TIVP030: PayPal (PYPL): Value Trap or Multibagger? w/ Daniel Mahncke & Shawn O’Malley

27:37So with that, just to summarize our conversation up until now, it sounds like you view the competitive landscape, including Stripe and ADN on the merchant side and Apple or Google Pay on the P2P side as something like an established oligopoly. where these major players will maintain their market share and then can continue to grow payment volume due to these industry tailwinds. And basically, in layman's terms, there's tough competition, but also this is a massive pie and there's more than enough to go around before PayPal's business is genuinely pressured. Is that fair to say? Yeah, exactly. That's kind of how I would have summarized it myself.

28:23But I think what makes PayPal even a bit more attractive than a year or two ago when I first looked at it is Alex Chris's new strategy which is now implemented and has started to see or gain some traction and that new strategy is basically about leveraging the advantages that come from PayPal's scale and its diverse business segments and basically eliminating all these redundancies that have made PayPal so slow in the past. In an interview, he said that he was surprised to see how isolated the teams at PayPal worked when he got there. And here's a short clip that just shows exactly that. And the biggest surprise, you know, back to your question is just, you know, how even with both sides of the flywheel, when I got here, the teams were really working in silos.

29:14There really wasn't a lot of work across the organization to figure out, okay, how do we drive a value proposition for consumers that is also going to drive success for our merchant. I suppose part of the reason has been Dan Schumann's focus on acquisitions. Companies were acquired to drive growth and increase PayPal's top line. And Alex, Chris called those empty calories, referring to a growing top line that doesn't really translate to the bottom line at any point. And he replaced almost the entire management team and cut back segments like Braintree, which is why revenues are more or less flat, while margins have significantly improved since then.

29:56I can't say I'm familiar with Braintree. Maybe you could explain exactly what that is and just give an overview of some of the other businesses that PayPal runs. It does seem like acquisitions are a big part of the story here for them. So the core is still the branded checkout and the wallet. That's the legacy business where PayPal has a high market share and pretty good margins. And as I mentioned earlier, if a store doesn't offer PayPal as a payment option, I'm immediately out. I'm inclined to just not make a purchase there. And Amazon is, like I said, the only exception. And I think that says a lot about both PayPal's and Amazon's mode, perhaps more about Amazon's mode though.

30:38And in case anyone doesn't know how just these transactions works. These transactions are pretty straightforward. You can pay with a balance, a card linked to your PayPal account, or just a linked bank account, for example. And PayPal keeps a low single digit percentage of every dollar on almost$500 billion of branded payment volume last year. The branded checkout translates into the singer's biggest profit pool because a major part of that fee actually survives as a transaction margin. And then you get that as a profit in the end but when a checkout slowed down in growth it's now about mid single digits so what alex chris did is he came up with a new business idea the guest checkout process called fast lane and similar to stripes link and the first time you use it you just enter your name your address and your card all of that normal stuff basically and paypal then tokenizes everything and the next time, whether it's the same site or shop or any other Fastlane merchant, you only need to enter your email once and then you're done.

31:44No password, no account, no PayPal app. And that's a big shift from Dan Schumann's ambition to drive as many PayPal accounts and new signups as possible. According to PayPal, Fastlane cuts guest checkout time from a minute or more to under 10 seconds, which is not too surprising. There's nothing more annoying, at least in my opinion, than having to fill out these long guest checkout pages. In early pilots, conversion rates jumped 50 % and 25 % of Fastlane shoppers were brand new to PayPal, while another half were inactive users. So the product is pulling new high margin volume back into branded checkout.

32:26fascinating to me i mean it sounds like a great product but also it sounds very very similar if not exactly the same as my experiences with link which is by stripe and i know that we actually use link to process payments for our intrinsic value community and it works well so again it's not immediately clear why paypal solutions would be better for us to use but i just find it hard to keep up with all these different payment processing solutions generally. Anyone who's listened to the show for a while will know I just get tired of FinTechs. It doesn't click for me. But that said, I definitely see why these universal guest checkout services are so valuable because it is a real convenience and time saver.

33:15And as a consumer, I would love to see a network effect like this become dominant where, I don't know whether it's PayPal or whether it's Stripe, everywhere you go online across the internet to check out, they have it set up so that it has your details remembered and you don't have to auto-populate every guest checkout. And it doesn't sound like any player, whether that be PayPal with Fastlane or Stripe and Link, have truly ubiquitous market share, despite the idea itself being very useful and compelling at a consumer level. I think Fastlane, I mean it's basically just PayPal's link. So it's what Stripe already did and they are now doing it.

33:57I couldn't see any major differences as well but businesses will simply choose what they are already using. If it's a PayPal business they will use Fastlane. If they have Stripe already they will use link. Again that's not really a competitive advantage but there can be only so many players in the market and it's not like they steal each other's market share a lot. So in Fastlane's case, it's not yet rolled out on a larger scale. So that's why the market share is not really big. And in the latest earnings update, that was quite weird. It was only mentioned once, although this was supposed to be one of the new sales and profit drivers.

34:34But the market for guest checkouts is about a trillion dollars. So it is a huge opportunity with, you know, space for Stripe and PayPal and perhaps one or two other guest checkout tools as well. But the strategy for PayPal is to integrate it with the biggest merchants first and then step-by-step with all the others. So I just assume there should be an update in an upcoming Fireside chat or perhaps the next earnings update. But we haven't even yet talked about Braintree. So it's essentially where PayPal again competes with the likes of Stripe and Adyen. It's primarily a B2B payment solution handling high volume transaction between businesses.

35:14But there's also a B2C support through payment methods like credit cards and even digital wallets like Apple Pay, Google Pay, and of course, Venmo. And in the past years, it has been a significant driver of payment volume growth. It processed roughly$575 billion in 2024, which is about a third of total volume. But the problem has been that the fee is just tiny. around 25 basis points. So it was top line growth that didn't really make it to the bottom line. That's why as part of his plan to eliminate what he calls these empty calories, Alex Chris decided to shift away from unprofitable customers in the B2B business segment.

35:59And I would say that strategy shift caused PayPal's transaction revenue to slow down in the past quarters. But if we look a bit deeper, then what we can see is the highest margin business, the branded checkout, grew 6%. P2P, so that's where you also find Venmo, grew 8%. And Venmo itself even grew 10%. So the business is definitely healthy and it is growing. And I expect that to show up more in top line growth once the 5 % to 6 % headwind of restructuring the B2B business is done. The increase in the transaction margin resulting from cutting these unprofitable operations is already showing in the numbers.

36:38even though it doesn't look that steep in this graphic we have on screen for Spotify and YouTube users. So two of the biggest shifts under the new management are first the push to re-accelerate growth in PayPal's highest margin business branded checkout through Fastlane, which simplifies guest checkout and boosts conversion. And secondly, on the Braintree side, the focus has shifted from pure volume to profitable volume. They're phasing out these low margin enterprise deals, which does weigh on revenue growth in the short term, I think, but it improves their transaction margins overall, which is sort of like PayPal's version of gross margin, as I've come to understand it.

37:23And it's interesting to think of certain transactions being incrementally more profitable than others. It's not something that would have otherwise occurred to me, but it does make sense. Just like any business, PayPal has customers and types of transactions that are more or less relatively profitable for it. Yeah, especially if you have contracts with certain big merchants that might have better conditions than others. and that makes the business for PayPal a bit less profitable than, you know, with some of the other merchants. And to me, the two points that you mentioned, they are just kind of turning around the business that has simply been kind of mismanaged in the years before Alex Chris.

38:06And there are a number of additional growth opportunities that PayPal is now going after. And I think those are sort of a call option. Fastlane and restructuring the B2B segment will be what turns PayPal's business into a more profitable company, but it's also on its way to return to double-digit growth in a year or two. Of course, also benefiting from just the fast-growing digital payments market in general. I think the e-commerce payment market is expected to go by 14 % CAGR and digital wallets like Venmo even faster. And there's a quote somewhere in the back of my head that goes something like, you would rather want to be wrong on a company in a growing industry than in a declining industry.

38:47And unfortunately, I don't remember who said it, but I think there's truth to that. PayPal was mismanaged for many years, but the tailwind of the overall growing industry combined with PayPal's size still enabled this company to remain highly profitable and avoid declining or losing share in its most important segments. And with the strategy shift now, there's a lot of optionality coming from these new ventures like ads or agentic e-commerce. When you think about the goldmine of data that PayPal is sitting on, it's almost a shame they didn't monetize this in any way earlier. Imagine the payment data of over 400 million people.

39:29And to give you, Sean, and the listeners an idea of what PayPal knows, there was even an article last year in the Wall Street Journal titled, It Has Your Money and Your Pants Size. And it might sound a bit dramatic, but I think it's accurate. But PayPal knows where you buy, how much you spend, and also the size you prefer when you buy Nike shoes versus the size you need if you buy on shoes, for example. And they also know all those infos on t-shirts, jackets, and all the other items that you and me buy. It also knows your favorite colors and at what times you like to buy, which is also a pretty interesting insight.

40:04very powerful data overall but one of the most powerful data points at least in my opinion might be that they know what you do as you know sean i have now finally booked my summer vacation and my friends sent me the money for their share over paypal so paypal knows where i will be and what i will be doing imagine how valuable that is for advertisers the idea for paypal or venmo for Americans and specifically you is that they will now include ads after you get sent money. So they know I will be in the Dominican Republic. Now, what will I need? Maybe a new linen shirt in beige size M from my favorite brand because people knows I bought my last linen shirt about two years ago.

40:49Perhaps also a snorkel because they know I don't have one and we have book trips to different islands famous for diving. And while I'm shopping anyway, I could also buy these cool new discounted swimming trunks that they just showed me in another ad. All of that highly targeted in the perfect moment right in the app. Boy, that is powerful. I feel like advertising businesses is kind of a core theme on this show now. With Airbnb, I talked a lot about how they could roll out an ad business, which they haven't done yet, surprisingly, where hosts could essentially pay to have their properties promoted in certain types of vacation searches.

41:28And then with Reddit, we talked about how they have this great opportunity to reach people by intent, showing ads about hiking gear in a hiking subreddit or showing an ad for commission-free trading in a conversation thread about the best stock brokerage account, stuff like that. And even with Uber, we talked about how promising their advertising business could be too, given that they know exactly where you are and where you're going in real time. So it might be very valuable for an advertiser to hit you with an ad for a massage when returning from the airport after a long trip once you get back from the Dominican, Daniel, or to plant the seed for a lunch order to someone who's commuting to work.

42:10That is prime real estate and first-party data. But I wasn't expecting advertising to come up today with PayPal yet. Now that I think about it, PayPal has some pretty decent advertising real estate. And in particular, they probably have the best set of consumer data for advertisers of really maybe any company we've looked at besides perhaps Alphabet and Amazon. But I'm not sure their data is that much better. It's just that they have a lot more real estate to monetize, if that makes sense. Every Google search is a billboard for an ad, whereas PayPal is sort of confined to their own apps and specifically when people are using those apps to show ads.

42:56So, you know, showing an ad on Venmo, the app. But to me, that is the difference between having great real estate or great data or both. But either way, I think there's a lot of room for them to grow the ads business, which tends to be a higher margin and thus could increase the percentage of every dollar of sales that converts to the bottom line. I knew that I could probably get you with the ad business. And there are many ways for PayPal to show ads. One option is the before the sale ads. Those are ads that PayPal thinks you will be interested in, and the merchants actually don't have to pay for these.

43:38PayPal only takes a cut when a sale actually occurs. And then you have the after-the-sale ads, which are based on smart receipts. So when I buy a new Louis Vuitton shirt, which was just a sneaky way to plug one of our latest episodes here about LVMH, then I will get a recommendation for, I don't know, let's say a jacket that fits well to the outfit. Now I thought the smart receipt might be the least powerful of these advertising tools, but surprisingly over 40 % of PayPal users open their receipts. So millions will see those ads at a time when they're in shopping mode anyway. And since you mentioned it, this advertising business reminds me a lot of the chance Uber saw and took.

44:22And that's a similarity not only to Uber, but also to Amazon. There's one person who was instrumental to building Amazon's and Uber's advertising business. And that person is Dr. Margrethe. After Amazon, Uber brought him on board and now he's at PayPal building their ad business. Okay, so that is very interesting. Not only do they have really powerful data, but the advertising real estate they can access is actually more compelling than I would have thought just a moment ago. It obviously sounds like it's more than just the ads on the side of the Venmo app that show when transferring money. That was sort of what I was initially imagining.

45:02I've actually never otherwise heard of these smart receipts, but I do think the idea makes perfect sense. And now I'm kind of thinking I can't imagine why every receipt doesn't have some sort of ad embedded into it. It seems like really prime real estate that has been kind of forsaken. it's a surprise generally how paypal didn't come up with this idea before alex chris and basically him just implementing a ton of new businesses and paypal has this unique ability to leverage its huge user base and build something like an integrated storefront as well that's the third way to monetize ads and a service they literally dropped just a couple of weeks ago So Mark Ritter said about this, quote, shopping is no longer something consumers do.

45:52It's something that comes to them. The storefront ads can be on any website on the open web. But instead of just showcasing the product and trying to lure you over to the website, there are buy now opportunities. So by using buy with PayPal, you can buy the product without ever leaving the website that you're currently on. Now I gotta admit, I'm not sure how well these will work because the main difference between, for example, these smart received ads and the ads after you receive money on PayPal or Venmo is that this time you're not actually looking to buy anything. And while more and more purchases are impulse purchases, rather than carefully considered decisions, this might be too quick for just the average person.

46:39But this is more or less criticism, not of PayPal's ads, and just more criticism of those type of ads in general. But this feature might be much more useful when you combine it with large language models like Perplexity, ChatGPT, and so on. It might not happen tomorrow, but I could imagine a shopping experience that starts on, let's say, ChatGPT and stays on ChatGPT until the end with directly integrated buy buttons from, for example, PayPal. So one step further would be, you know, the use of an AI agent and PayPal is actually already working on that. So instead of just starting and ending your shopping experience on ChatGPT, imagine it's not you who shops in the first place.

47:22Or to say with my vacation booking example, I could get my AI agent, compare flights, book the tickets and pay without me ever needing to open a browser. Because my PayPal wallet is embedded in the autonomous agent. PayPal launched such an agent software development kit in April and such an agent could help you, like I said, with literally everything and it would make a lot of the functions that PayPal already offers just much more easier. One of my favorite examples is subscription control. I don't know about you, Sean, but I constantly forget to cancel my subscriptions. So now PayPal offers this great service to manage subscriptions very easily and directly in the app.

48:07That could be even easier if it's just an agent doing it for you. I know all of this sounds a bit scary and also far away. I'm the first person who is really cautious with any payment details online. But I think this will become a reality much faster than most people are perhaps imagining right now. And I wouldn't include any of this in a PayPal variation model yet. But I want to mention it because it shows that PayPal is shifting towards being an innovator in the space again. And of course, there's huge potential in those businesses in the future. I was not aware of most of these ventures from PayPal.

48:45And for me, it feels like this old payment app that most young people are not directly using anymore, at least in the US, where people seem to go through Venmo more commonly. But also, it's another great example of how we're oftentimes blinded by where we live and even more so by our peer group. while the AI agents and even the direct buy buttons on LOMs might still be a couple of years out. I know that advertising is something that always gets me excited. So I just have to ask, when do you expect that to become a more significant part of PayPal's business? And maybe more generally, how is this turnaround showing up in the numbers right now?

49:28You already mentioned that they've increased their operating margins while revenue has slowed. Are there any more details you can share about that? I noticed that their operating margin hit a peak at over 18 % over the last 12 months, which is the highest in more than a decade for them. Yes, that's a good question. Because if you look at a company that is either performing a turnaround or at least a big strategic shift, and I think PayPal falls into the later category here, then you should look at the details to figure out how things are really going. When we looked at Estee Lauder two weeks ago, which was more of an actual turnaround, we spent quite some time figuring out what exactly caused the decline in the first place.

50:12And in PayPal's case, we need to understand whether the slower revenue growth actually helps margins. And if that's the case, when can we expect revenue to start growing faster again? When we look at the latest earnings report and go through the categories, we can see that branded checkout, the highest margin segment and a third of overall volume grew at 6%. P2P is even growing at 8%, mostly due to the strong double digit growth in Venmo. The only weakness is in PSPs or payment service providers, and that's essentially Braintree. In Q1 2024, this segment was growing at 24 % and last quarter it was basically flat, growing like 2%.

50:58In return though, PayPal's transaction margin grew 7 % year on year and that is in fact driven by the decrease in transaction expense because of the improved merchant and product mix. that's a complicated way of saying yes cutting down on unprofitable or low margin PSP business is the reason for improved margins and just two last details for I don't know the people who want to go really deep first the transaction margin dollar x interest on customer balances so the absolute dollars earned without including interest earned on you and mine paypal balances also grew 7%. So that's a good sign since interest rates are at least expected to go down in the future.

51:46And this shows that it wouldn't hurt PayPal's profitability, at least structurally. And second, while the transactions per active account declined 1%, which doesn't sound good at all, if you exclude Braintree transactions, growth was actually 4%. That's another kind of interesting angle to linger on, which is how much interest they generate from the float on custody client funds. I know Venmo, for example, I don't think it pays any interest on the money you keep in that account, yet you can keep your cash there. So presumably PayPal earns that interest themselves as an intermediary. But to come back to advertising, which I'm always curious to hear more about, do you have any idea of when we could actually see that further improve their margins?

52:39I would expect this to still take some time. The ads business was just started at the end of last year. And that only meant a slow rollout in the beginning, only in the US and only on-site ads. And in April of this year, they also started the off-site ads. So those are the ones that the merchants have to pay for immediately. And not only when a purchase happens. You can see all of them over the open web. So I would expect this to be gaining traction now. However, I don't think it will be meaningfully impacting the financials in this fiscal year. Maybe in Q4 though, when the most important part of the year for most merchants starts, but I wouldn't bet on it personally.

53:24So it looks like the strategy is already starting to show the first signs of success. I think it was not only a new CEO and ad expert who joined PayPal, but also pretty much an entirely new leadership team. Is that right? When Alex Chris walked in from Intuit, he replaced pretty much the entire management team within six months. Since much of the paper thesis is based on a strategy shift and the new management, I also wanted to spend some time getting a feel for the management team and their incentive structure even more so. I think it's safe to say that the management incentives align with what is publicly communicated as PayPal's strategy.

54:05Every member of the team is measured on two main metrics, and that's transaction margin dollars and free cash flow per share. And the new CFO, for example, is Jamie Miller, and she worked at GE and IBM prior. And her job is basically to keep operating costs slow and improve revenue to free cash flow conversion. A significant part of her pay is PayPal options, which she can only get in 2027. And they depend on whether PayPal's total shareholder return beats the S &P 500 over those three years. And if the stock is down on an absolute basis, the award is capped. The same goes for the rest of the management team as well.

54:46So they are incentivized to stay for at least three years and outperform the index, which I would say is great for investors. Yeah, I'm glad to hear that too. In so many cases, we see incentive structures where management is incentivized to simply grow earnings or hit certain stock price targets without really much appreciation for how that might implicitly encourage them to manipulate the earnings that they report just to meet quarterly targets that unlock more compensation for them or to temporarily push the stock to a certain price with, I don't know, really aggressive buybacks without really any care for what's best for longer term returns.

55:23And in this case, by comparing against the total shareholder return for the S &P 500, you remove some of those perverse incentives that can arise from targets that might otherwise sound noble, but like I said, can actually come with baggage. It's hard to outperform the S &P 500 index of some of the 500 best companies in the world over a multi-year period without genuinely being operationally excellent and thinking about what's best for the company's earnings power and also shareholder returns at large over time. And as shareholders, of course, that's exactly what we want management to be thinking about.

56:03So that is great to hear. But there is one more topic that I think we haven't talked about, which could be both an opportunity and a risk, depending on how you see it. I guess you are talking about the stablecoin topic, right? It's the elephant in the room. It is. Visa, MasterCard, PayPal, all of them traded lower recently on reports that stablecoins could disrupt their business model. however it does seem like the stocks have since recovered and there is a reason to think that stable coins could actually present opportunities for these businesses first and foremost i gotta admit i'm far away from you know being an expert on stable coins but one reason why the payments industry is watching stable coins so closely is that in theory they let you completely bypass the traditional card networks.

56:59A merchant who accepts USDC or PayPal's own stablecoin, PayPal USD, directly into a self-custody wallet pays a network fee measured in fractions of a cent instead of the roughly 2 % they currently hand over to Visa or MasterCard. And we talked about in detail how that process is going on our Visa episode. Settlement is instant. there are no chargeback rules and forex spreads collapse when the buyer and seller just use the same dollar-backed token. And that is the existential threat the card schemes have to face. Could the same thing disrupt PayPal? Yes and no. Yes, because 70 plus percent of PayPal's branded checkout volume ultimately goes through a Visa or a MasterCard.

57:46If a critical mass of merchants would so decide to use stablecoins instead of credit cards the 1.8 percent branded take rate gets squeezed but for stablecoins to gain momentum in consumer payments they have to be at least three parties adopting them first obviously the merchant who would issue it let's say amazon in this case for them the value is pretty clear because they save a lot of money on fees but then it already gets a bit tricky. Where is the incentive for consumers to change from what they are used to to stablecoins? And then potentially a dozen of them, one for each at least large retailer that creates its own token.

58:30There's no strong incentive there, I would argue, especially if you consider something like cashback and incentives on their credit cards. Let's even say these incentives would be matched, then who is paying for that? It would have to be the merchants selling on Amazon, but why should they pay for it? In the end, I see how Amazon would profit, but they seem to be the only party that has a clear benefit to implement them. Now, perhaps Amazon even has the market power to do that, but the other 99 % of retailers still couldn't. And Amazon is already not offering PayPal or Venmo for that matter as a payment option.

59:08So even if they pull it off, PayPal doesn't lose anything. If there's one thing that I know, as a matter of fact, It's that Americans love their credit card reward points. So anything that takes that away, they're not going to be happy about. But it just feels like this big game that merchants and banks and card networks are all in on. It feels like I guess you couldn't necessarily have a stable coin based credit card. But what I could imagine is that merchants try to push for online checkouts with their own tokens. So I don't know, the Walmart stable coin. And instead of getting cash back on a credit card, you get some kind of reward points that Walmart allocates to you with the fees, they say, from not having to pay merchant fees to issuer banks and Visa.

59:56And it's hard to say how popular that would be and if it could really rival maybe credit card points. But the idea is that major retailers use the rise of stable coins as a way to cut out payments middlemen and recycle the rewards from that back to users, incentivizing more spending at said merchant and also usage of their stable coin. And I know you already mentioned the PYUSD token, which is PayPal's own stablecoin. What role does that play? Could it be an option for PayPal to generate a good amount of money? How is adoption? Anything like that you want to speak to? And just the question that's going through my mind is, is it most likely that we'll be using a PayPal stablecoin or is it going to be a Walmart and Amazon stablecoin or none of the above?

1:00:45Yeah, that's the big question to ask. And in this case, PayPal was actually quite early with it. It was one of the few innovations that happened under Dan Schulman. The problem is that the coin didn't really gain traction. The entire stablecoin market right now is worth about$230 billion. Tether is responsible for roughly two-thirds of the entire outstanding market and supply. And the currently hype Circle stablecoin has a little over a quarter of the market as well. and every other coin just fights for the remaining outstanding supply. PayPal's coin is only 0.29 % of the market. So that's less than a billion dollars in volume.

1:01:26So it's basically nothing you could even talk about. To be fair though, the vast majority of stablecoins right now, about 90 % are currently used for crypto trading, not everyday commerce. And when stablecoins become more widely used for sending money to friends or paying a merchant, then we will actually see whether PayPal's stablecoin can start gaining some traction and get some volume going. Is it even a profitable business for payment providers? You mentioned the fees that Visa, MasterCard, and PayPal earn with transactions. And if those fees are going down, so will the profits of these companies, right?

1:02:07Couldn't that be a more serious drag on margins, even if their own stablecoins are getting used at scale. I guess the benefit with stablecoins too, though, is that there's no interest paid on them. So maybe the float where they get to keep some of that interest all for themselves offsets the lower transaction fees? That was exactly my first thought as well. And I guess the short answer is that some of those higher fees will go down and that probably hurts Visa and MasterCard more than it hurts PayPal. And in my Visa episode, I actually walked through those transactions and how they work. And as you could see, the highest fees are earned by the banks.

1:02:47The only high fee that will come under threat for PayPal would actually be cross-border fees. Those are very high and that's one of the few cases where stablecoins are actually quite big already and can become a much more consumer friendly and cheaper alternative. But let's quickly walk how I think PayPal could make money with its stablecoin. So I think there are three ways. The first one would be, as you mentioned, the float yield, which whenever someone exchanges the US dollar for a PayPal token, that dollar can be invested in T-builds earning around 4 % today, perhaps in the future rates lower than that.

1:03:26If you compare that to the fees that they might lose that significantly higher profit for PayPal. The second way to monetize it is taking a conversion spread whenever someone moves in or out of PayPal USD just as it does on foreign exchange or crypto trades for example. And then third the good old transaction fee. If let's say a Mexican freelancer gets paid in PayPal stablecoin via hyper wallet and immediately converts it to pesos PayPal can charge a low single basis point settlement fee and still be the cost of card networks or swift the hurdle rate of course is adoption py usd's billion dollar float pales next to tether's 100 billion plus or usdc's 30 plus billion and even within paypal's own ecosystem it's only a fraction of merchants having enabled stablecoin settlement right now perhaps that will go in the future but it's a long way to go.

1:04:29I think I've heard a lot today that makes me bullish. And even the stablecoin situation doesn't seem like as huge of a threat as you might think, even though the space is still very young and dynamic and we don't know how it will play out yet. It feels like another theme here is not just looking at relatively cheap stocks on our show or stocks with promising advertising businesses, but also companies that face some sort of uncertain existential risk. And not to say that stable coins are necessarily an existential risk, but some people think they are. And with Uber, the same kind of existential risk is there with robo taxis.

1:05:09And then with Google, there's a thread of LLMs like Chachubiti. And then same again with Adobe and generative AI. so like half our portfolio has some major long-term question mark lingering over what is otherwise an incredible business giving us what we think is an attractive entry valuation and the same seems to be here maybe to a lesser extent with paypal which does seem to be very very reasonably valued but before we get into the valuation i do want to ask you just what are the other bear arguments here that you see? What are the bear cases? The most obvious one to me is that PayPal remains this value trap that we've talked about as it has been for the last couple of years.

1:05:52But then again, when I look at the stability of their free cash flow and their buybacks, at some point, this should be reflected in the stock price. Earnings per share growth is what drives returns in the long run. We both know that. And it's interested me that earnings per share have compounded at more than twice the rate that the stock has over the last decade. That gap will not sustain forever. The stock will follow the earnings. That's just reality. So the question I'm asking is, is there anything else we should be aware of that might hinder their ability to continue to grow earnings in the same way in the future?

1:06:29Just briefly, I think that last sentence of you was basically the bull case for PayPal, just in one sentence and that's everything you need to know. But yes, there are some bear cases that might be worth mentioning. And the first one would be commoditization, which is kind of what we have talked about here and there in this episode as well. PayPal's take rate has been declining quite a lot in recent years. In 2020, it was 2.1%. In 2024, it was only 1.7%. So that's a pretty sharp decline. Now, a second possible bear argument is competition, something that we also discussed. And that's the biggest risk for PayPal.

1:07:05As I mentioned, I view this market as an oligopoly. And the market share data confirms that PayPal maintains its market share in at least the most important segments. But still, competitors like Etienne are going faster. And if Fastlane is not successful, perhaps we will see PayPal lose branded checkout market share at some point. All right. So how about we get to the most important part of the episode then, the valuation? PayPal still generates a substantial amount of cash, roughly$6 billion a year. And management is allocating that to a fairly aggressive share buyback program. And Alex, Chris has trimmed down top line growth a bit and is pushing new businesses like Fastlane, ads, and AI agents.

1:07:53So my question for you is, what do you make of all that? And how do you think about that in an evaluation? So the first thing I wanted to figure out is what are the most important metrics for PayPal, which is something we do for every company that we research. And I actually spoke with an investor who previously worked at PayPal and who covers the company's earnings reports every now and then still, and is also invested in the company. And I linked to one of his articles in the show notes. So if you want to check that out, you can simply find that. and he said that he wouldn't focus too much on metrics like user or account growth.

1:08:28That's interesting because intuitively, that's one of the first metrics you would look at. And Wall Street is doing the same. And even Dan Truman, you know, back then thought, okay, user growth is the most important. And that was kind of where his strategy was going. But the idea behind this is that PayPal is a mostly mature company when it comes to pure user growth. I think they figured that out themselves now. And of course, it can still grow a bit. but we talked about the geographical and the socioeconomic factors. PayPal is already the most used payment app in the world, excluding China. With all these new initiatives, it doesn't need much more pure user growth to grow the top line and especially the bottom line.

1:09:05You've researched AutoZone a while back, and that's one of these uber share cannibals. And PayPal, in my opinion, has a chance to kind of do the same while growing even a bit faster with its current venture. So perhaps you could talk a bit about that. AutoZone is one of my favorite stories to talk about. Yeah, because you just never expect that it would be one of the best stocks to have owned over the last two decades. This is a company with a very boring auto parts sales business. After all, it is not a high flying software giant. Yet they've run this simple playbook centered around really disciplined, profitable growth and just aggressive, aggressive share repurchases, putting almost all their excess cash to work directly compounding earnings per share.

1:09:48not necessarily by growing earnings, which they have, but also by reducing the amount of shares outstanding in the denominator of that earnings per share calculation. And it took a couple years until I think the market really was able to react and understand what AutoZone was doing. But three to four years of five to 6 % buybacks really drove the stock to explode. And so something similar could definitely be going on with PayPal, where you have a solidly profitable business that spits off enough cash to buy back even more stock as a percentage of the total market cap actually than AutoZone does.

1:10:26And I think since Chris took over, the buyback yield has averaged like a ridiculous 8 % a year. And the idea that Ulta could have done something similar and can continue to do something similar is what drew me to that stock. But PayPal is doing buybacks on almost another level. They're way more aggressive with what they're doing, which just speeds up the earnings per share compounding. Yeah, that's one of the most fascinating things about the PayPal opportunity in general. And instead of focusing on user growth or even revenue growth in general, the main idea of modeling PayPal is to see where the margin goes, how much free cash flow they can actually generate, and then assess the impact of those share buybacks.

1:11:09The inputs I focused on were the segments that make up total payment volume. So branded checkout, unbranded one, aka Braintree, and then the P2P part of the business. And from there, the total payment volume, we get to the transaction margin dollars. That's the total revenue, less transaction expense and transaction credit losses. So it's similar like gross margin, basically. Then we get to the operating income and later on free cash flow. And in PayPal's case, you don't really need much growth at all. I assume a single digit percentage growth in all segments on the higher end for P2P, mid single digits for branded checkout and low single digits for the unbranded checkout.

1:11:51What happened to you in transaction margin would then only grow at a cake of about 4%. I want to assume a 40 % conversion from transaction margin to operating income, which is in line with the historical data since Chris took over, then operating income would go about 4 to 5 percent slightly more than free cash flow however now we get to the buybacks and that's where it gets really interesting currently paypal is buying back stock at a mind-boggling yield of about nine percent this will not be sustainable as it's already 100 percent off free cash flow and should the stock price rise in the years to come the yield has to decline naturally and I expect PayPal to keep a share count decline rate of about 4%, assuming buybacks at a price to free cash flow of 14 to 15.

1:12:39And this would result in about 60 % of free cash flow. And in my model, I also created a table, I think similar to what you did in your ultra model, in which you can use to test out different decline rates at a 5 % rate, for example, PayPal would need to spend about 80 % of free cash flow going forward. Still realistic if you ask me and also what Alex Chris is communicating. And if you would then just give it an exit multiple like we always do, and this time price to free cash flow multiple of 15 and an additional margin of safety of 10%, this leaves us with an estimated fair value of about$97.

1:13:17If you would use a 4 % decline rate, the fair value would be somewhere around$92. dollars the idea being here you're really trying to figure out how much they can continue to eat their own stock reduce the number of shares outstanding to grow earnings per share by shrinking the denominator and then you're basically just referencing okay how much as a percentage of free cash flow can they sustainably put toward buybacks and and i see in your model here that there's an estimated annual turn of about 15%. And as always, we emphasize that word estimated, since this is obviously based only on our models, which are highly sensitive to the inputs that we assume.

1:14:00And modeling is really just a great exercise in thinking through a possible range of outcomes and internalizing the numbers. But that does sound promising. I mean, 15 % is, we've sort of arbitrarily set a 12 % expected return, you know, 12 % a year over five years as our hurdle rate. So it does seem like you think PayPal can clear that, which would make it a good contender to add to the portfolio. I do, I do. And I think the attractiveness of a PayPal investment, in my opinion, comes from all the optionality that you have with the businesses or the ventures that we have discussed. They do not yet add tangible value, so they couldn't be included here, but this is what PayPal could be worth in a steady state, and everything above that is just optionality, if you will.

1:14:48And if any of these ventures should be a bigger hit, and I personally suspect that the ads business has a pretty good chance of doing so, this could reside in much more profitable growth, which could finally be followed by a revaluation of the stock. And such a twin engine of profitable growth and multiple expansion could give the stock a much larger boost than what I've in my model right now, with a couple of percentage points more growth, closer to a 6 % share decline rate and a multiple of 19, which to be fair is significantly above the multiple PayPal is currently trading at, the stock's fair value could be closer to double of today's price.

1:15:27Alex Chris is getting for low teens growth by 2027 and 20 % plus EPS growth beyond that. Not even in my bull case is that bullish and Alex Chris is currently a low baller in regards to guidance. So I don't think he would just put this out if he didn't have an idea of how to get there. But having said that, he doesn't know what will be in 2028. Neither do I, neither do you or any listener here. But what it does tell me is that the buybacks would probably remain a vital part of the strategy. And I just like to hear that. That plus seeing the high predictability of PayPal's business makes me quite bullish and also willing to wait until the market sees the same potential that I see.

1:16:13One of the things we haven't discussed is that payments are almost by definition tied to economic cyclicality. It's just a matter of fact that fewer transactions occur in recessions and more occur when the economy is booming. So they're closely tied to the fate of the overall economy, for better or worse. And the other thing is that whether it be with the float in Venmo accounts or in stable coins, if interest rates fall back towards 0%, perhaps in response to a recession, that would almost be like a double whammy for that. Not only do you have lower payment volumes, but also less interest income.

1:16:45So this is nothing like a recession-proof business. But also, we haven't found many truly recession-proof businesses either, though. So I don't say that to knock them too much, but just as kind of a consideration for us. Yeah, that's totally true. I think we have some businesses who might be more recession-proof just by the level of diversification they have, even if you look at Alphabet, which has certain businesses that are certainly not recession-proof, but they are so diversified it's not really a problem. But as you said, most businesses that we own are not recession-proof. And what I personally look for is a company that can survive a recession.

1:17:23And I think PayPal is such a business. And you're right about the interest income. I'm not in the business of predicting interest rates, but I do think they will more likely be lower than higher in the long term. And that's why I like that the transaction margin dollar, excluding interest on customer balances, also grew 7%. But of course, this does not mean that the business won't suffer from lower rates because it certainly will. maybe this makes me a poor investor but i come back to gut feeling a lot which i think is really just a sense of pattern recognition that can develop over time and for me i i can't intuitively grasp why their service is better than competitors or why the take rate on payments won't just decline to essentially zero percent over time as we saw with brokerage businesses right schwab got disrupted by Robinhood and commission trading in the US at least went from$10,$20 a trade to essentially free.

1:18:26And so with PayPal, I kind of worry about that. I get that there's some advantage in product stickiness, there's relationships with merchants. And then to some extent, there's a network effect, especially around Venmo. But still, I struggle to see an argument for why Venmo should stand out as a winner against Apple Pay or Cash App long-term or why Fastlane is superior to Link. I've never used Fastlane, but I've definitely used Link dozens of times. And the whole payment processing thing just seems very commoditized to me, which maybe I'm naive, but it just seems like the consumer ends up winning the most or will be the one who wins the most over time as competition competes away those margins for what is a service that lends itself to being commoditized.

1:19:14There's no way to differentiate yourself in payments at a very first principles level. So I don't know, maybe that's just me overthinking things with the point being, I don't feel like I have a great intuitive sense for what makes PayPal a long-term winner. And then that raises concerns about their terminal value of at some point down the road, does this business just get completely displaced by something like stable coins? and you're left with this melting ice cube. So I don't know that that's my intuitive sense, but it doesn't really matter if what I think, because if they can continue to retain market share of a growing oligopolistic pie, and then more importantly, if you just look at the numbers, they do speak for themselves.

1:19:59It's a great counter argument to everything I just said. And this thing is a beast, a absolute beast, continuously compounding earnings, growing the top line, expanding margins, and allocating an ever-growing amount of cash to repurchasing stock and reducing the number of shares I was sending. So that is hitting me over the head of like, hey, dummy, don't overthink this. This business exists for a reason, and it's going to continue to exist. And obviously, I trust your judgment a lot, Daniel. So if you like the setup, and I think the management incentives are good too, then that just helps me get comfortable with it and maybe what gets me most excited beyond this track record of profitability and the large user base and the potential to run the auto zone playbook with buybacks is the potential for maybe this won't surprise anybody the potential for their ads business i remember for a long time i couldn't understand how venmo made money and then one day i saw ads on the app and i was like duh it's about time they did that but but either way they're probably going to make a lot of money with that was was my feeling so i feel like the potential for advertising here which genuinely as i said earlier wasn't something i expected to be part of the thesis but it makes me a lot more excited about paypal than i otherwise would be you know first thing i have to say is i'm just as guilty as you are on trusting my gut feeling and i think the main differentiator is that everyone that I know uses PayPal and that I just see this strong network effect that it does create play out every single day.

1:21:34To give a quick example of how that could matter going forward if ChatGPT and I know that's still a bit out but if ChatGPT should choose a partner to integrate a purchase button the question is who would they choose and in the EU it almost has to be PayPal. If they choose Apple Pay they would likely lose a lot of potential customers and when they partner with paypal anyway why not integrate it into other markets for example in the us too even if there's another bigger player like vanmo which is part of part of paypal but also apple pay sure they might also include apple pay but my point is that in a fast growing market and with paypal's market share i personally just have a hard time seeing them not being involved in these kind of innovations so with everything that we have discussed i would personally be in favor of establishing a position in paper.

1:22:27Now, when we are not equally excited about an opportunity, I like to go with the middle ground. And I think you would be fine with the 5 % position from what I've heard and you told me before, but how about we settle for 3 % now? And then when we see some more weakness, or perhaps we've done a bit more research and feel more certain about take rates and terminal value, we up it to 5%. What's your take on that? I think that sounds good, but it's also a cop-out because I know for anyone who listens to the show, we end up recording this a bit before we send out the newsletter. So my cop-out is if you want to see the final decision on position weighting, you should see our Intrinsic Value newsletter.

1:23:10and you can sign up at theinvestorspodcast.com. And we send out a free newsletter every week where we show the entire portfolio and we talk a lot more in depth about position sizing, updates on how our other portfolio companies are doing. So I feel okay about adding PayPal. I think I, over the course of the episode, it started to click for me a bit. Maybe I'm just clinging to the hope that they can really do something with advertising. That's getting me excited. Like you said, I don't think I would lose sleep at a 5 % position. I think that seems very reasonable for the valuation, especially when I look at the buyback yield.

1:23:46But yeah, we'll probably talk about it more. We'll probably stop recording this episode and we'll probably talk about it more. And then, you know, we send the newsletter. We'll have a more thorough update. Is that kicking the can too much? And it sounds perfect. And I mean, it's kind of of a cop out, but when you have, and you and I, we both know that the best, we have a community where we can talk to so many people who know these businesses very well, who are invested in them for years. I just think it makes sense. And it's kind of an obligation of us to get all the insights that we can and then make an even more educated decision.

1:24:22So we'll talk about it after we're ending the call, perhaps with some of the members in our Intrinsic Value community. And then everybody will know our decision when the newsletter is coming out. All right. And with that, how about we end the episode and you give us your hints for the next episode. On to the next. Well, I think the next one will be fun. The first hint that I'll give is that unlike PayPal, Alphabet, Adobe, and Uber, where we talked about these potentially disruptive headwinds in the future that are kind of existential technological changes, my pick for next week is a company that should actually benefit from an expected disruption of the status quo.

1:25:06and maybe I'll also mention it's like a second hint that this will actually come partially from the disruption of a legacy business at one of our portfolio companies I just mentioned. And then lastly, with the exception of NewBank, I think this company has had the fastest sales growth rate over the last decade of maybe any company we've looked at. So to recap there, it's a fast grower with a potential long-term tailwind to its growth coming from disrupting one of our other portfolio companies. That is all I'll say for now. Well, that sounds like a nice change of pace, I would say. Today, I will leave you then with a quote from Peter Thiel.

1:25:45He said, quote, The big idea behind PayPal was to create a new currency. We failed at that, but we just created a new payment system. A successful way to fail, if you ask me, and PayPal is still the largest e-commerce payment system in the world, and for both of us, it better stay that way. So with that, have a great day and see you next Sunday.