared to the early years of payment aggregation, we believe competitors still face substantially higher costs to generate awareness and adoption, given a dearth of natural, globally expanding merchant partners.

PayPal gained significant scale in the underserved small and mid-sized merchant payment markets, helping the Company carve out exceptional operating margins relative to other merchant payment service providers. However, we expect much of the Company’s future developed market growth will come by serving larger merchants that might pay lower acceptance rates, but more than offset those lower rates with disproportionately higher volume. Ironically, we think it is the separation of PayPal Holdings from eBay that should allow for an acceleration in PayPal’s growth, particularly with those larger merchants (e.g. Amazon) that previously shunned PayPal, given its position as a subsidiary to a competitor.

However, PayPal’s global scale continues to serve small and mid-sized merchants as well, particularly when it comes to opening up new geographical markets. For instance, earlier this year PayPal established its China Connect service with China’s largest bank card issuer, UnionPay. Prior to the launch of this service, it was difficult for non -Chinese merchants to accept UnionPay cards. PayPal Connect now allows any of PayPal’s 10 million merchants to accept payment from one of the several billion UnionPay cards in force6. PayPal captures this value by levying cross-border and foreign exchange fees in addition to typical acceptance fees. While cross border transactions represent about one quarter of PayPal’s transactions, we estimate that they represent a larger percentage of profitability and will continue to grow disproportionately to domestic TPV.

In addition, we expect PayPal will continue to leverage its leadership in mobile payments. Having processed over $45 billion in mobile TPV during 2014, a more than 18-fold increase compared to 20107, mobile now represents 30% of PayPal’s TPV through June 2015. The Company’s marquee mobile assets are its PayPal and recently acquired Venmo apps for iOS and Android, as well as Xoom for P2P wire transfer, and Braintree, which provides more robust merchant services, beyond just payment acceptance. While PayPal’s presence “in-store” (i.e. at the physical point of sale) is very limited, we expect the Company’s raft of investments in mobile will serve to blur the distinction between online and in-store payment experiences and help the Company take share from less innovative in-store payment incumbents.

A key element of our process involves diversifying our holdings based on their business models. While we recognize that PayPal Holdings and Visa (another portfolio holding) compete in the payments industry, we think their value propositions are substantially different. Consider, the payments industry is vast - approximately $200-$250 trillion of payments move through the global payments system, annually8. Usually, on one side of payments are merchants, and on the other side are card issuing banks and their customers. Visa is a key negotiator and enabler of payment interchange – authorizing, clearing and settling payments between card issuing banks and merchant banks. Visa captures value by charging network fees for each stop a payment makes through this payment system. In contrast, a core value proposition for PayPal is to provide payment aggregation for merchants, where PayPal essentially takes the place of a merchant bank, but without the complex and expensive underwriting process. PayPal captures value by taking the difference between what it charges the merchant for acceptance (and other ancillary fees), and the cost of interchange. So while both Visa and PayPal operate in the payments industry, we think their value propositions are substantially different, and therefore offer an acceptable level of diversification between their respective profitability profiles.

PayPal is a cash machine. Having long overcome the fixed costs necessary to run its business, we expect capital expenditure requirements should grow at a slower rate than operating cash flows. In addition, the Company’s balance sheet sports around $6 billion in net cash on a market cap of about $40 billion. Given the various reinvestment initiatives undertaken over the past few quarters, we think FCF can eclipse $2 billion over the next 12 to 18 months (which compares to management's 2015 guidance of $1.7 billion) and can compound at 15 to 20% over the next several years. Relative to PayPal’s current enterprise value (EV) of about $35 billion, this EV/FCF ratio represents an excellent opportunity as we think there are few companies capable of posting levels of high-quality growth.

From David Rolfe (Trades, Portfolio)'s Wedgewood Partners third quarter 2015 letter.

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