While we were positive on PayPal Holdings, Inc. (NASDAQ:PYPL) for a few months last year, we were neutral in our most recent article in November.
When we wrote our bullish essay, we expected a bounce since valuations had fallen sufficiently. While we weren’t quite there yet, options provided significant rewards for a low entry price.
Considering the price increase in the months after that post, the above trade might have been closed with almost 100% of the premiums captured without waiting out the entire term, as we proposed in our subsequent article.
After reviewing the Q3 results in light of the current macro climate, we were back in the neutral camp. The revenue run rate was barely keeping pace with the nominal GDP, and transaction volumes were declining. Yet, while transaction and operating margins were lower year over year, they performed better than expected. We calculated the fair value of this stock using free cash flow adjusted for stock-based compensation, with growth firmly in the past tense.
Fairly Valued
PayPal is now fairly valued and is unlikely to rise much higher. Margin compression and a probable recession are two downside possibilities. At 5% risk-free rates, one could argue that PayPal should be valued at a 13-15X free cash flow multiple, especially given the prospect of future expansion. The stock is rated neutral/hold by us. We would now only consider option entry at $60 or less, and we would close out our previously advised cash-secured puts at $70 strike.
Since then, the stock price has remained relatively stable, tracking the performance of another fintech fan favorite, Upstart Holdings, Inc. (UPST).
Following that, we’ll look at the fourth-quarter results.
Q4-2022
PayPal had a nice profit beat in Q4-2022 despite revenue coming in slightly below forecasts. This was far higher than our forecast, as we expected margins to remain sluggish.
Despite fierce competition, active accounts increased again, and payment transactions increased by 7%. The transaction margin is shown in the slide below, which, while lower than the 52.3% saw last year, is still pretty robust.
The same transaction margin resulted in an increase in operating margin vs 15.2% at the end of last year.
What We Think
The market was not impressed with those outcomes, and the early gains were lost in the days that followed.
Bulls may be frustrated and asking what the company needs to do to get a break. This response is divided into three sections. The first is that for growth stocks, revenue is always the narrative. You can dance to the rhythm of earnings, but if revenues fall short, there will be pressure. The fact that 38 analysts reduced their sales predictions while 37 raised their earnings estimates has a lot to do with this.
Estimates for revenue have been declining for some time as PayPal matures as a growth play. Predictions for 2026 have fallen over 30% in the last six months.
This is what occurs when analysts stretch a present growth track into infinity. After the cycle normalizes, these false expectations must be addressed.
The second component is that analysts continue to believe that margins will expand, as indicated by EPS growth outpacing sales growth.
While that may hold true until 2023, we believe they will have to lower forecasts again after then. We believe markets are already aware of this and are pricing in a very slow-growing company in the future.
Valuation
The value story is the final piece. PYPL stock may look to be a growth investor’s dream at 15X earnings. When investors paid 17X sales in 2021, the odds were clearly stacked against them. The issue is that those are non-GAAP earnings, which eliminate $1.31 billion in stock-based compensation.
This is how PYPL deploys free cash flow by issuing shares to employees and then repurchasing them. We and the majority of analysts who have invested outside of the bubble years of 2020 and 2021 believe that the GAAP figure is actually pretty accurate.
An approach is to calculate the adjusted free cash flow yield by taking the free cash flow supplied by the company and removing the stock-based compensation. The reasoning is that the early portion of the stock repurchase is simply being used as an offset to keep share counts stable, and you should not give the corporation credit for that. As a result, adjusted free cash flow is roughly $3.7 billion. You have a 4.3% adjusted free cash flow yield based on the current market capitalization.
We’re sorry to break it to you, but that’s not much in an era with risk-free Federal Funds rates of 5.5%.
Final Words
The good news is that PYPL has a reasonable market value. 4.3% adjusted free cash flow yield or 23 times GAAP profits actually is nice pricing in comparison to the market frenzy of the last two years. The bad news is that, if you understand the history of bubbles, it is far from low enough. Bubbles terminate with tremendous undervaluation, and we haven’t reached that point yet. Cisco Systems, Inc. (CSCO), Microsoft Corp. (MSFT), and Intel Corp. (INTC) are all notable instances of companies that struck a true bottom in March 2009 as their PE ratios compressed significantly from Dotcom days.
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