PayPal Holdings stock declined by a whopping 25% in one day. Investors seem dumbfounded, pointing to a dizzying “stream of consciousness” array of metrics, dispiritedly mumbled by management in a train-wreck of a quarterly report conference call designed to redirect investors away from a very straightforward announcement; GAAP earnings declined in 2021, and are set to fall further in 2022.
In 2021, GAAP earnings were $3.52 per share, down from $3.54 in 2020.
For 2022, GAAP earnings are forecast to fall from the $3.52 per share reported in 2021, to a range presently estimated to be as low as $2.97 per share to as much as $3.15 per share. Should the low estimate be met, this would represent a decline of 15.6%. If the high estimate is met, this would represent a decline of 11.5%.
$2.97 per share would represent an earnings increase of roughly 42% over the amount reported in 2019. However, if the low end of the estimate is achieved, then 4 year CAGR in earnings will wind up being a lousy, terrible, awful, 9% per annum.
A 9% annual compounded forecast increase in earnings over a 4 year period isn’t AT ALL what investors were anticipating when they purchased shares of PayPal in 2019.
Global consumers, multinational and local businesses, governments; all have embraced online payment platforms. PayPal represents a go-to service for hundreds of millions of consumers worldwide and is increasingly accepted by businesses large and small throughout the planet.
Which makes one wonder, “why on earth, with rampant price inflation, incredible growth in global money supply; why cannot PayPal grow its earnings at a level even sufficient to match that of your local community bank over a 4 year period?”
There are two potential and logical answers to that question. Neither answer will be pleasing to those presently long the stock.
1. Margins may never be as high in the future as they were in the past. EBAY Inc. was a far more profitable book of business than any other endeavor presently within the PayPal stable of divisions. Ebay announced in 2019 that they would be migrating away from PayPal to another vendor for payment processing (Adyen). Management at PayPal reacted by indicating that they would very quickly replace that foregone book of processing, through organic expansion in other areas. They explained that non-Ebay business was growing so rapidly, by and large, investors wouldn’t even notice the loss of said processing revenues.
What management failed to illuminate for the benefit of investors, and, what was clearly not picked up by street analysts, was an abnormally high level of profit generated on the Ebay processing business. PayPal was a wholly owned division of Ebay for many years, and, had such a sweetheart agreement, commanding such high profit margins, that a revenue multiple is required (I estimate 4X revenues from their non-Ebay processing) to overcome the loss of that Ebay business. Roughly $1.4 billion of revenues migrated from Ebay away from PayPal in 2021. That $1.4 billion only represented 5.5% of the total 2021 revenue, but accounted for a whopping 22.8% of net foregone earnings (roughly $.80 USD per share).
Further indicated, in tiny print, is that up to a further $1.2 billion of 2022 revenues from Ebay processing are still being estimated on current year guidance, which represents another $.68 USD of earnings that will cease to be earned after 2022.
Abnormally high margins on the soon-to-disappear eBay processing contract served to subsidize a number of marginally profitable divisions. That subsidy is coming to an end.
If one adds up the two sums, the Ebay account, which was annualizing just under $2.7 billion of processing revenues for PayPal in 2020, appears to have been producing overall margins of more than $1.48 per share, a margin of greater than 65%. As gross operating margins on the entire book of business, which still included Ebay processing revenues, was reported to be 15.2% on a GAAP basis in Q4 2021, it seems clear that whenever $1 dollar of Ebay processing leaves the PayPal system, a minimum of $4.28 dollars of new processing revenues needs to be found elsewhere to replace that loss. Therefore, if EBAY still has $1.2 billion of annualized business remaining at PayPal, then Paypal will need to grow non-Ebay revenues by a minimum of $5.1 billion, merely to hold the line on 2021 profitability, as all of the Ebay business eventually leaves.
It appears, given the data provided by management of Paypal, that it will take a minimum of $30.7 billion in annual revenues, for PayPal to be capable of earning, ex-Ebay, what they earned on the $25.6 billion of revenues reported for 2021, when they were still processing some of the Ebay account. This still understates the potential blow to the overall business, as the margins earned on Ebay processing are so high; the modest 5.5% revenue contribution is so disproportionately profitable to the overall book of business that it increases total margins by almost 2%. So, realistically, almost $32 billion in net revenues will be required for PayPal to match earnings, ex-Ebay, based on 2021 reports.
There seems a clear mismatch in forecast guidance and objective reality. If $32 billion in revenues is required to simply maintain earnings at the 2021 levels, and if PayPal is guiding towards 2022 revenues of $29 billion. then the reality of the situation is that it will take more than a fiscal year to grow EPS above the level reported in 2020.
This, given the guidance posted, is not even a 2022 turnaround, it appears to be a 2023 turnaround.
2. The business losses from newly acquired BNPL company, PAIDY, and organically generated BNPL initiatives might also be hitting the bottom line.
Unknown to most, PayPal was one of the very early pioneers of “Buy Now Pay Later”. They tried mightily, in Australia and a few other jurisdictions, more than a decade ago, to roll out the concept and come up with a formula to earn a profit. Profits were never earned and a sound business decision was made to put the entire concept on the back-burner; it was deemed one of those “interesting” concepts that lacked profit potential.
BNPL became a craze during the Covid-19 pandemic. Upstart companies, offering to goose up sales to merchants by relying upon credit arbitrage to sell products to those with poor credit, spent mightily to entice consumers to use a service that has been tried, shelved and dusted off again using a “this time its different, this time we have figured it out” motto. A media wave, created by VC firms, captured the attention of investors and equity capital was shoveled into a variety of public and private operators. Few ask the question “where is the profit margin” for the sector and when they do, plates are spun in the air and executives at the BNPL firms reply “look up in the sky, spectacular fireworks!” To this day, not a single BNPL player in the space is profitable on a GAAP basis; all of the business losses are being funded through equity raises.
Despite the lack of profit in BNPL, someone at PayPal made the decision, perhaps based on a certain level of desperation to stay relevant, perhaps based upon a hope that they could generate enough revenues from BNPL that investors would ignore bottom lines and focus upon top lines, to jump back into a concept already tried and considered profit draining. They rolled out BNPL on a wider scale and also purchased a Japanese BNPL player called Paidy. Paidy had been privately capitalized at $281 million and PayPal purchased the business for $2.7 billion US. Not once, in any of the data I have reviewed was there an indication that the purchase would be accretive. Therefore, it can reasonably be assumed to be dilutive. That transaction closed in Q4, 2021.
PayPal does not publicly offer a detailed breakdown by segment of the operating margins per division. However, given the significant decline in margins in Q4, coincidental with the greater system rollout of the BNPL service, and after taking into account reported continued losses among public BNPL operators, I consider it self-evident that Buy Now Pay Later represents a drag on earning; the only question to me represents the degree of loss. There is a risk in expanding a money losing BNPL business; other operators in BNPL report increasing losses, even as revenue increases. Credit arbitrage for non credit worthy customers can always grow revenues, but the bottom line is imperiled.
The 2022 guidance has a gaping hole in the assessment that no analyst took the time to press management about publicly.
PayPal guides for a GAAP Q1 2022 profit decline of 46% vs 2021 and revenue growth of 6%. They further assess that Ebay processing revenues in the first half of 2022 will be in the range of $600 million and that total revenue growth for 2022 will be in the range of 15%-17%. This suggests that revenues in Q3 and Q4 will need to accelerate by roughly 25% per quarter to meet the mid-point of that estimate. Corporate guidance in the back half of 2022 looks to be overly optimistic, perhaps to the tune of 5%. All the talk in the call was about new accounts and total processing volumes growing from $1.25 trillion to $1.5 trillion. Completely glossed over was the fact that if processing volumes are forecast to rise, by 20%, and total revenues are forecast to rise by 15%, and forecast profits are set to decline by 11.5%-15.6%, then margins MUST fall accordingly.
Investors buy growth stocks with an implicit understanding that rising revenues should result in expanding margins, and that should lead to abnormal profit increases. On that basis, Paypal is no longer a growth story.
PayPal management appears quite willing to sacrifice bottom line results for top line revenue. Unfortunately, the abnormal profits earned on the Ebay account are ending. Based upon results offered up to date, the business replacing the Ebay account carries a much lower margin. BNPL might offer no margin whatsoever. The shares plunged as sophisticated institutional accounts went over the math provided and identified gaps in the guidance, that many determined, through their sell decisions, were not plausibly likely to come to pass, within the coming year.
It will likely take longer than one year for PayPal to generate the former level of growth that justified the valuation of 6 months ago. It is also unlikely that the company will ever find a processing account that carries similar profit margins to that formerly earned off of Ebay. Furthermore, guidance for Q1 2022 indicate that the business margins look to be deteriorating. Every part of the guidance thrown up makes a case, almost a Hail Mary; that the back end of 2022 will be stronger and not just a little stronger, but growth acceleration beyond any quarter reported since 2019. Is that likely, is it even remotely possible?
Heaven forbid that the BNPL fad continues to vomit up losses for every company in the space, because PYPL has indicated that they intend to grow that biz and that, in my view, bodes ill for margins. Personally, I consider BNPL to be the financial equivalent of “cold fusion nuclear reactors”; both are great stories, neither work in the real world.
While the shares have fallen hard, this might not be a buy, it could as easily be a sell.
Not a single bit of positive news was contained within the guidance to reassure analysts that the situation will turn around in 2022; rather, the guidance contained a great deal of diversion away from the issues at hand, issues that nobody even were notified about until they were dropped, like a nuclear warhead, on an unsuspecting pool of analysts and the public. Even the bromides failed, because indicating that a turnaround might become visible, in several more quarters, to Wall street, is a standard way of indicating that they don’t know how to fix the problem, because they had no idea the problem existed.
Shayam Sankar recently stated: “The old world is fixated on the accuracy of the forecast. The new world is all about how well you manage the error in your forecast“.
On that basis, PayPal has totally failed both old world and new world investors; the recent forecast is inaccurate to the point of irrelevance; guidance riddled with errors isn’t worth the time invested in printing it and nobody should accept it at face value. Absolutely no attempt is being made to manage the multitude of discrepancies, easily determinable, within that forecast; all that is happening is a request for more time by a nervous executive, yet, they still intend to dole out billions in stock options and share compensation during 2022-2023. The margin implosion is such that it speaks to a meaningful lack of oversight in multiple business groups; this is a corporate culture issue. The CEO talks up the top line, but when push comes to shove, the top line revenue at PayPal is only 1/5 as valuable as the topline of Visa or Mastercard due to the margin differentials between those firms.
Those atop PayPal may be getting blindsided by divisional heads, who have themselves been blindsided by a lack of disclosure on operations. It is high time for fintech companies to use the word “no” when presented with business expansion plans that talk up non financial metrics such as “eyeballs” and “customer engagement”; the bottom line is what matters at the end of the day and margins drive those bottom lines. Even total account metrics are meaningless when it was disclosed that millions, possibly tens of millions of accounts, were opened up by botfarms in order to earn a new account opening bonus. The bonus applied for up to two account referrals, which means that for every 2 bot accounts created, there was already a bot account on the system. That fake account bonus debacle might have cost as much as $100 million in the last quarter alone. How many fake accounts remain on the PayPal books, is it 20 million, 50 million, 100 million? Who knows, because there is virtually no detail and certainly no accountability.
Almost everything that investors accepted at face value regarding the PayPal business model must now be questioned.
Alphabet ran into a similar problem some years back; that company developed a pattern of throwing high operating profits, willy-nilly, into an impressive array of money losing ventures. Outside shareholders howled, chastened executive tackled the issue head on and righted their corporate ship. Where PayPal and Alphabet differ is that Alphabet largely operates as a monopoly and generates margins roughly 2x higher than does PayPal. Paypal lacks monopoly status; there is limited leeway to turn this mess around. The Ebay margin buffer ends this year.
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