A high bar is hard to beat, and PayPal (PYPL) was facing remarkably high expectations leading to its earnings report on July 29. Fortunately for investors, PayPal outperformed those demanding expectations and the stock was rising by 4% after the report. Even a mediocre company can do better than expected when expectations are low, but it takes a top quality business to consistently beat aggressive expectations.
The fundamental picture in PayPal looks stronger than ever. With the stock trading at all-time highs, it makes sense to be patient when building a position in PayPal at current prices. However, valuation is not unreasonable at all based on cash flow generation. Besides, winners tend to keep on winning over time, and PayPal is performing like a winner.
Beating A High Bar
PayPal is crushing the market this year, the fintech leader has gained almost 60% while the S&P 500 is up by roughly 6.4% in the past twelve months. It is always difficult to assess how the market will react to earnings, and especially more in these kinds of situations. PayPal stock has been trading higher in anticipation of strong financial performance from the business, and this puts investors in an uncomfortable position.
Source: Seeking Alpha
With the stock trading at all-time highs and outperforming the market by a huge margin, there is no room for error in the earnings report. The company needs to beat expectations, preferably by a wide margin, in order to justify recent gains and to continue doing well going forward.
This is not happening to PayPal alone, many companies in sectors such as e-commerce, fintech, and cloud computing are currently in a similar spot. The digital transformation trend has accelerated demand for many of these industries, and the market is clearly reflecting this in stock prices.
The earnings numbers for the second quarter will be crucial in terms of assessing id prices have gone too far or if, on the contrary, there is still more room for upside left in many of these high growth leaders.
Investors with a long term horizon may well decide to tolerate the short term volatility and take a step back from all the noise surrounding stocks during earnings season. As long as the fundamentals remain healthy, one cent in earnings below or above expectations is really no reason to change your investment thesis for a company.
But data from earnings cannot be disregarded, and the long term is a series of short terms. Especially during challenging times, we can learn a lot about a company, its fundamentals strengths, and the quality of its management team by assessing performance in times of crisis and uncertainty.
Winners Keep On Winning
The recent numbers from PayPal were exceptional across the board. Transactions grew by 26% to 3.7 billion, and transactions on PayPal Checkout experiences grew by almost 40%. TPV grew at 30% on an FX-neutral basis, with a record of $222 billion. Management said that there was an acceleration in TPV growth during the quarter, and June was the highest growth rate in TPV since PayPal was separated from eBay.
Source: PayPal
The company added a record 21.3 million new customers in the quarter, increasing nearly 140% year-over-year. As a reference, new actives during the quarter were bigger than all of the new actives in the full year 2016. Nearly 1.7 million merchants signed up for PayPal during the quarter, and net actives for Honey were nearly triple the levels form the first quarter.
Source: PayPal
Solid operational performance was reflected on both the top and the bottom lines in the income statement. Revenue grew by 25% on an FX-neutral basis to $5.26 billion, accelerating after our strong 20% revenue growth in April.
Non-GAAP operating margin increased by a record 500 basis points to 28% of revenue. Solid revenue growth in combination with expanding profit margins allowed PayPal to deliver a 49% increase in non-GAAP EPS during the quarter, reaching $1.07 per share and outperforming expectations by $0.2 per share. Operating cash flow grew 103% and free cash flow grew 112% year over year.
Source: PayPal
Strength Begets Strength
The pandemic has accelerated the digital transformation revolution across the board, and PayPal is both a major driver and a leading beneficiary from this trend. The company is focused on several major drivers to capitalize on its growth opportunities going forward.
Source: McKinsey
PayPal is accelerating its in-store contactless payments as both consumers and merchants are rapidly moving towards digital payments across their online and offline experiences. The company is expanding its presence in all forms of omnichannel commerce, from point-of-sale in-store to buy online and pick up in-store, order ahead, pay at the table, and home delivery.
Digital wallets are another key growth engine. Venmo grew its TPV by 52% to almost $37 billion, and it reported revenue growth rates above 60% during the first 3 weeks of July. PayPal is planning to expand the range of services provided inside its wallets by rolling out additional services such as bill pay, subscriptions and rewards management, shopping tools from Honey, and new forms of credit and budgeting tools.
Valuation And Timing
When analyzing the impact of the pandemic on the company's value, we need to consider not only the financial implications but also, and more importantly, the strategic ones. Accelerating demand not only has obvious financial benefits for PayPal in the short term, but it also drives a substantial increase in value for shareholders when considering the strategic impact of this trend.
Size and presence are crucial sources of competitive strength in the industry. Merchants need to accept the payment methods that bring them customers, and customers want a payment method that is accepted everywhere. Users on both sides of the transaction attract each other to a leading payments platform such as PayPal. The same dynamic is at play in digital wallets, the more users and functionalities it has, the more valuable the service it provides.
PayPal is consolidating its position as a leading industry player at times when industry demand is being pulled forward, which is creating a lot of value for shareholders. It is not just about accelerating revenue growth, but rather about consolidating the company's leadership position in a spectacularly attractive market.
The company produced $2.4 billion in operating cash flow last quarter, if we analyze those cash flows, we get a price to operating cash flow ratio of 21.5 at current price levels. This is hardly excessive for a company that has just announced that it has doubled its cash flow year over year.
In terms of price action, PayPal stock is in a well-defined uptrend, and a sustained breakout above $185 could open the doors to further gains in the near term.
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