EBAY & PYPL: The Divorce is Final

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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July 17, 2015

EBAY & PYPL: The Divorce is Final

After a strong 2Q15, PYPL heads to its Monday spin with significant business momentum. Given the near term trajectory of e-commerce, and competitive moat of its small business focus, 2015 estimates look easily achievable and 2016’s are plausible, likely a recipe for appreciation. Still, the share price implies long term growth that may be difficult to achieve, as the nature of on-line payments changes and structurally advantaged rivals erode PYPL’s early mover gains over time. Meanwhile, forward-going EBAY has the benefit of lowered expectations – near term consensus expectations are modest, particularly with likely relief from FX headwinds in 2016, and the -4.5% declining cash flow CAGR implied by the “when issued” share price is, we believe, unrealistically pessimistic. We also see potential for a post-spinoff acquisition of EBAY, with BABA and GOOG having clear potential synergies. While it has been rumored, we don’t see an obvious TMT buyer for PYPL.

This note is solely the perspective of the SSR TMT team and does not represent the views of our Finance analyst.

  • Strong 2Q15 PYPL #’s show business momentum. PYPL’s 17% ex-FX sales growth is the product of strong underlying e-commerce growth and international expansion, with a competitive moat provided by historically sticky small merchant customers. We see expectations for 15% growth in CY15 and 16% for CY16 as achievable. In this context, PYPL investors would likely see attractive near term returns.
  • Significant risks to PYPL implied long term growth. The PYPL “when issued” price implies a 10-yr FCF growth CAGR of more than 11%. This will be difficult to achieve beyond the next 2-3 years. The consumer shift to mobile platforms will greatly favor payments utilities being integrated into the iOS and Android platforms and offering convenience, cost and functional advantages vs. 3rd party solutions like PYPL for m-commerce, in-app AND in-browser transactions.
  • EBAY expectations modest. Subtracting PYPL suggests expectations for less than 5% sales growth in 2016. Given a more neutral FX environment, more focused management and a still strong e-commerce environment, we believe upside more likely than downside. The “when issued” price for EBAY implies 10-yr annual cash flow decline of more than 4%. We believe that this is far too pessimistic.
  • EBAY may be more likely to be acquired. EBAY’s marketplace business, with its modest valuation, could make an interesting target for companies, like BABA or GOOG, looking to expand their presence in consumer e-commerce. Meanwhile, we do not believe that PYPL fits with any of the TMT names – GOOG, FB, AMZN, AAPL, BABA, etc. – that have been rumored as possible buyers.
  • PYPL may move out of the blocks faster post spin. We expect growth investors to drive trading in both names Monday, potentially boosting PYPL relative to EBAY. This advantage may be temporary, as EBAY will have strong appeal to value investors. Between the two, we see the opportunity in EBAY as more compelling, particularly given the potential of M&A.

The Spin Cycle

Just over 13 years after acquiring it, EBay is spinning out PayPal on Monday. For years management had pushed aside questions on a PayPal spinout, claiming important business synergies between the two businesses, but this past fall the story abruptly changed to the vocal approval of saber rattling activists and industry pundits. Based on the market reaction to yesterday’s earnings announcement and the generally buoyant trading in the “when issued” PayPal tracking listing, it would seem that the time is right to make the break.

Most of the attention has been around PayPal, growing at a 14% nominal pace in the just reported 2Q15 and 17% adjusting for the strong dollar. The 8 brokers who have published models collectively expect PayPal to grow sales 15% the full year and 15.6% next year, with EPS up nearly 18% in 2016. Given the likelihood that currency impacts will ease, the growth trajectory of the e-commerce market, and PayPal’s strong position in higher growth international and small business segments, we believe that these estimates are achievable.

PayPal’s growth profile has investors excited. Based on the $37.63 “when issued” price and the narrow consensus of $1.35 for forward earnings, PayPal trades at a more than 28x multiple, just under the multiples for ostensible rivals Visa and MasterCard, both projected to deliver somewhat less sales growth than PayPal over the next year. In this context, the near term environment looks favorable for PayPal investors.

Exh 1: Global Payment Volumes, PayPal versus V/MA/AXP 2011-2014

Of course, there is a big BUT. While PayPal rightly claims leadership in online payments, its $235B in 2014 transaction volume is a tiny portion of the more than 10T in total credit transactions reported by the top three credit card nets (Exhibit 1). PayPal also claims leadership in the nascent market of mobile payments, but more than 80% of its transaction volume still originates from desktop computers. PayPal touts the growth of its own credit platform and encourages low cost ACH funding, but the large majority of its payment funding remains high cost credit cards, which leaves it vulnerable to lower cost payment options. As consumer online activity rapidly shifts to mobile platforms, PayPal is facing significant initiatives from deep pocketed, technologically sophisticated competitors with considerable reach to both consumers and retail merchants and clear operating and cost advantages.

Two of these are ApplePay and AndroidPay, integrated deeply into the iOS and Android operating platforms. We have written about the advantages of these OS based payments solutions (see
http://www.ssrllc.com/wp-content/uploads//ftr/15.06.19-Mobile-Payments-TMT-Perspective.pdf
and
http://www.ssrllc.com/2014/09/september-15-2014-apple-pay-friend-and-potential-foe-to-the-payments-industry-status-quo/
). While PayPal’s small business skew may prove a speed bump as these solutions slowly come up to speed, the cost and functionality advantages of these native default payment utilities will be very difficult for PayPal to counter. We believe that Visa and MasterCard are likely to set “device present” rates for transactions made by mobile platform users via m-commerce in-store, in-app, and in-browser. These rates are not expected to be available to 3rd parties. Moreover, with the requirement that consumers establish a payments account with Apple or Google when they buy their new smartphone and the integration of the payment methodology as a default for transactions on the platform, the extra steps necessary to establish PayPal as a preferred payment mechanism, if it is even allowed, will be a substantial obstacle.

A very recent post by influential payments blogger Tom Noyes suggests another major threat. Visa is using its Visa Preferred Partner (VPP) program to offer significantly lower fees to select merchants that agree to promote its Visa Checkout on-line and mobile payment solution. According to Noyes, Visa works with acquirers to guarantee blended rates across cards of 30-40 bps. Combining this with tokenization, a new rate tier (cardholder present) and fraud liability held by issuing banks, he believes that Visa could engineer total e-commerce fees for merchants as low as 160 bps. In comparison, PayPal’s base e-commerce fees for credit transactions are 375 bps without a shift of liability to the banks. If Noyes is correct, Visa could be a MAJOR threat to PayPal’s bread and butter business.

In this context, with substantial risk of both share loss and price compression, we are concerned that longer term expectations for continued double digit revenue growth by PayPal will be very difficult to achieve. We expect adoption of ApplePay and AndroidPay to expand steadily, not only taking the lead for in-store mobile transactions, but also absorbing market share and driving transaction fees lower for in-app and in-browser purchases as well. We expect Visa, MasterCard and American Express to compete vigorously for e-commerce transactions as well, creating further pressure on the main part of PayPal’s business. We are also bullish on private label cards issued by merchants, but only insofar as they coordinate with Apple and Google’s payment platforms to reach consumers, and facilitate adoption and use.

We are also pessimistic as to the likelihood of an acquisition, at least by a TMT acquirer. The big names that have bandied about as potential buyers – Google, Apple, Alibaba, Amazon, and Facebook – either have their own competing payments initiatives with reasons to believe that they will be successful, or would see buying an expensive 3rd party payments platform as an unnecessary step.

Exh 2: eBay/PayPal Revenue by Segment Q1 2012 – Q2 2015

Boring Old EBay

The EBay Marketplace business has had muted results thus far in 2015, with total sales growth off from an average of 9% over the past 3 years to 5% ex-FX in 1Q15 and 6% ex-FX in 2Q (Exhibit 2). Of course, there have been some extraneous circumstances. Google hit EBay with a penalty last year for overly aggressive search engine optimization techniques, muting traffic from the search leader. About the same time, EBay suffered a security breach which forced it to require all of its users to reset their passwords. This also had a negative effect on top line momentum. Finally, the management attention devoted to executing Monday’s PayPal spin could have also contributed to a slow recovery from those 2014 hits.

Management has set cautious guidance for 2015 and 2016, setting a range of 0-5% for FX-neutral sales growth and projecting EPS growth faster than sales growth. Backing out the PayPal consensus projections from the EBay estimates suggests that analysts are following instructions, forecasting 4.6% revenue growth for 2016. We are comfortable with this. The total e-commerce market should grow at roughly twice that rate, giving EBay the opportunity to regain its focus and surprise to the upside.

Exh 3: Implied 10 Year Free Cash Flow Growth, EBAY / PYPL

More surprisingly, the implied stand-alone share price of $26.96 suggests a sharp negative trajectory with more than 4% annual declines in free cash flow over the next ten years in an e-commerce market that is almost certain to grow at a healthy pace (Exhibit 3). Essentially, the market is betting that EBay will fail, and fail big.

This is too pessimistic. We believe that many traditional retailers will struggle badly with the transition to “omni-channel” commerce bridging online, mobile app and in store shopping. As the complexity proves greater than their initial optimistic assessments, we believe EBay could prove an important partner for many as they get more realistic about coping with the sea change paradigm shift that is coming for retail merchants. We also believe that a bargain priced EBay could be an attractive M&A target, with Google and Alibaba, both with designs on expanding their own US e-commerce positions, likely interested.

Flashy PayPal may move off of the blocks faster after Monday’s spin. It will deliver the growth that TMT investors crave and is likely to beat numbers for a few quarters. Still, for the longer investment horizon, we’d rather own Ebay.

Exh 4: PayPal Payments Transaction Volume, 2005-2014

Exh 5: Ebay/PayPal Payments Metrics, 1Q 2014 – 1Q 2015

Exh 6: PayPal Key Metrics

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